State of play with SMSF Limited Recourse Borrowing Arrangements


Which direction will Treasury and the ATO head with Limited Recourse Borrowing Arrangements?

The use of Limited Recourse Borrowing within Self Managed Super Funds continues to capture the attention of trustees and advisers alike.

We are seeing some significant work being undertaken in this area of borrowing to provide greater clarity of section 67A & 67B introduced into the Superannuation Industry (Supervision) Act 1993 (“SIS Act”).

With this activity, I thought it appropriate to post an article outlining the current “state of play” in regards to SMSF Limited Recourse Borrowing Arrangements.  So where are we currently at with many of the ‘grey’ issues?

  • Definition of “Single acquirable asset” – the current ATO view of single acquirable asset for real property is based on its boundaries defined by legal title.  Therefore, the single acquirable asset definition is very restrictive as it does not allow for properties held over multiple titles including farmland and some commercial property.  A more common issue caught by this definition is the car-park attached to an apartment or office building that sits on separate title.  Where assets are inseparable, or where there is an ancillary asset of a very small value, the ATO may treat the assets as a single asset for the purposes of section 67A.  Previous information from the ATO has indicated that a car park does not meet this requirement.  It would be prudent to obtain a private ruling from the ATO where such inseparable or ancillary assets exist.
A workshop was conducted late last year by the ATO with selected representatives of the NTLG Super Technical sub committee to address issues impacting limited recourse borrowing arrangements.  The Institute of Chartered Accountants (“ICAA”) included as part of their submission for the ATO to adopt an accounting standards approach to identify what is a single acquirable asset.  The use of accounting standards looks at the “economic substance” of an asset, not simply the boundaries of legal title.  By taking this view it means that the component parts of an investment property are not looked at but instead they are treated as one whole asset.

It is my understanding that the ATO have taken this information on board and raised the issue back to Treasury as a technical priority issue.  Any change will need to balance the original policy intent of the changes in July 2010 with the current ‘logic’ provided by the industry.  As a result we are unlikely to receive any further information on the matter from Government until August or September this year.

Have you registered for the SMSF Limited Recourse Borrowing day?

  • Improvements regardless of source of funds are prohibited – arguably the most common question I get asked is whether the real property acquired can be improved using the super fund’s own money.  Regardless of the source of funds, any capital improvements would be in breach of the replacement asset rules contained within section 67B of the SIS Act.  Therefore if any capital works need to be undertaken on the property, they should be completed prior to purchase, otherwise at this stage we are stuck with only being able to repair an asset to its original state.
  • Repairs vs. Improvements – the already ‘grey’ issue within tax law now also resides within superannuation law with the introduction of section 67A(1)(a)(i) that allows the acquisition of an asset to include expenses incurred in maintaining or repairing the asset to ensure that its functional value is not diminished. The only guidance currently available is contained in Tax Ruling TR 97/23. The ruling applies a very rigid approach in determining what is a repair vs. improvement.

Read further information from my previous blog, are limited recourse borrowings beyond repair?

To understand some of the issues being confronted by the introduction of these changes to superannuation law and the application of TR97/23, let’s look at a few examples:

    • New hot water system — the replacement of a depreciable asset such as a hot water system would not be considered a repair for tax purposes. Accordingly, any new system would be capital and constitute a replacement asset?
    • Painting internal surfaces — if the painting involves a full refurbishment, which results in the interiors being changed, updated, upgraded or otherwise improved (i.e. the new asset is different either in form, quality or functionality than the original), the costs would be on capital account and therefore be in breach of the replacement asset rules.  If the painting merely puts the internal surfaces back to the condition that they were in, e.g. before the surface was damaged, the costs should be deductible as repair costs.
    • Replacing emergency lights — as with the hot water system, the new lights would generally be considered to be the replacement of depreciable assets and therefore not repairs.

I understand that issues regarding improvements to the acquirable asset have been discussed with Treasury as a priority technical issue.  We can only be hopeful that the ATO would not apply this very strict approach to real property owned within a SMSF (otherwise some tenants may be having cold showers!!)

  • Properties affected by natural disaster – with the significant impacts of floods, fires and other natural disasters over the past year, it was pleasing to see the Commissioner state that they would use their discretionary powers for a SMSF to retain its complying fund status (section 42A) to repair damaged properties, even where these repairs would constitute a replacement asset.

Refer to my previous post, replacing assets using limited recourse borrowings affected by natural disasters.

  • In-house assets – the ATO has made clear that in their view there will be a breach of the in-house asset rules if legal title is not transferred to the SMSF after the borrowing has ended.  By retaining the asset within the holding/bare trust, it will be an investment in a related trust.
  • Reviews of ATO Interpretative Decisions (ATOIDs) – expect the ATO to revisit ATOID 2010/162 – borrowing from a related party on more favourable terms to the SMSF.  This initial interpretive decision somewhat caught the industry by surprise with its initial views.  Further thought by the Regulator has suggested that they will go back to the drawing board on this ID to consider the arms-length requirements further and the impact of other areas of superannuation law where the SMSF obtains more favourable terms.  Refer to previous article, What interest rate can you charge your fund for a SMSF limited recourse loan?

These are just some of the mounting issues on the ATO’s plate that are needing to be dealt with on the issue of limited recourse borrowing arrangements.  

With an overlay of the Stronger Super support by the Federal Government to review limited recourse borrowing within two years (30 June 2013), it tempers some of the enthusiasm around for using this strategy within a self-managed super funds.  Hopefully we will see some light at the end of the tunnel shortly providing greater clarification to progress forward with this exciting strategy.

Download the SMSF Limited Recourse Borrowing day brochure to find out more information about the strategies and practical issues of using these highly effective arrangements within a Self-Managed Super Fund.

Register for the SMSF Academy Limited Recourse Borrowing day


I am pleased to announce as part of the launch of The SMSF Academy, an accredited training day for professionals on the topic of SMSF Limited Recourse Borrowing Arrangements.

This professional development day will be held in both Sydney and Melbourne.

Bringing together expertise from across the areas of legal, advisory, accounting/tax, lending and SMSF audit, this event provides the most comprehensive and practical training event ever assembled on the use of borrowing within Self-Managed Super Funds.

Borrowing within an SMSF to acquire residential property, commercial property, shares, warrants and managed investments have doubled over the last couple of years and is expected to grow further, with more than 75,000 trustees intending to use geared products within SMSFs.

CPD Points

We are currently in the process of having this event accredited with SPAA for continuing professional development points (which includes recognition for FPA members).  This day will also meet continuing professional hours required for all accounting bodies (CPA, ICAA, NIA).

Event Sponsors

We are pleased to have secured some great sponsors for both events that will add significant value to the day for attendees.  To-date these include Westpac, BGL, Banklink, Business Fitness, AR Group, Tenzing PropertyPractising Tax, NetActuary and Super Sphere.

For more information about this event, including the event brochure and registration details, click on the new SMSF Limited Recourse Borrowing day web page on thedunnthing blog.

Replacing assets using limited recourse borrowings affected by natural disasters


The ATO will exercise its discretion to allow for disaster-affected properties within SMSFs using borrowings to be replaced

It was pleasing to read recently in Investor Daily recently (23 March 2011) the Australian Taxation Office saying that it will use its discretionary powers to provide relief for SMSF trustees with limited recourse borrowing arrangements affected by the recent spate of natural disasters.

According to the article, the Tax Commissioner, Michael D’Ascenzo will use powers provided to him under the Superannuation Industry (Supervision) Act (SIS Act) to allow SMSF trustees to use limited recourse borrowings to repair the fund asset damaged by the disaster in question.

In many instances the type of repairs that are needed would normally be classified as an improvement to the asset or even a replacement asset.  As a result, the rebuilding of assets would be a breach of the requirements contained within section 67B of the SIS Act.

However, the Commissioner has indicated that he was willing to disregard breaches of the replacement asset rules contained within section 67B due to the extraordinary circumstances faced by some individuals.

“In financing repairs or incurring other costs, trustees may need to borrow funds and if trustees contravene the limited recourse borrowing provisions due to the natural disasters experienced Australia-wide, we would be favourably inclined to exercise the commissioner’s discretion under section 42A(5) of the Superannuation Industry (Supervision) Act 1993 to continue to treat the super fund as complying,” D’Ascenzo said.

“We are currently reviewing this matter with APRA (Australian Prudential Regulation Authority) and Treasury to ensure no unintended consequences arise.”

Whilst this is a logical and positive result for SMSF trustees affected by these natural disasters, it appears illogical as to why the replacement rules remain so restrictive to disallow somebody to replace a property that may have been burnt down in a fire?

Whilst discretion isn’t granted lightly by the Commissioner, I believe it does open the door ajar slightly for SMSF trustees to be able to ask for discretion to be applied in the future.

Watch our latest video on borrowing in super


Borrowing in super has become a very popular strategy with self-managed super funds since its introduction back in September 2007.  I see more and more SMSFs using borrowing, but you need to be aware of some of the traps in using this strategy.

When first introduced, superannuation borrowing was done using what was then called an “instalment warrant” which was somewhat confusing and technical.  The super laws changed again from 7 July 2010 and now borrowing inside a super fund is referred to as a “limited recourse borrowing arrangement”.

Even though the laws for borrowing in super changed again in 2010, there were only a few changes that were really significant from the original legislation.

What assets can I buy when borrowing using super?

The answer is simple. Any asset that a super fund can buy for cash it can borrow to buy.

There are four basic conditions when borrowing using super:

  1. The borrowing must be used for the acquisition of an asset;
  2. The asset must be held on Trust;
  3. The borrowings must be of a limited recourse nature and
  4. When the debt is fully repaid the Trustee of the super fund borrower has the automatic right to have the asset transferred.

A limited recourse loan is when if the borrower (the super fund) does not repay its loan, the only asset the lender can sell to get its money back is the asset that has been bought by the super fund borrower. The lender has no claim over the other assets of the super fund borrower.

How the borrowing laws work

When your super fund borrows it must buy “a single acquirable asset”, that is, it must buy one asset only.  However, a collection of identical assets qualifies as “a single acquirable asset”.  For example 1,000 Telstra shares is “a single acquirable asset”; a collection of several different shares is not.

The asset purchased by the super fund using the borrowings must be held on trust as shown in the diagram below:

This bare trust does nothing except hold the asset on trust for the borrowing super fund.  All activities relating to the acquired asset operate from the self-managed super fund.  The bare trust does nothing other than hold the asset on trust.  It does not have a Tax File Number, or an ABN.  All income is deposited into the super fund bank account and all expenses including loan repayments are paid from there to.

Any lending from a party apart from a traditional lender, such as a bank must be conducted on commercial terms (arms-length).

As mentioned earlier, a “limited recourse borrowing arrangement” bare trust structure now only allows for one “single acquirable asset”.  When the asset is repaid, title of the asset passes to the borrowing super fund.  There is no capital gains tax or GST implications for the transfer of this asset to the super fund.  With stamp duty however, you need to be careful as different States have different laws in respect of stamp duty.  It is important that you get the right advice before you proceed with any borrowing strategy.

The lender can only use the “single acquirable asset” as security.  If the borrowing fund does not pay its loan, that is it defaults, then only the single asset can be used to repay the lender.  This is why you will see the banks obtaining a personal guarantee to protect them from any shortfall in the value of the asset in the event of default.

The super fund can repay capital off the loan using:

  • the income from the acquired asset;
  • contributions made by the members of the fund; and
  • other income earned by the fund’s other assets.

A significant change from 7 July 2010 is the ability for a super fund to now be able to refinance an existing debt.

A super fund can borrow from a traditional Bank (there are many financial institutions offering SMSF loan products).  It can also borrow from:

  • the fund members,
  • a company
  • a (family or discretionary) trust
  • a relative or friend

Any lending from a party apart from a traditional Bank must be conducted on an arms-length basis.

A key attraction of limited recourse borrowing arrangements is the ability to buy property.  Many business owners use this strategy to acquire commercial property in which to operate their business from.

There are many other rules that affect borrowing in super.  You can for example borrow to develop property, however the rules around doing this are quite detailed and complex (See article “property development in a SMSF” for further details).

It is important that you seek advice before undertaking any form of limited recourse borrowing to acquire an asset.

Watch more videos on our YouTube Channel, SMSFAcademyTV.

20 things you need to know about undertaking borrowing inside a SMSF to acquire property


 

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Borrowing inside a SMSF has been an attractive option for many people considering the acquisition of property, whether it be commercially (i.e. for their business) or for residential investment.  Whilst SMSF borrowing can be an attractive option to consider, it has a range of important features that people need to be aware of when structuring such an arrangement.

New laws have now taken effect to borrowing inside superannuation from 7 July 2010, including the introduction of section 67A & s67B (repealed s.67(4A)).  For Trustees and professionals, you need to be acutely aware of the relevant Superannuation, Income Tax, GST and Corporations Law requirements (and trust deed) and how they impact any property purchase (or transfer of property) inside a SMSF.

To assist in understand some of these important issues, I have provided a list of 20 items below that need to be considered for a property purchase inside a SMSF.

  1. Your trust deed must allow for the borrowing in accordance with section 67A & 67B (no longer s.67(4A)), in particular that the trustee has power to borrow, grant security & allow assets to be held by custodians/nominees for the trustee.
  2. The trustee of the SMSF cannot be the trustee of the custodian trust (bare trust) – must be a separate trustee.  Would typically recommend a separate corporate trustee to act as the Custodian Trustee.
  3. The Custodian Trustee, Custodian Trust and SMSF must be in existence as at the date of purchase.  In certain circumstances, you may need to find a ‘shelf company’ for the Custodian Trustee to demonstrate that it was in existence at the time of the property acquisition (if property is already acquired).  The Custodian Trust would be dated as at the date of purchase.
  4. The Fund’s investment strategy needs be updated/prepared to consider the risk, liquidity, diversification and ability to discharge assets as and when they fall due.
  5. Need to consider how the loan is to be financed?  Bank loan or BYO banker NB. BYO Banker – you are the lender using existing equity to provide a loan to your SMSF (back-to-back loan).  As a guide, the SMSF is going to have to provide capital of at least 20% of purchase price for residential and at least 30%-35% for commercial.
  6. You need to consider the terms and conditions of the SMSF loan including duration, interest rate, interest only (IO) or principal and interest (P&I), loan-to-value-ratio (LVR).
  7. The Custodian trust is a bare trust.  It does nothing other than hold the property (or asset) for the beneficial owner, being the SMSF.  It does not require an ABN or TFN.
  8. All income generated from the property is deposited directly into the SMSF bank account just as all expenses attributable to the property are paid from the Fund (not by the Custodian Trustee).
  9. The borrowing is a limited recourse loan.  The lender or any other person under the arrangement only has rights in respect to the acquired asset.  All other assets of the SMSF are protected.
  10. The bank can (and will) ask for a personal guarantee in respect to a loan.  The guarantor needs to consider the risks inherent with undertaking such a guarantee.  The guarantor can be a fund member, however any shortfall paid by the member in their capacity as guarantor may constitute a contribution (and count towards the contribution caps)
  11. You can now refinance an existing SMSF loan if you can get a better deal (e.g. interest rate, terms, etc)
  12. You can only acquire one property in the Custodian Trust.  Only the land and building.  No Chattels that may accompany an acquisition (this would require a separate borrowing arrangement).  The law allows only for the acquisition of an “asset” (singular) or collection of identical assets.
  13. You can use borrowings to repair and/or maintain the property, not improve.   However, SMSFR 2011/D1, now confirms that you can improve an asset using existing super fund monies (or own resources where the amount would likely be treated as a contribution.
  14. You cannot obtain borrowings for the development of the property.   This does not constitute a replacement asset.  However, you can consider a limited recourse borrowing to acquire units in a SISR13.22C trust (to acquire property and develop) – see article, “property development using an SMSF Instalment Warrant”.
  15. Borrowed money can be applied to expenses incurred in connection with the borrowing or acquisition (such as loan establishment costs or stamp duty), or expenses incurred in maintaining or repairing the acquirable asset.
  16. Each state has different rules regarding stamp duty on the transfer of the property from the custodian trust to the SMSF.  You should seek expert legal advice on this matter upfront to save yourself potential double stamp duty!!
  17. There is no CGT upon transfer of the asset from the Custodian Trust to the SMSF (as there is no change in beneficial ownership).
  18. The acquired asset can be sold at any time by the trustee.  It does not require the loan to be repaid in full prior to selling the asset.  Proceeds of sale pay off the debt, with the remaining monies being transferred to the SMSF as beneficial owner of the property.
  19. An extension to an original borrowing may or may not constitute a refinance.  You need to consider the nature and extent of the variation and the intention of the two parties.
  20. Terms and conditions relating to a BYO Banker loan arrangement must be done on an ‘arms-length’ basis.  It must adhere to the requirements of s.109 of superannuation law.  Therefore, you would expect a commercial rate of interest on the borrowing.

There is no doubt that there are plenty more aspects to give consideration to when it comes to SMSF limited recourse borrowing arrangements.  Each transaction is unique and has its own peculiarities to consider.  Unlike the establishment of an SMSF, these arrangements are simply not an “off the shelf” solution.

These types of borrowings are gaining momentum and for the consumer it is of utmost important to ensure that the arrangement has been appropriately structured and operating correctly to ensure that it complies with superannuation law.

There is no substitute for obtaining expert advice…

(C) The SMSF Academy 2012
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