Super borrowing – top 10 tips and some alternatives Scott Hay-Bartlem, Partner, SMSF Specialist Advisor 11 October 2013

Overview Super borrowing been with us some years Downside of getting it wrong is quite serious… Becoming more common Quite technical Top 10 tips Some alternatives

A summary of the rules… SMSF trustees generally not allows to borrow Section 67A Allows trustee of SMSF to borrow Asset held on trust SMSF gets title after paying instalments Lender’s (and others’) right limited to asset Asset SMSF could have acquired

1. Get the structure right SMSF borrows Bare trust owns the asset If not Borrowing prohibition In-house asset

1. Get the structure right Bank SMSF Bare Trust non-recourse members $$$ Guarantees Contributes funds Sole Beneficiary Purchases

2. What asset? The SMSF must have been able to acquire In-house assets Buying from related parties Business real property Listed securities Some allowable in-house assets Market value Usual terms

2. What asset? (cont’d) Single acquirable asset SMSFR 2012/1 Single legal thing unless identical and identical value One title Must sell together legally ‘Unifying physical object’ ‘Permanent in nature’ ‘Not easily removed’ ‘Significant in value relative to the value of the asset’

2. What asset? (cont’d) Examples Strata lot + car park if must go together Building over two lots Off the plan + deposit Option + subsequent purchase Multiple drawdowns

3. Can I change the asset? Limits on replacement assets Repair Occasional and partial Restores function of asset without changing character Maintain Prevent defects, damage or deterioration Includes anticipation of defects

3. Can I change the asset? (cont’d) Improve Significantly altered for the better Substantial alterations Reference made to asset at time of acquisition

3. Can I change the asset? (cont’d) Examples Addition of dishwasher Fence Swimming pool Granny flat

4. Can a related party be the lender? Yes, but Arm’s length terms – would the bank have done it and what would the loan look like? Repayments Interest rate Document Security Guarantees If loan from a company, Division 7A

4. Can a related party be the lender? (cont’d) NTLG minutes June 2012 No or discounted interest loans Not arm’s length breach or contribution Non arm’s length income

5. Can a related party use the asset? Yes, but Written lease Arm’s length terms Tenant improvements Wholly and exclusively used in a business Sole purpose For example, Montgomery Wools case

6. When the loan is paid off… ATO – must transfer the asset to the fund Section 71(8) exemption from the in-house asset rules cease to apply CGT? ‘Absolutely entitled’? ‘Look through’ treatment proposed (still waiting on legislation)

6. When the loan is paid off… (cont’d) Duty S130B (new exemption) ‘Nominee contract’ provisions CGW has been successful Or duty on value of asset at time of transfer…

7. Update the investment strategy Section 52 covenant Formulate and update Does it deal with Proposed investment Borrowing Increased risk What happens on death of member Insurance

8. What if a member dies? If member dies with borrowing in place, what does the fund do? Breach of loan/guarantee? Are we required to pay a lump sum? Can we pay a pension? Can we transfer part of an asset? Are there other assets in the fund to provide benefit?

8. What if a member dies? (cont’d) Unallocated insurance Provides cash for paying out the interest Does not form part of the benefit Trust deed must allow (most do not) Premiums not from accumulation account Contribution caps as allocate from reserve Deductibility of premiums?

9. Can two SMSFs have one bare trust? No One trust per SMSF For multiple fund investments, look at Unit trust Joint SMSF

10. SMSF trust deed Does it allow? Borrowing power Often absolute prohibition pre-2007 Refer to repealed s67(4A)? Buy particular asset Power of attorney

Some alternatives Unit trusts Ungeared Unrelated Pre 1999 unit trust Installment contract/vendor finance ‘Joint venture’

Ungeared unit trusts Exempt from in-house asset rules Strict Requirements (Regs 13.22B & 13.22C) No debt or charges No loans, or investments in other entities Not acquired assets from related party (except business real property) Not lease assets to related party, except BRP Not carry on a business Arm’s length terms for all transaction If breach, investments become in-house assets

Ungeared unit trusts (cont’d) Very restrictive Tangible assets only If breach, the exemption Ceases to apply to the existing investment in that entity Can never apply to any further investment in that entity

Ungeared unit trusts (cont’d) Example Abbott SMSF establishes unit trust as sole unitholder Unit trust buys real estate from arm’s length party and leases to arm’s length tenant No borrowings, charges etc. Ungeared exemption can apply and units are not in-house assets SMSF could borrow to acquire But not buy from a member?

Ungeared unit trusts (cont’d) Example Unit trust borrows to buy more real estate Ungeared entity exemption no longer applies - units now an in-house asset

Unrelated unit trusts In-house asset rules only apply to a ‘related trust’ ‘Related trust’ if ‘group’ has: Fixed entitlement more than 50% of income/ capital ‘Control’ of trustee Ability to appoint remove the trustee

Unrelated unit trusts (cont’d) ‘Control’ of trustee Effective control - directions or wishes of the group Majority of trustees? Majority of directors? Majority of shares in corporate trustee? Tie breakers – casting vote?

Unrelated unit trusts (cont’d) ‘Group’ - s70E(3) Member + Part 8 associates Standard employer-sponsor + Part 8 associates Part 8 Associates (s70A, 70B, 70C) Relatives Tax law partnerships, other partners, spouses and children Other controlled entities More than 50% Effective or practical control

Unrelated unit trusts (cont’d) Example SMSF 1 & SMSF 2 are unrelated Each SMSF is completely unconnected and has 50% of units in unit trust Trustee is a company Two directors from each SMSF No casting vote Unrelated unit trust SMSF 1 SMSF 2

Unrelated unit trusts (cont’d) SIS Act does not apply Units not in-house assets Borrow and charge its assets Invest in other entities, including related parties and trusts Acquire assets from related entities Acquire multiple assets Develop/improve

Pre 1999 unit trust Rules changed 1999 Some grandfathered old trusts still out there Often able to buy new assets and borrow Where clients have them, can be better answer than LRBA

Limitations - unrelated unit trusts SIS Act – I thought it did not apply? Section 62 – sole purpose test Section 65 – financial assistance Section arm’s length terms

Summary Are opportunities And traps – need to get it right! Be aware there are other options

Limitations - unrelated unit trusts (cont’d) Anti-avoidance Section 66 – related party acquisitions Section 85 – in-house assets Section 71(4) – ATO discretion Cannot buy out other unitholder Ungeared entity exemption????

Thank you Scott Hay-Bartlem Partner TEP, SMSF Specialist Advisor