The use of Limited Recourse Borrowing within Self Managed Super Funds continues to capture the attention of trustees and advisers alike.
We are seeing some significant work being undertaken in this area of borrowing to provide greater clarity of section 67A & 67B introduced into the Superannuation Industry (Supervision) Act 1993 (“SIS Act”).
With this activity, I thought it appropriate to post an article outlining the current “state of play” in regards to SMSF Limited Recourse Borrowing Arrangements. So where are we currently at with many of the ‘grey’ issues?
- Definition of “Single acquirable asset” – the current ATO view of single acquirable asset for real property is based on its boundaries defined by legal title. Therefore, the single acquirable asset definition is very restrictive as it does not allow for properties held over multiple titles including farmland and some commercial property. A more common issue caught by this definition is the car-park attached to an apartment or office building that sits on separate title. Where assets are inseparable, or where there is an ancillary asset of a very small value, the ATO may treat the assets as a single asset for the purposes of section 67A. Previous information from the ATO has indicated that a car park does not meet this requirement. It would be prudent to obtain a private ruling from the ATO where such inseparable or ancillary assets exist.
A workshop was conducted late last year by the ATO with selected representatives of the NTLG Super Technical sub committee to address issues impacting limited recourse borrowing arrangements. The Institute of Chartered Accountants (“ICAA”) included as part of their submission for the ATO to adopt an accounting standards approach to identify what is a single acquirable asset. The use of accounting standards looks at the “economic substance” of an asset, not simply the boundaries of legal title. By taking this view it means that the component parts of an investment property are not looked at but instead they are treated as one whole asset.
It is my understanding that the ATO have taken this information on board and raised the issue back to Treasury as a technical priority issue. Any change will need to balance the original policy intent of the changes in July 2010 with the current ‘logic’ provided by the industry. As a result we are unlikely to receive any further information on the matter from Government until August or September this year.
- Improvements regardless of source of funds are prohibited – arguably the most common question I get asked is whether the real property acquired can be improved using the super fund’s own money. Regardless of the source of funds, any capital improvements would be in breach of the replacement asset rules contained within section 67B of the SIS Act. Therefore if any capital works need to be undertaken on the property, they should be completed prior to purchase, otherwise at this stage we are stuck with only being able to repair an asset to its original state.
- Repairs vs. Improvements – the already ‘grey’ issue within tax law now also resides within superannuation law with the introduction of section 67A(1)(a)(i) that allows the acquisition of an asset to include expenses incurred in maintaining or repairing the asset to ensure that its functional value is not diminished. The only guidance currently available is contained in Tax Ruling TR 97/23. The ruling applies a very rigid approach in determining what is a repair vs. improvement.
Read further information from my previous blog, are limited recourse borrowings beyond repair?
To understand some of the issues being confronted by the introduction of these changes to superannuation law and the application of TR97/23, let’s look at a few examples:
- New hot water system — the replacement of a depreciable asset such as a hot water system would not be considered a repair for tax purposes. Accordingly, any new system would be capital and constitute a replacement asset?
- Painting internal surfaces — if the painting involves a full refurbishment, which results in the interiors being changed, updated, upgraded or otherwise improved (i.e. the new asset is different either in form, quality or functionality than the original), the costs would be on capital account and therefore be in breach of the replacement asset rules. If the painting merely puts the internal surfaces back to the condition that they were in, e.g. before the surface was damaged, the costs should be deductible as repair costs.
- Replacing emergency lights — as with the hot water system, the new lights would generally be considered to be the replacement of depreciable assets and therefore not repairs.
I understand that issues regarding improvements to the acquirable asset have been discussed with Treasury as a priority technical issue. We can only be hopeful that the ATO would not apply this very strict approach to real property owned within a SMSF (otherwise some tenants may be having cold showers!!)
- Properties affected by natural disaster – with the significant impacts of floods, fires and other natural disasters over the past year, it was pleasing to see the Commissioner state that they would use their discretionary powers for a SMSF to retain its complying fund status (section 42A) to repair damaged properties, even where these repairs would constitute a replacement asset.
Refer to my previous post, replacing assets using limited recourse borrowings affected by natural disasters.
- In-house assets – the ATO has made clear that in their view there will be a breach of the in-house asset rules if legal title is not transferred to the SMSF after the borrowing has ended. By retaining the asset within the holding/bare trust, it will be an investment in a related trust.
- Reviews of ATO Interpretative Decisions (ATOIDs) - expect the ATO to revisit ATOID 2010/162 – borrowing from a related party on more favourable terms to the SMSF. This initial interpretive decision somewhat caught the industry by surprise with its initial views. Further thought by the Regulator has suggested that they will go back to the drawing board on this ID to consider the arms-length requirements further and the impact of other areas of superannuation law where the SMSF obtains more favourable terms. Refer to previous article, What interest rate can you charge your fund for a SMSF limited recourse loan?
These are just some of the mounting issues on the ATO’s plate that are needing to be dealt with on the issue of limited recourse borrowing arrangements.
With an overlay of the Stronger Super support by the Federal Government to review limited recourse borrowing within two years (30 June 2013), it tempers some of the enthusiasm around for using this strategy within a self-managed super funds. Hopefully we will see some light at the end of the tunnel shortly providing greater clarification to progress forward with this exciting strategy.
Download the SMSF Limited Recourse Borrowing day brochure to find out more information about the strategies and practical issues of using these highly effective arrangements within a Self-Managed Super Fund.