If a fund trustee is contemplating acquiring land to develop, there are a number of commercial and prudential requirements the fund trustee must consider from both a superannuation and tax law perspective. The investment must also be permitted under the fund’s governing deed.
This article is the first instalment in a four part series that will look at the common issues that should be considered by a fund trustee when developing land.
This article is the first instalment in a four part series that will look at the common issues that should be considered by a fund trustee when developing land. This update will focus on the superannuation issues faced by a fund trustee interested in acquiring and developing land directly, including commentary on the debate around whether a fund trustee is permitted to conduct a business, does a land development exhibit the relevant characteristics of a business and at what point will vacant land satisfy the indicia of ‘business real property’.
Over the course of the four updates, we will consider the key commercial aspects of entering into a land development and the structuring options, with a focus on how to structure and document a land development project to ensure the best outcome from a commercial and superannuation perspective.
Is the fund trustee in the business of property development?
The common view is that a fund trustee cannot operate a business as it would be inconsistent with the sole purpose test. This is a common misunderstanding - the sole purpose test does not necessarily prohibit a fund trustee carrying on a business. The sole purpose test merely requires a fund to be established and maintained for the purpose of providing retirement benefits to members and/or death benefits to members’ dependants.
The Commissioner has stated that 'if a superannuation fund is conducting a business, then it is not being administered for the sole purpose of providing benefits for the members and beneficiaries of the fund’ (NAT 2061). However, a fund trustee will not necessarily be carrying on a property development business just because it develops land - the nature and scale of the development, and whether the land once developed will be held or sold, will determine whether a business is being operated.
The Commissioner stated in SMSFR 2009/1 that the usual investment activities of a trustee will not be considered as carrying on a business, which could include developing vacant land. Thus the development of land may simply be the realisation of a capital asset. If the land development is likely to satisfy the requirements of a business, the fund trustee should ensure that the activities being carried out comply with the provisions of the Superannuation Industry (Supervision) Act 1993 (SIS Act) and in particular, the sole purpose test.
Can the fund trustee acquire vacant land from a related party?
A fund trustee is prohibited from acquiring an asset from a related party under section 66 of the SIS Act unless an exemption applies. The relevant exemption for current purposes permits a fund trustee to acquire real property from a related party if the property is acquired at market value and the property is ‘business real property’, which is defined as ‘any freehold or leasehold interest of the entity in real property … where the real property is used wholly and exclusively in one or more businesses (whether carried on by the entity or not), but does not include any interest held in the capacity of beneficiary of a trust estate’ (section 66(5) of the SIS Act).
Therefore, the development land must be used wholly and exclusively in a property development business. The business does not have to be conducted by the fund trustee and could in fact be carried on by a related entity. Generally, vacant land will be business real property even though construction of the building has not commenced if the land is in the early stages of development, for example engineers and surveyors are conducting initial work on the land (refer to SMSFR 2009/1 at paragraph 174). Importantly, there must be activities, operations or actions occurring on the land, such as installing sewer and stormwater drainage.
Structuring the development
An option for structuring land development projects is for the fund trustee to own the land and, depending on the size of the development, fund the development and engage contractors directly to undertake the work required. Alternatively, the fund trustee could engage another entity to carry out the development by way of a co-venture agreement. Arrangements of this nature are generally structured so that the fund trustee is entitled to the rent or net proceeds of sale while the developer is paid a fee (such as an amount equal to a proportion of the net proceeds of sale based on the contribution of the developer to the costs of the co-venture).
Structuring a property development as a co-venture can maximise the benefit to the fund trustee while minimising the risks if an experienced developer is used. The potential benefits to a fund trustee are:
- ensuring the fund trustee does not inadvertently breach the sole purpose test by carrying on a property development business (depending on whether the development is the mere realisation of a capital asset or a more substantial development that satisfies the indicia of a business); and
- allowing a fund trustee to acquire vacant land from a related party where the development has commenced (ie the preliminary stages are underway).
As the development land will be held by the fund trustee, the development land cannot be mortgaged or used as security for another transaction as the fund trustee is prohibited from charging its assets under regulation 13.14 of the Superannuation Industry (Supervision) Regulations 1994 (SIS Regulations). A ‘charge’ is broadly defined to include a mortgage, lien or other encumbrance.
Where a fund trustee is entering into a co-venture with a related party it should properly document the arrangement and ensure the arrangement is on arm's length terms.
Tenants in common
A fund trustee could purchase the development land as tenants in common with a related or unrelated party. Each owner should incur all liabilities and receive all income in accordance with their proportionate ownership.
Importantly, the development land cannot be used as security by the other party or the fund trustee will breach the prohibition on charging fund assets in regulation 13.14 of the SIS Regulations. Generally, the co–tenant will be prevented from securing only their interest in the development land as a lender will not be satisfied with the quality of the security provided as the lender will be prevented from selling the development land if the co–tenant defaults on the borrowing.
Further, the fund trustee cannot enter into an agreement to transfer the development land to the lender if the other party defaults without breaching regulation 13.14 of the SIS Regulations.
The ABC Superannuation Fund has decided to acquire vacant land from a related company, XYZ Pty Ltd, and build 4 townhouses with the intention that the townhouses will be sold. The land is worth approximately $1 million and the development will cost approximately $1.5 million. The fund has $3 million in assets.
The fund enters into a co-venture agreement with XYZ Pty Ltd whereby the parties agree that the fund will contribute $2.5 million to the venture, being $1 million for the land and $1.5 million for the development costs. XYZ Pty Ltd will undertake the development. Any additional costs will be financed by off-the-plan sales.
The parties agree that once the development has commenced, the fund will buy the land for $1 million on the basis that the land will satisfy the definition of business real property at this time. Under the arrangement, the fund is entitled to the profits but will pay the developer an agreed fee. This arrangement acknowledges the financial contribution of each party and the endeavours of XYZ Pty Ltd in managing and co-ordinating the actual development.
The acquisition of the property and subsequent development is permitted under the fund deed and is in accordance with the fund’s investment strategy and the developer’s constitution.
Tips and traps
Before a fund trustee enters into a co-venture agreement to develop land, it should:
- review the trust deed to ensure it has the power to enter into both the agreement and the development;
- review the fund’s investment strategy in light of the member profiles and consider whether the agreement is in the best interest of members and generally complies with superannuation law;
- obtain tax advice on any capital gains tax, stamp duty and GST liabilities; and
- review the terms of the proposed co-venture agreement to ensure the agreement reflects the parties’ intentions and provides for the termination of the agreement.
Stay tuned for our next update where we will consider some of the commercial aspects of entering into a land development.