Peter Burgess compares limited-recourse borrowing with related unit trusts to see how the options stack up.
With the introduction of the limited recourse borrowing rules, the trustees of self-managed superannuation funds (SMSFs) now have a wider choice of investment options. The ability of an SMSF to acquire an interest in an asset, even though it may not have the necessary capital to purchase the asset, is not a new phenomenon. In limited situations, SMSFs have for many years been able to invest in structures which utilise borrowed funds, either directly or indirectly, to acquire an asset.
In this article we discuss the use of a Division 13.3A unit trust, and briefly outline the main advantages and disadvantages of this approach versus a limited recourse borrowing arrangement.
What is a Division 13.3A unit trust?
A Division 13.3A unit trust is a related unit trust which satisfies the requirements of regulations 13.22C or 13.22B of the Superannuation Industry (Supervision) Regulations 1994 (SIS Regulations). Units acquired by an SMSF on or after June 28, 2000 in a related unit trust which complies with regulation 13.22C are excluded from the definition of an in-house asset in section 71(1) of the Superannuation Industry (Supervision) Act 1993 (SIS Act). This exclusion applies despite the unit trust being a related trust of the fund. The same exclusion applies to units acquired by an SMSF before June 28, 2000 in a unit trust which complies with the requirements of SIS Regulation 13.22B.
Furthermore, the general prohibition on SMSFs acquiring assets from a related party of the fund does not apply if the asset being acquired is a unit in a trust which complies with Division 13.3A. Therefore, as long as the related unit trust continuously satisfies the requirements of Division 13.3A, an SMSF can jointly invest in that trust with a member or another related party. Over time the units owned by the related entity can be acquired by the fund without contravening the in-house asset rules or the general prohibition on acquiring related party assets.
These arrangements can be useful in situations where funds may wish to purchase real property, but do not have sufficient capital to purchase the property themselves. Using a unit trust in these circumstances enables the property to be purchased by pooling the capital provided by other unit-holders with the capital provided by the fund.
‘The benefits of gearing are often reduced under a Division 13.3A unit trust’
Although Division 13.3A does not allow the related trust to borrow, the provisions of Division 13.3A do not preclude an investor in the trust using borrowed funds to acquire his or her units. Thus it is common under these arrangements for members to finance the purchase of their units in the related unit trust by using borrowed funds secured against one or more of their personal assets.
Superannuation contributions received by the fund enable the fund to acquire the units owned by members and other related parties over time. In turn, this enables such entities to retire any debt which may have been put in place when the units where originally purchased.
What conditions need to be satisfied?
In addition to the requirement that the related unit trust must not have outstanding borrowings, there are also a number of other conditions in Division 13.3A which the related unit trust must satisfy. For example, the assets of the unit trust must not include:
– an interest in another entity or an asset which has been acquired from or is being leased to a related party of the fund (unless the asset concerned is business real property); or
– an asset which is subject to a charge.
The unit trust must also not conduct a business or lend money to another entity unless the loan is a deposit with an authorised deposit-taking institution.
If the related unit trust fails to satisfy the requirements of Division 13.3A, the units held by the SMSF in that trust will be classified as an in-house asset. Similarly, if the related trust fails to satisfy the requirements of Division 13.3A any time after the original units had been excluded as an in-house asset under Division 13.3A, that related unit trust will never again satisfy the requirements of Division 13.3A. This would be the case even after the breach or event, which caused the related unit trust to fail the requirements of Division 13.3A, had been rectified.
How does it compare to a limited recourse borrowing arrangement?
If the asset being acquired is real property, a Division 13.3A unit trust is likely to be a more flexible structure compared to a limited recourse borrowing arrangement. Unlike a limited recourse borrowing arrangement put in place on or after July 7, 2010, a property acquired via a Division 13.3A unit trust is not restricted to a single title property or properties which otherwise satisfy the definition of a single acquirable asset. Similarly, unlike properties purchased under a limited recourse borrowing arrangement, there are no restrictions on improving or replacing the asset acquired via a Division 13.3A unit trust as long as the trust continues to satisfy the requirements of Division 13.3A.
There is also no requirement for finance to be provided on a limited recourse basis. If external finance is required by a related party to purchase their share of the units in the unit trust, it would normally be done by using borrowed funds secured against one or more of their personal assets. Therefore, the cost of external finance would arguably be lower compared to a limited recourse borrowing arrangement.
However, compared to a limited recourse borrowing arrangement where the fund typically has sole rights to the property’s capital gains and income, the fund may not have the same rights to income and capital gains under a Division 13.3A unit trust. Therefore, the investment benefits of gearing are often reduced under a Division 13.3A unit trust.
A Division 13.3A unit trust is not able to be used if the asset being acquired is an interest in another entity – for example, shares in a company or units in a unit trust. This therefore excludes a Division 13.3A unit trust from being used to acquire shares or managed funds. The Capital Gains Tax (CGT) implications of acquiring units over time also need to be considered along with the need to ensure the unit trust strictly complies with the conditions set out in Division 13.3A. As mentioned, if the unit trust fails these conditions the trust will never again be considered a Division 13.3A unit trust and the trust may need to be unwound, resulting in significant CGT, stamp duty and other costs.
Can a pre-’99 unit trust be converted to a Division 13.3A unit trust?
The effect of sub-regulation 13.22D(1) is that, where regulation 13.22B or 13.22C applies to units held by a superannuation fund and one of the events listed occurs, those units will no longer be excluded from the in-house assets of the fund under these regulations. It is the ATO’s view that sub-regulation 13.22D(1) is only concerned with events which happen after the commencement of the regulations on June 28, 2000 (Minutes of the NTLG Superannuation Technical Sub-Group meeting held on June 15, 2010).
Therefore, provided no event for the purposes of sub-regulation 13.22D(1) of the SIS Regulations has occurred since June 28, 2000, and the trust now complies with the requirements of SIS Regulation 13.22C, the fund is permitted to purchase new units in that trust without those units being classified as an in-house asset.
Using borrowed funds to acquire units in a Division 13.3A unit trust
Section 67A of the SIS Act requires that the borrowed monies are used to acquire a single asset which the SMSF is not otherwise prohibited from acquiring. As an SMSF is permitted to acquire units in a related unit trust which complies with Division 13.3A, borrowed funds under a limited recourse borrowing arrangement can be used to acquire units in a Division 13.3A unit trust.
In fact, the underlying property which is owned by the Division 13.3A unit trust is not restricted or limited by the conditions imposed under section 67A and 67B of the SIS Act. In other words the property owned by the Division 13.3A unit trust is not limited to a single title asset and can be improved or replaced as long as the unit trust continues to satisfy the requirements of Division 13.3A.
Using the borrowed funds in this way can be an effective strategy as it combines the flexibility of a Division 13.3A unit trust with the gearing benefits of a limited recourse borrowing arrangement. However, this strategy would be limited to the acquisition of real property; and if external finance is required it would be difficult for commercial lenders to accept the units in the Division 13.3A unit trust as security for the loan.
This could potentially be overcome if a related party is able to obtain the finance themselves and then on-lend the proceeds to the SMSF on a limited recourse basis. In ATO Interpretative Decision 2010/162, the ATO states that an SMSF is permitted to borrow funds from a related party of the SMSF under a limited recourse borrowing arrangement on terms more favourable to the SMSF.
However, what this Interpretative Decision didn’t say is that the transaction must demonstrate the characteristics of a loan and the documentation must clearly reflect that the trustee of an SMSF has made a genuine borrowing to acquire an asset.
Peter Burgess is the national technical director of the Self-Managed Super Fund Professionals’ Association of Australia (SPAA).
