Double CGT for some SMSFs

All those borrowing under a SMSF should be aware of the following.

Just received the latest Law Central Bulletin, Bulletin 299, which contains the an article on SMSF lending:


"A rather greedy bank has decided to do Instalment Warrants for its customers. While it did a great job protecting its security, our clients now suffer unforeseen tax consequences of double Capital Gains Tax. Be wary when a bank offers you a packaged arrangement with a "free" bare trust deed.

In this instance, the instalment warrant package included a trustee service and bare trust deed. The 'trustee service' is interesting. Mum, Dad or their company generally perform this job for free. However, the bank has decided to extract some more money out of the client - they ensconced their own little mate in as the trustee.

Now to the more sinister problem - when Brett Davies Lawyers sets up the Instalment Warrant, there is no Capital Gains Tax when it is eventually transferred into the Self Managed Super Fund. To achieve this, you need a bare trust arrangement where the SMSF is "absolutely entitled" to the asset.

...................

You can see the rest online at http://lawcentral.com.au/

TerryW

I raised the flags for this about a year ago now. A lot of people are in for some nasty surprises.

CGT AND Stamp Duty from SMSF Borrowings

Terry you are quite correct but it is far more common than you may imagine.
- Many banks (big and small) will seek to add clauses to an Instalment warrant that may affect "absolute entitlement" - Often just prior to the loan settlement.
- It affects BOTH CGT AND double stamp duty (rather than the transfer of title being under apparent purchaser provisions.)
- It seems to also be evident in some Instalment warrant deeds that SMSF's and their advisers can buy to use in their own structure. Its not confined to something the banks will hand you. So they can exclude themseves from liability.

A detailed paper on this matter can be found at http://prc.macquariegs.com.au/?client=mgs - Click on Instalment warrants and read about the "CGT problem". It cites case decisons regarding absolute entitlement.

This and many many other issues indicate the reasons to use experienced advisers (tax and trusts law) who are specifically knowledgable in any complex arrangement. Advisers who buy instalment warrants and assist their clients may actually become responsible for the cost of rectification later if they buy a problem instalment warrant.

I understand the authors of the paper above have carefully selected a bank that does not contain this issue and provide assurances through a Barristers opinion which is provided with each Instalment warrant involving the bank's loan. I understand that the facilitation of the loan with that bank is a part of their product price and not an extra cost in any case - But they only deal with professionals in practice and not clients themseves.

The cheap instalment warrant may not seem cheap when CGT and Stamp duty concerns are considered

CGT and Stamp Duty Issues

First of all I want to thank the reader to alert me of this post - I have read the messages of terryw and Adviserman and link by Adviserman (joined the forum on 20th Jan 2010).

There is this fear being generated by the author of the article http://prc.macquariegs.com.au/?client=mgs that if the bare trust is not drafted correctly and if it does not give "absolute benefit" to the trustee of the SMSF at all times, the bare trust is not a bare trust but a separate trust - which means that when the property is transferred to the trustee of the SMSF, CGT may be paid by the trustee of bare trust as it is legal owner of the property and since it is not a bare trust but a separate trust the asset belongs to the trustee of the bare trust and upon its sale - CGT will be payable. Some comments have also been made that stamp duty may also be paid as the property will move from trustee of the bare trust to the trustee of the SMSF.

One must note that the article of Macquarie group has quoted one clause from bare trusts of other organization to insinuate that if you purchase their deeds - you will have CGT issues. To get that one clause of the oppositions deed - they have purchased their deed and by publishing in their article have broken the copyright of the deed and I am aware of one organization which is suing them for their act. It amazes me on how one can draw a conclusion based on only one clause of the whole deed!


CGT issues.

Careful reading of the exemption on borrowing section of the SIS Act Sec 67 (4A), shows that the trustee of the SMSF is NOT obliged to take up legal ownership of the property (even after the loan is repaid to the lender).

Practically speaking most SMSF purchase IW on the stock exchange (in effect purchase the underlying asset) and sell IW as per their investment objective (in effect sell the underlying asset) - very rarely would a SMSF payoff the loan and transfer the asset SMSF.

If we look at the situation with a property's perspective, once the property is purchased with 70% or 65% LVR, there is no need to reduce the loan further as most likely it will be self funding with rental income looking after interest and other costs. However, it is possible to reduce the loan with new contributions or with positive gearing. But if you are a trustee of the SMSF and are already achieving un-realized gain on one IW property, the tendency will be to accumulate contributions to the next 30% deposit level and do it all over again, since the first property is not costing you anything. What i am trying to say here, there is no need to reduce the loan and most lenders are offering 25 year loan terms.


Cost of holding the property with the bare trustee

Assuming that the trustees decides to reduce the loan and pay off the loan, the SMSF trustee now has three choices

1) sell the property
2) do nothing - simply hold the property
3) transfer the property to the trustee of the SMSF

If the SMSF trustee decides to sell the property - CGT is triggered and if the fund is in pension phase, it is possible that no CGT is paid.

If the SMSF trustee decides to do nothing then the only cost to the fund is $212 ASIC review fees. For argument sake, say the property is held for 20 years after the loan is repaid, after keeping the loan for 25 years - total 45 years. The total cost to the fund is only $4240 ($212 times 20).

The purpose of the Macquarie Group Services article is get readers to buy "their deed" and their "arrangement", the cost of their deed is

$550 for application fees
$3300 for the bare trust deed
$440 to update to their SMSF deed
$820 for loan application fees with Westpac - please note that Macquarie group deed is not sold separately (residential)
+ 7.84% interest rate from Westpac in comparison to 6.41% from NAB

If SMSF trustee borrows $300,000 the difference in interest paid each year is $4290 which is more than the cost of holding the property with bare trustee for 20 years.

Why Macquarie Group Services purchases other firms deeds - why they break copyrights rules of other legal firms - why they just not sell their deed and let the purchaser go to any bank - why there should be a CGT issue threat to sell your documents are questions one must ask before dealing with them.

To conclude, there are three issues which cannot be ignored;

Firstly, any lender will have a first mortgage over the property, hence to transfer the property to the SMSF trustee whilst the loan is in place is not possible without the consent from the lender - hence the bare trustee cannot offer the property to be transferred to the trustee of the SMSF whilst the 1st mortgagee is in place.

Secondly, most of the borrowing by SMSF is via an internal lender - where the trustee has equity in assets outside of super, which are then mortgaged and then on lent to SMSF via a Disc. trust structure etc. Hence borrowing by external lenders should only be considered when there is no equity held by trustees in their other assets like, family home or other investment properties.

Lastly, even if the SMSF trustee is able to transfer the title of the property in its own name, even if the 1st mortgagee is in place, the SMSF trustee will become legal owner of a property which has borrowing and a charge over its property. The SMSF will then contravene Sec 67 (1) of SISA which does not allow borrowing and other provisions which do not allow a charge over the SMSF property.

Lawyers are known to scare consumers and put a premium price tag to their own product - for those who do not know, a bare trust deed is only 2 pages long - if you purchased it from Macquarie group - you have paid $2200 per page! Bad Luck if you got sucked in.

Manoj Abichandani
SSA SSAud, Tax Agent, FTIA,
SMSF Specialist Advisor
SMSF Specialist Auditor

Manoj,

I am not sure I agree with you.

Note I have not seen the MGS deed - no idea if it is good or not.

I appreciate that 67(4A) does not require the beneficiaries to have an "absolute entitlement", but what do you think of the E5 argument? Also, what are the tax repercussions generally if the smsf is not absolutely entitled....hmmmm.

Also, why does the trust deed need to mention "consent by lender" to transfer? that is obviously a requirement for registration of a transfer and is likely to be covered in the mortgage - so why mention "consent of lender" in the trust when that will affect "absolute entitlements"

I would have thought that in reality (and we wouldn' want it any different), the "transfer" to the super fund will only take place once the loan is repaid in full, and the "charge" is discharged - therefore, the property is transferred to the SMSF trustee without an encumbrance. In addition, why transfer the property anyways? As long as it is available to comply with 67(4A), if the smsf is absolutely entitled, who cares if the smsf trustee or the special trustee is the registered proprietor?

Eagerly waiting your reply.

Jack 321

The idea of property moving from trustee of the bare trust to the trustee of the SMSF is a big question mark.

Firstly, I must admit, as this is all new stuff, me and I doubt any other SMSF Specialist would have witnessed it. Further, MGS also quote some rulings which were decided in 2004 whereas the SMSF borrowing rules come into force sometime in September 2007 and in diffirent circumstances, hence the relationship of the two is remote.

Secondly, I have clearly pointed it out in my previous post, there is no legal need to move the property from the trustee of bare trust to the trustee of the SMSF - the only logical reason is to save the $212 annual review fee of the trustee of the bare trust - other than that, there is no other reason - quite frankly, we can finish our argument here as this a very small price to pay for our SMSF to borrow. Hence the situation to move the property will NEVER arise, we are now talking about an event which will NEVER HAPPEN, hence I do not understand that, how a siutation (CGT) will be a "PROBLEM" when likely hood of that event is virtually impossible.

Lastly, There is definately, no stamp duty to be paid when the property moves from the apparent owner to the real owner as the NSW stamp duty act looks at who paid for the property in the first place, please click on the below link to read the NSW OSR ruling

http://www.osr.nsw.gov.au/lib/doc/rulings/rrdut30.pdf
(must read this link to understand similarity in the CGT issue)

Since it is the SMSF (some of its own money and some borrowed) is the real owner of the property - hence, if CGT issue ever goes to court, it will be argued that the SMSF is the "real owner" and was the "absolute beneficiary" of the property "at all times".


Please remember that case laws quoted on the MGS site are situations where the real owner could take up a mortgage - in our situation, SMSF cannot take a mortgage (if it wants to remain complying) - however, I do not know, if the judges will take our SMSF case as being similar for CGT purposes to the cases mentioned in the MGS site, assuming if this matter will ever go to court.


I know your question is why put "consent of lender" in the deed, the answer is simple, because "it will be required in any case". Hence whenever the trustee of the SMSF (namely members) requires the property to be transferred to themselves, the bare trustee will offer it to the trustee of the SMSF, however "MUST seek consent of the lender" because the "mortgage documents insist" that they seek their approval. In fact, if the consent is not sought, any tranfer would be fraudulant.

We are now talking about a situation where members would directly want the SMSF trustee to own the property knowing that there is a charge over the property, this we all know will make the fund non-complying.

Quite frankly, I do not know what the fuss is about... What I know is wrong, is that MGS have used a scare tactic to sell their product - which I do not approve and give examples of other deeds, by purchasing the deed, copying from the deed and by breaking copywrite of the authors.

In this case, they have been undone, because there is nothing wrong with those deeds. In my opinion MGS should market their product by using their own marketing techniques and not by degrading others and wrongly labeling them as "problem deeds" that is not the "right way". They may / can claim that their deed has "no CGT issues", that is fine, but quoting from other deeds, and labeling them "problem deeds" where no court of law in this country has decided on this issue is wrong, I think they have crossed the line.

Even BAM toilet cleaner advertisement removes the labels from other containers when they claim that their cleaner "cleans better than others".


Manoj Abichandani
SSA SSAud, Tax Agent, FTIA,
SMSF Specialist Advisor
SMSF Specialist Auditor

Manoj

Interesting discussion. Will CGT occur when the SMSF becomes absolutely entitled to the asset ?

Coastymike

You see, the trustee of the SMSF is the "real owner" of the property from day one, but because SMSF are not allowed to borrow, it cannot hold a property with a debt on it, albeit an exemption applies, Sec 67 (4A) which says that - if or when - SMSF borrows, the asset has to be "held on trust" - which means that ownership of the asset is never in doubt - the real owner is and was always the trustee of the SMSF, because all the money is paid by the super fund (its own and borrowed) - so the question of CGT does not arise at any point of time.

Merely moving the property from the "apparent owner" to the "real owner" is the second leg of the same transaction. The SMSF acquired the property when it first purchased the property, giving it to the trustee to hold it (due to borrowing restrictions) and then taking it back (once the debt is retired) does not mean that there is change in ownership.

Let's look at it in a different way:-
Jack and John are two brothers - Jack uses his pocket money and borrows from dad and buys a toy - he gets enjoyment in holding the toy (rent) - John is too young to play with toys (trustee of the bare trust does not have a bank account or a tax file number) however house rules (SIS Act) say "the toy has to be put away in John box" till Jack earns more pocket money and return the borrowed amount to dad. In a few weeks Jack earns more pocket money (contributions) and returns dads loan. Now, Jack can keep the toy in his own box or leave it in John's box, it is up to Jack what he wants to do with the toy because the toy belongs to Jack on day one and always will continue to belong to him - irrespective of the fact it is in John's box - after all Jack and John live in the same house (the two trustees - SMSF and bare trust - have the same directors / shareholders). Once the loan is repaid to dad, house rules say (Section 67 (4A)) If Jack wants - he can put the toy in his box or leave it where it is - in Johns box (trustee of the bare trust), but the whole house (SIS Act and OSR) knows from day one - that it is Jack toy from the day it was purchased from the shop (vendor).

If the bare trust deed replicates the above simple story in one or two pages - everyone is happy and no CGT or stamp duty will be payable when property moves (if required) from trustee of the bare trust to trustee of the SMSF.


Manoj Abichandani
SSA SSAud, Tax Agent, FTIA,
SMSF Specialist Advisor
SMSF Specialist Auditor

In tax law, even a legal disability does not prevent a beneficiary from being absolutely entitled to trust assets.

Therefore a loan clause preventing the trustee legally transferring title until the debt is paid out (remember it must be limited recourse) does not seem too different.

However, there is no need for me to do any due dilligence on this one at the moment.

Cheers,

Rob

Manoj,

What about the rental income of the trust? Does the special trustee need to lodge a tax return?

(there is a point to my message above)....I think you know what I am getting at. I want us to consider the definition of a "bare trust".

“trust under which the trustee or trustees hold property without any interest therein, other than that existing by reason of office and the legal title as trustee, and without any duty or further duty to perform, except to convey it upon demand to the beneficiary or beneficiaries or as directed".

Do we have a bare trust when the trustee needs to take out insurance, needs power to sign a mortgage over the asset, and the trust requires that it acts subject to the requirements/directions of the lender/mortgagee? Also, what if there is an indemnity (I have seen this in a few of these deeds)...

My opinion is that people calling these deeds a "bare trust", when the trustee acts at the direction of the beneficiary, SUBJECT to the lender;s requirements (in the form of a clause in the special trust) is not a bare trust.

So my question is this.... How will the income be treated (say rent) if the trust deed is not a bare trust, or, to be more specific, not a trust providing absolute entitlements to the beneficiary?

Jack321 said:

(there is a point to my message above)....I think you know what I am getting at. I want us to consider the definition of a "bare trust".

“trust under which the trustee or trustees hold property without any interest therein, other than that existing by reason of office and the legal title as trustee, and without any duty or further duty to perform, except to convey it upon demand to the beneficiary or beneficiaries or as directed".

Do we have a bare trust when the trustee needs to take out insurance, needs power to sign a mortgage over the asset, and the trust requires that it acts subject to the requirements/directions of the lender/mortgagee? Also, what if there is an indemnity (I have seen this in a few of these deeds)...

My opinion is that people calling these deeds a "bare trust", when the trustee acts at the direction of the beneficiary, SUBJECT to the lender;s requirements (in the form of a clause in the special trust) is not a bare trust.

So my question is this.... How will the income be treated (say rent) if the trust deed is not a bare trust, or, to be more specific, not a trust providing absolute entitlements to the beneficiary?

Click to expand...

I guess you are referring to a "special trust" where there are nominal trustee duties to perform, but this is not a term used in tax law.

The ATO refers to a "bare trust" and "transparent trust" simultaneously, but whether a trust mentioned in this post is "transparent" for tax purposes depends on the facts of each case.

Check out the bare trusts used for finance or development, the beneficiaries often account for the activities as if in the role of principle, with the trustee being an agent. BUT any ATO audit will look closely at the activities and make their own decision whether the trustee is conducting something more.

However, given the accepted active role of trustees in those sectors, I think the articles on double CGT risk are perhaps a bit more of a marketing ploy for their products.

But again, I am not in a position to pursue this one at the moment. Not enough hours in a day !!

Cheers,

Rob

Jack321 said:

Do we have a bare trust when the trustee needs to take out insurance, needs power to sign a mortgage over the asset, and the trust requires that it acts subject to the requirements/directions of the lender/mortgagee? Also, what if there is an indemnity (I have seen this in a few of these deeds)...

Click to expand...

A bare trust is often quoted as one where a trustee has no "active duties".

However, the trustee is still bound to maintain the assets, and even reinvest proceeds.

Cheers,

Rob

Hmmm ... now I am not so convinced of the ATO's position.

PS LA 2000/2, paragraph 12:

" ....

12. A Secured Purchase Trust is a trust created to facilitate and secure the purchase or holding of Shares or Units. As such, the beneficiary may not have an absolute entitlement to trust property (the Share or Unit) because the trust property will be subject to a security interest until it is paid for.

... "

Where there is a sole beneficiary this might be easier to argue.

Cheers,

Rob

Rob G. said:

the trust property will be subject to a security interest until it is paid for.

Click to expand...

Maybe this refers to the situation where some margin lenders take beneficial ownership of the securities ... which is itself a CGT event.

Cheers,

Rob

I think you are mixing the issues - a special trust is not a fixed trust - where the trustee holds the asset for the benefit of the beneficiary - a bare trust is a different breed all together - here the trustee follows the instructions of the beneficiary and performs no other duties - a security trust is kind of similar - however since there is a loan on the underlying asset - the lender takes or can take priority over selling / disposing / transfer from proceeds - however after the loan is repaid - it then behaves and acts like a bare trust.

I suggest readers to purchase a book on Trusts available on Taxation Institute of Australia website - please note latest version is on print due to a recent case

manoj said:

I think you are mixing the issues - a special trust is not a fixed trust

Click to expand...

Only according to the definition in the NSW LAND TAX MANAGEMENT ACT 1956 - SECT 3A

In general trust law, a special trust merely has more duties than a bare trust.

Whether such a beast is a "transparent trust" for the ATO, as in not needing to file a tax return, is another issue which depends on the facts.

Cheers,

Rob