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Self Managed Super Fund (SMSF) Article
Instalment Warrants & SMSFs
By Tony Negline.
This article may be out of date.
4th July 2007
An Instalment Warrant is not a difficult product to understand. They are similar to buying something on lay-by. With Instalment Warrants, you make a down payment and after a period of time pay the outstanding amount. Like all lay-by arrangements, if the outstanding amount is not paid the original down payment is generally not returned to the putative purchaser.
There is one very important difference between Instalments and normal lay-by arrangements. Instalments charge interest and other costs on the amount of money outstanding.
Instalment Warrants were first offered in the 1990s. For about 15 years they were only offered over listed shares but more recently product providers have offered them on other asset classes such as residential property.
Ordinarily super funds cannot borrow. This is a strict prohibition unless the borrowing is non-recourse. That is, if the product user decides not to pay out the outstanding loan then the product provider cannot get back the loan balance from the user’s other assets.
Instalment Warrant providers are not charities and hence cannot be expected to loose money if the loan isn’t repaid. They protect themselves by using a put option which is only exercised if the product’s user decides not to pay its outstanding debts. If the product provider exercises this option then they are able to sell the shares so that they receive, at least, the outstanding loan so they do not end up loosing any capital. The cost of this option is often part of the borrowing costs.
Many Self Managed Super Funds have used Instalment Warrants to purchase shares. They have done this for a variety of reasons: they want to buy shares which they thought would appreciate over a period of time for a lower price; at the same time they might lack sufficient liquidity to buy the shares in the quantity they think is appropriate; similarly they want to get access to shares for less capital outlay than would ordinarily be the case; they want to use borrowing to generate higher investment returns and so on. If the loan is repaid then the investor will get to own their shares outright.
Whilst the Instalment Warrant is running, the investor still gets all the dividend payments and franking credits. Some investors have purchased Instalment Warrants because they wanted to gain access to additional franking credits which they believe help to reduce their income tax liabilities. It is true that franking credits do provide additional cash flow however it is incorrect to think they reduce the amount of income tax payable. Without going into any detail, franking credits represent income tax that has already been paid by a company. Sometimes this tax may have been paid many years beforehand. The franking credit is ultimately used to tax the dividend at the investor’s ultimate tax rate.
Until December 2002 some SMSFs used shareholder applications before the tax office and the Australian Prudential Regulation Authority decided that these applications contravened the super laws. Shareholder applications enable an investor who already owns shares to place those shares into an Instalment Warrant. The warrant product provider takes the shares into the product. The loan is created by the provider forward a cheque for the amount borrowed to the investor. The investor is then free to do whatever they like with the proceeds.
For example suppose you own shares in XYZ company which is currently trading at $10. An Installment Warrant provider has a five year Instalment over this share which can be purchase for $5.20 capital. If you purchased this with your current shareholding the provider would send to you $4.80. At some point this loan would have to be repaid.
It is a pity super funds can’t use this process. It is commonly accepted, but no one seems to know with 100% certainty, that when the Shareholder Application is fully operational the investor does not incur Capital Gains Tax when the shares are transferred into the Warrant. Super funds can still use the Shareholder Application process with a few more administrative steps. A fund would first need to sell the shares and then place the net of any CGT proceeds into an Instalment Warrant in the same share.
In November '06 the Assistant Treasurer announced ATO and APRA had decided that Instalments were not acceptable investments for super funds because they contravened the super laws. To cater for this revised interpretation, the Assistant Treasurer said the government would legislate to allow super funds to continue to use Instalments if the underlying asset could be directly owned by a super fund.
This legislation was introduced into Parliament last week and will take effect when the law has been passed by Parliament and has received Royal Assent. Parliament may only sit for between two and six weeks before the election is called which is not a lot of time to pass this type of law through Parliament. Hopefully the legislative process will be completed in the next couple of months. No one knows what would happen if the law is not passed and we had a change of government.
In the meantime the superannuation regulators have said that they will continue to allow super funds to use Instalment Warrants using new money only.
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