There appears to be growing enthusiasm amongst some advisers to recommend that their clients undertake property developments in their SMSFs, using limited recourse borrowing for finance. The basis for that recommendation appears to be that there are arguable grounds for doing so and the fact that the ATO has not expressly prohibited SMSFs from doing so. It is important for clients to be aware of the potential costs they may incur in testing whether that advice is correct.
The arguments in favour of property development tend to rely on a narrow view of the operation of the “sole purpose test” set out in s62 of the Superannuation Industry (Supervision) Act 1993 (SIS Act).
Historically, the prevailing view has been that this section requires a SMSF to be limited to prudential investment activities, which ruled out the carrying on of any business, including a business of property development.
The only substantive authority for that view was the High Court’s decision in Scott v Federal Commissioner of Taxation (No 2) 40 ALJR 265. That case did not deal specifically with section 62 and there is arguable scope for doubt as to its applicability.
For the trustees of an SMSF who are thinking about undertaking a leveraged property development in their fund, the question to address is whether they are prepared to be the test case on which this issue will be determined if they are singled out for audit on this issue.
If trustees are thinking seriously about following their adventurous adviser down this path, it is suggested that the following be borne in mind if it all goes wrong and the Commissioner forms the view that the fund is non-complying:
- The fact that that the ATO has not expressly ruled against property developments in SMSFs does not mean that it has approved of them as an investment appropriate to maintain the fund’s status as a complying fund.
- A breach of s62 may result in an SMSF being issued with a notice of non compliance by the Commissioner.
- If a super fund loses its complying fund status, it not only loses the future benefits of continuing as a complying fund, but it also retrospectively loses the benefit of previous concessional tax treatment and is taxed on net previous income at 45%.
- In many cases, this may mean that the fund effectively loses almost half of its assets in the form of tax.
- Often in cases where the ATO audits a superannuation fund and discovers a problem, there is a process entered into whereby the ATO will give the fund an opportunity to remedy its affairs so as to ensure that it remains compliant.
- However, in a situation where a super fund’s principal activities are the undertaking of property development, it may well be that the super fund is locked into contracts with lenders, builders and the like which means that it is effectively trapped in its current investment course.
- In those circumstances, the trustees may find themselves with no option but to dispute the non-compliance notice on the basis that the property development was within the scope of the sole purpose test.
- Trustees of an SMSF who receive an ATO notice that the fund is non-complying can apply for an internal review of that decision by the ATO.
- If the original decision is confirmed, the trustee can seek a review of the ATO’s decision before the Administrative Appeals Tribunal (AAT).
- Pending the hearing of the AAT application it would be possible for the trustees to apply to the AAT to stay the operation or implementation of the decision of non-complying status.
- If the trustees are unsuccessful before the AAT, it is possible to appeal against that decision to the Federal Court, however such appeals can only be made on a question of law.
Whilst there will always be scope for good advice to take advantage of the benefits of an SMSF as an investment vehicle, their use as a trading entity should be approached with a great degree of care.
There should be careful consideration of what the fall-back strategy will be (in particular, the funding of the review and appeal process) if the ATO takes a different view from the adviser on whose recommendation the project was undertaken.
Tony Riordan heads our taxation and superannuation groups and Craig Healy is a Senior Associate who deals with superannuation dispute resolution. They are both available to provide advice to trustees of super funds and to their advisors in relation to challenges to ATO decisions.