Australia: Update On Superannuation Fund Borrowing Arrangements

Last Updated: 28 August 2008
Article by Rick Goldberg

Much has been written on last year's amendment to the superannuation laws to permit superannuation funds to borrow for investment under specific conditions. However, the initial response from self-managed superannuation funds (SMSFs) was cautious. This was due to several factors including uncertainty as to the position of the new Rudd Government and Australian Taxation Office, investment market volatility, and perceived complexity of the borrowing arrangement. More recently the ATO has issued publications outlining its position, and some of the major banks have launched their products. The position is now clearer, and the level of interest from SMSFs and their advisers has increased. This article examines the ATO's current views, the choices to consider when setting up a borrowing arrangement, and some of the remaining technical issues.

Self-Managed Superannuation Fund Borrowing Arrangements under section 67(4A) of the SIS Act

The conditions in s 67(4A) of the Superannuation Industry (Supervision) Act 1993 under which a SMSF trustee is permitted to borrow money are generally as follows:

1. The SMSF trustee borrows money to acquire an asset.

2. The asset is held on trust so that the SMSF trustee acquires a beneficial interest in the asset.

4. The SMSF trustee has the right to acquire legal ownership of the asset by making one or more payments (i.e. instalment payments).

5. The lender's rights against the SMSF trustee for default on the borrowing are limited in recourse to the underlying asset only.

Typically, this allows a SMSF to borrow money to acquire an asset that the SMSF could not afford to purchase with its own cash. Depending on how the loan is structured, the income received by the SMSF from the asset (e.g. rent) can be used to pay the interest on the loan, and the loan principal can be repaid by the SMSF using contributions received during the loan term, or from the proceeds of sale of the asset at the end of the term. Implementing the arrangement involves signing several key legal documents. However, the process is straight-forward.

The Tax Office Position

The Tax Office has issued Taxpayer Alert (TA 2008/5) dated 4 April 2008, and Instalment Warrants and Super Funds - Questions and Answers updated on 30 June 2008. These publications clarify the Tax Office's views on some aspects of the borrowing arrangements.

Borrowing Arrangement need not be an Instalment Warrant

One of the interesting (and somewhat confusing) aspects of the new law concerns the issue of an instalment warrant. Financial institutions had been offering instalment warrant financial products for sometime. Typically, the product provided investors with capital protected exposure to listed securities. For SMSFs, the issue was whether the product amounted to a borrowing which was prohibited under the SIS Act. The Tax Office and APRA concluded that it did, but because of the prevalence of super funds investing in such products, the Government legislated to legitimise the practice. However, the resulting legislation only refers to an "instalment warrant" in the section heading. The conditions of the borrowing arrangement prescribed in the legislation do not require the arrangement to be an instalment warrant or a warrant. This is significant in a few respects.

First, it means that the new law is not restricted to only allowing traditional instalment warrant and warrant type arrangements in listed securities of the type offered by financial institutions. The borrowing arrangement is available to be used to acquire any type of asset as long as the asset is an asset that can be acquired by a superannuation fund under the existing SIS Act requirements, and the borrowing arrangement is structured in a way that satisfies the requirements of the new law. Therefore, the arrangement can be used to acquire real property, unlisted securities or alternative assets such as collectables. (Existing restrictions such as acquiring assets from related parties and acquiring in-house assets continue to apply.) This is confirmed by the Tax Office Q&A publication.

Secondly, there is an Australian financial services licence (AFSL) issue. The Corporations Act defines a "warrant" to be a financial product that is a derivative and is transferable. The instalment warrants offered by the financial institutions are typically warrant-based financial products. Hence, the financial institution requires an AFSL to issue the product and it is necessary to hold an AFS licence or authorisation to give financial product advice to an SMSF about investing in the product. However, a loan or credit facility is generally not a financial product. The new law allows for a borrowing arrangement to be structured as a credit facility that is not a warrant and therefore is not a financial product. This means that the lender is not issuing a financial product and therefore does not require an AFSL. Consequently, the lender can be a related party of the SMSF. It also means that advisers to the SMSF who are not AFS licensees, such as an accountant, do not require an AFSL to give advice to the SMSF about the borrowing arrangement. (However, note that if the asset to be acquired under the borrowing arrangement is itself a financial product, then an AFSL is required to give advice about investing in that financial product asset.)

Then who should be the Lender - Bank or Related Party?

The ATO has confirmed that the new law does not prohibit the lender from being a related party of the SMSF. The SMSF has a choice and the decision will typically be determined having regard to interest rate, loan to valuation ratio (LVR), security being provided, and loan application or setup fees.

Some major banks have launched their superannuation fund borrowing facilities and it is expected that more will come into the market in the foreseeable future. The new law requires that the lender's rights against the SMSF trustee (emphasis added) for a default on the borrowing is limited in recourse to the underlying asset. This is intended to prevent the lender having recourse against any of the SMSF's other assets. However, it does not prohibit the lender from having recourse against assets of other entities in the family group. Our observation is that most of the current offerings require the financier to be given additional security from entities other than the SMSF through the provision of personal guarantees or third party mortgages. These borrowing facilities can be contrasted with the typical instalment warrant that was capital protected where the lender had no recourse against the investor if there was a shortfall between the loan amount to be repaid and the capital value of the asset. Some SMSFs and their advisers have assumed that the superannuation fund borrowing arrangement must also be structured as a capital protected arrangement with the financier bearing the risk of any shortfall.

The financial institutions may also be charging:

  • an interest rate with a premium over their current investment property interest rate; and/or
  • a facility application or establishment fee that is significantly more than the fee charged for a regular investment property loan. An SMSF should also ascertain whether the fee includes all of the legal documents for the borrowing arrangement, or whether the SMSF must incur further fees with the SMSF's lawyers to produce some of the documents that are not provided by the financier.

For these reasons, there may be a compelling case for a SMSF to use a related party as the lender under the borrowing arrangement rather than the bank. The related party lender may have access to available cash funds under a "portfolio package", line of credit or similar facility. Typically, the related party pays an agreed "package" interest rate, and can then on-lend the funds to the SMSF under the borrowing arrangement. The related party lender must charge the SMSF the same or similar commercial interest rate that the financier would have charged to the SMSF if the financier had lent directly to the SMSF under the borrowing arrangement. If there is an interest rate premium, then the cost differential between the interest paid by the related party to the financier and interest received by the related party from the SMSF, is a cost saving that stays within the family group.

If the lender is to be a related party, extra care must be taken to ensure that all of the terms are commercial. Section 109 of the SIS Act requires the SMSF trustee to ensure that the transaction terms are no more favourable to the related party than those which it is reasonable to expect would apply if the SMSF trustee were dealing with the related party at arms length in the same circumstances.

There is no prescribed limit on the loan to valuation ratio. A significant consideration in what would be a commercially acceptable LVR is whether or not additional security is provided. If additional security is provided, the LVR may be higher. The interest rate will also depend on the level of risk assumed by the lender. If no additional security is provided, then a higher LVR should correspond with a higher interest rate having regard to the greater risk assumed by the lender. Conversely, if additional security is provided and the LVR is more modest, this may justify an interest rate in line with typical bank rates for residential investment property mortgages. If the borrowing arrangement is scrutinised by the ATO, the SMSF trustee must be able to substantiate that the details of the loan in terms of LVR, level of security, type of asset, and interest rate, are commercial and can be justified.

The ATO has said that it is still considering whether it is permissible for a borrowing to be guaranteed by a third party, particularly where the personal guarantee is provided by a member of the SMSF. Noting that a SIS Act requirement of a SMSF is for members to be trustees, the ATO expressed concern that a personal guarantee may result in recourse being made to the assets of the SMSF in the event that the guarantee is enforced against the trustee of the SMSF as the principal debtor. However, we believe the formality under which securities, and particularly personal guarantees, are provided recognises and distinguishes between a guarantee given in the guarantor's personal capacity and a guarantee given in the guarantor's capacity as a trustee. A personal capacity guarantee would not of itself provide recourse against trust assets for which the guarantor is a trustee. This can be readily addressed in the security documentation.

Further, if the legislation had intended to prohibit the lender having recourse against related party entities and their assets, the sentence in the legislation that "the rights of the lender against the RSF trustee for default on the borrowing..." need not have included the words "against the RSF trustee". We are hopeful that the ATO will ultimately come to the same conclusion.

What can the Borrowing be used for?

The new law says borrowed money must be applied for the acquisition of an asset. The ATO has confirmed that the borrowing arrangement cannot be used to finance an existing asset of the SMSF. Generally, this would prohibit the SMSF taking a loan to pay development costs for a property owned by the fund. However, it may possible to structure a borrowing arrangement to finance a development of a fund asset through the fund selling the development rights to a related entity and the fund borrowing to acquire an interest in the related entity.

One of the interesting issues that the ATO is still considering is whether the new law permits refinancing of the original loan. If the loan is structured on an interest only basis and if the SMSF desires to retain the asset at the end of the loan term, it would seem un-commercial to not allow the SMSF the opportunity to refinance the original loan facility. Hopefully, this will be favourably confirmed by the ATO.

The Security Trust Arrangement - a Separate Bare Trust

A key feature of the borrowing arrangement is that the SMSF is the borrower but the asset is held on trust for the SMSF so that the SMSF has the beneficial interest and the right to acquire the legal interest by making one or more payments. This feature requires the existence of a separate trust and an entity that acts as the trustee of that separate trust.

The separate trust has become known as the "security trust". The security trust must be established as a new bare trust or fixed trust. It is not a unit trust or a discretionary trust. The borrowing arrangement typically requires a declaration of trust deed to record the existence of the security trust.

The trustee of the security trust is typically referred to as "the custodian". In many respects, the role of the custodian as trustee of the security trust under the borrowing arrangement is similar to the role of a professional custodian company providing custody services on behalf of public managed funds and superannuation funds. The custodian holds the asset on a bare trust for the SMSF. Accordingly, from an accounting and tax perspective, all of the income and expenses relating to the asset will flow through and/or be borne by the SMSF.

The custodian can be a related party of the SMSF, and can be either individuals or a company. The only requirement is that the custodian must not be the same entity as the trustee/s of the SMSF. Otherwise, the security trust does not exist because the trustee and beneficiary of the security trust are one and the same.


Before you enter into a SMSF borrowing arrangement, we recommend that you do a careful financial and tax modeling of the arrangement. Gearing into a SMSF with its concessionally taxed treatment can produce very different results to a geared investment by an individual on top marginal rates. If the financial analysis is sound, the new law certainly provides an opportunity as part of the overall SMSF investment strategy.

Rick Goldberg is a Partner at Madgwicks and has over 18 years experience in corporate and commercial law. His particular areas of practice include funds management, superannuation and regulatory compliance.

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.

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