Pitfalls to Property Development in an SMSF and how to address them
You may be shocked to know there is no ban on property development in a self-managed super fund. In fact, engaging in property development through an SMSF can be a highly beneficial strategy. However, compliance with the superannuation law is essential.
An SMSF can undertake property developments by itself, in a partnership or indirectly through entities under various circumstances.
First, you must obtain an understanding of the following details:
• If the SMSF will own the property on which the development will be undertaken, will the SMSF be the sole or joint owner of the property with other development partners?
• If the property development will be carried on in another structure, what equity interest will the SMSF have?
• How many SMSFs are involved?
• Are there any existing connections between the parties to the development?
• Who will the development works be carried out by?
• How will the property purchase and development be funded?
• Will borrowings be required to fund the development?
• Upon completion, will the development be retained or sold by the parties?
Keeping these critical details in mind, it is also important to consider the Superannuation Industry (Supervision) Act 1993 (Cth) (SISA), which provides a strict compliance framework under which SMSFs are governed.
SISA considerations are essential. Non-compliance now results in automatic administrative penalties of up to $10,800 per trustee and per breach. The Australian Taxation Office also has a range of powers in circumstances where SISA is not complied with such as disqualification of a trustee to civil and criminal penalties.
Key provisions of SISA:
1. Sole Purpose Test – s 62
The sole purpose test is integral to superannuation regulation. This means the sole purpose of your fund must be for providing retirement benefits to your members or their dependents should a member die before retirement. This test is applied by the ATO to SMSFs and non-compliance with the test often results in the undoing of SMSFs.
Within a property development context, the following examples are situations which may be in breach of the sole purpose test:
• A related party is engaged with by an SMSF to carry out work on the development and is paid more than a market value consideration for the service provided
• Because of the project’s insufficient funds to complete the development, the SMSF becomes an investor in the project carried on by the related entity
• The value of adjacent land to the project held by a related party increases in value because of SMSF’s place of development
• A related party builder to the SMSF is sought to complete the development works because they had no other work
• The terms in which SMSF engages the related party are different from those the related a party would accept from an unrelated party
Non-compliance may also result in serious consequences including civil and criminal penalties. Further guidance on the application of the Sole Purpose Test is provided in SMSFR 2008/2.
2. Loans and financial assistance – s 65
Section 65 of SISA has a broad application and will be contravened where a loan or any other form of financial assistance is provided on commercial terms. The section specifically prohibits a SMSF trustee from providing the following:
• Loans to members of an SMSF or a relative of members
• Financial assistance to members of an SMSF or a relative of members
For property developments, s 65 prevents SMSF from participating in the development where it is participating by funding (for a return) where the property is owned by a member of the SMSF or a relative.
Section 65 is applicable where the member or relative was to also indirectly benefit via another structure in place.
For further guidance on the ATO’s application of s 65 within a property development context, see the SMSFR 2008/1.
3. Assets from unrelated parties – s 66
A necessary consideration to make is whether the SMSF is acquiring property from a related party. Section 66 requires great consideration in relation to SMSFs participating in a property development project as it operates to prohibit the assets of related parties from being acquired by an SMSF.
There are exceptions to s 66 which allow for a related party to acquire real property if the property is acquired at market value and complies with the “business real property test” contained in s 66(2)(b).
Satisfying this test requires that the property be used wholly and exclusively in one or more businesses. The test will be satisfied where the property is a commercial office building being leaded to a business which uses the building for conducting its business. The test will not be satisfied where the property is residential and only used by members as a residence.
There are instances where vacant land may satisfy the business real property test. For example, where the property development business owns the vacant land and is held as trading stock. Alternatively, the test may be satisfied where a business uses the vacant land for the purpose of storing unused machinery.
It should be noted that whilst there are scenarios that may fall into both examples, further examination of the facts of each case is required before a full determination.
Further guidance on the application of the business real property test is provided by the ATO’s view on the operation set out in SMSFR 2009/1.
How to engage related party builders and contractors to the development
Despite widespread awareness for the compliance requirements in s 66, there has been little consideration of its application where related builders and contractors are engaged in a property development.
The ATO confirmed in SMSFR 2010/1 that s 66 does not prohibit an SMSF from engaging a related party for the provision of services. Although, the Commissioner has stated that significant goods and materials provided to the SMSF, there will be an acquisition of those assets. This poses a problem whereby it is often the case that related parties are often required for building services in order to complete a development. In addition, the ATO’s valuation for goods and materials that are not insignificant is considerably low, which complicates the application of s 66 further.
How to avoid a breach of s 66
In circumstances where SMSF engage with related parties, the following precautions should be followed to avoid a breach of s 66 –
• The related party is engaged to only provide services
• The goods and materials necessary to complete the services should be acquired directly from an unrelated supplier. It is recommended that then agency arrangement be produced with the builder/contractor for facilitating the supply of all goods and materials required.
You should also consider the anti-avoidance provision contained in s 66(3). The anti-avoidance provision operates to prevent the SMSF from indirectly acquiring prohibited assets through other means.
4. Borrowing – s 67
Borrowing by an SMSF is prohibited by s 67 SISA. Although there are limited exceptions, the most accessible exception is where an SMSF is permitted to borrow in order to acquire assets under a limited recourse borrowing arrangement (s 67A SISA).
The primary obstruction to the ability of SMSFs to loan or invest money originates from the in-house asset rules in ss 82 and 83 SISA. An in-house asset is defined in s 71(1) SISA as:
• an “investment in” or “loan to” a related party;
• an “investment in” a related trust; or
• an asset “subject to a lease or lease arrangement” with a related party.
Although there is not a complete prohibition on in-house assets, the market value of all in-house assets in an SMSF cannot exceed 5%. Before SMSF seeks to participate in a property development by investing in another entity, you must consider whether the investment will cause in-house assets of the SMSF to exceed the 5% maximum limit.
With the definition of an in-house asset in mind, it is also necessary to consider what constitutes a “related party” for the purposes of determining whether an SMSF can participate in an entity. A related party is defined in 10(1) SISA as:
• Standard employer-sponsor of the fund; or
• Part 8 associate of a fund member or a part 8 associate of a standard employer-sponsor of the fund.
Breaking the definitions down
When identifying members to an SMSF, you should consider members who may be unnecessarily connected to the SMSF and can, therefore, be removed.
A standard employer-sponsor is defined in s 16(2) SISA as an employer who “contributes or would contribute, wholly or partly pursuant to an arrangement between the employer and a trustee of the regulated superannuation funds concerned”. If contributions are only made by an employer due to “arrangements between the employer and a member or members or the SMSF, the employer is not a standard employer-sponsor”.
The definition of Part 8 associates is contained in Pt 8 SISA and ss 70B to 70E, which require careful attention as its application often produces unexpected outcomes. Of particular importance are the following provisions –
• Section 70B – provides the definition of who is a Part 8 associate of an individual
• Section 70C – where the entity being tested is a company
• Section 70D – where the entity being tested is a partnership
5. Control of trusts and companies
The above definitions draw upon the control provisions, which work on the concept of a “group”, being the entity, you are testing and any Part 8 associates of that entity. When turning to control provisions, it is necessary to determine whether there is the requisite control by the entities.
Under s 70E(1), an entity controls a company if –
• A group in relation to the entity has a fixed entitlement to more than 50% of the capital or income of the trust
• the trustee or a majority of the trustees of the trust is accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of a group in relation to the entity (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed companies, partnerships or trusts), or
• a group in relation to the entity is able to remove or appoint the trustee, or a majority of the trustees, of the trust (s 70E(2); Interpretative Decision ID 2002/697).
6. Arm’s length terms: s 109
The requirement to be dealing at ‘arm’s length’ with your SMSF is an important part of investment transactions under superannuation law. Section 109 SISA requires that all investment transactions of an SMSF must be made and maintained on an arm’s length basis.
However, transactions are not required to be at arm’s length where they may be between related or associated parties. However, investment transactions must be at arm’s length where the transactions are on a commercial basis.
Examples of non-arm’s length transactions include –
• Paying ‘below market’ or ‘above market’ rent for a commercial property your business is renting from your SMSF
• Transferring shares into your SMSF at less than market value
• Where a distribution from a related trust is not paid (where it is owing)
• Artwork hanging in the member’s own home with no payment for the use of this asset
7. Investment Strategy
Another requirement of any SMSF is to give effect to an investment strategy as provided by reg 4.09(2) Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR).
Generally, investment strategies are generically prepared so that the majority of investments undertaken by SMSF trustees are unlikely to be inconsistent.
Within the context of property developments, the investment strategy must be reviewed and amended as required to reflect any future activities on the site. Failure to do so will result in a breach of reg 4.09 SISR.
When engaging in property development through an SMSF, ensure:
• the fund trust deed has been reviewed and updated to ensure it has the powers to enter the development;
• the SMSF investment strategy has been reviewed;
• Specialised advice has been obtained on the purchase contract and agency agreement
• The builder has provided services only and has not been reimbursed for purchased goods and materials
• All commercial services have been conducted at arm’s length
Written by Adjunct Professor, Dr Brett Davies and intern, Sophia Nugawela