With the value of equities falling through the floor, and the Reserve Bank continually slashing interest rates in an attempt to stimulate the economy, many institutional and private investors are starting to look again at property as a good investment opportunity. Some investment advisers consider that investment in direct property is a must for a superannuation fund trustee that wants a diversified portfolio of assets, whether it is at institutional level (where the fund offers member-directed investment strategies that include direct property), or at the large corporate or private fund level. And the recent high-profile problems with Real Estate Investment Trusts (REITs) have shown the pitfalls of investing in highly leveraged property securities.
There are a number of prudential issues that fund trustees must consider when weighing up direct investment versus co-investment through a unit trust, particularly whether or not the investment is consistent with the fund's investment strategy (especially where there is gearing) and in the best interests of members. But, as is often the case when trying to determine the commercial benefits of different structures for substantial property investments, the devil is often in the detail, and that detail inevitably involves a consideration of the different tax outcomes for different structures.
This article looks at recent changes to superannuation and tax law that have impacted on investment in real property by superannuation fund trustees, particularly around the pros and cons of direct investment as against investment in property through interposed unit trusts.
Exclusive ownership
Much has been written about how section 67(4A) of the Superannuation Industry (Supervision) Act 1993 (SIS Act) now allows superannuation fund trustees to borrow money to acquire assets using limited recourse loans. This has been a useful development for fund trustees, who are now considering whether they can justify a modest amount of gearing in order to obtain exclusive ownership of a commercial or retail property or infrastructure asset capable of generating reasonable returns over 20 or 30 years. Many fund trustees that might otherwise have financed such acquisitions from cash have had their reserves depleted recently with members switching from illiquid investment options into cash.
Trustees of most institutional funds would be relatively comfortable with fund assets being held by a nominee or custodian, as is required under section 67(4A) where a third party holds legal title to the asset on trust for the fund trustee. The fund trustee has a beneficial interest in the property and a right to call for a transfer of the legal title when the loan is repaid and the mortgage is discharged. Nevertheless, structuring an arrangement that complies with section 67(4A), and satisfies the commercial and legal requirements of each of the fund trustee, the lender and the custodian, but which also derives the maximum benefit from stamp duty and capital gains tax exemptions, can be quite difficult.
Stamp duty
The requirement in section 67(4A) of the SIS Act that the legal title to the property be held on trust for the fund trustee creates another layer of complexity from a stamp duty perspective. In addition to stamp duty on the acquisition of the property, each of the following steps will incur stamp duty unless an exemption is available:
- the transfer of the property from the vendor to the security trustee if the security trustee is not the named purchaser or transferee in the contract;
- the creation or acknowledgement of the security trust relationship; and
- the subsequent transfer from the security trustee to the fund trustee on the repayment of the loan.
Stamp duty can be a significant cost in a direct property transaction if there are no exemptions that apply. Fortunately, all the states and territories have one or more exemptions or concessions that might apply upon the transfer of the property from the security trustee to the fund trustee once the loan is paid out and any mortgage discharged. For CGT and GST reasons, the security trust relationship should be a 'bare' trust under which the security trustee's only duty is to deal with the property at the direction of the fund trustee.
Although most of the states permit the nomination of a transferee or the substitution of a purchaser without incurring additional duty, the circumstances in which this can be done are limited (except in Victoria). The nomination or substitution of the security trustee may result in additional duty. Furthermore, the exemptions referred to above may not be available unless the security trustee is the named purchaser or transferee in the contract. The availability of these exemptions and concessions will depend on the particular circumstances of the acquisition, the form of the documents recording the trust relationship and the time when the documents and relationship are created (and it is important to remember that the stamp duty provisions vary from state to state, so the structure of the arrangement needs to be tailored accordingly).
The considerations which may make a commercial custodial arrangement desirable for investment in equities - financial service licensing and capitalisation requirements, ease of administration, etc - are not an issue for direct property investment. However, section 67(4A) requires custody of the property to be held by a third party, and the potential application of stamp duty upon a change in legal ownership of the property does not lend itself to the usual, commercial custody arrangements.
In most cases, a special purpose vehicle controlled by the fund trustee will be the most appropriate entity to hold the legal title on trust for the fund trustee, because this will give the fund trustee the best chance of tailoring the kind of 'bare trust' arrangement which satisfies the requirements of section 67(4A), but also takes advantage of the stamp duty exemptions discussed above.
For income tax purposes, the Commissioner considers that a mortgage or security arrangement will not of itself prevent the fund trustee from having an absolute indefeasible interest in the capital and income of the property. This means the income from the property will flow through the security trustee and be taxed in the hands of the fund trustee in the same manner as any other arm's length income.
While this article has not looked at the land tax implications of entering into such an arrangement, the fund trustee would need to consider whether any land tax grouping or surcharge provisions apply to the security trust arrangement, and whether any concessions are available.
Other issues: refinancing and development/refurbishment
If a fund trustee borrows to buy real property and subsequently refinances the loan i.e. pays out the original loan and takes out a new loan on more favourable terms, the new loan is a new borrowing (SMSFR 2008/D4). This is a problem, because section 67(4A) prohibits the fund trustee from borrowing unless it is to acquire a new asset.
An arrangement could be structured whereby the principal loan from the third party financier is made to a related party of the fund trustee, and then loaned to the fund trustee by the related party to fund the purchase of the property. In this way the original loan from the third party financier can be refinanced without affecting the loan arrangement with the fund trustee. Obviously this arrangement raises a number of important commercial issues that must be addressed including the provision of appropriate security to the third party financier. The security could be in the form of a bank or other guarantee, provided no claim can be made against fund assets (other than the asset acquired with the loan) in the event the fund trustee defaults on the loan.
A grey area in the legislation that has not been resolved in subsequent updates from the Australian Taxation Office (ATO) is whether a fund trustee is prohibited from borrowing to develop or refurbish a new or existing property. The early noises from the ATO suggested that a fund could not use the principal borrowing to refurbish a property because the refurbishment was a new asset. This means that a fund trustee that is looking to develop or refurbish a property that it proposes to acquire will need to factor in the development or refurbishment being undertaken using the fund's existing resources.
Co-investment through unit trust
Superannuation fund trustees often invest jointly with other fund trustees or institutional investors through unit trusts to gain exposure to large direct property interests. There may be a number of reasons for this, including:
- cost (unable to gear until recently, many funds could not afford to acquire large property holdings through direct ownership);
- liquidity (the fund trustee may be able to sell or redeem its units if it wants to dispose of its interest in the property);
- diversification (a large single investment may not comply with the Fund's investment strategy nor the diversification requirements of the SIS Act); and
- the potential application of the 'sole purpose' test: certain activities associated with property ownership, such as property maintenance services, may be considered carrying on a business, which raises prudential issues for a fund trustee.
Investing with other fund trustees through a unit trust, so the trustee of the unit trust undertakes the relevant activities, can solve these problems.
However, the way in which unit trusts are taxed, and in particular the application to superannuation funds of the public trading trust rules in Division 6C of the Income Tax Assessment Act 1936, has limited the forms of investment that fund trustees undertake through managed investment trusts. Division 6C provides that a public unit trust will be taxed as a company unless its investment activities consist exclusively of 'eligible investment business' (ie passive, non-trading activities).
As a result of a quirk of legal history, a unit trust will be a public unit trust where a superannuation entity owns or controls 20% or more of the units on issue. Nevertheless, given investment through a unit trust offers such administrative convenience, many fund trustees will still structure their investments through an interposed unit trust, and will either:
- accept the company tax treatment of the unit trust, on the basis that the complying superannuation entity is taxed at 15% and is entitled to a refund of franking credits, which means the real cost is the potential loss of the CGT discount (effectively reducing tax from 15% to 10%) on any long term capital gains which would otherwise flow through the unit trust; or
- try to ensure the trustee of the unit trust sticks to 'eligible investment business' so the unit trust doesn't become a 'trading trust'.
Division 6C really becomes a problem when the unitholders in the unit trust include a mixture of superannuation entities and other tax entities. In this case the application of Division 6C to tax the unit trust as a company will give rise to real tax disadvantage to the other tax entities and it will be necessary avoid the unit trust becoming a trading trust.
The principal area of 'eligible investment business' is investment in land for the purposes of deriving rent. Unfortunately, these two key concepts have been interpreted restrictively to limit the forms of investment trustees of unit trusts can undertake without being taxed as trading trusts. As a result, fund trustees have not been able to invest through unit trusts in assets such as capital equipment necessary to exploit the land (ie cranes and lifts on a dock), because only investment in the land itself is permitted.
The Government introduced legislation to Parliament in late 2008 (the Tax Laws Amendment (2008 Measures No. 5) Bill 2008)) designed to make changes to certain aspects of the public trading trust rules, pending a more substantial review of the taxation of managed investment trusts being conducted by the Board of Taxation. The draft legislation clarifies that 'investing in land' includes investment in fixtures on land and chattels (ie movable property) which are closely related to the use of the land. This could open up a field of infrastructure and commercial investment not previously available because the trustees of managed investment trusts wanted to avoid being taxed as companies.
The draft legislation also includes a 'safe harbour' provision so that a fund trustee's investment in land is deemed to be for the purpose of deriving rent, even where up to 25% of the revenue derived from the investment is not rent, provided the revenue is not trading revenue or 'excluded rent' (ie income from profit-sharing arrangements).
This extension to the scope of 'eligible investment business' means that co-investment through a unit trust has a distinct advantage over direct investment using a geared structure for fund trustees. Fund trustees can invest in a range of property and infrastructure assets through unit trusts without contravening the public trading trust rules, so they will still have the advantage of 'flow-through' taxation from the interposed unit trusts.
On the other hand, a fund trustee wanting to invest directly in the same property or infrastructure assets using a geared structure that complies with section 67(4A) of the SIS Act would need to obtain separate loans in respect of each of the assets (meaning separate security trusts for each asset), or would need to devise a strategy to fund the acquisition which consisted partly of debt and partly of cash.
However, there is a potential 'Black Swan' for fund trustees investing through interposed unit trusts. The review of managed investment trusts being conducted by the Board of Taxation has raised the possibility of all gains made by managed investment trusts being taxed as revenue gains. As unit trusts are flow-through vehicles for tax purposes, these gains would (generally) be distributed by the trustee of the unit trust to unitholders. The consequences of all gains made by managed investment trusts being treated as revenue gains would be significant to fund trustees; they would be taxed at the rate of 15% rather than the concessional rate of (effectively) 10% available to fund trustees for long term capital gains. Industry groups have suggested it could lead to wholesale withdrawal of superannuation fund investments from managed investment trusts in favour of direct investments or investments through pooled superannuation trusts.
Conclusion
Section 67(4A) of the SIS Act has been seen as an important development for fund trustees wanting to take advantage of gearing to invest in direct property. There are certainly opportunities for fund trustees now that they can borrow money to acquire larger assets like commercial properties, but fund trustees need to be careful about how they structure such an arrangement to ensure they derive the maximum commercial benefit. In addition, with favourable changes being made to the taxation of managed investment trusts, the more traditional structure of fund trustees joining with other super fund trustees or other institutional investors to invest in property through closely-held unit trusts will become more attractive to fund trustees wanting to gain an exposure to property without having to borrow to do so.