Super Funds can borrow - Regulator hands SMSF trustees train ticket to the Moon

Super funds can borrow

By now everyone who is someone in SMSF industry has said or written something about Sec 67 (A) - the new exemption on borrowing for super funds - instalment warrants. 

We apologize for the length of this email - however promise that after reading this newsletter, you will be an "Expert" on this topic. If you find information contained in this newsletter useful, please click at the bottom of the email to forward this email to your friends.

 
But first, our assurance to those trustees, who have purchased our SMSF trust deed; they need not worry, as our trust deed allows purchasing any investment in instalments and allows trustees to borrow and mortgage property of the fund as long as the SIS Act allows it.

Background

The regulator and ATO have put restrictions on super funds to borrow and Section 67 clearly outlines their guideline.

These restrictions are justified, as the common belief is that if super funds could borrow, they may not be able to protect the fund's assets from risks which are associated with borrowing. This can however be challenged, as recently, some of the so called safe share investments have proved to be risky even without gearing. To prove our point, Allco Finance was $12 about three months back - not it is only about 5% of that value.

But if we take a step back and think in a different way, this restriction has really never been effective; as trustees of SMSFs  could always purchase shares in companies or units in a widely held trust (Geared Property Trusts etc) who borrow.

Further, trustees of  two SMSFs  could always invest in a unit trust that borrowed, as long as the geared unit trust was not controlled by one SMSF.

 
During  the '90s, many SMSFs  entered into related party transactions where they invested in a related geared unit trust. The trustee would purchase units in the geared unit trust, say with 20% required to purchase an asset, the unit trust then borrowed the remainder from a lender. In 1999, these funds were given 10 years to unwind their structure; these arrangements are currently embedded in some SMSFs.

Instalment Warrants

 
In the past ten years, many investment banks have developed new products including instalment warrants - where a trust is created and the trustee of this trust beneficially holds shares on behalf of the investor, the lender (normally the issuing authority of the warrant - the bank) nominates the trustee (related entity) who holds the shares as a custodian for the investor.

The investor (can be a SMSF) invests in one particular share IW or a bag of shares IW's, by paying a small initial instalment as part purchase price of the share. The remainder is then lent by the lender at an interest rate which is set annually. Generally the terms are that If the investor fails to pay the annual interest, the lender simply sells the underlying shares and recovers interest and the amount lent with no recourse (recover outstanding balance or loan protection) on other assets of the investor. Once all instalments are paid by the warrant holder, they are entitled to the underlying shares which are transferred from the custodian (property trustee) to the investor. LVR on  this lending is generally set at 50% to 60%.

 Any dividend earned is collected by the instalment holder. In some cases these warrants are self funded, where dividends are collected by the warrant issuer , interest is paid by dividend income and any imputation credit is passed on to the Investor (trustee of the SMSF). Any shortfall in interest is capitalized and any excess dividend reduces the loan amount.

These products were soaked by SMSF trustees, as instead of buying one share, trustees could buy two shares, with the same amount, due to gearing and instead of getting imputation credit @ 30%, had they invested in the one share, they could now get 60% for the same value of investment.

That meant,  investment in installment warrant had the capability to transfer valuable imputation credit to the SMSF, which helped to reduce tax on contributions. These credits created a tax shelter for the compulsory 9% and sacrificed salary into super and other non imputed income. Further, the investor got all the upswing in capital growth on the underlying share, however, due to gearing, was also exposed to risks associated with borrowing.

 
Many IPO's in uncertain times were sold in instalment e.g. Telstra T2, where the company issuing shares collected a portion of the money upfront and the remainder in one or more instalments.

However these transactions constituted borrowing and the regulator (APRA) and ATO in 2002 and 2003 issued guidelines on the use of this product. They claimed that Sec 67 was being breached and Super Funds investing in these warrants are not compliant as they were borrowing.

 
The confusion arose when ATO did not exercise their powers to ban trustees of SMSF from using these products. The coalition government before selling  their interests in Telstra in instalments (T3) issued a statement that the SIS Act would be amended, so that Super Funds will be able to purchase instalment warrants. The Intention was that government policy would be supported by legislation or was it to sell T3? SMSF's subscribed to T3 heavily and the rest is now history.

 
On 24^th September 2007, SIS Act was amended by inserting Section 67 (4A) which exempted  purchase of instalment warrants to be considered as a borrowing by a super fund.

 
What has caused all the excitement is the way the law has been amended ( intentionally or not?), this subsection talks more about a "borrowing structure" which has to be in place for an exempted borrowing, rather than giving approval to share instalment warrant, for which the legislation was originally to be introduced.

In essence, what the new law states : if the "borrowing structure" is in place, a super fund will be exempted from borrowing clause. Which means super funds can borrow to buy any asset, including property as long as the structure is in place.

Basically,  the borrowing structure should have the following characteristics;

Ø  The money is used for  purchase of a new asset,

Ø  The asset is held on trust so that the SMSF acquires a beneficial interest,

Ø  The SMSF has a right to acquire ownership of the asset by making instalment payments, this must be a right and not an obligation,

Ø  In case of default, the rights of the lender are limited against the fund for only the asset financed.

Other Issues

Superannuation laws  were amended to make unlimited drawings by a 60 year old pensioner, tax free. However, trustees are restricted on how much can be put in super. Concessional (deductible) contributions are restricted to only $50,000 with transition rule for 50 year old to $100K for five years and non-concessional (un- deductible) are limited to $150K per year with bring forward rules for next two years for under 65 year olds.

The ATO since 24^th September 2007 has stated that if a SMSF invested in an instalment warrant prior to the new legislation and if that investment breaches the new law, they may impose a penalty, or where possible, require you to rectify the contravention. For a full read of their opinion click here

What is allowed?

 
As per the new rules:

Ø  A member can lend to his SMSF on commercial terms;

Ø  A SMSF can purchase any asset including real estate. However, the same in-house rules apply as prior to new legislation, such as; you cannot sell residential property to your SMSF and no associates can live in a residential property owned by the SMSF etc.

Ø  If you take a loan from a third party, the third party can have a charge over the asset purchased by the Property trustee, however cannot put a charge over any other asset of the SMSF;

Ø  members may give personal guarantee over assets owned by them - this will give additional security to the lender. This personal guarantee may erode the non-recourse nature of the loan - however as long as other assets of the SMSF are protected from default, the loan arrangement should satisfy the SIS Act Section 67 (4A) conditions, however, we are not aware if personal guarantee has been approved by the ATO. The writer has lodged a request for a private ruling on this matter and is still waiting for ATO response.

Other SIS Act provisions relating to "Borrowing Structure"

Ø  Sec 62 - Sole purpose test - the SMSF should be created for the retirement of the members and ancillary purposes like payment to dependants on death etc

 Ø  Sec 62 (2) (f) - Investment Strategy - each investment should be consistent with the investment strategy of the SMSF

 Ø  Sec 66 - The SMSF should not acquire an asset from a related party

 Ø  Sec 71 - In house asset rule - the SMSF should not lend money or loan to an associated party

 Ø  Sec 109 - SMSF should have arms length dealing with associated parties

The Parties to the transactions

 
How it works?

1. Find target property
2. SMSF (if not already owned) / Property Trust and Corporate Trustee should be created
3. Roll over money from all existing Super Funds
4. Limited recourse loan documents signed by SMSF Trustee with the lender (if lender is a related party - loan documents may have to be drafted with recourse and instalment repayment conditions - interest rate has to be at market rate)
5. Lender will settle property from independent (can be related party in case of business property) vendor
   
6. The lender may insist on personal guarantee or may attach member's home as supplementary security. The writer feels that personal guarantee may be skipped by lenders if LVR are at 50% or lower.
7. The property is tenanted - tenant can be a related party in case of business real property - the rent is paid to the property trust (after depreciation expense) who hand over (distributes) the rent to the SMSF who is the beneficial owner. The SMSF declares rent as income and claims interest paid as expense to the lender.
8. Tax returns are lodged by the property trust and SMSF

Trustee of Property Trust

The trustee of the trust that will legally own the asset (the entity that holds the property in trust - property trustee) can be a member of the SMSF or the members of the SMSF or can be  Directors of the new trustee company.  

However, the legislation specifies that the asset should be "held in trust", the other school of thought emphasize that any member of the SMSF cannot be trustee of the property trust or director of the property trustee, as one cannot own an asset in trust for themselves - a basic trust rule.

 The law is silent on this issue, but in our opinion, a new corporation should be created for this purpose and all members of the SMSF should be directors of this new corporation with their advisor (or relatives) as additional directors with all administrative powers.

Once the loan is paid off - the advisor (or relatives) can then retire from their position and  property moved to the SMSF or  members  of the SMSF can be trustees of the property trust .

If a member or a related entity sells a "business property " to the trust, the vendor (member or related entity) can also be the trustee of this trust.

If the advisor (accountant) agrees to be the sole trustee (or sole director of trustee company) of the property trust - then this key problem is solved. Since the beneficiary (trustee of SMSF) in a bear trust has authority to fire the trustee, members of SMSF, by default,  have total control over the property trust and its trustee.

In house Vs Outside Trustee of Property Trust

Who can be the trustee of the property trust? - is a key issue - if the members of a SMSF can handle the transaction among themselves - or their advisor - they need not involve outsiders.

When you involve outside trustees, four  issues are of major concern.

1)      Cost; some operators like Quantum property warrants charge a loan fee which could be as high as 5% of the loan amount (e.g. a loan of $500K could mean an entry fee of $25,000);

2)      High Interest;  there is a "dial up" on interest rate each year to maintain the borrowing with outside parties, this income is like a retainer (trail income) for them ;

3)      Stamp Duty; Once the SMSF pays off all the installments, the property is still owned by the outside property trustee and to transfer the title to the SMSF could mean paying stamp duty for the second time. Stamp Duty on shares is abolished, but stamp duty on property may still be applicable in some states. Stamp Duty may be exempted in some states as there is no change in ownership of the underlying property. Again this issue is not yet tested.

4)      Depreciation; depreciation can only be claimed by the property trustee as they are the rightful  legal owners of the property. If depreciation is an issue the property trustee should be collecting rent and paying all property ownership expenses like council rates, land tax etc and then the trust should be filing a return with the ATO and distributing Tax Deferred income to the SMSF. All this can cause additional administrative burden and can increase cost to the SMSF.

What is the problem with this new legislation?

Ø  Those who want to enter into this transaction should be aware that deduction for interest is limited to 15% and if LVR is higher - the transaction can result in negative cash flow due to low rental return and high interest rates. This negative cash flow has to be funded by SMSF's other income or new contributions by the member.

 Ø  Any rent paid by the related entity (in case of business real property) has to be at market price.

 Ø  Capital gain may not eventuate at the time of selling the property as property values may not go up.

 Ø  Existing SMSF member owned negatively geared residential properties can not be sold to the property trustee. If commercial property is sold - Capital Gain Tax may apply to the member and the property trustee may have to pay stamp duty on purchase (some states have different rules - please check with your solicitor - Please note that stamp duty is applicable in some states when property is sold to the trust - however no stamp duty is paid when the property is being contributed in-specie).

 Ø  Before selling own business property to the Property Trustee, any other charge over the asset may have to be retired before the property can be transferred. The only charge this property is allowed is by the instalment funding lender.

What is good about this arrangement?

 
If the asset is held till retirement - till the member moves to pension phase, this transaction may result in no capital gain tax being paid on ultimate sale of the property.

 
Members can reduce the loan with deductible contributions ie. salary sacrifice arrangements.

 Variation 1 to the arrangement

This arrangement is very similar to the one discussed above - however in this variation the member (or related entities) gives a mortgage over their own assets with a full recourse loan to the lender and on-lend to the SMSF on a limited recourse loan.

 
For the member whatever interest he collects from the SMSF can be paid to the Lender.

A benefit of this arrangement is that as far as the outside lender is concerned - the borrowing structure is an internal structure of the member - as the lender holds assets which are not owned by the directly owned by the SMSF.

A point to note in this arrangement is that the  loan from the member to the SMSF will depend on the LVR  (equity) on own property(s) but the member can lend more than 100% of the purchase price of the property if there is enough equity outside the SMSF. The question here again is; why borrow for a 15% deduction of interest when higher deduction is available outside of super environment? -  provided the member has taxable income outside of super.

Readers must remember that in any case - if rental income is not sufficient to meet interest cost, the shortfall has to be funded by other income of the super fund or by new contributions by the members.

If the property is being used by a related entity, in case of business real property, market rent would have to be paid to property trust.

Variation 3 Contribution / Instalment warrant arrangement

 
If the trustee wants to contribute in-specie a part of the property as a contribution - the remainder can be sold to the Property Trustee in instalments.

For example Phil (62) and Mary (61) own a shop worth $2 Million. They receive $200K rent from the shop each year which is taxable in their hands. They set up a super fund and contribute $900K ($450K each - bring forward rules) as in-specie contribution to the SMSF - they contribute another $200K ($100k each) as deductible in-specie contribution for the year - for the remainder $900 they create a trust with a property trustee who co-owns the property with the SMSF (joint ownership), the trustee lends  the money to the SMSF on a non recourse loan.

All the rent will now be tax free if they convert the fund into pension phase - since they both are over 60 years any income streams from the fund would also be tax free - they may have to pay tax on interest income of $900K, the tax paid would be negligible due to income tax threshold and low income rebate, once they are over 65, Senior Tax offset will kick in with no tax to pay on interest income .

With rental income being more then pension payment, the SMSF may gradually pay off the loan to Phil and Mary.

The interest income can be re-contributed before they turn 65 to commence a second pension from the fund.

Advisors should only worry about capital gain tax to Phil and Mary and stamp duty issues in transferring assets to the SMSF (in some states any in-specie contributed amount is treated as exempt for stamp duty purposes).

 Train Ticket to the moon

The Regulator may seem to have issued the SMSF  trustees a train ticket to the moon with this new legislation, but before jumping into such structures, trustees should first consider the following issues:

Ø  Any gearing can have negative impact to cash flows, if higher LVR are opted, then rental income may not be able to cover interest income, in this case, the trustees must ensure that there is sufficient income of the fund ,or new contributions to fund the shortfall,

Ø  Gearing can increase returns but also multiply losses,

Ø  Interest may rise in the future, which can reduce capacity to repay future instalments as most of other income and contributions to the fund will be used up to fund interest component of the loan,

Ø  Some of these schemes are being sold by promoters at a high entry cost or by builders to sell their properties at an inflated price or by banks or other lenders at a higher interest rate then the normal standard variable interest rate,

Ø  Property Trustee could be subject to land tax each year,

Ø  Any investment can be sold at a price lower than purchase price, even if held for many years,

Ø  If higher then 70% LVR is chosen, trustees should be confident that there would be other income or contributions to the fund in the future to cover negative cash flow, only 9% SG contributions (or salary sacrifice) may not be enough,

Ø  If the fund is reaching pension phase - paying a pension to the member is important to meet pension conditions to ensure that the fund remains a compliant fund, in a negative cash flow situation the ability of the fund to pay a pension could be impaired.

Ø  Trustees should consider reviewing their trust deed and amend their investment strategy to include gearing.

Our Opinion

In any investment,  trustees must first chalk out cash flows, potential capital growth of that particular property and then exit plan before agreeing to commit themselves.

Another potential risk is regulatory risk, which means that the law could be changed to either the way the transaction is conducted or any future action which the trustee may have planned, e.g. . removing exemption on business real property under in-house asset rule.

Any new idea should not simply be embraced because it is new. Trustees should remember that property developers come masked as financial planners, bankers, advisors, accountants, solicitors etc.

The key to any investment is character of the asset and not how it is funded - Trustees should always separate the asset from how it is being funded - no asset becomes better because now it is easy to fund it.

A good buy is always a good buy whether it is inside or outside super.

Trustees should know their responsibilities, be aware of the law, do not leave it completely to your advisors, it is your fund which will become non-compliant - you are warned!

 Disclaimer: No information in this article should be taken as advise. Please seek your own legal advise before taking any action based on information provided in this article.