SMSF’s Borrowing to buy Property

Peter Johnson

CST Corporate Solutions Pty Ltd

Changes to SIS

• Tax Law amendment Bill No.5, 24 September 2007 two amendments to SIS Act section 67 & 71– Sec 67…borrowing prohibition clause…..has

new clause 67(4A)– Sec 71(8)…..definition of in-house assets…..

specifically excludes warrant trust as in-house asset

SMSF’s Borrowing to buy Property – Peter Johnson

New Section 67(4A)

Exception--installment warrants (4A)  Subsection (1) does not prohibit a trustee (the RSF trustee ) of a regulated superannuation fund from borrowing money, or maintaining a borrowing of money, under an arrangement under which:

• (a)  the money is or has been applied for the acquisition of an asset (the original asset ) other than one the RSF trustee is prohibited by this Act or any other law from acquiring; and

• (b)  the original asset, or another asset (the replacement ) that:– (i)  is an asset replacing the original asset or any other asset that met the conditions in this subparagraph

and subparagraph (ii); and– (ii)  is not an asset the RSF trustee is prohibited by this Act or any other law from acquiring;

• is held on trust so that the RSF trustee acquires a beneficial interest in the original asset or the replacement; and

• (c)  the RSF trustee has a right to acquire legal ownership of the original asset or the replacement by making one or more payments after acquiring the beneficial interest; and

• (d)  the rights of the lender against the RSF trustee for default on the borrowing, or on the sum of the borrowing and charges related to the borrowing, are limited to rights relating to the original asset or the replacement; and

• (e)  if, under the arrangement, the RSF trustee has a right relating to the original asset or the replacement (other than a right described in paragraph (c))--the rightsof the lender against the RSF trustee for the RSF trustee's exercise ofthe RSF trustee's right are limited to rights relating to the originalasset or replacement.

SMSF’s Borrowing to buy Property – Peter Johnson

New Section 67(4A)

• So what does it mean?– Trustee must borrow for purpose of acquiring an

asset, not against an existing asset– Asset must not be prohibited (ie.. Acquiring an asset

from a member)– Asset must be held on trust– SMSF Trustee can acquire the asset after it has paid

for it– Lenders rights against the trustee are only agains the

asset purchased

SMSF’s Borrowing to buy Property – Peter Johnson

New Section 71(8)• If, at a time:

(a) an asset (the investment asset ) of a superannuation fund is an investment in a related trust of the fund; and

(b)  the related trust is one described in paragraph 67(4A)(b) in connection with a borrowing, by the trustee of the fund, that is covered by subsection 67(4A); and

(c)  the only property of the related trust is the original asset or replacement described in that subsection;

• the investment asset is an in‑house asset of the fund at the time only if the original asset or replacement described in subsection 67(4A) would be an in‑house asset of the fund if it were an asset of the fund at the time.

SMSF’s Borrowing to buy Property – Peter Johnson

New Section 71(8)

• So what does it mean?– Without this section an investment in the warrant trust would be

an in house asset and therefore not allowed– This section does not allow the SMSF Trustee to take up units in

a Unit Trust (ATO Instalment Warrants and super funds – questions and answers)

– Other problems is unwinding a unit trust as this could trigger• Capital Gains Tax• Stamp Duty• GST

– May not be able to unwind if a related trust (can acquire residential real estate from a related party)

– Because of these issues a unit trust is not recommended

SMSF’s Borrowing to buy Property – Peter Johnson

Bare Trust Structure

• The recommended structure is a bare trust– This effectively makes the original asset an

asset owned directly by the SMSF– Only used to satisfy s67(4A) requirement that

the asset be “held in trust”– If structured correctly will mean no CGT,

Stamp Duty or GST upon unwinding the arrangement

SMSF’s Borrowing to buy Property – Peter Johnson

What is a Bare Trust?

• What is a bare trust?– An asset is held by the trustee for the

absolute benefit of a beneficiary.

• Who can be the trustee?– Anyone except the trustee of the SMSF (you

can’t hold an asset in trust for yourself).

SMSF’s Borrowing to buy Property – Peter Johnson

ATO Concerns – TA 2008/5

“monies advanced by a member or related party at zero or less than a commercial rate of interest could be characterised as a contribution to the SMSF. This may result in the trustee/member having to pay excess non-concessional contributions tax under Division 292 of the Income Tax Assessment Act 1997”

So you can lend to the fund yourself but it must not be at a discounted interest rate

SMSF’s Borrowing to buy Property – Peter Johnson

ATO Concerns – TA 2008/5

– “monies advanced by a member or related party at greater than a commercial interest rate of interest may result in:

• a breach of the sole purpose test outlined in section 62 of the SIS Act, on the basis that the excessive interest rate may mean that the SMSF is not being maintained solely for the purpose of providing superannuation benefits, and/or

• the trustee breaching paragraph 65(1)(b) of the SIS Act, whichprohibits the trustee from giving financial assistance to a memberof the SMSF or to a relative of such a member using the resourcesof the SMSF;”

So you can lend to the fund yourself but you must not profit from the fund by charging excess interest

SMSF’s Borrowing to buy Property – Peter Johnson

ATO Concerns – TA 2008/5– interest capitalised may result in the arrangement failing to meet the requirement

that the money borrowed is or has been applied for the acquisition of an asset under paragraph 67(4A)(a) of the SIS Act;

– a personal guarantee of the type outlined in paragraph 6 (d) above may result in recourse being made to the assets of the SMSF other than the asset acquired (or any replacement) in the event that the guarantee is enforced against the trustee as the principal debtor, contrary to the intent that the exception in subsection 67(4A) of the SIS Act only applies to limited recourse borrowings; and

– an asset of the type outlined in paragraph 6 (e) may result in breaches of the SIS Act or SIS Regulations (for example, intentionally acquiring an asset from a related party, which breaches subsection 66(1) of the SIS Act).

– Trustees are also reminded that existing fund assets cannot be placed into a limited recourse borrowing without breaching the SIS regulatory requirements.

SMSF’s Borrowing to buy Property – Peter Johnson

Other ATO Issues

• There are issues, listed below, in respect of which the Tax Office does not yet have a formal view. To the extent that these issues arise under a given arrangement, there may be concerns whether the arrangement complies with the law. These issues are: – Does an arrangement where a borrowing is guaranteed by a

third party satisfy the new laws, particularly where the personal guarantee is provided by a member or a related party?

– Does an arrangement that permits re-financing satisfy the new laws?

– Does an arrangement that permits capitalisation of interest satisfy the new laws?

– Can multiple drawdowns from a single loan facility satisfy the new laws?

SMSF’s Borrowing to buy Property – Peter Johnson

Other ATO Issues

• Other issues that are still being considered include: – What constitutes an ‘original asset’ and a

‘replacement asset’ for the purposes of the new law?

– What constitutes ‘maintaining a borrowing of money’?

• This publication will be updated when the Tax Office’s view is settled.

SMSF’s Borrowing to buy Property – Peter Johnson

Personal Guarantees– a personal guarantee of the type outlined in paragraph 6 (d)

above may result in recourse being made to the assets of the SMSF other than the asset acquired (or any replacement) in the event that the guarantee is enforced against the trustee as the principal debtor, contrary to the intent that the exception in subsection 67(4A) of the SIS Act only applies to limited recourse borrowings; and

– an asset of the type outlined in paragraph 6 (e) may result in breaches of the SIS Act or SIS Regulations (for example, intentionally acquiring an asset from a related party, which breaches subsection 66(1) of the SIS Act).

– Trustees are also reminded that existing fund assets cannot be placed into a limited recourse borrowing without breaching the SIS regulatory requirements.

SMSF’s Borrowing to buy Property – Peter Johnson

Personal Guarantees• TA 2008/5

– “a personal guarantee of the type outlined in paragraph 6 (d) above may result in recourse being made to the assets of the SMSF other than the asset acquired (or any replacement) in the event that the guarantee is enforced against the trustee as the principal debtor, contrary to the intent that the exception in subsection 67(4A) of the SIS Act only applies to limited recourse borrowings”

• How can this recourse be made?– Common law rights of guarantor against RSF Trustee to recover losses– Assets held in name of individuals as trustee of the SMSF may be

attacked by the lender and cause the SMSF to pay costs to defend• Refer to Article by Denis Barlin of SBN Lawyers• Deed of Guarantee in our documentation• Westpac requires Corporate Trustee of the SMSF

SMSF’s Borrowing to buy Property – Peter Johnson

Other Issues for Accountants• Providing Financial Product Advice

– Examples• Client without SMSF wants to buy an investment property and asks you the best

structure to buy the investment property in.• A client with money in the bank asks for advice as to the best way to purchase an

investment property• A client with shares in their SMSF asks about buying an investment property in their

SMSF• C Client with a retail super fund asks about buying a property through their super.

• Names on Trust Deeds – ensure they all match with the 100 points or you may have issues with the banks.

• Conveyancing – Now accountants will need to be involved– The Declaration of Trust is subject to stamp duty where it actually conveys a

property– Ensure dates of documents are correct– Mistakes will not be found out until you unwind the arrangement– NSW Revenue Ruling– Make sure names on contracts are correct

SMSF’s Borrowing to buy Property – Peter Johnson

Other Issues for Accountants

• The accountant will control this process as other stakeholders do not yet understand what is required – Bank Managers– Mortgage brokers– Real Estate Agents– Conveyancers– Solicitors

• But all these people will get to your client before you do!!!

SMSF’s Borrowing to buy Property – Peter Johnson

So how does it work?• The super fund can choose any property that it would be able to purchase under

SIS. The property must be purchased on an arms length basis. This includes business real property owned by the members or another related party.

• The legal title to the property must be held on trust by an independent trustee (the “Security Trustee"). The Security Trustee must not be the trustee of the SMSF (you can’t hold an asset in trust for yourself). The Security Trustee can be another company owned or controlled by a member of the SMSF. The beneficial title to the property will be held by the SMSF.

• The SMSF borrows directly from the Lender on a limited recourse basis. The only recourse the lender has is against the property being purchased. The lender may require personal guarantees from the members of the fund. The Security Trustee will provide a mortgage over the property in favour of the lender.

SMSF’s Borrowing to buy Property – Peter Johnson

So how does it work?• All financial dealings are direct with the SMSF. This includes loan repayments,

rents received expenses etc as if the property was owned by the SMSF. The SMSF can pay out or reduce the mortgage at any time (subject to the terms of the relevant loan). The accounts of the SMSF show the property as an asset, not a trust investment. Rental income and expenses are also shown in the SMSF accounts. There is no reason for the Security Trustee to apply for a TFN or ABN.

• When the mortgage is paid out in full, title to the property may be transferred tothe SMSF by the Property Trustee or the Property Trustee may continue asregistered proprietor. It is important that the structure clearly complies with allthe above requirements. Failure to do so may result in the SMSF becominga "non-complying" superannuation fund within the meaning of the SIS Act.

SMSF’s Borrowing to buy Property – Peter Johnson

ABN’s TFN’s Accounts etc

• The Security Trustee does not need to register for an ABN, TFN etc– Consider a special naming convention to help you internally

identify companies that will not need registration.– E.G. XYZ Property Nominee Pty Ltd.

• The asset is shown as a direct asset in the accounts of the SMSF

• The ABN of the SMSF is shown on a contract where the ongoing business GST exemption is being claimed or there is GST on any rent.– This will confuse solicitors– Similar to corporate manager of partnership of trusts

SMSF’s Borrowing to buy Property – Peter Johnson

Lenders

• Current Lenders:– NAB– Westpac– St George– Some specialist lenders such as Calliva & Mariner

• Be careful of specialist lenders – some have withdrawn from the market

• Get loan approval first• Cheapest to borrow in own name and then on lend

to the SMSF (need adequate equity)

SMSF’s Borrowing to buy Property – Peter Johnson

Lenders Requirements• All Lenders require specific powers in the SMSF Trust deed

so you will need an updated deed (post June 2008)– Power to borrow– Power to give security– Power to appoint a nominee– Conflict of Interest Powers (bare trustee is related to SMSF

Trustee)• Westpac require a corporate trustee for SMSF and Bare Trust• Meet lenders requirements BEFORE applying for the loan• You bank manager will probably NOT know his own bank’s

requirements

SMSF’s Borrowing to buy Property – Peter Johnson

Case Study• Client wishes to transfer the ownership of a commercial building to

her SMSF (she runs her veterinary business from this building)• SMSF not yet established• The client and their accountant approach CBA for SMSF loan, CBA

say they can assist and ask for supporting paperwork• Supporting paperwork is provided• Bank keeps paperwork for 1 week and then advises they can not

lend to the SMSF• The client then approaches WBC and asks about SMSF loans,

client is given a call centre phone number in QLD, client calls this number and is then referred to a NSW phone number

• The client then phones the NSW number only to be advised that SMSF borrowing is not available (note – WBC do offer a product)

SMSF’s Borrowing to buy Property – Peter Johnson

Case Study• Client comes to you saying they have equity in their own home and want to

purchase an investment property for $400,000 borrowing 110%• SMSF not yet established• You advise the client that they can borrow in their own name and lend that

money to an SMSF for the deposit and that the SMSF can borrow the rest.• You establish the SMSF and the client lends $160,000 to the SMSF for the

purchase of the property. • The fund then borrows the further $280,000 (being 70% of the purchase

price) to fund the remainder of the purchase• The client now has an appropriate structure where they can get tax

deductions for the principal payments on their property (assuming they can salary sacrifice or their SGC will suffice)

• They have not locked in their “deposit” as a non-concessional (undeducted) contribution

SMSF’s Borrowing to buy Property – Peter Johnson

What to do now?

• Get the word out to your clients – not just SMSF’s.– Run a seminar or do a mail out.– Make sure your clients know not to sign anything until

their Security Trustee is in place.

• Get loan pre approvals early• Ensure you are using the right

solicitors/conveyancers• Call us to take you through it

SMSF’s Borrowing to buy Property – Peter Johnson