Superannuation Borrowing (Instalment Warrants)

While the general prohibition against borrowings will remain in force there is now an express exception where the moneys borrowed are applied towards the acquisition of an asset, and the asset is held on trust for the fund's trustee until the loan has been repaid.

Details of our Instalment Warrant services are available byclicking here. A calculator designed to assist you with an estimate of fees for a DIY property warrant is available by clicking here. Our application form for a DIY warrant is available by clicking here.

Requirements for the exception

The borrowing is a borrowing by the trustee of the super fund

This is quite different to the geared unit trust arrangements which were popular in SMSFs some years ago. The loan should be recorded in the super fund's accounts and the fund's trustee will make repayments to the lender. The loan is not a loan to a trust even though the money may be paid directly to the nominee trustee by the lender.

The money is applied for the acquisition of an asset but this cannot be an asset already owned by the fund.

The asset must be one in which the fund could invest directly

This arrangement cannot be used to acquire an asset that could not be acquired by the fund in the ordinary manner. The purpose of the new laws is to permit borrowing to finance investment in otherwise permissible assets.

The asset is held on trust so that the fund's trustee acquires a beneficial interest in the asset
The asset must be held by some other entity on trust for the super fund's trustee until the loan is repaid.
The fund's trustee has a right, but not an obligation, to acquire legal ownership by making one or more payments (i.e., instalments)
The lender's rights against the fund's trustee for a default on the borrowing (including any interest or other charge) are limited to the underlying asset only

The loan must be a limited recourse loan. If the fund's trustee defaults the lender's rights are restricted to the asset being acquired. Any surplus would be returned to the fund's trustee but any shortfall is the responsibility of the lender.

The ATO has issued an alert which underlines the importance of taking special care in implementing this arrangement. Super fund trustees should ensure they have received adequate advice before entering into any borrowing. The fund's deed must also be reviewed.

The documentation used to implement any borrowing arrangement is critical as it is the detail contained within the documents which determines whether an arrangement meets the relevant requirements. For this reason, documents should be carefully drafted and should be a clear as possible to avoid any doubt that the arrangement fails any of the criteria for the new permitted borrowings.

A more detailed discussion follows.

Practical Issues

Investment Strategy

This is a fundamental consideration under section 52 of the SISA. The fact that a DIY Instalment warrant can be legally established for your Fund does not mean it should be. This product is a complex one. It must be established and managed in a highly prescriptive way. If you are not prepared to take these responsibilities seriously you will have problems in the future which could be of the utmost seriousness. In addition you should be particularly mindful of the cash flow impacts and timeliness issues involved.

Some SMSF trustees will use this product to negatively gear their fund and will therefore be relying on their ability to continue making contributions to the fund to cover the interest payments. This is legally allowable but should be carefully considered in the light of the serious problems which will arise if contributions cannot be made to the fund for any reason in the future.

What will happen on the unexpected death of a member and how will this affect the viability, or even desirability, of the investment. Insurance may be an important consideration.

Section 52(f) of the SISA requires that trustees formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the Fund including the risk involved in its investments, cash flow, composition of the fund's investments as a whole from a risk diversification point of view and the fund's ability to discharge its existing and future liabilities.

A separate Risk Management Statement is not required at law but it would not be remiss.

Unlike "canned" Instalment Warrant products DIY Instalment Warrants do not come with a tax ruling or professional custodial protection. This means extra care should be taken in both establishing and maintaining the Warrant.

Trust Deed

Most SMSF Trust Deeds will not allow this investment to be entered into as most prohibit borrowings. Even if the investment is allowable under the various regulations it is in breach of the Deed if the Deed has not been appropriately drafted. There need to be a number of other aspects considered also, not just an ability to borrow. The deed must or should have the following adequately covered giving the fund trustees the:

Power to borrow
Ability to hold assets via a nominee
Ability to borrow in excess of the loan to valuation ratio limitations imposed by the various Acts relating to borrowing limitations for Trustees generally
Ability to distribute the proceeds of life insurance payouts received at the discretion of the trustees and not be restricted to crediting them to the deceased member's account

Fund Trustee

The Fund Trustee arranges the borrowing for the Fund. Though there is no requirement under SISA an external financier will regard it as mandatory that the fund trustee be a constitutional corporation. They will not lend to a fund with individual trustees as it is much easier for a lender to breach a corporation than an individual in the event the loan goes into default. A prudent trustee would generally favour a corporate trustee in any case.

Nominee Trustee

The Nominee Trustee holds the asset on behalf of the SMSF trustees. It is highly advisable that this trustee is also a constitutional corporation though this is not a legal requirement and also not a requirement of most lenders. It must not be the same entity as the Fund trustee as this would mean that no trust exists at law and the arrangement fails.

The Role of the Nominee trustee

The Nominee Trustee holds the asset on behalf of the SMSF until the loan has been paid. The Nominee Trustee should act in this capacity ONLY. This is called a bare trust trustee. It should not collect rent, pay rates, lodge GST returns, etc. All of these transactions should occur directly within the SMSF.

If the Nominee Trustee becomes involved in "administering" the asset then it is possible that, on the eventual transfer of title to the SMSF, there may be stamp duty and capital gains tax applicable. This is therefore of fundamental importance.

The Lender

There is no barrier to the lender being an associate of the SMSF. A member can be the lender if required. Though the ATO are wary of this arrangement being used to provide a solution to the limitations provided by the contributions caps they realise that there are many bona fide reasons why such a borrowing may be reasonable. They do require all dealings to be on an arm's length basis however. This means that the fund must pay the lender the rate of interest applicable to a non-recourse loan.

If the lender is institutional or arm's length the documentation they provide should be carefully checked to ensure it complies.

The Loan Conditions

The terms of the loan can be extremely varied. If an external financier is being used then they will determine the conditions to a significant extent but, where the funder is an associated party, considerable flexibility can be employed. The loan may be interest only with one or more balloon payments of principal and interest. It may be for a short term such as one or two years or for a long term though the ATO may not be impressed with a term in excess of 30 years. It may be for an advance in excess of the purchase price of the property so as to include legal fees and other costs of acquisition. Where a loan is being made by an associated private company then advice should be sought to ensure that the ATO do not regard the loan as a Division 7A loan or deemed dividend. The terms and conditions should be properly documented.

The loan must be a non-recourse loan. That is the rights of the lender are limited to the asset being purchased. The lender has no rights to pursue a loss against any other of the fund's assets.

Be very careful here. We have seen the documentation used by at least one major lender that purports to be providing a non-recourse loan but then includes the standard terms and conditions for loans generally. When challenged, the response of a particular staff member was "do you want the loan or not."

This does not just give the lender excessive rights it also makes the whole arrangement in breach and lays the Fund open to serious ATO penalties.

Back to Back Loans

Where an associated party, such as a member, lends to the SMSF but has sourced the finance by borrowing independently from a funder under conventional loan arrangements secured by non-fund assets then the interest that the fund pays to the member must be more than the interest the member is paying the institution as the member's loan to the fund is a non-recourse loan. The market value margin should be independently determined but it could be as high as 3%. This margin will be regarded as assessable income in the hands of the member.

Multiple Draw Downs

Each Warrant is distinct and relates to a single loan. If there is to be any increase on the loan in the future it will constitute a new warrant.

Dividend reinvestment

If the Warrant is over shares then dividends MUST be paid in cash to the fund. The requirements under the SISA are that the assets held by the security must be limited to the original asset or a replacement asset. Additional shares from a dividend reinvestment plan fall outside the arrangement.

Tenants in Common

A warrant is allowable when taken over an asset as tenants in common.

Property Development

A warrant can only be used to acquire the property on completion. It cannot be used to fund a property development

Re-financing Loans

The ATO have indicated that they would like warrant holders to have the ability to refinance loans in the future. This is not clear presently but favourable clarification is expected in due course.

Personal Guarantees

Arms length lenders often require personal guarantees of the members. This has become unnecessarily controversial. Perhaps this condition may be abandoned if the loan to valuation ratio is small or the borrower is well established with the bank. Realistically this will not be avoidable in many instances so additional paperwork is required to ensure that the guarantee is of the member in the capacity of an individual and not in their capacity as a trustee or director of the trustee company. There has been a suggestion that the member must contract away their common law right to join the SMSF to any action that may be brought against them by the lender. It has been suggested that, in the absence of such an agreement, the member may join the Fund to the action and thereby place the balance of the Fund assets at risk. This is not correct. The High Court has upheld that, though the guarantor can join the Fund to the action the Fund's exposure is limited to the asset held as security for the loan. As a consequence the loan remains one of limited recourse even if the guarantor retains all their rights. (Gibbs ACJ - Aust Conference Assoc Ltd v Mainline Constructions P/L (in liq) (1978) 141 CLR 335 "surety who has paid ....... has the creditors rights but only those rights".)

You should also be aware that some commentators have suggested that the ATO will regard such an abrogation of rights as a contribution. [The writer is of the view that this is academic nonsense however you should make your own enquiries in this regard.]

What is of more significance is what must occur if the guarantee is called upon whilst the Warrant is still current. If the guarantor satisfies all or part of the Fund's liability under the guarantee the payment will be regarded as a contribution to the Fund as the value of the Fund will be increased by the payment. That means that a member or members must satisfy the rules surrounding contributions generally. It is possible that these rules cannot be satisfied. In this case the security asset will need to be sold and the Warrant terminated. Any shortfall after the proceeds of the sale of the security will then need to be satisfied by the guarantor. As the asset is no longer in the Fund at that stage and the Fund has no further liability under the limited recourse loan arrangement the payment of the shortfall is not regarded as a contribution. Careful attention should be applied to the Fund's ability to satisfy the Warrant payment schedule so the issue of guarantor payments does not arise.

Interest Tax Deductibility

Any surplus interest, after reduction of income received from the asset, is tax deductible to the fund to the extent that the fund is a taxable complying fund. If, therefore, the loan is producing a net interest drain on the fund and the fund accounts are in accumulation then the interest is deductible against other taxable income of the fund and will generate a tax credit accordingly. If the fund constitutes only pension accounts then no tax deduction is available. If the fund contains both pension and accumulation accounts and the investment is part of the unsegregated fund assets then a deduction can be taken prorata to the accumulation balances as determined by an actuary. If the fund contains both accumulation and pension accounts but the Warrant is wholly owned by the accumulation members or reserves than the interest will be fully deductible.

What happens on the Death of a Member

If there is no need for the Fund to pay out the value represented by the instalment warrant then it can be maintained subject to the Fund investment strategy. If it must be paid out of the Fund then the Warrant cannot continue. This will require any of a number of considerations including the following:

other assets of the Fund may be liquidated and the proceeds used to pay out the loan and extinguish the warrant
the property may pass from the Fund with a new borrowing, at normal commercial rates and conditions, arranged by the beneficiary. This will be subject to such a loan being available at the time.
the Fund may hold life insurance on the deceased which may be applied to the loan.
the Fund may hold life insurance on the deceased (with a deed that allows the payout to be applied at the trustee's discretion) which is directed to a Reserve which then acquires the Warrant, subject to the Investment Strategy, as a segregated investment.
the security property may be sold

The Asset Acquired

No asset currently owned by the fund can be acquired.

Virtually any asset allowable under the deed is acceptable though clearly, where tax deductibility of the interest is required, an income producing asset would be involved.

It the asset is to be acquired from a member or associate then all the SISA restrictions apply as they would if no Instalment warrant was being utilised. This includes the limitations on prohibited assets and the need to use arms length values at all times. Also remember that the acquisition of an asset from a member or associate trips a deemed realisation for capital gains purposes even though the beneficial ownership does not seem to change.

It is important that arms length considerations be applied at all times. If, in purchasing a commercial property from an associated party the SMSF acquires the property at less than arms length or, receives greater or less than arms length rental or acquires the asset under a warrant arrangement involving finance from an associated party at less than market interest then the whole of the income generated by the property could be taxed at 45%, any interest discount could be counted against contribution caps and/or the arrangement could breach the sole purpose test.

Stamp Duty

Stamp duty laws are State based, vary widely and will be applied accordingly. This cost should be ascertained prior to proceeding.

FSR

This arrangement is not regarded as a financial product under FSR however advice on the individual elements could well be so construed.

Insurance

Life and total & permanent disablement cover (even trauma cover) should be considered when creating a warrant especially if the viability of the arrangement requires contributions to be made on an ongoing basis on behalf of a member to the fund.

Tax Payer Alert

The tax office has issued an alert covering items about which they have concerns. These have already been dealt with above but may be viewed by clicking here

How we can help

Details of our Instalment Warrant services are available by clicking here. A calculator designed to assist you with an estimate of fees for a DIY property warrant is available by clicking here. Our application form for a DIY warrant is available by clicking here.

Comments and queries about this article should be directed to Tranzact Super.