How to pass the business use test
Determining whether the business use test has been passed is a complex process as it will depend upon the facts and circumstances of each situation.
There needs to be a study guide available on how to pass the business use test. The facts are that business real property (BRP) must be acquired from a related party at market value (refer to previous article) and comply with the BRP requirements.
Unfortunately, meeting the BRP definition is not just a box-ticking exercise. The reason is that a holistic assessment of the facts and circumstances is relevant in every case.
What is Business Real Property?
Under s66(5) SIS, the definition of BRP is any:
- Freehold or leasehold interest of the entity in real property; or
- Interest of the entity in Crown land, other than a leasehold interest, being an interest that is capable of assignment or transfer
It is confusing because a "leasehold interest in real property" is allowed under the first definition but excluded under the second as a "leasehold interest in Crown land".
Regardless, a leasehold interest in crown land is included in the first definition and is allowed as BRP.
Business Real Property Conditions
The primary conditions for real property to meet the BRP definition are:
- the SMSF or other entity must hold an eligible interest in real property as defined in s66(5)
- the real property must satisfy the business use test and be used wholly and exclusively in one or more businesses (whether carried on by the entity or not).
Ensuring the definition applies to the correct entity is vital; once again, reviewing the facts and circumstances of each case will determine whether the basic conditions are satisfied.
Where the SMSF or a related party acquires an interest in BRP from another related party, the definition applies to the related party selling the BRP.
Where the SMSF or related party is leasing BRP to another related party, the definition applies to the landlord or lessor granting the rights under the lease or lease agreement.
Enforceable Lease Agreement
The ATO's ruling on BRP is SMSFR 2009/1, which explains the application of BRP to SMSFs by focusing on whether the underlying land satisfies the business use test in the definition.
One of the strict requirements is that real property is the subject of an enforceable lease agreement between the SMSF and a related party. A valid commercial lease on arm's length terms is necessary for meeting the in-house asset (IHA) exemption for BRP.
The absence of an enforceable lease agreement, whether or not in place or lapsed, means the BRP becomes an IHA of the fund.
Holding an Eligible Interest in the Property
The first condition that applies to BRP is the entity must hold an eligible interest in one of the following property types:
- freehold interest – identified by a title over the land
- leasehold interest – exclusively possess the property under a lease
- interest in crown land – includes both freehold and leasehold interest
One of the most important rules is that any fixtures attached to the land form part of the BRP. SMSFR 2009/1 considers that two (2) tests must be applied to determine whether a fixture is attached to the land and constitutes real property:
- Degree of annexation test – where it is attached to the land other than by its own weight
- The object of annexation test – where it is for the better enjoyment of the freehold and not the building or other thing itself
A typical example is a demountable, which is a fixture and not part of the 'real property'. It becomes a fixture if the demountable is attached to permanent foundations and connected to water and electricity.
Passing the Business Use Test
The second condition is that the real property must pass the business use test, which is whether the underlying land satisfies the business use test.
The activities, operations or actions occurring on the land give the property's use to the business character.
Again, the property must be used wholly and exclusively in one or more businesses, which depends on the facts and circumstances.
Idle or dormant land not being used is not business real property. However, a human presence for physical use is not essential and includes grazing land on a farm, wind turbines or towers.
The Commissioner acknowledges that it would be impractical to apply the test "literally in every single case", allowing for a small amount of wriggle room.
As a result, "a minor, insignificant or trifling non-business use of the property can be accommodated under the wholly and exclusively threshold."
A notable exception is the special rules for a farm that will comply where the area for personal use and a residential dwelling does not exceed two (2) hectares, and private use is not the predominant use of the farm.
Determining BRP At a Point in Time.
BRP status is determined when the SMSF acquires the eligible interest in real property from a related party.
Because BRP has an exception from the IHA rules, the property must also meet the BRP test at the end of each income year.
By way of example, where the property is no longer used in a business but still rented to a related party, it will become an IHA of the fund.
Forgetting about having an enforceable lease agreement in place at all times can also wreak havoc. If the lease lapses through an administrative error, that will cause the IHA exception to cease and the property, if leased to a related party, to become an IHA of the fund.
What about when the tenants leave and the property becomes vacant?
The property still passes the business use test and continues to comply if the trustees intend to continue leasing the property to a business.
If the trustees decide not to rent the property to a business, it is no longer BRP.
A damaging turn of events is when the trustees manipulate a situation by using the property in a business for a short time when the SMSF acquires it. Then it is primarily used for non-business purposes afterwards and is not BRP.
Passing the business use test is not straightforward and understanding the BRP rules is essential to ensure that any BRP acquisition complies.
It will depend on the facts and circumstances of each situation, as there is no exhaustive list that suits every property type.
Reviewing SMSFR 2009/1 will help to understand the finer nuances and compliance requirements of acquiring BRP from a related party. And how to pass the business use test.
Shelley Banton, head of education, ASF Audits