Many building and similar contracts place SMSFs at risk

By Bryce Figot on 31/03/2021 in Investments, SMSF compliance, SMSF strategy, Trustee education

Overview

SMSFs appear to have a great appetite for investing in real estate and becoming involved with making improvements to property and, in some cases, property development.

However, while SMSFs frequently invest in property, many do not carefully review and negotiate their building and similar contracts to delete or exclude provisions which may result in contraventions of superannuation law.

SMSFs investing in real estate

The ATO figures (as at 30 June 2020) reveal that approximately 22% ($160.8 billion out of the total $733 billion) of total SMSF assets are invested in Australian real estate and this does not reflect the value of property held via listed and unlisted unit trusts and companies. This results in many SMSFs entering into a range of building and similar contracts including construction, repairs, improvements, renovations and more large-scale property developments.

Surprisingly most building contracts contain provisions that can easily result in contraventions of the Superannuation Industry (Supervision) Act 1993 (Cth) (SISA) and Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR). In our experience, we have found that many are not aware of these risks and do not carefully review their contracts or obtain input from lawyers with SMSF expertise in relation to the ramifications of such agreements.

Charging clauses in building contracts

Builders and trades people often take on a large financial risk with payment usually occurring at key stages of completion of their work. During this time the builder often incurs expenses for materials, equipment, labour, sub-contractors and a wide range of other costs. Naturally, builders expect to be paid for their services. Thus, it is standard practice that building and similar contracts include clauses enabling the builder to place a charge, mortgage, lien, encumbrance or security interest (Builder’s Charge) over property to secure payment. These provisions are solely designed to ensure the builder gets paid and can recover any outstanding fees, costs, interest on overdue payments (usually at penalty interest rates) and any legal recovery costs.

While builders and other suppliers may not formally register a Builder’s Charge over the property until the client falls into default or a dispute arises, these ‘charging’ provisions in contracts constitute a charge that contravenes regulation 13.14 of the SISR which states:

For the purposes of subsections 31(1) and 32(1) of the Act, it is a standard applicable to the operation of regulated superannuation funds … , subject to regulations 13.15 and 13.15A, the trustee of a fund must not give a charge over, or in relation to, an asset of the fund.

The term ‘charge’ is defined in reg 13.11 as follows:

“charge” includes a mortgage, lien or other encumbrance.

There is no requirement to register a charge for a contravention to occur. Registration of a charge on legal title only provides an effective notification to others about the existence of a charge such as a mortgage registered on title to land.

In Griffith v Hodge (1979) 2 BPR 9474, the Supreme Court of NSW citing Helsham J in Graham H Roberts v Maurebeth Investments Pty Ltd [1974] 1 NSWLR 93, held that where there is a clause in a building contract provided for a charge on the proprietor’s land as a form of security for payment, this clause by itself created a valid equitable charge. Waddell J stated at 9475:

“The charge given by [the contract] extends to amounts which might become due in the future. The builder therefore had an interest in the land which he was entitled to protect against the possibility that moneys would become due and owing and enforceable under the charge in the future”.

Waddel J also stated at [9476] that the clause enabled the builder to lodge a caveat to protect his interest in the land and this interest would continue until it was finally determined whether or not money is owing by the plaintiffs to the defendants pursuant to the building contract.

The Personal Property Securities Act 2009 (Cth) (PPSA) also allows builders to register a security interest in respect of personal property, such as building materials and equipment. Builders are encouraged to register their security interests so that in the event that the client (ie, the grantor of the interest) becomes insolvent, their registered security interests can be enforced under the Corporations Act 2001 (Cth) and take priority over any unregistered security interest.

Potential risks with SMSF building contracts

The risk of contravening the SISA and SISR arises where an SMSF trustee enters into a contract which contains clauses enabling another person (the builder or trades person) to place a Builder’s Charge over an SMSF asset such as real or personal property. The trustee will have contravened an important operating standard.

Many advisers are not aware that the mere existence of wording in an agreement, by itself, is sufficient to constitute a charge that can result in a contravention. Indeed, an equitable charge arises where a person such as a lender holds title to real estate even though there is no mortgage or other charge registered on title.

On the other hand, many advisers are aware that once a mortgage is registered on title of real property (or when a security interest is registered under the PPSA in relation to personal property) then a contravention occurs under reg 13.14. Many SMSF auditors search for charges over property owned by an SMSF. However, many advisers and SMSF auditors may not be undertaking appropriate searches for unregistered or equitable charges.

In relation to SMSFs investing in contracts for difference (CFD), the ATO has noted in ATO ID 2007/57 that the trustee provided a charge over fund assets by entering into an agreement under which fund assets were deposited with a CFD provider in fulfilment of the fund’s obligation to pay margin calls. The terms of the agreement stated the circumstances in which the fund’s assets would be realised, and showed an intention to create a charge over those assets. By entering into the agreement with the CFD provider, the trustee contravened reg 13.14 of the SISR; which is an operating standard under the SISA and a contravention under s 34(1) of the SISA.

Potential adverse consequences

There can be severe adverse consequences for both the SMSF and its trustees/directors for contravening SISA. These can include:

the imposition of administrative and civil penalties;
the fund being stripped of its ‘complying fund’ status and losing its concessional tax status and having to pay considerable tax, penalties and interest thereon; or
the SMSF trustees/directors being disqualified from acting as trustees/directors of an SMSF in the future.

Further, if the SMSF trustees/directors enters into a building and similar contract with related party this may potentially give rise to additional issues including:

engaging in non-arm’s length dealings with potential s 109 of the SISA or non-arm’s length income risks under s 295-550 of the Income Tax Assessment Act 1997 (Cth); or
providing financial assistance to a fund member or relative by entering into a building contract with potential consequences under s 65 of the SISA

Potential solutions

Invariably, a number of clauses may need to be revised or deleted from most standard or proforma building and similar contracts. These requests may prompt some resistance from builders and other suppliers who seek to retain these clauses for obvious reasons. Accordingly, this may require delicate negotiations and may require the parties to seek other options to encourage the builder or other supplier to proceed with a revised contract.

Naturally, DBA Lawyers would be pleased to review and provide assistance from an SMSF perspective. We can also assist the SMSF trustee’s existing lawyer who may be preparing the contract for the fund.

Top Navigation

Navigation