Building in an SMSF

[GaryT]

What are you thoughts on doing a development within an SMSF? The situation could be like this.

An SMSF has acquired land suitable to build a duplex development. No borrowings are required for either the purchase of the land or the subsequent development. The potential for capital gain or rental return is extremely good.

The builder is as associated person (son-in-law) but not a member of the fund. The builder is needed to access a builders licence. Accounts will be setup with the various equipment suppliers such that the SMSF will pay for materials and contractors directly as much as possible.

The builder will either not be paid or will be paid well under market rates for managing the building process.

Some small costs will have to be paid by the builder and reimbursed from the SMSF at cost just from a practicality point of view. Also the builder will employ tradesmen (as employees) and will on-bill these to the SMSF at cost (i.e. wages + allowance for on-costs).

The SMSF was set-up specifically for this project (transfer in of funds from another SMSF) and is not registered for GST and is not required to be registered. All members in the SMSF are in pension phase.

The intent is to keep the units and receive rental income.

Any issues with this scenario?

Also if the on-going situation changed such that the SMSF sold one or more of the units within 5 years of completion, would GST have to be paid on the sale, and GST claimed back on expenses less the required increasing adjustment.

Could this concept be repeated.

 

[Terry_w]

Hi Gary,

I would say you have to be wary of a few things.

If the builder is not paid market rates this may be considered a contribution to the SMSF.

Also have to consider whether this breaches the sole purpose test.

 

[Paul@PFI]

GST issues - This could elevate the view that the SMSF is operating a business. http://www.ato.gov.au/uploadedFiles/Content/ITX/downloads/ITX21960.pdf is a new publication that explains all GST issues.

The contribution issue poses a probable SMSF non-compliance concern. Tax Ruling 2010/1 addresses "what is a contribution". Contributions arise from a supply of services by an associate on non-arms length terms or for no consideration. A GST problem too as associate must value at market rates not actual consideration as the term "supply" doesnt mean paid. Non arms length income is punitively taxed. This issue a major red flag. And a blatant tax scheme as far as the Builder is concerned too.

This sounds like a business. No SMSF should run a business.

From a financial perspective if the SMSF has sole assets of rental properties and needs to pay pensions unless it has other liquidity it may be incapable of paying pensions..Need to review cashflows to determine how a 5%, or even a 8% minimum pension can be paid if rental yield is 6%.

 

[GaryT]

Thanks Terry & Paul. You have focused on the issues of concern.

Firstly is this a business as suggested by Paul:
This is a property development. SMSF trustees may increase the value of their property by repairs, improvements and development undertaken by the members or related parties themselves. The intent is to rent, I don't think there is any hint that this may be seen as a "business". Maybe if it was done 2 or 3 times in quick succession but not a once of as in this case.

Leading on from this is the sole purpose test as queried by Terry. Certainly carrying on a business would breach this test but this is not the case here. I am not aware of any instance where dealings were at arms length but the sole purpose test was held to have been contravened. The trick maybe in managing the arms length process.

Does paying the builder below market rates constitute a contribution:
TR2010/1 gives an example of an accountant who prepares the accounts for his own super fund at no cost and concludes that that this does not constitute a contribution. ATO ID 2010/162 although dealing with borrowing on terms favourable to the fund suggests that if a member or related party does not charge the fund for services, even though this may not be at arms length, it does not contravene section 109. Still some debate on this issue but maybe it can be overcome?

I acknowledge the GST issues for the builder which I had not considered.

The issue of cash flow is real but able to be managed if the SMSF has sufficient resources.

 

[Paul@PFI]

Thanks Terry & Paul. You have focused on the issues of concern.

Firstly is this a business as suggested by Paul:
This is a property development. SMSF trustees may increase the value of their property by repairs, improvements and development undertaken by the members or related parties themselves. The intent is to rent, I don't think there is any hint that this may be seen as a "business". Maybe if it was done 2 or 3 times in quick succession but not a once of as in this case.

The relationship between the builder and the SMSF can be looked at a number of ways. One is that the builder is undertaking a project and merely using the SMSF as a conduit to finance and reduce taxes. So rather than the dev happening in a business style structure eg Co, Trust etc its happening in a SMSF. One is passive and the other active. Repetitive. I will overlook that and skip to the outcome not the cause....The problem is the arms length relationship.

Only way to get certainty is a tax ruling. Let me say I wouldnt proceed without it. The non-arms length income problem nd isnt law that jumps out. Its in the 9197 Tax Act s295-550 and also s995-1.
1. A transaction (Yes)
2. Parties not dealing with each other at arms length (Yes);
3. Income derived by fund greater than would have been derived if parties were dealing at arms length. ie cost base is reduced. Im of the view the ATO might consider the lower cost base for the fund reduces depreciation etc - Thus a higher income.

If that doesnt work ATO would argue a scheme as defined by s66(3)...Jail is the penalty. And non-compliance. A Notice of NonC means 47% tax on the market value of the fund LESS any non-concessional contributions made since inception. That could get expensive.

So way I see it tax rate is 47%. Get a ruling.

 

[Paul@PFI]

TR2010/1 gives an example of an accountant who prepares the accounts for his own super fund at no cost and concludes that that this does not constitute a contribution. ATO ID 2010/162 although dealing with borrowing on terms favourable to the fund suggests that if a member or related party does not charge the fund for services, even though this may not be at arms length, it does not contravene section 109. Still some debate on this issue but maybe it can be overcome?
QUOTE]

The distinguishing feature here is really about the services that the accountant provides can be homogenous with someone else doing it. ie pay ITP $500 or pay the member trustee's firm. The important issue is arms length. Its a huge jump to a builder giving away a property.

I maintain s66 prevails. Or at least is an additional obstacle.
s66(3) is simple

(3) A person must not enter into, commence to carry out, or carry out a scheme if the person entered into, commenced to carry out, or carried out the scheme or any part of the scheme with the intention that:

(a) the scheme would result, or be likely to result, in the acquisition of an asset by a trustee or an investment manager of a regulated superannuation fund, where the asset is acquired from a person who has a connection (either direct or indirect through one or more interposed companies, partnerships or trusts) with a related party of the fund; and

(b) that acquisition would avoid the application of subsection s66(1) to the fund.

This often starts a debate about the Business Real Property exception in s66 since its the obvious parachute. The problem I forsee is the BRP must be BRP before acquisition AND acquired at market value.

 

[GaryT]

OK I really appreciate the multitude of road blocks you are exposing, I really do, but I guess I am looking for solutions as much as why it can't be done.

I think we have established that a single development should not constitute the carrying on of a business.

It is now obvious that the parties must be dealing at arms length to ensure the sole purpose test was not breached.

There also seems to be no problem with an associated party providing the building services subject to the parties acting at arms length or close to it. Basically as I read it the law says that if the parties are not at arm's-length, then they must act as though they are or on terms that do not disadvantage the SMSF. So any transaction involving a related party must be done so without creating any special favours or terms, and the price paid is a justifiable market price. If it does favour one party a little over the other, the favoured party must be the SMSF. I concede that it would be just better for both parties to act on terms consistent with an arms length transaction.

So what about the idea of entering into an suitably documented agreement to a developer who happens to be an associated party to do the development at commercial rates and conditions?