Note the following is only posted here to give readers the history and because of the reference in Newsflash 286. Interest free loans to your SMSF are definitely not being accepted by the ATO though nothing has been resolved through the courts. Taxpayers must have their loans on an arm’s length basis for the 2016 and following financial years.
Here is the private ruling claiming that interest free loans to your SMSF will result in the income earned on the asset purchased to be taxed at the maximum tax rate as non arms length income https://www.ato.gov.au/rba/content/?ffi=/misc/rba/content/1012582301006.htm
This is extremely alarming for people who have lent their SMSF money at zero or lower interest rates but it should be remembered that it is only a private ruling so has not gone through the same rigorous reviews public rulings do and certainly the conclusion should not be made that you cannot lend your SMSF money at below market rates as ID 2010/162, a public ruling says you can, unfortunately it does not specifically refer to zero interest rates.
Basically my opinion is this ruling is only about a very unique set of circumstances where the SMSF receives income from the custodial trust.
Now for those with an interest in this issue here is a more detailed explanation of my opinion.
It is point two that is the problem, they are saying the income earned from the investment of the money is not arms length income because the net result is higher.
From the Private ruling
Amount of income greater than might be expected if dealing at arm’s length
The final requirement of subsection 295-550(5) of the ITAA 1997, which is set out in paragraph 295-550(5)(b), is that the amount of the income (derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust) is more than the amount that the entity might have been expected to derive if the parties had been dealing with each other at arm’s length.
If the parties in this case were dealing with each other at arm’s length, the amount of income the Fund might be expected to derive through the Custody Trust is either:
– nil – on the basis that no lending on the proposed terms by the Family Trust might be expected and therefore no income might be expected to be derived by the Fund through the Custody Trust; or
– is less than under the proposed arrangement – on the basis that the Family Trust might be expected to lend on commercial terms that involve lower than 100% loan to value ratios given the nature of the assets to be acquired with the borrowed money and the limited recourse nature of the loans. Therefore, the substantially lower borrowed amounts available to be invested might be expected to generate less income to be derived by the Fund through the Custody Trust than under the proposed arrangement.
Either way, the final requirement of subsection 295-550(5) of the ITAA 1997 is satisfied.
Me again:
I have several problems with this statement, it shows that either the workings of the loan arrangement in this ruling are very different from the nor or a lack of understanding of what the custody trust is. It is a bare trust the income is earned by the SMSF so they are looking at the wrong section. Now they may be saying that this section should apply to the unit trust that is also referred to in the private ruling, here is the relevant paragraph from the ruling
All of the units to be issued by a unit trust which is to be established as part of this arrangement will be acquired with another amount of the borrowed money. The unit trust will invest the money paid to acquire the units in cash and interest bearing securities. All the units in the unit trust will be held by the Fund.
Me again
Here is the relevant section number the private ruling quotes http://law.ato.gov.au/atolaw/print.htm?DocID=PAC%2F19970038%2F295-550&PiT=99991231235958&Life=10010101000001-99991231235959 you can see at all times it refers to income, nothing about deductions being less. I believe subsection 5 was put in there to prevent people giving their SMSF units in a trust then streaming income into it which could then go into the SMSF. Fair enough still all about income. It is a very twisted interpretation in the private ruling to try and say that the income received from the trust is artificially higher because the trust is not paying interest on the money it used to buy the units. On the other hand the argument that more income is earned because more money is borrowed because the LVR is 100% has a point so I would steer clear of 100% lends.
Now this to me shows that maybe the person at the ATO who responded to this private ruling application thought that the funds were lent to the unit trust so it was the unit trust’s net income which was greater which of course would be income to the SMSF But this would not be the case as SMSFs are not allowed to invest in closely held geared unit trusts. Further that is not how it is described in the private ruling application. The idea is the SMSF borrows the money and buys the units in the trust so the income from the trust is the same it always will be it is just the lack of deduction for the interest in the SMSF.
Let’s go back to the real question of whether the income of the SMSF has been more than it would have been if it was dealing at arms-length. I have always considered this was intended to stop people paying huge rents on their business premises to their SMSF to get money into super and it is all about gross income.
Even if it does catch out this unit trust situation it is an unusual application to put the trust in there and a lot of SMSF borrowing is for direct property. If instead the SMSF purchased the shares or property, even though they would have to be held in the name of the bare trust, the income would go directly to the SMSF then the section quoted has no application at all. It is only the use of a unit trust to purchase the investments (understandably to avoid having to have a separate bare trust for each share purchase) that even gave the ATO some argument in this private ruling so normally again the interest free borrowing would be ok as per ruling quoted below.
Here are the minutes of the NTLG discussion on this topic https://www.ato.gov.au/Tax-professionals/Consultation–Tax-practitioners/In-detail/Technical-and-special-purpose-working-groups/Super-Technical-Sub-Group/Minutes/Super-Technical-minutes,-June-2012/?page=13
Private rulings and NTLG discussion minutes are not binding on the ATO. Here is an ID on the matter that has more weight than either of the above.
http://law.ato.gov.au/atolaw/view.htm?docid=AID/AID2010162/00001
Basically it says that you can lend to your SMSF at lower than market rates, just not higher, it does not discuss zero. The point I make here is based on the private ruling then a lower rate of interest would also be against the rules. Obviously it is not according to ID 2010/162 which is a considered ruling by the ATO that has to go through a much more rigid process than a private ruling. It is my opinion that the section referred to only refers to the gross income of the SMSF not net income and the gross income earned by the investment is arm’s length income it is just the net profit that is greater because interest is not charged. No stretch of the word income could mean income less deductions. The only way that could happen is if it was the income and deductions from another entity and that entity’s net income became the income of the SMSF and that is not what normal SMSF borrowings are about. The lending is to the SMSF not another entity.
Nevertheless if you are going to do this you had better apply for your own private ruling.
There are two other private rulings that say zero interest is ok. To quote 1012414213139
“In this case, the Fund will derive a greater level of taxable income because the rate of interest payable by the fund is reduced to 0%. That is, the level of taxable income derived by the Fund will be inflated as a result of a lower level of deduction amounts than would normally be incurred if the parties were dealing at arm’s length. However, subsection 295-550(1) of the ITAA 1997 does not apply in these circumstances as this subsection applies strictly to amounts of ordinary or statutory income, not taxable income.”
You can view these rulings on
https://www.ato.gov.au/rba/content/?ffi=%2fmisc%2frba%2fcontent%2f1012414213139.htm
https://www.ato.gov.au/rba/content/?ffi=%2fmisc%2frba%2fcontent%2f1012396819768.htm
SMSF Related Party Borrowing:
More Analysis
Summary:
Before reading the following analysis of rulings it is important to understand the sections of the ITAA 1997 that we are dealing with.
Section 295-545 is intended to tax non arms-length income received by a SMSF at 45%. The obvious intention is to stop people increasing the profits of their SMSF by redirecting profits from outside of super into the fund. This section defines the taxable income to which the 45% rate will apply as follows:
295-545(2)
The non-arm’s length component for an income year is the entity’s *non-arm’s length income
for that year less any deductions to the extent that they are attributable to that income.
It is important to remember the above definition is of taxable income and should never be confused with gross income (ie income before deductions)
Section 295-550(1) then goes on to define non-arm’s length income as follows:
SECTION 295-550 Meaning of non-arm’s length income
An amount of *ordinary income or *statutory income is non-arm’s length income of a *complying superannuation fund, a *complying approved deposit fund or a *pooled superannuation trust (other than an amount to which subsection (2) applies or an amount *derived by the entity in the capacity of beneficiary of a trust) if:
(a) it is derived from a *scheme the parties to which were not dealing with each other at *arm’s length in relation to the scheme; and
(b) that amount is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length in relation to the scheme
So the test has two limbs. The first is where there is an arrangement where the parties are not dealing with each other at arm’s length. Certainly interest free loans, poorly defined terms and 100% LVRs would be considered not to be arm’s length. But note there is an “and” after clause (a) which means that both (a) and (b) have to be met to be caught under this section.
Now at the start of this section 295-550 the word “amount” is defined as ordinary income or statutory income. It is not the net income after tax deductions. So if the income is received direct by the SMSF it is the source of that income that is measured. As this is likely to be rent from a third party tenant or a dividend from a listed company then (a) cannot apply.
Accordingly, a favourable loan from a member to a SMSF cannot be caught under this section because it is all about reducing net income or the fact that the SMSF may not have been able to borrow at all so would not have received the income. But the bottom line is that the income is received from a third party so forget about (b) we don’t even get past (a).
This view is also supported by PBR 1012414213139 and various statements made by the ATO that are listed below.
A misunderstanding has arisen due to the ATO issuing PBR 1012582301006 which states that a favourable loan from a member of a SMSF is caught by section 295-550, in the circumstances of that ruling. Commentators seem to be ignoring that this ruling considers the application of section 295-550(4) and 295-550(5) which are all about income received by a SMSF from a trust.
295-550(4)
Income *derived by the entity as a beneficiary of a trust, other than because of holding a fixed entitlement to the income, is non-arm’s length income of the entity.
295-550(5)
Other income *derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is non-arm’s length income of the entity if:
(a) the entity acquired the entitlement under a *scheme, or the income was derived under a scheme, the parties to which were not dealing with each other at *arm’s length; and
(b) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length.
Now if the income receive by the SMSF is from a trust that receives the rent and has benefited from a favourable loan then then yes the income is not from a third party so (a) applies and yes the gross income of the SMSF being the amount it receives from a related trust is artificially high because that trust did not have to pay interest so it should be caught. But this is not the normal circumstances. The loan agreement is normally between the lender and the SMSF.
The difference in this case is driven home in the ruling in this quote:
Fixed entitlement to trust income
Clauses 5, 6 and 8 of the sample Declaration of Custody Trust together clearly demonstrate that the Fund holds a fixed entitlement to the income of the Custody Trust for the purposes of subsection 295-550(5) of the ITAA 1997. Further, the applicant’s advisers agree with that conclusion. If that conclusion were wrong, any income derived by the Fund as beneficiary of the Custody Trust would be non-arm’s length income of the Fund pursuant to subsection 295-550(4).
The problem with the ruling application is that they are taking the line that the income from the investment is the income of the custodial trust and the custodial trust is the borrower. This would not normally be the case because the custodial trust should be a bare trust in favour of the SMSF this means that the income from the investment goes direct to the SMSF income tax return and the SMSF pays the interest on the loan, there is no detour via the bare (custodial) trust tax return, in a normal arrangement the bare trust would not be required to lodge a tax return, reference PS LA 2000/2.
The offending ruling:
PBR 1012582301006
Is very similar to 1012396819768 (see below) except this time it decides section does catch the arrangement, best explained with a quote from the ruling, note the words as a beneficiary of a trust;
Amount of income greater than might be expected if dealing at arm’s length
The final requirement of subsection 295-550(5) of the ITAA 1997, which is set out in paragraph 295-550(5)(b), is that the amount of the income (derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust) is more than the amount that the entity might have been expected to derive if the parties had been dealing with each other at arm’s length.
If the parties in this case were dealing with each other at arm’s length, the amount of income the Fund might be expected to derive through the Custody Trust is either:
– nil – on the basis that no lending on the proposed terms by the Family Trust might be expected and therefore no income might be expected to be derived by the Fund through the Custody Trust; or
– is less than under the proposed arrangement – on the basis that the Family Trust might be expected to lend on commercial terms that involve lower than 100% loan to value ratios given the nature of the assets to be acquired with the borrowed money and the limited recourse nature of the loans. Therefore, the substantially lower borrowed amounts available to be invested might be expected to generate less income to be derived by the Fund through the Custody Trust than under the proposed arrangement.
Either way, the final requirement of subsection 295-550(5) of the ITAA 1997 is satisfied.
It has already been agreed that the loan agreement is non arms-length in nature because of both the LVR, term and zero interest rate. But to get past the first point there must be non arm’s length income. None of the rulings quoted here doubt that the loan agreement is on terms better than arm’s length. Where this ruling takes a particularly ugly turn is that it considers the bare trust to be the entity to receive the income from the investment and incur the interest then distribute the net amount to the SMSF. If this is the case then yes the income of the SMSF has been increased by the lack of interest charged on the loan.
What I think we need to consider here is the very unusual circumstance where the deed for the bare (custodial) trust had a clause stating that the SMSF holds a fixed entitlement to the income of the custody trust for the purposes of subsection 295-550(5). In short all parties agreed that the SMSF received income as a beneficiary of the bare trust rather than in its own right. The ATO then takes this one step further and says that if there had been an interest charge then it would have been a deduction to the bare trust so the SMSF’s income for the purposes of section 295-550 is the difference between the gross income and the interest. If this was the case than I fully agree that it is caught by section 295-550(5) because, due to the arrangement that is not on arm length terms namely the lending agreement the SMSF’s income is artificially higher either because the interest rate is lower or because more money could be borrowed on account of the 100% LVR. This is where the main difference is with the other rulings below. This statement that puts the income and expense through the bare trust which is just not the way it is normally done. Normally the loan contract would show the SMSF as the borrower.
If this was to apply to all circumstances then even slightly more favourable terms would be caught and ATO ID 2010/162 would be a cruel joke designed to trap taxpayers by not telling the full story.
The problem seems to be unique to these particular circumstances and rests in the poor wording of the bare trust deed that attempts to consider the SMSF’s income to belong first to the custodial trust and the interest to be an expense of the custodial trust. Another quote from the ruling:
Fixed entitlement to trust income
Clauses 5, 6 and 8 of the sample Declaration of Custody Trust together clearly demonstrate that the Fund holds a fixed entitlement to the income of the Custody Trust for the purposes of subsection 295-550(5) of the ITAA 1997. Further, the applicant’s advisers agree with that conclusion. If that conclusion were wrong, any income derived by the Fund as beneficiary of the Custody Trust would be non-arm’s length income of the Fund pursuant to subsection 295-550(4).
Note the reference to section 295-550(4) basically catches trust income when there is no fixed entitlement. The only way out is for the rent or dividend not to be the income of the custodial trust in the first place. This is the root of the problem the arrangement treats the assets income as income of the custodial trust instead of the SMSF and the interest expense as a deduction to the custodial trust, as a result it is the net income of the custodial trust that is considered the gross income of the SMSF therefore the notional interest benefit is received by the custodial trust. It is normally the SMSF that borrows the money to buy the asset and it is the SMSF that pays the interest so the arrangement is different to the normal SMSF borrowings arrangement and the problem seems to be with the lending arrangement and the wording of the bare (custodial) trust deed.
Now if the rent or dividend income bypasses the custodial trust completely then all transactions would become part of the SMSF accounts and the income for the purposes of section 295-550 would be the rent or dividend received from the investment which is completely arm’s length so the first limb of section 295-550(1) or (5) cannot apply. This interpretation fits well because it does not contradict PBR 1012414213139
https://www.ato.gov.au/rba/content/?ffi=/misc/rba/content/1012582301006.htm
Other negative rulings:
These private rulings are yet to be posted on the ATO web site but are apparently also negative.
PBR 1012585947911
PBR 1012595001544
Positive Private Ruling Referring to Non Arm’s Length Issue:
PBR 1012414213139
This ruling specifically address whether a zero interest loan would be caught by section 295-550, it says it will not be. It included 100% LVR where the loan term was described as more than 10 years. An interest rate above the cash rate was set but then reduced to zero. It is absolutely crystal clear in this extract from the ruling:
Subsection 295-550(1) of the ITAA 1997 applies only to amounts of ordinary income (section 6-5 of the ITAA 1997) or statutory income (section 6-10 of the ITAA 1997). It does not capture taxable income (section 4-15 of the ITAA 1997), that is, the subsection does not require the consideration of the overall economic benefit obtained from the scheme.
Therefore, for subsection 295-550(1) of the ITAA 1997 to apply, the scheme must inflate the level of ordinary or statutory income derived as a result of the non-arm’s length dealings. Whether or not the level of taxable income derived by the entity is inflated as a result of a lower level of deduction amounts than would normally be incurred had the parties been dealing at arms length is not to be taken into account in applying subsection 295-550(1) of the ITAA 1997.
In this case, the Fund will derive a greater level of taxable income because the rate of interest payable by the fund is reduced to 0%. That is, the level of taxable income derived by the Fund will be inflated as a result of a lower level of deduction amounts than would normally be incurred if the parties were dealing at arm’s length. However, subsection 295-550(1) of the ITAA 1997 does not apply in these circumstances as this subsection applies strictly to amounts of ordinary or statutory income, not taxable income.
Note the question asked in the ruling application was whether the arrangement breached any of the non-arm’s length rules not specifically section 295-550(1) so it was open for the ATO to use section 295-550(4) or (5) to give a negative response.
https://www.ato.gov.au/rba/content/?ffi=%2fmisc%2frba%2fcontent%2f1012414213139.htm
ATO Public Ruling Also Positive:
ATOID 2010/162
This ruling is the only statement from the ATO on this page that the public is entitled to rely upon. It only addresses the question of lower interest rates not terms and LVR and it does not discuss section 295-550.
A quote from the ruling:
The terms cannot be more favourable to the related party than would have been the case had the parties been dealing at arm’s length, but there is no contravention of section 109 of the SISA if the terms are more favourable to the SMSF.
Now this ruling only addresses section 109 but it would be silly to suggest that the ATO says yes its ok while sniggering under its breath thinking lets suck them in and then wack them with another section that they hadn’t thought of. If it was going to be caught under another section then they should have mentioned it here.
http://law.ato.gov.au/atolaw/view.htm?docid=AID/AID2010162/00001
ATO Publicly Available Statements on the Issue:
ATO Super Technical Minutes
While the ATO answer only refers to section 109 the question clearly asks can a member lend to their SMSF interest free? To which the answer is clearly yes. So it can be assumed that the ATO has considered all relevant sections; A quote from the ruling:
Can an SMSF enter into a borrowing arrangement under s67A of the Superannuation Industry (Supervision) Act 1993 (SISA) with a related party if a zero rate of interest is charged by the related party lender and only principal repayments, with no imputed interest, are made throughout the loan term in accordance with the loan agreement?
Yes. A lower than market interest rate or the absence of a requirement to pay interest on money loaned to the trustee by a related party will not prevent the arrangement from being a borrowing for the purposes of section 67A of the SISA. The ATO recognises that while the obligation to pay interest may evidence the existence of a borrowing of money, it is not a necessary feature of such a borrowing (see paragraph 48 of SMSFR 2009/2).
If such a borrowing is entered into between an SMSF trustee and a lender that is a related party of the fund, a fact that the borrowing is interest free does not cause a contravention of paragraph 109(1)(b) of the SISA as that fact does not make the terms and conditions of the borrowing more favourable to the related party lender than would be reasonably expected if the parties were dealing with each other at arm’s length in the same circumstances.
https://www.ato.gov.au/Tax-professionals/Consultation–Tax-practitioners/In-detail/Technical-and-special-purpose-working-groups/Super-Technical-Sub-Group/Minutes/Super-Technical-minutes,-June-2012/?page=13
National Tax Liaison Group meeting December 2012
Is best summed up by the following quote from the minutes
• The ATO position on low rate loan arrangements and LRBA is that that they do not generally invoke a contravention of the SISA, do not give rise to non-arm’s length income under section 295-550 of the Income Tax Assessment Act 1997 (ITAA), do not invoke Part IVA of the ITAA 1936 and are not considered to give rise to contributions to the SMSF just from that one fact alone.
The minutes also address zero interest rates and the proceed to include them in the definition of low rate.