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Self Managed Super Fund (SMSF) Article
Instalment Warrants & SMSFs

By Tony Negline.

This article may be out of date.

5th December 2007

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Ordinarily superannuation funds are prohibited from borrowing. There are, however, a few exceptions, some of which have just been clarified.

Funds can borrow for brief periods to pay a benefit to a beneficiary or to settle an investment contract if they are awaiting the proceeds of asset sales to become available.

Recent super-law amendments have made it clear that, subject to satisfying certain conditions, a super fund can borrow if the outstanding loan does not have to be repaid. This is often referred to as a non-recourse loan.

These new rules were written to allow super funds to invest in a product commonly known as an instalment warrant or instalment.

These products have several stages over their lifecycle. Initially, the investor pays a deposit that represents the part-payment on the price of a share.

One share is purchased for each instalment warrant purchased. The whole purchase price of the share is met by a loan made by the product purchaser. During the life of the instalment, the investor will not receive any dividends and will need to pay some interest on the outstanding loan.

At the end of an instalment warrant's term, the investor either pays the outstanding loan and receives ownership of the shares or walks away. If the investor walks away, they lose their initial deposit and don't have ownership of the shares.

Importantly, as the loan is non-recourse the instalment warrant provider cannot chase the investor for the outstanding debt.

Before this amendment was made, quite a few self-managed super funds (SMSFs) actively used instalment warrants because it was one of the few ways they could leverage their assets. Many SMSF advisers were reluctant to recommend instalments because the super rules were not crystal clear that they could be used and the cost of the investment was often too high.

Now, instalment warrant providers are busy expanding their sales teams and reviewing their product and marketing material in the expectation that new legislation will encourage all the SMSF trustees to take a fresh interest in this product.

One innovation that appeared a few years ago that many SMSFs will now take a close look at is self funding instalments. This product takes the annual dividends and uses them to automatically pay the annual interest expense.

After paying the interest costs, some products take money left over and use it to repay some of the capital borrowed. The beauty of this product is that it dramatically simplifies the cash-flow impacts of product for the investor.

As an example, CBA shares are trading at $52 each. A product provider is prepared to offer an instalment warrant over this product for seven years for an upfront payment of $31.50 and final payment of $24 per share.

The $29 upfront contains an annual interest cost of $3 on the $24 loan as well as the cost of the option, which has cost another $0.50 per share. The option protects the instalment warrant provider by enabling it to exercise the option so they can sell the shares and receive at least the outstanding loan so they do not end up losing any capital.

Let's assume that CBA pays about $3 per share dividend each year, excluding any franking credits.

As the super fund tax rate is less than the company tax rate, the super fund will get refund of any excess franking credits, which represent tax paid by the company. Under normal arrangements, the investor would receive this dividend and then later on forward an interest payment to the instalment warrant provider. Self-funding instalments do away with this convoluted arrangement because the product provider takes the dividend and uses it to pay the interest cost.

If CBA increases the dividends it pays out to shareholders, the product provider will use this excess money to repay the $24 loan per share.

Ideally longer term (say more than five years) self-funded instalments are structured so the investor will have paid the interest cost and most of the outstanding loan via the dividend payments at the end of the product term.

Tax deductibility is one reason SMSF trustees will find this product attractive.

Another amendment made by the previous government makes the cost of the option tax deductible if the interest costs and the price of the option together are less than benchmark rates set by the Reserve Bank.

Before this amendment was made, the option's cost was not tax deductible to the investor.

For funds that pay income tax (because there is pre-retiree assets in the fund), instalments have become even more tax effective.

There are three important costs with these products: adviser commissions, interest costs (often charged annually in advance) and the price of the option.

Competition in this space is likely to be much fiercer than it has been so trustees need to be ready to drive a hard bargain with their advisers and product providers.

SMSF trustees will look at this product because it offers a chance to buy shares efficiently and for less outlay. It also allows them to leverage their fund's balance sheet, which may be necessary to drive sufficient fund returns so their members have enough assets for their retirement.

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