Suzanne Salter and Ruth Stringer provide trustees with a list of things to be aware of when gearing in superannuation.
Warrants were instrumental in originally sparking the debate that led to the Federal Government permitting gearing in superannuation funds in September 2007. The inherent flexibility within these structured investments came up against the relative inflexibility of the Superannuation Industry (Supervision) Act 1993 (SIS).
Now that the decision is made, product manufacturers have quickly come to market with structured loans for self-managed superannuation funds (SMSF) — but there are a few details that trustees need to watch out for.
Background
Historically, superannuation funds have not been allowed to borrow. This is set out in section 67 of SIS and has been in place in its present form since that Act commenced (generally July 1, 2004). Furthermore, the predecessor legislation to SIS contained similar restrictions.
The prohibition is that a superannuation fund trustee must not “borrow money”. The ban is absolute in the sense that there is no permitted level of borrowing.
However, there are a few very limited exceptions, such as borrowing, that are needed in order to settle securities transactions, subject to a restriction that the borrowing must be repaid within 90 days and must not exceed 10 per cent of the value of the assets of the fund.
Over time, many funds have sought ways of achieving outcomes that are economically equivalent to borrowing, gearing through derivatives for example, while ensuring compliance with the borrowing prohibition.
In the 1990s, the instalment warrant market developed on the back of innovative corporate capital raisings.
Indeed, one of the first instalments was actually the Telstra receipts that allowed investors, including super funds, to pay for newly issued Telstra shares in two instalments in a manner not too different to retail lay-by. Investment banks then improved upon this structure by making the second payment optional.
More recent enhancements include the self-funding instalment that streamlines the cash flow, capitalising interest and applying dividends to the loan repayments. Today, this market segment represents $2 billion in loan amount.
Key dates
On September 16, 2002, the superannuation regulators (Australian Prudential Regulation Authority and the Australian Taxation Office [ATO]) published an information memorandum that urged trustees of super funds to exercise extreme caution in the purchase of instalment warrants, for it had come to their attention that some newly developed instalment warrant products may infringe the prohibition against borrowing.
The guideline that accompanied this release indicated that some warrants were structured so as to involve a borrowing and as such, investment in these warrants would involve a breach of SIS by the trustee, whilst other instalment warrants did not involve any borrowing and were therefore allowable.
The regulators issued a number of guidelines superannuation fund trustees were required to consider when contemplating an investment in an instalment warrant.
On November 3, 2006, the regulators published another information memorandum which announced that, in their view, investment in instalment warrants entailed a borrowing for the purposes of section 67 and was therefore not an allowable investment.
On May 22, 2007, there was a political response to this announcement in that the then Minister for Revenue and Assistant Treasurer, Peter Dutton, announced that SIS would be amended to permit investment in instalment warrants.
Section 67(4A) of SIS
The amendment was duly made and the Tax Laws Amendment (2007 Measures Number 4) Act 2007 was enacted on September 24, 2007.
In summary, a new section 67(4A) was added to the SIS Act and this new section applies to an arrangement under which:
- money is borrowed and applied for the acquisition of an asset (other than one the superannuation fund trustee is prohibited by SIS or any other law from acquiring);
- the asset is held on trust so that the superannuation fund trustee acquires a beneficial interest in the asset;
- the superannuation fund trustee has a right to acquire legal ownership of the asset by making one or more payments after acquiring the beneficial interest;
- the rights of the lender against the superannuation fund trustee for default on the borrowing (or on the sum of the borrowing and charges related to the borrowing) are limited to rights relating to the asset; and
- if, under the arrangement, the superannuation fund trustee has a right relating to the asset, the rights of the lender against the superannuation fund trustee for the superannuation fund trustee’s exercise of its rights are limited to rights relating to the asset; and
- the section also caters for the situation where the original asset is replaced with another asset, in relation to which the same conditions apply.
Since the enactment of the new section 67(4A) of SIS, a number of instalment warrant products have been released to the market, which have been clearly framed to take advantage of this new exception to the prohibition against borrowing by superannuation fund trustees.
Some things to look out for in the product structure:
- Money borrowed must be used for the acquisition of an asset. That is, the money cannot be used by the super fund for any other purpose. This means that products involving a line of credit style credit facility may potentially be problematic because this may allow the super fund to apply funds for a purpose other than the permitted purpose.
- The lender’s rights of recourse in the event of default on the borrowing must be strictly limited to the asset or replacement asset.
- In some instances, in view of the limited recourse requirement, the lender will require a third party guarantee. In the case of a SMSF, these guarantees are sought from members of the SMSF in their personal capacity. It is possible to structure such guarantees so as to protect the SMSF assets in the event the guarantee is called upon. Such arrangements do not appear to infringe the requirements of the section. That said, the ATO has flagged that it is still considering the use of guarantees in this context.
- The loan may only be used to acquire assets if the super fund is otherwise permitted to invest in the asset under SIS. This means that the transaction needs to be carefully considered to ensure that it complies with the usual restrictions on superannuation investments, including the sole purpose test, arms length requirements, in-house asset restrictions and the like.
- Super fund trust deeds may not give the trustee the power to borrow since historically, the legislation contained a broad prohibition against borrowing. The changes to SIS do not give trustees the power to borrow. They merely relax the previous statutory restrictions and, as such, a trustee must first check that it has adequate power in its deed to borrow in order to take advantage of these rules. If the power is inadequate, then a trust deed amendment may be required.
Suzanne Salter is the head of structured investments at the Commonwealth Bank and Ruth Stringer is a partner at Blake Dawson.
