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.

 

Aggregated transfers in Queensland

Transfer duty in Queensland is imposed by the Office of State Revenue on all dutiable transactions, pursuant to the Duties Act 2001.

When transactions are related, the transfer duty payable on the transactions must be aggregated; meaning that, rather than assessing the value of the transactions separately (in which case a lower rate of duty may be payable), the value of the transactions are combined and duty is assessed on the combined value of the transactions.

What are “aggregated transactions”?

There are various circumstances that must be considered in determining whether transactions are aggregated.

Firstly, it is important to make clear that the aggregation of transactions relates not only to the transfer of real property, but also to acquisition of business and other interests in Queensland.

The negotiation of the Contract, method and terms of sale must be considered. The Office of State Revenue generally holds that property purchased at auction is not subject to aggregation (as the Buyer is unable to negotiate their purchase, and cannot guarantee that they will be successful at auction). If, however, the transactions were effected by a contract or negotiation, then the offer and execution of documents occurring for both transactions on the same day can also create an aggregated transaction. Further, any terms of a Contract implying that the transactions are linked (for example, settlement of Purchase A is subject to Purchase B also settling), creates a relationship between the transactions, resulting in aggregation.

Finally, and most obviously, the combined use of the subject of the transactions will result in aggregation.

What happens if my transactions are linked, but they aren’t assessed as aggregated?

Your solicitor will rely on information provided by you in determining whether the transactions are aggregated. In order for transfer duty to be correctly assessed when payable, it is important to make sure that you disclose any relevant information to your solicitor from the outset. Failure to do so could result in incorrect assessment of your transfer duty liability, which can incur Unpaid Tax Interest until rectified.

As the circumstances in which aggregated transfer duty is payable vary from case to case, it is best to speak to your solicitor if you are considering entering into any Contract or agreement which could result in an aggregation. As transfer duty in Queensland is calculated at progressive rates, failure to take this into account before entering into a transaction could result in a high rate of transfer duty being assessed than you anticipated.

If you would like to discuss a potential aggregation with our office, please feel free to contact Caitlin Bampton on 07 5574 3560 or caitlin@nautiluslaw.com.au

What’s in a name?

When entering into a Contract in Queensland, it is critical the Buyer’s and Seller’s names are complete, and correctly spelt.  Any omissions or errors can cause significant headaches and incur significant cost further on in the conveyancing process.

The Seller is the first party listed on the Contract.  The Seller’s details are the easiest to get right, as these must exactly match the title of the property (which can be discovered from a title search of the property, which your agent or solicitor can conduct before the Contract is signed).  If, for some reason, you are selling the property and the entity registered on the title is incorrect (say, for example, the title is registered in the joint name of two people, one of whom is deceased), please speak to your solicitor before the Contract is signed about the Seller’s name that should be reflected on the Contract, and any special conditions that must be inserted to address the variation between the Seller’s name on the Contract, and the name registered on the title of the property.

It gets a bit trickier when inserting the name of the Buyer.  If you are purchasing the property in your individual name, then your full legal name must be inserted (no nicknames, assumed names, or initials).  If the purchaser is a Company, the full company name and A.C.N. of the Company must be inserted (e.g. SMITH NOMINEES PTY LTD A.C.N. 123 456 789).  If you are purchasing the property as Trustee, then the full name of the Trustee and Trust must be entered (e.g. SMITH NOMINEES PTY LTD A.C.N. 123 456 789 AS TRUSTEE FOR THE SMITH FAMILY TRUST).

Firstly, if you sign a Contract that does not reflect the correct entity, leading to a change of the Contract, the Office of State Revenue may determine that any variation to the Contract to change the entity is a separate transaction, and may impose Transfer Duty on both the transfer reflected by the Contract, and the subsequent transfer to the correct Buyer.   At a minimum, your solicitor will need to make additional submissions to the OSR to enable a cancellation of the incorrect Contract – and generally you will have to pay the Seller’s solicitor fees as well.

For example, Mr Bob Jones sells his property to Mr John Smith, and an unconditional Contract is executed indicating these names (and Mr Smith does not provide any instructions to his solicitor indicating that the Buyer is a company or trust) (this is Transaction One).  One week before settlement, Mr Smith’s bank observes that the transfer documents do not indicate the name of the Trust purchasing the property.  Further discussion with Mr Smith reveals that he did indeed intend to purchase the property as Trustee, and didn’t realise that his solicitor needed to know this.  His solicitor approached the Seller’s solicitor, who agreed that the Contract could be amended to reflect the Buyer as Trustee.  However, Mr Smith signed the Contract in his own right, and then (it appears) decided that the purchaser would be the Trust.  As the Contract signed is immediately unconditional, the Office of State Revenue can determine that the change of Buyer from Mr Smith to Mr Smith as Trustee is a second, and separately assessable, transaction (Transaction Two).  Whilst the ultimate outcome is that both transactions are effected and the property is held in the name of the intended party (i.e. Mr Smith as Trustee), the effect of such a determination by the Office of State Revenue is that the respective Buyers have to pay transfer duty on each of the transactions – meaning that Mr Smith has to pay Transfer Duty on Transaction One, and Mr Smith as Trustee has to pay Transfer Duty on Transaction Two.  The double-payment of Transfer Duty would be entirely avoidable had the correct purchasing entity been inserted in the Contract from the outset.   Your lawyers may be in a position to apply for a cancellation of the first contract, nullifying Transaction One in terms of duties – but the process will incur additional costs – usually including costs payable to the Seller’s solicitor and the Buyer’s solicitor.

Secondly, indicating the correct entity on the Contract from the outset creates less potential for issues to arise as the transaction progresses.  An incorrectly listed entity requires amendment on the Contract, which can be made only if both parties agree.  It is also important to note that, if purchasing the property as Trustee of a Trust, a certified copy of the Trust Deed (and any variations) is required to be lodged with the Transfer documents after settlement.  As you may not have these easily accessible, it is best to allow sufficient time to locate these documents prior to settlement in order to avoid a last minute rush.

If you have any questions about the name that should be indicated on your Contract, please feel free to contact Caitlin Bampton on 07 5574 3560 or Caitlin@nautiluslaw.com.au.

Are you buying a Body Corporate Lemon?

Due diligence searches are an important factor when purchasing a commercial or residential property, and ensuring you are considering all important information is key to determining that the investment is sound and whether to proceed with the transaction.

As body corporate solicitors, we strongly urge all potential buyers of strata property to consider a thorough search of the historical minutes, financials and general communications available in the strata records to ascertain how the body corporate is functioning and to appreciate what expenses are anticipated. A search of the strata agenda, minutes, resolutions and other records available on a Body Corporate Records Inspection can demonstrate how well the property functions generally (for example, is the property governed by a dysfunctional committee and/or are there owners who make resolving Strata matters difficulty and/or are there expenses unmet (such as a roof repair that has been considered, but not addressed requiring a special levy). In addition to the “standard searches,” we strongly urge clients to conduct a Body Corporate Records Inspection to find the “skeleton in the closet.”

What is a Body Corporate Records Inspection?

A Body Corporate Records Inspection is a physical inspection of all records held by the relevant body corporate. Depending on the size and age of the body corporate, the records are anywhere from the size of a binder folder, to the size of several archive boxes. While the amount of information to be reviewed can be slightly overwhelming, it is important to examine all relevant records.

What do you look at in a Body Corporate Records Inspection?

As a general rule of thumb, we suggest reviewing all body corporate records from the previous 3 years.

There are, however, key documents that we would suggest reviewing:-

  • Account records

Recent accounts statements for the administrative and sinking funds will indicate the current balance of each fund. Bear in mind that the administrative fund pays for ongoing, day-to-day expenses (this can include gardening, general maintenance, insurance, body corporate manger’s fees), whereas the sinking fund pays for capital expenses (such as painting).

It is important to ensure there are sufficient funds coming into and maintained in the administrative account to fund ongoing expenses (there should be numerous transactions on this account), and to check the balance of the sinking fund (which, in most cases, rises steadily – if the account is decreasing, there may be large capital improvements that have been made for you to investigate).

  • Balance sheet and budget

Review and compare the balance sheet and budget for the current and prior financial years – look at whether there are any significant changes to the budget or balance sheet that are unexplained, and to ensure that levies charged throughout the financial year are sufficient to cover the budget for that year.

  • Reports

The body corporate may have commissioned reports for specific inspections of the complex – such as fire inspections, general building and pest inspections, or structural reports. Review these reports in detail to check for any concerns raised or recommendations made by the report writer, and check the body corporate records as to whether these have been addressed.

  • Insurance

Make a copy of the body corporate insurance (if you are obtaining finance, you will generally need to provide this to your lender). Review the insurance to ensure it covers all crucial elements, and check whether the building is insured for the recommended amount.

  • By-laws

Review the By-Laws for any changes and to ensure you have received the most current copy. Remember that the owner and tenant of the complex must ensure that these By-Laws are complied with at all times.

  • Correspondence

Although this covers a broad range of information to review, it is crucial that the correspondence is thoroughly reviewed – it might only be one line in an email that is enough to raise a “red flag” of a potential issue.

Unfortunately, there is no cheap or easy way to do the records inspection – however, while combing through several years of information about the body corporate can be time consuming, it is certainly a worthwhile exercise.

Residential Case Study: Jane’s purchase of Unit 3 University Drive

Jane signed a Contract for the purchase of Unit 3 University Drive – a unit on the second floor of a two story building (which is around 15 years old), in which there are eight units. The Contract contained a specific provision that she was permitted 14 days to conduct a body corporate records inspection, and had the right to terminate if the results were not satisfactory. When Jane initially provided her instructions, she advised she didn’t think the records inspection was necessary – the building looked stable, the unit was just intended to be an investment property, and the cost of the inspection was too high (at a few hundred dollars). Despite her solicitor warning of the potential issues that could be uncovered in a body corporate records inspection, Jane confirmed she didn’t want to pay for the inspection and to only conduct standard searches.

Her lawyer telephoned Jane on the date the condition was due to confirm she was prepared to let the date pass with no action, and did not require the search to be conducted – during the telephone call, Jane had a change of heart and requested that the inspection be conducted and results advised immediately (please try to avoid doing this to your solicitor – while we appreciate that you may change your mind, short notice of a change of your instructions may result in insufficient time to conduct the search – it is best to give your solicitor as much notice as possible). The lawyer was able to arrange an inspection of the records, and attended at the body corporate’s office to inspect same that afternoon. The person inspecting the records initially went through 3 years’ worth of records (as we suggest above) but, due to the size of the body corporate and age of the building, decided to inspect records back to 4 years instead.

A one line email 2 days before the 4 year mark was to the effect of one owner of a unit complaining that the structural issues with the building of their earlier email (dating back approximately one year prior) had not been resolved. This caused concern with the inspector, who then reviewed older reports and correspondence, which indicated that there was structural cracking in the building at two places, that could only be fixed by costly repairs (in the sum of approximately $40,000).

This outcome was reported to Jane, who, on the basis that the issue was unresolved (and assumed to have worsened due to inaction over the prior 4 years), elected to terminate the contract.

Commercial Case Study: John’s purchase of Unit 1 Industrial Estate

John signed a Contract for the purchase of a commercial unit from which he was going to run a manufacturing workshop. His contract contained a 14 day due diligence clause and he gave his solicitor immediate instructions to conduct a records inspection.

Upon inspection of the records, correspondence indicated complaints from unit owners of cracking in the foundation of the central carpark of the complex. Further investigation into the reports obtained by the body corporate revealed that the cracking was caused by the foundation of the building “slipping”, and indicated that action would eventually need to be taken, but was not yet critical. The body corporate had resolved that no action was to be taken at present, but was aware that the cost to repair the damage caused and to prevent further “slipping” was in the vicinity of $100,000.

Further investigation into the balance of the sinking fund indicated that the body corporate held approximately $300,000.

On the basis that the body corporate held a sufficient sum in the sinking fund so as to fund the repairs in the future, John did not object to the outcome of the records inspection and satisfied the condition.

What happens if I find a problem when I conduct an inspection?

If your lawyer reviews the contract for the purchase of a unit or apartment before you have sign it, they will most likely recommend that either a “due diligence” or “body corporate records inspection” clause be inserted. These types of clauses allow the buyer to inspect the records and, if an issue is revealed through the course of such investigations, will give rise to rights under the contract (such as to terminate). If you are alerted to an issue with a records inspection, we recommend you contact your lawyer as soon as possible to discuss appropriate action and to obtain advice as to your options. Once you have been fully informed of these matters, you can provided instructions on how you wish to proceed.

If you are considering purchasing a property that is part of a body corporate or have any questions about body corporate records inspections, please contact our Property Team on 07 5574 3560. Thank you, Katrina Brown, Senior Lawyer.