The use of gearing within SMSFs is sparking increased interest. Daniel Butler and Tina Conitsiotis detail some of the tips and traps associated with this type of strategy.
Limited recourse borrowing arrangements (LRBA) are becoming increasingly popular. However, if not handled correctly, they can give rise to numerous issues. This article discusses some of the common tips and traps associated with LRBAs and what to do if you find yourself in a sticky situation.
TRAP – related-party loans
Recent comments made by the Australian Taxation Office (ATO) have provided a basis for the implementation of related-party loans where the terms of the loan are more favourable to the related party. However, such loans can be problematic.
Consider John’s situation. His SMSF purchases property under an LRBA, the lender of which is a related party. The property is then leased to an unrelated party on commercial terms. The loan is for a period of 10 years and the interest rate is set above the Reserve Bank of Australia cash rate. The lender is willing to reduce this interest rate to nil. Is this allowable?
Non-arm’s-length income
We begin with a consideration of the non-arm’s-length income (NALI) provisions. Income – both ordinary and statutory – can constitute NALI in a variety of ways. The key way in this context is if the following two limbs are both met:
Limb A – the income is derived from a scheme the parties to which were not dealing with each other at arm’s length in relation to the scheme; and
Limb B – the income is more than the amount the fund might have been expected to derive if those parties had been dealing with each other at arm’s length.
In the above example, naturally the lender and SMSF are not dealing with each other at arm’s length, therefore limb A is satisfied. Limb B, however, requires more detailed consideration.
At first glance, the fact the property is being leased at commercial rates indicates the income derived from the property is the same as the SMSF would have been expected to derive had the loan been at arm’s length. However, the reduction in the interest rate causes the SMSF to save on an expense, thus indirectly increasing the income derived. Therefore, on closer inspection, limb B may be met on the facts.
The above example is taken from Private Binding Ruling (PBR) 1012414213139. Here, the ATO concluded the above facts did not constitute NALI. This is positive news, however, this PBR does not necessarily give free rein to favourable related-party loans.
Unless you are the specific taxpayer who obtained the PBR, you cannot rely on it. Further, the PBR only considered the NALI provision and not the broader superannuation law compliance of the transaction (discussed further below), nor did it consider the general anti-avoidance provisions. Additionally, the above scenario is relatively conservative.
Consider the implications if the loan-to-value ratio of John’s SMSF was 100 per cent. It is possible, if this was the case, the ATO would have taken a different view, especially if, without the favourable loan, the SMSF could not have otherwise afforded the property. The reasoning here is that by obtaining the favourable loan, the SMSF was able to acquire property that yields a better return, thus deriving more income than the SMSF would have obtained had it been dealing at arm’s length.
Superannuation law compliance
It is unlikely a favourable related-party loan would contravene section 109 of the Superannuation Industry (Supervision) (SIS) Act 1993, so long as the terms do not favour the lender. ATO Interpretative Decision 2010/162 supports this view. Further, non-binding comments made by the ATO in the 5 June 2012 National Tax Liaison Group superannuation technical sub-group suggest below-market-value interest rates do not constitute a contribution.
Other considerations include:
- The sole purpose test (section 62 of the SIS Act);
- Financial assistance to a member/relative of a member (section 65 of the SIS Act).
Conclusion
NALI remains the big uncertainty for related-party loans favouring SMSFs. Therefore, there is still some merit in loans having some semblance of an arm’s-length nature.
Practically, trustees might consider obtaining a PBR before entering into any favourable related-party loans. Although remember, the ATO will not always give consistent answers across PBRs.
TIP – insurance
Entering into an LRBA to acquire real estate could have serious implications upon the death of a member. For instance, the illiquid nature of real estate means it might be difficult to pay a member’s death benefit. Insurance can be used to solve this dilemma.
Example
Consider Sam and Graham. They are business partners and want to use their super to borrow to acquire the real estate where their business is conducted at a price of $2 million. To facilitate the acquisition, Sam and Graham have established a brand new SMSF. The SMSF holds $1 million cash, split equally between Sam and Graham.
The SMSF borrows $1 million and acquires the real estate under an LRBA. Sam dies. Upon Sam’s death, his benefits (that is, $500,000) are to be paid to his widow. However, the SMSF no longer has $500,000 in liquid assets.
Possible solution 1 – paying as pensions
Arguably one solution is for Sam’s death benefit to be cashed by way of pension. The advantage of this is it can allow the death benefit to be paid slowly over literally years and years. Naturally, this might be appealing given the illiquid state of the SMSF.
However, there are a number of sub-optimal aspects associated with this solution that might make it ultimately unattractive. For example, the SMSF could be negatively geared, and even paying the benefits out over years and years could be impractical or impossible. Further, after Sam’s death, Graham might not want to have his finances involved with Sam’s widow and vice versa. Further, Sam’s widow might want the $500,000 as soon as possible.
Possible solution 2 – maintaining insurance
The SMSF trustee might maintain a $500,000 life insurance policy in respect of each of Graham and Sam. This would mean that upon Sam’s death, the SMSF trustee receives a $500,000 cash payout from the insurance company. The SMSF is now liquid.
However, this raises another concern. The ATO has previously indicated it considers that an insurance payout forms part of the interest from which the premiums were paid. Therefore, at first instance, the insurance payout would form part of Sam’s interest in the SMSF.
This serves to compound the issue, as now Sam’s death benefit consists of the $500,000 and also the insurance payout. To tackle this, two variations on this insurance solution should be considered.
Possible solution 2A – maintaining insurance using cross-insurance
The insurance could be implemented through a cross-insurance strategy. That is, the premiums in respect of the policy on Sam’s life are charged against Graham’s member account and vice versa. This way, upon Sam’s death the insurance payout forms part of Graham’s member account, thus improving the liquidity of the SMSF and the ability of the SMSF to pay out Sam’s death benefit.
However, this solution is not perfect. Distorted premium costs could make this option unattractive. For example, consider if Sam was a 60-year-old smoker and Graham was in his 40s and in reasonable health. Graham might be unwilling to have Sam’s high premiums deducted from his account. Further, the insurance premiums are unlikely to be deductible.
Possible solution 2B – maintaining insurance using reserves
Another solution is to pay the insurance premiums from reserves. That is, the SMSF maintains a reserve account and pays premiums from that account.
However, this strategy is also not perfect. For example, maintaining a reserve can be tricky and additional paperwork is required. Further, any insurance payout would be ‘trapped’ inside a reserve and any attempt to allocate it out might give rise to excess contributions tax issues. Also, the premiums are again unlikely to be deductible.
Conclusion
Whenever an SMSF borrows, advisers should be alerting trustees and members to the need for insurance. This is especially the case where the SMSF involves business partners. Although not without its own problems, insurance does appeal to many with SMSF borrowings, especially where business partners are involved. Where a cross-insurance strategy is implemented, it is typically best to have some sort of overlay agreement executed at the outset to ensure the insurance is dealt with as intended.
IP – improvements
The trustee of an SMSF can borrow to repair or maintain an asset. However, it cannot borrow to improve an asset. That being said, in SMSF Ruling 2012/1, the ATO stated SMSF trustees can use their own cash resources to improve an asset, while subject to an LRBA, provided the improvement does not fundamentally alter the character of the asset to such an extent that it becomes a different asset. This provides for many planning opportunities.
Example
Consider Kylie. She wants to acquire residential real estate within her SMSF using an LRBA. She finds a property in the perfect location. Unfortunately, she is unimpressed with the existing house located on the land. Kylie intends to use non-borrowed money to demolish the house, and build a residential house that is not broadly comparable to the demolished house. This significant change is allowable. Note, however, if Kylie wanted to demolish the existing house, subdivide the land and then build multiple townhouses, she could not do so while the property was subject to an LRBA.
Practical implications
If the trustee decided to improve an asset that is the subject of an LRBA (using SMSF cash), ideally supporting documentation should be prepared and retained, evidencing that no borrowings were used to pay for the improvements.
A similar process should be adopted if the trustee borrows to repair or maintain an asset. Note, not all repairs or maintenance will be deductible as some may be considered ‘initial repairs’ and an SMSF will not generally be able to claim a deduction to the extent it derives exempt pension income.
TRAP – bare trusts
The legislation does not specify whether the holding trust needs to be a bare trust. However, having a bare trust is likely to maximise tax efficiency. More particularly, if the holding trust was not a bare trust, this may impact on the capital gains tax and goods and services tax treatment of the arrangement when the asset is transferred from the holding trustee to the SMSF trustee. In September 2011, the ATO indicated it was looking to clarify this issue in the near future, however, we are yet to receive clarification.
Various providers are circulating LRBA documentation that does not establish bare trusts. Rather, these trusts in some cases may have settled sums, 80-year vesting dates or provide the holding trustee with substantive powers. The use of such trusts in LRBAs could have potential downstream tax issues.
Other tips and traps
Multiple titles – Multiple titles may constitute multiple assets for SMSF borrowing purposes. However, if there is a legal impediment or a permanent, physical and valuable unifying object that prevents the titles from being sold separately, they may be treated as one asset. If there is more than one single acquirable asset, separate LRBAs may be required for each asset.
Chattels – Real estate may come with certain goods/chattels. Again, this gives rise to concerns regarding whether a single asset is being acquired. Ideally, such additional items should be deleted from the contract before it is signed and acquired separately.
Implications of a contravention – LRBAs are complex and must be structured and implemented correctly. A contravention could result in a fund becoming non-complying. Even if this does not occur, at the very least incorrect structures are likely to be required to be unwound, which could give rise to significant implications and costs. The ATO in Taxpayer Alert 2012/7 has indicated it may not approve of ‘botched’ LRBAs, for example, where the property was registered in the SMSF trustee’s name.
Summary
The above highlights the need to do the job properly in the first place and the importance for advisers to be on top of the rules.
