Assuming that there is nothing in the financial details of an SMSF to prejudice a lender against them, the ATO’s safe harbour provisions for limited recourse borrowing arrangements (LRBA) are at first glance conservative in nature: better terms are often available commercially. For example the safe harbour interest rate is the RBA’s Indicator Lending Rate. This rate is defined to be the average over a collection of bank’s variable rates for investors in real estate, thus better commercial rates will always be available – by definition. Examples of better commercial terms for loan to value ratios, the period of the loan, fixed interest rates and the period of fixed interest rate are easy to find.
The possibility of arm’s length LRBA’s with terms better than those provided by the safe harbour provisions is recognised in PCG 2016/5 in paragraph 4. Paraphrasing greatly, this paragraph states that not using the safe harbour provisions does not imply that an LRBA produces NALI. It goes on to state that replicating the terms of a commercial loan could be an example but that the ATO offers no guarantees.
The recent determination TD2016/16 clarifies the ATO’s position on how to determine NALI. Roughly, the determination states that income will be NALI only if the SMSF has derived more income from the non-arm’s length arrangement than it would have if the parties were dealing with each other at arm’s length. The method by which the ATO will determine if income is NALI is the focus of TD2016/16. The ATO will determine the terms of a hypothetical LRBA under the assumption that all parties are at arm’s length. They will then consider if the SMSF could or would have agreed to the hypothetical LRBA. If not, then all income derived from the existing LRBA is considered to be NALI. If so, then a comparison of the income streams generated by the existing and hypothetical LRBA’s is performed. This is essentially a specification of the steps the ATO will take to implement subsection 295-550(1) of the ITAA 1997.
Investors thinking about exploiting this should take care. The determination makes clear how the ATO will go about assessing if income is NALI but offers no protections: unlike the safe harbour provisions. For those wanting to invest in property via an SMSF the safe harbour provisions still offer the best certainty of avoiding an additional 30% tax on income.
It is worth noting that when the deductions and differences in tax rates are taken into account, the safe harbour provisions can be competitive in comparison to a lower interest rate loan held personally. It is therefore a good idea to get a comparison of expected rates of return between different holding structures for property investments. To request such a report complete the attached data sheet or contact me directly.
I have been in the process of enhancing the NetActuary property analysis models and will provide more information about the safe harbour interest rate and holding structures shortly.
Dr. Ben Whale