ATO provides clarity for SMSF limited recourse borrowing arrangements

Today has seen the release of the most anticipated ATO Ruling impacting superannuation for the year, with the issuing of draft SMSF Ruling, SMSFR 2011/D1.  This ruling addresses key concepts for limited recourse borrowing arrangements.

Most importantly, there are some ‘good news’ stories within this SMSF Ruling, with clarity being provided around the contentious issues of:

  • what is an ‘acquirable asset’ and “single acquirable asset’;
  • distinguishing between repairs and improvements; and
  • what constitutes a replacement asset.

The industry since the introduction of sections 67A and 67B is SISA from 7 July 2010, has argued that the strict interpretive view taken by the Regulator defining the acquired asset by its legal boundaries was too narrow and that it needed to consider the ‘economic substance’ of the asset.  Whilst not adopting this or other alternative views submitted from within the SMSF industry, the ATO’s interpretation within this ruling considers both the legal form and substance of the asset acquired.  As a result, this SMSF Ruling provides some real positives for limited recourse borrowings in respect to real property, in particular around improving the asset using cash from within a SMSF.

Single Acquirable Asset

It is the ATO view within the SMSF Ruling that where an asset can be dealt with separately, this will mean it is more than one asset for the purposes of the LRBA provisions.  The fact that someone wants to deal with the asset as a ‘package’ does not mean it is a single acquirable asset.  An exception however would be where laws of a State or Territory prevent the assets being dealt with separately.

The following within SMSFR 2011/D1 outline what does constitute a ‘single acquirable asset’ in accordance with section 67A (in addition with what we already know around land & buildings):

  • a factory or office building on more than one title;
  • off-the-plan apartments where the borrowing commences upon property being completed and strata-titled;

The following however does not meet the ‘single acquirable asset’ provisions and would require multiple LRBA arrangements:

  • Two or more adjacent blocks of land wanting to be sold together;
  • Farmland with multiple titles;
  • A house built in-situ
  • Apartment with separate car park (unless titles cannot be assigned or transferred separately);
  • Furnishings required to be purchased with serviced apartment
The ATO will only consider more than one asset to be a ‘single acquirable asset’ where the asset(s) cannot be sold separately (not by choice of the vendor and/or purchaser) or where there is any State or Territory law that be contravened by being sold separately.
The practical implications of this view appears to hit farmland more than any, where multiple titles are common.  The cheaper solution may be to consolidate titles before acquisition, rather than setting up multiple LRBA arrangements.   I think we’ll hear a fair bit more on this topic…

Repairs, Maintenance & Improvements

In what is a real positive for this legislation, the ATO have confirmed that money other than borrowings can be used to fund improvements (or for repairs or maintenance).  This includes using cash within the SMSF to undertake the improvements.  However, any improvements must not result in the acquirable asset becoming a different asset (replacement asset, s67B of SISA).  Conversely, any improvements undertaken with borrowed money is no allowed and a breach of subparagraph 67A(1)(a)(i).

This change to a ‘single acquirable asset’ is a question of fact and degree of the particular circumstances.  For example, a property may have been replaced entirely, altered to an extent that it now has a different purpose or function, the proprietary rights have changed, or altered in a way in which a single acquirable asset no longer exists (e.g. subdivided).

The ruling states that an asset can be acquired with a borrowing which is defective, damaged or suffering some deterioration.  This provides an ability to undertake ‘initial repairs’ (or restoration); however, the greater the state of deterioration of the asset at the time of acquisition using a LRBA, the more likely the changes will be regarded as a different asset (e.g. replacing broken windows vs. renovating a ‘run-down’ house).  It is therefore important to consider the asset’s qualities and characteristics at the time the SMSF entered into the LRBA.

The ATO uses various examples within the Ruling to demonstrate the difference between repairs and improvements for section 67A of SISA, along with where a change to a single acquirable asset becomes a different asset (replacement asset).

The following are allowed as improvements without resulting in a different asset:

  • An addition of a new pool or new garage;
  • The addition of a second story on a house, rather than simply replacing a roof;
  • With farmland, additional fencing, dams, bores or tanks were installed;
  • A house burnt down by fire and re-built with insurance proceeds (restored as the same asset)

These improvements must all be undertaken with monies other than borrowings used to improve the asset.  Borrowings cannot be used to improve the single acquirable asset (but the fund’s own cash can).

The following however are not allowed as they would result in a different asset:

  • Subdividing a vacant block of land;
  • Renovating (i.e. bathroom) using borrowings;
  • Developing a vacant block of land;
  • Demolishing a house and building 3 x townhouses;
  • Rezoning of an asset from residential to commercial (or vice versa);
  • A house burnt down by fire but constructed a different type of building (e.g. two units)

For the above ‘different assets’, you still have the ability to use a SIS Regulation 13.22C related trust arrangement to undertake some of these activities.  The SMSF is the contributor of the capital with cash and borrowings, with the ungeared unit trust being the purchaser & developer.

These draft views expressed by the ATO provide us with some much-needed guidance in this growing area of the self-managed super fund sector.  Clarity around a range of issues that were frustrating both trustees and professionals within the SMSF industry can now move forward with some comfort.

NB.  It is important to remember that this is a draft ruling currently available for public comment and represents the Commissioner’s preliminary views on limited recourse borrowing arrangements.  Comments are available to be made on the draft Ruling until 28 October 2011.

Access the ATO Ruling, SMSFR 2011/D1

I would be interested to hear readers thoughts and comments on this draft SMSF Ruling…

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.

Setting up a Self Managed Super Fund

After making the decision to setup a self-managed super fund, there are a range of important decisions and steps about how to structure and operate your fund to get it started.

When setting up a self-managed super fund, you take on the role of either a trustee or director of a company which acts as the trustee of your fund.  A trustee is a person or company that holds and invests the fund’s assets for the benefit of each member’s retirement.  You have the choice when establishing a self-managed super fund to have individual trustees or appoint a company to act as the trustee.

More than 70% of all self-managed super funds are established with individual trustees, with more recent statistics showing only 10% of new funds being setup with a corporate trustee.

It is a commonly held view that a corporate trustee is a far superior trustee structure within a SMSF, which was recently supported in the recommendations to government in the Super System Review.  Further information on this topic can be founding in my article, “which trustee structure is right for me?”

As a trustee or director, you are responsible for running the fund and making decisions that affect your retirement interests and that of each member. Therefore, you must act in the best interests of all fund members when making decisions, ensuring that the fund is managed separately from your own affairs and that the money in the fund is only accessed when the law allows you to do so, such as in retirement.

There are some important considerations when setting up a self-managed super fund, including deciding on whether each member will act as individual trustees or a company act as trustee in which you and the other members will be directors.  You also need to ensure that you are eligible to act as a trustee; therefore you can’t be:

  • a bankrupt,
  • someone charged with a dishonesty offence; or
  • have been subject to superannuation law penalties.

Furthermore, you must ensure that the fund meets the residency requirements to be a complying fund and receive tax concessions.

A self-managed super fund is allowed up to 4 members, with each member required to be a fund trustee or director.  This requirement is to promote engagement and equal responsibility amongst all members of the fund.  In addition, no member can be an employee of another member, unless they are related and finally no trustee can be paid for their duties or services as being a trustee.

It is possible to setup a self-managed super fund as a single member fund. Where the fund has a corporate trustee, you can also be the sole director of a trustee company.  Alternatively you must be only one of two directors ensuring that the other director is either related to you or is not employed by you.   Where you wish to have individual trustees, you must have two trustees in which in addition to you, must include a person you are related to or is not employed by you.

The process to setup a SMSF

The setup of a SMSF requires a range of steps to be completed to start operating your fund.  The first step is to arrange for a trust deed to create the fund.  This is the “book of rules” that will govern its operation and will include rules around acting as a trustee, membership, contributions, benefits and anything else to do with the fund.  The preparation of the book of rules is prepared by a lawyer who will draft the necessary rules for you.  This may be a standard set of rules or may require tailoring to meet specific requirements of the fund members.

The fund will also be required to appoint fund trustees, which must be consented to in writing.  You as a trustee will need to sign a trustee declaration within 21 days of becoming a trustee or director, stating that you understand your duties and responsibilities as a fund trustee or director of the corporate trustee.  You will need to complete for various registrations with the Australian Taxation Office to not only become regulated, which must be done within 60 days, but to also apply for a Tax File Number (TFN), Australian Business Number (ABN), along with potentially requiring additional registrations including GST and Pay-As-You-Go withholding (PAYGW).

You must apply to become a member of the fund and once accepted have the fund record your tax file number to ensure that it can accept certain contributions.

You will be required to setup a bank account for your self-managed super fund to manage the fund’s operations including accepting contributions, making investments, receiving investment income and pay all fund expenses and liabilities.  It is important that the super fund bank account is kept separate to any individual or business bank accounts that you may have.

Once the fund is legally established, it is important that an investment strategy is prepared that sets out the investment objectives and how you plan to achieve them, having regard to issues including diversification, risk and likely return from investments, liquidity of fund assets, the ability to pay benefits as and when they fall due, such as in retirement and generally meeting the member’s needs and circumstances.

You may wish to engage a licensed financial adviser to help you prepare an investment strategy, but you (and the other fund trustees) are responsible for managing the fund’s investments.   It is important that an investment strategy is documented to ensure that you can evidence your investment decisions and show that they comply with the law.

In addition, as the fund gets underway, you should give appropriate consideration to the appointment of professionals including an approved auditor, accountant or fund administrator, lawyer and financial adviser.  They will be able to assist in a variety of areas including the ongoing reporting requirements, insurance needs of the members and any death benefit nomination which sets out who receives your super benefits in the event of death.

Setting up a self-managed super fund gives you the opportunity to actively manage your own super and make your own investment choices, but with it comes responsibility.  Regardless of whether someone takes a more active role within the fund, each trustee or director is equally responsible.

Watch more of our videos on The SMSF AcademyTV.

(C) The SMSF Academy 2012
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