Michael Hallinan explains the implications of the proposed integrity measure amending the treatment of limited recourse borrowing arrangements.
What is the integrity measure?
The proposed measure is to include in the total super balance (TSB) of a member their share of any outstanding limited recourse borrowing arrangement (LRBA) debt. The measure only applies to small superannuation funds, such as small Australian Prudential Regulation Authority funds (SAF) and SMSFs.
The impact of the measure will be as follows:
a. it will affect the amount of the non-concessional contributions (NCC) cap space,
b. it will affect the ability of a member to make catch-up concessional contributions (CC) – that is, the ability to use the carry forward of unused CC cap space,
c. it will affect the ability of members to use the bring-forward strategy,
d. it will affect the amount of bring-forward NCC contributions that can be made, and
e. it will affect the ability of the fund to use the segregated asset method to determine exempt current pension income.
The measure does not affect a member’s ability to make CCs (other than catch-up contributions) or NCCs not subject to the cap, such as downsizer contributions, capital gains tax (CGT) contributions or personal injury contributions.
What is the commencement date of the measure?
The commencement date is proposed to be 1 July 2018 and the measure will apply to LRBAs entered into on or after 1 July 2018.
However, there are significant transitional rules relating to refinancing of pre-1 July 2018 LRBAs and, possibly, to LRBA arrangements that straddle 1 July 2018 – this may apply to LRBAs to purchase property off the plan entered into before 1 July 2018, but which settle after that date.
What is the mischief the measure is intended to counter?
The government has identified two mischiefs that justify the introduction of the integrity measure.
The first mischief relates to the economic effect LRBAs have on super funds. Effectively, LRBAs permit the capital value of the fund to be increased in a manner that is not caught by the NCC cap.
The second mischief relates to the ability of capital value to be removed from the fund (as a superannuation lump sum) – thereby reducing the TSB and so providing NCC cap space – and effectively recontributed as debt under an LRBA.
The government has stated the measure is not a response to the Financial System Inquiry recommendation that LRBAs should no longer be permitted under the Superannuation Industry (Supervision) (SIS) Act.
What is the current status of the measure?
The measure is intended to commence from 1 July 2018. The final form of the legislation to implement the measure has yet to be determined. Draft legislation was originally issued as part of the 2017 Measures No 2 Bill 2017. However, the relevant provisions were withdrawn from the bill during its passage through Parliament.
The government then commenced a consultation process on the proposed provisions by issuing the Superannuation Taxation Integrity Measures – Consultation Paper on 11 January 2018. This paper also dealt with a proposed amendment of the non-arm’s-length income provisions. The closing date for submissions was 9 February 2018.
Presumably, the final provisions will be introduced in bill form during the 2018 federal budget.
What are the proposed legislative changes?
This article is based on the terms of the exposure draft legislation. Obviously the final terms may be different when the measure is introduced in bill form.
The principal operative provision will amend the definition of total superannuation balance set out in section 307-230 of the Income Tax Assessment Act (ITAA) by the inclusion of a further paragraph (d) as follows (simplified):
Your total superannuation balance … is the sum of
a. your accumulation-phase values of non-pension interests,
b. your transfer balance account,
c. your super amounts in transit between super entities (not counted in above),
d. each LRBA amount you have.
The LRBA amount of a member is only relevant if the LRBA amount exists as at 30 June 2019 and following years. If an LRBA is entered into on or after 1 July and the LRBA amount is repaid on or before the following 30 June, the value of the LRBA amount as at 30 June will be zero.
Additionally, there will be an interpretation provision introduced as section 307-231 of the ITAA determining which LRBA arrangements are affected by the measure and a member’s participation interest in the LRBA.
Illustration of the measure
The MLC Fund is an SMSF whose members are Moe, Larry and Curley. On 1 December 2018, the fund enters into an LRBA. The initial loan amount was $400,000, with only Moe and Larry participating in the LRBA, and their participation ratios are 60 per cent and 40 per cent respectively. By 30 June 2019, the LRBA debt has been reduced to $320,000.
As at 30 June 2019, the TSB of Moe and Larry will be respectively increased by $192,000 (being 60 per cent) and by $128,000 (40 per cent) based on their participation shares in the LRBA. As Curley has not participated in the LRBA, his TSB will be unaffected.
Reporting of LRBA amounts
For contribution purposes, the value of the TSB of a member as at 30 June is the critical issue.
Consequently, the ATO will have to devise an LRBA amount reporting system that ensures the correct/real-time value of each member’s LRBA amounts as at 30 June are reported in a timely manner.
Given the delay in reporting member balances (from balance date to the date the fund lodges its annual return), the ATO will be forced to require trustees to separately report LRBA amounts at or within a short time frame after 30 June. This reporting may be part of the transfer balance event notification regime rather than the super transfer balance account report.
The onus on trustees to correctly report LRBA amounts will be significant. Presumably, the trustee will have to report one total LRBA amount for each member rather than attempting to reconcile the last reported LRBA amount with the current LRBA by means of increases and decreases of LRBA amounts of individual LRBA arrangements during the course of the financial year.
Illustration of the flow-on effects of LRBA amounts
Consider Shemp. He is the fourth member of the MLC Fund. Shemp has a total superannuation balance of $450,000 as at 30 June 2021. His total unused carry-forward CC cap is $80,000 as at 30 June 2021.
Shemp could, in respect of the 2022 financial year, make $105,000 worth of concessional contributions – being $25,000 cap and $80,000 of carry-forward unused CC cap.
He decides to undertake over 2021/22 and 2022/23 an LRBA where the borrowed amount is $1.2 million, a bring-forward strategy by making $300,000 of NCCs. As Shemp is currently 60, he is not restricted from using the bring-forward strategy by reason of his age.
Shemp undertakes the following transaction during the 2022 financial year:
- $25,000 of CCs (for ease there has been no indexation increase), and
- an LRBA where the borrowed amount is $1.2 million.
Shemp undertakes the following transactions during 2022/23:
- $25,000 of CCs (for ease there has been no indexation increase),
- $80,000 of catch-up CCs, and
- $300,000 of NCCs as part of the bring-forward strategy.
As at 30 June 2022, Shemp’s TSB will be $1,671,250 ($450,000 plus $1.2 million plus 85 per cent of $25,000).
Consequently, in respect of the 2023 financial year, Shemp will be precluded from making any catch-up CCs (as his TSB exceeds $500,000 at the start of the 2023 financial year) and he will not be able to implement a bring-forward strategy (as his TSB exceeds $1.6 million at the start of the 2023 financial year) and so has no NCC cap space.
Further, the MLC Fund will not be able to apply the segregated assets method in respect of 2021/22 and subsequent financial years) as one member has a TSB greater than $1.6 million.
However, Shemp could still make downsizer contributions in 2022/23 if he is eligible to do so as downsizer contributions are not subject to the NCC cap.
Timing will be everything when it comes to contribution planning. Had Shemp undertaken the bring forward and the making of the catch-up contributions in the 2022 financial year with the LRBA in the following financial year (2022/23), the contributions could be made and the increase in his TSB by the LRBA amount would only affect his NCC cap space in respect of the 2024 financial year.
How will it affect current LRBAs?
The proposed measure will only apply to LRBAs entered into on or after 1 July 2018. LRBAs entered into on or before 30 June 2018 will be grandfathered and the measure will not apply to members participating in grandfathered LRBAs.
There does seem to be one last golden opportunity for LRBAs to be in place before 30 June 2018.
How will it affect refinancing of current LRBAs?
Critically, refinancing of current LRBAs (that is, entered into on or before 30 June 2018) will not be affected by the measure, where the refinancing occurs on or after 1 July 2018.
Refinancing has its strict sense of the incoming lender/mortgagee lending no more than the payout figure under the arrangement with the outgoing lender/mortgagee.
Does the measure affect the terms on which LRBAs will be offered?
In a formal sense no as the measure does not, in any way, amend the provisions of the SIS Act permitting LRBAs; namely section 67A and section 67B. However, in an economic sense the measure may adversely affect a lender’s assessment of the fund’s ability to service and repay the loan by reason of the flow-on effect of the inclusion of LRBA amounts in the members’ TSB and the TSB’s role in determining the ability to make catch-up CCs and ordinary NCCs.
Problem of off-the-plan property purchases
Typically in an off-the-plan property purchase, the financing for the acquisition will only be considered when the project is nearing completion. The timing difference between entering into the contract of purchase and the time when moneys are drawn down under the loan could be one or two years or even longer.
Will an off-the-plan property purchase entered into on, say, 1 December 2017 where the loan is not drawn down until 1 December 2018 or 1 December 2019 be treated as a grandfathered LRBA arrangement? In the absence of the government making a policy exception to off-the-plan property purchases entered into before 1 July 2018 (the consultation paper does raise the possibility that yet-to-be-detailed transitional rules will apply to LRBAs that straddle 1 July 2018), the prospects are not bright.
As such, the trustee should possibly consider entering into a related-party loan facility before 1 July 2018 so there is at least a contractual commitment to provide loan finance to complete the purchase. If unrelated lenders were prepared to enter into such a drawdown facility now rather than later, it would be far better for the member.
At the very least, the trustee should formally document, before 1 July 2018, its intention that the off-the-plan property purchase is to be completed using borrowed monies and provide evidence of the trustee making preliminary loan inquiries.
Will interposed unit trusts have a new lease of life?
Could unit trusts be used to permanently grandfather LRBAs? If the unit trust were established before 1 July 2018 and the fund entered into an LRBA arrangement under which the borrowed money was used to acquire units in the unit trust, then presumably the underlying assets of the unit trust could be changed from time to time without affecting the acquired property being the units themselves. On this basis, changing the underlying property of the unit trust will not amount to the commencement of a new LRBA.
Given the safe harbour guidelines do not extend to unlisted units, it seems the lender must be an unrelated lender or a related lender where there has been an actual offer of finance by an unrelated lender that is precisely matched by a related-party lender.