The agricultural affinity

Many farmers are also SMSF members and choose to use their fund to hold the related agricultural property asset. SMSF Association head of technical Mary Simmons examines the finer details trustees must consider when embarking on this type of strategy.

SMSFs have long appealed to the farming community. In its submission to the Treasury consultation on the Better Targeted Superannuation Concessions changes, the National Farmers’ Federation opined that the anecdotal evidence suggests more than 30 per cent of Australian farm businesses have SMSFs. With the number of Australian farm businesses approaching 90,000, that’s about 30,000 SMSFs or 5 per cent of the entire 606,000-strong sector.

Future for farming property and SMSFs

Research shows primary producers are likely to be adversely impacted by the proposed Division 296 tax. This is mainly due to the variances in market values and taxation of unrealised gains, impact on cash flow and lack of alignment between market movements and lease yields.

Nonetheless, SMSFs still offer farmers opportunities in terms of their retirement income strategy, estate planning, succession and property management. But there are also some risks and technical challenges needing consideration.

Primary production business or hobby?

Over the years, many farmers have chosen to buy their farmland using their super savings and then lease the land to their farming business.

This is permitted provided the farmland is used wholly and exclusively in the farming operations to meet the definition of business real property (BRP) and all transactions are undertaken on an arm’s-length basis. However, it means the farmers must be running a primary production business and not a hobby farm.

Some indicators to support the fact a business is being run include the intent to make a profit, the frequency, the size and scale of the farming operation, being organised in a business-like way and maintaining appropriate records, and the execution of activities on an arm’s-length basis.

The business can be run by an unrelated third party, by a member or by a related party.

If the SMSF is in the accumulation phase, it will pay no more than 15 per cent tax on the rental income.

However, if the SMSF is in the retirement phase, the rental income will be tax-free. All along, the farming business continues to get a tax deduction for the lease payments.

Untangling the web of acquiring farmland

The tax-effective superannuation environment can be attractive to farmers, but there are many rules SMSF trustees need to be wary of, particularly when acquiring farmland from a member or a related party.

One of those rules relates to the sole purpose test. Under this obligation, the SMSF trustees need to establish the acquisition of the farmland was to provide retirement benefits for the fund members and not, for example, a mechanism to inject funds into the business to enable the farming operations to continue.

The acquisition also needs to be consistent with the fund’s investment strategy. Given farmland is likely to represent a significant proportion of an SMSF’s total assets, trustees need to demonstrate they genuinely believe the acquisition to be in the best financial interests of fund members. The investment strategy also needs to consider any lack of diversification and potential liquidity issues.

A trustee’s decision to buy the farmland must not result in the SMSF providing financial assistance to a member or a relative. For example, questions could be raised if a member who was suffering financial hardship had been unable to liquidate the property and the SMSF was the only willing buyer.

The SMSF trustees must ensure the farmland is acquired on arm’s-length terms. This means the acquisition must be on terms no more favourable to the member (the seller) than if the parties were dealing with each other on a commercial basis. Similarly, the acquisition must be on terms no more favourable to the SMSF (the buyer) than if the parties were dealing with each other at arm’s length – or tax penalties may apply.

It’s best to ensure the farmland is acquired at market value, best supported by an independent valuation at the time of sale.

As an alternative to buying the farmland in the conventional way, an SMSF is permitted to acquire the farmland as an in-specie transfer. This is where ownership of the farm is transferred from a member to the SMSF and the value of the property is treated as a contribution by the member(s) whose balance is increased accordingly.

Where the value of the transfer is greater than the member’s available contribution caps, it may be possible to treat part of the farmland as a contribution and the remainder as a sale. However, documentation is crucial. It’s important the contract be clear the SMSF is only buying part of the asset and the remainder of the asset is being acquired by way of an in-specie contribution.

Get this wrong and it could be considered a non-arm’s-length purchase tainting all income derived from the farmland forever. This includes any future capital gain. This is not something that can be fixed.

Living on the farm

An advantage of primary production property is it can continue to meet the definition of BRP, even if it contains a dwelling used for private or domestic purposes.

However, the size of the dwelling matters. The exception that allows the wholly and exclusively BRP threshold to continue to be met can only apply where the residential property on the farm does not exceed two hectares and where the domestic use of the land is not the predominant use.

This exception does not distinguish between who uses the dwelling for private purposes and who runs the farming business.

Where an SMSF allows a farmer to live in the premises, it is important this be reflected in a properly documented lease or leasing arrangement in relation to that property. Not only should the rent charged be at market value, but so too should all other terms of the lease arrangement.

Where the farmland is being leased to a member or related party, particularly where that person will be living in the residential property, the SMSF trustees will also need to consider the in-house asset rules.

Provided the farmland continues to meet the definition of BRP, then leasing any part of the property, including the house, to a member or related party is exempt from the in-house asset rules.

But must the member (farmer) pay rent to live in the house? To not pay rent will raise concerns with respect to whether the arrangement is at arm’s length and whether the SMSF is providing financial assistance to the member. The trustee would need to demonstrate any benefit provided to the member is not at a cost or financial detriment to the SMSF and that, somehow, rent-free accommodation does not favour the lessee.

To pay too much rent is also problematic. Above-market rent will trigger the non-arm’slength income provisions and tax the rent at 45 per cent, as well as taint the underlying farmland forever for capital gains tax purposes.

Holding a primary production property

The distinctive characteristics and uses of farms complicates the task for SMSF trustees trying to benchmark related-party transactions against arm’s-length dealings. For instance:

Valuations: The value of fund assets must reflect market value. Farmland is no different but presents challenges given the cyclical nature of the industry. It is important for trustees to understand what elements drive the value of their specific farm. This can range from location, crop productivity, produce demand, the state of the economy and government policies.

Lease arrangements: Given the cash-flow volatility of farming operations, farming leases typically deviate from conventional monthly rent payments, favouring annual or biannual lease payments. Furthermore, the returns on farming leases do not correlate directly with shifts in the underlying farmland as compared to other property. This makes it challenging to draw comparisons with an arm’s-length lease arrangement.

Property maintenance: Ordinarily, farmers are responsible for all maintenance work, such as fencing and irrigation, but in an SMSF this introduces unique risks under the non-arm’slength expenditure (NALE) rules.

Needless to say, the specific lease arrangement needs to be referenced, but also a distinction must be made between what is a repair and what is an improvement to the property.

Let’s consider the simple example of a member (the farmer) constructing a fence to improve the land owned by the SMSF. Where the work is conducted by the member, the fund will need to be charged for the work to avoid being caught by the NALE rules. If the fund is not charged for the work undertaken by the member, this may also be deemed to be a contribution because the value of the land has increased. To add to the complexity, any material used should be directly bought by the fund to avoid breaching the rules on what assets an SMSF can acquire from a member.

Borrowing: Given property prices, some SMSFs may rely on borrowed funds to buy farmland under a limited recourse borrowing arrangement (LRBA). Trustees entering an LRBA tend to have a higher tolerance to risk given the ongoing need to meet loan repayments. For example, given the volatility of farming income, it may be risky to rely heavily on the farm lease arrangement to service the loan. Alternatively, if relying on member contributions to service the loan, an LRBA may be at risk if contributions reduce because of the death or disability of a member.

Exit strategies and estate planning opportunities

Farming properties are often considered to be family legacies so there is a strong desire to pass down the property held in the SMSF to the next generation. Such sentiment requires careful exit planning and succession planning.

Where the intention is to keep the farm in the superannuation system, there are a couple of common scenarios trustees face.

The first relates to paying a member a pension. Generally, the amount of rental income generated by the farm will influence how long the asset can be retained in the SMSF. However, as pensioners get older, their minimum drawdown requirements increase so relying primarily on the rental income to cover pension payments becomes less feasible.

The other relates to the death of a member. The compulsory cashing rules require the trustee to pay out a member’s interest, as soon as practicable, following the member’s death. Although there may be scenarios where benefits may be paid as a death benefit pension, a lump sum payment is often inevitable. This is often due to limits imposed by the transfer balance cap, as well as the restrictions on the type of beneficiary who is eligible to receive a death benefit pension.

One option available to trustees is to inject new capital into the SMSF by introducing new members. With up to six members permitted in an SMSF, new members rolling over their super benefits can increase liquidity. This allows the farm to be retained in the SMSF to pass on to the next generation.

An alternative may be to sell the farm to another SMSF where the next generation are members. Where the buying SMSF has insufficient funds, an LRBA may be used to fund the acquisition. This option is only available if the farm still meets the BRP definition, otherwise the new SMSF will not be able to acquire the farmland from a related party.

Another option available is for the trustee to transfer the property out of the superannuation system as a lump sum in-specie benefit. The timing of the lump sum is important. For example, if the member is in receipt of a pension, the transfer could be treated as a partial commutation of that pension to minimise any capital gains tax. On the other hand, if the member has passed away, the in-specie lump sum death benefit should occur as soon as practicable.

Finally, any exit strategy needs to be carefully considered alongside stamp duty and capital gains tax consequences.