Borrowing in super and particularly in SMSF's continues to attract attention from all sorts of lobbyists and committees, for all the wrong reasons. Whether the strategy remains a viable one in the long term will be determined in the short to medium term probably by Government regulation.

What I want to focus on in this article is the ATO's change of attitude to funds borrowed at zero interest from related parties.

The ATO's original position was one where it appeared to be acceptable to borrow at zero interest rate from related parties. This was certainly the message that I picked up from a range of sources from the ATO.

Recently, a number of Private Binding Rulings have poured cold water on the assertion that zero interest rate loans would not be detrimentally taxed. In addition, two ATO Interpretive Decisions, ATO ID 2014/39 and ATO ID 2014/40 came to the view that an arrangement where a fund borrows at zero interest rate, will result in the fund being considered to have been derived as non-arm's length income. Non-arm's length income is taxed in a fund at the top marginal tax rate of 45%.

Given that this is the case and that income derived under these arrangements will be taxed at the top marginal rate, this article will examine what steps a fund trustee needs to take to protect the interests of the fund.

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This topic and others will also be covered in greater detail in the Wilkinson Superannuation Update Webinar Series 2015. The first of these seminars is free to those who book for the Autumn SMSF School worth $120, Click here to book or download brochure from here.

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If a related party lends to a self-managed superannuation fund interest free, there is now a high probability that the income derived will be taxed at the top marginal income tax rate.

This is a complete about face by the ATO. In November 2013, I wrote a blog that outlined that the ATO had in a number of ATO rulings, Private Binding Rulings and minutes of the National Superannuation Liaison Group confirmed that a zero interest loan would not:

1. Result in  the low interest loan giving rise to a deemed contribution to the fund
2. Mean that the fund had breached Section 109 of the Superannuation Industry (Supervision) Act 1993.
3. Mean that the income earned from the purchased assets were treated as non-arm's length income and taxed at the top marginal rate.

The ATO went so far as to confirm the above in two Private Binding Rulings that were issued in 2013.

Unfortunately the position has now changed. The ATO has now issued up to 20 further private rulings dealing with related party funds borrowing at zero or reduced interest rates. These private binding rulings confirm points one and two above, ie the low interest loan does not give rise to a deemed contribution or a breach of Section 109.

However, they have reversed their previous position with regard to point three and now argue that the provision of the low interest loan does give rise to non-arm's length income.

Click here to learn how your super can borrow

3.  So what has changed?

The ATO now state that the income is caught under Section 295-550(5) of the Australian Income Tax Assessment Act 1993. This section has the effect of taxing all of the income derived from the purchased asset at 45%, if the conditions under the Section 295-550(5) of the ITAA 97 are satisfied.

 The provisions of Section 295-550(5) of the ITAA 97 are as follows:

" Other income derived by the entity as a beneficiary of a trust through holding a fixed entitlement  to that 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"

4.   Does the fund derive the income from a trust in which it holds a fixed entitlement?

When a fund establishes a borrowing arrangement in an SMSF, the acquired asset is held by a bare trustee (under Section 67A) so that the trustee of the superannuation fund acquires a "beneficial interest" in the asset.

The establishment of the trust arrangement when a borrowing is entered into, is documented by the bare trustee deed. In the two instances dealt with by ATO ID 2014/39 and ATO ID 2014/40 the bare trust deed stated that the acquired asset was to be held for the absolute entitlement of the fund trustee.

Given the Commissioner's view in TR 2006/7 that "the complying superannuation fund has a fixed entitlement to a trust distribution if the entities entitlement to the distribution does not depend upon the exercise of the trustee's or any other person's discretion." It is clear that in circumstances such as those outlined in ATO 2014/39 and ATO ID 2014/40 that the ATO would form the view that the fund had a fixed entitlement to the income.

Click here to learn how you can lend to your super fund

5.   Does a scheme exist under which the fund derived income?

The ATO has consistently taken the position that a scheme exists if a related party lends to a super fund interest free.

The ATO have formed this view on the basis that a scheme is defined as:

1. Any arrangement
2. Any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

When the above definition is applied, the ATO comes to the view that a scheme would include the:

1. Way in which the fund acquired it's fixed entitlement to income in the trust  and/ or
2. Derived an amount or amounts of ordinary or statutory income as a beneficiary of the trust through holding that entitlement

6.    Are the parties dealing at arm's length?

The parties to the arrangement in this case are not at arm's length, because the members of the fund are;

1. The trustees/ or directors of the trustee company of the Superannuation fund
2. The trustees/ or directors of the trustee company of the Bare Trust
3. Either the lender or the controlling shareholder or trustee of the entity that is making the loan to the fund.

This does not mean that the parties to a zero interest rate loan could not be taken to be "dealing" at arm's length. However, in determining whether this is the case the ATO looks to the case of Federal Commissioner of Taxation v AXA Asia Pacific Holdings Pty Ltd (2010) in which Edmonds J stated "Any assessment of whether the parties were dealing at arm's length involves 'an assessment of whether in respect of that dealing they dealt with each other as arm's length parties would normally do. So that the outcome of their dealing is a matter of real bargaining"

Given the comments above, the factors that the ATO took into account in determining that the parties were not dealing with each other at arm's length in both cases included:

1. The LVR was higher than the commercially available
2. In one case the principal was repaid in one lump sum at the end of the loan
3. In the case of 100% LVR loan, personal guarantees were not provided
4. Additional security was not provided when LVRs exceed commercial levels
5. The interest rate was set at zero rate

The ATO took the view that the transactions would not have been entered into at all had the parties been dealing at arm's length. Therefore no income would have been derived and all the income is taxed under Section 295-550 at the top marginal rate.

The ATO view is that given the level of leverage, the setting of a zero interest rate and the failure to provide a commercial level of security that it was unlikely that any arm's length lender would have provided the finance to the fund.

Accordingly, in the ATO's view the income that would have been derived by the trust under a commercial arrangement is zero, because the loan would never have been made. Therefore the total trust income exceeds the arm's length amount and it would all therefore be taxed at the top marginal tax rate.

The ATO goes on to state in ATO ID 2014/40 that "It is no answer to this conclusion to say that the Fund could have obtained a loan from an arm's length lender on different terms of that the Fund could have used other means to have acquired the asset, as that is not the scheme into which the parties have entered.

Click here to learn how to set up a super fund

ATO ID 2014/39 and 2014/40 provides an important clarification regarding how to structure a super fund borrowing. These include:

1. If you have existing loans where the interest rate is other than an arm's length rate, then the loan should be refinanced, benchmarking against commercial practices.
2. For client's that have zero interest rate loan arrangements in place for a number of years, the trustees should seek professional help in approaching  the ATO to determine what steps need to be taken with regard to income derived in prior years.
3. For new loans, make sure that evidence exists that you have benchmarked your loan against current commercial practice.
4. Note; ATO ID 2014/39 and 2014/40 do not prohibit related party loans , they simply put the case that if the income derived under a scheme is greater than might be expected then Section 295-550 will apply.

When should funds borrow from a related party?

There will be circumstance when related party loans are still practical, some of these circumstances would include:

• A member of the fund borrows directly and lends to the fund under identical terms.
• The related party has the resources available to lend to the fund and benchmarks the loan against arm's length practice
• The fund is purchasing an asset off the plan with a long settlement time line. As there is lots of talk about borrowing in super being removed in the future, it may be worthwhile for the fund trustee to enter into a related party loan agreement, which can be drawn down when the settlement occurs. This will ensure that if borrowing is banned in the future, that the fund is doing all it can to ensure that it falls into any grandfathering arrangements that may be implemented at the same time.

This article only deals with some of the issues that have arisen with regard to the structuring of borrowing arrangements in SMSFs. To find out more information regarding the issues that you should be considering when borrowing in a SMSF subscribe to the Wilkinson Superannuation 2015 Webinar Series here. To sample Mark's webinar, attend the first webinar for free by coming to our Autumn SMSF-School Seminar, for more information, download brochure from here.

Mark Wilkinson of Wilkinson Superannuation has had 30 years' experience as the adviser's adviser on superannuation and retirement matters. Four times throughout his career he has run technical help desks for professionals on all things superannuation, as well as being a highly respected presenter and trainer on superannuation subjects.

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