Exposure draft released on consideration of Insurance, Separation of Assets and Valuation of Assets at Net Market Value for SMSFs

June 1, 2012 By Leave a Comment

The Super System Review submitted to Government back on 30 June 2010 made several recommendations to improve the operation and regulation of the self managed super fund sector. Many of these recommendations were accepted by Government and formed part of the Stronger Super reforms to take effect from 1 July 2012.  We have now seen the issue in of the draft regulations in respect to some of the recommendations around consideration of:

  • insurance within an SMSF investment strategy;
  • the inclusion as an operating standard the requirement to have fund assets held separately from personal or employer assets; and
  • fund assets to be valued at net market value for reporting purposes

Trustee requirement to consider insurance for SMSF members as part of their investment strategy

The proposed regulations are to insert a new paragraph into sub-regulation 4.09 (2) to ensure that trustees consider whether they should hold a contract of insurance that provides insurance cover for one or more members of the fund.  With less than 13% of SMSF’s holding insurance for members, this recommendation aims to ensure that trustees appropriately consider the holding of insurance for fund members.

There will be a requirement for trustees to consider whether to hold insurance for their members such as life insurance when they formulate, regularly review and give effect to the fund’s investment strategy. It is expected that trustees will evidence this requirement by documenting decisions in the funds investment strategy or minutes of trustee meetings that are held during an income year.

In addition to the consideration of insurance within a fund’s investment strategy, this regulation would also amend subsection 4.09 (2) to require trustees to regularly review the funds investment strategy.  This will require trustees to evidence this review by documenting decisions in the minutes of trustee meetings are held during the income year.

The separation of fund assets from personal or employer assets

These regulations would insert into sub regulation 4.09A to require that a fund trustee keep money and other assets of the fund separate from money or assets held by the trustee personally or by a standard employer sponsor.  Currently this requirement forms part of a covenant (section 52(2)(d) of SIS Act) that is deemed to be incorporated into the governing rules of the fund (i.e. trust deed).  The ATO is currently unable to enforce compliance with covenants and relies on voluntary compliance by trustees.

It is not uncommon within SMSFs that breaches occur within this existing covenant where investments are incorrectly held by the fund.  This may include the fund bank account or other investments that maybe incorrectly recorded in a member’s own name rather than in the capacity as trustee of the SMSF.  Contraventions of this existing covenant are one of the most commonly reported contraventions sent by auditors to the ATO.

With this regulation becoming a prescribed standard applicable to the operation of a SMSF, the Regulator will have powers to enforce fines of up to $11,000 for a person who intentionally or recklessly contravenes the standard.

Valuing fund assets at net market value

A SMSF is required under section 35B of the SIS Act to prepare a Statement of Financial Position and Operating Statement each income year.  From the 2012/13 financial year, all SMSF’s will be required to value an asset at its net market value when preparing accounts and statements.

Sub-regulation 8.02A(2) will define net market value as the amount that could be expected to be received from the disposal of an asset, in an orderly market, after deducting costs expected to be incurred in realising the proceeds of such a disposal.  Currently, SMSFs are generally able to choose either historical cost or market valuation methods to determine the value of fund assets when preparing financial statements.  There are however requirements for a fund in pension phase (see TD 2009/29) or for in-house asset purposes (see s.82, SIS Act) that assets should be valued at market value each year.

The lack of consistency in valuation methodology has not only lead to an impact on a member to not be able to ascertain the current value of their super benefits, but it also affects the reliability and usefulness of superannuation data to make accurate comparisons across the entire superannuation sector (where APRA regulated funds are required as reporting entities to value their assets at net market value as required by Australian Accounting Standard, AAS 25).

The requirement to value assets to their net market value will ensure that members are provided with current and accurate information about the financial position of their fund and entitlements, along with an ability to better compare and understand the financial information across all sectors of the superannuation system.  Failure to comply with this reporting requirement will carry penalties of $11,000 and is also a strict liability offence and carries a penalty of $5,500.

My views

It will be interesting to watch over the coming years as to the influence of the inclusion within the fund’s investment strategy to consider insurance.  I would argue that many SMSF trustees (not all) lack a solid written investment strategy, with a large number of funds only having something in existence to ensure compliance with the auditor’s sign off under the compliance audit.  Far too often it is not actually used as a tool to set objectives consider risk, diversification, liquidity and from 1 July, insurance.  With a large proportion SMSF members at or nearing retirement, the need for insurance traditionally diminishes over time.  I do however believe this to be a positive step with the number of younger SMSF members entering the market, in particular where individuals are now undertaking borrowing within superannuation to acquire assets.

You can access information about these draft regulations and explanatory memorandum on the Stronger Super website.

Filed Under: Announcements, SMSF, SMSF Compliance, Trustee education Tagged With: , , , , , ,

How the Commissioner’s views on borrowings could spark a property developer’s frenzy on SMSF trustees

May 30, 2012 By Leave a Comment

It quite amazing how far we have come with limited recourse borrowing arrangements over the nearly 2 years since changes were introduced on 7 July 2010.  Many people would recall at that time of the introduction of sections 67A and 67B into the SIS Act that many within the industry were highly critical of the very strict limitations that appeared to be imposed with the single acquirable asset definition, along with the supposed inability to make any changes to a particular asset held under such a borrowing arrangement.

The final SMSF ruling, SMSFR 2012/1 on the application of key concepts with limited recourse borrowing arrangements has certainly seen this view come full circle as the practical approach taken by the Commissioner within this ruling provides both clarity and some exciting opportunities for the acquisition of real property within a self managed super fund.

With the property market facing its own challenges in respect to attracting buyers, we have seen a shift with property developers looking to target the SMSF market to promote property to trustees as part of their fund’s investment strategy.  The original draft ruling issued in September 2011 provided clarity around the ability for a fund to acquire off-the-plan apartments, where the borrowing arrangement was entered into at the time the property was completed and strata-titled.  It appears that the final ruling, SMSFR 2012/1, has expanded the Commissioner’s view in respect to how a LRBA can be entered into to acquire property to be developed (whether an off-the-plan apartment or house and land).

So what has changed from the draft ruling to the final ruling in respect of property development?

The draft ruling discussed that a borrowing could only be entered into for an off-the-plan purchase once the property had been completed and strata titled.  This meant that the SMSF was required to fund the initial deposit and then obtain the SMSF limited recourse loan for the completion of the property.  This view appears to have slightly changed within the final ruling whereby, if a contract is entered into for an off-the-plan purchase of a strata titled unit (that is, the purchase of a unit that is yet to be built and strata titled) and under the contract a deposit is required upon entering into the contract with the balance payable at settlement after the unit is built and strata titled, each payment is applied for the acquisition of that strata titled unit.  Providing that the strata titled unit is a single acquirable asset, the deposit and the balance payable at settlement may be funded under a single LRBA.

The final ruling also expands in the construction of a house on land through the use of a limited recourse borrowing arrangement.  Previously it has been the understanding that when it came to the development of house and land, the draft ruling inferred that the land was the single acquirable asset and once a property is added it becomes a different asset (replacement), which is not permitted under section 67B.  Whilst this to some extent remains true, the final ruling outlines that a similar outcome results (to a OTP apartment) if the contract entered into is for the purchase of a single title vacant block of land along with the construction of a house on that land before settlement occurs.  In this situation the deposit paid upon entering into the contract and the balance payable upon settlement is applied for the acquisition, under that contract, of land with a completed house on it. The deposit and the balance payable at settlement may be funded under a single LRBA.

The ruling provides two examples of how structuring the purchase of house and land will ultimately dictate what is a single acquirable asset:

Purchase of land and construction of house using borrowings

The trustees of an SMSF want to enter into a LRBA where the single acquirable asset is a vacant block of land.  The SMSF intends that the borrowing will provide sufficient funds for the construction of a house on that block. Assuming that title to the vacant land transfers to the holding trust prior to the house being built, it is the vacant land that is acquired and held on trust under the LRBA .  This arrangement will cease to satisfy the requirements of section 67A if money borrowed under the LRBA is subsequently used to construct the house and thus improve and fundamentally change the character of the asset held on trust (that is, from vacant land to residential premises ).  This outcome is not altered even if the contracts entered into for the acquisition of the land and the construction of the house contain clauses linking the two contracts .

Acquisition of a yet to be constructed house on land using borrowings

The trustees of an SMSF want to 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 a LRBA. As the contractual arrangement is for the acquisition of land with a completed house on it, and settlement occurs once construction of the house is finished, the deposit and the payment on settlement can be funded under a single LRBA .

It is the Commissioner’s view that the second arrangement is for the acquisition of a single acquirable asset, being the land with the house constructed on it, as distinct from the first where the single acquirable asset is the land only.

The view’s expressed within this final ruling certainly open the doors for SMSF trustees to consider a greater range of new property development opportunities using limited recourse borrowing arrangements.  I think it would be fair to say property developers will certainly be ready and waiting.

Filed Under: ATO, Limited Recourse Borrowing Arrangements, Professionals, SMSF, SMSF Compliance, SMSF Strategy Tagged With: , , , , , , , , , , , ,

Final ruling provides good news for SMSF property investing using borrowing

May 25, 2012 By 1 Comment

If the industry was pleased about the draft ruling on limited recourse borrowing arrangements (LRBA), the final ruling, SMSFR 2012/1 has done nothing to wipe the smiles off trustee & industry faces.  The ATO has taken a practical approach in this ruling to key concepts including:

  • What is an ‘acquirable asset’ and a ‘single acquirable asset’
  • ‘maintaining’ or ‘repairing’ the acquirable asset as distinguished for ‘improving it’; and
  • When a single acquirable asset is changed to such an extent that it is a different (replacement) asset

Much of the industry feedback for the final ruling was to add further clarity and practicality to assist trustees and professionals alike to understand these key concepts.  Broadly, I think this ruling has achieved a more than satisfactory outcome for the specific issues.  There does however remain a range of outstanding issues that further clarification, including in-house assets, the concept of the holding trust vs. bare trust amongst others.

I have provided below a summary of my views from the final ruling, SMSFR 2012/1: Limited Recourse Borrowing Arrangements – application of key concepts:

Single Acquirable Asset

The final ruling has expanded on its initial views regarding the need to consider both the legal form and substance of the acquired asset, having regard to both the proprietary rights (ownership) and the object of those rights.  It explains that it may be possible to for an asset to meet the single acquirable asset definition, notwithstanding that the object of property comprises of separate bundles of proprietary rights (e.g. two or more blocks of land).

The final ruling further outlines factors relevant in determining if it is reasonable to conclude that what is being acquired is a single object of property.  These include:

  • the existence of a unifying physical object, such as a permanent fixture attached to land, which is significant in value relative to the overall asset value; or
  • whether a State or Territory law requires the two assets to be dealt together.

Where the physical object situated across two or more titles:

  • 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; or
  • a business is being conducted on two or more titles; or
  • the assets are being acquired under a single contract because, for example, the vendors wish to ‘package’ the assets

will mean that these assets will remain as being distinctly identifiable and not be identified as a single object of property.

Repairs, maintaining and improvements

The most pleasing aspect of reading the final ruling was the removal of any references to TR97/23, which from a tax perspective deals with repairs vs. improvements. Importantly, in distinguishing between repairs, maintaining and improving, the Commissioner applies their ordinary meaning having regard to the context in which they appear within s67A & s67B of the SIS Act.

The ruling provides a variety of practical illustrations that demonstrate what is a repair or maintenance (where borrowings can be applied) versus what would amount to an improvement (where borrowings can not apply, however the fund or member’s own resources can be applied for any improvement). In particular, the Commissioner has clearly indicated that restoration or replacement using modern materials will not amount to an improvement. The lines may be blurred somewhat if superior materials or appliances are used, how it would be a question of degree as to whether the changes significantly improve the state or function of the asset as a whole.

This distinction of repairs, maintaining and improving is critical because we must remember that borrowed funds can only be used for prescribed purposes – being the acquisition of a single acquirable asset, including expenses incurred in connection with the borrowing or acquisition, or in maintaining or repairing the acquirable asset. Where improvements are made with borrowed funds, this is a breach of not only the s67A exception, but then any maintenance of a borrowing beyond this becomes a breach of s67(1) (general borrowing prohibition).

In general terms, any improvements made to property where the single acquirable asset was for example the residential house and land is allowed whilst carrying a limited recourse loan, but only to the extent that it doesn’t become a different asset. For example, the addition of a pool, garage, shed, granny flat, additional bedroom, or second story are all allowable improvements without changing the character of the asset where it becomes a different asset (breaching the replacement asset rules in s67B).

Different (replacement) asset

It is important that the single acquirable asset is not replaced in its entirety with a different asset (unless covered under s67B).  When considering the object and proprietary rights of the asset, any alterations or additions that fundamentally changes the character of that asset will result in a different asset being held on trust under the LRBA.

The ruling provides a range of examples as to when an asset become a different asset including through subdivision, a residential house built on land, and change of zoning (residential to commercial).  There are however various examples that demonstrates that where such improvements don’t create a different asset, including:

  • one bedroom of house converted to home office
  • house burnt down in a fire and rebuilt (regardless of size) using insurance proceeds and SMSF funds
  • compulsory acquisition by government on part of property; and
  • granny flat added to back of property

Property development

When it comes to the use of a LRBA for the development of property, the ruling provides clarity around the importance of the terms of the contract of purchase as to what will constitute the single acquirable asset.   For an off-the-plan purchase (as was stated in the draft ruling), if a contract was entered into and under the contract a deposit was payable with the balance payable on settlement after being built and strata-titled, this is allowable under a LRBA (as the strata-titled unit is the single acquirable asset).  It is noted that a separate car park or furniture package will not meet likely be packaged into the single acquirable asset and require a separate (or multiple) LRBA.

The Commissioner has expanded his views further in the final ruling that a similar outcome occurs if the contract entered into is for the purchase of a single title vacant block of land, along with construction of a house on the land before settlement occurs.  Where the deposit is paid upon entering the contract and the balance payable upon settlement is applied for the acquisition, it may be funded by a single LRBA as the single acquirable asset is the land with a completed house on it.  Examples 9 and 10 within the ruling outline the important differences how house and land purchases need to be structured to meet the single acquirable asset definition.

Summary

In my view, the end result is a positive one for property investors within self managed super funds.  The scope available for improvements certainly makes this strategy appealing as well.  Fundamentally though, you need to ensure that the investment will stack up being held inside superannuation…

It will be interesting to watch the changing landscape of borrowing in super as the impact of this final ruling and the proposed licensing obligations on these arrangements unfold over the coming months…

 

Filed Under: Limited Recourse Borrowing Arrangements, Professionals, SMSF, SMSF Compliance, SMSF Strategy Tagged With: , , , , , , , , , , , , , , ,

Changing landscape when dealing with excess contributions?

May 22, 2012 By 1 Comment

Much has been talked about of the budget announcements impacting contributions, in particular a flat $25,000 concessional contribution cap that will apply across all individuals from 1 July 2012.  Whilst concessional contributions have been impacted, non-concessional contribution amounts will remain at $150,000 p.a. with the bring forward rule available for those under age 65.

Given the statistics that resulted from the last halving of the concessional contribution cap (see post, latest statistics on excess contributions tax), I would envisage further excess contributions tax issues resulting from many individuals 50 and over again requiring to change salary sacrifice arrangements down from $50,000 to $25,000.

The ‘get out of jail free’ card was always handy when playing Monopoly, and importantly we now have something like this available (in several forms) when it comes to dealing with excessive contributions.  These remedies outlined below may assist with any concessional contribution or non-concessional contribution cap breach:

  • Once off-refund of excess concessional contributions – Timing is everything when it comes to making contributions, in particular where employer obligations for SGC (and salary sacrifice) don’t mirror when a contribution is received and reported by a SMSF for contribution cap purposes.  Whilst many people got caught previously in the 2010 FY due to this timing issue, this time around any excessive amount of $10,000 or less can be disregarded by the Commissioner and be re-assessed within the individual’s tax return for the financial year.  Subject to their own marginal tax rate, this may provide a better outcome.  Read previous post on proposed changes to refund excess contributions (to be effective from 1 July 2011).
  • Contributions reserving – Another ‘get out of jail’ strategy was to effectively park any June contributions into a holding account or reserve within the SMSF, subject to the fund’s trust deed not prohibiting the use of reserves.  We have recently seen clarity provided by the ATO in the use of this strategy through ATOID 2012/16, which states that whilst the contribution for income tax purposes is assessable in the year paid into the fund, for contribution cap purposes, it counts in the year in which it is allocated.  See previous post for further details.  The use of a contributions reserving strategy can apply equally to non-concessional contributions.
  • De-minimus test – this change in view in March 2012 from the Australian Taxation Office certainly hasn’t made any headlines, but provided a significant shift in thinking by the Commissioner in collecting large ECT amounts triggered by small amounts.  The ATO are currently working through a series of these assessments previously raised to effectively refund an individual as a result of a disproportionate ECT liability due to a small breach of the concessional and non-concessional cap.  To date, we have no guidance on what constitutes a small amount to be disregarded.  More information on this can be found in my previous post, de minimus to help with contribution maximis
  • Returning Amounts – SIS Regulation 7.04(3) outlines that a fund can not accept a fund-capped contribution; that it a contribution which is greater than three times the non-concessional limit for someone under 65 years of age, or more than the non-concessional limit where someone is 65 years of age older.  Where a single contribution is made into an SMSF that is excessive, the trustees are obliged to return the excessive amount.  ATO ID 2009/29 outlines that there is effectively no timeframe to return the excessive contribution as it should not have been accepted by the super fund in the first place.  As a result, if an individual makes a single excessive contribution they have the ability to retain this amount without being subject to excess contributions tax.

Ongoing management of contribution caps is still the most important role you play to ensure that an individual does not breach their contributions caps.  Whilst still far from perfect, at least the law provides some opportunities to use the ‘get out of jail free’ card to address any potential excess contributions tax issues.

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Filed Under: ATO, Contributions, SMSF Tagged With: , , , , , , , , , , ,

Infographic of March 2012 SMSF statistics

May 20, 2012 By Leave a Comment

The Australian Taxation Office publishes a quarterly statistical report of Self Managed Super Funds.  The March quarter again showed strong signs of growth, with an additional 7,152 new establishments, taking the total establishments to 35,868 for the last 12 months.  This growth was coupled with positive share market data, which improved the total fund assets to more than $416 billion.

Take a look at the infographic to understand some of the other important data released from the March 2012 SMSF statistics.

Filed Under: Professionals, SMSF, Statistics, Trustee education Tagged With: , , , , ,
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