Gearing down

Upon the conclusion of a limited recourse borrowing arrangement, SMSF trustees have certain options as to how the associated structure will subsequently be treated. SuperCentral superannuation special counsel Michael Hallinan details the courses of action that are available in these circumstances.

Unwinding a limited recourse borrowing arrangement (LRBA) is the process whereby the asset that is held in the holding trust under the gearing procedure is transferred to the SMSF. An LRBA can only be closed down if the borrowing has been repaid. The principal issue arising on taking the action is whether the transfer of the asset to the SMSF gives rise to the charge of a proportionate transfer duty.

What is unwinding?

Unwinding an LRBA involves repaying the borrowing under which the asset, typically real estate, was acquired and then transferring it to the SMSF.

Closing down an LRBA therefore raises issues as to whether the transfer of the property is a capital gains tax (CGT) event or a taxable supply and whether the transfer is entitled to concessional transfer duty treatment.

When an LRBA can be unwound

LRBAs can only be unwound if the borrowing used to acquire the property has been repaid. If the gearing arrangement is unwound before the borrowing has been repaid, the LRBA will not be covered by section 67A of the Superannuation Industry (Supervision) (SIS) Act 1993 as subsection (1)(b) will cease to be satisfied. Consequently, the borrowing made pursuant to the LRBA will cease to fall within an exception to section 67(1) and a breach of that section will occur.

Why unwind?

There are a number of reasons why an SMSF trustee would want to unwind an LRBA. The first is recognising the structure has served its purpose. Secondly, doing so would avoid expenses such as the Australian Securities and Investments Commission annual review fee if the holding trustee is a company. Thirdly, the action would more readily identify the property as being an asset of the SMSF.

There is also the practical issue that if the LRBA is wound up soon after the borrowing has been repaid, it is more likely the supporting documents necessary to justify the claim for concessional or no transfer duty on the transfer to the SMSF will be readily available.

Finally, and most importantly, unwinding means the property will fall within the scope of the ATO’s 2014 SMSF LRBA In-house Assets Exclusion Determination (F2014L00396).

Reasons not to unwind

There are three principal reasons not to transfer an asset to the SMSF once the LRBA liability has been satisfied. These are concerns as to eligibility for concessional transfer duty on the transfer, if the acquired property is being sold directly to a third party, or a desire not to incur the expenses of the exercise.

Firstly, the doubt over the eligibility for concessional transfer duty may arise because the LRBA was not correctly structured from a transfer duties perspective.

Secondly, transferring the asset to the SMSF may not be applicable because the property is to be sold to a third party that will in turn allow the LRBA to be extinguished. The transfer may also be unnecessary in situations where the property will be sold shortly after the gearing liability.

Thirdly, the SMSF trustees may not want to commit to the costs of unwinding. This is the least justifiable motivation and ignores the expenses associated with maintaining the LRBA structure.

Is unwinding compulsory?

Until the issue of the 2014 determination, the answer to this question was yes. Since the issue of the determination, subject to two exceptions, the answer is no.

The reasoning for the position before the issue of the determination is as follows. While the borrowing associated with the LRBA was on foot, the holding trust was not treated as a related trust and consequently the interest of the SMSF in the holding trust was not considered to be an in-house asset. This exception is provided by section 71(8) of the SIS Act. However, this exception ceases to apply once the borrowing is repaid. As such, the interest of the SMSF in the holding trust would then be an in-house asset.

However, the determination has made the position radically different. This is because if it applies to the LRBA, there is no legal compulsion to unwind the gearing structure. The determination effectively continues the operation of section 71(8) after the borrowing has been repaid.

The 2014 determination will only apply to an LRBA if, assuming the borrowing was still on foot, it would have satisfied all the requirements of section 67A.

Should the determination no longer apply to an LRBA, the SMSF interest in the holding trust will be treated as an in-house asset at the first balance date occurring after the determination is no longer valid. This means the SMSF will have to divest its interest in the holding trust

If the 2014 determination ceases to apply to an LRBA, then the SMSFs interest in the holding trust will at the first balance date occurring after the determination ceases to apply be treated as an in-house asset and the in-house asset divestment rules will be triggered and the SMSF will have to divest its interest in the holding trust.

With regard to the exceptions mentioned above, the first exception relates to LRBAs where the holding trustee was a group company of the lender. Commonwealth Bank of Australia (CBA) preferred an LRBA structure where the purchaser was the SMSF and the contract of sale had an express provision the vendor was to transfer title to a named company that was a group company within the CBA group. This arrangement was chosen to further protect the commercial interests of the lender. On the repayment of the borrowing, it was a term of the arrangement the property would be transferred to the SMSF. Where the LRBA is structured along these lines, then the property must be transferred on repayment of the borrowing due to the applicable contractual terms.

The second exception arises if the SMSF intends to undertake actions in relation to the property, for example, redevelopment or substantial renovations, which will result in the property becoming a ‘different property’ for the purposes of the replacement asset rules of SIS Act section 67B. If the redevelopment or renovation results in a different asset, then the holding trust will cease to satisfy the requirements of section 67A with the consequence that the precondition for the application of the 2014 determination will cease to be satisfied. In this situation the property must be transferred to the SMSF before the next balance date.

The unwinding process

LRBAs can be unwound in one of two ways. The first method is to transfer the property to the SMSF. The second is to sell the property to a third party and transfer the net proceeds of sale to the fund.

The first approach requires the holding trustee to transfer legal title to the property to the SMSF, while the second calls for the holding trustee, after being duly instructed by the fund, to sell the property to a third party. The sale price must be market value and the sale terms must be the normal conveyancing terms.

Reference to a third party means any purchaser other than the SMSF. The purchaser could be an unrelated individual or company or could be a member.

If the purchaser is a member of the SMSF, or an entity controlled by the member, then a sale price less than market value will be an improper transfer of value from the SMSF to the buyer and a sale price greater than market value will be an improper transfer of value from the acquirer to the fund.

Once the sale has been completed, the net sale proceeds, after payment of items such as conveyancing fees, must be paid to the SMSF. The net sale proceeds cannot be left in the holding trust as the sale proceeds are not treated as a permissible replacement asset of the property.

The holding trust will terminate once the transfer of title has been effected or the net sale proceeds paid to the SMSF as there will no longer be any trust property. While no document is needed to effect this termination, it would be prudent for trustee minutes to be prepared to record the means and relevant details as to how this was achieved. As the holding trust is a transparent trust for taxation purposes, the preparation of a final tax return is not required.

Taxation issues of unwinding

Before the enactment of Division 235 of the Income Tax Assessment Act (ITAA) 1997, pertaining to instalment trusts, the taxation issues of unwinding an LRBA were primarily concerned with whether the SMSF was absolutely entitled to the property as against the holding trustee.

However, since the enactment of Division 235 the only issue is whether the LRBA is covered by section 67A. If it is, then there are no taxation issues on unwinding. If not, there will be significant taxation issues not only upon unwinding, but also during the existence of the LRBA.

The operative provision is section 235-820 of the ITAA, which applies retrospectively from 24 September 2007. The effect of this provision is that:

a. the property is treated for income tax and CGT purposes as being owned by the SMSF,

b. any act of the holding trustee in relation to the property is treated as being an act performed by the SMSF, and

c. the cost base or reduced cost base of the property in the hands of the holding trustee is treated as being the cost base for the SMSF.

Accordingly, as long as section 67A of the SIS Act applies then:

a. if the LRBA is unwound by transfer of the property to the SMSF, the transfer itself has no CGT consequences and, in respect of any subsequent disposal of the property by the SMSF, will be subject to CGT using the cost base (or reduced cost base) which applied to the holding trustee plus any further cost base adjustments to reflect costs incurred by the SMSF since the transfer, and

b. if the LRBA is unwound by sale of the property by the holding trustee and payment of the net sale proceeds to the SMSF, the disposal of the property will be treated as a disposal by the SMSF and not by the holding trustee, the cost base (or reduced cost base) that would have applied to the holding trustee is attributed to the SMSF and any capital gain or capital loss is derived by the SMSF, not by the holding trustee, and will be assessable or exempt depending on the circumstances that apply to the fund and whether the interest of the SMSF in the holding trust was a segregated or unsegregated pension asset.

The legislation that introduced Division 235 of the ITAA did not amend the goods and services tax (GST) legislation. Consequently, LRBA arrangements must be structured so the holding trust is a bare trust. If this is the case, then for GST purposes any taxable supply will be treated as having been made by the SMSF.

Transfer duty and unwinding

In the absence of an applicable concession or exemption, the transfer of the property from the holding trustee to the SMSF would give rise to normal transfer duty. This is because the transfer is one of dutiable property from one legal entity to another legal entity.

All jurisdictions provide either a concession or exemption for transfers from the holding trustee to the SMSF. However, the preconditions for entitlement to the concession or exemption must be strictly satisfied and the onus is on the SMSF to prove these have been satisfied. In the absence of doing so, proportionate duty will apply.

As a broad statement, the concession or exemption is based upon either the ‘apparent purchaser’ or ‘custodian transfer’ concession or exemption. The relevant basis for the concession, relevant statutory provision and duty amount is set out in Table 1.

Concessional duty amounts as at 1 July 2024

Accessing the various concessions usually depends on the SMSF being a complying superannuation fund, providing documentary proof the entire purchase price of the property was met either directly or via a borrowing, documentary proof of a loan by the SMSF, documentary proof the entire loan proceeds were applied in the purchase of the property and documentary proof the duty applicable to the acquisition of the property by the holding trustee has been paid.

Documentary proof is direct evidence, such as the stamped contract of sale, proof duty has been paid in respect of the transfer to the holding trustee, and loan documents and extracts from the fund bank account evidencing the flow of money from the fund into the purchase price of the property. Most revenue authorities will accept PDFs of the various documents, particularly if a revenue authority assessment number is included.

Where there is no direct evidence or it is missing or incomplete, secondary evidence may be accepted, such as audited financial statements of the SMSF that show its interest in the property/holding trust as an asset.

In jurisdictions that have both apparent purchaser and custodian transfer exemptions, the applicable exemption will depend on the underlying structure of the LRBA, that is, whether it was structured as a custodian acquisition or as an apparent purchase.