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New total super balance measure now law - what does it mean for LRBAs?

19/11/2019

Introduction

Legislation has now been enacted to include a member’s share of any LRBA borrowing in their total superannuation balance.  This measure is described by the Government as an “Integrity Measure” as it is intended to address two mischiefs arising from the interaction between LRBAs and the non-concessional contribution cap. 

The relevant legislation is the Treasury Laws Amendment (2018 Superannuation Measures No 1) Act 2019 which received Royal Assent on 2 October 2019.  The relevant provisions apply from 1 July 2018.

This measure will only apply to small superannuation funds (ie SMSFs and APRA regulated funds with 4 members or less) and commences from 1 July 2018.  Only new LRBAs commencing on or after 1 July 2018 will be affected by the measure. 

While this measure may apply to an LRBA, it does not mean that the LRBA is necessarily on non-commercial terms.  This measure could apply to an LRBA with the income arising from the LRBA still being taxed as non-arm’s length income of the SMSF.  In short, the application of the measure to a particular LRBA is independent from the issue of whether the terms of the LRBA are non-commercial, with the consequence being that the income arising from the LRBA is taxed at 45% as non-arm’s length income.

This measure will apply to LRBAs in SMSFs where:

(a)    the lender is an associate of the SMSF; or

(b)    the member or members participating in the LRBA have satisfied an unrestricted release condition (such as attained age 65 or being “retired” for superannuation purposes), regardless of whether the member is actually in retirement phase.

LRBAs in force on or before 1 July 2018 will not be affected by the measure.  Additionally, refinancing a pre-1 July 2018 LRBA on or after 1 July 2018 will not cause the LRBA to be affected by the measure.

An LRBA will be in force before 1 July 2018 if there has, in relation to the LRBA, been a borrowing before 1 July 2018.  A borrowing means a drawdown of money under a loan agreement/deed and not merely an unexercised contractual right to drawdown money.

The Government’s motivation as to the measure is, it seems, driven by the possibility that LRBAs could be used to manipulate the non-concessional contributions cap.

Impact of the Measure

The impact of the measure will be as follows:

(a)    it will affect the amount of non-concessional contribution cap space of a member;

(b)    it will affect the ability of a member to make “catch up” concessional contributions – that is the ability of the member to utilise the carry forward of unused concessional contributions;

(c)    it will affect the ability of a member to both utilise the “bring forward” of non-concessional contributions and also the amount of “bring forward” cap space; 

(d)    it will affect the entitlement of the spouse of the member to claim a tax offset for contributions made by the spouse for the member;  and

(e)    it will also affect the ability of a small superannuation fund to utilise the “segregated” asset method to determine the exempt current pension income of the fund.

The mischief

The Government has identified two “mischiefs” which justify the introduction of the Integrity Measure. 

The first mischief relates to the economic effect which LRBAs have on super funds.  Effectively, LRBAs permit the capital value of the fund to be increased in a manner which is not caught by the non-concessional contributions cap. 

The second mischief relates to the ability of capital value to be removed from the fund (as a superannuation lump sum) – thereby reducing the total superannuation balance of the relevant member and so providing non-concessional cap space – and effectively recontributed as loan capital pursuant to an LRBA.

The Government has stated that the Integrity Measure is not a response to the Financial System Inquiry recommendation that LRBAs should no longer be permitted under the SIS Act.

The legislative change

The principal operative provision will amend the definition of “total superannuation balance” set out in s307-230 by the inclusion of a further paragraph (d) as follows (in a very simplified form)

Your total superannuation balance……is the sum of 

(a)    your accumulation phase values of non-pension interests

(b)    your transfer balance account

(c)    your super amounts in transit between super entities (not counted in above)

(d)    each qualifying LRBA amount you have.

(Simplified text has been used)

The LRBA amount of a member is only relevant if:

(a)    the LRBA amount exists as at the end of the financial year;  and

(b)    at least one of the following conditions apply at the end of the financial year:

(i)    the lender under the LRBA is an associate of the SMSF; or

(ii)    the member has, at the end of the financial year, satisfied an unrestricted release condition.

The LRBA amount of a member is simply their proportion of the LRBA borrowing outstanding as at 30 June.  In the case of a single member fund – the proportion will be 100% of the LRBA borrowing at 30 June.  In the case of a multi-member fund – the trustee will have to determine each participating member’s proportion of the LRBA borrowing. 

If, at the end of the financial year, the lender under the LRBA is not an associate of the SMSF and no member participating in the LRBA has satisfied an unrestricted release condition, then no portion of the borrowing will be included in the total superannuation balance of the participating members.

Example 1

The ABC Fund is an SMSF with three members, Andy aged 66, Brett aged 61 and Calvin aged 55.  They are all retired.  As at 30 June 2019 the SMSF had one LRBA on foot with an outstanding balance of $600,000.  Disregarding the impact of the LRBA, the total superannuation balance (“TSB”) of each member is $1,300,000 (Andy); $300,000 (Brett) and $250,000 (Calvin) respectively.

Only Andy and Brett participate in the LRBA.  Their participation is in the ratio of 60% to 40%.  Calvin does not participate in the LRBA.

The lender under the LRBA is a bank.

The effect of the measure is to include $360,000 in the total superannuation balance of Andy and $240,000 in the total superannuation balance of Brett.  The measure does not affect Calvin as he is not participating in the LRBA.

The impact on Andy is:

•    TSB is now $1,660,000 as at 30 June 2019.  Consequently in respect of 2019/20 financial year, Andy has a nil non-concessional contribution cap (“NCC cap”) space and is ineligible to instigate a “bring forward” of non-concessional contributions.

•    In the absence of the measure Andy would have had a $100,000 NCC cap space for 2019/20 and a “bring forward” cap space of $200,000.

•    Andy can still make up to $25,000 of concessional contributions for 2019/20 but cannot make any “catch up concessional contributions” for 2019/20 as his TSB as at 30 June 2019 exceeds $500,000.

The impact on Brett is:

•    TSB is now $540,000 as at 30 June 2019.  Consequently in respect of 2019/20 financial year, Brett has a $100,000 NCC cap space and remains eligible to instigate a “bring forward” of non-concessional contributions of up to $300,000.

•    In the absence of the measure Brett would have had a $100,000 NCC cap space for 2019/20 and a “bring forward” cap space of $300,000.

•    Brett can still make up to $25,000 of concessional contributions for 2019/20 but cannot make any “catch up concessional contributions” for 2019/20 as his TSB as at 30 June 2019 exceeds $500,000.  In the absence of this measure, Brett’s TSB would have been $300,000 and so, he could have made catch-up concessional contributions in respect of 2019/20.

In respect of Calvin, he has not participated in the LRBA.  Consequently his TSB has not been increased as at 30 June 2019.  As his TSB as at 30 June 2019 is $250,000, his contributions caps for 2019/20 have not been affected.

Example 2

If, in the above example, Brett were not retired then he would not be caught by the measure and his share of the LRBA amount, being $240,000, would not be included in his total superannuation balance.  This follows as Brett would not have satisfied an unrestricted condition of release.

If, in the above example, Brett were not retired and the lender were an associate of the SMSF then $240,000 would be included in the total superannuation balance of Brett (even though he has not satisfied an unrestricted release condition) as the lender is an associate of the SMSF.

Does the measure affect the terms on which LRBAs will be offered?

In a formal sense no – as the measure does not, in any way, amend the provisions of the SIS Act permitting LRBAs; namely s67A and s67B.

However, in an economic sense, the measure may adversely affect lender’s assessment of the SMSF’s ability to service and repay the loan by reason of the flow on effect from the inclusion of LRBA amounts in the members’ TSB and the TSB’s role in determining the ability to make catch-up concessional contributions and ordinary non-concessional contributions.

What if the LRBA satisfies the “safe harbour” guidelines?

Satisfying the “safe harbour” guidelines will not prevent the Integrity Measure from applying to a particular LRBA (assuming the preconditions for the application are present).  The “safe harbour” guidelines are directed to the issue whether the LRBA is on arm’s length terms.  The Integrity Measure is addressing potential abuses of the non-concessional contribution cap.

Application of the measure to LRBAs – unrestricted release condition

A member participating in an LRBA will have their share of the outstanding LRBA debt (as at 30 June) included in their total superannuation balance if they have satisfied (as at 30 June) an unrestricted condition of release.  Whether or not the member is in retirement phase is irrelevant.  Consequently, a member could satisfy an unrestricted release condition and not have commenced a retirement phase pension but still be caught by the measure.

The unrestricted release conditions are:

(a)    retirement on or after attaining preservation age;

(b)    terminal medical condition;

(c)    permanent incapacity; and

(d)    attainment of age 65.

It should be noted that a member can have a retirement phase pension but not themselves have satisfied an unrestricted release condition.  This would be the case if the member is receiving a death benefit in the form of an income stream. 

Application of the measure to LRBAs – Associated Lenders

A member participating in an LRBA will have their share of the outstanding LRBA debt (as at 30 June) included in their total superannuation balance if the lender is an associate of the SMSF.  In this case it is irrelevant whether the participating members have satisfied an unrestricted release condition.

If the lender is an associate of the SMSF it is irrelevant that the terms of the LRBA satisfy the “safe harbour” guidelines.  If the lender is an associate of the SMSF and the terms of the LRBA are not arm’s length, then the total superannuation balance of the participating members will be affected and the income derived from the LRBA will be treated as non-arm’s length income of the SMSF.

A lender will be an associate of the SMSF in the circumstances set out in s318(3) of the Income Tax Assessment Act 1936.  Unfortunately, this provision recursively defines “associate” by reference initially to any entity that benefits under the trust and if that entity is a natural person (such as a member) then defines the associates of a natural person in s318(1). 

Additionally, an entity (whether a natural person, company, trustee) benefits from the SMSF if the entity actually benefits or is capable of benefiting (eg by exercise of a power of appointment) directly or indirectly (through one or more entities) from the SMSF.

The associates of the SMSF would include:

(a)    each member of the SMSF;

(b)    a relative of a member of the SMSF;

(c)    a partner (general law or tax law) of a member of the SMSF;

(d)    a partnership (general law or tax law) in which a member is a partner;

(e)    the spouse or child of an individual who is a partner (general law or tax law) of the member;

(f)    a trustee of a trust where the member (or an entity which is an associate of the member by reason of another paragraph) benefits or is capable of benefiting from the trust; and

(g)    a company which is controlled (whether by reason of majority voting interest or by reason of sufficient control over the directors/board of the company by the member) whether directly or indirectly by the member (and or by the associates of the member).

In practice, if the lender is the member, their spouse or a company or a trust they control, the lender will be an associate of the SMSF and so the measure will apply.  However, merely having an ownership interest in a company or a trustee of trust does not necessarily mean that the company or trustee is controlled by the member.  Consequently, if the ownership interest in the company or trustee is a minority interest and other entities having ownership interests are not associates, then the company or trustee may not, in fact, be an associate of the SMSF.

Problems with “off the plan” purchases

Typically, in an “off the plan” purchase, the financing for the purchase will only be considered when the project is nearing completion.  The timing difference between entering into the contract of purchase and the time when moneys are drawdown under the loan could be one or two years or even longer.

Will an off the plan purchase entered into on say 1 December 2017 where the loan is not drawn down until 1 December 2018 or 1 December 2019 be treated as a grandfathered LRBA arrangement?  In the absence of the Government making a policy exception for off the plan purchases entered into before 1 July 2018 (the Consultation Paper does raise the possibility that yet to be detailed transitional rules will apply to LRBAs which straddle 1 July 2018), the prospects are not bright. 

The application provision provides that if the borrowing was in place before 1 July 2018, the borrowing will be outside the measure.  On this basis, any loan contract/deed entered into on or after 1 July 2018 which is to complete an off the plan purchase which was entered into before 1 July 2018 will be caught by the measure.