Structuring – Borrowed/Non-Borrowed Funds

1. Introduction
2. Investing as tenants in common with a related party
3. Investing in a related non geared unit trust from non-borrowed and borrowed funds
4. Investing in a pre-11 August 1999 unit trust
5. Investing in a geared unit trust
6. ATO Alerts

Introduction

Your SMSF may not have sufficient funds to purchase an Asset and you may need to obtain funds from another source. You may want to use your own personal funds, or funds of your passive investment company/trust or trading business. Alternatively you may want to borrow from the bank or a related party. In these circumstance you will need to give thought as to the ‘structure’ used to purchase the asset. A few of these different structures are discussed below.

Investing as tenants in common with a related party

If your purchasing property and your SMSF needs an additional 40% of the purchase price including purchase costs your SMSF can purchase the property as tenants in common with yourself, or any other related party (or non related party) by clearly stating this tenants in common % interest in the contract to purchase. This has the additional benefit of the non SMSF tenant is able to borrow to purchase the 40% interest against other assets, but not the asset purchased. Remember the asset purchased by the SMSF cannot be secured by a loan unless in accordance with the <borrowing rules>. Also it is advisable not to purchase a property as tenants in common where any part of the property is to be used as security for the non SMSF party’s borrowings, see the Superannuation Circular No II.D.6 for more info.

Whenever a SMSF acquires property with a related party, always consider the <sole purpose test>. Assessing the test is a subjective test and an assessment of the facts and evidence. Therefore care should be made in substantiating the intentions for the purchase. Provided that the asset has been purchased with the provision of retirement benefits in mind, and the main purpose of acquiring the asset was not for the benefit of the related party, then the sole purpose test will be satisfied where this can be substantiated.

Property Development – Tenants in common can be used with bare trust/partition agreements that can identify which intended subdivided lot belongs to a particular tenant.

Limitations 1: Where the asset earns income or requires maintenance expenses then care must be made to ensure that the correct percentage of income is distributed to the tenants and expenses paid by the tenants. A way of simplifying this is the opening of a tenant in common bank account which is reflected in the same percentages. You need to make sure that the bank account forms reflect this tenant’s in common relative percentage.

Limitation 2: As SMSF cannot purchase from a related party in excess of 5% (unless listed shares, share/unit that satisfies <Reg13.22c>, business real property) then the SMSF can never increase its interest or percentage ownership in a residential property for example. Furthermore its rights to sell its interest may be restricted and this may not be viewed favourably by the ATO. Accordingly an agreed mechanism for the SMSF to sell its interest would prudently be required prior to acquisition.

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Investing in a related non geared unit trust from non-borrowed and borrowed funds

From Non-Borrowed Funds

What makes the Unit Trust a Related Party

What the unit trust must do to prevent becoming an in house asset

From Borrowed Funds – Funds Property Development in the Unit trust by way of gearing in the SMSF to acquire the units

 From Non Borrowed Funds

In many ways using a unit trust (that does not/will not have borrowings) achieves the same objective as above. Some advantage are:

• (1) The percentages are clearly known as it is largely determined by the number of units the unit holder owns compared to the total units issued.
• (2) A Unit trust allows a number of parties to acquire units in the unit trust with greater ease
• (3) The unit trust can have a corporate trustee whereby some or all of the unit holders can be directors or independent directors of the trustee can be appointed, this can make attending to the day to day requirements of the trust/property easier
• (4) Disposing of an interest in the asset by selling the units to another party is arguably easier as the units can be clearly identified and sold
• (5) The Unit trust can acquire a increasing interest in the unit trust by the SMSF buying units from a related party. The acquisition of units from a related party is excluded from the in house asset rules provided the rules in the section are followed in particular reg <Reg13.22c> and reg 13.22d. Of course units could be issued in the unit trust too to achieve the same effect, however this is not necessary given the exemption.

However it does have some disadvantages compared to a tenants in common:

• Where the Unit trust is geared the unit trust cannot be a related party otherwise it will become an ‘in house asset rule’ which presently allows only 5% of the SMSF fund balance to be invested. The In house assets rule prevents an SMSF investing in a related trust unless an exception applies such as the non geared unit trust exception. See below for the meaning of related party.
• Where a unit trust makes a profit/net income for accounting/trust purposes and the distribution is unpaid the ATO forms the view this will meet the extended definition of a loan and therefore breach the SIS act, and may breach other sections if the UPE continues to be unpaid. A solution to fix this problem where no cash is available is to issue further units at market value to the value of the UPE. SMSFR 2008/D1 indicates should be done within 30 days. Be sure to check your trust deed before issuing units.

What makes the Unit Trust a Related Party

Largely, where the SMSF controls the unit trust , then the unit trust will be a related party. Determining Control is a subjective test and quantitative test. Basically a unit trust will be a related party where a group related to the members (1) control more than 50% of the units or (2) can appoint/remove the trustee (3) the trustee could reasonable be expected to act in accordance with the group related to the members.
The group refers to a definition called part 8 associate, it basically includes the members, employer sponsor, relatives, entity controlled by a part 8 associate, for example a members business partner can be included as a part 8 associate.

What the unit trust must do to prevent becoming an ‘in house asset’

In order for the SMSF to invest in the related party unit
trust, the related party must not be a ‘in house asset’. An in house asset largely
preventing a SMSF to acquire units, to avoid this, the Unit Trust should comply
with <Reg13.22c>, broadly it should:

1. not have an asset previously owned by a related party (except business real property)

2. not have borrowings

3. not have loaned funds to a related party

4. not invest in another entity

5. not encumber its assets in any way (charge or issue securities, or guarantee, etc)

6. not entered into a lease agreement with a related party (unless business real property)

7. not carry on a business <Reg13.22d>

For more on what the ATO considers Carrying on of a business in the context of a SMSF <click here>.

From Borrowed Funds Property Development in the Unit trust by way of gearing in the SMSF to acquire the units

The trustee borrows on a limited recourse and arm’s length terms, which are held on trust by a custodian pursuant to the requirements of section 67A of the SIS Act. The assets of the unit trust cannot secure the borrowings, but can be the units acquired and any other assets held outside the fund, for example personal guarantees given by the fund members.

Importantly, the rights of a guarantor are limited to the asset acquired with the loan. Therefore, a guarantor exercising their right of subrogation can only claim against the asset acquired with the borrowing. In light of this, a guarantor may need to waive or limit their right of subrogation to ensure compliance with the limited recourse requirements of <section 67A> of the SIS Act. Accordingly given most senior lenders would want to issue securities against the land itself within the unit trust then the requirements of the limited recourse arrangement would be breached and accordingly this strategy may only work with related party lenders who lend funds that meet these rules.

The guarantor’s rights may be excluded or limited by the express terms of the guarantee (refer to ATO ID
2010/17). The amount waived by the guarantor could be deemed to be a contribution to the fund (refer to Taxation Ruling TR 2010/1).

 

 

There is no guidance on whether a change to the land held by the unit trust would be deemed to be a change to the unit in the unit trust. A Change to the units held by the SMSF would contravene S67A given the SMSF had borrowed to acquire the units.  Remember where you are uncertain on any aspect of the law in relation to a proposed transaction you can seek a private ruling from the ATO, see the <ATO-Link>.
Remember that <carrying on of a business> is considered by the Australian Taxation Office (ÄTO”) as not acceptable, however it does acknowledge that it does not necessarily represent as a breach of the SIS act, ie the <sole purpose test>. The ATO has stated that activities that have a business like feel may not be considered to breach the sole purpose test in the case of property that is subdivided. Factors that need to be considered are the scale of the activity, the profit motive and the financial impact on the fund, as well as considerations about whether the property is developed for rental or sale.  Put simply, a subdivision and construction of property for the purposes of sale may more likely be considered to breach the sole purpose test than a subdivision and construction of property conducted for the purposes of rental/investment.

 

Documenting a property development arrangement

The contractual arrangements that should be put in place to govern the development of vacant land held by a fund trustee will depend on the structure of the transaction.

Investing in a pre-11 August 1999 unit trust

In brief, the rules relating to unit trusts pre 11 August 1999 were less restrictive and caused many advisers to recommend unit trusts be created wholly owned by the SMSF for purposes of investing. The ATO later restricted the rules with transitional rules ending on 30.6.09.
From 1 July 2009, any pre 11 August 1999 unit trusts owned by a SMSF are worth retaining as the rules are less restrictive than post 11 August 1999 unit trusts. Advantages are:

• Can invest in other entities; and
• Can borrow to invest in other entities
• Can borrow to invest in another property
• Can carry on a business
• lease assets to a related party (but at arms length s109)
• unit trust as a charge over all or some of its assets

These above opportunities are caveated by s109 acting on an arms length basis and s52(2)(c) acting in best interests of beneficiaries and s52(2)(d) having rgard to the investment strategy.
A disadvantage of using a pre 11 August 199 rust to borrow is where there is insufficient cash to meet expenses. The solution of issuing further units is restricted as it cannot issue further units to the SMSF beyond the 5% in house asset cap. The alternate solution would be to issue units to related party members at market value subject to making an assessment for any transaction costs making it uneconomic.

 

Although transitional arrangements were provided by subdivision D of Part 8 of the Superannuation Industry (Supervision) Act 1993 (SISA) to allow an investment in related unit trusts held before the end of 1999 not to count as an in-house asset, an SMSF must still comply with other super laws outlined in the SISA.

 

As an SMSF trustee, you are prohibited from using a fund’s resources to provide financial assistance to members or relatives of members of the fund. We have taken the view this encompasses financial assistance given indirectly by an SMSF, for example, where a related unit trust lends money to fund members or their relatives. In this circumstance, the resources of your SMSF are used if an arrangement or transaction relies on your SMSF’s assets.

 

There may also be a breach of the SISA if loans to members are on terms which are not at arm’s length, for example, where there is no interest payable on the loan. In this circumstance, the trustees of the SMSF are not dealing at arm’s length with the trustees of the unit trust during the term of the investment. This is because they allowed their investment in the unit trust to continue despite the unit trust taking actions which may have been detrimental to any expected returns on the investment. <ATO-Links: SMSFR 2008/1; SIS-s109; SIS-s65>

Investing in a geared unit trust

If you read the section on non geared related party unit trust you would have understood what makes a Unit Trust a related or non related party unit trust. In order to invest in a post 11 August 1999 Unit Trust that has borrowings, then the Unit Trust must NOT be related.
Further many of the restrictions do not apply, the obvious rules that will apply include ensuring the investment complies with the sole purpose test and investment strategy.

ATO Alerts

The ATO is focusing on SMSF’s and acquiring property under borrowing arrangements, here are recent alerts <ATO-Link>.

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