The superannuation borrowing rules have been much discussed but some outstanding points have remained unsettled. Practically, whether a superannuation fund could make improvements to a property acquired under a borrowing arrangement (and what that term meant) was unclear.
The Commissioner’s views are set out in Draft Ruling SMSFR 2011/ D1 on the following three key points:
what is a ‘single acquirable asset’;
what constitutes ‘maintaining’ or ‘repairing’ an asset versus an ‘improvement; and
when is an asset a prohibited replacement asset.
The underlying theme is that the Commissioner appears to be against property development being undertaken in a borrowing arrangement. The problem for the Commissioner was that with the recent storms and floods it meant that many properties owned through superannuation fund borrowing arrangements needed significant improvements and in some cases needed to be completely rebuilt.
The answer seems to be to draw a distinction between restoring the asset back to its former glory and creating a new asset.
Single acquirable asset = multiple titles
Hall & Wilcox’s view is that where:
a property has been constructed across two or more certificates of title, the asset as a whole will constitute a 'single acquirable asset'; and
certificates of title cannot be dealt with separately ie real property and accompanying car park(s) on accessory titles, the assets will constitute a 'single acquirable asset'.
The Commissioner’s view in SMSFR 2011/D1 supports our view.
The Commissioner’s view is that where assets can be dealt with separately, they will not constitute a single acquirable asset. It is not sufficient that there are commercial reasons for treating the assets as a single asset, for example, the lender will only lend over a group of assets.
Therefore, apartments and car parks that are not on a single certificate of title or restricted dealing assets (ie they cannot be transferred separately under State Laws) will not be a single acquirable asset so must be bought under separate borrowing arrangements with respective loans that cannot be cross collateralised.
Also, farm land across multiple titles will not be treated as a single acquirable asset, so multiple trust structures and corresponding loans will be required.
We expect strong submissions on this aspect of the draft ruling.
Maintaining or repairing an asset is allowed
The draft ruling confirms that a trustee may draw down further amounts under a superannuation fund borrowing arrangement to maintain or repair an asset. (However, a trustee will not be permitted to borrow to fund maintenance or repairs to an existing fund asset).
The limited recourse loan documents should provide for further draw downs as permitted under the superannuation law. Each draw down constitutes a new loan, but is dealt with under the existing trust arrangement.
The Commissioner takes the view that:
‘maintaining’ an asset refers to preventing damage or deterioration to an asset to ensure the ‘functional efficiency’ of an asset; and
repairing an asset refers to restoring the ‘functional efficiency‘ of the asset without changing its character, for example, remedying defects and damage.
So what does the ‘functional efficiency’ of the asset actually mean? The Commissioner gives the following examples of what is maintenance or repair and therefore, permitted under the Superannuation Industry (Supervision) Act 1993 (SIS Act) and what is an ‘improvement’ that will breach the borrowing rules:
A fire damages a part of the kitchen (cooktop, benches, walls and ceiling). Restoration of the damaged part of the kitchen would constitute repair of what is a subsidiary part of the asset being the house and land. |
If the kitchen was also extended by extension of the house this extension would be an improvement.
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The guttering on the house is replaced and the house is repainted. A fence is replaced. A fire alarm is installed to comply with new council requirements. This would be repair or maintenance. |
The addition of a new pool or a new garage would be an improvement.
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| A cyclone damages the roof of the house. Replacement of the roof in its entirety is a repair. |
The addition of a second storey to the house at the time of also replacing the roof would be an improvement.
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Replacing a section of the cattle yards or the existing fencing is a repair.
Ensuring the bores, windmills, tanks and troughs continue working is repair or maintenance. This would include laying new pipes between the tank and trough. |
Each of the following additions is an improvement:
- a new set of cattle yards;
- a new bore, tank, windmill and trough;
- a dam;
- a further two kilometres of fencing.
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Improving an asset is not allowed
The Commissioner has taken the view that while a trustee cannot use borrowed funds to improve an asset, the trustee could use the existing assets of the fund. However, the devil is in the detail and the fine print is that any improvements must not change the asset such that it is a different asset. What this essentially means is that the trustee cannot develop the property will the borrowing is on foot.
The Commissioner gives the following examples:
| Vacant block of land on single title. |
The vacant block of land is subsequently subdivided resulting in multiple titles. One asset has been replaced by several different assets as a result of the subdivision.
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| Vacant block of land on single title. |
A residential house is built on that vacant land (still single title). The character of the asset has fundamentally changed from vacant land to residential premises.
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| A house and land. |
The house is demolished and is replaced by three strata titled units. The character of the asset has fundamentally changed along with the underlying proprietary rights. This has created three different assets. |
| A house and land. |
Rezoning of the land is granted and the house is renovated and is now commercial premises. The character of the asset has fundamentally changed from residential premises to commercial premises. This is a different asset.
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| A four bedroom house and land. |
A fire destroys the four bedroom house and a four bedroom house is constructed using insurance proceeds. Rebuilding a four bedroom house does not fundamentally change the character of the asset held under the Limited Recourse Borrowing Arrangement (LRBA). Rebuilding the house restores the asset to a house and land. |
The above represents good news for those SMSF investors trying to decide whether that new kitchen is a repair or an improvement but not much comfort for those SMSF investors looking to develop property in a SMSF that has been acquired under a borrowing arrangement. In fact based on the draft ruling SMSF investors should take care with:
- any subdivision of land; and
- rezoning of residential to commercial premises.
Restructuring of the arrangement will be required.
Conceptually, there does not seem to be much distinction between building a house on vacant land and rebuilding a house on newly vacant land. The basis is the functional approach taken by the Commissioner – this functional approach will be subject to further submissions before the draft ruling is finalised.
Watch this space for the final instalment of the Commissioner’s views on superannuation borrowing arrangements!