We are often asked, in the context of a proposed limited recourse borrowing arrangement, about self-managed super funds buying property assets from related parties or undertaking construction.
Given the sole purpose test for SMSFs is to provide retirement income, it's probably not surprising that this area is notoriously heavily scrutinised. It's also very easy to get wrong due to the multitude of rules regulating risk and related party acquisitions.
Simply put, the Superannuation Industry (Supervision) Act 1993 ("SIS") prohibits a regulated fund from intentionally acquiring an asset from a related party. This is our starting point - let's look at some examples of how this works in practice.
Case Study #1 - SMSF buys residential property from the builder (related party).
One of the exceptions to the SIS rule is the acquisition of business real property, acquired at market value. A residential property can be considered "business real property", but be careful.
Business real property includes a freehold interest in real property where it is used wholly and exclusively in one or more businesses. SMSFR 2009/1 makes it clear that the use of property, considered under the business use test, covers any activities, operations or actions occurring on the land, regardless of who undertakes them. Any, and all, such uses of the property must meet the requirements of the business use test i.e. that the property be utilised "wholly and exclusively" in one or more businesses. The business real property exception in SIS is concerned with the status of the property when the SMSF acquires the freehold interest from the builder.
The residential property could, therefore, be acquired, and the SMSF could borrow to acquire it, if the builder carries on a "business" and the property is used wholly and exclusively in that business or some other business.
Case Study #2 - SMSF buys vacant land and engages a builder (related party) for construction.
There are two elements to the building: the provision of goods (materials) and the provision of services (building work). A problem with the building materials would arise if any of them were purchased from the builder, as that would be an acquisition from a related party and, potentially, a breach of SIS. The solution may be for the SMSF to pay directly for all building materials and not have them flow through the builder first.
The second element relates to the provision of services by the builder. This is permitted if the SMSF trustees are individuals, and the builder is not one or more of those individuals operating a building business as a sole trader. This could cause problems because SIS prohibits a trustee from being remunerated for any services provided on behalf of a SMSF. SIS does not, however, prohibit a related party from being remunerated for such services, therefore the builder could be a related entity but not a trustee. In this instance, it's important to note that that all services must be billed at arm's length prices.
The trick here is when the SMSF wants to borrow for these works, leading us to our final case study.
Case study# 3 - SMSF buys vacant land and engages a non-related builder for construction.
It's not so simple when a SMSF wants to borrow to acquire land, and then build. SIS allows the SMSF to borrow for acquisition costs, but the SMSF cannot use borrowed money to construct the building, because that is not an acquisition cost. SMSFR 2012/1 makes it clear that, while borrowings cannot be used to improve a single acquirable asset, money from other sources could be used to improve (or repair or maintain) that asset. Any improvements, however, must not result in the acquirable asset becoming a different asset.
The ruling goes on to say that, when a residential house is built on vacant land, the character of the asset has fundamentally changed from vacant land to residential premises, making it a different asset. The bottom line is that, the SMSF could borrow to buy the land but cannot then construct a new building on it, using other funds, while the loan remains outstanding. This leaves super funds with two solutions:
Whilst there are some circumstances in which related third party acquisitions are fine, you'll understand why care needs to be applied if you consider some of the scenarios we've outlined above.
These examples are fairly straightforward and reasonably simple to deal with; however, arrangements can become complex and involve very careful consideration. Please call us if you have questions or need to discuss any issues regarding related party acquisitions.