Thinking about a gearing strategy for your SMSF? When planning a borrowing in your SMSF to buy an asset such as property or shares (known as a “limited recourse borrowing arrangement” or LRBA), you can choose to borrow from a commercial lender or a private party. This could even be a related party of the SMSF, such as the SMSF members or the members’ family trust.
Bypassing the banks might seem like a great way to draw on wealth you hold outside the SMSF to build your retirement savings. But be aware that if related-party LRBAs don’t reflect “arm’s length” or commercial terms there may be big tax headaches for the trustees.
The “non-arm’s length income” (NALI) rules essentially penalise uncommercial dealings by an SMSF that favour the fund. This tax penalty applies where the SMSF enters into an arrangement where it does not deal with the other party at “arm’s length”; and earns more income than it might have been expected to earn under an arm’s length arrangement. As a result, the income from the arrangement is taxed at a hefty penalty rate of 45%.
So how does this risk arise for LRBAs? In an audit situation, the ATO would examine terms like the interest rate, the loan-to-value ratio (LVR) and the term of the loan, and compare these to the terms that would hypothetically exist under an arm’s length (or commercial) arrangement.
If the terms of your related-party LRBA aren’t what the ATO considers “arm’s length”, you’re exposing your SMSF to a NALI risk and a potentially complex dispute with the ATO about exactly how much penalty tax you owe.
Fortunately, the ATO has developed guidelines and if your LRBA meets these, the ATO considers that the arrangement is on arm’s length terms. For property LRBAs (residential and commercial), the terms must be as follows:
Interest rate: benchmarked to a certain RBA indicator rate, which is 5.94% for 2019–2020. The rate can be either variable or fixed for up to five years.
LVR: maximum of 70%.
Term: maximum of 15 years.
Repayments: principal and interest, payable monthly.
Security: registered mortgage over the property.
If your arrangement doesn’t meet these guidelines you would need to demonstrate, using documented evidence, that it reflects an arm’s length dealing.
If you’re interested in using an LRBA to help grow your super, contact us for expert advice. We can help you consider your lending options and ensure your LRBA is structured for compliance certainty.