Webb Martin Consulting - Expert Tax Advice

Issue #7

Borrowing to invest by Superannuation Funds

A topic that has generated much discussion in recent months is the ability of superannuation funds, including self managed superannuation funds (SMSFs) to borrow to invest, subject to certain conditions being satisfied.

The Superannuation Industry (Supervision) Act 1993 (SIS Act) was amended as from 24 September 2007 to allow trustees of superannuation funds, including SMSFs, to borrow to invest in assets where certain conditions have been met. The borrowing permitted by the amendments to the SIS Act must take a specified form of a limited recourse nature. The amendments were primarily intended to permit a superannuation fund to invest in instalment warrants (which were previously held by the ATO to involve a borrowing), but are drafted sufficiently broadly that they appear to allow superannuation funds to borrow to purchase an asset of any class that the fund is ordinarily permitted to acquire, subject to all the relevant conditions being satisfied.

Background

Prior to the introduction of the new legislation, the view of both the ATO and APRA (Australian Prudential Regulatory Authority) was reflected in a joint media release dated 16 December 2002, which warned that investment in instalment warrants by superannuation funds may breach the prohibition against borrowing contained in section 67 of the SIS Act. Guidelines issued by the ATO and APRA on that date also provided that investments in instalment warrants were likely to contravene SIS Regulation 13.14, which prohibits superannuation funds from granting a charge over an asset of the fund.

The amendments, which took effect from 24 September 2007, are contained in the Tax Laws Amendment (2007 Measures No. 4) Bill 2007, and took the form of inserting subsections 67(4A), 71(8) and 71(9) into the SIS Act. Subsection 67(4A) contains an exception to the general rule prohibiting a superannuation fund from borrowing money.

What is an instalment warrant?

An instalment warrant is an investment that enables the purchase of an asset over time by making an initial part-payment and then paying the remaining instalment(s) plus interest and the cost of setting up the loan to fund the asset at a later date. Traditionally, instalment warrants have been used to provide geared exposure to listed shares.

The final payment under an instalment warrant is generally structured as a ‘limited recourse’ loan. This means that, at any time, the investor can default and forfeit the asset being purchased under the agreement and any payments that have already been made. In other words, there is no liability to the holder of the instalment warrant beyond the value of their equity in the underlying asset - the lender’s rights against the investor are limited to the value of the underlying asset. When all the instalments under the warrant have been paid, the asset is transferred to the investor.

The new legislation

The mechanism for the changes allowing superannuation funds to borrow to invest in assets upon certain conditions is largely contained in the new subsection 67(4A) of the SIS Act.

Subsections 71(8) and 71(9) of the SIS Act have also been inserted to prevent an instalment warrant arrangement from being automatically counted as an in-house asset. Now, if holding the asset directly would breach the in-house asset rule, the superannuation fund must not invest in an instalment warrant for that asset.

Subsection 67(4A) of the SIS Act is drafted in a very broad fashion, and sets out the conditions which must be satisfied without using the term ‘instalment warrant’ (except in the heading to the subsection).

The Explanatory Memorandum to the Bill introducing the new provisions provides that the exception in subsection 67(4A) will allow a superannuation fund to borrow money in accordance with an arrangement that has the following features:

• the borrowing is used to acquire an asset that is held on trust so that the superannuation fund trustee receives a beneficial interest and a right (but not an obligation) to acquire the legal ownership of the asset (or any replacement) through the payment of instalments;
• the lender’s recourse against the superannuation fund trustee in the event of default on the borrowing and related fees, or the exercise of rights by the fund trustee, is limited to rights relating to the asset at the time of the action. These rights may include taking possession of, or disposing of, the asset; and
• the asset (or any replacement) must be one which the superannuation fund trustee is permitted to acquire and hold directly. The asset may be any asset (e.g. real property, works of art in certain circumstances or listed securities) a fund would be permitted to invest in directly. The existing investment restrictions, such as those on in-house assets and acquiring certain assets from a related party of the fund, continue to apply.

The scope of the exception

As it can be seen from the Explanatory Memorandum, provided that the various conditions are met, it now appears possible for the trustee of a superannuation fund to borrow to invest in not just listed shares (as is the case in traditional instalment warrants), but in any asset the fund would be permitted to invest in directly.

In setting out the conditions for the exception to the prohibition against borrowing, subsection 67(4A) is drafted in sufficiently broad terms that borrowing arrangements other than traditional instalment warrants may also comply with the provision.

This broad drafting also seems to allow for a number of different ways to structure the borrowing. We understand that some financial institutions are starting to offer loan products that satisfy the requirements set out in subsection 67(4A). Generally, superannuation funds may also be able to enter into related-party lending arrangements, by either:

• borrowing directly on a limited recourse basis from a related party; or
• borrowing indirectly on a limited recourse basis from a related party who borrows on a full-recourse basis from a bank or other financial institution.

Further issues to consider

It is important to note that while subsection 67(4A) of the SIS Act provides an exception to the general prohibition against a superannuation fund borrowing, all other relevant provisions of the SIS Act must be considered in relation to the acquisition of an asset via a limited recourse loan. In particular, any borrowing should be consistent with the investment strategy of the fund and the age and risk profile of the member(s). It is generally recommended that SMSF trustees also have regard to cashflow and liquidity requirements and commercial issues regarding borrowing to make an investment, as well as other tax issues, such as land tax, stamp duty, CGT and GST. Whether a borrowing in the form of a limited recourse loan is allowed by the trust deed of a SMSF is also a key consideration.

It should be noted that the ATO has not yet finalised its view on how it will administer the exception under subsection 67(4A) of the SIS Act. Although there has been a lack of practical guidance on the exception provided to date, it seems that the ATO is carefully observing the application of the borrowing exception.

A recent speech by Michael D’Ascenzo, the Commissioner of Taxation, highlighted that interest under a limited recourse arrangement may not always result in an allowable tax deduction (due to the way repayments are structured in some cases). Similarly, Nick Sherry, the Federal Minister for Superannuation and Corporate Law, has recently indicated that he is also keeping a close watch on the release of new superannuation products involving borrowing.

The introduction of the borrowing exception in the SIS Act represents a significant change in the way clients may structure their investments via SMSFs. In advising clients interested in borrowing via an SMSF, practitioners should ensure that they have a good understanding of the specifics involved in structuring and accessing the exception.

This edition of ‘The Assessment‘ was prepared by Jeremy Khaw. If you have any comments in regards to the contents of this edition please feel free to pass them on to Jeremy at jeremyk@webbmartinconsulting.com.au .