SMSF trustees may consider increasing the diversity of their portfolios through investing in an overseas property. While this strategy may appear sound on the surface, Daniel Butler warns there are numerous elements to consider when assessing such a course of action.
Overseas property investment may appear attractive to many, such as an investment in an apartment in Paris, a Balinese beachfront villa, or a ski chalet in Colorado. However, when an SMSF is the purchaser, there are a number of compliance traps to navigate.
SMSF trustees can purchase property either by an outright purchase or borrow using a limited recourse borrowing arrangement (LRBA). To illustrate the potential risks involved, each of these types of investments will be considered in turn.
Investment with no borrowings
In short, an SMSF trustee can purchase a property overseas. However, there are many compliance hurdles. Some of these are listed below.
- Sole purpose test. The acquisition meets the sole purpose test. In other words, is the SMSF being maintained solely for the prescribed purposes (for example, to provide retirement benefits)? In the famous Swiss Chalet Case (Case 43/95 [1995] ATC 374) a superannuation fund trustee invested in a unit trust, the assets of which included a Swiss chalet. The question in this matter was whether the fund met the then equivalent of the sole purpose test. The problem was not so much the investment itself, but that fund members and their friends stayed in the chalet without paying rent. The fund was held to have contravened the sole purpose test. Accordingly, it is important that an SMSF trustee only acquire real estate because the trustees genuinely believe it is an appropriate way to achieve the core purpose of providing retirement benefits. Moreover, some SMSF members also mistakenly believe the Australian Taxation Office (ATO) will never know they are using the property overseas, especially if it is in a distant location. However, immigration, phone, credit card, GPS and other records can readily pin you to the scene of the crime these days. We have had the opportunity to represent clients who were asked by the ATO to prove they did not use the overseas property owned by their SMSF or related structure.
- In-house assets. This is a big issue if it is not the SMSF trustee acquiring the property itself, but rather a company and the SMSF trustee acquires shares in the company (see below). Particularly if an overseas bank account is required, this may restrict the investment.
- SMSF deed and investment strategy. The acquisition must be authorised by the deed and consistent with the fund’s investment strategy.
Perhaps the most prevalent risk that may restrict SMSF trustees from investing overseas is the in-house assets rule. This is because some overseas jurisdictions require that property be held by a company or similar vehicle in the foreign country. This type of restriction is usually designed to preclude too many non-residents acquiring local property in the overseas country. Practically this means the SMSF member will often need to establish a company in the overseas jurisdiction and the SMSF trustee will invest in shares of that company. The company’s share capital will be used to finance the acquisition of the overseas property. In some Asian countries it is not unusual to see SMSF trustees paying a local native to hold the title on their behalf and I have questioned how solid this arrangement was under the local native rules.
On its face, the investment by an SMSF in an overseas company’s shares is an investment that is an in-house asset, which itself is a serious contravention subject to considerable penalties. However, if the investment meets the exceptions outlined in 13.22C of the Superannuation Industry (Supervision) (SIS) Regulations 1994 (that is, non-geared company or non-geared unit trust), then the investment will not contravene the in-house asset rule. One of the requirements of this exception is that the assets of the company being acquired must not include a loan to another entity, unless the loan is a deposit with an authorised deposit-taking institution within the meaning of the Banking Act 1959. As such, if there is an overseas bank account established (or required to be established), the investment in that company by the SMSF trustee will be an in-house asset unless the overseas bank account complies with our banking legislation. As a result, the shares in the company would need to be disposed of by the SMSF trustee.
Unfortunately, many SMSF trustees are lambs to the slaughter as smooth real estate agents tell them they are buying real estate, but when the deal is done, and the advisers get involved, the detailed requirements of the local jurisdiction’s law become apparent and a company or similar structure may be needed. This results in many falling into this compliance trap with great downside risk and substantial costs to unwind the transaction.
If the jurisdiction allowed the SMSF to invest in the property directly (without a local company intermediary), then the above risk would be extinguished. However, our experience has shown that numerous popular overseas jurisdictions require a company to be established.
Investment with borrowings
If the SMSF trustee were to borrow to acquire the property using an LRBA, this poses even further risks.
Firstly, if the property being acquired had to be held via a foreign company, we question whether a bank would be willing to lend to acquire overseas property. Practically, the bank would be lending money to acquire a piece of paper (being shares in the foreign company). Our experience is that banks will be very reluctant to lend on this basis where the security is shares in a company or units in a unit trust. Moreover, we have found few overseas banks that provide documents that are consistent with section 67A requirements and thus the LRBA may not be limited recourse or may otherwise contravene the law.
As an alternative or as supplemental to taking security over the shares of the foreign company, the bank may seek to take security over the overseas property itself. If it were to do so (and the property was held via a foreign company), this would contravene the requirements of regulation 13.22C of the SIS Regulations. As such, the SMSF trustee’s investment in the foreign company would be an in-house asset, again with numerous potential penalties and downside risk.
If a related party were to lend instead of a bank, it is questionable whether that lending would be considered arm’s-length unless evidence can be gathered that the LRBA terms and conditions are consistent with arm’s-length practices.
Our experience has also proven that dealings with different overseas jurisdictions can result in complicated legal analysis to ensure everything is properly bedded down. For example, many overseas countries do not recognise trusts and the legal system in some countries requires an examination of a lengthy chain of title, and there is a need to ensure all legal matters are tied down adequately to satisfy Australian legal requirements as well as satisfying the overseas rules.
Tax issues
Broadly, the country in which the real estate is situated generally has the prime taxing right in relation to any income or capital gains made from the property. However, the provisions of a double tax treaty (DTA) that Australia may have with its overseas major trading countries may change this treatment.
In the event the overseas income or gains are also taxable in Australia, there may be a credit provided for certain overseas taxes against any Australian tax payable on such amounts.
However, if an SMSF is entirely in pension mode, there is no Australian tax to offset. This is because the pension exemption conferred on Australian superannuation funds does not cover overseas income that is taxed in a foreign country or any withholding taxes, which may be the final tax imposed by the overseas country.
However, if, as in the case above, the SMSF has invested in shares in a United States company (and that company has invested in real estate), a different tax analysis is required. For example, if the SMSF invested in a property in the US, a federal US withholding tax of 5 per cent of the gross amount of any dividends applies where the SMSF owns more than 10 per cent of the voting power. This withholding tax is generally the final federal US tax payable on that dividend. If the SMSF was entirely in pension mode, no further Australian tax would be payable on such income and the SMSF would not receive any credit for or refund of the US tax paid.
However, if the SMSF was not entirely in accumulation mode, it would generally be entitled to offset any Australian federal tax with the US federal tax on such foreign income.
Note that when dealing with the US, state and other local taxes may also be applicable and these generally do not get recognised under Australian tax law.
Under Australia’s foreign tax laws, there are some countries, especially a number of tax havens, where overseas income or gains may need to be reported and tax paid even though no money has been received by the Australian taxpayer, especially under Australia’s foreign tax accruals regime.
Increased costs
In addition to the compliance aspects outlined above, there are often inflated costs for the transaction that must be taken into account. These may include costs in sourcing the property (for example, a buyer’s agent or advocate in the foreign country), having repairs and maintenance undertaken and the costs for the lawyers and advisers overseas to complete the purchase and provide ongoing advice. In addition, overseas tax compliance may arise and a range of other reporting and other obligations.
On top of these costs, if an SMSF were to borrow to acquire the property using an LRBA, there would be costs in obtaining documentation to allow the fund to borrow and specialist legal advice both in Australia and overseas to ensure the arrangement complied with the laws in both countries.
There may also be unexpected ongoing costs, such as overseas land and wealth taxes, and costs associated with dealing with tenants (for instance, evicting a tenant may not be a straightforward process in overseas jurisdictions).
Such costs should be considered before embarking on overseas property investment.
Conclusion
SMSF trustees can invest in overseas property. However, the compliance requirements, coupled with increased costs, may not make the investment as attractive to SMSF trustees as they first thought. Expert legal, accounting and related advice should be obtained both in Australia and the overseas jurisdiction before SMSF trustees make this type of investment.
