When a self-managed superannuation fund invests in real estate, it can seem like a reasonably straight forward arrangement, with specific super rules that allow borrowing and ATO guidance, to help the fund stay tax compliant. But what happens when land owned by the fund ripens for development? What about commercial property that needs significant modification or modernisation?
The rules that allow funds to borrow to acquire assets do not exist for the improvement of existing assets. To compound the funding issues, the compliance pathway for a fund seeking to engage in this further activity has significant complexities that need to be navigated.
Introducing other investors and the importance of “arms-length”
The first issue is access to funding. Where the fund does not have the existing financial resources to complete a project by itself, it may find that investment in the project with others is a prudent option. When engaging in co-ownership or a profit-sharing arrangement with other parties, there are a myriad of tax and superannuation rules that need to be navigated, to determine whether compliance can be achieved in a practical way and to ensure ongoing compliance.
A very important facet of the arrangements that self-managed superannuation funds enter into, is the requirement to structure them on an arm’s-length basis. This is not so much of an issue when the parties are in fact, at arm’s-length to each other, as you would expect ordinary market and commercial forces to do much of the work here. It is much more of an issue where fund members have other business or family relationships with co-investors, requiring the fund to be careful to structure its arrangements, as though the fund was at arm’s-length.
From a superannuation compliance standpoint, a fund must not only ensure that the investments it enters into are no less favourable to it than at arm’s-length but it must also maintain its investments, so that they continue to meet this requirement. Failing to do this can not only breach these specific arm’s-length rules, but can also raise the question as to whether the fund is providing financial assistance to its co-investors. This can result in a further and additional breaches, including breaching the financial assistance and sole purpose tests. The sole purpose test requires that the fund is maintained for the sole purpose of providing retirement benefits to its members.
Getting it wrong can also affect the fund's tax rate
On the flip side, if the arrangement is more favourable to the fund, it risks triggering taxation integrity rules that can result in all of the income from the investment being taxed at the highest marginal rate, rather than the concessional or tax-free rate, that the fund would otherwise enjoy.
Watch out for the in-house asset rules
How the project is structured to allow co-participation, can also impact on whether the type of investment is compliant for the fund or not. Taking equity in a co-venturing structure such as an incorporated joint venture (i.e. a co-owned company) or a unit trust can raise concerns as to whether the investment is considered to be an “in-house asset” of the fund. “In-house assets” in these circumstances can arise, where a fund has invested in a “related party”.
Although it’s too much to fully explore the scope of “related party” here, it’s enough to generalise that an entity that the fund invests in will often be a “related party”, where the fund acquires control and/or a majority stake in that entity. This can arise by the fund holding factual control or majority ownership or where it would have that control or ownership, if it also held the interests of other investors, who are considered by the rules, to be ‘associates’ of the fund.
The issue with an investment being considered an “in-house asset”, is that it will breach compliance rules where more than 5% of fund assets (by value), are in-house assets. Although there are some exemptions from the “in-house asset” rules that could potentially allow a fund to invest in a controlled or majority owned company or unit trust, they cease to apply if the investment vehicle borrows, gives security over its assets or carries on business activity, to name a few.
There is additional flexibility when investing with unrelated parties
In contrast, where the fund does not have the above control or ownership and the arrangement is bona fide and properly structured with unrelated parties, it can be a very flexible structure from the fund’s point of view, potentially allowing the investment structure to borrow, secure and carry out or manage the project, without causing compliance failures for the fund.
Can you save duty using unincorporated joint ventures?
One potential draw-back of restructuring land to a company or trust, is unnecessary stamp duty, particularly where there is no compelling reason to change legal title to the land. This may arise for example, where the project will not be a long-term hold, with plans to dispose of the asset, at project completion.
A common structure that can be implemented in many States in these circumstances is an unincorporated joint venture. Properly implemented each party has their own roles clearly defined in the agreement, which may include the fund remaining a passive landholder, with other parties taking on the role of funder, project developer, manager etc. A note to Victorian practitioners here though, that “economic entitlement” rules may otherwise trigger duty on investing in this type of structure.
How complicated are they?
It is common to see two-party ventures (i.e. the fund and a second fully funded entity) which are simpler structures to maintain but they can expand beyond two parties, where there are a number of investors in the project or a need for further role separation. A drawback here however, is that by retaining ownership of the land in the fund, the land cannot be used as security for project borrowings and the fund cannot borrow its financial contributions to the project (if any). However, it is not uncommon for the co-venturer to borrow against its own assets, for its own financial contribution to the project.
Where security and borrowing by the fund is not required, the crucial outcomes under an unincorporated joint venture are to ensure that the contract and conduct of the participants, adequately addresses the arm’s-length, financial assistance and financing restrictions for the fund and ensures that entry into the contract does not result in the fund “investing in” any related party.
Conclusion
Although purchasing land is relatively straight forward for a SMSF, improving land is a different story. The wrong structure can introduce compliance issues with non-arms-length arrangements, financial accommodation, “in-house” assets, borrowing prohibitions, the sole purpose test and unnecessary stamp duty. It can also result in the loss of concessional tax treatment in the fund, for that investment.
However, despite the scope of issues, it is usually possible to achieve the fund’s objectives in a commercial and compliant manner. More than most other investments however, it will require specialist advice, preferably in both income tax and superannuation compliance.
