Changes from draft ruling
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.
Single acquirable asset
The money borrowed under an LRBA can only be used to acquire:
- a single acquirable asset; or
- a collection of identical assets with the same market value,- for example, shares of the same class in the same company acquired at the same price.
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:
- the existence of a unifying physical object, such as a fixture attached to the land which is permanent in nature and not easily removed and that is significant in value relative to the value of the asset; or
- whether under a law of a state or territory the 2 assets must be dealt with together.
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:
- there is a physical object situated across 2 or more titles and that physical object:
- is not significant in value relative to the value of the land; or
- is temporary in nature or otherwise able to be relocated or removed relatively easily therefore not preventing the titles being dealt with separately;
- a business is being conducted on 2 or more titles; or
- the assets are being acquired under a single contract because, for example, the vendor wants to deal with the assets as a package or the lender will only lend over a group of assets.
Borrowings applied for repairs (but not improvements)
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.
Maintaining the asset
The ruling defines "maintaining" as:
- work done to prevent defects, damage or deterioration of an asset, or in anticipation of future defects, damage or deterioration,
- which work merely ensures the continued functioning of the asset in its present state.
Repairing the asset
According to the ruling, "repairing" means:
- remedying or making good defects in, damage to, or deterioration of, an asset, and
- contemplates the continued existence of the asset.
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.
Acquiring asset in need of repair (restoration)
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.
Improving the asset
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:
- substantial alterations, or
- adding new substantial features or rights.
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).
Draw downs for repairs
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:
- the additional borrowings are applied in maintaining or repairing the asset held under the LRBA; and
- the later draw downs are provided for under the terms of that LRBA.
Improvements using money not borrowed
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.
Different (replacement) assets
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):
- subdivision of land - vacant block of land on single title subsequently subdivided resulting in multiple titles. One asset has been replaced by several different assets as a result of the subdivision;
- house built on vacant land - residential house built on vacant block of land on a single title. The character of the asset has fundamentally changed from vacant land to residential premises. This is a different asset;
- house destroyed and replaced with strata units - residential house is demolished following a fire and is replaced by 3 strata titled units on land. The character of the asset has fundamentally changed along with the underlying proprietary rights. This has created 3 different assets;
- residential house converted into restaurant - residential house is converted into a restaurant by renovations which include fitting out a fully functioning commercial kitchen. As a result of the renovation the character of the asset has fundamentally changed from residential premises to restaurant premises. This is a different asset;
- home office - one bedroom of a residential house is converted to a home office. This would not ordinarily result in a change in the overall character of the asset as a residential house. The conversion of the bedroom into an office does not result in a different asset;
- superior house rebuilt after fire - 4 bedroom house is destroyed by fire and a new superior residential house is constructed on that land using both insurance proceeds and additional SMSF funds. Rebuilding another residential house (whether of the same size or larger) does not fundamentally change the character of the asset held under the LRBA. The addition of a garage, for example, would also not change the character of the asset;
- home extensions (bedroom, pool, garage etc) - while each of the following changes would be improvements for a residential house and land, each (or all) of the changes would not result in a different asset: extension to add 2 bedrooms; addition of a swimming pool; extension consisting of an outdoor entertainment area; addition of a garage shed and driveway; addition of garden shed;
- compulsory resumption of land - to allow a road to be widened, a local government authority undertakes the compulsory resumption of a minor portion of the frontage of a property which has a residence on it. While the resumption results in the existing property title being replaced, the minor extent of the resumption is such that the fundamental character of the asset, taking account of not only the proprietary rights but also the object of those proprietary rights, remains that of being the residential property;
- granny flat - to be constructed in the backyard of a property which already has a 4 bedroom residence established on it. The granny flat will have 2 bedrooms, a family room, a kitchen and a bathroom and will be connected to utilities such as electricity, water and sewage. The character of the asset would remain residential premises and thus the construction of the granny flat would not result in there being a different asset.
Alterations to asset by tenant
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:
- the alterations do not fundamentally change the character of the asset (eg a tenant's fit out of office space); or
- in the case of the addition of fixtures that do fundamentally change the character of the asset, the fixtures remain the property of the tenant.
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.
Off-the-plan property purchases
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:
- 1. Two adjacent blocks of land.
- 2. Factory complex on more than one title.
- 3. Farmland with multiple titles.
- 4. Apartment with separate car park.
- 5. Serviced apartment and furnishings.
- 6. Purchase of residential premises.
- 7. Completed "off the plan" apartment.
- 8. House built in situ on land already owned by the SMSF.
- 9. Purchase of land and construction of house using borrowings.
- 10. Acquisition of a yet to be constructed house on land using borrowings.
- 11. House built over two titles.
- 12. Replacement of equipment following an insurance claim.
- 13. Purchase of cattle property and construction of a shed using SMSF funds.
- 14. Purchase of a small farm and construction of a residence using SMSF funds.
- 15. Commercial building extensions using SMSF funds.
Date of effect
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).
Thomson Reuters comment
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:
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More Cleardocs information on related topics
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- SMSF Death Benefit Nomination – binding or non binding
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