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Self Managed Super Funds Draft Ruling: Changes to the Limited Recourse Borrowing Arrangement

The Australia Taxation Office (ATO) has recently released a draft ruling changing the application of the limited recourse borrowing arrangement (LRBA) provisions to self managed superannuation funds (SMSFs). 
The LRBA provisions (the provisions) permit a SMSF trustee to borrow money for the acquisition of a ‘single acquirable asset’ including borrowing for the maintenance or repair of that acquirable asset, but not for improving the asset.  Under the provisions an acquirable asset is any form of property, other than money, that the trustee is not otherwise prohibited from acquiring . 
For the asset to be a ‘single acquirable asset’ it must be identifiable physically and legally as a single asset, such that if assets can be dealt with separately this will mean that they are more than one asset for the purposes of the provisions. 
The following examples are given to provide guidance as to what is meant by a ‘single acquirable asset’:

	Acquirable asset	Whether it is a ‘single acquirable asset’
1	Two adjacent blocks of land.  The vendor will only sell the two blocks together, however, there are no physical or legal impediments to the two blocks of land being sold separately.	The two blocks of land are not a single acquirable asset and cannot be acquired under one LRBA.  However, each block could be acquired under a separate LRBA.
2	A factory complex on more than one title.  A trustee wants to acquire a factory under an LRBA.  The factory covers three separate titles.	The factory is a single acquirable asset and can be acquired under one LRBA.
3	Farmland with multiple titles.  A trustee wants to acquire a farm under an LRBA.  The farm comprises of two separate titles although has been conducted as a single primary production business.	As there is no physical or legal impediment to the land represented by separate titles from being dealt with separately, e.g. if one of the titles is sold leaving the farming business to be conducted on the remaining title, the farm is not a single acquirable asset and cannot be acquired under one LRBA. However, if the farming business consisted a piggery conducted in a large shed constructed over both titles, then it would be a single acquirable asset.
4	Apartment with separate car park.  A trustee wants to acquire an apartment with a separate car park under an LRBA, and the apartment and car park are on separate titles, however, the laws of the State do not allow the two titles to be sold separately.	As the two titles cannot be dealt with separately, the apartment and car park is a single acquirable asset.

As stated above the money borrowed under the LRBA may be applied in acquiring the asset but also in carrying out repairs and maintenance to the asset at the time of the acquisition or at a later date.  The provisions make it clear that a trustee cannot borrow money to improve the single acquirable asset. 
Significantly, the draft ruling has clarified the distinction between when an asset is repaired or maintained as against when it is improved for the purposes of the provisions.  Determining if an acquirable asset has been repaired or maintained or if it has been improved, is a question of fact and degree in each case having regard to the appearance, form, state and condition of the asset at the time when the asset is acquired under the LRBA, taking into account the following considerations:

• Whether the acquirable asset’s functional efficiency is substantially increased resulting in an improvement to the asset; and
• Whether the acquirable asset’s value is substantially increased resulting in an improvement to the asset.

Minor or trifling increases in functional efficiency or value will not amount to an improvement. 
The following examples are given to provide guidance as to when something is a repair or maintenance as compared with when something is an improvement:

	Repair or maintenance example	Improvement example
1	A fire damages a part of the kitchen.  Restoration of the damaged part of the kitchen would constitute repair of that part of the asset and not improvement of the asset as a whole.	If the kitchen was also extended this would be an improvement.
2	The house is repainted, the guttering is replaced, a fence is replaced, and a fire alarm is installed to comply with new council requirements.  These would constitute repairs or maintenance.	The addition of a second storey to the house would be an improvement.
3	Replacing a section of cattle yards of a farm, ensuring the bores, windmills, tanks and troughs continue working, laying new pipes between the tank and trough, and repairing fencing would constitute repairs of maintenance.	Each of the following would be an improvement: New cattle yards; A new bore, tank, windmill and trough; A dam made; Further fencing.
4	Replacing broken windows in the house is a repair.	A substantial renovation of a rundown house would be an improvement.

Perhaps most importantly, In addition to providing clarity on repairs versus improvements, the ATO has changed its position on using money other than borrowings to improve an asset.  Previously a SMSF trustee could not use money from any source to improve an asset.  Under the draft ruling, although borrowings under an LRBA cannot be used to improve a single acquirable asset, money from inside the SMSF can be used to improve that asset provided the improvement/s do not result in the character of the asset from being altered such that it becomes a fundamentally different asset.
Whether an improvement to a single acquirable asset results in a fundamentally different asset is a question of fact and degree on the facts of each case having regard to the legal and physical characteristics of the single acquirable asset at the time when the asset is acquired under the LRBA, taking into account the following considerations:

• Whether the acquirable asset has been entirely replaced by another asset – the replacement asset would be fundamentally different asset ;
• Whether the acquirable asset has been altered to such an extent that it now has a different function or purpose – the altered asset would be a fundamentally different asset;
• Whether the proprietary rights have changed – this would result in a fundamentally different asset; and
• Whether the single acquirable asset has been altered so that it is no longer a single acquirable asset, e.g. if part of the asset can be sold off separately – this would result in a fundamentally different asset. 

The following examples are given as to when an improvement to a single acquirable asset results in a fundamentally different asset having regard to the physical object and the proprietary rights comprising the asset:

	Single acquirable asset	Whether it is a different asset(s)
1	Vacant block of land on single title	Subdividing a vacant block into multiple titles would fundamentally change the character of the asset.
2	Vacant block of land on single title	Building a house on a vacant block would fundamentally change the character of the asset.
3	A house and land	Demolishing the house and replacing it with three strata titled units would fundamentally change the character of the asset and create three different assets.
4	A house and land	Rezoning the land and renovating the house as commercial premises would fundamentally change the character of the asset.
5	A house and land	The single acquirable asset is a house built over two titles.  If the house is relocated so that it stands on only one of the titles, this would fundamentally change the character of the asset as there are now two separate assets, the block of land with the house on it, and the vacant block, able to be dealt with separately.
6	A four bedroom house and land	If a fire, flood, cyclone or other natural disaster destroys the house and a similar house is constructed using insurance proceeds, the rebuilding of the house would not fundamentally change the character of the asset as the asset is merely restored to what it was at the time of entering into the LRBA.
7	A hayshed and land	If a fire, flood, cyclone or other natural disaster destroys the hayshed and a house is constructed, this would fundamentally change the character of the asset as the asset is now residential premises serving a different function and purpose to that previously served by the land and hayshed.

 

Finally, the draft ruling is subject to a period of industry consultation and public comment.  When the final ruling is issued, it is proposed to apply to arrangements entered into on or after 7 July 2010.  The ruling (whether draft or final) is not legally binding on the Commissioner – it represents the Commissioner’s view about the way in which the provisions apply to self managed superannuation funds.  However, the fact that you acted in accordance with the final version of the ruling would be a factor in your favor in determining what action will be taken in response to a breach. 

Please conact Jessica Kinnear should you have any queries in relation to this article.