Gearing in Super
Section 67 of the Superannuation Industry (Supervision) Act 1993 (SISA) defines that a superannuation fund is restricted from directly borrowing (except in limited circumstances).
A fund may however, invest in financial products that are internally leveraged such as a geared unit trust or instalment warrants, following amendments made with effect from 24 September 2007, without breaching superannuation legislation. SIS Regulation 13.14 also prohibits a trustee from giving a charge over, or in relation to, a fund asset.
What are Instalment Warrants?
Warrants are generally issued at a certain percentage (typically 50%) of the value of the underlying investment. Even though the investor does not fully own the investment, they are entitled to the full level of income that flows through.
Effectively the issuer makes a loan to the purchaser for the amount of the remaining instalment(s), with the interest in the underlying shares being held as security. The interest expense for the "loan" is paid up-front as part of the first instalment.
Ownership fully transfers to the holder upon payment of the final instalment.
It is suggested that, for tax reasons, a corporate trustee of the fund should not be the trustee of the instalment trust.
The new rules
Before examining the strategy, reference should be made to the ground rules for such investments.
The amendments to s.67(4A) and s.71(8)-(9) of the Superannuation Industry (Supervision) Act 1993 (“SIS”) have the broad effect that SMSFs can gear into any asset the fund can lawfully acquire provided that certain fundamental conditions are met.
The critical aspects of the legislative changes are that:
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The underlying asset be held by a trustee (the security or debt instalment trustee);
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The SMSF has a beneficial interest in that underlying asset;
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The SMSF had a right to acquire legal ownership of the underlying asset by making payments after acquiring the beneficial interest;
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The rights of the lender against the SMSF for default on the borrowing are limited to rights relating to the original asset; and
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The only asset of the security/debt instalment trust is the relevant underlying property.
In this context an investment in a related trust forming part of an instalment warrant arrangement which meets the requirements of the borrowing exception in s.67(4A) will only be an in-house asset under s.71 where the underlying asset would itself be an in-house asset of the fund if it were held directly.
How it works
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The above diagram can be best described as follows:
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Mr. A & Mrs. A are trustees and members of their SMSF.
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They wish to acquire an asset allowable to be purchased within superannuation law requirements.
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They have insufficient superannuation to acquire this, but are interested in gearing to acquire the asset.
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Based on meeting certain loan-to-value (LVR) ratios, the bank (or friendly lender) provides a loan to acquire the asset.
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The loan is provided on a limited recourse basis. The lender may wish to obtain a personal guarantee from the individuals (this is currently flagged as an area of concern for the ATO).
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The asset is purchased and held through a custodian trust, with the SMSF creating an instalment warrant to have effective ownership of the asset (but with an obligation to repay debt by way of instalments).
What are the benefits for a self-managed fund?
Tax deductions
The structure of instalment warrants (the unpaid instalment is essentially a loan) allows a tax deduction for the interest cost of the "loan" or borrowed portion. Australian tax law allows a deduction for interest where it is incurred on borrowed monies to the extent the loan is used in producing assessable income.
For a superannuation fund that invests in a warrant, with the underlying asset being a share which is paying a dividend, the question of deductibility is reasonably straight forward. However, expert tax advice is recommended to clarify the position in relation to the tax deductibility of borrowing costs.
A higher level of dividends/franking credits
If the self managed fund invested in an instalment warrant, it would be entitled to the full dividend/franking credit of the entire underlying value of the shares, even though full ownership has not passed to the holder until the remaining instalment(s) have been paid.
The benefits of gearing
Assuming an investment into instalment warrants is consistent with the fund's investment strategy, it can allow the fund to obtain the benefits of leverage by maximising gains on rising share prices (and conversely, increasing losses if prices fall).
The risk on the downside can, however, be limited due to the fact that the remaining instalment(s) can simply be "defaulted" if prices were to move unfavorably.
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Check carefully the features of the warrant, as they are not all the same, and have regard to their appropriateness for the fund.
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Ensure that the fund maintains sufficient liquidity for the remaining instalment(s), if they are to be paid.
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Ensure the asset will not breach the in-house asset rules. Particularly, if it will be an in-house asset but is currently within the 5% limit, the expected asset growth will remain within that limit after the expiry of the warrants.
SMSF & Property Investing with Borrowings
SMSF & Borrowing - right mouse click and 'save target as' to download SMSF & Borrowing in property article.
The ability of a SMSF Trustee to borrow from a bank, credit union or related party in order to finance the acquisition of residential or commercial property has sparked a lot of interest in the SMSF industry.
Gearing in super has seen a renewed interest by SMSF trustees in diversifying their share and managed fund investments into property.
There was a perceived barrier to entry previously as to why SMSFs and property did not mix under the old super laws. Prior to 1 July 2007 the Superannuation Laws prevented many SMSFs from acquiring residential or commercial property for the following reasons:
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The lack of borrowing capacity by the trustee meant that a SMSF had to buy property investment with the direct resources of the fund. For the majority of SMSFs, property required too much cash and was also an illiquid investment.
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Once over age 65 a member had to commence an income stream – they could not stay in the accumulation phase within their fund. The problem with the previous income stream (i.e. allocated pension) from a long term investment perspective was that the draw down requirements for the pension grew higher as a person got older. If a property was used to fund the pension at some stage the rent would not cover the pension payments thereby creating a cash problem for the trustee and possibly insolvency.
From a SMSF trustee perspective, the Simpler Super laws now favour long term investments such as property for many large SMSFs.
This is due to the Simpler Super laws, as enacted, allow a member of a SMSF to retain benefits in their superannuation fund past age 65 without having to pay a pension or take a lump sum. Members can still access a pension with some of their superannuation benefits but they can limit their draw downs to suit their lifestyle budget.
Outlook has developed a complete solution for individuals wishing to discuss gearing in super, including advice, lending, legals, and ongoing compliance. Contact us to discuss your requirements further.