This SMSF Ruling, released on 23 May 2012, explains the Commissioner's views on the limited recourse borrowing arrangement (LRBA) provisions in ss 67A and 67B of the Superannuation Industry (Supervision) Act 1993 (SIS Act). The ruling explains the key LRBA concepts of:
The ruling was previously issued as Draft Self Managed Superannuation Funds Ruling SMSFR 2011/D1 (see my article on the Draft Ruling here). While the final ruling is consistent with the draft ruling, it has been substantially revised to provide further information and clarify various issues. Additional illustrations are provided to set out where a borrowing under an LRBA can be used to repair (or maintain) an acquirable asset, contrasting prohibited situations which result in an improvement. The ATO has also included specific information on the application of the LRBA provisions to property development and off-the-plan purchases. Most of the examples from Draft Ruling SMSFR 2011/D1 have been revised to provide further details.
Broadly, an SMSF can only borrow money (and maintain a borrowing) pursuant to an LRBA. An LRBA entered into from 7 July 2010 must only apply to a single "acquirable asset" held on trust which the SMSF is not otherwise prohibited from acquiring directly: s 67A. In addition, if an SMSF borrowing is used to acquire an asset, then that asset can only be replaced with a "replacement asset" according to the circumstances in s 67B.
The ruling provides that money borrowed under an LRBA can be applied in maintaining or repairing (but not improving) a single acquirable asset. While borrowings under an LRBA cannot be used to improve an acquirable asset, the ATO says money from other sources (eg accumulated funds held by the SMSF) could be used to improve (or repair or maintain) that asset. However, any improvements must not result in the acquirable asset becoming a different asset (ie a "replacement asset" in circumstances not covered by s 67B).
An "acquirable asset" is any form of property (other than money) that the SMSF trustee(s) are not otherwise prohibited from acquiring under the superannuation law. Although "property" can include proprietary rights or the physical objects of proprietary rights (eg land or machinery), the ATO says it is necessary to consider the meaning of property in both senses to determine whether money borrowed under an LRBA has been used to acquire a single acquirable asset.
The money borrowed under an LRBA can only be used to acquire:
The Commissioner considers that a single object of property may be acquired even if it is comprised of separate bundles of proprietary rights (eg if there are 2 or more blocks of land). However, this will only be so if it is reasonable to conclude that what is being acquired is distinctly identifiable as a single asset.
Factors relevant in determining if it is reasonable to conclude that what is being acquired is a single object of property include:
However, the ATO considers that each of the following circumstances would not on their own be sufficient to support a conclusion that it is a single object of property:
Money borrowed under an LRBA may be applied in "maintaining" or "repairing" (but not "improving") the acquirable asset: s 67A(1)(a)(i). To determine if an asset has been repaired or maintained (or whether it has been improved), the ATO says reference is made to the qualities and characteristics of the asset at the time the asset is acquired under the LRBA. To this end, the ATO says an asset is improved if the state or function of the asset is significantly increased.
If an asset is already owned by an SMSF(and is not subject to borrowing), the Commissioner says a borrowing to pay for repairs to, or maintenance of, that asset would not satisfy the LRBA provisions.
The ruling defines "maintaining" as:
According to the ruling, "repairing" means:
The ATO says a repair is usually occasional and partial work to restore the function of the asset without changing its character and may include restoration to its former appearance, form, state or condition.
That is, a repair merely replaces a part of something or corrects something that is already there and has become worn out or dilapidated through ordinary wear and tear, or is damaged whether accidentally or deliberately. In this respect, the Commissioner states that his views on repairs are consistent with Ruling TR 97/23 on deductions for repairs.
If an asset is 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, the ATO says the subsequent repair of the asset using borrowings under the LRBA may be allowed under s 67A(1)(a)(i). The ATO considers that restoration of that part of the asset is a repair for LRBA purposes if similar, or modern equivalent, materials are used. For example, replacing some broken windows in a house immediately following the acquisition of the house and land under an LRBA, is a repair for which borrowings can be used.
However, the ATO warns that the more run down an asset is at the time it is acquired under the LRBA, the more likely that changes to that asset will significantly improve its state or function such that the changes are improvements (and not repairs). For example, if a run down building is acquired under an LRBA and the building is substantially renovated following its acquisition to enable it to be tenanted, this would be an improvement for which borrowings under the LRBA could not be used.
In contrast to a repair, the ATO considers that an asset is improved if the state or function of the asset is significantly increased through:
The ATO says this is a question of fact and degree to be determined objectively and without reference to the actual use of the acquirable asset. Minor or trifling increases in the state or function of the asset will not amount to an improvement.
The Commissioner illustrates distinctions between repairs (or maintenance) and improvements with the following (edited) table:
Improvements (not permitted with borrowed money)
Fire damages part of a kitchen (cooktop, benches, walls and ceiling).
If house extended to increase size of kitchen this would be an improvement.
Guttering on house replaced with modern equivalent and house repainted. In replacing guttering a leaf guard can be fitted as minor or trifling addition to asset as a whole.
Pergola built to create outdoor entertaining area.
Cyclone damages roof of house. Replacement of roof in its entirety with modern equivalent is a repair.
Addition of second storey to house at time of also replacing roof would be an improvement.
Fire destroys a 3 bedroom residential house. Rebuilding broadly comparable house is not an improvement as it restores asset.
Rebuilding a residential house that is not broadly comparable to that destroyed is an improvement. If the funds to rebuild are from an insurance company and not from borrowings this does not affect the LRBA.
Residential house acquired under an LRBA and rented out for a number of years. Area now a "real estate hot spot". Decision to renew kitchen which, although functional, is significantly out of date and showing wear and tear. The design of kitchen is improved and modern equivalent, rather than superior, materials and appliances are used. Changes do not significantly improve state or function of asset as a whole.
Residential house is acquired under an LRBA and is rented out for a number of years. Area now a real estate hot spot. Decision to demolish house. Rebuilding a residential house that is not broadly comparable is an improvement. However, if the funds to rebuild are not from borrowings this does not affect the LRBA.
Farm (on single title) - is the single acquirable asset under an LRBA. At the time of entering into the LRBA the farm includes one set of cattle yards, 4 bores including windmills, tanks and troughs and 3 km of fencing:
Each of the following further additions is an improvement: further set of cattle yards; further bore, tank; windmill and trough; further dam; further shed; further 2 km of fencing.
Machinery or equipment - item of earth moving equipment acquired under an LRBA. Immediately after its acquisition money borrowed under LRBA is used to fund repairs to hydraulic system of the asset to return it to its full functionality. This would be a repair.
A major overhaul of the asset is carried out with all significant parts of the asset being replaced. This is likely to be an improvement as changes have significantly improved the state or function of the asset.
Note that the improvements listed above could be carried out provided that the SMSF uses its own money (and not borrowed money). According to the Commissioner, these improvements would not fundamentally change the character of the asset to such an extent to result in a different asset (see below).
While each later draw down under an LRBA is a technically a new borrowing, the ATO accepts that an LRBA that satisfies the requirements of s 67A when entered into will continue to satisfy those requirements if:
While borrowings under an LRBA cannot be used to improve a single acquirable asset that is the subject of the LRBA, the ATO says money from other sources could be used to improve (or repair or maintain) that asset. However, any improvements must not result in the acquirable asset becoming a different asset. Remember that an improvement to an asset using money from other sources may have excess contribution implications for the SMSF members as it will effectively increase the capital of the SMSF: see Ruling TR 2010/1 here.
An asset acquired under an LRBA can only be replaced with a "replacement asset" in the circumstances in s 67B.
If the asset is changed to such an extent that its character is fundamentally changed, the Commissioner says this will result in a different asset being held on trust under the LRBAand the exception under s 67A to the borrowing prohibition ceases to be satisfied -from the time the change to the asset is made. To determine if the character of the asset as a whole has fundamentally changed, the ATO says both the characteristics of the physical object (assuming it is not an intangible asset) and the attributes of the proprietary rights comprising the asset should be considered.
The ruling sets out scenarios to illustrate when a change to a single acquirable asset results in a different asset (in breach of the replacement asset rules in s 67B):
The ruling states that alterations made by a tenant to a rental property that is held under an LRBA will not result in a different asset if:
If property is leased by the holding trust, the tenant may be permitted to make changes to that property (eg by adding a fixture). If the changes made by the tenant are of such significance that they result in a different asset being held on trust under the LRBA (and the fixture becomes the property of the holding trust), the ATO says the exception under s 67A ceases from the time the change to the asset is made. However, the ATO acknowledges that particular laws of a state or territory may mean that property in a fixture remains with the tenant.
The ruling provides some additional information on the application of the LRBA provisions to property development. The Commissioner states that the deposit (and balance payable at settlement) under a contract for an "off-the-plan" purchase of a strata titled unit can be funded under a single LRBA. The Commissioner warns that the strata titled unit must be a single acquirable asset. Accordingly, the outcome may differ if the acquisition is of the strata titled unit and another asset (such as a separately titled car park or a furniture package).
Likewise, the ATO accepts that a single title block of land (acquired pursuant to a contract of purchase with an initial deposit and the balance payable at settlement) can be funded under a single LRBA.
However, the ATO warns than an option to acquire an off-the-plan purchase of a house or unit must be funded under a separate LRBA to any subsequent acquisition of the house or unit.
The final ruling has revised most of the 15 examples from Draft Ruling SMSFR 2011/D1 to provide further details. The final ruling includes 5 new examples (but 5 of the previous examples from the Draft Ruling have been omitted, including the one on the subdivision of land). The final examples cover the following scenarios:
The Ruling applies to arrangements entered into on or after 7 July 2010 (including an arrangement that is a refinancing of a borrowing of money under an arrangement entered into before, on or after 7 July 2010).
While the final ruling provides some welcome clarification on the Commissioner's views on key aspects of the LRBA provisions, it only covers a few pieces of the LRBA puzzle. Given the complexity involved, an SMSF looking to acquire property via an LRBA should obtain independent advice in relation to the borrowing agreement and the establishment of the holding trust structure. Such planning will help to ensure that the documentation will substantiate favourable tax treatment and prudential compliance in the years ahead. Breaches of the SIS Act can result in severe penalties (and criminal sanctions), not to mention the transaction costs to unwind a non-compliant structure. Before entering into an LRBA, it is also vital to plan ahead to avoid any adverse tax, stamp duty or GST consequences over the life of the investment.
Note also that an asset is only an acquirable asset if neither the SIS Act nor any other law prohibits the SMSF trustee from acquiring the asset: s 67A(2). That is, the arrangement must still comply with other superannuation and tax rules. Further details on the superannuation borrowing rules exception are outlined in Thomson Reuters' Australian Superannuation Handbook and Australian Financial Planning Handbook.
Source: This article was first published in Thomson Reuters' Weekly Tax Bulletin. To subscribe to Weekly Tax Bulletin, or for more information, please:
You can read earlier Clearlaw articles on a wide range of SMSF topics here.
Leigh is a partner in the Maddocks Tax & Revenue team.
Leigh regularly provides advice on:
His advice covers both direct and indirect tax considerations.
Leigh advises Australian and multinational companies, high net worth individuals, accountants and financial advisers on all areas of taxation law.
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