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.

 

Have SMSFs become the target of property spruikers?


I read with great interest recently in the Australian newspaper, an article titled “Setting up an SMSF to buy property a risky strategy” (13 November 2012) regarding ASIC commissioners Peter Kell and Greg Tanzer focusing a taskforce on aggressive marketing of speculative property developments with SMSF limited recourse borrowing arrangements.

Whilst there appears to be a lot of ‘hype’ around SMSF borrowing arrangements, it has highlighted the lack of a Government response to introducing these arrangements into the financial services licensing regime.  It was June 2010 when Treasury released its first consultative paper around licensing and bringing these arrangements under the financial consumer protection framework.  A further consultation occurred in February 2012 and now nearly two and a half years later the industry is still waiting.   The consensus from submissions generally supported bringing these rules into the licensing framework to avoid the situations highlighted in the newspaper article.

So to the Regulators, I commend you in targeting those looking to make a quick buck from consumers with borrowing in super, but let’s get a regulatory framework in place to ensure we have the right licensing framework and regulatory protections.  I just hope this doesn’t put a nail in the coffin for the use of SMSF limited recourse borrowing arrangements…  I kind of believe the framework around the legislative definitions and operation of such arrangements was heading down the right track!

Do you think SMSF borrowing will be hear to stay?

 

Launching the Top10 SMSF strategies for 2012-13


I’m pleased to announce the launch of my Top10 SMSF strategies for 2012-13 webinar to be held at 11am AEST, Thursday, 23 August 2012.  With more than 410 attendees to last year’s session, this is the most anticipated SMSF webinar for 2012!!

In addition to the webinar, all attendees will receive a free copy of the Top10 SMSF strategies eBook, which will be available in flip-book for the first time, allowing for users to read on PC, iPad, iPhone and android devices.  Last year’s eBook had more than 1,000 downloads, with this year’s book providing more than 70 pages of content on each strategy, their the key issues and considerations when implementing.

This year’s Top 10 includes a diverse range of strategies across the entire life-cycle of SMSFs – from contributions, to investing including using borrowings, running pensions, reserves and estate planning.  This year sees a growing emphasis to pension strategies as more baby-boomers move into draw-down phase in their SMSFs.  There are however some fantastic strategy opportunities right across the superannuation spectrum for both accumulators and retirees.

Find out more and register

Numbers are strictly limited. 

I look forward to you joining me for this session.

Sponsors

Proudly supported by the following sponsors:


   

How the Commissioner’s views on borrowings could spark a property developer’s frenzy on SMSF trustees


It quite amazing how far we have come with limited recourse borrowing arrangements over the nearly 2 years since changes were introduced on 7 July 2010.  Many people would recall at that time of the introduction of sections 67A and 67B into the SIS Act that many within the industry were highly critical of the very strict limitations that appeared to be imposed with the single acquirable asset definition, along with the supposed inability to make any changes to a particular asset held under such a borrowing arrangement.

The final SMSF ruling, SMSFR 2012/1 on the application of key concepts with limited recourse borrowing arrangements has certainly seen this view come full circle as the practical approach taken by the Commissioner within this ruling provides both clarity and some exciting opportunities for the acquisition of real property within a self managed super fund.

With the property market facing its own challenges in respect to attracting buyers, we have seen a shift with property developers looking to target the SMSF market to promote property to trustees as part of their fund’s investment strategy.  The original draft ruling issued in September 2011 provided clarity around the ability for a fund to acquire off-the-plan apartments, where the borrowing arrangement was entered into at the time the property was completed and strata-titled.  It appears that the final ruling, SMSFR 2012/1, has expanded the Commissioner’s view in respect to how a LRBA can be entered into to acquire property to be developed (whether an off-the-plan apartment or house and land).

So what has changed from the draft ruling to the final ruling in respect of property development?

The draft ruling discussed that a borrowing could only be entered into for an off-the-plan purchase once the property had been completed and strata titled.  This meant that the SMSF was required to fund the initial deposit and then obtain the SMSF limited recourse loan for the completion of the property.  This view appears to have slightly changed within the final ruling whereby, if a contract is entered into for an off-the-plan purchase of a strata titled unit (that is, the purchase of a unit that is yet to be built and strata titled) and under the contract a deposit is required upon entering into the contract with the balance payable at settlement after the unit is built and strata titled, each payment is applied for the acquisition of that strata titled unit.  Providing that the strata titled unit is a single acquirable asset, the deposit and the balance payable at settlement may be funded under a single LRBA.

The final ruling also expands in the construction of a house on land through the use of a limited recourse borrowing arrangement.  Previously it has been the understanding that when it came to the development of house and land, the draft ruling inferred that the land was the single acquirable asset and once a property is added it becomes a different asset (replacement), which is not permitted under section 67B.  Whilst this to some extent remains true, the final ruling outlines that a similar outcome results (to a OTP apartment) if the contract entered into is for the purchase of a single title vacant block of land along with the construction of a house on that land before settlement occurs.  In this situation the deposit paid upon entering into the contract and the balance payable upon settlement is applied for the acquisition, under that contract, of land with a completed house on it. The deposit and the balance payable at settlement may be funded under a single LRBA.

The ruling provides two examples of how structuring the purchase of house and land will ultimately dictate what is a single acquirable asset:

Purchase of land and construction of house using borrowings

The trustees of an SMSF want to enter into a LRBA where the single acquirable asset is a vacant block of land.  The SMSF intends that the borrowing will provide sufficient funds for the construction of a house on that block. Assuming that title to the vacant land transfers to the holding trust prior to the house being built, it is the vacant land that is acquired and held on trust under the LRBA .  This arrangement will cease to satisfy the requirements of section 67A if money borrowed under the LRBA is subsequently used to construct the house and thus improve and fundamentally change the character of the asset held on trust (that is, from vacant land to residential premises ).  This outcome is not altered even if the contracts entered into for the acquisition of the land and the construction of the house contain clauses linking the two contracts .

Acquisition of a yet to be constructed house on land using borrowings

The trustees of an SMSF want to enter into a contract to acquire, as a ‘package’, land with a yet to be constructed house on it and to fund the acquisition using borrowings under a LRBA. As the contractual arrangement is for the acquisition of land with a completed house on it, and settlement occurs once construction of the house is finished, the deposit and the payment on settlement can be funded under a single LRBA .

It is the Commissioner’s view that the second arrangement is for the acquisition of a single acquirable asset, being the land with the house constructed on it, as distinct from the first where the single acquirable asset is the land only.

The view’s expressed within this final ruling certainly open the doors for SMSF trustees to consider a greater range of new property development opportunities using limited recourse borrowing arrangements.  I think it would be fair to say property developers will certainly be ready and waiting.

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…

 

(C) The SMSF Academy 2012
%d bloggers like this: