ATO clarifies SMSF borrowing

The Australian Taxation Office has recently provided more clarification on borrowing arrangements for SMSFs. Stephen Bone puts into context three major areas of the draft ruling.

In the recently released draft self managed superannuation funds (SMSF) ruling SMSFR 2011/D1, the Australian Taxation Office (ATO) has provided welcome clarification on a number of key issues relating to limited recourse borrowing arrangements (LRBAs).

By softening their stance on some of these issues, the ATO has opened up greater opportunities for SMSF trustees considering LRBAs and allowed them to invest with greater certainty.

The draft ruling provides clarification on a number of areas:

• Meaning of a single acquirable asset;
• Difference between maintaining, repairing and improving an asset; and
• When an original asset becomes a different asset.

Meaning of a single acquirable asset

Under an LBRA, a SMSF trustee is restricted to acquiring a single asset or a collection of identical assets that are treated as a single asset, such as company shares or units in a unit trust.

For the average SMSF trustee, direct share investment may be impractical due to diversification issues, the cost of multiple borrowing arrangements and the requirement to buy and sell shares in one parcel. As a result LBRAs in a SMSF have largely been restricted to property investments.

The ATO view on real property investment has been clear since the legislation was amended on 7 July 2010; real property held on separate titles was not allowed under a single borrowing arrangement. In the draft ruling, the ATO has conceded it may be possible to acquire a single property asset that is held over two or more legal titles.

Example: Factory complex on more than one title

A SMSF wants to enter into a LRBA to acquire a factory complex that is covered by three separate legal titles. As there is a physical impediment to selling each legal title separately, the factory complex is considered to be a single acquirable asset and can be acquired under one LRBA. 

This arrangement may only be possible where the property can be distinctly identifiable as a single asset. If there is no physical or legal impediment to each individual property title being acquired separately, the property will be considered as multiple assets and will require multiple borrowing arrangements. 

Example: Farmland on multiple titles

A SMSF wants to enter into a LRBA to acquire a farm that is covered by two separate legal titles. While the farm has always been conducted as a single primary production business there is no physical or legal impediment to each farm title being sold separately. As a consequence, the farm is considered to be two separate assets and would require two LRBAs. 

The draft ruling has also provided confirmation that an ‘off the plan’ property purchase can be acquired by an SMSF using a LRBA. The initial deposit is paid by the SMSF using existing funds to secure the property and an LRBA is used to finalise the purchase when the property has been completed.

Difference between maintaining, repairing and improving an asset

Recent natural disasters throughout Australia served to highlight the importance of the concepts ‘maintaining’, ‘repairing’ and ‘improving’ an asset when it comes to LRBAs. 

Maintaining an asset involves the prevention of damage or deterioration to an asset and ensures the functional efficiency of the asset is maintained in its current state. Repairing an asset restores the functional efficiency to its former state without changing its character. It generally involves the replacement of something that has been worn out or damaged through natural wear and tear.

An improvement to an asset increases the value and functional efficiency of the asset through new additions and features that substantially alter the nature of the asset. These improvements would provide benefits over and above the value of a general repair.

For example, restoring the damaged part of a kitchen that has been destroyed by fire would constitute a repair. Extending the house to install a new kitchen of greater size and functionality would be an improvement.

Legislation allows money borrowed under an LRBA to be used in connection with maintaining or repairing an asset, but not improving an asset. This is because the improvement of an asset would fundamentally alter the character and value of the asset used as security by the lender, potentially increasing the risk to the fund.

In what is being seen as a departure from previous views, the ATO has indicated via the draft ruling that improvements to an asset are only restricted when funded from borrowed monies.

Improvements to fund assets using existing SMSF resources is considered acceptable and would not breach LRBA rules provided the improvements do not result in the original asset becoming a different asset.

Example: Renovation of property

A SMSF enters into an LRBA to purchase a residential property. The fund renovates the property, adding a second storey to the house using borrowings under the LRBA.

The addition of a second storey improves the value of the asset, and as borrowed money was used, the arrangement no longer satisfies the requirements of the LRBA provisions. If the renovations had been funded from a source other than borrowings, the improvements would be permissible.

When an original asset becomes a different asset

There are very limited circumstances in which an asset may be replaced and these generally relate to investments in shares and unit trusts. It is therefore important to consider whether any improvements to the original property result in a different asset being held on trust under the LRBA.

If the character of the original acquirable asset is fundamentally changed and replaced by a different asset, the arrangement ceases to satisfy the requirements of the LRBA provisions.

Example: Subdivision of land

An SMSF enters into a LRBA to acquire a vacant block of land. The land is subsequently subdivided into two separate titles. The original asset has now been replaced with two separate assets and the LRBA provisions are no longer satisfied.

Example: Reconstruction of house damaged by fire

A fire destroys a four-bedroom house held under a LRBA. A new four-bedroom house is constructed using the proceeds from an insurance policy. Rebuilding the house is simply restoring the asset to what it was prior to the fire and does not fundamentally change the character of the asset. The arrangement continues to satisfy the requirements of the LRBA provisions. 

The draft ruling is welcome in an area that is increasingly seen by many to be a relatively restricted field of investment for SMSF trustees. However, it is important to keep in mind that that the SMSF ruling is still in draft form and may be subject to change when finalised.