Session 13B: SMSFs & Real Property Applications

SPAA 2011 SMSF National Conference Wed 23 February 2011 – Fri 25 February 2011

Stephen Heath Partner, Wallmans Lawyers

DICTIONARY

Terms used in this paper:-

"ATO" means the Australian Taxation Office.

"ITAA" means the Income Tax Assessment Act 1997.

"ITAA 1936" means the Income Tax Assessment Act 1936.

"Regulations" means the Superannuation Industry (Supervision) Regulations 1994.

"SIS" means the Superannuation Industry (Supervision) Act 1993.

"SMSFR 2010/1" means Self Managed Superannuation Fund Ruling 2010/1.

"SMSFR 2009/1" means Self Managed Superannuation Fund Ruling 2009/1.

"SMSF/s" means self managed superannuation fund/s within the meaning of SIS.

SESSION 13B – SMSFs AND REAL PROPERTY APPLICATIONS

1. Introduction

Participants in the superannuation industry will be well aware of the rise to prominence of SMSFs over the last 10 years. The rise to prominence has been a veritable revolution both in the superannuation market (SMSFs represent an ever increasing percentage of total superannuation funds assets under management) as well as in the broader market place (SMSFs representing the preferred vehicle for private wealth creation).

The simplification of the taxation rules applicable to superannuation which took effect 1 July 2007 has had a big part to play in the SMSF rise to prominence. The main drivers have been the abolition of the RBL regime, enhanced flexibility in benefit design options (pension income streams) and a tax free regime for benefits for members having attained age 60.

The agenda of the ATO to change its interpretation of the Division 7A ITAA 1936 deemed dividend rules in the context of unpaid past distributions, as spoken for by Taxation Ruling TR 2010/3, is also considered to be a relevant factor.

1.1. Family Trust Model

The point can be made by reference to observing what the standard models to structuring real property asset holdings has been and to compare that to current day and emerging practice.

In the context of related party real property holding arrangements the standard model has been as follows:

The common practice has been for a real property used in a business (a private company being the vehicle of preference for this purpose) to be owned by a family trust, which extracts rents from the trading company and makes distributions to a "dump company", which distributions have usually been left unpaid. This has enabled amounts otherwise representing profits to be extracted out of the trading company and to be retained by way of a store of value in the trust entity. That in turn has usually meant that trust distributions have not been paid and instead other investments have accumulated in the family trust.

However, the ATO have taken an aggressive stance with family trusts in recent times as follows:-

1) Trust cloning / splitting practices have been stamped out by amendments to CGT Events E1 and E2 now providing that any attempt to create discrete shares under a trust, often a desired succession objective, will carry adverse CGT consequences;

2) Taxation Ruling TR 2010/3 expressing the view that when a trust makes an unpaid distribution to a company the company's forbearance to demand payment will constitute financial accommodation of the trust and therefore will be deemed to be a loan. By virtue of being a deemed loan a deemed dividend (unfranked) arises by virtue the operation of Division 7A ITAA 1936. Generally speaking Division 7A has the effect of deeming loans by private companies to

Family Trust

Land

owns

Dump Company P/L

Trading Company P/L

rent

lease

unpaid distributions

Other Investments

owns

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shareholders / associates of shareholders to be dividends paid out of profits of the company; and

3) Trusts being exposed to demanding trust loss tax rules and being required to make "family trust elections" for a range of reasons.

A number of problems have therefore emerged with the trust ownership model as follows:-

1) The risk of deemed dividends;

2) Even if the structure works the standard tax rate is 30% and possibly more tax on ultimate distribution; and

3) There are succession problems with passing ownership of a trust to the next generation as creating fixed interests is difficult.

1.2. Superannuation Model

It is now clear that the trust ownership model has been replaced by what might be described as the "SMSF ownership model". This has seen many trusts dismantled and the real property assets migrated to SMSFs. The challenge for planners has been to surmount the limits on superannuation contributions applicable since 1 July 2007 and the general prohibition on SMSFs borrowing and granting charges.

The SMSF ownership model might be described as follows:-

Under this model a number of favourable outcomes are able to be locked in:-

1) A Trading Company P/L takes a taxation deduction for its rent expense and the SMSF only pays 0% / 15% on that income, depending on whether it is in accumulation or pension phase.

2) Private wealth accumulates in the SMSF without any need to distribute income with the applicable tax rate on realised gains being limited to 0% / 10%: again depending on upon whether assets are referrable to accumulation or current pension liabilities. An effective tax rate of 10% applies when A SMSF derives taxable capital gains on assets held for more than 12 months (Division 115 ITAA ⅓ general discount for superannuation funds).

3) Once members attain age 55 / 60 pensions can be provided with the usual outcome being that the proportion of the SMSF assets supporting the pensions operates under the tax exemption for income referable to current pension liabilities and with pension income in the hands of the members being tax exempt / attracting taxation concessions.

4) Succession can also be achieved by next generation family members being joined as members of the SMSF. In that event contributions by or in respect of the next generation family members can acquire "equity" in the underlying SMSF assets as their accumulation account balances grow and the pension account balances of the elder generation ultimately diminish.

Owns

A SMSF

Members A Family

Over Age 55 Land

A Trading Company P/L

Rent

Lease

Pension Income

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To date the ATO have not applied any "squeeze" on these sorts of practices and in light of the ATO agenda with family trusts the SMSF model has become the preferred model.

This paper focuses on various real property applications which have emerged with SMSFs over the last few years as well as seeking to define the range of practices which are authorised by the superannuation and taxation legislation.

2. Business Real Property

It is common for SMSF trustees to look to acquire real property from related parties and/or to enter into related party leasing arrangements. The acceptability of those practices depends in a large degree as to whether or not the real property is "business real property".

There are a number of provisions in SIS which govern related party dealings.

Section 62 of SIS requires superannuation fund trustees to make and maintain their investments for the sole purpose of funding member retirement benefits.

Section 109 of SIS requires dealings between superannuation funds and related parties to be struck on terms which do not provide non arms length benefits to the non superannuation party. Section 295-550 ITAA has similar effect in reverse by taxing income arising to a superannuation fund from related party dealings, which is considered to be excessive (non arms length income), at the highest personal marginal rate.

In practical terms the effect of section 109 SIS and section 295-50 ITAA is that all dealings between SMSFs and related parties need to be struck on an arms length basis.

The most important provisions which relate to real property are section 66 of SIS (prohibition on acquisitions from related parties) and section 71 of SIS (definition of in-house assets).

2.1. Section 66 SIS

Section 66 of SIS generally prohibits superannuation fund trustees from intentionally acquiring assets from related parties. "Related party" is defined in section 10 SIS to include members and employer sponsors in relation to a superannuation fund as well as relatives and companies / trusts controlled by any combination of any group of such persons.

An important exception to the general prohibition on related party acquisitions is contained in section 66(2)(b). Subparagraph (b) applies where a superannuation fund with less than 5 members acquires an asset which is "business real property of the related property acquired at market value".

A number of the words and phrases used in section 66 warrant careful analysis and consideration.

2.1.1 "Acquire" / "asset"

Section 66 only applies in the first instance where the superannuation fund "acquire(s)" an asset from a related party. There can also be circumstances where the existence of an "asset" also requires consideration.

The issue of whether there is a relevant acquisition is not always easily determined. The general law interpretation of "acquire" is broad and includes transfers for consideration, transfers in specie and property rights acquired by the granting of rights by another (see Palinkas v Palinkas [2009] NSWSC 92 and Allina Pty Ltd v FCT (1991) 28 FCR 203). In any event as regards contributions it should be noted that Cook v Benson (2003) 214 CLR 370 stands for the proposition that contributions to superannuation funds are for consideration by virtue of the accretion to the member's interest in the superannuation fund. A contribution in specie of real property does raise a question of how or whether such an acquisition would be at market value. In light of the limits on superannuation contributions it will be incumbent on the

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superannuation fund trustee to record the "acquisition" / contribution by reference to the market value of the property. The ATO accepts that an in specie contribution can be at "market value" but that will require the dollar value of the contribution to be accurately assessed at the contribution time.

2.1.2 Assignments of Contracts

Land acquisitions from unrelated parties will generally not give rise to any issues. However, an issue does arise where a land contract is written in the name of a related party of a superannuation fund and the benefit of the contract is later assigned to the superannuation fund.

The issue is explained in the above diagram. "Asset" is defined in section 10 SIS to mean "any form of property and to avoid doubt includes money" though "acquire an asset" is defined in section 66(5) as not including acceptance of money. It should be noted that the SIS "asset" definition, in requiring the existence of property is a narrower definition then the ITAA "CGT Asset"definition which extends to contractual rights and other events which do not require the existence of any property.

An assignment of a contract as described in the above diagram would seem capable of being described as the acquisition of an asset. The issue arises of whether rights under a land contact are in the nature of property so as to qualify as an asset. In the absence of settlement and payment of the purchase price the position at general law will be that a real property contract will be a "chose in action" which is most likely "proprietary" though not necessarily an interest in real property.

Therefore, it may be that the assignment of the land contract from B to B SMSF in the above example will be an acquisition of an asset which will not be "business real property" and consequently that would breach section 66.

Whether the ATO would take such a rigorous approach to the interpretation of section 66 is uncertain. It should be noted that writing the contract as an "and/or nominee" contract coupled with a contemporaneous letter of nomination from the superannuation fund would avoid the issue altogether.

2.1.3 Granting of Rights

An issue which sometimes arises in the context of stamp duty and capital gains tax is the question of the true characterisation of what happens when an entity grants fresh rights to another party in respect of property. The most common example of this is the granting of a lease. Other examples include the granting of options, restrictive covenants and other property rights such as easements. At general law a lease is not the disposal of a pre-existing asset but rather the creation of rights by virtue of the grant of the lease. Whilst an asset, in that context does not seem to be disposed of (see CSD v JV (Crows Nest) Pty Ltd (1986) 7NSWLR529), it seems from the perspective of the grantee that an asset will have been acquired "from" another party.

Land

Third Party

Owns

B

B SMSF

Writes contract for sale of land

Assigns contract

Acquires

- 5 -

Certainly the general assumption about the operation of section 66 may be that the granting of options / rights of use / lease in respect of an asset by an entity to a related superannuation fund would not be considered to be a prohibited acquisition though on a strict reading and by reference to the general law such an assumption appears to be optimistic. Whilst it is rare to sight a real property lease being granted to a superannuation fund the safest interpretation is to conclude that the "lease" would need to be business real property to justify the fund accepting the lease.

2.1.4 Market Value

The acquisition of an asset from a related party will not breach section 66 if the asset is "business real property" immediately before the acquisition, subject to the acquisition being at "market value". "Market Value" is defined in section 10(1) of SIS to mean:-

"in relation to an asset, means the amount that a willing buyer of the asset could reasonably be expected to pay to acquire the asset from a willing seller if the following assumptions were made:

(a) that the buyer and the seller dealt with each other at arm's length in relation to the sale;

(b) that the sale occurred after proper marketing of the asset;

(c) that the buyer and the seller acted knowledgeably and prudentially in relation to the sale."

This definition does accord with the general law interpretation of the term.

Use of the words "the sale occurred after proper marketing of the asset" raises a "double entendre", one interpretation being that the cost of a full marketing campaign might need to be set off against the price. A different interpretation is that an assumption needs to be made about "proper marketing" which implies that all potential uses of the land need to be contemplated with an "eye" to the best attainable price.

The classic example is the conundrum of primary production land which has been rezoned to an authorised residential subdivision usage. There is also a question about the assessment of market value of land which is likely to be, but is not yet rezoned.

The above example demonstrates the point.

It may be that a valuer has provided a certified valuation for the land at say $1M based on the SIS "market value" definition.

This appears, at least at a superficial level, to be uncontroversial.

C Family Trust

Farming Land C SMSF

Owns $ Market Value

Acquires land as farming land

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The land may comprise 200 hectares and it may be readily determined that the going price for land having those characteristics and for use in primary production activities is around $5,000 per hectare.

Land valuation principles are likely to have regard to both existing usages as well as all authorised usages; including most profitable usage. If residential subdivision is an authorised usage of the land then there is a question of the land "market value" if the going rate for subdivision land having those characteristics is $500,000 per hectare.

It is questionable in those circumstances how a valuer could only assess a $1M value.

The most difficult scenario is to assess a land acquisition where there is good reason to believe that broad acre land zoning guidelines are likely to be relaxed / changed. There is often advance notice of this sort of event since consultation is usually held with stakeholders and developers are often "in the know" about activity in certain regions; usually land bordering towns / cities.

In the above example the following course of events might transpire:-

(a) Land acquired by C SMSF for $1M being broad acre farm land of 200 hectares.

(b) Land is rezoned by State Government as rural living authorising subdivision into 5 hectare allotments able to be improved by construction of residential accommodation.

(c) A property developer who has been making overtures to C Family Trust for over 12 months offers a contract to C SMSF for all the land for a total price of $40M equating to $1M for each notional 5 hectare allotment. The contract may well carry a long settlement, instalment payments and may be conditional upon subdivision approval into 40 titles being obtained within say 12 months.

(d) C, the sole member of C SMSF turns age 55 the day before the contract is written and C SMSF commences a transition to retirement pension on the day the contract is written.

(e) C SMSF ultimately collects $35M as ultimate settlement of the contract and after resolution of several contractual difficulties C SMSF records the $34M capital gain as tax exempt income as being entirely referrable to C SMSF's current pension liabilities.

(f) The week after collecting the final instalment payment C SMSF is advised of an ATO audit.

There are obvious tensions with these sorts of scenarios where arguments can be put supporting compliance with all SIS standards and yet the outcomes leaving a professional advisor feeling somewhat uncomfortable. ATO audit activity with respect to SMSFs conducting real property strategies is likely to result in tensions but ultimately a better understanding of the demarcation between acceptable and non acceptable practice.

2.1.5 Business Real Property

The most important aspect of section 66(2)(b) is the definition of "business real property". The ATO provides a detailed exposé of its interpretation to the "business real property" definition in SMSFR 2009/1.

"Business real property" is defined in section 66(5) as follows:-

"... means:

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(a) any freehold or leasehold interest of the entity in real property; or

(b) any interest of the entity in Crown land, other than a leasehold interest, being an interest that is capable of assignment of transfer; or

(c) if another class of interest in relation to real property is prescribed by the regulations for the purposes of this paragraph – any interest belonging to that class that is held by the entity;

where the real property is used wholly and exclusively in one or more businesses (whether carried by the entity or not), but does not include any interest held in the capacity of beneficiary of a trust estate."

A number of observations can be made about the definition as follows:-

(a) The definition clearly extends to freehold / leasehold and Crown land interests in real property. The ATO notes in SMSFR 2009/1 that freehold interest will encompass strata title / community title interests.

(b) To date no classes of other real property interest have been specified in the regulations as anticipated by paragraph (c) of the definition.

(c) The real property must qualify as business real of the related party immediately prior to the acquisition time. This requires the land to be used in a relevant business at the time of the acquisition though the business / businesses need not be conducted by the transferor related party.

2.1.6 Existence of a Business

The existence of a business is not always easily determined. A transfer subject to a commercial lease, which may attract the GST going concern exemption, will usually meet the test since the lessee will conduct a business.

Where there can be difficulties is with land held as trading stock or as what might be called a "revenue asset", where a lease may have recently terminated or where land, which is fundamentally commercial in nature, is in the process of being converted to an alternate usage.

The problem can sometimes be got around by the grant of a fresh lease immediately before transfer.

The trading stock / revenue asset situation can produce difficulties. Land held as trading stock, notwithstanding the lack of supporting jurisprudence, does now seem to be accepted as a relatively common practice by property developers. The definition of "trading stock" in section 70-10 ITAA merely requires that an asset be held for the purpose of sale though that must be in the "course of a business". For SIS purposes "Business" is defined in section 66(5) as including:

"... any profession, trade, employment, vocation or calling carried on for the purposes of profit, including;

(a) the carrying on of primary production; and

(b) the provision of professional services;

but does not include occupation as an employee."

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This definition probably does not wavier significantly from the general law meaning of the term.

One thing that may have been overlooked by the ATO in SMSFR 2009/1, or at least perhaps not have attracted sufficient comment, is that land sales can give rise to profits on revenue account, without the land being trading stock and/or there being a relevant business. This seems to be a conclusion able to be reached from CoFT v Whitfords Beach Pty Ltd 150 CLR 355 and its approval of the reasoning in the old English decision in California Copper Syndicate v Harris (1904) 5 Tax Cas 159. Whilst Whitfords Beach involved an extensive subdivision of 1,584 acres the High Court held that the profits where taxable on revenue account as ordinary income but did not feel the need to conclude categorically that the company had conducted a business. The reasoning was that an isolated transaction conducted in a business-like manner (an adventure in the nature of trade) with a view to profit would not necessarily be a business but could give rise to profits assessable on revenue account.

Care therefore does need to be exercised when determining when land is business real property particularly where the land is considered to be the subject matter of the relevant business. In SMSFR 2009/1 and 2010/1 the ATO does accept that land can be held in connection with a land development business conducted by the owner of the land.

2.1.7 Further Issues with Business Real Property

(a) The whole of the land must be used in a relevant business. Therefore, if there are multiple tenancies and one is vacant at the transfer time the definition may not be satisfied.

(b) Water rights as discrete items of property (that is water rights not entrenched by definition in any associated real property interest) will not be business real property.

(c) Other interests such as oyster leases / marina berths may be capable of qualifying as business real property though that will require careful analysis having regard to the legal characteristics of the rights in question.

(d) Real property of a fundamental commercial nature will not be precluded from being business real property because a tenant may be a "not for profit" entity.

(e) Under the general law fixtures to land will be considered be part of the land and therefore will not be considered as separate assets and will pass with ownership of the land. Fixtures are to be contrasted with items such as plant and equipment, lessee's fit out and items (usually described as chattels) which may only rest upon the land by their own weight.

(f) Demountables structures may be fixtures but that will depend upon the degree of annexation; connection with electricity and water / sewerage may support demountables as fixtures by virtue of having a permanent annexation with the land.

(g) The definition of business real property provides that:-

"Business real property does not include an interest in real property held in the capacity of beneficiary of a trust estate".

This qualification appears to be no more than an affirmation of units in a real property holding unit trust not being included in the definition. It is suggested the High Court decision in CPT Custodian Pty Ltd v CSR (2005) 221ALR196 would compel this conclusion in any event. A unit holder in a unit trust does not hold a fractional or beneficial interest in

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the trust property and the same reasoning will apply to shares in a company.

(h) Section 66(6) provides that primary production land can satisfy the "business real property" definition notwithstanding that an area not exceeding 2 hectares is used for private and domestic and purposes subject to that usage not being the predominant usage of the real property.

The above transaction will therefore not breach section 66 though it is suggested that the entire property would need to be leased on commercial terms. The rent paid by D Family for the farmhouse should be at an arms length rate, absent which there is a risk of a breach of section 109 SIS.

(i) Generally speaking residential property will not qualify as business real property since there will not be a relevant connection with a business. If a superannuation fund member owns a beach house which is in the hands of a leasing agent the property will not have a sufficient nexus with the leasing agent's business. The beach house is not used in the leasing agent's business as such. The ATO in SMSFR 2009/1 does accept that a residential property would be capable of comprising part of an entity's property investment business. Care should be take with this observation because it is often the case that the establishment of a portfolio of rent producing properties (residential or commercial) is more in the nature of a private wealth creation exercise as distinct from the conduct of a business. Considerable scale and coordination of operations would be required to enable a safe conclusion about the existence of a business.

3. Tax Planning and Commercial Issues

Any transaction involving a disposal by a related party of business real property is likely to give rise to issues of stamp duty, GST and capital gains tax. The convention with stamp duty is that the purchaser pays and it is suggested that convention should be observed by superannuation funds in related party dealings.

As regards GST whilst GST is not payable on the supply of second hand residential property most supplies of business real property will be chargeable with GST. In some cases the supplier will not be registered or required to be registered for GST or an application of the GST going concern exemption will avoid the need for GST to be charged. For the going concern exemption to be available the supply of the land must constitute the supply of the entire enterprise, both parties must be registered for GST and agree in writing to the application of the going concern exemption.

This does bring the question of the formalities needing to be attended to in the context of related party land acquisitions. The temptation usually will be to proceed directly to execution of a land transfer in registrable form. The striking of a formal contract and a settlement statement to adjust the rates and taxes etc may be considered to be overly formal. Nevertheless there is no

D Family Trust

40 Hectare title

½ Hectare farmhouse

D SMSF

D Family Farming

Partnership

D Family

$ Market Value

Acquires

Lease

lease of farmhouse

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detriment in proceeding in that way and that will ensure that the GST going concern exemption, if applicable, is dealt with as a term of the contract. In some jurisdictions stamp duty is payable on the land contract and in practical terms that may necessitate the production of a contract in any event.

Capital gains tax liabilities can be a deal breaker for some related part transactions. The CGT event which occurs can however often offer planning opportunities.

Where the desire has been to migrate real property from a related party to superannuation it is common to seek to apply the Division 152 ITAA small business concessions. For individual and trust transferor taxpayers the Division 115 ITAA 50% CGT general discount would also usually apply. The issue sometimes arises as to the mechanics of the retirement exemption under Division 152-D when the transfer of the property may be intended to qualify as the payment of a CGT roll-over amount. The ATO issued ATO ID 2003/454 to provide that the transfer of the asset, giving rise to the gain in the first instance, could also qualify as the making of the CGT roll-over amount payment. That ATO ID has now been withdrawn as Division 152-D no longer requires actual capital proceeds. However, the underlying principle remains unchanged that the transfer of the asset which gives rise to the gain can itself constitute the payment for the purposes of the retirement exemption. This can alleviate the need for the superannuation fund to "pay" the entire purchase price.

Section 292-100 ITAA is a relatively new provision (effective 1 July 2007) which provides a lifetime limit for each individual of $1M for certain capital gains amounts or proceeds to be conveyed to superannuation. To date the section 292-100 contribution capability does not appear to have been widely used in the market place.

In a related party transaction section 292-100 can be utilised to enable superannuation funds to access and effect transactions which may otherwise may not be achievable.

On the above facts we assume that E Family Trust has owned Business Real Property for more than 12 months and that the CGT cost base for the asset is $500,000.

A CGT event occurs by E Family Trust selling Business Real Property to E SMSF at its market value of $1M. The consideration for the acquisition of the Business Real Property is evidenced by E SMSF drawing a promissory note in favour of E Family Trust (that is, in the first instance E SMSF does not have any money).

The small business 15 year exemption (subdivision 152-B ITAA) will apply in the following way and subject to the following conditions:-

1) The small business CGT "basic conditions" must be satisfied. Basically these conditions require E Family Trust to be a small business entity (group turnover less than $2M) or

(ii) Promissory Note $1M

E Family Trust

Business Real Property

(Market Value $1M)

E SMSF

E Trading Co Pty Ltd

E

Leased

Acquires (i)

(iii) Endorsed Promissory Note (iv) Section 292-100 contribution

Owns

- 11 -

satisfy the maximum net asset value test ($6M net assets) and satisfy the active assets test with respect to the business real property.

2) E Family Trust must have owned the Business Real Property for at least the preceding 15 years.

3) In at least 15 years during E Family Trust's ownership period of the Business Real Property there must have been a "significant individual".

A significant individual in relation to a discretionary trust must be a natural person who has received distributions of at least 20% of any distributions of income or capital. A trust will be taken to have had a significant individual in respect of any year of income in respect of which distributions have not been made.

4) E (on our facts, the relevant person) must be a significant individual of E Family Trust for the disposal year and the disposal of Business Real Property must be in connection with E's retirement after age 55 or E's permanent incapacity.

5) E Family Trust must make a payment or payments to a CGT concession stakeholder within 2 years after the CGT event. On our facts E Family Trust has made a payment to E by endorsement of the promissory note (described in step (ii)). Notably the amount of the payment is equivalent to the full amount of the capital proceeds.

The ITAA does not provide guidance on what the characteristics of the payment to be made by E Family Trust might or should be. The trustee of E Family Trust will need to find authority under the trust deed for the payment. It is suggested that it might be described as a distribution of trust capital.

6) All the above conditions satisfied, E Family Trust can disregard the whole $500,000 gain under the 15 year exemption and in doing so does not adopt the section 102-5 ITAA method statement and therefore does not apply the CGT general discount (even if applicable as it otherwise would be here).

7) Under section 152-125 the amount of E Family Trust's payment (in this case $1M to E) can be disregarded by E Family Trust and E up to the amount calculated as "Stakeholder's participation percentage x Exempt amount".

The exempt amount is a reference to the amount of the disregarded gain being $500,000 on our facts. The stakeholder's participation percentage, in the case of E Family Trust (being a discretionary trust), is calculated by reference to the number of CGT concession stakeholders in relation to E Family Trust for the disposal year. A CGT concession stakeholder is a person who is a significant individual and a spouse of such a person who receives any distribution from the trust for the disposal year.

If E is the only CGT concession stakeholder then his stakeholder's participation percentage will be 100%. That being the case the full $500,000 disregarded gain of E Family Trust is also disregarded in E's hands.

One might expect that would have been the case in any event without the need for section 152-125. At least that appears to be the case with discretionary trusts whilst in the case of unit trusts and companies deriving 15 year exempt gains ultimate distributions to unitholders / shareholders pro rata to their holdings is required to avoid an application of CGT Event E4 / dividend outcome.

8) Division 152-B provides a ready entree to an application of section 292-100 ITAA which authorises contributions to superannuation up to $1M for individuals sourced out of moneys referable to the Division 152-B concessions.

9) In the context of E Family Trust having made a $1M payment to E for Division 152-B purposes section 292-100(4) will apply to enable E to make a special style of superannuation contribution. Section 292-100(4) applies where a trust has disregarded a capital gain under Division 152-B or where a trust could have disregarded a gain but for an event not producing a capital gain (this enables an individual to access trust capital

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proceeds to make a superannuation contribution even if this trust does not make a capital gain).

10) If E was permanently incapacitated at the time of the CGT event it should be noted that (for section 292-100 purposes at least) the condition requiring the asset to have been held by E Family Trust for 15 years is not required to be satisfied. It is a precondition for this rule that E not have been permanently incapacitated when the asset was acquired (section 292-100(6)).

11) E must make a contribution to a superannuation fund within 30 days of receipt of the payment from the trust. The payment is limited to the lesser of the contribution cap (section 292-105: $1.1M for 2010 year), the payment received from E Family Trust and the stakeholder's participation percentage applied to the capital proceeds.

12) The least of these amounts is $1M for E and therefore E is authorised to make a contribution of up to $1M.

13) On our facts E makes the contribution to E SMSF by endorsing the promissory note. For the contribution to qualify under section 292-100 E must make a choice in accordance with section 292-100(9) which involves a choice in the approved form being provided to the E SMSF trustee.

By way of modification of the facts if the Business Real Property was worth $2M and E's spouse was also over age 55 and retiring then the entire property could still be acquired by E SMSF by E Family Trust making payments of $1M to each of E and E's spouse and by ensuring that each of them were CGT concession stakeholders for the disposal year.

This strategy is a powerful means of both migrating value to superannuation and enabling assets carrying significant capital gains to be migrated to superannuation tax effectively.

In seeking to access this strategy the following circumstances in particular need to be present:-

i) an individual is, retiring / able to procure retirement having attained age 55; and

ii) a business asset must have been held under that individual's control for at least 15 years.

Whilst the conditions to satisfy section 292-100 can obviously only be met in very specific circumstances it should be noted that this outcome can apply notwithstanding that:-

i) the business real property is a pre-CGT asset (section 292-100(5)); and

ii) even if the capital proceeds do not produce any capital gain the contribution able to be made to superannuation is only limited by the contribution's stakeholder's participation percentage and the amount of the capital proceeds and not the gross capital gain (section 292-100(4)(a)).

4. Section 71: In-House Asset Definition

It is often desired that SMSFs make their real property assets available to related parties for their use. There is an impediment to this provided by the in-house asset standard which includes in the in-house asset definition:-

"an asset of the fund subject to a lease or lease arrangement between a trustee of the fund and a related party of the fund...".

A superannuation fund will breach the in-house asset test if it makes an investment which is an in-house asset, the value of which exceeds more than 5% of the total superannuation fund net value.

"Lease arrangement" is broadly defined in section 10 of SIS to mean:-

"any agreement, arrangement or understanding in the nature of a lease (other than a lease) between a trustee of a superannuation fund and another person, under which the

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other person is to use, or control the use of, property owned by the fund, whether or not the agreement, arrangement or understanding is enforceable, or intended to be enforceable, by legal proceedings."

Therefore, prima facie, related party leasing arrangements (involving all styles of lease / making available for arrangements) by SMSFs are all but prohibited as giving rise to in-house assets. There are, however, some important exceptions to the in-house asset definition as follows:-

4.1. Section 71(1)(g) of SIS which applies to funds with less than 5 members. This provision excludes from the in-house asset definition:-

"real property subject to a lease, or to a lease arrangement, enforceable by legal proceedings, between a trustee of the fund and a related party of the fund, if, throughout the term of the lease or lease arrangement, the property is business real property of the fund (within the meaning of subsection 66(5))".

4.2. Section 71(1)(i) which excludes assets which are held on a tenancy in common basis with a related party. Such an asset (not being business real property) will however be an in-house asset if it is subject to a lease or lease arrangement with a related party.

4.3. Section 71(1)(j) which excludes "an asset included in a class of assets specified in the regulations".

Division 13.3A of the Regulations specifies regulations for that purpose.

The effect of Division 13.3A is to exclude from the in-house definition investments by SMSFs in related companies and trusts (generally that is any such entity which the SMSF and/or its related parties control, usually evidenced by majority shareholding / unit holding) subject to the company / trust balance sheet meeting SIS requirements as if that entity was the superannuation entity.

Therefore, if a controlled company / trust merely owns a business real property which is not mortgaged or acquired with borrowed moneys the shareholding / unit holding would not be an in-house asset.

F P/L BALANCE SHEET $

Assets Liabilities & Equity

BRP 1,000,000

Accrued Rent 50,000

50,000 Retirement Earnings

1,000,000 Paid-up Capital (F SMSF)

Assuming F Pty Ltd's balance sheet is clear as above; that is, there are no borrowings or investments which, if made by F SMSF direct might compromise compliance with SIS, the F SMSF shareholding will not be an in-house asset. If F Pty Ltd had therefore

F P/L BRP

F SMSF

Owns

100% Shares

- 14 -

borrowed to support some of the purchase price Division 13.3A would not apply and the F SMSF shareholding would be an in-house asset. It is not always clear why a superannuation fund would want to hold a property in this way.

Returning to section 71(1)(g) if a related party lease is not to result in the underlying asset being an in-house asset then it should be noted that

1) The lease needs to be enforceable by legal proceedings. This means that there must be a written lease evidencing commercial terms of leasing though it should not be necessary for the lease to be registered.

It is worth contemplating how the SMSF would / should act in the event of default of payment of rent or if there is some other breach of the lease by the related party lessee.

2) The property must remain business real property throughout the term of the lease. If the property ceases to be business real property the termination of the lease will suffice to avoid the property becoming an in-house asset as there would not then be any related party leasing arrangement.

3) Business real property only includes the land in question and fixtures to the land but not otherwise any other asset / property held in connection with the land. Any associated assets not being fixtures to the land will not be business real property.

5. Borrowings / Mortgages: Unit Trusts and Instalment Warrants

Superannuation funds are generally prohibited from borrowing (section 67 of SIS) and granting mortgages / charges (Regulation 13.14 of SIS Regulations). This has been an area of tension in planning going back beyond the advent of SIS. Prior to 11 August 1999 (when the in-house rule was modified) it had been possible for superannuation funds to avoid making an in-house asset investment by acquiring units in a controlled unit trust and then procuring the unit trust to borrow and grant security. That never sat well with the Regulator and that exact structure was challenged in Trevisan's Case (Trevisan v FCT (1991) 91 ATC 4416) where the Federal Court held that units in a unit trust are not an investment in the trustee and in consequence of that the units were not in-house assets under the definition which applied at the time.

On 11 August 1999 the in-house asset definition was reworded to provide a definition of "related party" and "related trust", an investment in any such entity from that time by a superannuation fund being an in-house asset. Since then there has no doubt been much thought given to how a SMSF might invest in a controlled entity without making an in-house asset investment. The new provisions appear to have been effective to achieve the intended outcome.

5.1. Investments in Unit Trusts

The SIS prohibitions on borrowings does raise a question of the circumstances in which a superannuation can invest in another entity. This issue is determined by whether or not such an entity is a "related party" or "related trust" of any investing superannuation fund. The example below gives insight into investment arrangements which may be acceptable.

G Unit Trust Land

Bank ASMSF

BSMSF

CSMSF

Acquisition

Mortgage loan

$

⅓⅓⅓

unitholdings

- 15 -

G Unit Trust will not be a related party / related trust of any of the SMSF unitholders provided it does not contribute to any of those funds as a standard employer sponsor and provided the members of the different funds are not relatives of each other or partners of each other in a business. This assumes as outlined above that the unitholdings are ⅓each as between the unitholders (see further comment below about how G Unit Trust might be controlled). If G Unit Trust was a related party / related trust of any of the investing SMSFs then the referable unitholding would be an in-house asset and by reference to the 5% authorised threshold for in-house assets, it could be expected that the in-house asset standard would be breached.

Section 70E(2) of SIS provides that G Unit Trust will not be "controlled" (and hence not a related trust / party) in relation to any of the investing superannuation funds unless a group (any combination of associates in relation to that fund) hold fixed entitlements to more than 50% of the units, controls the trustee or controls the appointment and removal of trustee. One would ordinarily expect that in the context of ⅓ unitholdings that no unitholder, together with its associates, would control the trustee or the power of appointment and removal of trustee.

Notwithstanding the borrowing by the G Unit Trust and the granting of a mortgage by it, both actions will be actions of the G Unit Trust trustee and therefore cannot be attributed to the unitholders.

There is an issue of personal guarantees which are sometimes required of proprietors / natural person controllers of proprietors by financiers. This does raise a question of whether the guarantees result in a need for a guarantee fee to be paid so that the arrangement is able to be justified as being maintained on an entirely commercial basis. Experience suggests that the Regulator has generally tolerated this though it may not be a matter which "sits that comfortably".

One sometimes encounters a structure such as G Unit Trust operating as a hybrid trust. Non-superannuation entities invest together with superannuation entities with the different parties holding units carrying different rights. Non-superannuation entities may borrow, be seeking a tax deduction for their interest expense and hold units which carry preferential but limited income entitlements with only a right to return of capital on winding up or redemption. The superannuation fund unitholders may hold units carrying rights to all other income and capital. This style of structure does carry a risk of the income flowing to the superannuation funds being deemed to be non arms length income under section 295-550 ITAA by the ATO. This sort of strategy admittedly does carry some intuitive appeal though more often than not results in disappointment (see Colonial First State Investments Ltd v Commissioner of Taxation [2011] FCA 16)

5.2. Borrowings: Instalment Warrants

Section 67A of SIS authorises superannuation funds to borrow in specific circumstances. This is a controversial provision which enables SMSFs to access real property investments (and for that matter any other style of investment generally authorised) otherwise not accessible to business proprietors or otherwise requiring a more cumbersome ownership structure; tenancy in common for example. The diagram below describes how an instalment warrant borrowing might proceed:-

H SMSF

H Nominees P/L Land

Bank

Nomination

Legal title

Mortgage

Limited recourse loan

HMember

Personal guarantee

- 16 -

Borrowing is authorised under section 67A subject to:-

5.2.1 A split between legal and beneficial ownership as between H SMSF and H Nominee P/L.

This does raise the question of whether the terms of bare trust are such as to constitute a Division 6 ITAA 1936 trust estate. On the basis that the superannuation fund is required to be the beneficial owner of the land it is suggested that that would not be the case. The circumstances of a bare trust relationship are more akin to H SMSF being absolutely entitled to the asset as against H Nominees P/L in which case the "trust" would not be so much a Division 6 ITAA 1936 trust as a section 106-50 ITAA style trust (where the beneficiary is absolutely entitled as against the trustee in which case the trust is disregarded for tax purposes);

5.2.2 The borrowed money being applied to the acquisition of a specific asset; and

5.2.3 Lender recourse against the borrower being limited to the asset which has been acquired with the borrowed money.

This means generally speaking that the loan to valuation ratio limit will be conservative, the loan will be principal and interest (with no capitalisation of interest) and the loan term will be short, probably not exceeding 15 years. Some / most arms length lenders are likely to require supporting personal guarantees. This has caused controversy by virtue of the guarantor's right of subrogation, to the extent it may arise, resulting in indebtedness of H SMSF to H which will be a SIS breach. Industry reaction to that has been to document these arrangements by severing the right of subrogation thereby avoiding any offending indebtedness ever arising. Whilst an effective response to the problem it does suggest that any guarantee payment by H would be taken to be a contribution to H SMSF which is in fact the view held by the ATO. There may be consequences of that by virtue of the ITAA limits on superannuation contributions.

A vendor financed related party acquisition is capable of satisfying the section 67A requirements though care should be taken to ensure that the terms of such an arrangement are on an arms length basis.

There does not seem any reason on a literal reasoning of section 67A that related party financing arrangements cannot occur. The instalment warrant borrowing concept within superannuation is relatively new and it remains unclear whether the underlying policy will continue to support these arrangements.

Matters requiring careful attention with instalment warrant borrowings supporting real property acquisitions are as follows:-

1) Where the real property is intended to be developed / subject to capital works expenditure after acquisition.

I Family Trust

BRP $1M Value

I Nominees P/L

I SMSF

Owns

Legal title

Deed of Nomination

Acquires land $500K & $500K vendor finance

Vendor finance converted to loan

Mortgage

- 17 -

2) Where one borrowing is made with respect to a multiple title acquisition.

3) A longer term borrowing may result in tax losses accruing in the superannuation fund if the borrowing remains on foot when the fund moves into pension phase.

4) Approach to be taken when the debt is ultimately repaid. It is not compulsory that legal title be conveyed at that time and in fact there could be adverse stamp duty ramifications.

5) Registration of the superannuation fund for GST purposes is likely to be required and this will be best dealt with by the nominee acting as an undisclosed agent.

6. SMSFs which own Real Property and Pay Pensions

There is a question of whether SMSFs which may be top heavy in illiquid real property investments will be capable of supporting long term pension liabilities.

Assumptions:

1. Pension payments are paid on the minimum pension for account based pensions under Regulation 1.06(9A) of SIS Regulations.

Extracting from Schedule 7 of the Regulations the relevant age brackets and pension factors for assessing the minimum pension payable are as follows:-

Age Brackets % Factor

65 – 74 5

75 – 79 6

80 – 84 7

85 – 89 9

90 – 94 11

The percentage factor is the percentage to be applied to the pension account balance at the start of each year. For a pensioner aged 65 with a $100,000 account balance at the start of a year, that would mean a minimum pension of $5,000 for that year.

2. Valuation of property at commencement $1M.

J SMSF

Business Real Property

J Member

owns

J P/L

rent @ 7% property value

lease to

pays pension income stream

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3. Pension is commenced for J at age 65.

4. Business real property is the only asset of J SMSF at commencement of pension.

5. CPI is 3% for each year during the term of the pension and rent / capital value of property is assumed to increase at that same rate equally throughout the pension term.

6. Investments accruing from net rents yield at 6% per annum.

Issue: Capacity of J SMSF to support Pension

The issue to be assessed is the question of sensitivity of the illiquid business real property asset and the supporting rents to the ability of J SMSF to satisfy minimum pension payment obligations over the term of the pension.

Age of J

Account Balance at Year of Commencement ($)

Value of Business Real Property ($)

Value of Other Investments ($)

Pension Payable ($)

65 1M 1M 0 50,000

70 1,267,538 1,159,274 108,264 63,377

75 1,583,205 1,343,916 239,289 94,992

80 1,869,015 1,557,967 311,048 130,831

85 2,101,417 1,806,110 295,307 189,127

90 2,166,449 2,093,796 72,653 238,309

91 Deficiency not available to

support pension

Conclusion:

The illiquid investment does support the pension for many years (on these assumptions for 25 years) but that outcome is directly dependent upon sustained cash flow return exceeding 6%. That of course assumes a consistent fund earning rate of 6% on other investments and 7% rent yield on the property.

Once the pension rate (at ages 85 – 89 at 9%) escalates above the property yield / return on other investments the superannuation fund soon becomes insolvent from a cash flow perspective. The ATO does not accept that pension payments can be funded by in specie distributions. At age 91 it would therefore be incumbent upon the trustee to take some action. That might be any of the following actions:-

1. sale of the property;

2. termination of the pension and payment of superannuation lump sum commutation;

3. termination of the pension in whole or in part with the commuted amount reallocated to a member's accumulation for J; or

4. admit cash contributions in respect of another member.

The investment returns of the fund are sensitive to:

1. no defaults on rent payments;

2. costs of running the fund not being excessive; and

- 19 -

3. land holding costs; capital improvements / repairs may be incurred. Land tax and other landlord liability issues all involve unforseen cost for the landlord.

The outcome of this case study is not surprising. In short, cash returns on investments need to roughly match the percentage factor under Schedule 7 of the Regulations. The modest percentage factors up to age 85 are helpful in assisting superannuation fund trustees to proceed with some confidence in ensuring that fund liabilities can be met as and when they arise.

The relaxed benefit design rules (ability to commute pension back to accumulations at any time for example) which have applied since 1 July 2007 do provide assistance to funds with cash flow issues.

7. Land Speculation in Superannuation

Land speculation in superannuation gives rise to many issues. There is interest in SMSFs operating in this area as many SMSFs are cashed up and have funds available to fund acquisitions / infrastructure works of real property. Also many land speculators are aware of the potential "super profits" able to be extracted from speculative land activity and will be desirous of accessing the concessional tax rates available to superannuation funds.

The role of superannuation and trusts has historically been to invest in relatively passive and risk averse investments. Section 350 of SIS does specifically provide for the operation of trust law generally and does provide for all applicable State and Federal law to apply to SMSFs.

As regards trust law the attitude to speculative investments is commented on in Jacobs: Law of Trusts in Australia (7th Edition) at para [1806] as follows:-

"A discretion to invest, however wide, will not permit speculation by a trustee. Even if the investment is authorised, the trustee must act prudently and must be satisfied that the particular security is one which will protect the trust assets."

There is authority for this statement contained in Sidey v Huntly (1900) 21 LR (NSW) Eq 104.

Coupled with this fundamentally conservative position the statement is often made that "superannuation funds cannot conduct businesses".

There is an issue then of the extent to which SMSFs might be justified in indulging in speculative real property activities. Notwithstanding the above comment modern day practice involving most trusts being managed and conducted by trustees for their own benefit and/or the benefit of their family has blurred the obligation of trustees to act in such a strictured way. Rather the modern day view seems to be more along the lines that beneficiaries do not require the assistance of equity when they also act as trustee or perhaps put another way, members of a family group (at least when harmony prevails) are not generally inclined to pursue actions for breach of trust.

7.1. Can SMSFs conduct property developments / subdivisions?

The ATO seems to accept the modern day view expressed above in SMSFR 2009/1 and SMSFR 2010/1.

The issue is more a matter of "how" than "if".

Section 62 of SIS requires that superannuation fund trustees effect and maintain their investments with the sole purpose of funding retirement benefits for the members. There is an issue of the tension between that requirement and a land speculator seeking to use their SMSF as a warehousing vehicle for taxable profits. To date there is little evidence to suggest that the regulator is particularly concerned about this though the question of where the "goal posts" stand may be a matter which is tested more rigorously over the next four years.

The ATO however does touch on two issues in SMSFR 2009/1 and SMSFR 2010/1 which warrant consideration:

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7.1.1 Lessee's Improvements

If a SMSF acquires vacant land and grants a head lease to a related party authorising it to conduct capital works on the land to support a subletting arrangement the ATO suggest that that will give rise to the acquisition of an asset by the fund from that related party head lessee. The implication seems to be that that asset will not be business real property and therefore will breach section 66 of SIS.

Such a strategy might be explained in the following terms:

Under this model the following outcomes can arise:

(a) interest deductibility for expenses incurred by the Related Party in borrowing to fund the capital works should be available;

(b) Division 43 ITAA capital works write off for Related Party at 2½% of its expenditure spread over the 40 year term of the head lease;

(c) financial modelling of rents on head lease and sub leases to justify commercial return to Related Party over the term of the lease. This will require consideration to the cost of the capital works, the cost of servicing any debt capital works expenditure and rent under the head lease relative to the benefit of the Division 43 deductions, rents on the sub leases and any benefit from a back end compensation payment;

(d) on termination of the head lease the Related Party may become entitled to "sever and remove" the lessee's improvements and/or a right to compensation from K SMSF for the value of the lessee's improvements;

(e) K SMSF will own the land and all fixtures to the land; and

(f) rents from the head lease flow to K SMSF with any capital gain arising to K SMSF on ultimate disposal and rents derived by the fund deriving the taxation concessions applicable to superannuation funds.

The ATO suggests there may be an offending acquisition of an asset by K SMSF from the related party by virtue of the capital works funded by the Related Party passing for the benefit of K SMSF as the owner of the land. That is in consequence of the general law position that an owner of land owns everything which is affixed to the land.

What asset it is that is said to be acquired from the Related Party, and when it is acquired, is not clear.

The ATO view may be correct though it is suggested that it strains the words to suggest that anything is acquired "from" the Related Party and to suggest that

K SMSF Related Party

Vacant Land Tenants

Head Lease

(Long term lease around 40 years)

owns sub-leases

capital works

- 21 -

whatever might be acquired can be characterised as an asset which is not business real property.

7.1.2 Building Contracts with Related Parties

The ATO contends for the view that benefit obtained under a building contract with a related party will constitute the acquisition of an asset if "product" is obtained under the contract as distinct from mere services.

The above arrangement might be generally acceptable for superannuation law purposes subject to the superannuation fund both acquiring the land and striking the building contract on arms length terms.

However, the ATO contends that if the builder provides anything other than services (that is "product" for infrastructure / building works) then that will be the acquisition of an asset from the builder.

Again, the ATO could be correct, though it does strain the words to suggest, when one strikes a building contract that involves the builder sourcing product, that that involves the landholder acquiring an asset from the builder.

It may be that if the builder can proceed by acting merely as the agent for the superannuation fund in the acquisition of all product, that the building contract can be characterised as only a contract for the provision of services. This may not be practical for builders accustomed to sourcing product through trade discounts for all their building activities though acquiring as an undisclosed agent may be the practical solution.

8. Conclusion

The SMSF revolution and the Australian appetite for real property investments means that the superannuation model described in paragraph 1.2 above has come into mainstream use. Further, other strategies have emerged and will continue to emerge if the existing legislative framework remains in place. It is suggested that the underlying policy considerations will come to be tested at some point and that, even if legislative change does not follow, the ATO will ultimately come to test, more rigorously than it has to date at least, the boundaries of acceptable practice.

Come what may, well considered real property strategies should continue to serve the interests of SMSF members for the foreseeable future.

Stephen Heath Wallmans Lawyers

Super Fund

Land

Related Party Builder Building Contract

owns

Arrangement of infrastructure / subdivision works