The intricacies of holding overseas direct property

Direct property is a very popular SMSF asset class, but there are many elements requiring consideration should trustees want to own real estate located overseas, writes Jeff Song, Superannuation associate division leader at Townsends Business and Corporate Lawyers.

Armed with the general flexibility in investments and the option of using a limited recourse borrowing arrangement (LRBA), owning real estate in SMSFs has been a popular investment choice for trustees. According to the ATO’s latest statistics from June 2021, direct Australian real estate investment by SMSFs, that is, residential and commercial properties combined, represents around 15 per cent of total net assets held by all SMSFs.

Many of these funds would have benefited from the consistently performing Australian property market. In the residential sector, for example, the weighted average of the eight capital cities Residential Property Price Index rose by 16.8 per cent over the past 12 months, despite the uncertainties presented by the COVID-19 pandemic.

In light of this type of performance, we recently have had an increase in the number of inquiries from SMSF trustees on overseas property investment. In a nutshell, it is not prohibited by the Superannuation

Industry (Supervision) (SIS) Act 1993, but perhaps due to the intrinsic risks and complexities, it has been reserved for a relatively small number of SMSFs. The ATO quarterly statistics from June 2021 note about 0.1 per cent of total SMSF assets are invested in overseas properties, both commercial and residential. Nevertheless, seasoned property investors may consider it appropriate for their SMSFs in the name of diversification and perhaps more lucrative potential returns. In this article, we discuss a number of points SMSF trustees should consider when contemplating overseas property investment.

SMSF investment rules

The applicable provisions under the SIS Act are, of course, the same regardless of the property’s geographical location, however, the foreign laws applying to the property may hinder the trustee’s compliance with the requirements.

As with any other SMSF investment, trustees have to check the fund’s trust deed to confirm they have all the necessary authorities to invest in overseas property. Many deeds would permit any form of investment irrespective of the geographic location of the investment, but if required, the trust deed can be amended subject to the amendment rules provided in the current deed.

The proposed overseas investment should be consistent with the SMSF’s current investment strategy, which has regard to the whole circumstances of the fund, including, but not limited to, the risk and return of fund assets and the required cash flow of the fund. When considering the risk and return of overseas property investment, consideration needs to be given to additional risks associated with fluctuations in exchange rates as any rental profit or realised capital gains will eventually need to be converted to Australian dollars. Also, properties are generally illiquid and could be even more so depending on their geographical location. The local conditions should be checked to assess how illiquid the investment would likely be, together with the anticipated cash-flow requirements of the fund.

The overseas property investment must also be for the sole purpose of providing retirement benefits for fund members. Generally, this test is passed if it is a genuine investment to produce income and/or capital appreciation in order to provide benefits to members after their retirement, or to members’ dependants after their death, so long as there are no other purposes.

So if the trustees are excited about an attached right to use community facilities, such as a golf club, which they plan to use during their vacation, discuss with them the sole purpose test and whether the investment is appropriate to be held in their SMSF. Also, members in or nearing retirement phase should expect higher scrutiny from the auditor and the ATO on this issue if the investment will likely hinder commencement of a pension due to lack of cash flow or require commutation of any pension. In a different context of property development, an example of a possible contravention provided by the ATO in its SMSF Regulator’s Bulletin SMSFRB 2020/1 was where “the SMSF trustee decides to cease paying its members a pension so that the SMSF could use its cash reserves to make an additional contribution to a struggling property development venture”.

Potential limitations on available ownership structure and SIS compliance implications

As a mandatory covenant, SMSF trustees are required to keep the fund assets separate from any personal asset. This generally requires all trustees, or the corporate trustee, to be registered as the owners of the asset in their capacity as the fund trustees and where the ownership registry doesn’t recognise any trustee capacity, a deed of acknowledgement of title should be in place to formally document that the asset is held by the trustees as an asset of the fund.

With overseas property investment, the relevant local conveyancing and property laws must be checked with local lawyers to see if foreign individuals or a foreign company can be registered as the owner and if not, check available options for property ownership by foreign trusts. Trustees then should seek separate advice from an Australian superannuation lawyer to discuss and select an appropriate ownership structure from a SIS compliance perspective.

If permitted by the local laws, having the corporate trustee, an Australian Pty Ltd company, as the owner of the property would be the simplest option. The official evidence of the property ownership in that country and a formal valuation can be provided for annual audit purposes. The SMSF is a unique structure to Australia and it is likely the foreign property registry system would not properly recognise and show on title the owner’s capacity as trustee of the SMSF. In this case, a deed of acknowledgement of title can be signed by the trustee to clarify that the property is an asset of the fund. Care needs to be taken to ensure that such a deed doesn’t inadvertently constitute a resettlement or a declaration of a new trust.

Individual trustees as the owners

If the relevant local laws do not permit a foreign company to own land in their jurisdiction, but permit foreign individuals to do so, one option is to change the fund’s trustee to its members and then acquire the property in the name of the individual trustees. This is generally not recommended though and should be one of the last resorts to consider, given the normal downsides with having individual trustees for a fund and further the potential difficulties and uncertainties when dealing with the foreign registries and tax offices in case of an unforeseen need for a change in ownership due to a necessary change in trustee, such as the death of a member. Trustees must not assume the foreign jurisdiction recognises and provides tax/duty exemptions or concessions for transactions arising due to a change in trustees of a trust, and advice from an appropriate local expert, such as a property/tax lawyer, must be sought to consider this aspect.

Setting up a local entity

At times, setting up a local entity, that is, a company established in that jurisdiction, may be necessary so that the company holds the property as an intermediary vehicle. The structure may also serve another purpose in allowing pooling of funds from one or more other parties as shareholders or co-investors. The SMSF’s investment is then in the local entity as a shareholder and if that company is deemed related to the fund, the investment would be subject to the in-house asset rules with limitation on its value capped at a maximum 5 per cent of the total value of the fund.

The local entity will be deemed a related party if the members, together with any of their related parties, either hold a majority of shares in the company or control the decisions of the company’s board of directors either by being appointed as a majority of its directors or controlling decisions of the majority of directors otherwise.

The 5 per cent limit can be overcome if the company is set up as a 13.22C, or ungeared, entity under the SIS Regulations, subject to the normal restrictions outlined by regulations 13.22C and 13.22D. Using this structure, the SMSF may hold more than a 50 per cent share, or even 100 per cent, in the company without the application of the 5 per cent in-house asset limit, but significant restrictions will apply to what the company can and can’t do. This will effectively rule out any other investment activities by the company, such as acquiring listed shares, lending, borrowing, giving a charge over any company asset or developing the property.

As an illustration of how easily the in-house protection under SIS regulation 13.22C can be lost irreversibly, an act of opening a foreign bank account in the name of the company and making a small deposit could trigger the loss of the protection unless the foreign bank is an authorised deposittaking institution under Australia’s Banking Act 1959. Check local requirements to see

if it is possible to just open and maintain a foreign currency account with an Australian bank for the purpose of receiving rents and paying expenses. If opening a bank account with a foreign bank is necessary, ensure you choose a bank that has an authority granted by the Australian Prudential Regulation Authority to carry on a banking business in Australia.

Bare trustee of an LRBA

Another exception to the in-house asset rules is available for a bare or holding trust used in connection with a complying LRBA. There is no prohibition under the SIS Act on having a foreign entity acting as holding trustee of an LRBA. The problem, however, is that there aren’t many commercial financial institutions in Australia that would lend to an SMSF on limited recourse terms for the purchase of an overseas property. If a foreign bank is willing to do so, it is unlikely its terms will fully appreciate and appropriately limit the recourse to the single acquirable asset. Given the scarcity of commercial loans to benchmark against, a related-party LRBA loan may be at risk of being in breach of the arm’s-length provisions under section 109 of the SIS Act, as well as the risk of a penalty tax rate applying to any ordinary or statutory income from the investment under the non-arm’s-length income (NALI) provisions of the Income Tax Assessment Act 1997.

Using an LRBA therefore will pose further compliance risks unless the trustee can find a commercial lender that will approve a loan for the purchase on limited recourse terms that fully complies with the LRBA provisions of the SIS Act (whether the trustee actually borrows from the lender or uses the institution’s parameters to benchmark their terms when using a related-party loan).

Taxpayer in a foreign country

By owning an overseas asset, the trustee, or the local entity set up to hold the property, may become subject to a whole myriad of foreign laws. Just like we have conveyancing, leasing, duties, land tax, income tax and local government laws in Australia, the foreign country will likely have its version of different rules applying to property ownership. So the important issues to be discussed with a tax specialist with the necessary expertise in the area include the details of:

• any tax reporting obligations to the foreign tax office,

• any tax liability in that country to be borne by the SMSF as the investor, and

• any applicable double tax treaty between Australia and the relevant country to take into account the tax the SMSF will pay in Australia on the income, that is, the 15 per cent concessional tax payable by SMSFs, to avoid any double tax on the income.

SUMMARY

Exposure to overseas markets could be an important strategy for a fund to diversify investments and safeguard the retirement savings from potential volatility in the local investment markets. There is much to consider with any overseas investment, but directly owning an overseas property in an SMSF adds a whole layer of complexity and it’s important to ensure trustees seek the necessary advice early from both Australian advisers and those in the foreign jurisdiction to check if the proposed investment can satisfy the compliance requirements, what it will entail in terms of costs and taxes, and, last but not the least, whether it’s still commercially viable.