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If you answered no to this question on the basis that a residential property is not one of the listed exemptions to the general prohibition on trustees acquiring assets from related parties, you may wish to stop and reconsider. A recent self-managed superannuation fund (SMSF) ruling released in January this year confirmed the answer may not be so simple.
In accordance with section 66 of the Superannuation Industry (Supervision) Act 1993 (SIS Act), the trustees of a regulated superannuation fund are generally prohibited from intentionally acquiring an asset from a related party of the fund.
Subsection 66(2) then provides a specific exception to the general prohibition to allow the trustees (or investment manager) of a super fund with less than five members — SMSF or small Australian Prudential Regulation Authority (APRA) fund — to acquire business real property (BRP) from a related party at market rate.
In relation to real property (ie, land and any buildings permanently fixed to the land) a trustee of an SMSF will only be permitted to acquire the property, either by way of sale or by accepting it as an in-specie contribution, from a related party where the property meets the definition of a BRP.
The SIS Act defines BRP in relation to an entity to mean:
- any freehold or leasehold interest of the entity in real property; or
- any interest of the entity in crown land, other than a leasehold interest, being an interest that is capable of assignment or transfer; or
- another class of interest in relation to real property as proscribed by related regulations.
Where the real property is used wholly and exclusively in one or more businesses (whether being carried on by the entity or not), but does not include any interest held in the capacity of beneficiary of a trust estate.
Additional rules apply to extend the definition of BRP to properties used in a primary production business where the area set aside for a dwelling used primarily for private or domestic purposes does not exceed two hectares and that use is not the dominant use of the land.
Therefore, for a property to meet the definition of BRP it must be able to pass a business use test that requires the property to be wholly and exclusively used in one or more businesses.
Business use test
In its recent SMSF ruling on BRP (SMSFR 2009/1), the Australian Taxation Office (ATO) clarifies that for a property to satisfy the business use test, there must be some element of physical use of the property — that is, activities, operations or actions occurring on the land that is connected to an underlying business purpose.
For example, manufacturing operations carried on within premises constructed on real property will clearly involve the physical use of that property.
However, the ruling also clarifies that where there is non-physical use of an asset — that is, an entity using an interest in a property to derive income (rent) or gains — the mere fact that an entity uses the property in a non-physical way does not prevent the BRP definition being met.
For example, the ruling outlines that where an owner leases out a residential property to a residential tenant, it is only the tenant’s physical use of the property that is assessed under the BRP definition. The ruling then goes on to clarify that “even though the use of the property is ostensibly for a non-business purpose … it remains possible for that use to be connected to a property investment business carried on by the owner”.
In addition, the ruling outlines that where land is purchased for development as part of a property development business, and the land is physically used to realise the development plans, the land subject to the development could meet the BRP definition.
Carrying on a business
An important aspect of satisfying the BRP definition is that the property must be being used in a business. In relation to a residential investment property, this will require the property being used in a property investment business or a property development business.
While it will normally be obvious if a business is being carried on, it can sometimes be difficult to determine, especially where the business being carried on is subsidiary to a person’s main income-producing activity.
In general, whether or not a business is being conducted will depend upon an objective assessment of a number of factors. These include:
- profitability of activities;
- size and scale of operations carried on;
- repetition and regularity of business-like activities
- level of effort involved;
- separate business records kept;
- existence of employees; and
- business activities carried on continuously and systematically over a period of time, not on an ad-hoc basis.
For further guidance regarding the factors that are relevant to determining whether a business is being carried on see Taxation Ruling TR 97/11.
Therefore, where a residential investment property is owned and used as part of running a legitimate business of leasing out residential investment properties, that property could satisfy the definition of BRP.
To illustrate, the ruling provides an example of a taxpayer who owns 20 residential investment properties that are leased to long-term residents. The taxpayer manages and maintains the properties on a full-time basis, living on the income generated from the leases.
In this case, the ruling confirms that the scale of the operation together with the elements of repetition and purpose indicate that the taxpayer is operating a property investment business.
In addition, even though the tenants use the properties for private or domestic purposes, this use remains incidental and relevant to the taxpayer’s property investment business.
Therefore, the residential investment properties would satisfy the definition of BRP.
To contrast this, the ruling sets out another example where a separate taxpayer owns 10 residential investment properties that are leased to long-term tenants. However, in this case the taxpayer uses the services of a property agent to manage the premises.
In this situation, the taxpayer would not be considered to be running a property investment business as they use an agent to manage the properties. As a result, the properties would not satisfy the BRP definition.
Other considerations
If a trustee is considering acquiring a residential investment property on the basis that it satisfies the definition of BRP, they will also need to consider a range of issues. These include:
- ensuring the property is valued at market value by an independent valuer;
- the potential impact of capital gains tax (CGT) to the transfer and the client’s eligibility to claim the small business CGT exemptions (note that where a property’s main use is to derive rent it will generally not qualify as an active asset for the small business CGT rules);
- the potential impact of stamp duty that could apply to the transfer;
- taking into account the impact of any goods and services tax liability that could apply to the transaction;
- ensuring the fund’s investment strategy and trust deed allow for the fund to hold direct property; and
- if the property is being acquired by the SMSF using a borrowing, ensure the arrangement satisfies all the requirements of the instalment warrant borrowing rules.
While residential property held by a related party will normally be a prohibited asset, in certain situations it can satisfy the definition of BRP and could be acquired by an SMSF trustee.
Craig Day is senior technical manager at Colonial First State.
