Can an employee acquire a residential property as an investment in the employee’s Self Managed Superannuation Fund (SMSF), if the employer is a property developer?

Answer:  Maybe, maybe not.

This question asks whether an employee is a related party of their employer (or the employer a related party of the employee’s SMSF) for purposes of Section 71 Superannuation Industry (Supervision) Act 1993 (SISA), in respect to the In-House Asset Test and Section 66 of the SISA, in respect to the prohibition against acquiring certain assets (including residential property) from a related party.

There is no default rule that an employee is an associate of their employer.  The analysis does not, however, end at that fact.

A related party of another is defined at section 10(1) of the SISA as a member, a standard employer sponsor of the Fund, or a Part 8 Associate of either the member or the standard employer sponsor of the Fund.

Assuming the employee’s SMSF is not an employer sponsored fund, the question is whether the employer may nonetheless be a Part 8 Associate of the employee.

A Part 8 Associate is defined at section 70B of the SISA as a relative of an entity (if the employee is unrelated to the employer, no problem), a partner of the entity (if the employee is not a partner – then not a problem), a trustee of a trust for which the entity is “controlled” (if the employee has no influence over the trust, receives no income or capital, etc. – then not a problem), or if the employee has a “sufficient influence” or “majority voting interest” in the entity (this could be the area in which the test is relevant, because as an employee she may have significant influence over the conduct of the entity), or another Part 8 Associate of the employee has this influence (for example, a family member controls the employer or a related entity of the employer).

In respect to the question of “sufficient influence”, we consider section 70E of the SISA, and note that it may be the case that the employee has considerable conduct in the employer’s affairs.

For example, the employee may, for a property developer, determine the properties to be acquired and/or developed, and be charged with the derivation of investors and the profit sharing relationships.  The employee may also, in such circumstances, receive a bonus on the development projects.  The directors may rely on the employee to provide recommendations across the business.  In this case, the employee may likely have “sufficient influence” to be a related entity to his employer.  Similarly, if the employee received, as a consequence of employment, the right to demand an asset as compensation for the services to the employer, this may be “sufficient influence” to be a related party.

On the other hand, if the employer is a property developer, and the employee is a secretary with float tasks over administration matters, it is quite likely the employee has little or no influence over her employer.

The circumstances in which section 70E may apply in an employee/employer relationship are complicated and should be considered on the facts and circumstances (consider for example the relationship between employer and employee for purposes of the Fringe Benefits Tax Assessment Act 1986 (Cth)).

Provided the employee is not a Part 8 Associate (nor a related party of the employee) to the employer, then the employee may acquire assets of the employer at arm’s length and commercial terms (subject to satisfying at all times section 62 of the SISA, being the Sole Purpose Test), without restriction under the test of section 66 (restricting acquisitions of assets from members and their related parties), and section 71 (In-House Asset Test) would not apply if the asset was acquired.

Notwithstanding the above, any transaction must be compliant with section 109, with every stage of the acquisition, including any vendor finance arrangements, made on arm’s length and commercial terms.  Whilst sections 67 and 67A do not prevent an employer from lending money to an employee (subject to any restrictions posed by Division 7A of the Income Tax Assessment Act 1997), the finance arrangements (limited recourse borrowing arrangements) must be such that the vendor (employer) does not retain title over the asset pending settlement of the borrowing.

If you have any queries regarding the subject of this article, please do not hesitate to contact Katrina Brown via email or on 07 5574 3560.

Related Party LRBAs and PCG 2016/5: A review and recommendations for Trustees for Smooth Sailing

The release of PCG 2016/5 comes as no surprise, which follows on the back of the Australian Taxation Office (ATO) publications ATO ID 2015/27 and ATO ID 2015/28, which set the tone for related party Limited Recourse Borrowing Arrangements (LRBAs).  The ATO’s 2015 position clarified that nil interest rates and/or interest rate terms being other than “commercial” in nature, constituted “non-arms’ length income” within the meaning of subsection 295.550(1) of the Income Tax Assessment Act 1997 (ITAA97).

PCG 2016/5 sails past interest rates, and now gives the ATO’s position on the entirety of related party LRBAs, including requirements for principal and interest monthly payments, security, terms of lending and standards for setting fixed and variable interest rates.

IS ANYONE REALLY SURPRISED BY PCG 2016/5?

Given the overriding “sole purpose test” at section 62 of the Superannuation Industry (Supervision) Act 1993 (SISA) – what would lead anyone to think a related party LRBA could be made on other than an “arms’ length” basis, with a commercial standard of reference required?  Let’s think this through – we are limited in acquiring assets from members and “related parties” of members by section 66 of the SISA, we are prohibited from providing financial assistance to members and relatives of members by section 65 of the SISA and we are required to deal with investments at an “arms’ length” in accordance with section 109 of the SISA.  So, does it come as any real surprise that, if a member or a related party of the member is going to lend money to the self-managed superannuation fund (SMSF), it has to be on commercial terms?

It scares me when Trustees lose sight of the overriding black cloud of Part IVA of the ITAA97, and forget that the ATO has the benefit of hindsight in assessing anti-avoidance schemes.  Looking beyond Trustees, those of us advising Trustees must also be alert to our civil, and possible criminal, exposure under SISA, including but not limited to section 55 of the SISA, which puts us, as advisors, on the line to pay losses or damages suffered by any “person” (not limited to members) as a consequence of another “person” (not limited to trustees) involved in a contravention of a SISA covenant.   Remembering the Courts and Financial Ombudsman Service quite often favour the consumer, we need only look to section 52 of the SISA to appreciate the broad liability stacked on our shoulders when giving advice to SMSF Trustees of any nature which is other than, on its face, based on all parties acting on commercial arms’ length terms.

Let’s look, therefore, at PCG 2016/5.  Whilst the ATO provides us with peace of mind as to its interpretation of “arms’ length terms” for purposes of related party LRBAs in the Safe Harbour provisions, the ATO recognises at paragraph 4 of PCG 2016/5 that other arrangements may nonetheless be based on arms’ length terms.

Safe Harbour 1:  The LRBA and real property (commercial or residential)

Interest Rate Reserve Bank of Australia Indicator Lending Rates for banks providing standard variable housing loans for investors. Applicable rates:

– For the 2015-16 year, the rate is 5.75%[1]

– For the 2016 17 and later years, the rate published for May (the rate for the month of May immediately prior to the start of the relevant financial year)

Fixed / variable Interest rate may be variable or fixed

–  Variable – uses the applicable rate (as set out above) for each year of the LBRA

–  Fixed – trustees may choose to fix the rate at the commencement of the arrangement for a specified period, up to a maximum of 5 years.

The fixed rate is the rate published for May (the rate for the May before the relevant financial year).

The 2015-16 rate of 5.75% may be used for LRBAs in existence on publication of these guidelines, if the total period for which the interest rate is fixed does not exceed 5 years (see ‘Term of the loan’ below)

Term of the loan Variable interest rate loan (original) – 15 year maximum loan term (for both residential and commercial)

Variable interest rate loan (re-financing) – maximum loan term is 15 years less the duration(s) of any previous loan(s) relating to the asset (for both residential and commercial)

Fixed interest rate loan – a new LRBA commencing after publication of these guidelines may involve a loan with a fixed interest rate set at the beginning of the arrangement. The rate may be fixed for a maximum period of 5 years and must convert to a variable interest rate loan at the end of the nominated period. The total loan term cannot exceed 15 years.

For an LRBA in existence on publication of these guidelines, the trustees may adopt the rate of 5.75% as their fixed rate, provided that the total fixed-rate period does not exceed 5 years. The interest rate must convert to a variable interest rate loan at the end of the nominated period. The total loan cannot exceed 15 years.

Loan to Market Value Ratio (LVR) Maximum 70% LVR for both commercial and residential property

If more than one loan is taken out to acquire (or refinance) the asset, the total amount of all those loans must not exceed 70% LVR.

The market value of the asset is to be established when the loan (original or re-financing) is entered into.

For an LRBA in existence on publication of these guidelines, the trustees may use the market value of the asset at 1 July 2015.

Security A registered mortgage over the property is required
Personal guarantee Not required
Nature and frequency of repayments Each repayment is of both principal and interest

Repayments are monthly

Loan agreement A written and executed loan agreement is required

Safe Harbour 2:  The LRBA and a collection of stock exchange listed shares or units

Interest Rate Reserve Bank of Australia Indicator Lending Rates for banks providing standard variable housing loans for investors plus 2%. Applicable rates:

–  For the 2015-16 year, the interest rate is 5.75% + 2% = 7.75%[2]

–   For the 2016-17 and later years, the rate published for May plus 2% (the rate for the May before the relevant financial year)

Fixed / variable Interest rate may be variable or fixed  – Variable – uses the applicable rate (as set out above) for each year of the LBRA
– Fixed – trustees may choose to fix the rate at the commencement of the arrangement for a specified period, up to a maximum of 3 years (see ‘Term of the loan’ below). The fixed rate is the rate for May plus 2% (the rate for the May before the relevant financial year)

The 2015-16 rate of 7.75% may be used for LRBAs in existence on publication of these guidelines, if the total period for which the interest rate is fixed does not exceed 3 years (see ‘Term of the loan’ below)

Term of the loan Variable interest rate loan (original) – 7 year maximum loan term

Variable interest rate loan (re-financing) – maximum loan term is 7 years less the duration(s) of any previous loan(s) relating to the collection of assets

Fixed interest rate loan – a new LRBA commencing after publication of these guidelines may involve a loan that has a fixed interest rate set at the beginning of the arrangement. The rate may be fixed up to for a maximum of 3 years, and must convert to a variable interest rate loan at the end of the nominated period. The total loan term cannot exceed 7 years.

For an LRBA in existence on publication of these guidelines, the trustees may adopt the rate of 7.75% as their fixed rate, provided that the total period of the fixed rate does not exceed 3 years. The interest rate must convert to a variable interest rate loan at the end of the nominated period. The total loan cannot exceed 7 years.

LVR Maximum 50% LVR

If more than one loan is taken out to acquire (or refinance) the collection of assets, the total amount of all those loans must not exceed 50% LVR.

The market value of the collection of assets is to be established when the loan (original or re-financing) is entered into.

For an LRBA in existence on publication of these guidelines, the trustees may use the market value of the asset at 1 July 2015.

Security A registered charge/mortgage or similar security (that provides security for loans for such assets)
Personal guarantee Not required
Nature and frequency of repayments Each repayment is of both principal and interest

Repayments are monthly

Loan agreement A written and executed loan agreement is required

[1] Interest is to be calculated monthly on a compounding basis.

[2]Interest is to be calculated monthly on a compounding basis.

So, what happens if you can’t fit your arrangements into the Safe Harbours?  You aren’t sunk just yet.

LET’S CONSIDER THE LOAN TERMS…

If your client borrowed from a commercial lender to on-lend to the SMSF, what does the commercial lender’s terms to the client look like?

To keep this simple, let’s create a reference:

Client Pty Ltd, as Trustee for Client Superfund, borrows from John Smith, the sole director of Client Pty Ltd and sole member of Client Superfund, to acquire Greenacre for $500,000.  John borrowed $530,000 from Awesome Bank, secured against his home, on a 30 year interest free term, with the first 5 years being interest free only, with principal and interest from year 6.  John gave a personal guarantee, and also offered up security against his personal share portfolio.  The LVR was 80% of the combined value of John’s home and his share portfolio.  The interest on the loan is variable, based on Awesome Bank’s published rates.  Awesome Bank has their own internal assessment processes for determining variable rates.  John’s advisor told him that he could on-lend at the Awesome Bank’s rate for the full acquisition value, on matching loan terms.  John’s advisor also made sure John registered a mortgage over the property.  What happens now?

Can John rely on Awesome Bank’s terms to escape the Safe Harbours?  Not entirely.

Awesome Bank has recourse against John’s income as well, as the security and later acquired assets of John (through the personal guarantee).  John only has recourse against the real property owned by the SMSF, and nothing else.  Accordingly, given the additional risk, one would expect a commercial lender in John’s position would have either required higher interest rates, shorter terms or a varied LVR.  However, the terms of Awesome Bank’s lending to John are nonetheless material; the first approach for John is to seek out Awesome Bank’s LRBA terms.  If Awesome Bank’s LRBA terms at the time of acquisition were more lenient than the Safe Harbour provisions, John has a commercial “arms’ length” reference to hold to support a variation from the Safe Harbour.  However, to the extent his LRBA terms are more favourable than the Awesome Bank’s LRBA terms, John would need to vary his own LRBA to match (even if the variation was less than the Safe Harbour provisions).

What if Awesome Bank did not offer LRBA lending at the time of acquisition?  Perhaps John could then look to Community Bank instead.  If Community Bank has lending terms which were more lenient than the Safe Harbour provisions, then John would have a commercial “arms’ length” reference to support a variation.

To the extent John tries to find “arms’ length” terms different to the Safe Harbour provisions, he is best to ensure the comparative is truly “commercial”.  John should not look to his best mate Bob, who is a third party lender, to provide the “commercial” comparative – unless Bob is a recognised credit provider who has engaged in LRBA arrangements as a regular component of his business (which business commenced well before the publication of ATO ID 2015/27 and ATO ID 2015/28).

LET’S CONSIDER SOME STRATEGIES…

Let’s say that John has to figure out how to raise the shortfall in the LVR.  What are some options?

  1. John could make additional concessional and non-concessional contributions (subject to the contribution caps and restrictions) by allowing part of the loan to be paid down (do not forget the paperwork and required transactions!);
  1. John could invite new members to the fund and their rollovers and/or contributions could be used to reduce the loan (make sure the investment strategy is considered for each);
  1. John could sell the asset (which could be difficult by 30 June – but it is an option); and/or
  1. John could re-finance through Awesome Bank, and give Awesome Bank a personal guarantee (hopefully Awesome Bank values his business).

What if John is in pension phase, and he has to fund increased repayments on the LRBA from the SMSF?  John could look to any of the above options, and he could also:

  1. Commute his pension and roll back to growth phase;
  1. Commute his pension, and commence a part pension with the balance of his member interest in growth phase; and/or
  1. Vary the terms of his pension to reduce his payments to the statutory minimums.

PCG 2016/5 is not the end of the world, but it is a wake-up call to all advisors in the SMSF space to favour conservatism in strategies.  There may be litigation which flows out of PCG 2016/5, given some advisors made exceedingly ambitious strategic recommendations to clients who will not be able to float adequate remedial action by 30 June 2016.  The ATO has given advisors a bit of leeway and, with a bit of creative manoeuvring, many SMSFs can sail to the Safe Harbours with minimal frustration (consider the above options, if the client could fund to lend – the client may likely remediate by treating funds as contributions).

If you would like to discuss PCG 2016/5 or what the ATO Safe Harbours mean for you or your clients, please contact Katrina Brown on 07 5574 3560 or via email.

 

Estate Planning Myths Series: When I die, a percentage of my estate is paid to the government as a “death tax”

We often encounter the misconception that when you die, a set percentage of your estate is paid as a “death tax”.

The good news is that “death tax” was abolished in Australia more than 40 years ago.

There are, nonetheless, taxes and charges borne by the executor or administrator of deceased estates, notwithstanding that the “death tax” was abolished.  This article considers a number of such examples.

COURT FEES:  If the estate obtains a grant of probate, the government imposes registration fees according to Court rates.

ESTATE INCOME TAX:  Tax may be payable on certain income or capital transactions which occur as a consequence of a person’s death.  Whilst “death” is not a taxable event, the disposal of assets by the estate and the receiving of income during the administration of the estate, gives rise to potential tax assessable circumstances.  The tax may be borne by the beneficiaries who become “specifically entitled” to the benefit of the income arising, or the tax may be held by the executor and payable from the estate proceeds.

ADJUSTMENTS FOR SOLE PROPRIETORS:  If an estate has a business, and stock or depreciation calculations must be adjusted at death as a consequence of the deceased trading as a sole proprietor or partner, then there may be a “tax” which arises to the extent of the adjusted values.

SUPERANNUATION DEATH BENEFITS PAID TO NON-TAX DEPENDANTS:  If superannuation death benefits are paid to non-tax dependants, then a tax case arise in respect to the taxable elements.  The theory here is that the concessional tax treatment attaches to the member of the superannuation fund, and not to his/her estate beneficiaries.

CAPITAL GAINS GENERALLY:  The taxation of capital gains in a deceased estate is complicated, but it can generally be said that if an asset with a capital gain passes to a beneficiary, the tax on the disposal (whenever that may be) by the beneficiary is borne by the beneficiary.  In other words, there is no tax on the capital gain on the distribution of the capital asset to the beneficiary.  However, when the beneficiary disposes of the capital asset, the capital gains will then become assessable income to the beneficiary.  If the capital asset was acquired by the deceased prior to 20 September 1985, the beneficiary will be assessed on the capital gain between the date of death and the disposal by the beneficiary.  If the capital asset was acquired by the deceased after 20 September 1985, and the asset was not a main residence (or a residence qualifying for exceptional treatment), then the beneficiary will be assessed on the capital gain between the cost base of the deceased (the purchase price, plus other allowed costs which have been expended since purchase to maintain and hold the asset) and the proceeds of sale received by the beneficiary.  There are tax concessions and exemptions which apply in limited circumstances, depending on the nature and use of the asset; however, “death” is not the triggering event for the tax on such capital assets.

SUMMARY:  Whilst there is no “death tax” per se, executors and beneficiaries alike are well advised to seek the advice of a tax lawyer or accountant well versed in taxation of deceased estates.  There are appropriate strategies to ensure beneficiaries are not subject to excessive taxation.

We welcome you to contact our Estate Planning Team, on 07 5574 3560 or via email to discuss your questions in respect to probate, estate administration and taxation of deceased estates.

SMSF Blueprint – a welcome resource for superannuation trustee planning and strategy

“SMSF BLUEPRINT” LAUNCH  – A WELCOME RESOURCE FOR SUPERANNUATION TRUSTEE PLANNING AND STRATEGY

During the last year, it has been my pleasure to assist Julie Dolan, of SMSF Blueprint, with ideas and concepts desperately needed by our clients who utilise self-managed superannuation funds (SMSFs) in their investment portfolios.I am pleased to see the launch of SMSF Blueprint in the industry, and have offered to share the platform with our clients to assist in the dissemination of what we believe to be a sound tool for our clients.  The firm receives no remuneration whatsoever, but I believe strongly in the platform and its usefulness to our clients – so wanted to share this resource with you.

Whilst Julie is a consultant with the Firm, I find her educational platform to be an astounding educational benefit and compliment to the offering of our team generally.

I, along with Julie, have advised many trustees across Australia this year in respect to SMSF compliance, and this educational platform was established by Julie and her partners to address what appears to be an industry wide confusion as to trustee obligations and strategies.  I have been consulted on a number of non-compliant SMSFs in the last year, and I am concerned about the expanding enforcement powers of the ATO generally (not  to suggest that I disagree with the enforcement process, and its purpose in the marketplace).

Breaches of the rules and regulations can be a very costly exercise – as demonstrated by a recent case in which a 62 year old trustee was handed down an 80 hour community service order after failing to lodge multiple years’ tax returns.

Along with its existing compliance powers, the ATO introduced its new penalty regime effective from 1 July 2014. Penalties of up to $10,200 per trustee for certain breaches of the rules and regulations can be handed down by the ATO. These penalties are payable by the trustee and cannot be reimbursed from the fund.

I am a subscriber to SMSF Blueprint, and find the content to be brilliant and easy to use.  I ca use it with clients for demonstration purposes, and general education. However, it is a platform that you can subscribe to for ongoing compliance and training purposes.  Plus, Julie and her team offer strategic ideas in respect to planning ideas.  The platform changes constantly, with new content on legislation and forward planning ideas.

I am recommending the platform for all of my clients, and making it a mandatory subscription for my new SMSF clients because the risks of not complying are too great.  It is such an easy and convenient platform, you can watch the videos anytime and anywhere.  It is like having a financial advisor at your fingertips – and certainly gives you the fuel for informed discussions with your financial advisor and accountant.  I personally think the platform saves clients’ money, because they can do research and investigate ideas on their own – and then go to the specialists for advice on the suitability and implementation process on those ideas that they find worthwhile considering.

Of course, I am always here to help you in your SMSF planning – but I believe clients should be informed, and the SMSF Blueprint platform is a minimal cost for a vast resource to SMSF trustees.

If you would like to speak to Julie, please feel free to give her a call on 040 445 5001, or email her.   Definitely have a look at SMSF Blueprint, if you are considering or managing a SMSF – I think you will be quite pleased at the platform.

For your convenience, you can click here to view the link that I use to link through to SMSF Blueprint.

Katrina Brown BA ATIA SSA TEP
Senior Lawyer