COVID-19 Changes to the SMSF Landscape – Part 4: Related Party LRBAs

The goal posts of commerciality are changing in the wake of COVID-19.

This has implications for:

  1.  SMSF related party tenancies affected by COVID-19
  2.  Related party limited recourse borrowing arrangements (LRBAs) affected by COVID-19

The SMSF audit is critical to the decisions trustees and their advisers make today.

No one wants a train wreck with their SMSF auditor.

What steps are required to navigate post COVID-19 territory with the auditor’s green light?

Let’s have a look now at related party LRBAs. 

As with related tenancies, an arm’s length standard of dealing is essential to avoid compliance breaches and the incurrence of non-arm’s length income (NALI).  See the Australian Banking Association’s website for information on the commercial standard in dealing with real estate investment loans.  Industry relief for these loans provides a temporary deferral of loan principal repayments up to 6 months. Interest will accrue on the loan over this period and must be caught up at a later point.

A related party lender may therefore offer the same to their SMSF without jeopardising the principle of arm’s length dealing (SIS section 109) and without giving rise to NALI.

IMPORTANT – Do not vary the interest rate or extend the loan term due to COVID-19

Changes in interest rate or loan term are not covered by the ATO’s benchmark guidance for related party borrowings. As explained in the ATO’s FAQ guidance, all principal repayments and interest may be deferred for 6 months due to COVID-19’s financial impact. The need for any further relief must be reviewed at the end of this deferral period, in line with industry practice.   

Preparing the SMSF for audit

The SMSF auditor must form an opinion as to the commerciality of related party borrowing arrangements.

They will need sufficient appropriate audit evidence from SMSF trustees to support this opinion. This should include:

Minute / resolution: A minute or resolution should confirm the change in terms to the loan agreement. This document must include the reason for a change in terms.  It should refer to current banking practice in support of the measures implemented and set a timeframe for the review of these measures (ie, 6 months).  

Loan repayment schedule: An updated loan repayment schedule should be provided, showing a temporary freeze on principal repayments and the accrual of loan interest over the deferral period. At this point, industry expectations in relation to catch up payments are unclear and will be revisited at a later date. The repayment schedule must fall in line with any known commercial standard.

What the Auditor must do

If the auditor finds that a related party LRBA has not been commercially maintained, they must:

  • Recognise a contravention of SIS Act section 109 and the incurrence of non-arm’s length income by the SMSF and communicate these matters to the trustees in the management letter.
  • If the contravention of section 109 is material, modify the Part B Compliance Audit Opinion. If the contravention is reportable under the Regulator’s reporting criteria, report the section 109 contravention (and any other contraventions) as usual to the ATO.
  • If the financial statements do not recognise the correct tax provision resulting from NALI and the misstatement is material, modify the Part A Financial Statement Audit Opinion.

Conclusions

For those SMSFs swimming between the flags, the annual audit should prove no obstacle.

Do not adjust either the interest rate or loan term in response to the COVID-19 crisis. All repayments of principle can be deferred 6 months and the interest in this period capitalised.

In terms of audit evidence, just ensure that the change in loan terms is documented, that the rationale for adjustment is explained, and that the accrual of interest is borne out by a revised loan repayment schedule.

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