Super borrowing – top 10 tips and some alternatives

Scott Hay-Bartlem, Partner, SMSF Specialist Advisor 11 October 2013

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Overview • • • • • • Super borrowing been with us some years Downside of getting it wrong is quite serious… Becoming more common Quite technical Top 10 tips Some alternatives

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A summary of the rules… • SMSF trustees generally not allows to borrow • Section 67A Allows trustee of SMSF to borrow • Asset held on trust • • SMSF gets title after paying instalments Lender’s (and others’) right limited to asset • Asset SMSF could have acquired

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1. Get the structure right • • • SMSF borrows Bare trust owns the asset If not • Borrowing prohibition • In-house asset

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1. Get the structure right Guarantees Bank members $$$ SMSF Contributes funds Sole Beneficiary Bare Trust Purchases non-recourse

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2. What asset?

• The SMSF must have been able to acquire • In-house assets • Buying from related parties • Business real property • Listed securities • Some allowable in-house assets • Market value • Usual terms

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2. What asset? (cont’d) • Single acquirable asset SMSFR 2012/1 • Single legal thing unless identical and identical value • One title • • • • • Must sell together legally ‘Unifying physical object’ ‘Permanent in nature’ ‘Not easily removed’ ‘Significant in value relative to the value of the asset’

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2. What asset? (cont’d) • Examples • Strata lot + car park if must go together • Building over two lots • Off the plan + deposit • Option + subsequent purchase • Multiple drawdowns

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3. Can I change the asset?

• Limits on replacement assets • Repair • Occasional and partial • Restores function of asset without changing character • Maintain • Prevent defects, damage or deterioration • Includes anticipation of defects

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3. Can I change the asset? (cont’d) • Improve • Significantly altered for the better • Substantial alterations • Reference made to asset at time of acquisition

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3. Can I change the asset? (cont’d) • Examples • Addition of dishwasher • Fence • Swimming pool • Granny flat

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4. Can a related party be the lender?

• Yes, but • Arm’s length terms – would the bank have done it and what would the loan look like?

• Repayments • Interest rate • Document • Security • Guarantees • If loan from a company, Division 7A

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4. Can a related party be the lender? (cont’d) • NTLG minutes June 2012 • No or discounted interest loans • • Not arm’s length breach or contribution Non arm’s length income

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5. Can a related party use the asset?

• Yes, but • • Written lease Arm’s length terms • Tenant improvements • Wholly and exclusively used in a business • Sole purpose • For example, Montgomery Wools case

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6. When the loan is paid off… • ATO – must transfer the asset to the fund • Section 71(8) exemption from the in-house asset rules cease to apply • CGT?

• • ‘Absolutely entitled’?

‘Look through’ treatment proposed (still waiting on legislation)

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6. When the loan is paid off… (cont’d) • Duty • • S130B (new exemption) ‘Nominee contract’ provisions • • CGW has been successful Or duty on value of asset at time of transfer…

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7. Update the investment strategy • Section 52 covenant • • Formulate and update Does it deal with • Proposed investment • Borrowing • Increased risk • What happens on death of member • Insurance

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8. What if a member dies?

• If member dies with borrowing in place, what does the fund do?

• Breach of loan/guarantee?

• Are we required to pay a lump sum?

• Can we pay a pension?

• Can we transfer part of an asset?

• Are there other assets in the fund to provide benefit?

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8. What if a member dies? (cont’d) • Unallocated insurance • Provides cash for paying out the interest • Does not form part of the benefit • Trust deed must allow (most do not) • Premiums not from accumulation account • Contribution caps as allocate from reserve • Deductibility of premiums?

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9. Can two SMSFs have one bare trust?

• • • No One trust per SMSF For multiple fund investments, look at • Unit trust • Joint SMSF

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10. SMSF trust deed • Does it allow?

• Borrowing power • Often absolute prohibition pre-2007 • Refer to repealed s67(4A)?

• Buy particular asset • Power of attorney

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Some alternatives • Unit trusts • Ungeared • Unrelated • Pre 1999 unit trust • • Installment contract/vendor finance ‘Joint venture’

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Ungeared unit trusts • • Exempt from in-house asset rules • • • • • • • Strict Requirements (Regs 13.22B & 13.22C) No debt or charges No loans, or investments in other entities Not acquired assets from related party (except business real property) Not lease assets to related party, except BRP Not carry on a business Arm’s length terms for all transaction If breach, investments become in-house assets

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Ungeared unit trusts (cont’d) • • • Very restrictive Tangible assets only If breach, the exemption • Ceases to apply to the existing investment in that entity • Can never apply to any further investment in that entity

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Ungeared unit trusts (cont’d) • Example • • Abbott SMSF establishes unit trust as sole unitholder Unit trust buys real estate from arm’s length party and leases to arm’s length tenant • No borrowings, charges etc.

• Ungeared exemption can apply and units are not in-house assets • SMSF could borrow to acquire • But not buy from a member?

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Ungeared unit trusts (cont’d) • Example • Unit trust borrows to buy more real estate • Ungeared entity exemption no longer applies units now an in-house asset

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Unrelated unit trusts • • In house asset rules only apply to a ‘related trust’ ‘Related trust’ if ‘group’ has: • • • Fixed entitlement more than 50% of income/ capital ‘Control’ of trustee Ability to appoint remove the trustee

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Unrelated unit trusts (cont’d) • • • • • ‘Control’ of trustee • Effective control - directions or wishes of the group Majority of trustees?

Majority of directors?

Majority of shares in corporate trustee?

Tie breakers – casting vote?

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Unrelated unit trusts (cont’d) • • ‘Group’ - s70E(3) • • Member + Part 8 associates Standard employer-sponsor + Part 8 associates Part 8 Associates (s70A, 70B, 70C) • • • Relatives Tax law partnerships, other partners, spouses and children Other controlled entities • • More than 50% Effective or practical control

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Unrelated unit trusts (cont’d) • Example SMSF 1 & SMSF 2 are unrelated • Each SMSF is completely unconnected and has 50% of units in unit trust • Trustee is a company • Two directors from each SMSF • No casting vote

Unrelated unit trust SMSF 1 SMSF 2

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Unrelated unit trusts (cont’d) • SIS Act does not apply • Units not in-house assets • Borrow and charge its assets • Invest in other entities, including related parties and trusts • Acquire assets from related entities • Acquire multiple assets • Develop/improve

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Pre 1999 unit trust • • • • Rules changed 1999 Some grandfathered old trusts still out there Often able to buy new assets and borrow Where clients have them, can be better answer than LRBA

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Limitations - unrelated unit trusts • SIS Act – I thought it did not apply?

• • • Section 62 – sole purpose test Section 65 – financial assistance Section 109 arm’s length terms

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Summary • • • Are opportunities And traps – need to get it right!

Be aware there are other options

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Limitations unrelated unit trusts (cont’d) • • Anti-avoidance • • • Section 66 – related party acquisitions Section 85 – in-house assets Section 71(4) – ATO discretion Cannot buy out other unitholder • Ungeared entity exemption????

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Thank you

Scott Hay-Bartlem

Partner TEP, SMSF Specialist Advisor

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