Deducting tax from LRBA costs
Setting up an LRBA to acquire an asset can be very costly. Advisers need to be across what the potential tax strategies are, and which ones are available to their client.
With a limited recourse borrowing arrangement (LRBA), a trustee of an SMSF may incur the normal expenses associated with borrowing to invest in real property.
• loan establishment fees
• legal expenses
• stamp duty
• valuation and survey fees
• brokers’ commission
• title search fees
• costs for preparing and filing mortgage documents
But it does not stop there. It is also necessary to incur additional costs in order to comply with the LRBA rules under sections 67A and 67B of the Superannuation Supervision (Industry) Act 1993 (SIS Act). This is because under the SMSF LRBA rules, the asset acquired with the borrowing must be held on trust (holding trust) in which the SMSF holds a beneficial interest in the asset. Some of the costs that may be incurred to set up an SMSF LRBA include:
• Amendment to the SMSF trust deed in order to allow the SMSF to borrow and for an asset of the SMSF to be held on trust.
• Establishment of the holding trust and associated LRBA documentation.
• Preparation of a loan agreement where the lender is a related party of the SMSF.
• Converting the fund’s trustee structure from individual trustees to a corporate trustee (required by some lenders).
• Establishment of a company as the holding trustee to own the asset (required by most lenders).
• Loan application fees and the cost of a lender to have the loan arrangement reviewed independently, or by their in-house legal advisers.
• Independent financial advice sought in relation to the LRBA. As a condition of the loan, some lenders require SMSF trustees to demonstrate that they have received independent financial advice.
Therefore the cost to set up an LRBA can be quite substantial. The next question that arises is whether any of these costs are deductible when they are incurred or are they capitalised into the cost base of the LRBA asset?
Income expense versus capital expense
Generally, the tax deductibility of expenditure incurred by an SMSF is determined under section 8-1 of the Income Tax Assessment Act 1997 (ITAA97), unless a specific provision applies, for example, the deductibility of tax related expenses under section 25-5.
A deduction is only available if the expenditure is incurred in gaining or producing assessable income of the SMSF, unless that expenditure is of a capital nature.
In regards to amending an SMSF trust deed, the ATO generally accepts SMSF trust deed amendments as being tax deductible. However, based on Taxation Rulings TR 93/17 and IT 2672, the ATO could argue that an SMSF that amends its trust deed for the sole purpose of allowing it to comply with the LRBA rules is a capital expense and not deductible, unless the SMSF trustee was also able to demonstrate that the deed amendment was required in order for the fund to comply with the SIS Act.
TR 93/17 also states that upfront investment-related expenses are of a capital nature and not deductible. These upfront investment expenses could include a financial plan prepared by a financial adviser for an SMSF trustee seeking advice on an SMSF LRBA strategy.
Deductibility of borrowing expenses
Under section 25-25 of the ITAA97, expenses that are incurred in relation to borrowing for the purpose of producing assessable income are specifically deductible. The deduction for the borrowing expense (where greater than $100) is claimed over five years, or over the length of the loan, whichever is the lesser.
Therefore the general expenses that relate to the borrowing of money, such as loan establishment fees and mortgage broker commissions would be deductible under section 25-25. Expenses that relate to the transfer or acquisition of the property, such as stamp duty and legal fees are not deductible as a borrowing expense and form part of cost base of the asset acquired.
It can be argued that SMSF trustees could apply section 25-25 to claim a tax deduction for all the costs that are connected with the set up of an SMSF LRBA (see list above), even though they are capital in nature and would not normally be deductible under section 8-1. This is because the expenditure is required to borrow money and the borrowed money is used for the purpose of producing assessable income.
Business capital costs
Section 40-880 of ITAA97 allows deductions over a five-year period for expenses incurred by a taxpayer to set up a business structure, such as a company or trust (also known as blackhole expenses). However, the capital expenses of setting up an SMSF (including a corporate trustee), or an SMSF LRBA would not be deductible under section 40-880, as an SMSF is generally not considered to be carrying on a business.
It is worth noting that the above deductions are only available to those SMSFs paying tax (that is, in accumulation phase). If the SMSF is in pension mode and the LRBA asset is supporting the payment of the pension, then the SMSF will not pay tax, nor will they be able to claim a deduction on any of the expenses relating to the asset.
Andrew Yee, director of superannuation, HLB Mann Judd