Damage to properties in recent floods and cyclones has prompted a rethink on the rules around improving assets. Peter Burgess explains.

Recently the Commissioner of Taxation announced that the Australian Taxation Office (ATO) will use its discretion in certain situations to overlook breaches of the limited recourse borrowing rules. Specifically the Commissioner said that the ATO would be “favourably inclined” to treat a self-managed superannuation fund (SMSF), which owns flood- or cyclone-damaged buildings, as a complying fund, even if the building repairs would normally constitute an improvement under the Tax Act. This concession potentially applies Australia-wide to SMSFs that own properties damaged by a natural disaster.

While this may be welcome relief for some individuals who have suffered hardship as a result of the recent floods and cyclones, it also illustrates the practical limitations of the replacement asset rules for SMSFs that acquire properties under a limited recourse borrowing arrangement on or after July 7, 2010. Indeed the very fact that the Commissioner’s discretion may be needed in these situations is an indication that the ATO is already facing practical difficulties with the application of the replacement asset rules.

The Explanatory Memorandum (EM) to the Superannuation Industry (Supervision) Amendment Act 2010, which inserted new sections 67A and 67B, says that sub-paragraph 67A(1)(a)(i) was inserted to:

“…clarify that money under a limited recourse borrowing arrangement applied for the acquisition of an asset can be used for expenses incurred in maintaining or repairing the asset, to ensure that its functional value is not diminished, but not to improve the asset, as this would fundamentally change the nature of the asset used as security by the lender, potentially increasing the risk to the fund.”

In the context of a limited recourse borrowing arrangement, it is difficult to understand why repairs and improvements are treated differently. Regardless of whether a particular outlay repairs an asset or improves an asset, the money spent is subjected to the risks arising from any future default on the loan.

‘It is difficult to understand why repairs and improvements are treated differently’

Nevertheless, the ATO says that the law clearly states that you cannot use borrowed funds to make improvements to a property. At the National Tax Liaison Group meeting held on September 7, 2010 the ATO stated: “An improvement may change the state or nature of the asset such that it will give rise to a different asset to the single acquirable asset that was the subject of the arrangement. This would be the outcome regardless of the source of the funds used to improve the asset. As the rights of the lender under the arrangement must be limited to rights relating to the single acquirable asset, or a replacement asset (as defined in section 67B), no money can be used to improve the asset if the improvement results in a different asset.”

The ATO’s interpretation of section 67B has important implications for trustees wanting to use the available cash in their SMSF to finance the improvement of an asset acquired under a limited recourse borrowing arrangement. In the ATO’s view, if the arrangement was put in place on or after July 7, 2010, the acquired asset is not permitted to be improved, even if the improvement is financed by the fund itself.

Repair versus improvement

In many cases, trustees and practitioners may experience practical difficulty in deciding whether particular expenditure would constitute a repair or an improvement. In many instances, it may be obvious that the expenditure has improved the physical appearance or income-producing potential of the property. In other instances, it may require the careful weighing up of the various factors and exercising judgement based on commercial experience to determine whether or not the property has been improved. Given the importance of this distinction in the context of the limited recourse borrowing rules, it will be critical that trustees and practitioners exercise caution when exercising this judgement.

Tax Ruling TR 97/23 provides some practical guidance on how the ATO distinguishes between a repair and improvement for income tax deductibility. While this ruling addresses the tax deductibility of expenditure incurred by a taxpayer for repairs, it nevertheless provides useful guidance on the ATO’s likely approach to the distinction between a repair and an improvement in a limited recourse borrowing arrangement.

The ruling refers to a “repair” as work which makes good or remedies defects in, damage to or deterioration of the property. For example: • Replacing part of the guttering or windows damaged in a storm; • Replacing part of a fence damaged by a falling tree branch’; • Replacing electrical appliances or machinery; • Replacing permanent fixtures, such as locks and exhaust fans et cetera. An “improvement”, on the other hand, provides a greater efficiency of function in the property and involves bringing the property into a more valuable or desirable form, state or condition than a mere repair would do. In other words, work would be considered to be an improvement if the work extends the property’s income-producing ability, significantly enhances its salability or market value, or it extends the property’s expected life.

A repair involves restoring the item by the replacement or renewal of a damaged or worn-out part, but not the reconstruction of the entire item. An item is more likely to be considered an “entire item” if it can be separately identified as a principal item of capital equipment. For example, replacing a separately identifiable principal item of capital equipment – such as replacing a complete fence or building or replacing items such as free-standing stoves, refrigerators and furniture in premises used for income-producing purposes – would ordinarily constitute a capital improvement.  In contrast, replacing a window in a factory, or a roof or wall may not be a capital improvement because these items are an integral or inseparable part of the property.