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ATO concerns with SMSF property development: SMSFRB 2020/1

04/06/2020

The ATO has issued SMSFRB 2020/1 (“SMSFR”) to highlight its main concerns in relation to SMSF property development.  It is comprehensive and traverses structuring, investment rules, NALI and the anti-avoidance provisions.  SMSF trustees that enter into property development projects must understand the complexity of such ventures and implement all the applicable rules from start to completion in a manner consistent with retirement income objectives.  All transactions should be carefully documented.

The ATO strongly encourages SMSF trustees considering property development to seek professional advice and to approach the ATO for advice if necessary.
This article explains the main ATO concerns.  
1. In-house assets
An ungeared unit trust or company that meets the requirements of SIS Regulation 13.22C is excluded from being an in-house asset (“IHA”).  The reg. 13.22C related unit trust is often used as an interposed entity in SMSF property development.  The SMSF maintains the borrowing to invest in the ungeared unit trust which carries out the property development. The exemption in Regulation 13.22C however ceases if the unit trust or company fails to meet any of the conditions in Regulation 13.22D.  
The ATO is concerned that the unit trust may not meet all the conditions and therefore fail the IHA exception.  In addition, the ATO highlighted the hefty consequences of such contravention.
1.1 Regulations 13.22C and 13.22D requirements
The Reg. 13.22D additional conditions are:
the trustee or company must not conduct a business.
all transactions of the unit trust or company have to be conducted on an arm’s length basis.
The basic Reg 13.22C requirements are recapped below.  The unit trust or company must not:
hold an interest in another entity including units in another trust;
lease property to a related party of the fund or enter into a lease arrangement with a related party of the fund except for a legally binding lease over business real property (“BRP”);
make a loan to another entity; 
borrow money or allow a charge over an asset of the entity;
acquire an asset from a related party of the fund or an asset that has been owned by a related party of the fund within the previous three years (unless the asset is BRP).
The ATO reiterates it is critical that the unit trust or company complies with both the above regulations at the time the investment is acquired and at all times when the investment is held.  Failure to comply at any time is catastrophic because if any of these conditions are not met, “all investments held by the SMSF in that related company or trust including future investments in it will be in-house assets.”
1.2 Asset no longer exempt IHA
A breach of the IHA exception can never be fully rectified.  The repercussions are severe.  The following is an extract from the SMSFR.   “The asset can never be returned to its former excluded state, even if the trustee fixes the issue that caused the asset to cease meeting the relevant conditions.  The fund will be required to dispose of the shares or units it holds in excess of the 5% limit within 12 months.  In many cases this requires the sale of underlying property or a significant restructure that could be costly to both the development and the SMSF.” Will this lead to funds intentionally becoming non-compliant because they know that the development can be finished within the 12 month period and then sold so no effective breach is recorded? 
1.3 The ATO is also concerned that some lease arrangements under the Reg. 13.22C BRP exception may not be established or renewed through a formal written process leading to the finding there is no valid binding lease.  (For full details, please refer to SUPERCentral article “SMSF: Dealing at arm’s length”.
2. The use of limited recourse borrowing arrangements (“LRBA”)
In SMSF property development, an LRBA is often used either
to fund the purchase of the real property to be developed by the SMSF; or
to acquire the shares or units in the reg 13.22C property development entity.  
In the former situation, the real property to be developed is the acquirable asset.  In the latter situation, the shares or units is the acquirable asset.
The ATO has expressed concerns in relation to significant aspects of these arrangements.
2.1 SMSF purchase the real property to be developed
Under an LRBA, the borrowed funds cannot be used to pay expenses incurred to improve the acquirable asset (subsection 67 (1)(a)(i) SIS act).  Where the SMSF borrows to purchase the property to be developed and then uses its own funds to develop the property it will not contravene the above prohibition.
The issue of concern relates to the acquirable asset. While the SMSF may use its own funds to develop the property, the ATO considers that property development generally changes the character of the property and it will cease to be the same acquirable asset and the SMSF will not meet the LRBA requirements. (SMSFR 2012/1). 
However, this does not prevent the SMSF from acquiring a property with an LRBA and additionally use the funds to maintain or repair the acquirable asset as an investment.  This is distinguished from property development, which will change the character of the acquirable asset.
2.2 SMSF acquires shares or units in the property development entity
Where the SMSF borrows under LRBA to invest in a related reg 13.22C or an unrelated trust or company which undertakes the property development, the single acquirable asset is the shares or the units.  The SMSF trustee will not have to be concerned about whether the borrowed funds have been used to improve the asset or generally change the character of the property.
The ATO’s concern in this situation is the “arm’s length dealing” aspect of the LRBA.  The SMSF is borrowing to acquire the Reg 13.22C units or shares, and not the underlying property which is held by the unit trust or company. The lender of the LRBA is usually a related party, given the unique nature of the single acquirable asset.   
The SMSFRB specifies that in such circumstances the ATO safe harbour terms in PCG2016/5 cannot be relied on to show that the terms are consistent with an arm’s length dealing.  These safe harbour terms only apply to borrowings over real property or listed shares and investments/units.  
Where the acquirable asset is private company shares or units the SMSF “would need to demonstrate that their terms reflect an arm’s length dealing, for example, by showing that they replicate terms of a commercial loan available under the same circumstances.”
The ATO also cautioned that it may be difficult to identify an arm’s length lender that would provide finance for this kind of transaction as the lender can only be provided with a security over the units and not the underlying real property.
Given the importance of the arm’s length requirement and the lack of market data in relation to comparable loans, it may be worthwhile for SMSF trustees to consider this aspect in depth through market research, commercial valuation or failing to match the terms, consult the ATO before proceeding with such arrangement.
2.3 Example
An SMSF entered into a property development project using the related ungeared unit trust structure.  The initial investment by the SMSF in the unit trust was $400,000.  The unit trust used this amount to purchase land to be developed.  To fund the development of the property, the SMSF subscribed for additional $300,000 of the units using an LRBA.  The Lender asked for security over the land which is granted by the unit trust.  As the unit trust has allowed a charge over the asset of the trust, a 13.22D event arises.  This will cause the investment in the units of the related geared unit trust by the SMSF to be considered an IHA of the Fund.  Apart from this, the SMSF will also have to substantiate the arm’s length terms of the LRBA under both regulation 13.22D and NALI. 
3. NALI
Full details of NALI are provided  in the following SUPERCentral articles. 
NALI – Non arm’s length income new rules and implications
SMSF:  Dealing at arm’s length
Generally where parties to the SMSF transaction are related, the inference is that they will not be dealing at arm’s length but this inference can be reversed.  Proper documentation, procedures and records are integral to this process.
In relation to land development in an SMSF, both the overall structure as well as specific transactions would need to be conducted on an arm’s length basis.  SMSFRB provides examples of such transactions.
Purchase of land and other assets.
Terms (including use of personal or related party guarantees) of LRBA or other entities involved in the development.
Where a related party is engaged to provide services in their professional capacity (e.g. building construction), whether they are charged for these services or paid less than the arm’s length rate.
The return on investment and income or capital entitlements.
4. Joint Venture Arrangements
A joint venture may be carried out in the form of a partnership, company, trust or other arrangement.
Care must be taken by the SMSF trustees to ensure that the arrangement, particularly with a related party is a true joint venture.  The ATO has expressed concern that in exceptional situations (e.g. SMSF has provided a capital outlay with no rights other than a return on final investment), the investment may in some circumstances be construed as a loan or an investment in the other party and an IHA of the fund.
5. Providing financial assistance to members (Section 65 SIS Act)
The following situations would cause ATO concerns in relation to financial assistance to members.
The SMSF becomes an investor in the property development carried out by the related party because otherwise there would be insufficient funds to complete the property development.
A related party is engaged to provide services as a means of providing them with work or where they are paid more than market value.
SMSF funds are used to finance elements of the property development on non-arm’s length terms or where the SMSF receives little or no consideration.
6. Record keeping
It is important the SMSF keep the necessary records to establish and maintain it has met the applicable requirements.  All transactions should be documented to ensure:
there is proof of arm’s length dealings
the arrangements put in place reflect the legal status
the parties intend, and they are permitted by the SMSF deed and investment strategy, to undertake the property development.
It is also important to maintain good record keeping procedures to ensure payments relate to the expenses of the property development.
7. Sole Purpose Test
The SMSF trustee would need to demonstrate that the property development decision is solely to pursue the retirement goals of the members and not influenced by the goals of the business or other entities.
Using an example in the SMSFRB, where an SMSF trustee ceased to pay its members a pension so that the SMSF could use its cash reserves to make additional capital contribution to a struggling property development venture, may indicate that the SMSF has been used for the purpose of ensuring the property development’s success above the retirement needs of the members. This may cause a contravention of the sole purpose test.
8. Other concerns
Some other areas of concern include:
use of the arrangement to manipulate the member’s transfer balance accounts by deliberately undervaluing an asset when it enters retirement phase for the transfer balance cap;
poorly implemented LRBAs and/or funding arrangements resulting in breach of the SIS and Tax Act provisions.
non-arm’s length property development arrangements which may potentially attract the application of Part IVA of the ITAA 1936 and/or Division 165 of the GST Act 1999.
Conclusion
Given the complexity of property development projects, the general necessity of SMSFs to borrow to fund such development, the SIS investment standards, LRBA specific requirements, NALI and other measures, it is imperative that SMSF trustees seek competent professional advice before entering into a property development venture which is also subject to the investment strategy.
On the other hand, LRBAs can potentially augment retirement benefits if they are part of an integral investment strategy that meets the SIS requirements.  

The ATO has issued SMSFRB 2020/1 (“SMSFR”) to highlight its main concerns in relation to SMSF property development.  It is comprehensive and traverses structuring, investment rules, NALI and the anti-avoidance provisions.  SMSF trustees that enter into property development projects must understand the complexity of such ventures and implement all the applicable rules from start to completion in a manner consistent with retirement income objectives.  All transactions should be carefully documented.

The ATO strongly encourages SMSF trustees considering property development to seek professional advice and to approach the ATO for advice if necessary.

This article explains the main ATO concerns.  

1. In-house assets

An ungeared unit trust or company that meets the requirements of SIS Regulation 13.22C is excluded from being an in-house asset (“IHA”).  The reg. 13.22C related unit trust is often used as an interposed entity in SMSF property development.  The SMSF maintains the borrowing to invest in the ungeared unit trust which carries out the property development. The exemption in Regulation 13.22C however ceases if the unit trust or company fails to meet any of the conditions in Regulation 13.22D.  

The ATO is concerned that the unit trust may not meet all the conditions and therefore fail the IHA exception.  In addition, the ATO highlighted the hefty consequences of such contravention.

1.1 Regulations 13.22C and 13.22D requirements

The Reg. 13.22D additional conditions are:

  • the trustee or company must not conduct a business.
  • all transactions of the unit trust or company have to be conducted on an arm’s length basis.

The basic Reg 13.22C requirements are recapped below.  The unit trust or company must not:

  • hold an interest in another entity including units in another trust;
  • lease property to a related party of the fund or enter into a lease arrangement with a related party of the fund except for a legally binding lease over business real property (“BRP”);
  • make a loan to another entity; 
  • borrow money or allow a charge over an asset of the entity;
  • acquire an asset from a related party of the fund or an asset that has been owned by a related party of the fund within the previous three years (unless the asset is BRP).

The ATO reiterates it is critical that the unit trust or company complies with both the above regulations at the time the investment is acquired and at all times when the investment is held.  Failure to comply at any time is catastrophic because if any of these conditions are not met, “all investments held by the SMSF in that related company or trust including future investments in it will be in-house assets.”

1.2 Asset no longer exempt IHA

A breach of the IHA exception can never be fully rectified.  The repercussions are severe.  The following is an extract from the SMSFR.   “The asset can never be returned to its former excluded state, even if the trustee fixes the issue that caused the asset to cease meeting the relevant conditions.  The fund will be required to dispose of the shares or units it holds in excess of the 5% limit within 12 months.  In many cases this requires the sale of underlying property or a significant restructure that could be costly to both the development and the SMSF.” Will this lead to funds intentionally becoming non-compliant because they know that the development can be finished within the 12 month period and then sold so no effective breach is recorded? 

1.3 The ATO is also concerned that some lease arrangements under the Reg. 13.22C BRP exception may not be established or renewed through a formal written process leading to the finding there is no valid binding lease.  (For full details, please refer to SUPERCentral article SMSF: Dealing at arm’s length).

2. The use of limited recourse borrowing arrangements (“LRBA”)

In SMSF property development, an LRBA is often used either

  • to fund the purchase of the real property to be developed by the SMSF; or
  • to acquire the shares or units in the reg 13.22C property development entity.  

In the former situation, the real property to be developed is the acquirable asset.  In the latter situation, the shares or units is the acquirable asset.

The ATO has expressed concerns in relation to significant aspects of these arrangements.

2.1 SMSF purchase the real property to be developed

Under an LRBA, the borrowed funds cannot be used to pay expenses incurred to improve the acquirable asset (subsection 67 (1)(a)(i) SIS act).  Where the SMSF borrows to purchase the property to be developed and then uses its own funds to develop the property it will not contravene the above prohibition.

The issue of concern relates to the acquirable asset. While the SMSF may use its own funds to develop the property, the ATO considers that property development generally changes the character of the property and it will cease to be the same acquirable asset and the SMSF will not meet the LRBA requirements. (SMSFR 2012/1). 

However, this does not prevent the SMSF from acquiring a property with an LRBA and additionally use the funds to maintain or repair the acquirable asset as an investment.  This is distinguished from property development, which will change the character of the acquirable asset.

2.2 SMSF acquires shares or units in the property development entity

Where the SMSF borrows under LRBA to invest in a related reg 13.22C or an unrelated trust or company which undertakes the property development, the single acquirable asset is the shares or the units.  The SMSF trustee will not have to be concerned about whether the borrowed funds have been used to improve the asset or generally change the character of the property.

The ATO’s concern in this situation is the “arm’s length dealing” aspect of the LRBA.  The SMSF is borrowing to acquire the Reg 13.22C units or shares, and not the underlying property which is held by the unit trust or company. The lender of the LRBA is usually a related party, given the unique nature of the single acquirable asset.   

The SMSFRB specifies that in such circumstances the ATO safe harbour terms in PCG2016/5 cannot be relied on to show that the terms are consistent with an arm’s length dealing.  These safe harbour terms only apply to borrowings over real property or listed shares and investments/units.  

Where the acquirable asset is private company shares or units the SMSF “would need to demonstrate that their terms reflect an arm’s length dealing, for example, by showing that they replicate terms of a commercial loan available under the same circumstances.”

The ATO also cautioned that it may be difficult to identify an arm’s length lender that would provide finance for this kind of transaction as the lender can only be provided with a security over the units and not the underlying real property.

Given the importance of the arm’s length requirement and the lack of market data in relation to comparable loans, it may be worthwhile for SMSF trustees to consider this aspect in depth through market research, commercial valuation or failing to match the terms, consult the ATO before proceeding with such arrangement.

2.3 Example

An SMSF entered into a property development project using the related ungeared unit trust structure.  The initial investment by the SMSF in the unit trust was $400,000.  The unit trust used this amount to purchase land to be developed.  To fund the development of the property, the SMSF subscribed for additional $300,000 of the units using an LRBA.  The Lender asked for security over the land which is granted by the unit trust.  As the unit trust has allowed a charge over the asset of the trust, a 13.22D event arises.  This will cause the investment in the units of the related geared unit trust by the SMSF to be considered an IHA of the Fund.  Apart from this, the SMSF will also have to substantiate the arm’s length terms of the LRBA under both regulation 13.22D and NALI. 

3. NALI

Full details of NALI are provided in the following SUPERCentral articles:

NALI – Non arm’s length income new rules and implications

SMSF:  Dealing at arm’s length

Generally where parties to the SMSF transaction are related, the inference is that they will not be dealing at arm’s length but this inference can be reversed.  Proper documentation, procedures and records are integral to this process.

In relation to land development in an SMSF, both the overall structure as well as specific transactions would need to be conducted on an arm’s length basis.  SMSFRB provides examples of such transactions.

  • Purchase of land and other assets.
  • Terms (including use of personal or related party guarantees) of LRBA or other entities involved in the development.
  • Where a related party is engaged to provide services in their professional capacity (e.g. building construction), whether they are charged for these services or paid less than the arm’s length rate.
  • The return on investment and income or capital entitlements.

4. Joint Venture Arrangements

A joint venture may be carried out in the form of a partnership, company, trust or other arrangement.

Care must be taken by the SMSF trustees to ensure that the arrangement, particularly with a related party is a true joint venture.  The ATO has expressed concern that in exceptional situations (e.g. SMSF has provided a capital outlay with no rights other than a return on final investment), the investment may in some circumstances be construed as a loan or an investment in the other party and an IHA of the fund.

5. Providing financial assistance to members (Section 65 SIS Act)

The following situations would cause ATO concerns in relation to financial assistance to members.

  • The SMSF becomes an investor in the property development carried out by the related party because otherwise there would be insufficient funds to complete the property development.
  • A related party is engaged to provide services as a means of providing them with work or where they are paid more than market value.
  • SMSF funds are used to finance elements of the property development on non-arm’s length terms or where the SMSF receives little or no consideration.

6. Record keeping

It is important the SMSF keep the necessary records to establish and maintain it has met the applicable requirements.  All transactions should be documented to ensure:

  • there is proof of arm’s length dealings
  • the arrangements put in place reflect the legal status
  • the parties intend, and they are permitted by the SMSF deed and investment strategy, to undertake the property development.It is also important to maintain good record keeping procedures to ensure payments relate to the expenses of the property development.

7. Sole Purpose Test

The SMSF trustee would need to demonstrate that the property development decision is solely to pursue the retirement goals of the members and not influenced by the goals of the business or other entities.

Using an example in the SMSFRB, where an SMSF trustee ceased to pay its members a pension so that the SMSF could use its cash reserves to make additional capital contribution to a struggling property development venture, may indicate that the SMSF has been used for the purpose of ensuring the property development’s success above the retirement needs of the members. This may cause a contravention of the sole purpose test.

8. Other concerns

Some other areas of concern include:

  • use of the arrangement to manipulate the member’s transfer balance accounts by deliberately undervaluing an asset when it enters retirement phase for the transfer balance cap;
  • poorly implemented LRBAs and/or funding arrangements resulting in breach of the SIS and Tax Act provisions.
  • non-arm’s length property development arrangements which may potentially attract the application of Part IVA of the ITAA 1936 and/or Division 165 of the GST Act 1999.

Conclusion

Given the complexity of property development projects, the general necessity of SMSFs to borrow to fund such development, the SIS investment standards, LRBA specific requirements, NALI and other measures, it is imperative that SMSF trustees seek competent professional advice before entering into a property development venture which is also subject to the investment strategy.

On the other hand, LRBAs can potentially augment retirement benefits if they are part of an integral investment strategy that meets the SIS requirements.