Keep the guidance coming

Kris Kitto posed some questions in relation to a previous posting about the recent limited recourse borrowing amendments, and in particular on the question of whether an improvement constitutes a replacement. I thank Kris for his questions, and apologise for not responding earlier. I had delayed my response in the hope that there may be some guidance from the ATO. And whilst we have seen several recent Interpretative Decisions, it seems that until the ATO is asked to make a specific determination on the issue, we are left to make our own assessment of how the provisions apply.

Kris asked

Can a property within a new S67A instalment warrant arrangement be improved by using other SMSF cash (i.e. from contributions etc) without breaching the
new provisions?

When does a replacement asset come about by way of improvements made?
Does it mean 'substantial' improvements or any old minor improvement that can't
be considered a repair?

In the context of improvements, the legislation only takes issue where the borrowed money is applied in improving the acquirable asset. The legislation is silent on the fund using its own money to undertake the improvement.

As for whether improvement creates a replacement asset, there is no specific reference in the legislation itself. Rather, the legislation contemplates that there be 'another single acquirable asset'. In the case of real property where the asset is a particular lot, it seems to me that improving the asset does not result in there being 'another ... asset', unless the lot is exchange for another or others, or perhaps where the lot becomes subject to an encumbrance (eg an easement). Even 'substantial' improvements seem unlikely to cause there to be 'another ... asset'.

That said, there is always a need to tread carefully in this new area. I look forward to the ATO providing some guidance in the near future.

Limited recourse borrowing and the ATO

The ATO released an Interpretative Decision last Friday addressing one aspect of a limited recourse borrowing arrangement - that is whether an SMSF trustee contravenes section 109 SIS if it borrows money from a related party under a limited recourse borrowing arrangement on terms favourable to the SMSF.

Correctly, the ATO concluded that this does not breach section 109.

What the ID doesn't say is whether this creates any other issues for the arrangement. Yesterday, Money Management posted an article (ATO SMSF decision queried Money Management) suggesting that the ATO had given the "green light" to SMSFs borrowing from related parties on beneficial terms. And an article in today's AFR has a similar flavour.

Comments made both within those articles and in response to them suggest on the one hand that caution should be exercised, but on the other hand that there are wider opportunities to be exploited.

I would suggest a more cautious approach be adopted. The ID had a very limited scope - the application of section 109. It makes no comment about other issues including:

• whether the discount to the arm's length rate of interest enjoyed by the superannuation fund is a contribution?


• whether the arrangement gives rise to non-arm's length income to the SMSF

I expressed concern in an earlier post about the Cooper Review recommendation of a general review of superannuation borrowing in 2 years' time. It seems to me that when comments begin to surface pushing the interpretation of announcements far beyond the limits clearly intended, the industry runs the risk of losing the concessions that for the most part are not abused.

Replacement by way of improvement

Now that the limited recourse borrowing arrangements have passed both houses, and we await Royal Assent, our minds turn to what the changes mean for superannuation funds now wanting to borrow.

The EM to the Bill suggests that "the replacement by way of improvement of real property" will give rise to a replacement asset, that will not be permitted under the new regime.  This is curious in a number or respects:

• where in the Act does it say that an improvement of real property gives rise to a replacement asset - perhaps there are regulations yet to be promulgated;
• if there is no change to the title, it is difficult to see how there has been any change to cause the acquirable asset to change to a replacement asset;
• what degree of change is necessary to cause an improvement (no doubt the issue of repair vs improvement will come to the fore).  What about watering the lawn - is that an improvement?
• and what mischief is this designed to address - presumably to prevent development occurring, but what about relatively minor improvements aimed at enhancing the value of the property?

And finally, what if the superannuation fund uses its own money rather than borrowed money to undertake the improvement.  After all, the restrictions in the new provisions are all about the way in which the money borrowed is applied, rather than other funds made available from the superannuation fund.

Single acquirable asset

The bill introduced into parliament last week proposing amendments to the superannuation borrowing exemptions is, for the most part, welcome confirmation that limited recourse borrowing arrangements are here for the foreseeable future.

However, one concern with the proposed changes is the restriction of these arrangements to 'single acquirable assets' and collections of identical assets with the same market value, particularly in the context of real property.  It would seem from reading the bill and the EM that where, say, a residential house is constructed over 2 lots, each lot will be a single acquirable asset, and the property would have to be held in 2 trusts, with separate loans for each lot.  And this appears to be so, even if the lots are on one title.  Similarly, a fund that wanted to borrow to acquire a strata-titled commercial building would have to have a separate trust and separate borrowing for each lot, despite the lots together comprising the building that the fund wished to acquire.

Ideally, the legislation should recognise that assets with a single use would comprise a single acquirable asset.

It will be interesting to see whether financiers will be willing to enter into arrangements involving multiple loans and multiple trusts to fund what in essence is the acquisition of a single asset that just happens to comprise multiple lots.

Forced to market

One of the less controversial recommendations out of Cooper Phase Three is the recommendation that SIS legislation relating to acquisitions and disposals between related parties should be amended so that where an underlying market exists, all acquisitions and disposal of assets between SMSFs and related parties must be conducted through that market.

This recommendation would, however, modify the existing rule under s66(2) SIS that allows the trustee to acquire a listed security directly from a related party where  the security was acquired at market value.

And when you think about it, unless the market is very thinly traded, it will be very unusual for a particular buyer and a particular seller - in this case the SMSF and related party - who otherwise want to deal with one another directly to in fact connect with one another in the market setting.

In a sense, the way the recommendation operates is to prohibit transfers of assets between SMSFs and related parties where a market exists, unless through some quirk of fate, the parties happen to be dealing with one another via the market.

The recommendation ends up imposing upon the parties the additional transaction costs - typically brokerage or commission - which they would not otherwise incur under the current arrangements

A rose by any other name

One of the more intriguing recommendations from the Phase Three preliminary report is that SMSFs be prevented from being established or renamed using a name which is the same or similar to an existing APRA-regulated fund.  This recommendation came out of an ASFA submission.

The concern is that it would be too easy to 'mirror' a well-established APRA regulated fund.  No evidence is offered to suggest that this is an existing problem, or even likely to be a problem in the future.  It's hard to imagine how this might be a problem.  There are sufficient facilities for those needing to ascertain whether a fund is regulated or not. An employer who contributed to such a fund without making appropriate checks would either be reckless, grossly negligent or deliberately fraudulent.

Sure, it's a simple matter to make the amendment, and it won't have any major impact on most SMSFs, but one has to ask whether this change - like the banning of collectables - fixes a problem which at worst is marginal.

In-house in the dog house

For most SMSFs, the in-house asset rules have operated virtually as an absolute prohibition against the fund holding in-house assets.  This is despite the limited scope for funds to hold 5% of their assets as in-house assets.

One of the difficulties with the 5% rule is that it required the trustee to remain vigilant.  If the value of the in-house asset moved significantly relative to the value of the other fund assets - and there were many instances of this during the GFC - the fund could be caught out unwittingly.

It proved to be the saviour for some pre-1999 unit trust arrangements, allowing a slight buffer where the trustee didn't get their calculations quite right.  Otherwise, the SMSF needed to have a considerable value such that 5% was significant enough to make a worthwhile investment.

So the recommendation that SMSFs wind their in-house assets down to nil will not have a major impact.

Interestingly, the same rules will not apply to APRA-regulated funds - typically funds with substantial balances, where 5% is enough for a worthwhile investment.

Leverage - don't let the horse bolt too far

History has a habit of repeating itself.  I remember in the mid-90's the threat that the in-house asset rules would be tightened if superannuation fund trustees exploited the loophole which allowed wholly owned unit trusts to be established in order to undertake borrowing which was otherwise prohibited within the superannuation fund itself.  Not surprisingly, the threat was ignored, and indeed the practice increased.  True to its word, the government changed the in-house asset rules, leaving us with the grandfathering provisions in Subdivision D Part 8.

The comments about leverage in the Phase Three - Preliminary Report have a familiar air.  The Panel makes it clear that they don't like leverage (or perhaps it is more correct to say they don't like direct leverage - as they do not seem concerned about managed investment schemes which effectively provide indirectly for leverage).  But they are happy to tolerate it for another 2 years, at which time a review should be held.  By that stage we will have had the instalment warrant rules for around 5 years.

I doubt that in 2 years' time we will have seen borrowing at a level which would cause it to become the 'significant focus of superannuation funds' that the Panel is concerned to avoid.  But if they do, it will be interesting to see what they propose to unwind it.  Will we be left with another set of grandfathering provisions.  I hope not.

Sorry Commissioner, I didn't realise I was going so fast

In an earlier blog I pointed out my concern with the ATO's treatment of the excess contribution tax issue.  The ATO has taken a very strict approach, arguing (quite correctly) that the current law provides no flexibility when it comes to imposing penalties for non-compliance.

The issue of the inflexibility of the penalty regime, not surprisingly, was taken up in the latest report from the Cooper Review.  Their recommendation is to adopt a "speeding ticket" model - that is, an administrative penalty could be imposed by the ATO on trustees (rather than as a tax on the fund) on a sliding scale, depending on the seriousness of the breach.  The trustee would then have a right to seek internal review by the ATO, or ultimately contest the penalty in court.

This approach was seen as preferable to the approach adopted in other areas under the Taxation Administration Act.

Either approach would certainly be better than the regime that presently exists.  And it does make sense to penalise the trustee rather than the fund (albeit that in many cases the member will ultimately lose out).  What will be interesting (assuming this recommendation is adopted) is to see how prescriptive the regulations will be, and how much discretion is given to the ATO.

Size matters - sometimes ...

There were 2 "size" related comments in Cooper's Phase Three - Preliminary Report.


The first was about membership size.  Currently capped at 4 - or more correctly, fewer than 5 - most submissions called for an increase in this otherwise supposedly arbitrary limit.  I say "supposedly", because it seems to me that the cap of 4 is not arbitrary, but instead reflects the trust law in each state which generally caps the number of individual trustees at a maximum of 4.  The panel's recommendation is for no change here, because of the "complications inherent in expanding the limit" - which appears to be an allusion to the state trust law requirements, as well as possibly the cumbersome nature of running a fund with a large board of trustees/directors.


The other size issue concerned fund asset size.  Sensibly, the board does not believe there should be a mandated minimum fund size.  Introducing an arbitrary limit would not have worked.  There are examples of where funds with otherwise low assets are justifiable - most notably insurance only arrangements.  And to set a minimum could have sent the wrong message - i.e. if you have (say) $200,000 in superannuation, then you ought to have an SMSF.


It comes down to whether the particular circumstances warrant having an SMSF.  Size is only one of many factors to be considered.

Over 60s win - again

I will let the dust settle on the Government's Response to the Henry Review.  But I will make the initial observation that the winners (again) at least from a superannuation perspective are those over 60.

Take this scenario: I am a superannuation fund member with an account balance of $750,000.  I want to maximise concessional contributions (through salary sacrifice arrangements).  Depending on my age after 1 July 2012, the outcomes are quite different:

• if I'm under 55 I am stuck with the $25,000 cap on concessional contributions.
• if I'm 55 to 59, I could retire to trigger a condition of release, and could then take out $250,001. I would be taxed on this amount.  I would then qualify for the higher $50,000 concessional contribution cap - but given that I had to cease gainful employment with the intention of not returning to work, I might have some difficulty convincing the ATO that I'd had a genuine change of heart.  I could then recontribute the net amount as a non-concessional (assuming the bring forward of the non-concessional caps was available).
• if I'm 60 to 64 I will need to cease gainful employment.  I could take $250,001 tax free, and recontribute it as a non-concessional (again assuming the bring forward was available).  I can immediately return to work and qualify for the $50,000 concessional contribution cap.
• if I'm 65 to 74, I simply need to satisfy work test - which shouldn't be difficult if I'm looking to make salary sacrifice contributions.  My major difficulty is that I can't access the bring forward provisions.

We still need to see the detail of this proposal - it's not clear at what point the member balance needs to be under $500,000, and whether this could be repeated in future years (assuming the non-concessional cap bring forward isn't completely exhausted).

But even as a one-off it may be worth considering.

Ten Guiding Principles ...

Today the Cooper Review issued its Ten Guiding Principles for SMSFs as part of the Phase Three - Preliminary Report.  As an aside, try Googling "Ten Guiding Principles" - as far as guiding principles are concerned, ten seems to be just about the optimum number.  But I digress ...

Over the next few posts I intend to delve into the Report further.  For today, my comments on the SMSF Decalogue:

1. Ultimate responsibility - "... SMSF members have effectively assumed sole responsibility for the adequacy of their retirement savings."  I'm not sure that 'adequacy' is the right term.  There are plenty of people running SMSFs who aren't convinced of the adequacy of their savings, but are constrained by, for example, the contribution caps.  Would it not have been more appropriate to talk about taking sole responsibility for the management of their retirement savings?
2. Freedom from intervention - no arguments on this one.  When it comes to intervention, less is preferred to more in the SMSF environment.
3. ... but not complete absence of intervention - the Report points out that it is the government that ultimately underwrites the risk of SMSF failure.  Whilst that might be true, it must be remembered that many of those running their own SMSFs will have other resources that would be called on long before the social security system is asked to kick the tin.  Notwithstanding this, access to tax concessions warrants intervention where the rules are broken.
4. Service providers - interestingly, it's not just SMSF trustees that will be affected by the recommendations.  There is a clear emphasis on raising the bar for service providers.  Again, something I welcome.
5. Gatekeeper on establishment - it's not clear how to reconcile this with the first point.  And it's not clear why the industry now needs a gatekeeper.  If it ain't broke ...
6. Consistent treatment with APRA-regulated funds where appropriate - the 'level playing field' approach is the appropriate starting point.  After all, super is super, and there must be common elements across the board.  Splitting the system in two will add to complexity, which creates uncertainty, which diminishes confidence.
7. Recognition of special risks in an SMSF environment - as with 5, how is this reconciled with the first point.
8. Leverage - I will say more about the specific comments on leverage in later posts.  What is curious here is that the Principle says that 'the Panel believes that there is room for leverage in SMSFs' but reading the Report suggests that leverage is only appropriate to cover short term liquidity issues.  Which is correct?
9. Compliance, rather than prudential, regulatory focus - no real argument here.  Where members are trustees and vice versa, it is reasonable to assume that prudential management should almost take care of itself.
10. Pursuit of excellence - I wonder if this is going to be like herding cats.  How far can a 'dispersed and non-institutionalised' sector of the super industry be cajoled into adopting best practice (whatever that means), and at what point will the push back commence.  Government and regulators have learnt that many of the assumptions about the way SMSFs had operated - eg the level of fees being paid - were simply wrong.  Developing best practice is going to be a significant challenge, especially if incorrect assumption continue to be made.

Taxpayer Alerts - an appropriate way to deal with excess contributions?

It's almost a month since the ATO issued Taxpayer Alert TA 2010/2.  Entitled "Circumvention of Excess Contributions Tax", it warns taxpayers that the insertion of specific provisions in SMSF trust deeds which create a separate trust to hold amounts which, if treated as contributions, would cause the contributions caps to be exceeded.

The Alert questions the effectiveness of these arrangements (presumably from a legal perspective) but is very short on legal arguments against such arrangements.  The Alert also appears to make adverse assumptions about the motives for including these provisions in the deed.

The reality is that these clauses are included in SMSF deeds for much the same reason as many other provisions are included in deeds - to ensure compliance with, and to prevent inadvertent breaches of, the SIS Act and Regulations.

What is most concerning about the ATO's approach on this issue is what it says in a more general sense.  The Commissioner, in responding to concerns about the harsh outcomes regarding excess contributions, has consistently responded by pointing out that the legislation gives the ATO no room to move. The impression that the ATO seems to have wanted to convey is 'We'd love to help, but our hands are tied'. However, when presented with an approach that provides both a practical and technical solution, the ATO has preferred to maintain the hard line, without any technical backing.  It begs the question: has the ATO been genuine in their concern about their inability to be flexible on this?

Several submissions have been made.  The ATO's response will be interesting to observe.

Accountants, Advisers and Super

One of the oldest rivalries in the SMSF arena was (not unexpectedly) reignited with Minister Bowen's announcement on the weekend.  Already this is being reported as lessening competition by removing accountants from the SMSF establishment arena.


These comments are premature.  Bowen has already indicated that there will be an alternative arrangement  - albeit yet to be determined.


One suggestion might be to have a quite specific licensing regime in the SMSF area - with SPAA already offering their accreditation as a benchmark.  A regime which raises the bar across the board must be good for fund members.

Overhaul of Financial Advice - another step towards convergence?

Minister Bowen's announcement today, although not unexpected, contains some 'interesting' elements:

• a statutory duty to be imposed on financial advisers - but what additional protection does this offer clients over and above the common law duty?
• confirmation that accountants will lose their exemption for SMSF advice, but no hint of what will replace it
• no recognition that these reforms may impact most on those who are otherwise least able to afford fee-for-service advice

On this last point, the latest announcement from the Cooper Review last week might hint at how the government proposes to address this - by running advice through the MySuper model.