Property development in SMSFs: ownership via a unit trust or a company

The third article on property development for an SMSF covers investing in a unit trust or company that undertakes the property development. In the last article we covered an SMSF owning the property directly or by using a limited recourse borrowing arrangement to acquire the property. This involved a number of issues for trustees to consider in relation to the development and situations where the property development was unable to go ahead. In comparison, if an SMSF was instructed to invest in a unit trust or shares in a company that undertakes the development, a greater level of flexibility may be available. However, there may be a number of issues to be considered.

When a decision is made for an SMSF to purchase units in a unit trust or shares in a company that undertakes the development, trustees need to take account whether the ‘in-house assets’ rules apply to the investment. ‘In-house assets’ includes any investments, loans or leases that are considered to be related parties of an SMSF.

Under the in-house asset rules an SMSF is required to limit the total in-house assets it has to no more than 5% of the value of the fund’s total investments at market value. The test is applied when the fund’s in-house assets are acquired. The test is also applied to the balance of the fund at the end of each financial year.

If the SMSF’s investment in the unit trust or company is not an in-house asset, there may be no limit to what can be invested in the unit trust or company. However, what is ultimately invested in the unit trust and company can depend on the fund’s investment strategy. Whether an investment qualifies as an in-house asset can be important as it may limit additional amounts that may invested on behalf of the SMSF if the unit trust or company requires additional amounts to assist in financing the property development.

The main issues that determine whether an investment by an SMSF in a unit trust or company is considered an in-house asset will depend on:

• Whether related parties control the unit trust or company. A member, trustee or director of the corporate trustee of the SMSF may be considered to be a related party of a unit trust or a company. Control of a unit trust or company, either individually or as a group, means that:
  • Related party unit holders have a right to more than 50% of the capital or income of the unit trust; or 
  • the majority of trustees are accustomed or under an obligation to act as directed by a group of related parties; or
  • related parties can remove trustees or appoint a majority of trustees of the trust.
    
• Whether the unit trust or company has borrowings. If the unit trust or company is controlled by related parties, which includes the SMSF as indicated earlier, the investment will be included in the in-house assets of the SMSF and the total in-house assets will be limited to 5% of the market value of the fund.
  If related parties do not control the unit trust or company, then the unit trust or company can borrow. Providing the SMSF along with other related parties do not have control, then the value of the units or shares will not be included in the fund’s in-house assets.
• Whether the unit trust or company does not have borrowings and meets the requirements of SIS Regulation 13.22C. If the requirement is met, this will exclude the investment from being included in the fund’s in-house assets. To qualify, the unit trust or company:
  • must not have investments in another entity; 
  • must limit what it leases to related parties to business property;
  • must not have a charge over its assets, such as a mortgage or caveat; and
  • not make a loan to another entity with the exception of a deposit with an authorised deposit-taking institution, such as a bank.

If any of these rules are not complied with continually, the investment will then be included in the value of the in-house assets of the SMSF. This could lead to the fund breaching the 5% test. It is important that compliance with these rules is carefully monitored.

• Whether the units or shares can be acquired by the superannuation fund from a related party. As a general rule it is not possible for an SMSF to acquire assets from a related party. However, there are a number of exceptions which include in-house assets on the condition that the SMSF will not breach the in-house asset rules after the acquisition has taken place.
  

In addition to the structure, finance arrangements and control of the unit trust or company is another aspect as to whether the income and capital distributions received by the SMSF are on an arm’s length commercial basis. If the amounts received by the SMSF do not meet an arm’s length commercial rate of return, or expenses are not on an arm’s length basis, the fund may be taxed at penalty rates of 45%.

An SMSF can be instructed to invest in a unit trust or company to obtain the benefits of developing a property. However, care needs to be exercised depending on whether related parties control the trust or company; whether it is geared or ungeared; or whether the SMSF and other related parties control the company. In view of the complexity of the different aspects of these arrangements, it is always necessary to see whether an SMSF will comply with the SIS Act and Regulations as well as whether the structure chosen will suit the property development. Therefore, do the right thing and seek professional advice.

Make sure you know what you’re doing if the SMSF decides to invest in a unit trust or company to develop the property. In addition, the SMSF should stay within the superannuation rules at all times.