Oh dear, not another glitch with borrowing in SMSFs

Is there an ATO ruling denying imputation credits on LRBA loans for share purchase?

Yes, Sam. There is a private ruling that leads to this conclusion. The issue was also raised at an SIRN meeting a few months ago but as yet doesn’t seem to have been followed up. Hopefully if there is technically a denial of franking credits as a result of the 45 day holding rule a solution can be worked out which doesn’t penalise trustees. After all, it was one law that forced them into a structure which caused problems in another law. That seems a bit unfortunate. Then again, maybe they just pushed the envelope a little too far.

Why is it super fund regulations that have caused the problem? Anytime an investor borrowed more than 70% via a limited recourse loan, wouldn't they have this problem?

The Super Regs just require the LRBA structure, they don't require the loan to go over 70%. It sounds like affected investors should be looking at their tax advisers?

It never pays to flirt with franking credits. The anti-avoidance provisions are just too nasty.

That’s true Richard for sure. But it’s the limited recourse nature of the loan which apparently causes the problem. That’s the thing that effects the delta. And that’s the thing which the super fund regulations insist on. It must be limited recourse to be permitted under SIS. Pushing the loan to valuation ratio and possibly MATERIALLY diminishing the risk of loss? That’s all on the members/trustees I think. How tax advisors are involved might be another issue.

Stephen, what happens if the SMSF borrows 70% leaving 30% initially at risk, which is fine, and then the market falls 10%, such that only 23% is now at risk?

Good point Alex. I think that is a risk. But section 160APHJ(9) of the ITAA 1936 seems to suggest that if a taxpayer takes a position in relation to shares, then provided they continue to hold that position and don’t enter into any other positions then the delta of the position remains the delta of the position on the day on which the shares were acquired. I think that could provide some comfort in the circumstances you describe. But it might also mean that trustees who are currently in this position can’t apparently fix it by throwing in some equity.

I disagree.

An LRBA is not a delta position, and even if it was, the LVR doesn't translate exactly to the net delta.

The underlying single-acquirable-asset is still exposed to the full opportunities for gain, and all of the opportunities for loss. The LRBA simply limits the loss beyond 100% of the single acquirable asset.

A mortgage is not called into default as soon as the LVR is above 70% or even 80%. The LVR is simply a ratio at a snapshot in time.

The fact that a LVR can start at 70% and go up to 80% during asset price volatility proves that the net delta position is not less than 0.3. Further, how do you arrive at a net position of less than 0.3 when there is no limit on the upside, while the LVR is free to fluctuate from time to time??

Thanks Adrian.

Section 160APHJ(2) of the ITAA 1936 provides the meaning of position. It states that a position in relation to shares is anything that has a delta. It then provides an ‘inclusive’ list “without limiting the generality” and at paragraph (f) pro0vides “a non-recourse loan made to acquire the shares”. The relevant EM states “a non-recourse loan, that is, a loan which is repayable only up to the value of certain property (eg. shares), effectively contains a put option to sell the shares to the lender, and a delta can be calculated in relation to this notional option.” It is pretty easy to equate a “LRBA” with a “NRBA” so I think a LRBA is a position which has a delta. Or a delta position. The relevant section is an “or” section not an “and” section. You don’t have to materially diminish the risk of loss AND the opportunity for gain. One will do. A LRBA limits the risk of loss, as you say, to the value of the shares when/if a default occurs. The question then is, by how much?

You arrive at the net position using the combination of long and short positions. The share purchase is a long position. The LRBA is the short position (because of the notional put option). You have to go deep into regulations to find which delta numbers attach to certain positions. But it would seem that where you borrow more than 70% of the funds to acquire the shares (as apparently some trustees are doing), then the shares are not at risk and there is no entitlement to franking credits. Probably never has been. Maybe never will be.

As Stephen intimates at the outset, allowing limited recourse borrowing through Telstra and Commonwealth Bank privatisation started the borrowing frenzy: 'clever' merchant bankers increased the gearing above the initial 50%, introducing hot (sizzling?) warrants, and a few built derivatives on them.

Bad enough, one would have thought. Towards its dying days, the Howard-Costello regime subtly (or not...) removed the existing requirement for the underlying asset to be a listed (and hence more liquifiable) security. Internal concerns voiced within policy-making were dismissed as puritanical party-pooping by the political masters. Any asset will now do, subject to the LRBA structure. Try your grandma's antique clocks (duly securitised, remember the GFC?) and subject to legal form, thou shalt pass muster.

In expecting the ATO to address the consequential problems is I think too onerous. The ATO do not make these laws, and in the heat of budgetary policy-making, tax or other regulators get little by way of look-in. The post-party retching that we now see is left for the ATO nanny to clean up.

Ignoring the many occasions ATO behave as if they make the law (rather than being a mere creature thereof)and the fact that ATO is genetically programmed to maximise revenue regardless of intent or ethics, point the finger at myopic policy-makers.

Two measures will help:one, like regulations now requiring a Productivity Commission ok to balance costs with benefits, make all tax measures subject to a post-facto disclosure of the pros and cons considered before introduction; two, rather revolutionarily, make ATO subject to anti-avoidance itself so a taxpayer may tear the veil of many ATO 'schemes', declaring the Commissioner guilty of tax fraud.

We need an Ayn Rand here. Will she reincarnate?

Thanks Ramani. Those are interesting ideas. I actually didn't realise the ATO was running schemes. I thought that was mainly the dominion of what we might term 'promoters'. Nonetheless, would you suggest a "dominant purpose" or "sole purpose" test with respect to the ATO anti-avoidance provision? By which means would you test whether or not the test was satisfied? Who would receive the penalties and GIC that the ATO would be hit with? Who would bring the action? I think that the new(ish) rules in relation to collectables and personal use assets might squash the idea of throwing your grandma's clocks into a SMSF nowadays. I don't think that shall pass muster. I have always found the ATO to be pretty much focused on applying the law as it stands. I think they generally have very high regard for intent and ethics. And I think they can, and probably will, address this.