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After the relief
The COVID-19 pandemic saw short-term financial relief measures introduced to make the repayment of limited recourse borrowing arrangements a little easier. Mary Simmons, technical manager with the SMSF Association, examines the courses of action SMSF trustees must consider now these provisions are coming to an end.
Gearing has always been a popular wealth accumulation strategy, so it is hardly surprising limited recourse borrowing arrangements (LRBA) have been attractive to SMSFs as a way to invest in concessionally taxed superannuation.
The raw numbers tell the story. Since their introduction in 2007, LRBA growth has been steady, with ATO annual statistics confirming that in 2018, 10.2 per cent of SMSFs reported an LRBA, up slightly from the 9.5 per cent reported the year before. These LRBAs accounted for 92 per cent of the total value of borrowings reported by SMSFs in 2018, also an increase from the previous year of 89 per cent. In terms of their dollar value, LRBAs stood at $50.2 billion at 30 June 2020, up 11.1 per cent from $45.2 billion at 30 June 2019. At $50.2 billion, they comprised 7.1 per cent of net SMSF assets.
This growth has always attracted criticism. Those opposed to SMSFs having access to this debt instrument primarily argue they pose too much risk, not just to the individual SMSF but the superannuation system. The Cooper review (2010) into superannuation noted those objections, but did not suggest stopping SMSFs from borrowing, although it did suggest a future review. The Financial System Inquiry went a step further and made their abolition one of its recommendations, one of the few the federal government chose to ignore.
But the government, like the Cooper review, hedged its bets, commissioning the Council of Financial Regulators and the ATO to monitor any risk. Their findings, released in February 2019, confirmed that assets held by SMSFs under LRBAs were unlikely to pose a systemic risk to the financial system. Monitoring was set to continue with another report due in 2022.
Much of the criticism of LRBAs is based on a lack of understanding as to how they work. And there is a level of complexity with LRBAs and SMSFs are well advised to seek specialist advice before entering into such a loan agreement. What’s more, this level of complexity has gathered an extra layer thanks to COVID-19, especially as it relates to maintaining an existing LRBA.
The ATO’s LRBA loan relief was only ever designed to offer SMSF trustees short-term cash-flow assistance where a fund was able to show that it was financially impacted by COVID-19 and the relief provided was consistent with what commercial banks were offering.
Some SMSFs with either residential or commercial property were able to rely on the Australian Banking Association’s (ABA) relief package as a guide to an arm’s-length arrangement to benefit from a temporary deferral of loan repayments for up to six months. For SMSFs that were subsequently able to demonstrate they genuinely needed an extension, they may have been eligible for an extension to March 2021. This extension was not automatic, and documentation needed to be in place to support that a review of the SMSF’s capacity to start repaying the loan was undertaken.
With many loan deferral periods already ended and the remainder set to end in March 2021, now is the time to review LRBAs to ensure the loans are maintained in accordance with the law. Below is a snapshot of some of the issues trustees need to understand, depending on whether they opt to retain the loan, restructure the loan or discharge the debt at the end of any deferral period.
Restart LRBA repayments
For SMSFs that can no longer rely on the ATO’s administrative concession to ensure the non-arm’s-length income (NALI) provisions will not apply, they will need to ensure they are back to full repayments and all repayments are at arm’s length.
Repayments should reflect that interest over the deferral period was accrued and capitalised. There needs to be evidence to indicate any loan contract variations that required interest to be capitalised and repayments to be made over an extended loan term are in line with the ATO’s relief.
This is to ensure the variations do not amount to a rescission or replacement of the original contract, or no fundamental changes were made to the character of the loan such that a new borrowing arises. Where an SMSF is relying on the ATO’s safe harbour provisions, it is important to note the maximum loan terms acceptable to the tax commissioner to ensure that protection against NALI is not put at risk.
From 1 July 2018, NALI of an SMSF now also comprises the original NALI, that is, inflated income derived directly as a result of a non-arm’s-length scheme, and the new non-arm’s-length expenditure or NALE provisions. This means trustees need to be even more careful now to ensure income derived on or after 1 July 2018 is not considered NALI.
A simple example could be where an SMSF continues to capitalise interest accruing on a related-party LRBA for a longer period than was permitted under the ATO’s COVID-19 loan repayment relief.
Safe harbour
Although the ATO did not alter Practical Compliance Guideline PCG 2016/5 to reflect any loan relief, the protection offered by the safe harbour is not lost, provided any changes to an existing LRBA arrangement are in accordance with the regulator’s COVID-19 relief requirements. SMSFs relying on the safe harbour can continue to do so provided any temporary loan repayment relief matches what commercial banks were offering or the ABA’s requirements.
Where relying on the ATO’s safe harbour provisions, it is important to note the capitalised interest during any loan repayment deferral period reflects the correct interest rate.
The rate used by the ATO is the Reserve Bank of Australia Indicator Lending Rate for banks providing standard variable housing loans for investors, based on the published rate in May each year. For the year ending 30 June 2020, the relevant interest rate was 5.94 per cent a year, whereas from 1 July 2020 the interest will accrue at the reduced 2021 yearly rate of 5.10 per cent.
Source of funds
There is no limitation under the law who the lender is, provided the LRBA is on commercial terms. However, where the lender is a related-party company, or even a trust in certain circumstances, the complexity of any COVID-19 loan relief is compounded by the need to comply with requirements set out in Division 7A of the Income Tax Assessment Act (ITAA). Unless the loan meets strict criteria, which includes the need for the SMSF to make a minimum annual repayment, it is at risk of being deemed an unfranked dividend.
Traditionally, an LRBA with a potential Division 7A issue needs to meet both Division 7A criteria and the ATO’s PCG 2016/5 to ensure the loan is not deemed a dividend under Division 7A and is on arm’s-length terms as required under the Superannuation Industry (Supervision) Act and the ITAA. When compared to the requirements under Division 7A, the PCG currently allows for a higher interest rate, allows a shorter maximum term, sets a lower maximum loan-to-value ratio, and requires a mortgage to be registered. Therefore, given the ATO’s safe harbour guidelines are more restrictive, best practice has been for trustees to follow the safe harbour guidelines to ensure the loan satisfies both criteria.
Where COVID-19 affected an SMSF’s ability to make the minimum annual repayment required for Division 7A purposes by 30 June 2020, the ATO has allowed SMSFs to seek an extension of the repayment period. Should the ATO approve the extension, an SMSF will have until 30 June 2021 to pay any 2019/20 shortfall plus the minimum annual repayment required for 2020/21.
What is important to note is the ATO has recently confirmed its online content will be updated to clarify the Division 7A relief in relation to COVID-19 allows any unpaid interest on the loan for 2019/20 to be capitalised.
Restructure or vary an LRBA
With the current low interest rate environment, some SMSF trustees may be considering their refinancing options as it could mean significant savings in monthly repayments.
Should an SMSF trustee opt to refinance an existing LRBA where there is a related-party lender, it is essential the new borrowing is secured by the same asset or assets as the old borrowing and that the refinanced amount is the same or less than the existing LRBA. If these criteria are not met, the refinancing with a related party will be considered a newly established LRBA. As a result, all members of the SMSF whose interests are supported by the asset purchased with the related-party LRBA will have to include their portion of the outstanding balance of the LRBA in their total super balance calculation.
Where SMSFs are refinancing and wish to be afforded the protection of the ATO’s safe harbour, it is important to ensure the maximum term of the loan acceptable to the commissioner is not exceeded. The maximum loan term permitted is either 15 years for real property or seven years for listed shares/units and takes into account the duration of any previous loan(s) relating to the asset.
For SMSF trustees considering refinancing an existing arm’s-length loan with a related-party loan, the conservative approach is not to rely solely on complying with PCG 2016/5 as a ‘get out of NALI free’ pass. Reference to Tax Determination 2016/16 suggests there is an additional requirement for an SMSF trustee to prove they or it could or would have entered into the LRBA with an arm’s-length lender to ensure NALI does not apply.
Finally, where an SMSF trustee is considering refinancing, it is important to review the loan agreement to determine whether a penalty interest provision is included. Although this is not a feature of a related-party loan agreement prescribed by PCG 2016/5, it is possible one exists and could be triggered if the SMSF repays a loan early or refinances.
Discharge the debt and/or sell the asset
Despite any LRBA loan relief available to SMSFs, there is still the possibility some trustees may be forced to sell the underlying asset due to the loss of rental income and/ or fall in market value.
Where the asset is sold, the sale proceeds should be used to discharge the loan with any remainder paid to the SMSF. All borrowed monies under the LRBA must be repaid and the loan cannot be retained and used to acquire another asset.
Depending on the loan-to-value ratio, it is possible, with significant falls in the price of the underlying asset, that the SMSF may lose any amounts initially contributed to the acquisition of the asset. This is despite the safeguard offered by LRBAs that should the value of the asset be less than the value of the debt and a sale be forced, the lender does not have recourse to other assets of the fund.
Where an SMSF trustee is unable to meet their loan repayments and defaults on the LRBA, a lender may also have the option to call on any personal guarantees. If a guarantee is called on, and the guarantor pays the SMSF trustee’s debt to the lender, the guarantor should seek to recover its loss from the SMSF trustee, provided it is limited to the SMSF’s rights in the underlying LRBA asset. Where the SMSF holds onto the asset and the guarantor forgoes their right of indemnity against the SMSF trustee, this will result in a deemed contribution unless the value of the single acquirable asset is insufficient to meet the debt to the lender or the guarantor.
