On 14 September 2011, the Australian Taxation Office (ATO) released Draft Self Managed Superannuation Funds Ruling SMSFR 2011/D1 (the draft ruling). The draft ruling explains key concepts relevant to limited recourse borrowing arrangements (LRBAs) put in place on or after 7 July 2010.
Importantly, the draft ruling clarifies the ATO’s previous preliminary view on asset improvements and provides a number of examples to illustrate the extent to which improvements or alternations can be made to an asset acquired under a LRBA without contravening the asset replacement rules in section 67B of the Superannuation Industry (Supervision) Act 1993.
The draft ruling states that an asset acquired under a LRBA can be improved as long as the improvement is not funded by a borrowing under the LRBA, and the improvement does not result in a new asset being created.
In the draft ruling, the ATO defines an improvement as a change to the asset which provides a greater efficiency of function. This usually involves changing the asset in a way which increases the value or desirable form, state or condition of the asset. In other words, an improvement involves the addition of new and substantial features or rights to an acquirable asset that substantially increase the asset’s value or functional efficiency.
The ruling provides an example of a SMSF which purchases a three bedroom residential property under a LRBA. After the acquisition, the SMSF renovates the property by adding a bathroom. As the addition of the bathroom has increased the value of the property and its functional efficiency, the renovation is considered to be an improvement.
On the other hand, a new asset is created if the character or purpose of the original asset has changed as a result of the improvement or alteration. In the above example, the renovation has not changed the character or purpose of the property originally acquired under the LRBA and therefore it is not considered to be a new asset.
Importantly, in a LRBA context, the distinction between a repair and an improvement is only relevant if the repair is being financed by a borrowing under the LRBA. This distinction is not relevant if the repair is being financed by the SMSF directly or by some other source. All that matters in these situations is that the change to the acquirable asset does not fundamentally change the character or purpose of the asset such that it becomes a different asset.
This approach also enables the use of insurance proceeds to rebuild a property destroyed or damaged by an insurable event such as a fire or cyclone. Because the reconstruction or repair is not being financed by a borrowing under the LRBA, it is irrelevant whether or not the construction merely repairs or improves the property.
However, it is important that the repair or reconstruction does not result in a different asset to the original asset acquired under the LRBA. An important consideration would be whether the asset has been entirely replaced by another asset, as this would constitute a new asset under section 67B of the Act.
The draft ruling uses the example of a house which is destroyed by fire and is subsequently rebuilt using the insurance proceeds. As rebuilding the house is restoring the asset to what it was at the time of entering into the LRBA, it does not result in a new asset for the purposes of section 67B of the Act. Although the house has been entirely replaced, the acquirable asset itself has not been entirely replaced because it has been constructed on the same land as the previous house.
In contrast, if the acquirable asset was a piece of artwork which was being stored in a professional gallery and the gallery and the artwork was destroyed by fire, replacing the artwork with a similar piece of artwork would be in breach of section 67B. The artwork in this situation has been replaced in its entirety, and the replacement piece of artwork is not covered by section 67B.
Whether or not the asset has been improved or replaced in a LRBA context requires an assessment of the extent of the improvements to determine whether the improvements have fundamentally changed the character of the asset such that it becomes a different asset.
In some situations, it may be difficult to determine whether the improvements have resulted in a new asset being created.
For example, what if when rebuilding a house destroyed by fire an additional shed is also added which will be used for commercial purposes? In this situation, a further assessment would need to be undertaken to determine whether or not the acquirable asset is now serving a different function and purpose to that previously served by the asset originally acquired under the LRBA.
The draft ruling suggests there is a significant amount of scope to improve or alter an asset without that asset being considered a new asset for the purposes of section 67B. The draft ruling uses the example of a property which is damaged by a cyclone and states that the addition of a second storey to the house at the time the house is repaired would constitute an improvement but not a new asset for the purpose of section 67B.
Similarly, the addition of a new pool or a new garage to that asset would be an improvement but not a new asset for the purposes of section 67B.
Peter Burgess is SPAA’s national technical director.
