In view of the draconian provisions of the non-arm’s length income rules, the administration of related party limited recourse borrowings requires careful attention. If the NALI provisions are triggered the net income generated by the asset, as well as its ultimate taxable capital gain, will be taxed at 45%. Fortunately, this matter has not been a focus of the regulator to date, though this could change.
Given the total impracticality of the conditions required to satisfy the arm’s length requirements in the real world – an unconditional letter of offer from a bank – related party LRBAs are invariably arranged under the safe harbour provisions. It is relatively simple to set the interest rate, and the principal and interest payments required at inception but, except for a short period in which interest rates may be fixed (5 years for a 15-year property loan or 3 years for a 5-year listed securities loan) the interest rate, and subsequent monthly repayments, must be reviewed each year. Indeed, many of the related party loan documents I have seen have failed to take advantage of any fixed interest period at all. The result is that many such arrangements are likely to fail the minimum reduction required, especially in a rising interest rate environment where increases to monthly payments are necessary.
Loans that have been reduced by more than is required are not an issue but balances that are higher than they should be require immediate attention. Whilst satisfying the safe harbour provisions requires compliance with various items, the proper reduction of the loan balance is fundamental, so we have developed a reporting tool that compares the balance of an existing related party loan to what it would be if the safe harbour conditions had been stringently applied. It also gives an indication of required monthly payments, all included in a comprehensive report. Reducing the loan balance to what it should be does not guarantee compliance, but the ATO is more likely to exercise its discretion where there has been a proactive attempt at rectification.
This tool is available, free, to our Alliance Partners.
