Borrowing and SMSFs - Australian SMSF provider · • The SMSF is looking to borrow $600,000 using...

Borrowing and SMSFs

Agenda

What is SMSF Limited Recourse Borrowing?

Single Acquirable Asset/Replacement Asset

Repairs and Improvements

SMSF Borrowing Strategies

SMSF Borrowing Steps

Alternatives to SMSF Borrowing

Services to support SMSF Borrowing

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What is Limited Recourse Borrowing?

• Money borrowed is used to acquire a single asset or group of identical

assets.

• Acquired asset is held in trust and SMSF receives beneficial interest and

right to acquire legal ownership by making one or more payments.

• The lender and/or any other person has limited recourse against the

SMSF trustee.

• The amount that can be recovered is limited to the value of the acquirable

asset.

• The asset is one that can be acquired by the SMSF.

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Example

• Steve’s SMSF has $2,000,000 in assets and is looking to purchase an

investment property in line with the fund’s Investment Strategy.

• He arranges for his SMSF to borrow $1,000,000.

• The SMSF buys a $1,500,000 commercial property with $500,000 of its own

funds and $1,000,000 of borrowed funds.

• The title to the property is held in the name of the Holding Trust Trustee.

• Rental income is paid to the SMSF.

• The SMSF makes loan repayments to the bank.

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The following diagram outlines the typical structure:

Holding Trust

SMSF Lender

Borrowed money added to

SMSF money

Asset

All income and capital

gains paid to SMSF

Lends

funds to

SMSF

Security held

over security

trust assets

SMSF repays lender

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What assets can be acquired?

• An asset must be a ‘single acquirable asset’ and one that is not prohibited

under superannuation law.

• For example, the asset may be:

– Listed securities

– Commercial property

– Shares in private companies

– Residential property

– Units in a unit trust

• An asset can be acquired from a related party, provided it comes under one

of the exceptions in the SIS Act.

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What is a Single Acquirable Asset? • Shares in one company – i.e. BHP, but cannot be shares in a collection of

companies.

• Property on one title.

• Unless there is a legal and/or physical impediment that means the property

on more than one title must be deal with as a single asset.

• Therefore property on several titles can be treated as a single acquirable

asset if there is a legal impediment to selling them separately or there is a

physical impediment to selling them separately.

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Acquire a Single Asset

Example - Apartment with separate carpark:

• The trustee of an SMSF wants to enter into a LRBA to purchase an

apartment with a separate carpark.

• The apartment and carpark are each on a separate title.

• The laws of the State in which the apartment is located do not allow the two

titles to be disposed of separately.

• As the two titles cannot be assigned or transferred separately, the

apartment together with the carpark is a single acquirable asset.

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Replacement Asset • Current rules are very strict and limit what is an acceptable replacement

asset:

– Shares in a company or units in a unit trust that are identical to the

original and have the same market value.

– Shares that are issued as a result of a fully paid up instalment receipt.

– Shares in a company or units in a unit trust replaced by others due to

takeover, merger, demerger or restructure.

• The concept of replacement generally only applies to shares and units

in a unit trust and NOT to property investments.

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Acquire a Single Asset

Example – Company Takeover:

• Company B acquires all the shares in company A in a Takeover.

• All shareholders in company A are issued with shares in company B on a

one for one basis.

• This would satisfy the requirements of s67B(5)(a)(i) and s67B(5)(b)(i) .

• However if the takeover involved shares and cash, this would not be a

suitable replacement asset.

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Repairs Allowed • The repair of a property would not be considered the replacement of that

property.

• From ATO SMSFR 2012/1:

• “An asset may be acquired in a state in which a part of the asset is defective,

damaged or suffering some deterioration of what would be considered to be

its normal level of function. Restoration of that part of the asset is a repair for

LRBA purposes if similar, or modern equivalent, materials are used”.

• Restoring something to its original form and function will not contravene the

borrowing rules.

• Borrowed monies can be used to undertake a repair, but one needs to be

mindful the repair is not considered an improvement.

• Run down buildings that are substantially renovated could be

considered an improvement of property.

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Repairs Allowed

Example - Renovation of property using borrowings:

• The Yeung Super Fund is purchasing a residential property using a

borrowing arrangement for $750,000 including costs.

• The old kitchen is removed and a new kitchen is installed using borrowed

funds.

• So long as the new kitchen is essentially the same in form and function, it is

considered a repair, not an improvement.

• Therefore under s67A of the SIS Act the borrowing arrangement could be

used to fund the kitchen repair.

• The greater the state of deterioration, however, the greater the

likelihood alterations/restorations will be considered an improvement.

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Improvements

Improvements Allowed

• But only so long as they do not fundamentally change the character of an

asset.

• Cannot be paid for with borrowed monies (SIS Act s67A(1)(a)(i)).

• But an SMSF can use its own cash resources to pay for improvements as

per SMSFR 2012/1.

• But the improvement cannot change the legal nature of the asset or it

may be considered a different asset.

• A property asset cannot be replaced.

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Improvements

Example of improvement – using the fund’s own money

• The Gardener Super Fund enters into a LRBA to purchase a house.

• The fund wants to improve the house by building a new garage and

installing a swimming pool.

• The fund pays for these improvements using its own resources.

• Whilst this is an improvement, it is not a new asset:

• “The improvements listed would not result in a different asset as the

changes do not fundamentally alter the character of the asset or the

proprietary rights held under the LRBA”.

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Improvements

Example - different type of building

• A four bedroom house subject to an LRBA is demolished.

• The SMSF applies for council approval to have the land sub-divided, and

two units built on separate titles.

• The construction of the two units on the land fundamentally alters the

character of the land and house that existed at the time when the LRBA

was entered into.

• Consequently, the original asset, being the land and the four bedroom

house, has been changed.

• The asset is now dual occupancy dwellings resulting in a different asset.

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‘Off The Plan’ Purchases

• Can borrow to purchase ‘off the plan’.

• SMSFR 2012/1 expressly allows for this.

• Amount paid by SMSF trustee to secure purchase of an apartment ‘off the

plan’ is not borrowing.

• The payment is not a separate asset from the actual purchase (i.e. this is

not an option to buy the apartment).

• LRBA does not come into effect until asset is completed (the acquirable

asset).

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SMSF Borrowing Strategies Example:

• The Aurora SMSF pays $65,000 (10% deposit) to developer to buy an ‘off the

plan’ apartment in August 2011.

• Trustees speak to Lender who agrees on completion to lend money to SMSF

to settle purchase.

• In May 2013 the development is finished and the apartment is strata titled

and ‘certificate of occupancy’ issued.

• In July 2013 the SMSF secures finance from a Bank for a LRBA to settle

purchase.

• In August 2013 apartment settles.

• OK as per paragraphs 64 and 65 of SMSFR 2012/1.

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SMSF Borrowing Strategies Can SMSF borrow to undertake property development?

• No – contrary to s67A(1)(a)(i) and paragraphs 66 and 67 of SMSFR 2012/1.

Example

• An SMSF borrows to buy a vacant block of land.

• As part of the LRBA the Trustees want to construct a house on the block of

land.

• As the house does not exist building the house will alter the physical aspects

of the original acquirable asset – that being vacant block of land.

• Therefore the borrowing rules have been contravened and the arrangement

will need to be unwound.

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SMSF can borrow to buy units in a related unit trust

• Superannuation Legislation and Regulations allow an SMSF to invest in a

related unit trust (s66(2A)(a)(iv) and s71(1)(j)(ii)).

• The unit trust would need to comply with Regulation 13.22C.

• The SMSF trustee could borrow to acquire units in related non-geared unit

trust.

• Unit trust trustee uses cash to buy land.

• Unit trust trustee uses remainder of cash to develop land.

• These LRBAs would most likely be related party loans.

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Case Study

• The ABC SMSF is looking to purchase a $1.2m commercial property.

• The purchase price is $600,000 and development will be $600,000.

• The ABC SMSF has $600,000 in cash.

• The SMSF is looking to borrow $600,000 using a Limited Recourse

Borrowing Arrangement through superannuation.

• A related party of the fund uses non-super assets as collateral for

borrowings and on-lends the $600,000 to the SMSF.

• A unit trust is established to buy the $600,000 property and develop it.

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Lender

SMSF

$1.2m Property

Development

Holding Trust

Loan to related party of

SMSF

Mortgage over non-super

assets

Loan of $600,000 to fund

$1,200,000 ($600,000 own

money and $600,000

borrowed)

Income and capital

gains paid to SMSF Unit Trust

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Is this allowed?

• YES – this arrangement would be permitted under the provisions of s67A of

the SIS Act as a loan has been made to the SMSF for the purposes of

acquiring units in a unit trust which owns ungeared property.

• The operation of the unit trust would need to meet the requirements of

Division 13.3A of the SIS regulations as they relate to ungeared property

investments.

• This would require the property to remain ungeared to satisfy those

requirements.

• The security offered to the bank by the borrowers would need to include

property other than that owned by the unit trust.

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• This arrangement could also be used where it is decided not all assets are

to be tied up in superannuation.

• The super fund and a related party could buy units in the unit trust.

• The SMSF could acquire units from the related party.

• The acquisition of units from a related party of the SMSF is permitted by

s66(2A).

• Section 66(2A)(a)(iv) provides an exception under s71(1)(j) to acquisition of

assets from related party – being Reg 13.22C.

• The units would need to be acquired at market value and there may be

Stamp Duty and CGT implications.

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Can another structure be used for a property development?

• Yes - another option is to invest in an unrelated geared unit trust.

• Would need to ensure the unit trust is not a related party or group in relation

to a member of the SMSF controls the trust.

• If an unrelated unit trust Reg 13.22B and 13.22C cease to apply – i.e. unit

trust can conduct a business, borrow money, put a charge over assets, etc.

• Need to be ensure the unit trust never becomes a related unit trust.

• Otherwise Reg 13.22D says it is tainted forever and becomes an in-house

asset.

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Case Study

• The ABC SMSF and an unrelated entity are looking to undertake a property

development worth $5m.

• The ABC SMSF has $1,000,000 in cash and uses $500,000 as collateral for

a Limited Recourse Borrowing Arrangement (borrows $500,000).

• The related party has $1,000,000 in cash (may be borrowed).

• A related party of the fund uses non-super assets as collateral for

borrowings and on-lends the funds to the SMSF.

• A unit trust is established to undertake the property development.

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Case Study 5 (cont.)

• The SMSF and the unrelated party each take a 50% stake in the unit trust

with 50% voting rights.

• The Trust Deed says a third party is required to settle dispute.

• The Unit Trust borrows the remainder of the funds required ($3,000,000) for

the property development from a bank.

• The Unit Trust will need to ensure it has sufficient capital and appropriate

loan terms to meet its obligations under the development phase prior to the

flow of rental income.

• The SMSF will also need to ensure it is able to make loan repayments prior

to the receipt of distributions.

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Lender

SMSF $1,000,000

$5m Property Development

Holding Trust

Loan to related party of SMSF

Mortgage over non-super assets

Loan of $500,000 to fund

$1,000,000 ($500,000 own money and $500,000 borrowed) for SMSF

Income and capital gains paid to SMSF

Income and capital gains paid to other entity

Unit Trust $2,000,000

Other Entity

$1,000,000

SMSF & other entity invest $1,000,000 each

Bank Loan $3,000,000

50% of units 50% of units

Bank lends U/T $3m secured against U/T assets

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Issues for Consideration

• Cashflow – how the bank loan principal will be repaid, given the net income

of the unit trust will need to be distributed to unitholders.

• Funding to repay the principal may be made by subscription for additional

units by the unitholders on a pro-rata basis.

• In the case of the SMSF, additional units would need to be purchased by

the SMSF directly and not through the Limited Recourse Borrowing

Arrangement.

• Loan could be repaid by the sale of the development, with net capital

proceeds distributed to unitholders.

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Who can be the Lender?

• There are no restrictions on who can lend money to the SMSF.

• The member can obtain a loan from a bank using other assets as security

and then on-lend the money to the SMSF.

• The terms of a related party loan cannot be more favourable to the related

party than would have been the case if the party’s had been dealing at

arm’s length (s109 of the SIS Act).

• However, there is no contravention of s109 of the SIS Act if the terms are

more favourable to the SMSF.

• The ATO has even stated a loan can be a zero interest rate (NTLG Minutes

June 2012).

• Other aspects of SIS Act need to be considered, however, such as the Sole

Purpose Test (s62).

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Steps involved in SMSF borrowing

Each state and territory is different, so specialist advice is required.

1. Adviser/Accountant and Trustee/s determine whether borrowing is

appropriate – cash flow analysis, insurance, lender requirements, etc.

2. Check the fund’s Trust Deed to ensure the SMSF Trustee has the power to

borrow, grant security and allow an asset to be held by the Holding

Trustee/s/ nominees for the SMSF Trustee.

3. Check the fund’s Investment Strategy to ensure it allows for the acquisition

of the investment asset and permits borrowing for that purpose.

4. Source the asset for purchase and negotiate the price and reach agreement

with the Vendor.

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5. Finalise borrowing arrangements with the lender, including the in-principle

loan approval.

6. Establish the Holding Trustee (best practice is a company), which should be

a Bare Trust.

7. Arrange for the Holding Trust Trustee to resolve in writing to act as Holding

Trustee of the asset for the SMSF Trustee.

8. Arrange for the SMSF Trustee to resolve in writing to purchase the asset

and to appoint the Holding Trustee to act for the SMSF Trustee as Holding

Trustee of the Holding Trust.

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9. Arrange for the Holding Trustee (NOT the SMSF Trustee) to sign the

purchase contract.

10. Ensure the SMSF Trustee provides all the deposit money for the purchase

directly from the SMSF’s account.

11. Arrange for the Holding Trust Trustee and the SMSF Trustee to sign the

Trust Deed of the Holding Trust.

12. Arrange for the SMSF Trustee (the SMSF Trustee is the borrower) to sign

all loan documents with the lender.

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13. Complete the purchase of the asset using only the SMSF’s money and the

loan from the lender.

14. Submit the Holding Trust Deed to the stamp duty authority for payment or

stamping of stamp duty at Settlement.

15. When the loan is eventually repaid, transfer the asset from the Holding

Trustee to the SMSF Trustee.

Only nominal stamp duty (or no stamp duty) on transfer from Holding Trustee to

SMSF Trustee provided the Holding Trust Deed was previously stamped – if

required in the particular state and the Holding Trust is a Bare Trust.

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SMSF Borrowing


ATO Taxpayer Alert 2012/7

• LRBA structures not being set up correctly.

• Wrong entity name on title.

• Breach of the SMSF borrowing rules.

• Borrowing to invest in related unit trusts breaching Regulation 13.22C.

• Can lead to asset becoming an in-house asset.

• Limited to 5% of the fund’s assets.

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Zero interest rates

• Recent Private Binding Rulings from the ATO has caused some

consternation.

• If the related party loan is less than commercial rates, penalty rates of tax

may apply to the income from the asset subject to the LRBA.

• The ATO had originally stated in an ATO ID (2010/162) that an SMSF

Trustee does not contravene the requirements of an LRBA if the loan was

on terms more favourable to the SMSF.

• This position was further clarified in the National Tax Liaison Group (NTLG)

Superannuation Technical Minutes of June 2012; a meeting between the

ATO and the Superannuation Industry.

• The ATO was asked can an SMSF enter into a related party loan at zero

interest rate?

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Zero interest rates

• The ATO’s response was yes.

• In a recent Private Binding Ruling the ATO said as far as they were concerned:

– If the loan documentation specified that no interest was to be charged on a loan, then the fact that interest was not charged would not give rise to a deemed superannuation contribution.

– The fact that a Fund was able to borrow interest free from a related party did not mean that the income derived by the Fund would be taxed a 45% as non-arm’s length income under current tax law.

• Non-arm’s length income is a provision in the Tax Act that levies tax on income at the top marginal rate if the ATO deems the dealing is not on commercial terms (i.e. on arm’s length terms).

• The reason for their view was the amount of income that the Fund derived as a result of interest not being charged, was not greater than the amount of income that would have been derived had interest on the loan been charged in the first place.

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Zero interest rates

• However the ATO view has (maybe) changed in a more recent Private Binding Ruling.

• SMSF borrowed from a related party (a Family Trust) to buy ASX listed shares (each parcel of shares under its own LRBA).

• Also bought units in a related unit trust (which then purchased cash and fixed interest investments).

• Furthermore, the related party loaned the Fund 100% of the purchase price of the acquirable assets.

• The terms of the loan were such that the SMSF would repay the loan as a single lump sum at the end of the loan term (or earlier) as agreed between the borrower and the lender.

• No loan term was specified (although the loan agreement did state the loan advancement would have a term of several decades).

• There was no personal guarantee or security provided by the lender to the borrower.

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Zero interest rates

• The ATO argued the non-arm’s length income provisions contained in the

Tax Act apply to the income received by the Fund because:

– Either no income would be received because the lender would not have loaned

the fund money at zero interest, so the Fund would not have received any

income from the investment, or

– The net income would have been reduced if interest was charged at a rate other

than zero.

• Whilst many in the SMSF media are concerned by this, it is important to

remember:

– Private Binding Rulings only apply to the relevant taxpayer.

– Look at the specifics of the particular case.

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Zero interest rates

• In reaching this conclusion, the ATO stated other factors in this particular case

came into play:

– The lender was not – by way of charging interest – compensated for the opportunity

cost in lending the principal, or for the additional risk assumed in relation to the

recovery of the principal in the event of the borrower’s default under the loan (given

the limited recourse nature and lack of other security);

– Rather than periodic, regular payments of the principal sum, only a single lump sum

repayment at the end of the loan term(which could be several years) was required;

– 100% of the value of the assets to be acquired was lent, rather than a lower loan to

value ratio, given the nature of the assets to be acquired with borrowed Funds, namely

shares and units in a unit trust (and given the limited recourse nature of the loans);

– No insistence by the lender on the giving of personal guarantees by the members of

the Fund as security for the borrower’s performance under the loans; and

– The absence of mechanisms in the lender’s favour to protect the underlying value of

the units in a private trust to be acquired with the borrowed Funds, particularly given

the limited recourse nature of the loans, lack of other security and the kind of ‘cash’

assets in which the unit trust proposed to invest.

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SMSF Borrowing


Financial Services Inquiry

• Noted SMSF Borrowing ‘embryonic’ but growing.

• If allowed to continue, ‘may create vulnerabilities for the superannuation

and financial systems’.

• Not supported by facts – 0.51% of SMSF assets held in LRBAs.

• LRBA growth static over the last 12 months.

• Paucity of regulation of advice is the main issue!

• Any legislative amendment likely to be Grandfathered.

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Alternatives to borrowing

Example – Alternative to borrowing

• Richard wishes to purchase the premises through which he runs his

business.

• The premises is a factory in an industrial estate worth $600,000.

• Richard’s SMSF – the Richard Super Fund – has $300,000 to invest in the

property.

• Richard does not want his Fund to enter into a LRBA.

• Richard instead will use his PPR as collateral for a loan of $300,000 to his

Family Trust – the Richard Family Trust.

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Example – Alternative to borrowing (cont.)

• A unit trust is established.

• Richard’s SMSF and his Family Trust each own 50% of the units.

• The unit trust will acquire the factory from Richard for market value.

• Stamp Duty considerations need to be taken into account.

• Also CGT for Richard (but maybe eligible for Small Business CGT

Concessions?).

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• Some may be reluctant for their SMSF to lend, or the investment may not

satisfy lender criteria.

• Therefore the non-geared unit trust arrangement may be more attractive for

funds that are in a position to invest jointly with other parties.

• As we know, an SMSF can acquire units in a 13.22C unit trust from a

related party.

• This provides options for the SMSF to increase its stake in the unit trust,

with income it has received from the unit trust and contributions.

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SMSF

Family Trust

Lender

Non-Geared Unit Trust

Property

50% 50%

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• Let’s say we are now 10 years into the future.

• The unit trust has continually satisfied the non-geared related party unit trust

rules.

• The Richard Super Fund has acquired all the units in the unit trust from the

Richard Family Trust.

• The Family Trust uses the proceeds to extinguish the loan.

• The SMSF now owns all the units in the unit trust, which owns the factory.

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SMSF

Unit Trust

Property

100%

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• Trustees should, however, obtain advice regarding stamp duty.

• Most jurisdictions have a land rich regime which charges duty on certain

transfers of units within a private unit trust if certain thresholds are

exceeded.

• In Victoria, the land rich provisions apply if landholdings are more than $1m

and the landholdings comprise 60% or more of the trust’s assets.

• In NSW, the thresholds are $2m and at least 60% of the value of all the

trust’s assets.

• Therefore Trustees should also seek State or Territory specific advice on

land rich laws.

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Services to support SMSF Borrowing

• Advice – technical, structuring and procedural advice

• Structures – establish borrowing structures

• Documents – written resolutions, trust deed for the bare trust, information

pack including guidelines for conveyancers, stamping pack, leasing pack,

loan agreements, mortgage documents and step by step completion

instructions

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Disclaimer

This presentation was prepared by SuperIQ Pty Ltd (ABN 27 147 105 164) (“SIQ”). Material contained in this presentation is a summary only and is based on information believed to be reliable and received from sources within the market. The information is believed to be accurate at the time of compilation and is provided by SIQ in good faith. However, the statements including assumptions and conclusions are not intended to be a comprehensive statement of relevant practice or law that is often complex and can change. It is not the intention of SIQ that this presentation be used as the primary source of readers’ information but as an adjunct to their own resources and training. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. SuperIQ does not guarantee the performance of any fund or the return of an investor's capital. No representation is given, warranty made or responsibility taken as to the accuracy, timeliness or completeness of any information or recommendation contained in this publication and SIQ will not be liable to the reader in contract or tort (including for negligence) or otherwise for any loss or damage arising as a result of the reader relying on any such information or recommendation (except in so far as any statutory liability cannot be excluded). Individual circumstances, in particular relating to self managed superannuation funds, may vary greatly. This presentation has been prepared for general information purposes only and not having regard to any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (express or implied) or other information should be acted upon without obtaining specific advice from an authorised representative.

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See your future clearly

1300 660 598

superiq.com.au

1800 625 644

superconcepts.com.au

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