Agenda. What is SMSF Limited Recourse Borrowing? Single Acquirable Asset/Replacement Asset. Repairs and Improvements. SMSF Borrowing Strategies

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1 Borrowing and SMSFs

2 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 2

3 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. 3

4 What is Limited Recourse Borrowing? 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. 4

5 What is Limited Recourse Borrowing? The following diagram outlines the typical structure: SMSF repays lender Lender Lends funds to SMSF SMSF Borrowed money added to SMSF money Holding Trust Security held over security trust assets Asset All income and capital gains paid to SMSF 5

6 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. 6

7 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. 7

8 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. 8

9 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. 9

10 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. 10

11 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. 11

12 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. 12

13 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. 13

14 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. 14

15 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. 15

16 SMSF Borrowing Strategies 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). 16

17 SMSF Borrowing Strategies Example: The Aurora SMSF pays $65,000 (10% deposit) to developer to buy an off the plan apartment in August 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. 17

18 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. 18

19 SMSF Borrowing Strategies 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. 19

20 SMSF Borrowing Strategies 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. 20

21 SMSF Borrowing Strategies Lender Mortgage over non-super assets Loan to related party of SMSF Loan of $600,000 to fund SMSF $1,200,000 ($600,000 own money and $600,000 borrowed) Holding Trust Unit Trust Income and capital gains paid to SMSF $1.2m Property Development 21

22 SMSF Borrowing Strategies 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. 22

23 SMSF Borrowing Strategies 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. 23

24 SMSF Borrowing Strategies 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. 24

25 SMSF Borrowing Strategies 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. 25

26 SMSF Borrowing Strategies 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. 26

27 SMSF Borrowing Strategies Lender Mortgage over non-super assets Loan to related party of SMSF Loan of $500,000 to fund SMSF $1,000,000 $1,000,000 ($500,000 own money and $500,000 borrowed) for SMSF Holding Trust SMSF & other entity invest $1,000,000 each 50% of units 50% of units Other Entity $1,000,000 Income and capital gains paid to other entity Income and capital gains paid to SMSF Unit Trust $2,000,000 Bank Loan $3,000,000 $5m Property Development Bank lends U/T $3m secured against U/T assets 27

28 SMSF Borrowing Strategies 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. 28

29 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). 29

30 SMSF Borrowing Steps 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. 30

31 SMSF Borrowing Steps Steps involved in SMSF borrowing 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. 31

32 SMSF Borrowing Steps Steps involved in SMSF borrowing 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. 32

33 SMSF Borrowing Steps Steps involved in SMSF borrowing 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. 33

34 SMSF Borrowing Issues for Consideration 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. 34

35 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? 35

36 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. 36

37 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. 37

38 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. 38

39 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. 39

40 SMSF Borrowing Issues for Consideration 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. 40

41 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. 41

42 Alternatives to borrowing 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?). 42

43 Alternatives to borrowing Example Alternative to borrowing (cont.) 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. 43

44 Alternatives to borrowing Example Alternative to borrowing (cont.) Lender SMSF Family Trust 50% 50% Non-Geared Unit Trust Property 44

45 Alternatives to borrowing Example Alternative to borrowing (cont.) 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. 45

46 Alternatives to borrowing Example Alternative to borrowing (cont.) SMSF 100% Unit Trust Property 46

47 Alternatives to borrowing Example Alternative to borrowing (cont.) 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. 47

48 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 48

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