SMSF borrowing — recent developments

We consider the latest in SMSF borrowing, focusing on when a holding trust is a bare trust and why it matters.

Is a ‘holding trust’ a bare trust?

The status of the ‘holding trust’ may have a significant bearing on the LRBA’s long-term CGT and related tax efficiency. Bill Shorten, the then Assistant Treasurer announced on 10 March 2010 that the government would make LRBAs ‘look through’ so that a holding trust does not suffer adverse tax treatment. This announcement was confirmed in Media Release (No 008), which stated:

These changes will … confirm … there is no CGT applicable at the time the last instalment is paid …

As the Government previously announced, a superannuation trustee who enters into a [LRBA] … will be treated as the owner of the asset for income tax purposes.

Legislation giving effect to these changes will be introduced as soon as practicable. …

No such legislative cure has yet been finalised. Thus, there is a need to carefully document each LRBA and this, in turn, depends on who supplies the LRBA documents. Unless these documents are drafted with tax efficiency in mind, they may give rise to significant adverse tax outcomes.

The starting point here is that a ‘bare trust’ has generally over time been eligible for ‘look through’ treatment for tax purposes.

However, DBA Lawyers has come across numerous suppliers’ holding trusts (which are provided as part of the supplier’s LRBA documents) that do not constitute a bare trust. Rather, the trustee has substantive powers and obligations thereby giving rise to a trust that could be taxed as a separate entity. This is particularly the case with some documents provided by banks and financial institutions that are primarily designed to protect lenders’ rights and do not appear to have regard to the SMSFs’ interests, eg, tax efficiency.

What happens if an SMSF holding trustee is not a bare trust?

Unless a holding trust is a bare trust, on a technical tax analysis, the following tax issues may arise:

• Income tax — income tax at the highest marginal rate plus the Medicare levy could apply to any net income derived by the holding trustee unless it distributes same prior to each 30 June (ie, treated like a discretionary or fixed trust is treated under div 6 of the Income Tax Assessment Act 1936 (Cth)).
• CGT — a CGT event could occur when title to the property is transferred from the holding trustee to the SMSF trustee. The ATO’s stance has been that this transfer must occur immediately after repayment of any borrowing otherwise an SMSF might have in-house asset issues.
• Income tax returns — income tax returns reflective of the income tax and CGT implications could apply as per their usual application to trusts under div 6.
• GST — if the property involves commercial property, then the holding trust itself may need to register for GST and lodge BASs. See the ATO’s comments in paragraph 37 of GSTR 2008/3.
• Income tax returns — income tax returns may need to be lodged with the ATO including regular activity statements as the trust may not constitute a transparent trust under the ATO’s administrative practice reflected in PS LA 2000/2.

Best practice

Given the significant downside ramifications that may arise if the LRBA documents are not appropriately drafted, you should ensure any LRBA documents you are using do not place you at risk. Having said this, we understand that the ATO is currently not taking strict enforcement action in respect of holding trusts that are associated with an LRBA by an SMSF.

Nevertheless, the law in this area is far from clear and the ATO’s current administrative practice might change. Until a legislative fix is implemented, this uncertainty remains.

Naturally, DBA Lawyers has drafted their LRBA documents with the above considerations in mind. We continue to see a range of other suppliers who are not on top of these tax issues and whose documents place their clients at risk. The banks and financial institutions also tend to place their customers at risk.

Where an option exists of choosing between a law firm with sound tax and SMSF experience or bank/financial institution documentation, we would generally recommend the law firm documents be chosen, which should better protect the SMSF’s interests.

* * *

This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.