There are a number of compliance tips and traps to navigate when an SMSF purchases an overseas property.
SMSF trustees can purchase property either by an outright purchase or by borrowing using a limited recourse borrowing arrangement (LRBA). To illustrate the potential risks involved, each of these types of investment will be considered in turn.
Investment with no borrowings
In short, an SMSF trustee can purchase a property overseas. However, there are many compliance hurdles. Some of these are listed below.
• Sole purpose test — the acquisition meets the sole purpose test. In other words, is the SMSF being maintained solely for the prescribed purposes (eg, to provide retirement benefits)? In the famous Swiss Chalet Case (Case 43/95  ATC 374) a superannuation fund trustee invested in a unit trust, the assets of which included a Swiss chalet. The question in this matter was whether the fund met the then equivalent of the sole purpose test. The problem was not so much the investment itself, but that fund members and their friends stayed in the chalet without paying rent. The fund was held to have contravened the sole purpose test. Accordingly, it is important that an SMSF trustee only acquire real estate because it genuinely believes it is an appropriate way to achieve its core purpose of providing retirement benefits. Moreover, some SMSF members also mistakenly believe the ATO will never know that they are using the property overseas, especially if it is in a faraway destination. However, immigration, phone, credit card, GPS and other records can readily pin you to the ‘scene of the crime’ these days. We have had the opportunity to represent clients who were asked by the ATO to prove they did not use the overseas property owned by their SMSF or related structure.
• In-house assets — this is a big issue if it is not the SMSF trustee acquiring the property itself but rather a company and the SMSF trustee acquires shares in the company (see below). Particularly, if an overseas bank account is required, this may restrict the investment.
• SMSF deed and investment strategy — the acquisition must be authorised by the deed and consistent with the fund’s investment strategy.
Perhaps the most prevalent risk that may restrict SMSF trustees from investing overseas is the in-house assets rule. This is because some overseas jurisdictions require that property be held by a company or similar vehicle in the foreign country. This type of restriction is usually designed to preclude too many non-residents acquiring local property in the overseas country. Practically, this means that the SMSF member will often need to establish a company in the overseas jurisdiction and the SMSF trustee will invest in shares of that company. The company’s share capital will be used to finance the acquisition of the overseas property. In some Asian countries I have come across SMSF trustees paying a local native to hold the title on their behalf and I have questioned how solid this arrangement was under the local native rules.
On its face, the investment by an SMSF in an overseas company’s shares is an investment that is an in-house asset, which itself is a serious contravention subject to considerable penalties. However, if the investment meets the exceptions outlined in 13.22C of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (‘SISR’) (ie, non-geared company or non-geared unit trust) then the investment will not contravene the in-house asset rule. One of the requirements of this exception is that the assets of the company being acquired must not include a loan to another entity, unless the loan is a deposit with an authorised deposit taking institution within the meaning of the Banking Act 1959 (Cth). As such, if there is an overseas bank account established (or required to be established), the investment in that company by the SMSF trustee will be an in-house asset unless the overseas bank account complies with our banking legislation. As a result, the shares in the company would need to be disposed of by the SMSF trustee.
Unfortunately, many SMSF trustees are ‘lambs to the slaughter’ as smooth real estate agents tell them they are buying real estate, but when the deal is done and the advisers get involved, the detailed requirements of the local jurisdictions law become apparent and a company or similar structure may be needed. This results in many falling into this compliance trap with great downside risk and substantial costs to unwind the transaction.
If the jurisdiction allowed the SMSF to invest in the property directly (without a local company intermediary) then the above risk would be extinguished. However, our experience has shown that numerous popular overseas jurisdictions require a company to be established.
Investment with borrowings
If the SMSF trustee were to borrow to acquire the property utilising a LRBA, this poses even further risks.
Firstly, if the property being acquired had to be held via a foreign company, we question whether a bank would be willing to lend to acquire overseas property. Practically, the bank would be lending money to acquire a piece of paper (being shares in the foreign company). Our experience is that banks will be very reluctant to lend on this basis where the security is shares in a company or units in a unit trust. Moreover, we have found few overseas banks that provide documents that are consistent with s.67A requirements and thus the LRBA may not be limited recourse or may otherwise contravene the law.
As an alternative or as supplemental to taking security over the shares of the foreign company, the bank may seek to take security over the overseas property itself. If it were to do so (and the property was held via a foreign company), this would contravene the requirements of reg 13.22C of the SISR. As such, the SMSF trustee’s investment in the foreign company would be an in-house asset again with numerous potential penalties and downside risk.
If a related party were to lend instead of a bank, it is questionable whether that lending would be at arm’s length unless evidence can be gathered that the friendly party LRBA terms and conditions are consistent with arm’s length practices.
Our experience has also proven that dealings with different overseas jurisdictions can result in complicated legal analysis to ensure everything is properly bedded down. For example, many overseas countries do not recognise trusts and the legal system in some countries requires an examination of a lengthy chain of title and there is a need to ensure all legal matters are tied down adequately to satisfy Australian legal requirements as well as satisfying the overseas rules.
In addition to the compliance aspects outlined above, there are often inflated costs for the transaction that must be taken into account. These may include costs in sourcing the property (ie, buyer’s agent or advocate in the foreign country), having repairs and maintenance undertaken and the costs for the lawyers and advisers overseas to complete the conveyance and provide ongoing advice. In addition to these costs, a structure such as a company may need to be established in that jurisdiction — ongoing maintenance costs are also likely to apply. Overseas tax compliance may arise and a range of other reporting and other obligations.
In addition to these costs, if an SMSF were to borrow to acquire the property using an LRBA there would be costs in obtaining documentation to allow the fund to borrow.
There may also be unexpected ongoing costs, such as overseas land and wealth taxes and costs associated with dealing with tenants (evicting a tenant may not be a straightforward process in overseas jurisdictions).
Such costs should be considered before embarking on overseas property investment.
SMSF trustees can invest in overseas property. However, the compliance requirements, coupled with increased costs, may not make the investment as attractive to SMSF trustees as they first thought. I strongly recommend that expert legal, accounting and related advice be obtained both in Australia and the overseas jurisdiction before SMSF trustees buy overseas property.
Daniel Butler, director, DBA Lawyers
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