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Self Managed Super Fund (SMSF) Article
Why Super Funds Can't Borrow
By Tony Negline.
This article may be out of date.
10th November 2004
Super funds are not permitted to borrow money except in limited circumstances.
This hasn’t always been the case. Before June 1986 super funds could, and did, borrow money without any restriction.
Why was the change made? In 1986 the movement towards employees foregoing salary increases for super contributions was just beginning and the last thing the government of the day needed was a regulatory environment where people’s enforced saving was exposed to unnecessary risks.
Since ’86, the official view has been that gearing in super funds is risky and that it is inappropriate that lenders can acquire “a claim over fund assets ahead of [super fund] members”. An additional point will probably be that super fund tax concessions that are given to help people fund their retirement income needs and it would be irresponsible to allow these concessions to be abused. This is a good, prudent and robust response. Who could possibly argue against its logic?
When there is no real relationship between super fund trustees, the investment managers and the members, there is some logic in the above arguments as there are many stories of imprudent investment decisions being made and innocent investors getting caught out as their life savings have been destroyed by imprudence.
But does this policy make sense for Self-Managed Super Funds where the trustees are the members? The trustees are making decisions about their own money.
If we were to apply this borrowing prohibition consistently across the tax code there would be no concessions for any borrowings. With the stroke of a pen, the capital gains tax exemption on geared family homes would be removed as would interest deductions for investments such as margin lending arrangements and property. Also out the window would be the building write-off arrangements for new buildings bought with borrowings.
Why should super tax concessions be the only area subject to this rule?
Any university undergraduate studying Accounting 101 can tell you why gearing is an important investment characteristic. Gearing accelerates returns which builds wealth faster. Companies listed on the ASX that the market thinks have too little debt or too much debt often trade at a discount. Too much debt the market thinks the company has too much risk. Not enough debt the market assumes the company is not trying to take advantage of its opportunities.
The regulatory authorities have said that not all liabilities of super funds will be borrowings. The Australian Prudential Regulation Authority in Circular II.D.4 states that, “whether a particular transaction constitutes a borrowing will depend on the facts and applicable legal principles in any given case. In general, however, a borrowing usually involves receiving a payment from someone in the context of a lender/borrower relationship on the basis that it will be repaid. A transaction which gives rise to a debtor/creditor relationship does not necessarily give rise to a lender/borrower relationship, and hence may not necessarily represent a borrowing for the purposes of this restriction.”
The ATO, the regulator of SMSFs, have said that they agree with this view.
If the loan is non-recourse, that is a debt for which the borrower is not personally liable to repay, then it appears that a super fund can purchase that investment.
What are ways that a super fund can use this limited concession? Before making any investment a trustee needs to make sure that any investment fits within their fund’s Investment Strategy.
A super fund could invest in any company, which itself has borrowed money for investment or operational purposes, that is not associated with the fund members or their relatives as long as the investors of that business are not personally liable for the company’s debts.
The trustees could also decide to invest in a range of financial instruments. Some fund managers have created geared managed funds where the manager borrows money within the trust to magnify longer term returns. As with all managed funds, all tax impacts that hit the managed fund, such as franked dividends and capital gains tax, are passed through to the investor.
Another product is Instalment Warrants (IW). These products allow investors to buy shares on lay-by. To use an IW the investor must pay part of the current share price. Within the IW structure the issuer buys the shares by lending the investor the remainder of the share price. The shares are held in a trust until the investor pays interest on the borrowings and the remaining purchase price of the shares. The investor can elect not to pay the outstanding loan. If this occurs then the investor would lose their initial deposit but would not have to pay the outstanding loan. The warrant issuer protects their own interests by using a derivative. Super funds may only deposit new monies into IWs.
The use of derivatives require trustees to create a Risk Management Statement. What must be RMSs is a topic for another day.
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