The treatment of limited recourse borrowings in relation to a member’s total superannuation balance has changed. Brian Hor explains how the new rules work and the benefits gearing can still provide.
Limited recourse borrowing arrangements (LRBA) are a great way to enable SMSFs to use the power of borrowing to leverage returns from investment, particularly real property investment.
However, the alleged role of rampant SMSF investors using LRBAs to purchase residential real estate and thereby drive up house prices (particularly in Sydney and Melbourne) to astronomical levels so as to become out of reach for hapless first home buyers has become a hot political issue to which the federal government has been unable to resist finding some sort of solution.
The result was the announcement of new so-called “integrity measures” to rein in the voracious appetite of SMSF investors by effectively making LRBAs less attractive in some important respects.
What are the new rules for LRBAs?
The new rules relating to LRBAs were put forward in the exposure draft of the Treasury Laws Amendment (2017 Measures No 2) Bill 2017: limited recourse borrowing arrangements. Schedule 1 of the bill sought to amend the transfer balance cap and total superannuation balance rules that were previously enacted through the Treasury Laws Amendment (Fair and Sustainable Superannuation) Act 2016.The draft bill purported to add section 294-55 Repayment of limited recourse borrowing arrangement to the Income Tax Assessment Act 1997 (ITAA 1997), which provided that a transfer balance credit arises in your transfer balance account if:
- SMSF makes a payment in respect of an LRBA, and
- as a result, there is an increase in the value of a superannuation interest that supports a superannuation income stream of which you are the retirement-phase recipient.
In this regard, the resulting credit is the amount of increase in value and it arises at the time of payment.
The draft bill also purported to amend section 307-230(1) of the ITAA 1997 to include in your total superannuation balance an LRBA amount under a new section 307-231. An LRBA amount arises where:
- an SMSF has made a borrowing under an LRBA,
- the borrowing has not been repaid at the time of working out your total superannuation balance, and
- the asset or assets that secure the borrowing support, to some extent, a superannuation interest of yours.
The LRBA amount is then calculated as being your proportion of the outstanding balance of the LRBA, based on your share of the total superannuation interests supported by the asset that is subject to the LRBA.
Why are the rules being introduced?
Officially the reason why the government is introducing the new measures is to prevent SMSF members from using LRBAs to circumvent the superannuation contribution caps, and will effectively transfer otherwise taxable accumulation growth to the tax-free retirement phase not captured by the new transfer balance cap measures. This is expected to occur where there is a repayment under an LRBA that transfers value from accumulation interests into retirement-phase interests.The government also wanted to ensure that where a fund has LRBAs in place, the total gross value (not just the net value after deducting the amount of the borrowings) of its assets is taken into account in working out the individual members’ total superannuation balances to prevent SMSF members from ‘double-dipping’ by:
- making further non-concessional contributions, which can only be made if a member’s total superannuation balance is below the general transfer balance cap, and/or
- using any unused portion of their bring-forward non-concessional cap (which is only possible if their total superannuation balance is under $1.6 million).
When will the new rules become law?
On 15 June 2017, both houses of Parliament passed the Treasury Laws Amendment (2017 Measures No 2) Bill 2017, which included the measure whereby a transfer balance credit arises in your transfer balance account as a result of a payment in respect of an LRBA, which gives rise to an increase in the value of a superannuation interest that supports a superannuation income stream of which you are the retirement-phase recipient.However, the bill did not include the further measure to include in your total superannuation balance your proportion of the outstanding balance of an LRBA. It is submitted that this does not necessarily mean the government has abandoned that measure – rather, it is suggested the government is seeking further industry consultation regarding the potential impact of the measure and may introduce it later in a revised form, although when that might be is anyone’s guess.
How will they work in practice?
The exposure draft explanatory materials provide some helpful examples of how the new rules will work, which are summarised below.
Example 1 – How transfer balance credits arise from LRBA repayments
Bob is 65 and is the sole member of his SMSF. Bob’s super interests are valued at $3 million and are based on cash that his SMSF holds.Bob’s SMSF acquires a $2 million property after 1 July 2017, using $500,000 of the SMSF’s cash and an additional $1.5 million it borrows through an LRBA.
Bob then commences an account-based super income stream. The super interest that supports this super income stream is backed by the property, the net value of which is $500,000 (being $2 million less the $1.5 million liability under the LRBA).
Bob therefore receives a transfer balance credit of $500,000 under item 2 of the transfer balance debits table in subsection 294-25(1) of the ITAA 1997.
In the first year, Bob’s SMSF makes monthly repayments of $10,000. Half of each repayment is made using the rental income from the property. The other half of each repayment is made using cash that supports Bob’s other accumulation interests.
As a result, at the time of each repayment, Bob receives a transfer balance credit of $5000, representing the increase in value of the super interest that supports his super income stream. However, the repayments sourced from the rental income that the SMSF receives do not give rise to a transfer balance credit, because they do not result in a net increase in the value of the super interest that supports his super income stream.
Note that if a transfer balance credit results in a member having an excess transfer balance, an amount equal to the credit can be rolled back through a commutation or partial commutation of the superannuation income stream. The commutation will entitle the member to a transfer balance debit to reduce their overall balance.
Example 2 – How LRBAs will count towards a member’s total superannuation balance
Peter and Sue are the only members of their SMSF. The value of Peter’s super interests in the fund is $1 million, while the value of Sue’s super interests is $2 million. All of the assets of the fund that support their interests are cash.The SMSF acquires a $3.5 million property, using $1.5 million of its own cash and borrows an additional $2 million using an LRBA. As a result, the SMSF now holds assets worth $5 million (being the sum of the remaining $1.5 million in cash and the $3.5 million property). The fund also has a liability of $2 million under the LRBA.
Of its own cash that it used, 40 per cent ($600,000) was supporting Peter’s super interests and the other 60 per cent ($900,000) was supporting Sue’s interests. These percentages are also taken to reflect the extent to which the asset supports Peter’s and Sue’s super interests, as follows:
a) Peter’s total super balance is $1.8 million. This is comprised of:
- the $400,000 cash that still supports his super interest,
- the 40 per cent share of the net value of the property (being $600,000), and
- the 40 per cent share of the outstanding balance of the LRBA (being $800,000).
b) Sue’s total super balance is $3.2 million. This is comprised of:
- the $1.1 million cash that still supports her super interest,
- the 60 per cent share of the net value of the property (being $900,000), and
- the 60 per cent share of the outstanding balance of the LRBA (being $1.2 million).
Is it all doom and gloom?
The measure that seeks to capture repayments under an LRBA that amount to a transfer of value from a taxable accumulation account to a tax-free pension account is not, it is submitted, a deal breaker for most fund members seeking to establish an LRBA.However, adding the outstanding balance of an LRBA to a member’s total superannuation balance could well be, given that:
- a member can only make non-concessional contributions if they have a total superannuation balance of less than $1.6 million (quite apart from the $1.6 million transfer balance cap on pension transfers), and
- the ability to make catch-up concessional contributions, where unused concessional contributions (annual cap $25,000) from 1 July 2018 can be carried forward for up to five consecutive years, only applies where the member’s total superannuation balance is less than $500,000.
Therefore, if a member needs to rely on making non-concessional contributions (and/or catch-up concessional contributions) to enable their SMSF to pay off an LRBA (especially if residential real estate is concerned, where the rental returns alone are unlikely to cover the loan interest and other holding costs), the party may well be over before it gets started.
While the government did not introduce this measure in the bill passed by Parliament, it is submitted it is still likely to be introduced in some guise, given the continued political focus on housing affordability.
But before you think LRBAs are dead and buried, consider the following:
- LRBAs are perhaps now more important than ever as a way of leveraging returns, since both concessional and non-concessional contribution limits are being reduced,
- for younger members with a low total superannuation balance seeking to accelerate the accumulation of assets in their SMSF, using a carefully managed LRBA strategy could be a tax-effective way to lock in the acquisition of high-performing assets funded by concessionally taxed superannuation contributions and earnings, and
- even for members who have already reached their $1.6 million transfer balance cap for tax-free pension-phase purposes, assuming the SMSF has other resources to fund LRBA repayments without needing to solely rely on additional member contributions, using LRBAs can be a great way to increase their accumulation balance for estate planning purposes:
a) to make tax-free lump sum death benefit payments to their tax dependants,
b) to pay tax-effective death benefit pensions to their Superannuation Industry (Supervision) Act dependants (subject to their respective transfer balance caps), and
c) to make lump sum payments to the member’s estate to fund tax-effective testamentary discretionary trusts under their will – particularly where beneficiaries such as minor children and grandchildren are involved, given the concessional tax treatment under section 102AG of the Income Tax Assessment Act 1936 in relation to “excepted trust income” received by such beneficiaries.
So even if the measure to add the outstanding balance of an LRBA to a member’s total superannuation balance is enacted, there may still be opportunities to take advantage of LRBAs depending on the individual circumstances of the member.