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SMSFs getting practical to invest in land with others

The force of the superannuation law is that investment in land by a SMSF needs to be prudent. An investment needs to be considered in a business-like way.

Limited recourse borrowing is one way to fund investment in real estate. SMSF principals may prefer to arrange equity investment from private connections outside of the SMSF.

Investment as a tenant-in-common?

I am frequently asked about SMSFs participating in land investments as a tenant-in-common with related and unrelated entities of the principals of the SMSF. It is apparent from the NTLG Superannuation sub-committee technical minutes of June 2011, released by the Australian Taxation Office, that tenants in common arrangements for SMSFs are not going to be prudent for the SMSF without careful and restrictive implementation. Wherever other tenants in common could borrow, or use or risk their interest as security, the SMSF tenant-in-common is exposed to uncontrolled risks which would bring into question, for instance, whether the SMSF:

1.    has acted prudently pursuing the investment for members for whom it is bound to provide;

2.    has breached regulations which prevent charges, or the potential for them, being taken over SMSF property; or

3.    has satisfied the sole purpose test.

Investment through a trust?

The tenant-in-common option is frequently turned to because of the restrictive regime that has applied in relation to the investment by SMSFs in related trusts since 1999. Shortly stated, a post 1999 investment by a SMSF in a trust, which is related to the principals of the SMSF, a “related trust”, is treated as an “in-house asset” and more than 5% of the assets of a SMSF in in-house assets can leave the SMSF non-complying.

Non-geared unit trust – expressly relieved from being a related trust

The SIS Regulations provide an express exception. A superannuation fund can invest in a non-geared unit trust (NGUT) to which Regulation 13.22C applies without the NGUT being taken to be a “related trust” and thus the investment isn’t taken to be an investment in an “in-house asset”.

This express exception is especially limited and, aside from relief from “related trust” treatment causing in-house asset difficulty, offers no expansion in the kind of investment that can be pursued with superannuation money. In other words, the investment still needs to address 1 to 3 above, for instance.

The Regulation 13.22C and 13.22D requirements and restrictions on NGUTs essentially mirror the restrictions on regulated superannuation funds. NGUTs cannot borrow and they can only “lend” to operate a bank account. They cannot secure or charge their assets. (A non-SMSF unit holder in a NGUT could give a security over his, her or its units but security could not be given over the assets of the NGUT.) A NGUT cannot run a business – unlike with superannuation funds, this is a direct requirement. Loss of NGUT status, so that the NGUT becomes a related trust triggering in-house asset difficulties follows the merest breach under Regulation 13.22D which can put complying status of a SMSF investor at the mercy of the ATO.

Practicalities

1.    Nevertheless a carefully implemented NGUT can be the most practical way to pursue unitised investment in land by related parties and unrelated parties of a SMSF with the SMSF.

2.    Compliance with the regulations needs to be closely monitored as stated. Any debtor or creditor, aside from a bank for the (credit only) trust bank account, potentially causes loss of protection from related trust status. Funding of, and money flow to and from, the NGUT without breaching the rules is thus practically challenging. The trustee needs to raise equity (unit) funding whenever any extra funding is required. From a practical and paperwork burden perspective, using partly-paid units is a strategy that might be considered wherever the trust needs a flexible equity facility.

3.    The activity of the NGUT that invests in land also needs to be monitored and carefully planned and structured. It is possible for real estate activity by trustees to be considered the carrying on of a business under tax rules. As stated a NGUT cannot carry on a business under the NGUT regulations nor, if it has a trust deed to suit, under its trust deed.

4.    Under the special trust rules in NSW, a special trust pays land tax at the highest land tax rate without a threshold. A SMSF can attract a better land tax rate. A NGUT will not automatically qualify for the rate for a SMSF to the extent a SMSF invests in it. However if the NGUT is a “fixed trust” under the land tax rules then a better rate than the special trust rate can be achieved. Hence there can be advantage to structuring a NGUT with a trust deed so that the NGUT can be treated as a fixed trust under the land tax rules.

5.    A carefully crafted trust deed can be very useful to assist the trustees of a SMSF and a NGUT to keep within the express requirements and restrictions on NGUTs.

Can I have the real estate in my SMSF?

Real estate can be provided in kind to a member as a superannuation benefit. Prohibitions can apply to acquisitions of real estate from members but this prohibition does not apply going the other way. That is: from a fund to a member on a payment out of the fund as a superannuation benefit.

Still a condition of release needs to be met before a superannuation benefit is provided by a SMSF. Let us say that the fund is in pension mode and the member is over the age of sixty-five so a condition of release is met for a benefit to come from the member’s superannuation balance in the fund to the member.

Difficulties providing a real estate benefit from a SMSF in an income stream

A SMSF in pension mode must face these difficulties before releasing a benefit in the form of real estate:

  • the Australian Taxation Office (ATO), if not the superannuation laws unequivocally, require that a pension (a superannuation income stream) benefit must be paid in money and not in kind;
  • the benefit can take the SMSF out of pension mode, where the income of the SMSF is tax exempt on its earnings; and in to accumulation mode, where the fund is taxable at 15% on its earnings; depending on how the commutation of pension is done. This could inadvertently cause the capital gain, the SMSF makes on the disposal of the real estate as a benefit, to be taxable to the SMSF; and
  • the SMSF may not have paid a minimum annual pension payment for the year as required by the superannuation income stream regulations.

Partial commutation solution

A partial commutation of a pension is a work around for these difficulties. A partial commutation of a pension is a commutation of less than the member’s pension balance in the fund as a lump sum. That is the member needs to have remaining member pension balance after the commutation. The ATO has indicated that a partial commutation:

Doing it

There are a number of traps to implementing this solution:

  • The governing rules of the SMSF must allow for partial commutations of pensions, the trustee must have a power under the governing rules to pay benefits in kind and the pension arrangements or agreement with the member must reflect this.
  • The member needs to trigger the partial commutation and the benefit in kind in accordance with the pension arrangements or agreement.
  • The trustee of the SMSF must value the real estate to ascertain the amount of the lump sum benefit being paid to debit to the member’s account.
  • The member getting the real estate benefit must have a sufficient member account balance remaining after the debit to treat the satisfaction of the benefit in kind as a partial commutation of the pension.
  • The fund and conveyancing documentation needs to be prepared on an arms length basis as required under superannuation law.

Although there is no capital gains tax if the fund remains exempt from tax in pension mode, other taxes and duties on a transfer of real estate can still apply.

For instance:

  • GST can apply to the transfer of commercial premises or new residential premises from a SMSF where the fund is registered or is required to be registered for GST.
  • Stamp duty liabilities vary significantly from state to state. Victoria has concessions on the transfer of dutiable property to a beneficiary of a trust. In New South Wales there is generally no relief from full ad valorem duty. A concession which applies in New South Wales on the transfer of dutiable property to a superannuation fund as a contribution does not apply to a transfer out the other way as a benefit.

Thus, to recap our disclaimer, partial commutation of a pension to provide real estate from a SMSF should be considered case by case and specific advice should be taken in relation to the above general comments.

Is a transfer to a SMSF by a related holding trust, after repayment of a LRBA to purchase residential property, prohibited by s66 of SISA?

Is a transfer to a SMSF by the trustee of a holding trust, who happens to be a related party of the SMSF, after repayment of the borrowing under a limited recourse borrowing arrangement – LRBA, to purchase residential property, prohibited by section 66 of the Superannuation Industry (Supervision) Act 1993 (“SISA”)?

Section 66 of the SISA prohibits a SMSF from acquiring residential property, which is not business real property, from a related party of the fund.

Returning an asset that is already in the SMSF

A similar question arises when a SMSF receives a return of an asset of the fund from a custodian or an investment manager, which incidentally happens to be a related party, which is similarly not covered by any exemption in section 66. Technically the SMSF has acquired the asset from a related party; the legislation could be clearer providing exceptions in section 66 for these cases especially as the scope of acquisition prohibited by section 66 is expressed in very wide terms: see paragraphs 88 to 109 of SMSFR 2010/1.

But an acquisition, being the return or resumption of the asset, not for consideration (value) from a related party, does not really explain the actual transaction happening. In these cases, the SMSF is acquiring or resuming title or legal ownership of an asset it already owns beneficially. So, in the case of a LRBA of residential premises, section 66 would be concerned with who the residential property was originally acquired from, not with the” acquisition” of the asset from the related holding trust once the borrowing is paid out.

As with a custodian or investment manager, the power of the related bare trustee of a holding trust to hold the asset, and the power to transfer the asset back to the trustee of the SMSF, is stated or is implicit in the SISA itself – see sections 67A and 123.  As a matter of statutory interpretation those powers should prevail over the prohibition in sub-section 66(1): generalia specialibus non derogant   Nevertheless a clearer description of the scope of the acquiring prohibited, and of exceptions, would be preferable to relying on that maxim though SMSFR 2010/1 issued by the Commissioner of Taxation does helpfully state at paragraph 113:

It is therefore necessary to take a holistic approach to the transaction to determine objectively what it is that the trustee or investment manager is actually acquiring. If, for example, something is being purchased by a trustee or investment manager, a relevant question is what is the trustee or investment manager paying money to acquire. While many transactions involve rights, an acquisition is of rights only if the substance of the transaction is rights.

What is the whole LRBA really about?

From a holistic viewpoint the SMSF, which already holds beneficial ownership of the residential property, is, in substance, concluding the acquisition from the original vendor by taking legal title to the residential property by the transfer from the holding trust. It follows that the acquisition of legal title from the related holding trustee is the exercise of a right to acquire legal title which is not the “substance of the transaction”.

The Australian Taxation Office may not necessarily take the same view.