If you have not been following this development, you may find this summary useful when assisting SMSF clients to manage their LRBA arrangements.
The determination will be known as the Self Managed Superannuation Funds (Limited Recourse Borrowing Arrangements - In-house Asset Exclusion) and, when it becomes law, it will be taken to have commenced on 24 September 2007.
That means it aligns with the date upon which it became possible for SMSFs to use borrowed funds to purchase property assets for their funds. The ATO made the determination retrospective to ensure SMSFs who entered into arrangements before it became law were not 'disadvantaged'.
This ATO clarification is based around the idea of introducing a "test time" to determine when an asset held in a related fund is or is not an in-house investment.
According to the tax office, the determination will mean that, at the beginning of a limited recourse borrowing arrangement (that period of time before the borrowing has begun and before the related trust actually holds the asset), if it can be safely assumed that the borrowing will occur and the trust will hold the asset then that asset will not be considered to be in-house at those test times.
There is a proviso that accountants, advisers and trustees will need to get their head around. You'll still need to make sure that the asset wouldn't be an in-house asset of the fund once the borrowing is in place and the bare trust does hold the asset. That means you still need to apply all the other existing in-house assets tests before advising a trustee that it is safe to go ahead and borrow money to purchase a property.
At the other end of the process, when the LRBA loan has been paid off but the property still sits in the bare trust, the determination should mean that, if the application of Subsection 71(8) of the SIS Act results in the asset NOT being an in-house asset at all times from when the related trust begins to hold it (par 71(8)(c)) until the loan described in par 71(8)(b) is repaid, then it won't be considered to be an in-house asset at this latter test time.
Again, anyone offering SMSF specialist advice will still need to check that there was no other reason that the asset might be considered in-house other than that the LRBA had been repaid and the property was still sitting in a related trust.
Possible advantages for trustees
According to the ATO, the main advantage of this determination is that it should prevent potential situations where, unintentionally, a real estate investment, that is not yet, or no longer, the subject of an LRBA could be deemed to be an in-house asset because it is held in a related trust.
As all SMSF specialists know, the in-house rules set out in Part 8 of the SIS Act impose a limit on the in-house assets that a self-managed super fund can hold. That limit is currently 5% of the total market value of the fund's assets (as per Sec 82). It would be quite common for a major real estate asset held in a bare trust to have a value greater than 5% of the overall market value of the fund's assets.
Civil and criminal penalties apply, as set out in Section 84, if the in-house asset rules are contravened.
Subsection 71(8), which provides the exception under which, if a related trust is set up as a requirement of an LRBA, the asset that it holds legal title to is not considered to be in-house. However, the loose ends that the ATO is attempting to tidy up have caused concern for some accountants, advisers and their clients who've believed that steps have needed to be taken at the beginning and end of LRBAs to ensure the SMSF didn't fall foul of the 5% in-house asset rule.
Because Subsection 71(8) has been time sensitive, the ATO argues that there may have been periods of time when trustees have potentially been in breach of the in-house investment rules. The first may have occurred during the period of time when a contract for the acquisition of the asset has been entered into and a substantial deposit paid under the contract, but the actual loan to fund the payment of the balance of the acquisition cost of the asset did not get put in place until near or on the settlement date.
The second 'window of time' in which an SMSF may technically find itself in breach of the 5% in-house asset rule is the period when the asset continues to be held in the related trust after the borrowing has been repaid.
Another situation in which, before the implementation of this new legislative instrument, an SMSF may find that it is not covered by the exemption provided by Subsection 71(8) is if the fund is acquiring a property 'off the plan'. This one is easy to overlook as it arises because the exclusion only applies for the time the related trust actually holds the property.
If the LRBA is structured in such a way that the borrowing covers the deposit, the period between the payment of the deposit and settlement at completion of the property's development, is, technically not covered by Subsection 71(8).
Accountants and advisers need to also remind their SMSF clients that the new legislative instrument will not apply unless they have reasonable prospects of obtaining the necessary finance to complete the purchase of the asset that will be placed under the control of the related trust.
Straightforward in-house test
The ATO, in its explanatory statement for the new legislative arrangement, provides a test that can be used to ensure that trustees can rest easy that their geared real estate investment won't be deemed to be an in-house asset from the date they sign a contract and pay a deposit through to the time they transfer ownership of the property from the holding trust to the SMSF.
"Given the requirements of Subsection 71(8)... it must be reasonable to conclude, for example, that:
1. The only property of the related trust will be the property referred to in paragraph 71(8)(c); and
2. That asset would not be an in-house asset of the fund if directly held by the SMSF"
Just to quickly refresh your memory as to the definition of an in-house asset. An in-house asset is generally defined as:
1. An investment in a related company or trust ie the SMSF owns shares in a related company or units in a related trust
2. An asset of the SMSF that is leased to a related party
3. A loan made by an SMSF to a related company or trust
Who exactly is a related party? A member of the fund, including members who have deferred their entitlement to receive a benefit, and pension recipients. A standard employer-sponsor of the fund. For example, an employer who contributes or would contribute in accordance with arrangements between the employer and trustee. Finally, a Part 8 associate of a member or employer-sponsor (relative, spouse, business partner, etc).
New rule has limits
It's also worth remembering that the new instrument is not intended to give 'indefinite' relief from the in-house rules and it is incumbent on trustees to ensure there are no 'unreasonable delays' in commencing the LRBA, acquiring the asset by the trustee of the holding trust, or transferring the asset to the SMSF at the conclusion of the loan.
If an SMSF has multiple LRBAs in place that are for the same asset in the same holding trust, the ATO has clarified that the exemption allowed under Subsection 71(8) remains valid until the last payment of the last limited recourse loan that relates to the asset in question.
The new rule is intended to offer further protection from the asset being considered in-house during that uncertain period of time between the final payment of the last loan and the transfer of the asset to the SMSF. Again, the trustee(s) will need to ensure they avoid unreasonable delays in transferring real estate assets out of related trusts at the conclusion of a limited recourse borrowing arrangement. This may very well be the downside that the ATO has failed to consider when drafting the new arrangements.
A contrary view
Some of the submissions received by the ATO in relation to this issue make interesting reading and imply that the 'risk' to trustees if the status quo prevails is a bit of a storm in a teacup. The Superannuation Committee of the legal practice division of the Law Council of Australia, for instance, argues in its submission that SMSF trustees holding assets in a holding trust would not be in danger of falling foul of the in-house rules because their interest in the trust doesn't actually constitute an investment.
"The committee has previously stated its view that, even in the absence of section 71(8) of the SIS Act, a SMSF's trustee's holding of an asset in a holding trust for the purposes of satisfying Sec 67A(1) (or former 67(4A)) would not create an in-house asset issue for the fund. This is because, while the holding trust would be a 'related trust' for the purposes of the SIS Act, the arrangement would not constitute 'an investment in a related trust of the fund' as required by Section 71(1)."
The Law Council of Australia takes the view that to 'invest' means to apply assets in any way, or to make a contract, for the purpose of gaining interest, income, profit or gain. This follows from the definition of 'invest' in Section 10(1) of the SIS Act.
It goes on to argue that an SMSF trustee doesn't actually make an investment in the holding trust. Rather, they hold their interest in the holding trust for the purpose of satisfying the legislative requirements in relation to the borrowing. The Council concludes that if the asset continues to be held in the holding trust at the conclusion of the LRBA it is most likely for the sake of convenience.
"Any interest, income, profit or gain will arise from the SMSF trustee's beneficial interest in the asset held in the holding trust, not from the holding trust itself. Consequently, there would be no in-house asset for the purposes of the definition in Section 71(1)."
The Law Council also considers that the Section 71(8) exclusion would apply to a holding trust during the periods both before and after an LRBA is in place. "This is because there would still be a necessary 'connection with a borrowing' during those periods for the purposes of Section 71(8)(b).
In fact, the Law Council takes the view in its submission, that rather than create certainty, the new legislative instrument could actually cause confusion. It is critical that the ATO has not provided any detailed analysis to support its contention that there are 'holes' in the application of Section 71(8) as it currently applies.
It takes issue, in particular, with the ATO's insistence that SMSF trustees avoid unreasonable delays in transferring the ownership of the asset from the holding trust to the SMSF. In practice, as we all know, there are certain situations where it may be advisable for the asset to remain in the holding trust indefinitely.
Stamp duty is, of course, the most significant reason why it may be in the best interests of the SMSF not to transfer the ownership of the asset. Likewise, if its investment strategy is to sell the asset in the short or medium term, it may be advisable to avoid the transfer costs and leave the asset in the holding trust until it is sold.
What you need to do
This is a 'watch and act' situation for accountants and advisers with SMSF clients who already have LRBA arrangements or who are considering entering into such an arrangement. It is definitely worth being mindful of the Law Council's considered and expert legal opinion that the current legislative arrangements are more than adequate to protect SMSFs from breaching the in-house assets requirements of the SIS Act.
If, however, you don't subscribe to that view, you will still need to take care to factor stamp duty costs into the equation when providing guidance to SMSF trustees with current limited recourse borrowing arrangements or if they are considering using such a strategy. Unless the ATO's current draft is amended before it is implemented, SMSF trustees may find themselves incurring increased stamp duty and transfer costs because they will no longer have the option of maintaining holding trusts indefinitely.
We believe the following issues will require particular attention if the new rule is applied in this fashion:
1. Ensure documentation drafted at the outset of the LRBA, including the SMSF trust deed, so the trustee is clearly informed about what, if any, taxes will apply when the asset is transferred from the holding trust to the SMSF trustee.
2. Likewise, the trustee needs to be fully informed of the stamp duty that will be levied by the relevant state or territory revenue office
3. Will GST and capital gains apply if the asset is transferred to the SMSF
We have read some recent press articles lately which imply that so long as the asset that was the subject of the LRBA remains the single acquirable asset within the bare or holding trust, that the new rule will mean that asset can remain in the trust indefinitely. However, our interpretation of the ATO's new instrument, in its current form, runs contrary to this interpretation.
All three of the eventualities listed above may be excellent reasons for retaining the real estate investment in the holding trust indefinitely following settlement of the LRBA. It remains to be seen whether the new legislative instrument will prohibit this use of holding trusts. In which case, one could be excused of thinking that this move by the ATO is more about generating revenue for state and federal coffers than it is about providing legislative certainty for SMSF trustees.
position that ATO has taken in this matter.
The first challenge will be to remain competitive against the 'big end of town' - those major institutions such as AMP and Westpac who are now offering 'one stop shop' solutions for SMSF trustees. Trustees will no doubt be attracted to a big, 'safe' and trusted brand offering SMSF services, from fund setup through to administration and investment advice.
At the other end of the market, truly professional and expert SMSF accountants, advisers and administrators will need to be vigilant of the activities of unethical spruikers and real estate salespeople masquerading as SMSF specialists. Accountants and advisers, in particular, will need to be extremely vigilant about the service providers they use for things like trust deeds. They will need to ensure the business models utilized by providers are robust and that they will be able to deliver on promises of service longevity.
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