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…
I’ve spent the past week presenting at professional development days for 
