ATO issues Taxpayer Alert on SMSF limited recourse borrowing arrangements

By Julie Steed, Technical Services Manager

The Australian Taxation Office (ATO) recently released a Taxpayer Alert (TA 2012/7, click here to access it) which outlines the ATO’s concerns that some arrangements entered into by an SMSF to acquire property do not comply with the law.

The ATO is concerned that it may not be possible to simply restructure or rectify the arrangements, and unwinding the entire arrangement could lead to a forced sale of the asset, potentially at a substantial loss to the fund.

In this article we provide an overview of the issues that that ATO is concerned about and the potential consequences of poorly structured arrangements.

Direct property investments using limited recourse borrowing arrangement

Under a limited recourse borrowing arrangement (LRBA), the SMSF borrows money to directly acquire a property which is held via a holding trust. The rights of the lender in the event of default of the loan are limited to the asset over which the borrowing is held.

Issues of concern

• The borrowing and the title of the property is held in the individuals' name and not in the name of the trustee of the holding trust. The SMSF pays part or all of the initial deposit and the ongoing loan repayments.
• The title of the property is held by the SMSF trustee not the trustee of the holding trust.
• The trustee of the holding trust is not in existence and the holding trust is not established at the time the contract to acquire the asset is signed.
• The SMSF trustee acquires a residential property from an SMSF member.
• The acquisition comprises two or more separate titles and there is no physical or legal impediment to the two titles being dealt with, assigned or transferred separately.
• The asset is a vacant block of land. The SMSF trustee intends to use the same borrowing to construct a house on the land. The land is transferred to the holding trust prior to the house being built.

Superannuation issues that could arise from such arrangements

• The arrangement may be in breach of the sole purpose test (SISA² section 62).
• The arrangement may be in breach of the borrowing provisions (SISA section 67).
• The asset acquired is not a single acquirable asset (SISA section 67A(2)).
• The asset is subject to a charge in breach of the borrowing provisions (SISA section 67A(1)(f)).
• The deposit paid by the SMSF and/or loan repayment by the SMSF may be considered as a breach of the benefit payment standards (Part 6 of the SISR³).

Taxation issues that could arise from such arrangements

• The members may be required to include the SMSF loan repayments in their assessable income (Division 304 of the Income Tax Assessment Act 1997 (ITAA 1997)).
• The income and its associated deductions from the investment should be declared by the individual members rather than by the SMSF, where the investment is not held for the beneficial interest of the SMSF.

Property investments using related trusts

An alternative to the traditional LRBAs is for a related unit trust to be used to acquire a property and the SMSF members borrow money to acquire units in the related ungeared unit trust. The unit trust itself does not borrow money to acquire the property but uses the monies received from the SMSF members (and potentially other related parties).

Issues of concern

• The asset acquired by the unit trust is used as a security for the money borrowed by the SMSF members to subscribe units in the unit trust.
• The assets of the unit trust include an asset that was acquired from a related party of the SMSF which is not business real property.
• The assets of the unit trust include real property which is leased to a related party of the SMSF and the real property subject to the lease is not business real property.

Superannuation issues that could arise from such arrangements

• The investment arrangement may be in breach of the sole purpose test (SISA section 62).
• The SMSF's investment in the unit trust fails to meet the ungeared unit trust requirements (SISR13.22C).
• The SMSF's investment in the unit trust is an in-house asset (SISA section 71) and therefore counts towards the 5% in-house assets limit (SISA section 83).

Taxation issues that could arise from such arrangements

• The SMSF may become non complying and have its income taxed at 45 per cent.
• The unit trust may incur a capital gains tax liability in relation to the disposal of the property.
• The members and the SMSF may be required to include a capital gain in their assessable income an amount on redemption of their units in the unit trust.

Summary

While the limited recourse borrowing arrangements can be used by clients to acquire assets that they would not otherwise have access to, it is important to ensure that they are aware of the risks and issues that must be considered before commencing any of these strategies.

Purchasing a property using the borrowing arrangements requires careful consideration of the suitability of the underlying asset, any required alterations and improvements, an understanding of all of the costs, sufficient liquidity to cover unforseen events and that compliant loan documentation and structure are in place. Advisers and accountants should be aware that the ATO will be watching out for the arrangements outlined within this Taxpayer Alert.

³Superannuation Industry Supervision Act 1993 (SISA)
⁴Superannuation Industry Supervision Regulations 1994 (SISR)