Considering the amount of column-space in the mainstream media devoted to discussion on superannuation borrowing arrangements in recent years, it would be understandable for consumers to consider that net inflows into such arrangements within self-managed superannuation funds (SMSFs) are in the tens of billions of dollars, especially given record prices currently being evidenced in the Australian property market.
While anecdotal evidence across the financial planning industry certainly shows that superannuation borrowing has been a hot topic of discussion between advisers and their clients, the reality is that assets secured by limited recourse borrowing arrangements (LRBAs) account for a very small amount of assets as compared to the total level of assets held by SMSFs.
According to the Australian Taxation Office (ATO) quarterly SMSF Statistical Report1 (as at June 2014), there are estimated to be more than 534,000 SMSFs with total assets of $557 billion. Of this total, assets held by SMSFs under LRBAs account for $8.3 billion, or 1.5 per cent.
Despite LRBAs securing such a small proportion of overall SMSF assets, caution is nevertheless recommended when advising on such strategies due to the relative complexity of the technical elements underpinning a complying LRBA, as well as the potential for such a strategy to be disallowed at some future point due to legislative change.
FSI recommendation: ban SMSF borrowing
Recommendation 8 of the final report of the Financial System Inquiry2 , which was released on 7 December 2014, provides that the Government should restore the general prohibition on borrowing by superannuation funds on a prospective basis, with the exception of temporary borrowing by funds for short-term liquidity management purposes remaining.
The prime reason cited for this view was to ¬’prevent the unnecessary build-up of risk in the superannuation system, and the financial system more broadly’ due to a rapid take-up of LRBAs in the five years between June 2009-2014, as well as to ensure that the policy objective for superannuation remains ¬’as a savings vehicle for retirement income, rather than a broader wealth management vehicle’.
It was also noted in the final report that superannuation borrowing arrangements are an opportunity for the contributions caps to be circumvented, which is seemingly at odds with the aforementioned policy stance.
To date, this recommendation has not been adopted by the Federal Government, though comments by Assistant Treasurer Josh Frydenberg at the recent SMSF Association Conference3 appear to indicate that the correct policy focus in this advice area is of key importance, and as a result, consultation with relevant industry stakeholders is imminent.
Other recent developments regarding LRBAs
Other recent developments potentially affecting the advice landscape for LRBAs include:
‘Look-through’ treatment between the LRBA holding trust and the SMSF trustee
Draft legislation was released on 19 January 20154 to give effect to current industry convention that provides for look-through income tax treatment in relation to LRBAs such that:
- All income and expenses associated with the LRBA are that of the SMSF trustee, not the holding trust/custodian;
- Interest expenses applicable to the LRBA loan which are otherwise deductible based on the general rules, will be deductible to the SMSF trustee; and
- The SMSF trustee is effectively treated as the owner of the asset from the date the asset is acquired under the LRBA, and no capital gains tax event5 will arise on payment of final instalment.
Importantly, this draft legislation seeks to amend certain income tax consequences associated with an LRBA. It should be noted that the various state and territory duty elements are not affected by this proposed legislation. As at the time of preparation of this article, this draft legislation has not received Royal Assent. It remains to be seen what the final legislative outcomes in this advice area will be.
Nil interest rate borrowings and non-arm’s length income
On 12 December 2014, ATO Interpretative Decisions ATO ID 2014/39 and ATO ID 2014/40 were published. These ATO IDs confirm that ordinary and/or statutory income derived by an SMSF via an LRBA in circumstances that include a nil interest rate, will be considered non-arm’s length income, and therefore subject to tax at 47 per cent (irrespective of whether the fund is in pension phase or not).
This is just one of the many reasons why LRBAs between related parties should always be on commercial terms.
Conclusion
Despite the political and media ‘noise’ surrounding the various technical elements relating to LRBAs, borrowing within superannuation can make sound sense for clients with the appropriate circumstances. While establishing an LRBA can be complex, suitable financial, tax and legal advice are essential to ensure the borrowing arrangement is complying with all relevant tax, superannuation and duty laws.
Catherine Chivers is the strategic advice manager at Perpetual Private
Footnotes:
- Australian Taxation Office, SMSF Statistical Report (June 2014) available at: https://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/Statistics/Quarterly-reports/Self-managed-super-fund-statistical-report—June-2014/ – accessed 23 February 2015.
- Australian Government, Financial Services Inquiry Final Report (28 November 2014) available at: http://fsi.gov.au/publications/final-report/chapter-1/direct-borrowing/ – accessed 23 February 2015.
- The Hon Josh Frydenberg MP, Assistant Treasurer, Address to the SMSF Association, Melbourne (20 February 2015) available at: http://jaf.ministers.treasury.gov.au/speech/001-2015/ – accessed 23 February 2015.
- Explanatory Memorandum, Tax and Superannuation Laws Amendment (2015 Measures no.2) Bill 2015: Instalment warrants (19 January 2015) available at: http://www.treasury.gov.au/~/media/Treasury/Consultations%20and%20Reviews/Consultations/2015/Look%20through%20treatment%20for%20instalment%20warrants/Key%20Documents/PDF/EM_Instalment_Warrants.ashx – accessed 23 February 2015.
- Specifically, Capital Gains Tax event E5.
