Family loans – do ATO accepts these???

[HCMCity]

Hi all you accounting and tax experts,

As the subject indicated, seeking advice on the tax deductions and implications of privately arranged family loans to purchase IP – do ATO accept them??? Here is a scenario to give the situation a bit more realistic dimension in practical terms:
- Party A lent a family member (Party B) $80,000 to buy an IP in 2000 worth $140,000; Party B financed the remaining $60,000 for an IP bank loan
- for this ‘family’ loan, an agreement was drawn up and signed by both parties to set out the terms, conditions and responsibilities of each party involved just like any bank loan agreement
- for this ‘family’ loan, Party A agreed to charge Party B a fixed interest rate of 5% for the terms of the agreement of 15 years
- annual interest charged (not compounded) would be accrued until the payout of the loan
- Party B also agreed to the condition that during the terms of this ‘family’ loan Party A can request Party B to pay the loan out (principal + accrued interest) at anytime at the discretion of Party A
- if Party A made no loan payout request, then the ‘family’ loan will see out the terms of 15 years
- now in 2013, Party A have requested a loan payout from Party B
- payout calculations are:
i) interest charged, $80,000 x 0.05 x 13 = $52,000
ii) total payout, $80,000 + $52,000 = $132,000
- Party B decides to refinance existing IP bank loan from $60,000 to $192,000 (assuming no principal have been paid off to existing IP bank loan) to accommodate the ‘family loan payout

THE QUESTIONS ARE:
1. can Party B claim interest deduction ($52,000) from ‘family’ loan on existing IP? Consequently, Party A would need to declare interest receive from Party B to ATO.
2. can Party B claim future interest deductions on re-financed new IP bank loan of $192,000?
3. if for whatever reasons the interest charged ($52,000) from ‘family’ loan can not be claimed (essentially, the ‘family’ loan is now considered to be charging 0% interest rate for the past 13 years)
a) would the ATO accepts the $80,000 ‘family’ loan as a form of finance and therefore, allow Party B to re-finance the existing IP bank loan to incorporate this $80,000 to a new IP bank loan worth $140,000
b) if so to the above, can Party B claim future interest deductions on the re-financed new IP bank loan of $140,000?

To me, this scenario is straight finance transaction between two parties, just as if Party B elected to get the $80,000 loan from a commercial bank. Party B was lucky enough to get a good interest rate deal from a family member and so from a cost-saving perspective I can’t see why Party B would not take advantage of the deal. It was formally executed with signed agreement just like any bank loans.

I am very interested in comments, advice and insights to what others think.

 

[Terry_w]

Commercial loans between family members should be treated as any other loan. Make sure written agreements in place and proper proceedures followed.

 

[Rob G.]

I am very interested in comments, advice and insights to what others think.

You expect comments & advice on a public investor forum regarding at call loans under non-commercial terms ?

Better to seek legal and taxation advice, both for you & the lender. Here are the reasons that you need to seek advice using more detail.

The first hurdle is the deductibility of a loan under non arm's length terms between related parties.

5% at call on an unsecured loan is definitely way below commercial terms - was it intended to be an outright gift with the hope that some family favour would be returned in the future ?

Assuming it is tax deductible as a presently existing liability ...

As a guide, and only based on the above facts, this appears as a 'qualifying security' under Division 16E ITAA36.

Therefore it is treated as an accruals loan and an amount is tax deductible each year (and your lender should probably be declaring income each year).

The accrued interest is calculated 6 monthly at an effective rate of 1.883% per period, or equivalent to a 3.8% annual. The reason for the lower rate is that it uses a present value.

If you are a taxpayer who has a two year review period then you may only be allowed to amend the last two years of tax returns to include deductions for those respective years only. The rest is lost. You might be a four year review taxpayer depending upon circumstances.

Correspondingly, your lender may have to consider making a voluntary disclosure to the ATO regarding any tax shortfall from not declaring interest income the last 13 years. There is no time limit for review if there is fraud or evasion. Note that undeclared assets and income may also affect entitlement to tax offsets and centrelink benefits for the lender.

Next hurdle - the refinancing.

If the ATO argues that the funds were a gift then there is no presently existing obligation to refinance. They could also argue that it is statute barred based on time lapse and implied behaviour notwithstanding your original loan document.

If the ATO accepts that a debt actually exists, then the purpose of the refinance will be reviewed because it is a new borrowing so ordinary principles will be applied

Cheers,

Rob

 

[HCMCity]

Thanks Rob for your thoughts on this.

Better to seek legal and taxation advice, both for you & the lender...
The first hurdle is the deductibility of a loan under non arm's length terms between related parties.

I did very briefly ran through this scenario to my accountant. In which he said was fine as long as there are documents to support the loan arrangement/ agreement

It appeared that Terry_w has similar view to my accountant on this. "Commercial loans between family members should be treated as any other loan. Make sure written agreements in place and proper proceedures followed." I'm confused now, some said yes and others said no ???

5% at call on an unsecured loan is definitely way below commercial terms - was it intended to be an outright gift with the hope that some family favour would be returned in the future ?

It can't be a gift when interest are been charged for the loan (to use the money). The intention with many family arranged loans is to help out family members. Hence, the low interest rate. It becomes a win-win situation instead of the bank takes it all. When a family member has spare cash which he/she is not intending to use (for whatever reasons) - instead of leaving it in the bank, so the bank can use the money - lends it to family members to help out with the mortgage (reduces the interest pay to the bank). I can't really see why it's a problem, especially if interests are charged and declared just like any lenders.

As a guide, and only based on the above facts, this appears as a 'qualifying security' under Division 16E ITAA36.

Therefore it is treated as an accruals loan and an amount is tax deductible each year (and your lender should probably be declaring income each year).

The accrued interest is calculated 6 monthly at an effective rate of 1.883% per period, or equivalent to a 3.8% annual. The reason for the lower rate is that it uses a present value.

If you are a taxpayer who has a two year review period then you may only be allowed to amend the last two years of tax returns to include deductions for those respective years only. The rest is lost. You might be a four year review taxpayer depending upon circumstances.

Correspondingly, your lender may have to consider making a voluntary disclosure to the ATO regarding any tax shortfall from not declaring interest income the last 13 years. There is no time limit for review if there is fraud or evasion. Note that undeclared assets and income may also affect entitlement to tax offsets and centrelink benefits for the lender.

Thanks for the insight. Interesting to see your interpretation. My accountant have flagged that it is OK to repay interest in lump sum if that is what the loan agreement conditions are and you have signed it. I thought that was very weird and ill-informed of his advice.

May need to re-consider whether I should use my accountant's service - it appeared he really does not know all his taxation rules. Which brings me to another point, we take accountant's advice but if their advice is ill-informed, we will need to take on the consequences. Their hands are wipe clean. How is that fair? I guess you can sue them for compensation but is it really worth it and by that time - it's too late.

 

[Terry_w]

I did very briefly ran through this scenario to my accountant. In which he said was fine as long as there are documents to support the loan arrangement/ agreement

It appeared that Terry_w has similar view to my accountant on this. "Commercial loans between family members should be treated as any other loan. Make sure written agreements in place and proper proceedures followed." I'm confused now, some said yes and others said no ???

I mentioned 'commercial loans'. By this i mean on commercial terms similar to what 2 unrelated parties would enter into.

Without seeing all the relevant details atm it doesn't appear this would be commercial loan agreement. I don't know of any commercial lender that will charge interest in one hit after 15 years.

How was the interest on this loan treated as it accrued?
Was it declared and claimed in tax returns?
Have any payments been made?
Is the lender statute barred from calling in the loan after 15 years with no repayments? Look at the limitations Act.

The ATO may be thinking this was a gift which may have been recategorised as a loan several years later.