Taking advantage of the new rules for superannuation borrowing

David O'Connell explains the advantages of the new rules for superannuation borrowing.

Superannuation funds are generally prohibited from borrowing. Originally the Superannuation Industry (Supervision) Act 1993 (SIS Act) only explicitly permitted trustees to borrow funds to assist with short-term cash flow issues.

A reason for the general prohibition on borrowing is to protect members’ retirement savings by discouraging trustees from exposing funds to excessive risk.

As the Government sees itself as the ultimate underwriter of the risk of superannuation fund failure, many of the measures in SIS legislation are designed to protect members’ benefits and thereby reduce the burden on the social security system.

Instalment warrants

It wasn’t until 2007 that superannuation trustees were permitted to enter into long-term loan agreements for the purchase of assets.

In September of that year, section 67 (4A) was inserted into the SIS Act, which allowed trustees to borrow to acquire an asset they would be permitted to acquire directly.

However, the loan must be limited recourse to ensure that the only assets of the fund used as security are the assets purchased with the borrowings.

In addition, while the fund must have a beneficial interest in the asset, the asset must be held by a third party. The fund must then have the option to fully acquire the asset by making one or more final payments.

An interesting point to note is the explanatory memorandum associated with this legislative change gives the impression that the framers of this legislation intended, at least initially, only to legitimise and give certainty regarding the pre-existing practice of superannuation funds investing in commercially available instalment warrants.

However, it was soon realised the borrowing exemption could be applied to other arrangements that had the characteristics of an instalment warrant.

This amendment has been popular with SMSFs and has allowed many funds to acquire assets they may not have been able to purchase previously due to insufficient funds.

This is particularly true since the limit was placed on contributions and their subsequent reduction, which has made it difficult to contribute in-specie a large and indivisible asset such as a business property.

The assets that have been acquired under this borrowing provision have generally been property (both business and residential) but there is no restriction on the asset that can be bought other than its acquisition is not prohibited by any other legislation.

Recent legislative changes

Due to the difference between the initial intent of the framers when the 2007 amendment was being drawn up and how the legislation came to be interpreted and used, there has been some uncertainty in the industry regarding this provision.

This has resulted in differing views and, to address some of these concerns, in July 2010 the Government amended the borrowing provisions which involved replacing section 67 (4A) of the SIS Act with two new sections, 67A and 67B.

While the new sections broadly allow the same type of borrowing arrangements as before, there is now no reference to instalment warrants.

The new sections are more explicit especially in relation to what the borrowed funds can be used for and when the borrowed asset can be replaced.

The new sections only apply to borrowing arrangements entered into on or after 7 July, 2010 whereas arrangements in place before this date are subject to the superseded section.

A borrowing that was subject to the old law will become subject to the new law when the trustee is deemed to have entered a new arrangement, such as when they refinance.

Due to subtle differences between the laws, it may be beneficial for a trustee to remain subject to the old system.

Differences between regimes

The first major difference is the new legislation specifically prohibits the borrowing of funds to improve the asset acquired.

Conversely, if the borrowing arrangement was in place when the new laws took effect, the Australian Taxation Office (ATO) has provided guidance that the trustees may draw down on their borrowing to make capital improvements.

However, the improvements must materially alter the character of the asset and thereby effectively create a replacement asset.

The new legislation states borrowings can only be used to acquire a single acquirable asset. In the case of shares, this also includes a parcel of shares where all the shares are of the same class in the same company.

Where the trustee wishes to borrow to acquire shares in a number of companies, they would need to put in place a borrowing arrangement for the shares of each company.

This differs to the old rules under which a portfolio of different assets could be held under a single borrowing arrangement.

In addition, whereas a dividend reinvestment plan under a single borrowing arrangement is possible under the old rules, it is not permitted under the new rules.

Another difference outlined in the guidance recently released by the ATO is that under the pre-July 2010 rules, assets can be bought and sold within the holding trust.

This would effectively allow share trading with borrowed funds.

This possibility has been prohibited under the new rules, which restrict the replacement of assets to limited events such as where new shares are issued due to corporate actions.

As part of the process of outlining differences between the ATO’s interpretation of the old and new legislation, they also provided some guidance on borrowing from related parties.

While there is no reference to the borrower in the legislation, the ATO has stated that if all other legislation is complied with, then borrowing from a related party is allowed.

In addition, the ATO has stated there is no prohibition on a related party borrowing on a full recourse basis and on-lending the funds to the trustee under a limited recourse arrangement at a higher interest rate.

However, the transactions need to be at market rates and other SIS rules such as the sole-purpose test and the fund not providing financial assistance to the members.

Summary

The recent changes to the legislation on borrowing within a superannuation fund, along with the Q&A on Limited recourse borrowing arrangements by self-managed super funds published by the ATO, have provided greater certainty around these arrangements.

The ATO has also tightened the rules of these arrangements and it is important that trustees are made aware of any new restrictions.

In addition, there will be pre-July 2010 arrangements that do not comply with the new rules.

A thorough investigation of these arrangements needs to be completed where the loan is to be refinanced and there is a possibility the borrowings will become subject to the new legislation.

David O’Connell is head of technical services at Fiducian Portfolio Services.