Prevailing market conditions can pose problems in acquiring shares using LRBAs


investors

Whilst most of the attention with limited recourse borrowing arrangements (LRBAs) has centred around property transactions, there has been a need to clarify a range of issues on other acquirable assets, in particular assets allowable as a collection of identical assets under the definition of a single acquirable asset (SAA).

It’s not uncommon when placing an order of shares that there may be insufficient volume at a particular price to acquire shares or units.  This is particularly common where the shares are to be acquired at the prevailing market price.  This results in the single order being ‘filled’ over multiple share prices or even different dates.   This however poses a problem for those undertaking any share acquisitions using a limited recourse borrowing arrangement, because of the strict interpretation of a collection of assets” within the single acquirable asset as defined within s67A(3) of the SIS Act.

The question was asked of the ATO recently (via National Tax Liaison Group (NTLG) Superannuation Technical sub-group, September 2012) as to whether a single order of shares filled over multiple prices or dates will still meet the definition of a single acquirable asset.

To understand the issue, let’s consider the following example:

ABC Super Fund enters in a LRBA to acquire #42,500 shares in NewCo Limited at the prevailing market price. This single order is undertaken by the trustees through their CommSec account.  Due to the share volumes available at the time of the order and movement in the prevailing market price, the purchase of the shares were completed in three tranches:

  • 01/10/2012 – #30,000 @ $4.70
  • 01/10/2012 – #10,000 @ $4.72
  • 02/10/2012 – #2,500 @ $4.67

Have we got a problem?

It is important to note that the policy intent around the changes introduced on 7 July 2010 were to prevent borrowing arrangements over multiple assets in which may permit the lender to choose which assets are sold in the event of default.   Whilst a strict interpretation of s67A would mean this transaction would fail as a single acquirable asset, the ATO has stated that in circumstances such as these, they are prepared to ignore short delays in fulfilling a single on-market order to purchase shares or a single on-market order at the prevailing market price which might result in some shares being acquired at different prices.

For the trustees of the ABC Super Fund, the ATO would allow these this single order to be filled over multiple transactions, given the short timeframe to fulfil the order (based on the prevailing market conditions).

Whilst providing a logical outcome for fund trustees, the Regulator has also made it abundantly clear that it will not allow trustees to embark on a course of action to accumulate or sell down shares as an acquisition of a ‘single acquirable asset’.

Do you see much activity with LRBAs to acquire assets other the property?

Alarms bells ringing with ATO around property investing in SMSFs


After only just discussing the regulatory focus by ASIC on SMSFs and property investments, we have seen further regulatory “alarm bells” ringing through the ATO’s release of taxpayer alert, TA 2012/7.  A Taxpayer Alert is an “early warning” of significant new and emerging higher risk tax and superannuation planning issues or arrangements that the ATO has under risk assessment, or where there are recurrences of arrangements that have previously been risk assessed.  With the growing amount of ‘hype’ in the use of these type of strategies, the alert is a timely reminder to ensure such arrangements comply with the strict nature of superannuation law.

It is often lost in the conversation, that borrowing is ordinarily prohibited in superannuation.  Limited exceptions apply, with the ability to enter into a limited recourse borrowing arrangement for prescribed purposes.  The specific purpose of the borrowing must be for the acquisition of a ‘single acquirable asset’.  To say ‘near enough is good enough’ simply won’t cut it when it comes to compliance with these requirements.  Failure to comply with sections 67A & 67B of the SIS Act, will mean that any maintenance of the loan will be in breach of the borrowing provisions.  With an inability to sell a brick-at-a-time, the unwinding of these arrangements can be difficult, and potentially expose the fund to a significant loss on a forced sale.

What problems are the ATO seeing with property investments using LRBAs?

  • The borrowing and title of the property is held in the individual’s name and not in the name of the trustee of the holding trust.  The SMSF has paid the deposit and ongoing repayments;
  • The title of the property is held by the trustees of the SMSF, not the trustee of the holding trust;
  • The trustee of the holding trust is not in existence and the holding trust is not established at the time the contract to acquire the asset signed;
  • The SMSF acquires residential property from a member;
  • The acquisition comprises two or more titles and there is no physical or legal impediment to the two titles being dealt with, assigned or transferred separately; or
  • The asset is a vacant block of land, with the intention to construct a house on the land.  The land is transferred to the holding trust prior to the house being built.

These problems throw up a whole range of compliance concerns, including:

  • potential breach of the sole purpose test in section 62 of SISA;
  • failure to comply with section 67 which prohibits a SMSF from borrowing money or maintaining a borrowing;
  • the acquired asset not meeting the single acquirable asset definition under section 67A(2) as it comprises two or more proprietary rights;
  • the acquirable asset is subject to a charge which would prohibit the fund from borrowing money or maintaining a borrowing of money under section 67A(1)(f); and
  • where the title is incorrectly held in the name of the individual and not the trustee of the holding trust, the deposit and/or loan repayments may breach the payment standards, effectively drawing on preserved benefits prior to meeting a cashing condition.

As highlighted by the Commissioner, there is a lot of talk about the benefits of limited recourse borrowing in super, but not a lot about the risks.  It is important to remember, responsibility ultimately rests with the trustees to comply with superannuation law.  Ensuring that the fund’s governing rules allow for borrowing (and assets to be held in a custodian arrangement), and that the decision is consistent with the fund’s investment strategy are all critical elements to ensure compliance.  Failure to do so, can render the fund non-complying, effectively meaning the fund is subject to a 45% tax rate which is applied to its income and market value of fund assets (other than undeducted contributions).  Furthermore, civil and criminal penalties could also apply.

Related trust arrangements

The taxpayer alert also highlights a range of concerns around the use of related unit trust structures to acquire property.  Once the ‘darling’ of the SMSF sector, the use of unit trusts has somewhat diminished with the inability to typically leverage inside these trusts, nor put a charge over the assets of the trust.  These strict requirements are outlined within SIS Regulation 13.22C.

The ATO concerns with these arrangements appear to stem from investments that are failing to adhere to the requirements of SISR 13.22C and subsequently become in-house assets under section 71 of SISA, thereby counting towards the allowable 5% limit.

It is not to say these strategies don’t provide some fantastic outcomes for individuals, but the decision process to establish a SMSF and consider acquiring property is not something to be taken lightly.  These alerts and investigations by the Regulators highlight the need for “buyer-beware” when it comes to property in SMSFs.

 

Final ruling provides good news for SMSF property investing using borrowing


If the industry was pleased about the draft ruling on limited recourse borrowing arrangements (LRBA), the final ruling, SMSFR 2012/1 has done nothing to wipe the smiles off trustee & industry faces.  The ATO has taken a practical approach in this ruling to key concepts including:

  • What is an ‘acquirable asset’ and a ‘single acquirable asset’
  • ‘maintaining’ or ‘repairing’ the acquirable asset as distinguished for ‘improving it’; and
  • When a single acquirable asset is changed to such an extent that it is a different (replacement) asset

Much of the industry feedback for the final ruling was to add further clarity and practicality to assist trustees and professionals alike to understand these key concepts.  Broadly, I think this ruling has achieved a more than satisfactory outcome for the specific issues.  There does however remain a range of outstanding issues that further clarification, including in-house assets, the concept of the holding trust vs. bare trust amongst others.

I have provided below a summary of my views from the final ruling, SMSFR 2012/1: Limited Recourse Borrowing Arrangements – application of key concepts:

Single Acquirable Asset

The final ruling has expanded on its initial views regarding the need to consider both the legal form and substance of the acquired asset, having regard to both the proprietary rights (ownership) and the object of those rights.  It explains that it may be possible to for an asset to meet the single acquirable asset definition, notwithstanding that the object of property comprises of separate bundles of proprietary rights (e.g. two or more blocks of land).

The final ruling further outlines factors relevant in determining if it is reasonable to conclude that what is being acquired is a single object of property.  These include:

  • the existence of a unifying physical object, such as a permanent fixture attached to land, which is significant in value relative to the overall asset value; or
  • whether a State or Territory law requires the two assets to be dealt together.

Where the physical object situated across two or more titles:

  • is not significant in value relative to the value of the land; or
  • is temporary in nature or otherwise able to be relocated or removed relatively easily; or
  • a business is being conducted on two or more titles; or
  • the assets are being acquired under a single contract because, for example, the vendors wish to ‘package’ the assets

will mean that these assets will remain as being distinctly identifiable and not be identified as a single object of property.

Repairs, maintaining and improvements

The most pleasing aspect of reading the final ruling was the removal of any references to TR97/23, which from a tax perspective deals with repairs vs. improvements. Importantly, in distinguishing between repairs, maintaining and improving, the Commissioner applies their ordinary meaning having regard to the context in which they appear within s67A & s67B of the SIS Act.

The ruling provides a variety of practical illustrations that demonstrate what is a repair or maintenance (where borrowings can be applied) versus what would amount to an improvement (where borrowings can not apply, however the fund or member’s own resources can be applied for any improvement). In particular, the Commissioner has clearly indicated that restoration or replacement using modern materials will not amount to an improvement. The lines may be blurred somewhat if superior materials or appliances are used, how it would be a question of degree as to whether the changes significantly improve the state or function of the asset as a whole.

This distinction of repairs, maintaining and improving is critical because we must remember that borrowed funds can only be used for prescribed purposes – being the acquisition of a single acquirable asset, including expenses incurred in connection with the borrowing or acquisition, or in maintaining or repairing the acquirable asset. Where improvements are made with borrowed funds, this is a breach of not only the s67A exception, but then any maintenance of a borrowing beyond this becomes a breach of s67(1) (general borrowing prohibition).

In general terms, any improvements made to property where the single acquirable asset was for example the residential house and land is allowed whilst carrying a limited recourse loan, but only to the extent that it doesn’t become a different asset. For example, the addition of a pool, garage, shed, granny flat, additional bedroom, or second story are all allowable improvements without changing the character of the asset where it becomes a different asset (breaching the replacement asset rules in s67B).

Different (replacement) asset

It is important that the single acquirable asset is not replaced in its entirety with a different asset (unless covered under s67B).  When considering the object and proprietary rights of the asset, any alterations or additions that fundamentally changes the character of that asset will result in a different asset being held on trust under the LRBA.

The ruling provides a range of examples as to when an asset become a different asset including through subdivision, a residential house built on land, and change of zoning (residential to commercial).  There are however various examples that demonstrates that where such improvements don’t create a different asset, including:

  • one bedroom of house converted to home office
  • house burnt down in a fire and rebuilt (regardless of size) using insurance proceeds and SMSF funds
  • compulsory acquisition by government on part of property; and
  • granny flat added to back of property

Property development

When it comes to the use of a LRBA for the development of property, the ruling provides clarity around the importance of the terms of the contract of purchase as to what will constitute the single acquirable asset.   For an off-the-plan purchase (as was stated in the draft ruling), if a contract was entered into and under the contract a deposit was payable with the balance payable on settlement after being built and strata-titled, this is allowable under a LRBA (as the strata-titled unit is the single acquirable asset).  It is noted that a separate car park or furniture package will not meet likely be packaged into the single acquirable asset and require a separate (or multiple) LRBA.

The Commissioner has expanded his views further in the final ruling that a similar outcome occurs if the contract entered into is for the purchase of a single title vacant block of land, along with construction of a house on the land before settlement occurs.  Where the deposit is paid upon entering the contract and the balance payable upon settlement is applied for the acquisition, it may be funded by a single LRBA as the single acquirable asset is the land with a completed house on it.  Examples 9 and 10 within the ruling outline the important differences how house and land purchases need to be structured to meet the single acquirable asset definition.

Summary

In my view, the end result is a positive one for property investors within self managed super funds.  The scope available for improvements certainly makes this strategy appealing as well.  Fundamentally though, you need to ensure that the investment will stack up being held inside superannuation…

It will be interesting to watch the changing landscape of borrowing in super as the impact of this final ruling and the proposed licensing obligations on these arrangements unfold over the coming months…

 

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.

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.

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