SMSFs and property investment – avoiding the pitfalls

It doesn’t come as a surprise that some SMSF investors are tempted by overseas property investments. However, there are a number of compliance traps they must navigate, according to Daniel Butler and Nathan Papson.

The high Australian dollar coupled with the fallout from recent economic events has made overseas property investment more attractive to Australians.

As such, many people have the opportunity of investing in such property via their self-managed super funds (SMSFs).

A prospective investment in an apartment in Paris, a Balinese beachfront villa, or a ski chalet in the US, may tempt some investors.

However, when individuals use their SMSFs as a vehicle for these types of investments, there are a number of compliance traps that they must navigate.

SMSF trustees can purchase property either by an outright purchase (ie, no borrowings), or an investment using borrowings. To illustrate the potential risks involved, each of these types of investments will be considered in turn.

Investment with no borrowings

In short, an SMSF trustee can purchase a property overseas. However, there are many compliance hurdles. Some of these are listed below.

• Investment strategy — the acquisition must be consistent with the investment strategy of the SMSF;
• Sole purpose test — the acquisition meets the sole purpose test. In other words, is the SMSF being maintained solely for the prescribed purposes (eg, to provide retirement benefits)?

In the famous Swiss Chalet Case (Case 43/95 [1995] ATC 374), a superannuation fund trustee invested in a unit trust, the assets of which included a Swiss chalet. The question in this matter was whether the fund met the then equivalent of the sole purpose test.

The problem was not so much the investment itself, but that fund members and their friends stayed in the chalet without paying rent. The fund was held to have contravened the sole purpose test.

Accordingly, it is important that an SMSF trustee only acquire real estate because it genuinely believes it is an appropriate way to achieve its core purpose of providing retirement benefits.

In-house assets — this is a big issue if it is not the SMSF trustee acquiring the property itself, but rather a company and the SMSF trustee acquires shares in the company.

Particularly if an overseas bank account is required, this may restrict the investment.

Perhaps the most prevalent risk that may restrict SMSF trustees from investing overseas is the in-house assets rule.

This is because some overseas jurisdictions require that property be held by a company or similar vehicle in the foreign country.

Practically, this means that the SMSF member will need to establish a foreign company and the SMSF trustee will invest in shares of that company.

The company’s share capital will be used to finance the acquisition of the overseas property.

On its face, this investment is an in-house asset.

However, if the investment meets the exceptions outlined in 13.22C of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (‘SIS’) (ie, non-geared company or non-geared unit trust) then the investment will not contravene the in-house asset rule.

One of the requirements of this exception is that the assets of the company being acquired must not include a loan to another entity, unless the loan is a deposit with an authorised deposit-taking institution within the meaning of the Banking Act 1959 (Cth).

As such, if there is an overseas bank account established (or required to be established), the investment in that company by the SMSF trustee will be an in-house asset.

As a result, the shares in the company would need to be disposed of by the SMSF trustee.

If the jurisdiction allowed the SMSF to invest in the property directly (without a local company intermediary) then the above risk would be extinguished.

However, our experience has shown that numerous popular overseas jurisdictions require a company to be established.

Investment with borrowings

If the SMSF trustee were to borrow to acquire the property, this poses even further risks.

Firstly, if the property being acquired had to be held via a foreign company, we question whether a bank would be willing to lend to acquire overseas property.

Practically, the bank would be lending money to acquire a piece of paper (being shares in the foreign company).

Our experience is that banks will be very reluctant to lend on this basis where the security is shares in a company or units in a unit trust.

As an alternative to taking security over the shares of the foreign company, the bank may seek to take security over the overseas property itself. If it were to do so (and the property was held via a foreign company), this would contravene the requirements of 13.22C of the SIS. 

As such, the SMSF trustee’s investment in the foreign company would be an in-house asset.

If a related party were to lend instead of a bank, it is questionable whether that lending would be at arm’s length. This, in itself, may contravene superannuation laws.

The other alternative is that the lending may be considered as a contribution if the terms of the lending are more favourable to the SMSF.

Increased costs

In addition to the compliance aspects outlined above, there are inflated costs for the transaction that must be taken into account.

These may include costs in sourcing the property (ie, buyer’s agent or advocate in the foreign country) and costs for a lawyer in the overseas jurisdiction to complete the conveyance and provide advice on ownership restrictions, etc.

In addition to these costs, a structure such as a company may need to be established in that jurisdiction — ongoing maintenance costs are also likely to apply.

Legal advice should then be obtained in relation to the superannuation compliance requirements of the investment.

In addition to these costs, if the fund were to borrow to acquire the property, there would be costs in establishing documentation to allow the fund to borrow.

There may also be unexpected ongoing costs, such as costs to do with the management of the property, local taxes and costs associated with the tenancy (evicting a tenant may not be a straightforward process in overseas jurisdictions).

Such costs should be considered before embarking on overseas property investment.

Conclusion

SMSF trustees can invest in overseas property. However, the compliance requirements, coupled with increased costs, may not make the investment as attractive to SMSF trustees as they first thought.

It is recommended that expert advice be obtained both in Australia and the overseas jurisdiction before SMSF trustees buy overseas property.

Daniel Butler is the director and Nathan Papson is a lawyer at DBA Lawyers.