Amendments in superannuation law mean SMSFS can now build up their assets with borrowed money.
By Michael Laurence
Following recent amendments to superannuation law, self-managed superannuation funds (SMSFs) are unequivocally permitted to borrow to buy investments, within strict conditions. This represents a highly significant change that superannuation specialists forecast will transform the investment practices of many thousands of funds.
The amendments to the Superannuation Industry (Supervision) Act, in effect from September 2007, exist despite the general legal prohibition on borrowing to invest by self-managed funds that has been in force since the 1980s, and remains in force. In effect, the new borrowing provisions are an exception to the rule.
Martin Heffron, co-principal of Heffron Consulting, an SMSF administrator and consultancy in NSW, sums up the expected impact of the amendments with a few, carefully chosen words: 'This is a dramatic change to the superannuation landscape.'
Apart from enabling SMSFs to build up their assets with borrowed money, Heffron points out: 'The capital growth on these assets can be sheltered in an extremely tax-effective way [given the concessional tax treatment of fund earnings].' And SMSFs can keep adding to their assets through gearing within the new provisions, unhindered by the annual contribution caps.
Sydney tax and superannuation lawyer Robert Richards CPA, principal of Robert Richards & Associates, explains that the path is now clearly open for funds to borrow without using traditional instalment warrants, provided the new borrowing rules are met. By traditional warrants, he is referring in this context to structured products pro-moted in recent years by the likes of fund managers and merchant banks that package the loan and the geared assets together.
The expectation of some superannuation specialists, including Richards, is that SMSF trustees will eventually favour the selection of their own investments rather than using packaged arrangements.
However, Richards warns that many lenders, including at least one of the big four banks, simply do not understand that the recent amendments allow SMSFs to borrow.
'It will take them some time to come to terms with the amendments.'
Clarity for funds
Michael Davison, superannuation policy adviser for CPA Australia, says the borrowing amendments have brought clarity to the issue of whether SMSFs can use such means as instalment warrants or other means to borrow to invest.
In simple terms, a traditional instalment warrant is a type of derivative that enables a borrower to acquire an investment through the payment of instalments. (Although the borrowing amendments are headed 'instalment warrants', the actual legislation does not mention them.)
Until the passing of the amendments, fund trustees had reason to be confused about how the long-standing legal bar on SMSFs borrowing to invest operated in practice.
Fund managers and investment banks had been widely marketing instalment warrants to SMSFs for several years. These were unquestionably a means for them to borrow.
But regulators were clearly getting concerned about this apparent inconsistency. The ATO and the Australian prudential regulation authority (APRA) reached the view that the investment in traditional instalment warrants by SMSFs was a breach of both the legal ban on borrowing in superannuation law and the in-house asset rules (discussed later in this article).
The regulators' stance encouraged the Howard Government to announce that the borrowing amendments would be introduced into parliament.
Strict conditions
Under the amendments, SMSF trustees are permitted to borrow to invest (whether or not using instalment warrants) provided three conditions are met. The asset being purchased must be held in trust until the fund pays all outstanding repayments. After making one payment, fund trustees receive a beneficial interest and a right, but not an obligation, to acquire the legal ownership of the trust-held asset through the payment of all instalments.
In the event of default, the lender's recourse against fund trustees is limited to its rights in relation to the asset being purchased with the loan. The lender cannot make a claim against any of the fund's assets. This is the position even if the asset being purchased decreases in value, and part of the principal debt and fees remain unpaid. The amendments do not prohibit the lender from taking possession of the asset being acquired with the loan, even though the fund may have paid a substantial deposit on that asset.
The borrowing is used only to acquire an asset that a SMSF is permitted to acquire under the Superannuation Industry (Supervision) Act. This means, for instance, that a fund is still barred from buying residential property or unlisted shares from fund members and other related parties. And a fund, with certain exceptions, must not have 'in-house assets' that exceed more than 5 per cent of its total asset value.
(In-house assets include investments or loans in related parties, and lease arrangements with related parties. Exceptions to the in-house asset rules include business real estate, whether or not occupied and leased by any of the members' businesses as tenants.)
Dividends, rents and member premises
Richards says that an SMSF will be able to earn returns such as dividends or rents from the asset being purchased while it is still held in the special trust.
'Interest on the investment loan is deductible to the fund,' he explains. 'And capital gains tax (CGT) will not be triggered when the asset is transferred from the trust to the fund after the final payment.'
If SMSFs use the new borrowing provisions to buy their members' business premises, the funds would then rent the premises back to the businesses at commercial rents.
The super funds would acquire a potentially appreciating asset and a known tenant. Rent and capital gains are taxed at the concessional superannuation rates. Further, the funds get the usual tax benefits of being a landlord.
Risks and strategy
The first risk of borrowing to invest by a SMSF is that an asset may fall sharply in value before the loan is discharged, and concerned fund trustees might decide to default on the loan if there is little expectation that its value of the asset will recover.
Davison points out that although a lender cannot make a claim against other assets of the fund in the event of default, a fund could lose any payments of capital, interest rates and fees up to the time of the default. Consider the example of a fund that holds $100,000.00 in cash and has no other assets. If that $100,000.00 is used as a deposit to acquire real estate or shares under the new borrowing provisions, the entire value of the fund could be lost following a default. And the members may have also given personal guarantees for the loan.
Davison says another risk of borrowing is that an SMSF will acquire an extremely valuable asset that could dominate the rest of its investment portfolio, making the members' retirement savings particularly vulnerable to a fall in value of that asset. And depending on the other assets in its portfolio, the fund may have difficulty paying member retirement or death benefits if, say, real estate cannot be readily sold for a reasonable price.
As Davison emphasises, an SMSF must consider if a costly property or share portfolio, financed under the new borrowing provisions, fits within its investment strategy. Under super law, fund trustees are required to prepare and implement an investment strategy that has regard to the whole circumstances of the fund including, among other things: the risks, likely returns, liquidity and diversity of each investment; the overall portfolio's diversity including risks of limited diversity; and ability to pay member benefits.
But after reflecting on these matters, fund trustees who decide to acquire, say, one piece of real estate and no other assets, would not be breaching superannuation law, provided the asset is within its investment strategy.
Regulator action
Expect regulators to target SMSFs and product promoters that fail to comply with the new borrowing conditions. Assistant commissioner for superannuation Ian Read recently signalled that the use of instalment warrants by SMSFs is 'on our radar' for 2007-08 to catch those that breach super laws. Davison believes that ASIC will be on the alert for possible misleading statements by promoters. Further, the ATO warns that an instalment warrant [or any borrowing arrangement] put in place by a SMSF before the law changed in September 2007 must comply with the new provisions.
Davison urges accountants to ensure that they do not breach state legal practitioners legislation in relation to in-stalment warrants. 'The general view is that trust deeds must be prepared by legal practitioners, not accountants,' he insists, 'unless accountants are also practising legal practitioners.'
Borrowing to invest
Three self-managed superannuation funds (SMSFs) examined in these case studies have had varying success in borrowing to invest under the new provisions, effective from September 2007.
Case study one
Circumstances: The trustees of a SMSF in Victoria with $10 million in assets wanted to borrow $20m using instalment warrants to buy an already-selected property for development.
Action: The well-informed trustees were ready to proceed as soon as the amendments to allow SMSFs to borrow to invest passed into law. The size of the transaction meant that the fund trustees had decided not to use an off-the-shelf trust deed for the special trust that would hold the property until the final instalment was made. Rather, a trust deed was drafted for their particular needs.
Cost: The total fee for accountancy advice, legal advice and document preparation was $20,000.
Comment: Tax and superannuation lawyer Robert Richards CPA, who gave advice to the fund's accountant, and drafted the trust deed and set up the trustee company for the special trust, says the fund trustees were fortunate to have an excellent relationship with a lender. This relationship meant the loan was easily raised, whereas many SMSFs that are choosing their own investments, rather than using structured packages (with the lending and asset together), are having difficulty gaining finance.
Case study two
Circumstances: The trustees of an SMSF in Western Australia wanted to borrow $300,000 using instalment warrants and to make a deposit of $100,000 from cash already in the fund to acquire a $400,000 home unit. And as with case study one, the fund tried to be ready to move as soon as the law changed in September.
Action: Given the size of the transaction, the trustees decided to use a generic, off-the-shelf trust and trustee com-pany that is designed for SMSFs to borrow to buy shares or real estate under the recent amendments.
Cost: The total fee for accountancy advice, legal advice and document preparation was $6000.
Comment: Richards, who gave advice to the fund's accountant, and drafted the trust deed and set-up the trustee company, says, 'This transaction has not got off the ground' because the trustees have been unable to find a willing lender. This is despite the trustees offering personal guarantees for the loan.
Case study three
Circumstances: The trustees of a SMSF in Adelaide wanted to buy a $600,000 home unit, borrowing $500,000 and using $100,000 from the fund's cash holdings for the deposit.
Action: The trustees had an off-the-shelf trustee deed and trustee company ready to use as soon as the amend-ments took effect. The trustees initially had difficulty raising the finance but fortunately had a good relationship with a mortgage broker and the transaction will proceed.
Cost: $6000, as in case study two.
Comment: Richards, who again prepared the documents and advised the fund's accountants, says it is disappoint-ing that most financiers do not yet understand the amendments.
