Just as simpler super begins to look just that – simple – recent amendments to superannuation legislation have opened the door to new borrowing opportunities for super funds.
From September 24, 2007, the general prohibition on superannuation funds from borrowing under s67 of the Superannuation Industry (Supervision) Act (SIS Act), subject to limited exceptions, has been relaxed to allow super funds to borrow to purchase any asset that they would otherwise be able to acquire, subject to certain strict instalment warrant like conditions.
Background to Instalment Warrants
Instalment warrant arrangements in Australia have developed since the 1990's and have typically been created in respect of listed securities, managed investment funds and, more recently, direct property investment. Most notably perhaps was the warrant offered for the privatisation of Telstra (T1, T2 & T3)
An instalment warrant generally gives the holder the right to purchase the underlying asset (eg listed shares) from the issuer (eg a bank) at a particular price on or before a certain date. There are a number of different types of warrants with the design or terms often varying from provider to provider and from product to product.
In the past SMSF trustees have invested in instalment warrants, such as Telstra, on the basis that they did not constitute a borrowing or charge at law. However, in November 2006, it was declared by the Australian Taxation Office (ATO) and Australian Prudential Regulation Authority (APRA) that the use of such products by super funds did constitute 'borrowing'. In response to industry pressure, the Government subsequently amended the borrowing provisions to allow funds to continue investing in these products.
These amendments have wider implications in that they not only confirmed the current status allowing super funds to invest in commercial instalment warrants, but they also allow trustees to put in place their own private instalment warrants in order to borrow to purchase any asset, provided certain requirements have been satisfied. This represents a major concession for superannuation funds where the trustee can now borrow to directly acquire assets such as real property.What are the new rules?
The new exception provided in s67(4A) of the SIS Act sets out how a fund trustee can now borrow money or maintain a borrowing of money under an arrangement where:
- The borrowing is used to purchase an asset that the fund trustee could have acquired directly without beaching the SIS Act;
- The asset is held on trust for the super fund so that the fund trustee acquires a beneficial interest in the asset (a security/debt instalment trust is established over the asset);
- The fund trustee has the right to acquire legal ownership of the asset after making one or more payments; and
- The borrowing is limited recourse. That is, in the eventuality that the fund trustee defaults on the loan, the lender will have recourse against the 'finance' asset and any other property offered as guarantee. This means that the assets of the super fund will not be at risk under this financing structure.
Further amendments to the in-house asset rules ensure that the establishment of the security/debt instalment trust to satisfy the above rules would not be an in-house asset provided the asset being acquired is the only asset held by the trust and it would not be an in-house asset if acquired directly by the fund.
How it works
The new provisions allow the trustee of a SMSF to enter into a form of limited recourse borrowing. The simple rule to remember is that if the fund can acquire the asset directly, then it can also acquire the asset by borrowing the money through an arrangement described above. The changes still ensure that people cannot use the new rules to avoid in-house asset rules under the SIS Act.
An example of an appropriate transaction would be a residential property acquired from, and leased to, a third party. If, on the other hand, the fund trustee purchased the residential property under the new arrangements from a fund member, or one of the member's relatives, the fund trustee will breach the in-house asset rules on the basis that the residential property would have been an in-house asset had the fund trustee acquired the residential property directly.
A trustee will put down a deposit for the property. The fund trustee nominates for the loan to be advanced by the lender to the entity that
will purchase the asset for the remaining balance and hold it 'on trust' for the fund trustee (remembering the legal owner of the asset must be someone other than the fund trustee, which to avoid confusion may be classified as the Custodian).
In terms of the lender, s67(4A) of the SIS Act contains no limitation on the identity of the lender and there are currently no regulations as to matters such as the setting of interest, the number, frequency and level of repayments, the term of the warrant, or the size of the initial instalment, although usually this is approximately 20%. These decisions are negotiated between lender and the trustee, however where the lender is related, s109 of the SIS Act (arm's length dealings) will apply.
The forms of borrowing which might be considered include:
- A direct loan from a bank or other financial institution;
- An indirect loan from a bank or other financial institution (where a member or related entity borrows the required funds providing security from other assets and on-lends the funds to the trustee under arrangements meeting the criteria); or
- A loan from a related party (either personally from the member or from a related entity)
In addition, the fund trustee has the following options in relation to interest and final payment:
- Make interest payments over the term of the arrangement, pay the principal and take legal ownership of the asset;
- Make both interest and principal repayments over the term of the loan, leaving no balance outstanding on the loan at the end of the term.The fund trustee can then take legal title of the asset; or
- Make some or all of the payments on the loan and then, either on or before the end of the term, direct the Custodian to sell the asset. The fund then pays back any loan outstanding, with the balance of monies, if any, kept within the fund.
If the fund trustee defaults on the loan the lender has the right to sell the asset and recoup the monies outstanding on the loan, remembering the loan is limited recourse. From the outset, the fund trustee has the right to the income generated from the asset. Whether the income received is assessable and any interest paid is tax deductible will depend on whether the fund is in accumulation or pension mode.
Issues for Consideration
The usual SIS Act restrictions will still apply as well as general investment and commercial principles.
Key consideration needs to be given to issues such as:
- The tax implications (including income tax, capital gains tax, goods and services tax, stamp duty and land tax)
- Sole-purpose test
- In-house asset rules
- Arm's length dealing
- Related party acquisition rules
- Commercial issues (such as location, capital growth, rental opportunities etc..)
Specialist and expert advice should be obtained before entering into any borrowing arrangement. Both the new nature of this provision and the specific way it needsto be constructed means that getting the right advice is imperative. Failure to comply with the rules will place the entire fund at risk of non-compliance (not just the property) with penalties of 46.5% of the total balance of the fund applicable for breaches.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.