The Tax Office has clarified its stance on limited recourse borrowing arrangements, and Peter Burgess explains the implications.

On September 14, 2011, the Australian Taxation Of­fice (ATO) released Draft Self Managed Super­annuation Funds Ruling SMSFR 2011/D1 (the draft ruling). The draft ruling explains key concepts relevant to limited recourse borrowing arrangements (LRBAs) put in place on or after July 7, 2010.  Importantly, the draft ruling clarifies the ATO’s previous preliminary view on asset improvements, which appeared to impose severe restrictions on asset improvements under an LRBA, irrespective of the source of the funds used to finance the improvement.  The ATO’s previous view was supported by the Explana­tory Memorandum (EM) to the Superannuation Industry (Supervision) Amendment Bill 2010, which says the replacement of an asset by way of improvement of real property is not an allowable replacement asset for the purposes of sub-section 67B of the Superannuation Industry (Supervision) Act 1993 (the Act).

The EM also states that a replacement asset arising from an insurance claim covering the loss of the original asset is not an allowable replacement asset for the purposes of section 67B of the Act.  The inability to improve an asset acquired under an LRBA, or to rebuild the asset in the event the asset is destroyed by fire, flood, cyclone or similar, imposed severe limitations on the use of LRBAs by SMSF trustees. Fortunately, in the draft ruling the ATO takes a different approach which arguably is still consist­ent with the EM and the policy objectives of the Superannuation Industry (Supervision) Amendment Bill 2010. Paragraph 30 of the draft rulings says: “Although borrowings under an LRBA cannot be used to improve a single acquirable asset that is the subject of the LRBA, money from other sources could be used to improve (or repair or maintain) that asset. However, any improvement must not result in the acquirable asset becoming a different asset.”

Essentially, this paragraph says that borrowed funds under the LRBA must not be used to finance an improvement to an asset acquired under an LRBA, but funds from other sources can be used to improve the asset, as long as the improvement does not change the asset to such an extent that it becomes a different asset. The definition of a single acquirable asset in sub-paragraph 67A(1)(a)(i) of the Act requires that the borrowed funds under an LRBA be applied for the acquisition of a single acquirable asset and can include expenses incurred in connection with the borrowing or acquisition but not expenses incurred in improv­ing the acquirable asset. Therefore, in the context of an LRBA, an improvement which is financed by a borrowing under the LRBA will result in the acquirable asset breaching the definition of a single acquir­able asset. This will be the case even though the improvement may not result in the acquirable asset becoming a different asset.

Given that borrowed funds can be used to repair or maintain but not improve an acquirable asset, the distinction between a repair or maintenance and an improvement is ex­tremely important if the repair or maintenance is being financed by borrowed funds under the LRBA.  In a previous ATO ruling (TR 97/23), the ATO defined an improvement as a change to the asset that provides a greater ef­ficiency of function. This usually involves changing the asset in a way that increases the value or desirable form, state or condition of the asset more than a mere repair would do. In other words, an improvement involves the addition of new and substan­tial features or rights to an acquirable asset that substantially increase the asset’s value or functional efficiency. In contrast, a repair replaces or corrects something that is already there and has been damaged, is worn out or has deteriorated over the passage of time.  The ruling provides an example of an SMSF that purchases a three-bedroom residential property under an LRBA. After the acquisition, the SMSF renovates the property by adding a bathroom using borrowings under the LRBA. As the addition of the bathroom has increased the value of the property and its functional efficiency, the renovation is considered to be an improvement. As the money borrowed under the LRBA has been applied to improve the asset, the SMSF is in breach of sub-paragraph 67A(1)(a)(i) of the Act.

The draft ruling also states that: “Minor or trifling increases in functional efficiency or value as compared with the acquirable asset as a whole will not amount to an improvement.”  This suggests that the ATO has no intention of being overly pedantic when it comes to assessing whether or not something is a repair or an improvement in the context of an LRBA. This is a practical approach, and assuming this view prevails in the final ruling, it presumably provides SMSF trustees with some “wriggle room” in situations where a repair has been undertaken using slightly different material to the material used in the origi­nal construction of the property. In an LRBA context, the distinction between a repair and an improvement is only relevant if the repair is being financed by a borrowing under the LRBA. This distinction is not important if the repair is being financed by the SMSF directly or by some other source. All that matters in these situations is that the change to the acquirable asset does not fundamentally change the character of the asset such that it becomes a different asset. This requires an assessment of the extent of the improve­ments to determine whether or not the improvements have fundamentally changed the character of the asset such that it becomes a different asset.