There has been recent press publicity regarding SMSF members transferring life estate interests in business real property (‘BRP’) by way of an in kind or ‘in specie’ contributions to self managed superannuation funds (‘SMSF’).
This article briefly examines some of the key points relating to these transactions and provides an update on my latest experience with the ATO on this topic.
Background to life estate interest transfers of BRP
Most transfers of real estate effect a transfer of the ‘fee simple’ estate. However, a transfer of a life estate interest, on the other hand, entitles the life tenant to possession of the property together with any income from that property throughout the period of the life tenancy. Professor Butt in Land Law, 4th edition, Lawbook Co, Sydney stated:
A legal life tenant (that is, a tenant for life of a legal estate) is entitled to possession of the property, since the right to possession follows the legal estate.
It is important to note that the life tenant is only entitled to the possession and income from the property throughout the life of the person’s life (ie, the life in being, who is the person who’s life expectancy is relied on to determine the life estate interest).
Note that a life estate interest can only be acquired from a member or related party of the property qualifies as BRP as an interest in residential property cannot be acquired from a member or related party under s 66 of the Superannuation Industry (Supervision) Act 1993 (Cth) (‘SISA’).
Example of a life estate interest
For example, a 65 year old male is expected to live around 19 years and has a life tenant factor of 0.57393 (as confirmed in SDA011 by the Australian Government Actuary, on behalf of RevenueSA, based on the Australian Life Tables 2010-12 using a discount rate of 5% per annum). If the property is valued at $1,000,000, such a life estate interest would be valued at $573,930 using the Australian Government Actuary factors (which factors the ATO have recommended be used in valuing life estate interests). The value of a life estate interest is therefore significantly less than the value of the full ‘fee simple’ ownership.
This has important implications for those seeking to transfer BRP to an SMSF as most do not wish to pay significant upfront capital gains tax (‘CGT’), goods and services tax (‘GST’) and stamp duty costs on transferring property to an SMSF. If significant upfront tax is payable, this strategy may not be a viable proposition.
However, some may be inclined to ‘suffer’ or accept tax imposts on a significantly lower amount and thus here is where the transfer of a life estate interest in BRP to an SMSF may initially appear more attractive than transferring a ‘fee simple’ estate.
Are there any tax concessions applicable?
In some cases, however, certain tax concessions may be available. For instance:
- Some CGT relief may be available under the CGT small business concessions in div 152 of the Income Tax Assessment Act 1997 (Cth) (‘ITAA 1997’). Typically, such relief is only available where BRP is used in the taxpayer’s business or in an affiliate’s business or in a business conducted by an entity connected with the taxpayer. (Note that an asset whose main use by the taxpayer is to derive rent will generally not otherwise qualify as an active asset under s 152-40(4)(e).)
- GST relief may also be available under the going concern exemption in s 38-325 of the A New Tax System (Goods and Services Tax) Act 1999 (Cth) if a commercial lease is in place in respect of the BRP and having regard to GSTR 2002/5.
- In some jurisdictions such as Victoria, New South Wales and Western Australia, there may be duty relief in respect of the transfer of an interest in BRP to an SMSF by a member provided the criteria in the applicable duty legislation are satisfied.
Typical tax treatment on the creation of a life estate interest
The ATO have outlined the tax treatment of life interests in detail in its ruling TR 2006/14. The following briefly summarises the tax analysis to the grantor of a life estate interest from this ruling.
Broadly, if the asset was acquired prior to the introduction of CGT on or before 7.30pm on 19 September 1985 there would be no CGT liability to the grantor on the grant of a life estate interest to a grantee (life tenant).
Broadly, if the asset was acquired after the introduction of CGT, then a CGT event will arise in respect of the partial disposal of the life estate interest by the grantor upon the grant of a life estate interest.
Grantee’s tax treatment
On the other hand, the grantee would broadly acquire a post-CGT life estate interest in the property and have a deemed market value cost base. Thus, a subsequent sale, surrender or release of that life interest prior to the expiration of the period to which that life estate interest is based would give rise to a CGT event resulting in a capital gain or capital loss at that time.
Is there any gain or loss on revenue account?
Naturally, careful consideration should also be given before granting a life estate interest if the property is held on revenue account as any gain would still be assessable and any loss potentially deductible. For example, a gain on the disposal of a partial interest on property that was acquired with the intent to resale at a profit or where the property constituted trading stock would be on revenue account. Thus, any gain on the grant of a life estate interest would be assessable as ordinary income even if CGT relief under div 152 applied.
Tax treatment is critical to determine whether the grant of a life estate interest is viable
As you may appreciate from the above, in addition to satisfying all the usual superannuation rules under the SISA, those contemplating this strategy should ensure the tax considerations do not render it unviable.
ATO scrutiny and private binding rulings
From my recent communications with the ATO, the ATO’s current view is that this type of strategy may not be effective and the ATO is seeking to closely scrutinise these transactions from both a regulatory and tax perspective. This view is despite a number of positive private binding rulings (‘PBR’) regarding these transactions having previously been issued. In particular, I understand that the ATO is examining whether one or more anti-avoidance provisions will be applied and the ATO are likely to encourage applications to seek ATO input on the anti-avoidance provisions.
Thus extreme care is needed to ensure that each and every regulatory and tax provision is satisfied and appropriate evidence is retained. The grounds for any tax saving should also be appropriately addressed as the ATO may seek to apply the non-arm’s length income provision in s 295-550 of the ITAA 1997 and/or the general anti-avoidance provision in Part IVA of the Income Tax Assessment Act 1936 (Cth).
Those contemplating this strategy should therefore carefully consider whether they should seek a PBR on the tax issues including the potential application of the anti-avoidance provisions. Taxpayers that proceed without a favourable ruling are subject to the risk of the ATO scrutinising the transaction and making adjustments.
It is interesting to note that no mention of seeking ATO input was made in the recent press publicity regarding this strategy. In the event a particular adviser does not anticipate any ATO risk, clients should seek written confirmation from the adviser in this regard and in any event seek independent expert tax advice.
Should SMSF specific advice from the ATO also be sought?
As discussed above, the ATO will also examine whether the SISA provisions have been satisfied (including the sole purpose test, the arm’s length test and the provision of financial assistance to a member or relative). Thus, expert legal advice and/or SMSF specific advice from the ATO should also be considered in respect to satisfying the SISA provisions.
There are a range of other considerations that need to be carefully considered including:
- If the ‘life in being’ dies tomorrow or in the next few years (ie, every individual may die prior to their life expectancy), the life estate interest expires and full ownership in the property reverts to the grantor of the life estate interest. Thus, SMSF trustees should carefully consider their investment strategy and ensure the SMSF deed authorises this type of investment especially if the trustee would not otherwise consider purchasing a life estate interest from a third party.
- There are estate planning considerations that need to be considered as once the life estate interest expires the property reverts to the grantor and therefore may be dealt with in the member’s estate which could be subject to testator family provision claims. However, if the fee simple estate is transferred to the SMSF, the property may subsequently be directed to a nominated adult child without forming part of their parent’s deceased estate.
- This type of investment may lack liquidity and give rise to extra scrutiny from auditors and other advisers due to its novel nature. Moreover, a life tenant generally has a statutory power of sale and could therefore sell their interest and have any resulting capital converted to another asset. A trustee can also be sued if they do not prudently invest trust assets especially in balancing the interests of life tenants and the remainder beneficiaries (see, eg, Nestle v National Westminster Bank Plc  1 All ER 118 and Re Mulligan (Deceased)  1 NZLR 481
Those contemplating a life estate interest strategy should seek expert advice on all the tax and regulatory aspects. In addition to obtaining written advice from an adviser, ATO input especially in the form of a positive PBR and SMSF specific advice also addressing the relevant anti-avoidance provisions is strongly recommended. However, there is no guarantee that a positive ATO opinion will be forthcoming and those that proceed without this comfort need to be aware of the risks that this may entail.
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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.