Frequently we see comment on the need to have legally documented and correctly settled related party loans etc. The question that often comes up is - What rate of interest ? The key factor to this is really not one of attempting to reflect a competitive commercial rate akin to a bank. Some say the rate should always be higher - Why must profit occur ? Some say you may want to charge many % more than a bank benchmark rate to reflect a higher degree of risk however in a non-arms length situation it could be argued that the risk of default will always be lower. I dont adopt the view that a profit must be generated. In many instances there may be a back-to-back loan arrangement eg Mum borrows from CBA and then onlends to the Family Trust. Why not use a back to back rate ? Some argue its isnt commercial. I don't think it matters. If Spouse A defaults isnt the other spouse affected ? How can a margin truly reflect risk ? The key tax factor in a non-arms length arrangement is that the terms are arms length. What does that mean ? An example can be found in a SMSF Ruling of all places as Superannuation / Tax Law imposes far greater onus on a non-arms length loan arrangement than almost any other example we can consider. TD 2016/16 contains the ATO views on those terms. eg rate, security etc. Looking at that ruling provides substantial insight into the ATO views on non-arms length lending. But that ruling does NOT mean that all of the terms and conditions must meet or better the views of the Commissioner in TD 2016/16. The fundamental issue the Commissioner has is that the arrangement must not produce excessive non-arms length income which then produces a tax benefit (taxed concessionally to the fund). It can broduce the same or less and the Commissioner may have no concern. This excessive income test is paramount. This test of the excessive income needs to consider if a tax benefit occurs....Part IVA. A scheme. Where a back to back facility occurs it is easily to argue that no excessive income occurs, hence how may Part IVA apply ? It is very difficult to argue a income shifting scheme occurs where a person borrows from bank A and onlends at the same rate to another party who is related. My concern occurs when a related party loan is undertaken with features such as : - A shift of net income arising from interest occurs from a high rate taxpayer to a less rate taxpayer. eg Mum has savings (gifted from Dad) who onlends money to Dad to buy a investment property that is negatively geared. Mum has zero taxable income prior to the arrangement and Dad has very high income prior to the arrangement. eg Dad gives Mum $700K savings and Mum uses this to repay a loan on their home. The loan is redrawn and lent to Dad at an arms length rate for him to buy an investment property which is negatively geared. This could be a scheme. - A high rate is used to shift net income to a taxpayer with a lower marginal rate while providing a high deduction to a high marginal rate taxpayer - Undocumented loans on all occasions - Offshore related party loans denominated in a currency without consideration of exchange risks. This may indicate a offshore gift masked as a loan. - Related party loans where there is no regular monthly payment (was it a gift ?) - poor accounting for the indebtedness between the parties
I draw up a lot of related party loan agreements for clients and most of these are back to back loans with (example) A borrowing from CBA and onlending to spouses or trustees. I have done some at rates linked to the underlying bank + a margin of 1% (on the clients accountant's advice) but mostly at the same rate without margin now.
These sorts of margins are really trivial and should pose no concern at all. Materiality is the issue. However it is important that taxpayers understand that not all related party loans are OK. Where the outcome is that a higher income earner gets a improved deduction (interest expense) and the lower income earner earns income that is taxed at a lower rate then a scheme may be in effect. The loan agreement may be totally compliant but merely be an element of a tax scheme. This is especially so when a round robin transaction sees the spouse access funds that they lend to their spouse. ie Husband inherits $100K, gifts this to wife who then lends it to husband. If for example the wife was to inherit then there may be a very different outcome...ie not a scheme. Ditto if they borrow (personally). Problem is they seek a loan agreement and ignore the first key issues. I always enquire into how they obtained the funds they propose to lend. Some bizarre stories....often with "but all I want to do is"...."get a improved tax deduction". The Commissioner could cancel the tax benefit (ie treat the interest deduction as zero or limit the taxpayer neg gearing loss to $0.00. In practice the Commr doesnt normally also disregard the spouse income...Double the tax effect and penalties + interest are never nice.
I agree One common one is gifting money to a trust and then borrowing it back. This is fine, but if the trust was charging interest the interest would unlikely to be deductible even where the funds were borrowed for investment purposes.
