David Shirlow explains how to use insurance to address SMSF property investment liquidity.
The use of insurance to address self-managed super fund (SMSF) liquidity needs in relation to property investment is becoming increasingly topical, given the growing interest in both limited recourse borrowing arrangements (‘LRBAs’) and focus on regulatory aspects of various fund risk insurance arrangements, including their tax effectiveness.
Large property assets, loans and liquidity needs
There are a variety of reasons why an SMSF trustee may want to consider using insurance to cover liquidity needs of the fund, particularly in the event of a benefit becoming payable upon the death or disability of a member.
Typically, these considerations arise where the fund holds a large asset such as real estate, which the trustee will not want to dispose of quickly (or at all) in the event of such a benefit becoming payable.
This might be because there are good investment reasons why the asset should not be disposed of within a short time of the demise of one of the fund members.
For example, this could be the case where the asset is intended to be continued for use in a family business by surviving members.
There might also be related cashflow considerations if the fund has a limited recourse borrowing arrangement (LRBA) in place in relation to a large asset.
The relatively recent introduction of new LRBA rules in the SIS Act (section 67A and B), coupled with the ATO’s interpretation of those rules in SMSFR 2011/D1, is certainly increasing interest in this subject.
The fund’s rules on insurance
For life and total and permanent disablement (TPD) insurance to be primarily for liquidity purposes, the SMSF’s governing rules will need to differ from the norm, since fund deeds typically provide for insurance benefits to be added to the insured member’s account balance and be included in any benefit payable in the event of that member’s death or permanent incapacity.
Under this scenario, since the extra cash the insurance generates for the fund must be paid out to meet the equivalent extra superannuation benefit liability, the fund’s liquidity requirements to pay the benefit are not necessarily addressed.
Instead, the governing rules could provide for the insurance benefit to be applied wholly or partly to address its liquidity needs, rather than to increase the benefit payable.
The aim is to be able to apply some or all of the insurance cover to provide the cash benefit required to be able to pay benefits in full as soon as practicable, and/or finance debt repayments, without selling the asset.
There are a variety of ways this can be done.
Premium deductibility issue
The recent draft ruling TR 2011/D6 flags the ATO’s increasing interest in the purposes for which SMSFs might take out life or TPD insurance, other than to directly increase benefit payments. The purpose is relevant to the deductibility of the insurance premiums.
In example 9 of the draft ruling, the ATO describes a scenario where a fund takes out additional insurance for the purpose of covering its liabilities in relation to the repayment of its debt under a LRBA, in the event that a fund member died or suffered TPD.
This is in addition to existing cover that was for the purpose of providing benefits in that event. The additional cover is funded by a single premium and was to reduce each year in line with the reduction of the debt by way of a single premium.
The ATO states that the premium for the additional cover would not be deductible, as it would not be for the purpose of meeting the fund’s liabilities to pay benefits.
In the ATO’s example, the fund’s rules are said to be silent on the application of insurance proceeds but, as indicated earlier, there are a variety of ways in which the rules can provide for insurance proceeds to be dealt with, including giving the trustee a discretionary power as to the extent to which the proceeds will be applied for particular purposes.
Impact of Stronger Super measures
In establishing new insurance arrangements for an SMSF, it is important to have regard to the impact that the Government’s proposals to amend superannuation laws will have on the types of insurance policies that a fund trustee may take out.
While it appears that SMSF trustees will not be subject to the proposal currently before Federal Parliament to require APRA fund trustees to formulate and give effect to an insurance strategy on the kinds and level of insurance policies offered to members, they are likely to be subject to the Government’s proposal to:
“… Align insurance definitions with the conditions of release so that insurance is consistent with the purpose of superannuation and that insurance monies are available to members…” (as stated in Minister Bill Shorten’s Stronger Super statement of 21 September 2011).
This measure is proposed to take effect from July 2013, subject to transitional rules.
While it is possible that it would preclude risk insurance being taken out for purposes other than immediate benefit payment, alternatively the measure may merely ensure that the definitions used in policies taken out by fund trustees align with the benefit payment standards.
Certainly the SMSF industry is likely to be arguing for the latter approach.
Some other issues to consider
Aside from the topical tax and regulatory issues discussed above, it is important for practitioners to carefully consider a range of other issues in exploring the insurance options for liquidity purposes, such as:
- Which account(s) insurance premiums are to be paid from (particularly if the proceeds are to be used at least in part to pay benefits)
- Whether there are ways to manage benefit payments (e.g. by paying out income streams rather than lump sums) which can assist in optimising the after-tax cost of insurance
- The cost of inserting the appropriate insurance provisions in the fund’s governing rules, and the flexibility and longevity of those provisions.
David Shirlow is the executive director, Macquarie Adviser Services.
