Taking advantage of super leveraging

Market turbulence and falling super balances have scared off many clients and advisers from leveraging strategies.

However, recent stabilisation of markets may prompt some people to reconsider borrowing to invest.

Borrowing within superannuation can be achieved by a super fund investing in internally geared managed funds, geared trusts, tradeable securities or, more recently, instalment warrants.

Instalment warrants

Changes to the borrowing rules for super funds legitimised the use of instalment warrants within super funds. Trustees have been given the flexibility to use an instalment warrant within super as a means of leveraging.

The borrowing rules are available to all super fund trustees, but it is trustees of self-managed super funds (SMSFs) who took the greatest advantage of the rules.

The borrowing rules mean that SMSF trustees can borrow and invest into substantial assets that the fund may not have been ordinarily able to purchase because of the lack of sufficient funds.

This has provided SMSF trustees an opportunity to invest into large ‘lumpy assets’, such as property or, in other cases, listed shares and securities.

While there is no restriction on the type of investment that can be acquired via an instalment warrant, the structure cannot be used to circumvent superannuation law.

An instalment warrant trust can only acquire an asset that would ordinarily be able to be acquired by the super fund.

This means that warrants cannot be used to get around the rules relating to the acquisition of assets from related parties.

Restrictions on borrowing

There are restrictions on the loan used for borrowing within an instalment warrant:

• limited recourse — a lender cannot recover any outstanding debt from any asset of the super fund, except to the extent of the investment being purchased or its replacement; and
• ownership — the super fund has a beneficial interest in the asset. The super fund acquires the right to legal ownership of the investment after the instalments are finalised.

Due to the limited recourse restriction of borrowing within super funds, commercial financiers may consider loans within super funds as high risk, resulting in a higher interest rate.

Likewise, a commercial financier may require a low loan-to-value ratio before approving a loan.

Super fund trustees have the choice of obtaining finance from either an unrelated party or a related party.

Obtaining finance should be conducted on an arm’s-length basis and on a genuine commercial basis, particularly if obtaining finance from a related party.

If the interest rate on a loan to the super fund is below commercial rates, then the arrangement may be characterised as a contribution to the fund.

In contrast, if the interest rate is above commercial rates, then a concern may be raised as to whether the fund is being maintained solely for superannuation purposes.

The option for a related party to provide the finance may present an opportunity in relation to the fund’s investments. Individuals with sufficient liquid assets can lend money to the super fund to increase the funds available to acquire assets. This strategy may provide an option for individuals who have maximised super contributions to increase the amount available to the super fund for investment.

Getting started

Super fund trustees should ensure that any borrowing within the fund is permitted by both the super fund trust deed and investment strategy. An outdated trust deed may restrict borrowing.

Implementing an instalment warrant trust requires some working knowledge of trusts. This may be an area that clients and advisers have little exposure to and may require an understanding of new concepts.

An instalment warrant trust is a bare trust, which holds the investment, or its replacement, on behalf of the fund. When the loan is paid out, the fund may exercise the right to acquire the investment or sell it.

Trustees of bare trusts do not have any active duties, the trust is designed to hold an asset on behalf of a beneficiary.

In contrast, trustees of fixed and discretionary duties, are required to actively participate in the management of a trust.

The trustee of a bare trust may be either an individual or a company.

The appointment of trustees to an instalment warrant trust can be complicated as the trustees should not be the same trustees as the SMSF.

If the SMSF has a corporate trustee, the same company should not be a trustee of the bare trust, but can be another company or composed of other individuals.

If the SMSF has individual trustees, then they both should not be trustees of the bare trust.

However, either individual could be the trustee of the bare trust.

For example, Mr and Mrs Jones are trustees of the Jones Family Super fund. While Mr and Mrs Jones should not be trustees of the bare trust, either Mr or Mrs Jones could be a trustee of the bare trust.

Opportunities

Care needs to be taken so that the strategy complies with the legislation and your clients avoid the potential pitfalls around the acquisition of assets and borrowing restrictions.

Instalment warrants provide super funds an opportunity to leverage their exposure and acquire large assets that may have been beyond a super fund’s short-term financial limitations.

Troy Smith is a technical services specialist at ING Australia.