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One of the outcomes from the rapid rise in Australian property prices in recent years has been the significant increase in property development activity by self-managed superannuation funds (SMSFs).
The ATO, as the regulator of SMSFs, responded by releasing an information bulletin setting out the potential risks of property development activity through an SMSF and highlighting areas that can create compliance concerns.
This Regulator’s Bulletin SMSFRB 2020/1 was released in March 2020 and provides an insight for SMSF trustees on the potential issues that need to be considered. It also sets out common scenarios that will often give rise to a breach of the super rules.
There is a common misconception that property development activities carried out through an SMSF would automatically result in a breach of the superannuation rules. This is not the case. Where these activities are carried out correctly, they are absolutely allowed and the ATO clearly states:
“Property development can be a legitimate investment for SMSFs, and the Commissioner does not have any concern with SMSFs investing in property development where it complies with the Superannuation Industry (Supervision) Act 1993 (SISA) and Superannuation Industry (Supervision) Regulations 1994 (SISR).”
SMSF trustees contemplating development activity involving their SMSF would therefore need to work through the relevant rules and requirements.
There are specific areas of both the superannuation and tax laws that SMSF trustees need to be familiar with before entering into any form of property development.
The sole purpose test
Any SMSF involvement in the development must be for the sole purpose of providing the fund members with retirement benefits. There can be no form of current day benefit given to the members by including the SMSF in the project.
This will require a clear reasoning as to why the SMSF is involved in the development and what the trustees expect to achieve at the conclusion.
Where a related party is also involved in the development, it is important that the SMSF trustees act only in the best interests of the fund members.
SMSF investment strategy
SMSF trustees need to consider their fund’s investment strategy and what it allows. In most cases, updating the fund’s strategy documentation would need to be carried out before any action is taken.
Clearly defining why the SMSF is involved in the property development and what outcomes are likely to be achieved should also be included in the fund’s investment strategy.
Trustees will need to refer to the fund’s trust deed and ensure that all activities are in accordance with the rules contained in their deed.
All transactions entered into and carried out need to be at arm’s length. Neither party to the transaction should be treated more favourably than the other.
If the terms of the arrangement or transaction are seen to favour the other party (the non-SMSF participant), then there would be a breach of the SIS arm’s-length rules (Section 109). This will often lead to a contravention that needs to be reported by the fund’s auditor.
Conversely, if the terms of the arrangement or transaction are seen to favour the SMSF, then it would create a non-arm’s length income issue under the tax rules. When this occurs, all SMSF income (and capital gains) from the development are taxed at the top marginal tax rate instead of the concessional rate given to super funds. This is set out in the Income Tax Assessment Act Section 295.550 and will be the result regardless of whether the other party to the transaction is related or not.
Of course, where there are related parties involved in the development then this becomes even more relevant.
Related party involvement
It is possible for an SMSF to carry out a property development together with, or involving, related parties. But it will require the fund trustees to consider the relevant compliance issues, including:
- The arm’s-length rules that were covered above
- The trustee remuneration rules (read more about the trustee remuneration rules)
- The need to maintain clear and concise paperwork for all decisions and transactions that take place.
Commonly used structures
How a property development is structured is an important issue that trustees will need to consider.
It is quite common for a separate entity to be used for the development activity, with the SMSF then taking out an interest in that entity. For example, a unit trust or company is often used as the development entity with the SMSF acquiring units in the unit trust or shares in the company.
This can then give rise to further compliance complications where the development entity is deemed to be a related party. This will occur where the SMSF alone or together with the fund’s related parties ‘control’ the entity.
Where a related entity is used as the entity to carry out the development, keep in mind the restrictions that will apply to that entity, including:
- The related entity cannot borrow or lend any money. This can be an issue where there is an overrun on the costs for the development and where completion requires additional funding.
- The assets of the related entity cannot be subject to any charge or be used as a form of security. This creates an issue where other parties involved in the development, such as an unrelated developer, want to place a charge over the underlying property up until the completion of the development.
- The related entity cannot acquire any asset from a related party unless that asset is business real property.
- The related entity cannot carry on a business and cannot invest in any other entity. This can be problematic if the development activities of the entity are deemed to be a business. Specific advice should be sought on when activities may be seen as carrying on a business.
- All transactions carried out through the related entity must be on arm’s-length terms.
If any of the above restrictions aren’t met, the SMSF’s investment in the related entity will become an in-house asset and therefore included in the overall 5% limit on all in-house assets. It can also lead to further compliance complications.
SMSF borrowing rules (limited recourse borrowing arrangements)
The superannuation rules allow an SMSF to borrow money where the borrowings are used to acquire an asset (a “single acquirable asset”). However the borrowing rules do not allow any amount borrowed to be used to “improve” (or develop) a fund asset.
In addition, the character of any asset acquired under a borrowing arrangement cannot fundamentally change. A property development would in most cases change the character of an asset and hence create a compliance issue.
Therefore, trustees need to keep in mind that:
- If the SMSF uses its own resources to buy a property, it cannot then borrow to develop that property
- If the SMSF borrows money to acquire a property, it cannot use its own resources to develop the property if the development fundamentally changes the nature of the property while it remains under the limited recourse borrowing arrangement.
This makes property development involving a limited recourse borrowing arrangement extremely difficult.
Although property development activity within a self-managed super fund is allowed, trustees must have a clear understanding of the relevant rules and restrictions they will need to adhere to.
Trustees will also need to maintain clear and concise evidence on all transactions that take place, particularly where those transactions involve a related party.
The SMSF investment strategy and trust deed will often be scrutinised by auditors and the ATO where property development activity takes place, so make sure that these documents are kept up to date.