Taxpayer Alert - Limited Recourse Borrowing Arrangements

In this ATO alert, the ATO has provided advance warning as to its concerns with limited recourse borrowing arrangements entered into by self managed superannuation funds. 

First, the ATO has concerns that the basic rules for an arrangement to qualify as a limited recourse borrowing arrangement are not being satisfied.  Secondly, the ATO has concerns that more complex arrangements involving unit trusts are being used in conjunction with limited recourse borrowing arrangements, which breach other superannuation provisions.

LRBAs are complicated investment structures.  Any arrangement must satisfy the basic LRBAs rules (set out in s67A) and the general SIS investment rules as well as having the desired capital gains tax attributes, GST features and, in particular, do not involve additional stamp duty.

Basic rules

The basic rules are, in essential terms, that a single asset must be acquired under the arrangement.  The asset which is acquired must be an asset which the super fund could acquire on an ungeared basis.  The money borrowed to acquire the asset must be borrowed by the super fund.  The asset must be held on trust for the super fund.  The rights of the lender against fund assets must be limited to the asset acquired pursuant to the arrangement.  Finally, once the loan is repaid, the asset must either be sold to a third party or transferred to the super fund.

Usually (and the banks will usually insist – purely for their own self interest), the super fund will also contribute to the purchase price from its own monies – whether from contributions or from selling other assets.

Additional elements

In order for the transaction to be tax efficient a number of other elements must be satisfied.  For example, from a capital gains tax perspective the ownership of the acquired asset by the holding trustee must be treated as ownership of the super fund (otherwise the transfer of title from the holding trustee to the super fund will be a CGT event).  For this to occur the super fund must be absolutely entitled to the acquired asset as against the holding trustee from the moment the holding trustee obtains legal title to the asset.

Also from a GST perspective, in order for the arrangement to be GST efficient, any taxable supplies involving the acquired asset should be treated as being provided by the super fund.  This is achieved by the holding trust being a bare trust.

From a stamp duty perspective in order for the arrangement to be duty efficient, only one ad valorem duty liability must be incurred.  In most jurisdictions (but not Queensland) this is achieved by the holding trust being a resulting trust, the existence and terms of which are confirmed by a written trust instrument.  Without proper structuring from a duty perspective, double ad valorem duty could be incurred.  For completeness, it should be noted that in some jurisdictions concessional duty may apply instead of ad valorem duty: for example in NSW where the acquired property is business real property which is individually owned by a member of the super fund.

Documents required and transactions order

Surprisingly, the main determinant of the documents required for a limited recourse borrowing arrangement and order in which those documents are signed is not the SIS Act but the stamp duty legislation of the relevant jurisdiction.  Essentially, the SIS Act specifies the end state of the structure but the other legislation specifies how the end structure is implemented.

Significance of the Taxpayer Alert

The ATO has indicated that in some LRBAs the basic rules are not being followed.  The ATO has listed a number of “concerns” which are set out below, followed by our commentary.  We have restricted our comments to LRBAs where the acquired asset is real estate as the vast majority of LRBAs are concerned with real estate.   While it is possible to have LRBAs where the acquired asset is personal property (eg shares) – these arrangements have different issues.

Concern (a)

The borrowing and title of the property is held in the individuals’ name and not in the name of the trustee of the holding trustee.  The SMSF funds part of the initial deposit and the ongoing loan repayments

The borrowing must be by the super fund.  The parties to the borrowing are the lender and the trustee of the super fund.  The members may in fact be the lenders, but they are not the borrowers.  The acquired asset must be held by the trustee of the holding trust.  The trustee of the holding trust could be one or more members or a company.  However, the same company or group of individuals cannot be both the trustee of the holding trust and also trustee of the super fund.  Where the trustee of the holding trust is one or more of the members of the super fund, then the holding trust deed evidences their holding as trustee for the super fund.

Concern (b)       

The title of the property is held by the SMSF trustee not the trustee of the holding trust

While there remains a debt outstanding under the LRBA, title to the acquired property must be held by the holding trustee.  When the debt is repaid under the LRBA, the acquired property will be sold to a third party or, alternatively, the property must be transferred to the super fund. 

If the arrangement has not been correctly structured from a stamp duty perspective, the transfer to the super fund will be subject to ad valorem duty. 

Concern (c)        

The trustee of the holding trust is not in existence and the holding trust is not established at the time the contract to acquire the asset is signed.

Due to stamp duty considerations, the structure of most LRBAs is that the party to the contract of sale is the trustee of the holding trust.  On settlement of the contract of sale, the title to the property is transferred from the vendor to the holding trustee.

If the entity which is the holding trustee is not in existence at the time the contract of sale is signed, either there is no enforceable contract of sale or the contract is between the vendor and a different party. 

The holding trust will come into existence once the holding trust enters into the contract of sale.  The completion of the contract of sale does not involve a replacement of one acquired asset (ie the rights under the contract of sale) with another asset (ie the real estate when title is transferred on settlement).  A holding trust deed is often signed after exchange and before settlement to evidence (not create) the existence of the holding trust as well as for stamping and conveyancing purposes.

In some jurisdictions (for example Queensland, South Australia and Northern Territory) an holding trust deed is signed before exchange and the holding trust deed must operate as an agency authorisation by the super fund to the holding trustee.

Concern (d)

The SMSF trustee acquires a residential property from the SMSF member.

One of the basic rules for a LRBA, is that the “single acquirable asset” must be an asset which the trustee could have acquired on an ungeared basis.  A trustee of an SMSF is prohibited from acquiring (this covers both buying and receiving the property as a contribution) an asset from a related party of the fund (such as a member). 

While this prohibition is subject to a number of exceptions (the main one being the “business real property” exception), no exception applies to real estate which is non-business real estate.  Merely renting out real estate does not constitute the real estate as business real property.

Concern (e)

The acquisition comprises two or more separate titles and there is no physical or legal impediment to the two titles being dealt with, assigned or transferred separately.

A basic rule for a LRBA is that it must relate to a “single acquirable asset”.  Where the asset is real estate, each separate piece of real estate (ie each separate title) constitutes a distinct asset.  Consequently, where real estate consists of two or more titles, each separate piece of the real estate must be the subject of its own LRBA.

There is an exception where two or more pieces of real estate either cannot be separately sold (eg a unit strata and car space) or a physical structure joins the two pieces of real estate (eg a factory built across two or more titles).  Merely placing a disused bath tub across the boundary or building a fence which sits on the boundary will not be sufficient.

Concern (f)

The asset is a vacant block of land.  The SMSF intends to use the same borrowing to construct a house on the land.  The land is transferred to the holding trust prior to the house being built.

Another basic rule of a LRBA is that the asset while held by the holding trustee cannot be materially changed.  The justification of this rule is that changing the land (eg by constructing a building on the land) changes the asset and it is the lender which benefits from the change.  This undermines the limited recourse nature of the arrangement.

The situation of a vacant block is different from a situation where real estate with an existing structure is purchased and the structured is repaired and/or maintained, which is permitted.

Also an arrangement where the super fund is buying a completed structure (eg “off the plan” purchases and “house and land” purchases) is not caught by this rule as the asset which is acquired is the completed structure and not the separate elements which are used to make the completed structure.