What’s the problem with a property development it’s just another investment?
The first hurdle you face with a property development is the “sole purpose test”. S 62 of the SIS Act is unequivocal, a superannuation fund, including an SMSF, must be run for the sole purpose of providing retirement income, with a few permissible “ancillary purposes” such as death and permanent disability. When you are undertaking property development you are also undertaking a commercial activity and effectively carrying on a business (if you are doing it all yourself).
If you are outsourcing the project development and merely funding it through the SMSF then many of the problems disappear, you are not running a business, and if the property developers are unrelated, then you do not have any of the related party payment issues. In this case, it is usually safe to continue.
What is wrong with carrying on a business?
The ATO has said that carrying on a business need not be a breach of the sole purpose test (SMSFR 2008/2) (though it may be if not done properly) but it doesn’t like them and will investigate them closely.
The problem with carrying on a business are several. One, it is generally to generate income today, not for retirement. If all of that income is going to the fund, this is not going to be a problem, but if some of that income is going to a related party then we run into another problem (see payments to members or related parties).
There is also the issue that the trust deed and investment strategy must permit this kind of investment. According to the case Kirkman v Booth a trust deed must specifically permit a business to be carried out. Even though this case did not involve an SMSF the rules around trust deeds are no different. Many older trust deeds will not and will, therefore, need to be updated. Even newer deeds will need to be reviewed to ensure it is permissible.
The investment strategy must also be updated to allow for this type of investment. When reviewing the investment strategy, it requires more than just allowing for a property investment. The risk profile will also need to be reviewed. Property development is inherently risky and may involve unexpected cost overruns, delays and the vagaries of the market. Also, it must be in the interest of all members, and all members must agree to it. This must all be addressed in the investment strategy.
The ATO has warned that when reviewing the carrying on of a business in an SMSF, it will be on the lookout for:
- The trustee employs a family member (we look at things such as the stated rationale for employing the family member and the salary or wages paid)
- The business carried on by the fund has links to associated trading entities
- There are indications the fund's business assets are available for the private use and benefit of the trustee or related parties.
Payments to members or related parties
A superannuation fund is specifically prohibited from providing non-retirement benefits to members and related parties. S 65 of the SIS Act prevents a trustee of an SMSF from providing financial assistance to members or relatives of members. Therefore, if a member of the fund or a relative, including a ‘Part 8 Associate’, receives a benefit from the fund in the form of payments towards the costs of the development, there is the potential for there to be a breach.
Financial assistance will not be provided if the member or related party is paid market rates, however, if underpayment is charged then there is likely to be a form of financial assistance that breaches the section.
There is also the problem of section 17A which prohibits SMSF trustees from receiving a benefit for duties or services as a trustee. Thankfully S 17B ensures s 17A does not generally apply where:
- The trustee performs the duties or services other than in the capacity of trustee;
- The trustee is appropriately qualified, and holds all necessary licences, to perform the duties or services;
- The trustee performs the duties or services in the ordinary course of a business, carried on by the trustee, of performing similar duties or services for the public; and
- The remuneration is no more favourable to the trustee than that which it is reasonable to expect would apply if the trustee were dealing with the relevant other party at arm's length in the same circumstances.
Therefore, if an SMSF trustee is also the builder and being paid for services as a builder, they can only do so where they are qualified and are in the business of property development. It also means the trustee must be paid market rates (payment over or under may bring about other issues as well).
For many SMSF wanting to undertake a property development, the trustees involved won’t be in the business of property development so will need some form of a workaround.
Finally, consideration must also be given to S 66 which prima facie prohibits an SMSF from acquiring assets from related parties. This becomes very difficult for SMSF when engaging a related party to undertake the development. SMSFR 2010/1 permits the payment to a related party for “services” related to the property development but prohibits building material to be bought from a related party as these are assets of the related party.
One solution to this is for the SMSF to enter into an “agency” or “reimbursement agreement” with the related builder which states that the builder is not buying the material for themselves (and thus their asset) but on behalf of the SMSF. Again this must be crafted properly, and you can still run into the problem of the “arm’s-length” requirements.
Even where your dealings with related parties are permissible, they must always be at arms-length prices. Part of the reason for doing the development in-house rather than getting an external provider may be that it is hopefully cheaper to do so. However, if payments are under or over market prices, then there will be a breach of these requirements. Therefore, it is important that such transactions are well documented and that proof exists of payments at market rates. (It may be a good idea to get third-party quotes as proof)
Section 295‐550 (1) of the ITAA 1997 provides that an amount of income is non‐arm’s-length income if:
(a) it is derived from a scheme the parties to which were not dealing with each other at arm's length in relation to the scheme; and
(b) that amount is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm's length in relation to the scheme.
This makes it clear that services provided by related parties cannot be at no cost or at prices well below market prices. If they are then there is a good likelihood that this will be considered to be non-arm’s-length income. Remember that non-arm’s-length income is taxed at the highest marginal rate.
When dealing with property development at non-market rates there is another potential issue to contend with; payment considered to be a contribution. TR 2010/1 says:
In the superannuation context, a contribution is anything of value that increases the capital of a superannuation fund provided by a person whose purpose is to benefit one or more particular members of the fund or all of the members in general.
Therefore, where services are provided below market value this will in effect increase the capital of the SMSF and is thus a contribution. The ATO also made it clear at the March 2013 NTLG meeting that where a related party improves an SMSF asset at no cost to the SMSF, for the purpose of benefitting the fund, this will constitute a contribution reflective of the increase in market value of the fund’s assets.
This provides even greater danger today where there are caps on contributions and may cause a fund member to be in breach of the new cap rules.
What structures can an SMSF use for property development?
If you have gotten through all the problems highlighted above, you will then need to consider what kind of structure can I use to invest in property development?
- The simplest means is to employ an unrelated property developer to undertake the development. The main advantage of this is that you avoid all the related party transaction issues highlighted above. One way to do this is through a joint venture (JV) where the SMSF buys the land and goes into a JV with a builder to actually do the construction or improvements.
- Another simple process is for the SMSF to undertake the development by itself. e.g. Fund buys house and uses funds from the SMSF to make improvements to the house.Just remember you can’t use borrowings to make improvement so the fund must be able to fully pay for the purchase and development.You also face the issues raised above about related party payments.
- Ungeared related unit trust is a third option. Generally, a related trust would run foul of the in-house assets rules; it would be a rare fund that could be involved in a property development that amounted to less than 5% of its total assets.However, there is an exemption for ungeared trusts as set out in Reg 13.22C of the SISR.
- Unrelated unit trusts. In this situation where no SMSF owns 50% or more of the units in a unit trust (doing so would mean it was in control of the trust and thus a related trust). The simplest way would be to have three unrelated trusts with say 1/3rd interest each. This also has the advantage in that the unrelated unit trust can borrow. E.g. Set up ABC Unit Trust, owned equally between SMSF’s DEF, GHI and JKL.
You really should check with your accountant as to which is the best structure as there are many pro’s and con’s and what is best for one fund may not be for another.
Yes, you can enter into property development using your SMSF, but there are many issues to be wary of, so it must be done diligently.