Oh dear, not another glitch with borrowing in SMSFs
Purchasing shares for your SMSF under a highly-leveraged Limited Recourse Borrowing Arrangement should take into account the ATO’s 45-day rule, or risk losing the imputation credits.
Could SMSFs lose imputation credits on highly-leveraged share portfolios? Well, it pretty much looks like that is the case.
Before getting into the detail about the most recent problem with Limited Recourse Borrowing Arrangements (LRBAs) and SMSFs, it’s worthwhile putting the issue in context.
Borrowing and unintended consequences
LRBAs allow an SMSF to leverage an investment portfolio, real property or listed shares say, which may be acquired using a LRBA. They were permitted to enable superannuation funds to participate in the Telstra sell down because it was structured as an instalment warrant. In other words, investors were loaned part of the purchase price, hence superannuation funds had to be permitted to borrow for them to participate in that sell down, and consequently, LRBAs started.
An unintended consequence of allowing funds to leverage with LRBAs has been that wealthy SMSF members are using LRBAs to get significant amounts of their wealth into their SMSF by simply lending money to their fund for it to acquire assets. That, of course, defeats the purpose of the contribution limits because there is no limit to the amount that can be lent to an SMSF. In effect then, this form of leveraging drives a Mack truck through the contribution rules.
However, that unintended consequence is currently being addressed by the ATO through application of the non-arms-length income rules (NALI), which makes that strategy less appealing because, in order to avoid those provisions, these transactions have to be completed on arm’s length terms.
Consequences of ’45-day rule’
Nevertheless, another issue with LRBAs has arisen and that is the 45-day rule, which means that in certain circumstances where an SMSF leverages Australian shares it can lose its rights to imputation credits attaching to the dividends received.
The 45-day rule says, in effect, that to be eligible to claim imputation credits, an SMSF trustee must be at least 30% ‘at risk’ for at least 45 days, where risk is measured using the financial concept of ‘delta’, which is the percentage change in the price of one security relative to the percentage change in the price of another or to the market as a whole.
However, here is the problem: buying shares under a LRBA necessarily reduces the risk of an SMSF trustee holding those shares. This is because the LRBAs regulations are, in effect, a risk transfer mechanism as they include an effective put option to the lender, limiting the risk of loss to the borrower to the value of the shares on default. That is, there is ‘limited recourse’ to the other assets of the SMSF.
The ATO seems to be of the view that where more than 30% of the risk is transferred away from an SMSF trustee, the 45-day rule will not be satisfied and so the SMSF trustee is not entitled to imputation credits. For example, if the borrowed funds under the LRBA represent more than 70% of the purchase of the shares, the trustee does not receive the imputation credits as the SMSF is less than 30% ‘at risk’.
Yet in ATOID 2015/27, the ATO has said that the loan funds can represent 100% of the purchase price of the shares.
What should be done?
It looks like the ATO is entitled to amend prior year returns of SMSFs who claimed franking credits where the LRBA is more than 70% of the value of the shares, and penalties and interest could apply.
However, it is super fund regulation that forced SMSFs to use a borrowing structure (LRBA) that can, in these circumstances, deny the tax benefit of imputation credits.
It seems reasonable that, because this problem was caused by government regulation, the ATO should cut affected SMSFs some slack. Perhaps they could be given time to restructure the arrangements so that they are not booby trapped in future?
About the author
Stephen Lawrence, sessional associate lecturer, with Gordon Mackenzie, Senior Lecturer, Taxation and Business Law School UNSW. These views are considered an accurate interpretation of regulations at the time of writing but are not made in the context of any investor’s personal circumstances. Readers should obtain professional advice before acting.
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