LRBAs and related-party leases: what you need to know
There are tips and traps associated with limited recourse borrowing arrangements (LRBAs) and related-party leases – some of which may surprise SMSF practitioners.
A common strategy implemented by business clients is to acquire business real property (usually the premises from which their business is run) via their SMSF and then lease this property to a related party. Borrowings are often used to finance the acquisition.
The above is typically a standard transaction. However, where the complexity arises is where the related-party tenant wishes to make changes or improvements to the property. Invariably, on the exit of a prior commercial tenant a refurbishment is required. Indeed, economic changes may force a change in use and layout during a lease term.
Does the installation of such a fit-out contravene the prohibition of related-party acquisitions? Do any improvements give rise to a new asset for SMSF borrowing purposes? Does the value of the fit-out count as a contribution?
This article answers some of the above questions and highlights the other tips and traps associated with such a strategy. The results are likely to surprise you.
Consider Alistair. Alistair is the sole director and shareholder of a company that runs a dental surgery. The surgery is expanding rapidly and is in need of new premises. Alistair finds a retail premises for sale in a prominent location that perfectly suits his needs.
On the advice of his accountant, Alistair establishes an SMSF. The SMSF enters into an LRBA and borrows to acquire the retail premises. Following settlement, the SMSF leases the premises to the related company on arm’s length terms.
The company requires a special fit-out to be installed in order to suit the surgery’s particular needs. This fit-out will include, among other things, walls being erected to create new zones, furniture and other equipment being bolted into the floor and special lights being fitted.
Alistair is concerned that the installation of the fit-out will affect the superannuation law compliance of the acquisition.
Prohibition of related-party acquisitions
The starting position is that if an object is affixed to a property, it will form part of the property. This is known as the ‘doctrine of fixtures’.
With reference to the above example, this means that any item the company attaches to the property will constitute an acquisition of that item by the trustee of the SMSF. This is an acquisition from a related party and, at first instance, appears to contravene s.66(1) of the Commonwealth Superannuation Industry (Supervision) Act 1993 (‘SISA’). The ATO has confirmed this view in SMSFR 2010/1 in regards to an acquisition of materials.
That being said, the doctrine of fixtures does not strictly apply in the case of tenants fittings. More particularly, the general position is that an item affixed to the land by a tenant is the property of the landlord; however, the tenant has right of removal. See TEC Desert Pty Ltd v Commissioner of State Revenue  HCA 49, where it was stated that:
25. As noted above, in the Court of Appeal, reliance by analogy was placed upon the law respecting "tenant's fixtures". That law concerns the rights of persons who have limited interests, such as life interests and leases for a term, or their personal representatives, to sever and remove from the land what admittedly are fixtures in the sense of the term as just discussed. Unless and until that right of severance and removal is exercised, the fixtures form part of the realty.
26. Upon this aspect of the subject, it is said in Megarry and Wade:
"Prima facie, all fixtures attached by the tenant are 'landlord's fixtures', i.e. must be left for the landlord at the end of the lease. But important exceptions to this rule have arisen, and fixtures which can be removed under these exceptions are known as 'tenant's fixtures'. This expression must not be allowed to obscure the fact that the legal title to the fixture is in the landlord until the tenant chooses to exercise his power and sever it. The tenant may do so only during the tenancy or (except in cases of forfeiture or surrender) within such reasonable time thereafter as may properly be attributed to his lawful possession qua tenant."
The above position can typically be rebutted through the insertion of suitable ‘retention of ownership’ clauses in the lease and other documentation. In very broad terms, such clauses state that any items the tenant affixes to the property remain, at all times, the sole property of the tenant and the tenant must remove said items upon expiry of the lease. Moreover, there is usually a ‘make good’ clause under which the tenant has to ensure the property is left in the same condition as the property was provided (at the commencement of the lease) at the end of the lease term, with fair wear and tear excepted.
(The law surrounding leases is jurisdiction-specific and advice from a legal practitioner in the location where the property is located should be sought to settle the specific wording of such clauses and confirm their efficiency in the relevant jurisdiction.)
Assuming express ‘retention of title’ and ‘make good’ clauses exist in the lease and the fit-out is easily removed upon termination or expiry of the lease, the installation of the fit-out should not contravene s.66(1) of the SISA. That is, the tenant would retain ownership of any affixed items and therefore there would be no acquisition by the SMSF trustee.
The ATO is likely to agree with this conclusion and provides the following analogous example in SMSFR 2010/1 :
… A member of an SMSF leases SMSF property and retains the right to remove office partitioning at the end of the lease term. If the member subsequently removes the office partitioning an asset has not been acquired by the SMSF. If the office partitioning is not removed, a trustee or investment manager acquires an asset (assuming it is of value at the end of the lease term) for the purposes of subsection 66(1). However, depending upon the circumstances it may not have been intentionally acquired by a trustee or investment manager.
The above also suggests that even if the company failed to remove the fit-out following termination or expiry of the lease, the prohibition of related-party acquisitions would not be contravened. This is because a lease that includes suitable ‘make good’ and ‘retention of ownership’ clauses provides good evidence to suggest that the SMSF trustee had no intention of acquiring any assets associated with the fit-out and therefore any such acquisitions are unintentional.
The insertion and nature of any ‘make good’ and ‘retention of ownership’ clause depends on the economic conditions and whether the landlord or the tenant has the greater negotiation position.
SMSF borrowing rules
An SMSF trustee is prohibited from borrowing to improve an asset (SISA s.67A). Examples of improvements include building a new garage, constructing a pool or adding a second storey to a residential property (SMSFR 2012/1).
Although SMSF trustees cannot borrow to improve an asset, the ATO takes the view that an asset that is the subject of an LRBA can be improved so long as the improvements are paid for using money that has not been borrowed and do not alter the character of the asset to such an extent that the asset becomes a new asset (SMSFR 2012/1).
The change from retail premises to a dentist surgery should not convert the property to become a replacement asset. However, this will therefore not cause any concern under the SMSF borrowing rules.
The ATO provides the following guidance in SMSFR 2012/1 –:
If property is leased by the holding trust, the tenant may be permitted to make changes to that property, for example by adding a fixture. …
However, particular laws of a state or territory may mean that property in a fixture remains with the tenant. If this is the case, the changes made by the tenant would not result in a different asset being held on trust under the LRBA.
The above implies that where a lease contains suitable ‘retention of ownership’ and ‘make good’ clauses, the installation of a fit-out (such as the one proposed in the above example) will not give rise to a new or replacement asset.
Identity of payee
When implementing a strategy such as the above, it is important that the related-party tenant pays for all materials and costs relating to the fit-out and not the SMSF trustee. If the SMSF trustee was to pay for some of the expenses, this could give rise to a number of compliance issues, including constituting an early access scheme or contravening the arm’s length rules, financial assistance rules or sole purpose test.
The ATO takes the view in TR 2010/1 that a contribution is anything of value that increases the capital of the fund and was made by someone with the purpose of benefiting one or more fund members. A suitable ‘retention of ownership’ and ‘make good’ clause will be relevant here also. Such clauses mean that the capital of the fund is not increased by the installation of the fit-out as the tenant retains ownership of these assets. Therefore, suitable documents should minimise any contribution risk associated with the above strategy.
As alluded to in the above quote from SMSFR 2010/1 , on expiration of a lease, there may be an unintentional acquisition of a fit out on the departure of a related party tenant. At this stage, a contribution, as well as a s 66, exposure may exist. However, it is generally argued that an old fit out is worthless (and may have a negative value being the cost to refurbish and update the premises). Nonetheless, care needs to be taken to minimise such risks.
Arm’s length rules
It is also important that the SMSF trustee and related tenant are at arm’s length. This means benchmarking the terms of the lease, ensuring rental payments are actually made regularly and on time and amending the lease rental and other terms as necessary in line with ordinary market and industry practice. Evidence of benchmarking should be retained moving forward.
In-house assets include assets of a fund that are subject to a lease or lease arrangement between the trustee and a related party. One exception to this rule is where the lease or lease arrangement is in respect of business real property.
It follows that the above strategy will typically only be appropriate where the underlying real estate is commercial in nature. Leasing residential real estate to a related party is likely to give rise to in-house asset concerns. The same is true in respect of leasing plant and equipment related to a fit out that is separate to the building.
The ATO’s ruling SMSFR 2012/1 does not provide much guidance on when improvements will change the character of commercial premises or business real property. Submissions have been made to the ATO to provide further clarification and more examples to establish ‘safe harbours’ for advisers.
Acquiring real estate under an LRBA and then leasing same to a related-party tenant can be a worthwhile strategy for SMSFs. However, where a tenant fit-out is required, complexities can arise.
To minimise any superannuation law compliance risk, it is imperative that the relevant paperwork is appropriately drafted from the outset. Typically, the insertion of express ‘retention of title’ and ‘make good’ clauses in the lease and related documentation will be key. Involvement by a local legal practitioner with experience in superannuation and tax law is recommended.
Daniel Butler, director, DBA Lawyers and Tina Conitsiotis, laywer, DBA Laywers.