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Self Managed Super Fund (SMSF) Article
Loans the lifeblood of self-managed fund
By Tony Negline.
This article may be out of date.
3rd June 2009
Long-term borrowing to build wealth has been a feature of the Australian economy for many years. Many people have personally purchased residential investment properties using finance. It's reasonable to assume that a lot of people who have borrowed have intended to use some or all of the wealth they created for their retirement.
Before the late 1980s it was possible for super funds to borrow to invest. Back then superannuation was really run by employers and the super fund was often used to provide capital to run the business.
As superannuation became available to more and more pre-retirees the government stopped super funds from borrowing and also stopped super funds investing the majority of their assets in sponsoring employers.
The platitude for these prohibitions against borrowings, which are still sometimes trotted out, are that superannuation is a long term investment designed to provide retirement income and because investment borrowing is too dangerous super tax concessions should not be given it.
In reality we have the strange inconsistency that you can borrow in you own name, or in the name of a family trust or even company, to build your retirement wealth but you can't do the same transaction in your super fund.
During the 1990s investment banks began offering products which allowed investors to borrow in order to invest in the sharemarket. The most popular of these products were called Instalment Warrants. These effectively gave investors the ability to buy shares (or pre-defined parcels of shares) on lay-by and also provided the investor with 'down-side' protection. If the value of the underlying share fell then the investor could walk away and the bank could not seek to have the outstanding loan repaid.
For over 10 years many super funds, particularly Self Managed Super Funds, were happily using these products because they were deemed to fall outside the super-funds-can't-borrow rules.
In 2006 the ATO dropped a bombshell on this practise. The Tax Office had received legal advice saying that Instalment Warrants were not allowed because they breached the borrowing prohibitions in the super laws.
The Howard Government announced that they would legislate to provide legislative certainty because the use of instalment warrants "is long standing and widespread and superannuation fund investment comprises a significant proportion of the instalment warrant market," said Peter Dutton the then responsible Minister.
In time the government did legislate to allow these products but did so in an interesting way. In practise the rules did allow these investment bank products to continue to be used. But the rules are actually reasonably flexible, although not without their complexities, and this flexibility is creating an interesting phenomena.
The new rules demand that while the loan is outstanding, it is held in a security or bare trust. The wording of this trust deed is crucial to the proper operation of the arrangement.
Small super funds are now beginning to use these structures to invest in residential property. Vince Scully who is Technical Adviser at SMSF Finance Specialists, believes that investors with at least $200,000 in super, who thus far have elected not to run their own Self Managed Fund, are beginning to show an interest in this structure because they can now borrow using the Instalment Warrant structure and buy property.
Peter Townsend of Townsends Business & Corporate Lawyers says that most of the interest is coming from people who "have enormous faith in Australian real estate". Townsend says that 98% of the arrangements he has set up involve the purchase of property.
The reason these investors will be looking to set up a Self Managed Fund is that retails super funds will not be able to provide the Instalment Warrant structure to their investors.
Already many retail super funds are facing reasonable outflows into Self Managed Funds by their higher account balance clients. If Scully is right and large numbers of retail super fund investors would be interested in using this structure then inflows into Self Managed Funds might become even more significant than it already is. It's no surprise that some large super fund lobbyists are making louder and louder statements against the instalment warrant structure.
So will the government change the rules? It's difficult to know. A spokeswoman for Senator Sherry said that the government is "closely monitoring" the gearing situation.
At a practical level there are many issues to consider before entering into one of these transactions including:
- Does a super fund's trust deed allow the fund to invest in the bare trust that will hold the asset? Is the super fund allowed to borrow?
- Chris Batten, Managing Director of Macquarie Group Services says that if the arrangement is not set up properly, penalty super fund taxes might apply to the income and capital distributed by the trust
- Batten also says that if the trust deed for the trust which holds the asset is poorly drafted then capital gains tax might apply when the asset is transferred to the super fund
- If the initial purchase of the property or the transfer of the property to the super fund once the loan is repaid are not done properly then ad valorem stamp duty might apply
- All of the major banks are now offering loan products in this area. They all have slightly different requirements. Some are allowing up to 70% loan-to-value ratio (LVR). Others seem to be only permitting up to 50% LVR.
We will discuss all these and more issues about this structure next week.
Tony provides services to SUPERCentral Pty Limited. Peter Townsend is the Managing Director.
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