Fabian has more than 20 years’ experience in the financial services industry. Since 2000, Fabian has been one of AMP’s technical experts, supporting financial advisers to keep up-to-date with changing regulations and requirements.
In recent years, Limited Recourse Borrowing Arrangements (LRBAs) have enabled many SMSFs to borrow money in order to acquire a variety of property investments.
This article is for educational purposes only and is no longer available for CPD hours.
However, the role that LRBAs are able to play when property transactions involve an element of property development often causes confusion, added complexity and potentially missed opportunities.
Limitations and misconceptions
It is now reasonably well understood that the ability exists for SMSF trustees to borrow money, under an appropriate LRBA structure, in order to buy an asset – in practise, this has typically involved a property asset. And, while the structure required for a complying LRBA must be well understood, it is a discussion that is beyond the scope of this article.
However, when it comes to acquiring property (or any asset) under an LRBA, it is critical to remember that the money borrowed must only be used to acquire an asset, and the asset must be a single acquirable asset.
Further, it is this asset and this asset alone that the fund can use as security for any borrowings undertaken by the SMSF under an LRBA – even though the asset is held in a separate holding trust.
Importantly though, money borrowed under an LRBA cannot be used to improve an asset (whether that be an existing asset of the fund or an asset that is acquired under an LRBA).
It would appear though that this restriction has led to the misconception that an SMSF is unable to conduct improvements to an asset that has been acquired under an LRBA, whereas quite the opposite is true.
An SMSF asset acquired under an LRBA can be improved as long as two critical points are not overlooked:
Money used to conduct the improvement must be money that the fund already holds. This could be, for example, existing cash holdings or amounts contributed by members. Money borrowed by the fund cannot be used to finance improvements; and
The improvement to the property cannot result in the nature of the asset being changed.
Jace and Sophie have an SMSF with assets of around $400,000, which includes $200,000 in cash accounts.
They decide to borrow $400,000 to buy a residential property under an LRBA.
As part of the acquisition, they also plan to spend around $150,000 (from their existing cash holdings) to add an extension, comprising of an additional bedroom, pergola and a new garage.
Such an improvement would be permitted because:
it was financed using existing fund assets (ie, not with borrowed money); and
notwithstanding the scale of the improvements, it will not result in a change to the character of the asset. That is, it’s still a residential property.
On the other hand, there are numerous other examples where development activities would result in a change to the nature of an asset. Such improvements would not be permitted while the LRBA is in place, regardless of the source of the finance. This includes things like:
land acquired with a view to future sub-division;
vacant land acquired for subsequent development; and
residential property (often a house) acquired with the view of being replaced with a townhouse/unit/complex or similar.
In saying that, it should be noted that while the above transactions are prohibited while an LRBA is in place, once the loan has been repaid, and the legal ownership of the asset returned to the fund, there is nothing preventing the property asset being redeveloped (albeit using existing fund assets) to the point where the character changes.
Peter and Eliza have an SMSF. They have also entered into an LRBA to acquire a residential property.
They plan to rent the home to unrelated tenants for around 10 years while they repay their LRBA (ie, it will be held as an investment property). They expect to have the loan repaid in around 10 years, at which time the property title will subsequently be transferred to the fund.
Using a combination of accumulated cash holdings and additional member contributions, the property will be demolished and replaced with three free-standing villas/townhouses.
While this development activity clearly results in a change to the nature of the original asset, it will not result in a breach of the LRBA requirements as the development activity will only occur after the LRBA is extinguished, and will be conducted using existing fund assets (ie, not borrowed money).
For the sake of completeness, it’s also worth noting that not all arrangements involving the development of vacant land will be treated in the same way.
For example, consider a scenario involving an SMSF acquiring a property ‘off-the-plan’ under an LRBA. That is, where fund trustees enter into a contract to acquire, as a ‘package’, land with a yet to be constructed house on it and to fund the acquisition using borrowings under an LRBA.
As the contractual arrangement in these scenarios is for the acquisition of land with a completed property on it (ie, the completed home is the single acquirable asset), and settlement occurs once construction of the house is finished, the deposit, progress payments and the payment on settlement can all be funded under a single LRBA.
A troublesome solution
In some cases, where otherwise prohibited property development activities (such as those listed above) are required, the use of a unit trust structure has often been presented as a potential solution.
The reason such an approach may be considered a suitable strategic solution lies in the fact that the single acquirable asset, ie the asset being acquired by the SMSF under the LRBA, in this case is the collection of identical units in that unit trust (as opposed to the actual property itself). The property in question is subsequently acquired by the unit trust.
As such, any required property development activity would be conducted by the trust and not the SMSF. The overall result being that while the property (which is owned by the unit trust) is being developed, the nature/character of the units (owned by the SMSF under an LRBA structure) remains unchanged.
It should be noted that the use of these trusts, typically ungeared unit trusts (or 13.22C trusts), introduces further strategic complexity that must be given due consideration – a detailed discussion of these issues are beyond the scope of this article.
This solution also poses significant practical limitations. This is largely due to the fact that, as noted earlier, the collection of units in the unit trust is the single acquirable asset that was acquired under the LRBA. As such, it needs to be remembered that from an SMSF borrowing perspective, it is only these units that can be used as security for the SMSF’s borrowing.
Further, due to the restrictions placed on these unit trust investments, the property held within the unit trust cannot be offered as security.
In practise, this has proven to be a significant obstacle when it comes to securing finance through a commercial lender – as commercial lenders are unlikely to look favourably on these units as their only recourse.
The trouble with related party lenders
Of course, a potential solution to this practical limitation may involve the SMSF borrowing money from a related party, for example, a fund member, as opposed to a commercial lender.
The use of related party loans under an SMSF LRBA has been the source of considerable discussion for several years.
In more recent times, the focus of these discussions has revolved around the possibility that such private loan arrangements could result in the income derived by the fund (under this arrangement) being treated as Non-Arm’s Length Income (NALI), which would attract tax at the highest marginal tax rate (ie, currently 47 per cent).
In this context, the NALI provisions are likely to apply where the SMSF is considered to have derived more income under the LRBA than it might have been expected to derive if the parties had been dealing with each other at arm’s length.
The good news on this front is that the ATO has provided SMSF trustees with some safe harbour provisions (via PCG 2016/5), ensuring that this tax outcome can be avoided if the terms and conditions associated with these related party loans meet a set range of criteria.
Unfortunately though, these safe harbour provisions only apply to direct property investments and investments in listed securities. They do not extend to related party loans when the asset in question is, for example, units in an unlisted unit trust.
As a result, SMSF trustees who choose to employ this type of unit trust strategy to achieve a property development exercise are exposing themselves to potentially significant tax penalties should their loan arrangement not be considered as being on commercial terms.
According to the ATO’s recently released Tax Determination TD 2016/16, an SMSF trustee(s) must be able to:
1. Identify what the terms of the borrowing arrangement may have been if the parties were dealing with each other at arms’ length (ie, a hypothetical borrowing arrangement); and
That it is reasonable to conclude that the fund could have, and would have, entered into the hypothetical borrowing arrangement based on factors such as the fund having sufficient capital available, the ability of the fund to service the loan, and whether the arrangement would be an optimal use of their funds and earnings accretive.
In particular, if the fund trustees are unable to meet this second requirement, all of the income derived from the arrangement would be treated as NALI. That’s because the fund could not and/or would not have been able to enter into the arrangement in the first place. Therefore, any income generated from the arrangement is more than the amount of income that would have been possible (under arm’s length terms).
Determining whether a loan is on commercial terms
Without the ability to rely on the safe harbour provisions, the challenge for SMSF trustees is in being able to conduct a thorough benchmarking exercise which compares the terms of their related party loan arrangement against those offered under a commercially available loan arrangement – and to then ensure that the two are consistent.
In the absence of a readily available market for these types of loans, such a task may prove difficult to complete.
Based on the limited guidance provided by the ATO on this aspect, it is clear that this exercise must go beyond simply addressing the level of interest rate that is charged. SMSF trustees must consider the totality of the loan terms including, but not limited to:
the interest rate;
whether the interest rate is fixed or variable;
the term of the loan; and
the loan to market value ratio (LVR).
Given the level of complexity, and the potentially hefty tax penalties involved, it would be prudent for SMSF trustees to seek appropriate binding advice from the ATO by way of a private binding ruling prior to proceeding.