Instalment Warrants & SMSFs: Regulatory Issues Checklist 29 January 2008 Introduction Recently interest has been ignited in the prospect of smsf trustees acquiring assets through usage of instalment arrangements. This is a product of a combination of legislative developments, namely the introduction of: non-concessional contribution limits and removal of RBLs under the Income Tax Assessment Acts of 1936 & 1997 (ITAA36 & ITAA97); and a new exception to the prohibition on borrowing by smsf trustees under the Superannuation Industry (Supervision) Act 1993 (SIS). Once contribution limits have been reached, leveraging existing assets within the parameters of the new SIS borrowing restriction is a potential means of funding acquisition of further assets, with a view to maximising retirement benefits without the need to guard against benefit limits. The Government intends for it to be possible to have instalment arrangements in relation not only to listed securities (as has traditionally been the case) but also real property and other assets. This is clear from both the policy statements announcing the proposal to introduce the new SIS borrowing exception and the legislation itself. This explicit broadening of scope of instalment arrangements has also sparked interest (although, as commentators have observed, aspects of this development seem to run counter to the Government s efforts in 1999 to constrain the ability of smsf trustees to invest in related geared trusts). This newsletter explores some of the issues which need to be considered by smsf trustees and their advisers in implementing an instalment arrangement. In talking about instalment arrangements we are referring to a situation involving the following features. The smsf trustee does not have the funds available (or simply doesn t want to apply available funds) to acquire the legal title to a particular asset ( underlying asset ), so an arrangement is entered into, using finance from another party ( lender ), which is expected to lead to the smsf trustee ultimately acquiring the asset. Legal title to the asset is acquired from its original owner ( seller ) by the trustee of a trust ( instalment trustee ) using the finance in addition to any initial payment from the smsf trustee. Instalment Warrants & SMSFs: Regulatory Issues Checklist Page 1 of 7
The smsf trustee acquires a beneficial interest under the instalment trust, and is expected to acquire legal title to the asset upon making a payment to the instalment trustee. The lender s recourse against the smsf trustee in the event of a default in payment of the borrowing or fees is limited to rights in respect of the asset. In the arrangements we will consider, the proposal would be for an amount to be borrowed by the smsf trustee and immediately applied towards the purchase of an asset which upon purchase is held by the instalment trustee. Lender borrowing arrangement SMSF trustee funds for purchase Seller beneficial interest legal title to underlying asset Instalment trustee (Other arrangements are possible, such as a loan directly to the instalment trustee, but we will not focus on these here.) In response to strong demand from advisers for information, we have compiled a list of some of the regulatory issues for an smsf trustee to consider in implementing an instalment arrangement along the lines described. It is a general guide only. Many of the answers to these and other relevant questions will depend on the precise manner in which the arrangement is structured. The issues are highly technical in nature, so in many respects this newsletter may be heavy-going. For some, its main value may be to highlight some possible issues for legal advisers to address. Indeed, it will generally make sense to have these issues (along with any others that arise for the particular arrangement) covered off in legal advice from the lawyer that prepares the relevant documentation, including documentation on any loans, trusts, acquisitions and leases. We have not addressed taxation issues at this stage. In many cases (for example, where the underlying asset is real property) these may include GST, stamp duty and land tax issues. Of course the latter two will vary from state to state. Instalment Warrants & SMSFs: Regulatory Issues Checklist Page 2 of 7
Investment Compliance Issues Does the smsf trustee have power under the smsf s governing rules to enter the instalment arrangement? Some specific questions on this are: If money is being lent to the smsf trustee initially (then applied on trust), does the trustee have power to borrow under the fund s governing rules? Is there power under those rules to invest in an instalment trust/warrant arrangement? Are the investment powers under those rules limited so as to prevent the smsf trustee from acquiring a legal interest in the underlying asset? (refs include: smsf fund s deed, as amended; general trust law, s52 SIS) Will the smsf trustee be fulfilling its investment strategy obligations if it acquires an interest in the instalment trust? SIS requires fund trustees to formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the fund. Trustee investment obligations also arise under the general law. Typical concerns may relate to: fund liquidity (for example, where the underlying asset is unlisted); diversity of the investment portfolio (particularly where the amount invested is or will be a substantial percentage of the fund s total portfolio; return on investment having regard to investment objectives and expected cashflow requirements. (refs include: s52 SIS, general trust law) Will the borrowing arrangement be within the SIS borrowing exception for instalment arrangements? To meet the SIS borrowing rules, key attributes for the arrangement include that: 1. the borrowing is for the acquisition of an asset (and presumably not to cover the capitalisation of interest); 2. the smsf trustee is not prohibited by SIS or other law from acquiring the underlying asset, including any asset replacing the original underlying asset (in some typical listed security instalment warrant arrangements underlying assets can be replaced, and this is permitted); 3. the smsf trustee acquires a beneficial interest in the underlying asset (i.e. is the beneficiary of what we are referring to as an instalment trust) and has a right to acquire legal ownership of that asset by making instalment payments; 4. the lender s rights against the smsf trustee in the event of: default on the borrowing (and related fees); or exercise of a put option, relate only to the underlying asset. (refs include: s67 SIS, especially ss(4a)) Discussion of these attributes is covered under other bullet points. Would the underlying asset be an in-house asset if held by the smsf trustee? This is an important question at the outset of the arrangement, even though the smsf trustee is not proposing to acquire the underlying asset directly itself at that stage. This is because if the answer is yes, and if the market value ratio of the fund s in-house assets were to exceed 5% as a result of its acquisition, this would mean that from the outset the instalment arrangement would not comply with condition 2 of the SIS borrowing exception described above. Subject to a list of specific exceptions, an in-house asset is: a loan to, or an investment in, a related party; an investment in a related trust; or Instalment Warrants & SMSFs: Regulatory Issues Checklist Page 3 of 7
an asset subject to a lease arrangement between the smsf trustee and a related party. Typically, therefore, in-house assets are shares, units or other interests in related entities. So, for example, if the underlying asset is real property it will generally not be an in-house asset unless it is leased to a related party. (refs include: s71 SIS) Is the underlying asset to be leased? If so, to whom? If the underlying asset is not business real property (e.g. residential property, machinery, art) and it is be leased to a related party then a number of issues may arise. It could be an in-house asset, and its acquisition may be prohibited if the market value ratio of the fund s in-house assets were to exceed 5% as a result of the acquisition. In these circumstances the instalment arrangement may not comply with condition 2 of the SIS borrowing exception (described above) from the outset. While timing may have a bearing on the result in various cases, it may be worthwhile avoiding related parties as lessees for these underlying assets. (refs include: s71, s83 SIS) Would the underlying asset be acquired from a related party? If the seller of the asset is a party related to the smsf trustee (such as a member, their relative, or an entity they control) then condition 2 of the SIS borrowing exception would be breached from the outset unless the asset falls within the exceptions to the SIS prohibition on acquisition of assets from related parties (such as business real property or a listed security). (refs include: ss66,67 SIS) Would the interest in the instalment trust be an in-house asset? If the smsf trustee controls the instalment trust then it may be that the instalment trust is a related trust. Therefore, on the face of it, the interest in the instalment trust might be an in-house asset. However, there are some specific carve-outs which overcome this. Firstly, if the instalment trust is a typical instalment warrant over listed securities it generally won t be a related trust. Secondly, if the underlying asset is not an in-house asset and the instalment trust otherwise meets the SIS borrowing exception (described above) then typically the smsf trustee won t be breaching the in-house asset rules by acquiring an interest in the instalment trust even if it is a related trust. (refs include: definition of related trust, excluded instalment trust s10, s70e, s71(1)-(8), s83 SIS) Is the beneficial interest in the underlying asset being acquired from a related party? If so, is the SIS prohibition breached? SIS generally prohibits acquisition of assets by a fund trustee or investment manager from a related party. There are exceptions to this rule which relate to certain categories of assets, but these may not help if the prohibition can be said to apply to the beneficial interest rather than the underlying asset itself. (For example, whilst there is a business real property exception, it could be argued that this exception may not apply even if the underlying asset is business real property, because what is being acquired here is an interest in that property rather than the property itself.) Instalment Warrants & SMSFs: Regulatory Issues Checklist Page 4 of 7
It is arguable that the SIS prohibition should not be applied too literally in assessing acquisition of beneficial interests as it would have the unintended consequences in relation to many typical arrangements. (To take another example, under many instalment arrangements the smsf trustee could be said to acquire its beneficial interest in the underlying asset from the instalment trustee. The smsf trustee will usually be entitled to all the income and capital of the instalment trust, so the instalment trustee may appear to be controlled by the smsf trustee and therefore be a related party. This line of reasoning would often produce absurd results and arguably a more substantive approach should prevail.) However, in the absence of ATO guidance on the issue, it may be desirable to have the issue addressed in legal advice. (refs include: SIS definitions of Part 8 associate & related party s10, s66, s70e) If legal ownership of the underlying asset is ultimately acquired by the smsf trustee, would that acquisition be from a related party? If and when the underlying asset is ultimately transferred to the smsf trustee there will be no problem if the asset falls within one of the exceptions to the SIS prohibition on related party acquisitions (for example, business real property). If it doesn t fall within an exception, then the SIS prohibition may still come into play if the instalment trustee is to be regarded of a related party of the smsf trustee (on the basis described above). We await clarification from the ATO on this issue. It is questionable whether the SIS prohibition was intended to apply on that basis alone. (refs include: SIS definitions of Part 8 associate & related party s10, s66, s70e) Is money being lent to the smsf trustee? Under some of the more typical proposals we have seen money is to be lent to the smsf trustee who will then apply it (together with other fund money) to acquire an asset which is to be held in the name of the instalment trustee. A number of questions can arise in relation to these arrangements, including the following. Is a payment by the lender to the smsf trustee actually a contribution for SIS and tax purposes? One might expect that a loan payment under a typical instalment arrangement ought not to be regarded as a contribution. Nevertheless, it would be desirable to have ATO confirmation of this, since significant tax penalties might be incurred if contribution caps are exceeded as a result of such a payment. (If the arrangement was structured so that the loan was to the instalment trustee then this is likely to be even less of an issue. Bear in mind that different structures may give rise to different tax outcomes, though.) If the lender is a related party, can the smsf trustee be treated as having acquired any interest from the lender under the arrangement? If the arrangement with the lender involves nothing more than the borrowing (i.e. is not the source of the smsf trustee s beneficial interest) then one might expect that this it will not cause a breach of the SIS prohibition against acquisition of assets from related parties. We do not have the ATO s view on this, though. Otherwise, the issues here are similar to those discussed in the section discussing acquisition of the beneficial interest from the instalment trustee. (refs include: ss 66 & 67 SIS, Divs 290 & 292 ITAA97) Instalment Warrants & SMSFs: Regulatory Issues Checklist Page 5 of 7
Is the finance from a commercial lender or from a related party? If an arm s length lending institution such as a bank is lending directly then one would expect the borrowing to be on an arm s length basis, so typically the SIS requirement for any relevant transactions to be on an arm s length basis would be likely to be met. On the other hand, the proposal may be for a member or some other party related to the smsf to provide the finance. This might be out of the lender s own resources. Alternatively, it may involve on-lending an amount borrowed from a bank. Whatever the arrangement, it will be necessary to ensure that the loan (or on-loan, as the case may be) is on appropriate terms. This question includes consideration of the duration of the borrowing, the interest rate, limitations on the lender s recourse (if any) and any guarantees or other security provided by entities other than the smsf trustee. Is the finance limited recourse? What is its interest rate? If recourse is limited in line with the SIS borrowing exception requirement then it might be expected that: o the interest rate and loan-to-value ratio will reflect that limitation; or o additional security will be provided by other means. Either way, it might be expected that the interest rate would be commercial. While it may be possible to argue that a lower interest rate can apply without breaching SIS arm s length rules, the potential tax implications of this approach suggest that it would be important not to deviate from commercial rates without knowing the views of the ATO here. (refs include: s109 SIS) Is security for the finance provided by another party? It may be that security for the finance is to be provided by a party other than the smsf trustee, given the limitations on recourse involving the smsf trustee. Security could conceivably be in the form of a guarantee provided by the instalment trustee itself or some party other than the smsf trustee. If so, careful consideration will need to be given to what reward, if any, the guarantor is getting for its commitment. This may impact on whether the arrangement meets the SIS arm s length tests, assuming the guarantee relates to transactions involving the smsf trustee. (refs include: s109 SIS) Security could also be in the form of a mortgage or other charge granted by the instalment trustee over the underlying asset. SIS prohibits the smsf trustee (as distinct from the instalment trustee) from giving a charge over (or in relation to) a fund asset. It should be possible for the smsf trustee to comply with this rule provided it does not have an interest in the underlying asset before it becomes subject to the charge. In contrast, on current regulators views, there is likely to be a breach if, for example, the smsf trustee originally owned the underlying trust and transferred it into the instalment trust arrangement. (refs include: SIS regs 13.11, 13.14, Joint Press Release of ATO & APRA, 16 December 2002) Instalment Warrants & SMSFs: Regulatory Issues Checklist Page 6 of 7
Is the underlying asset being managed on commercial terms? If, for example, the underlying asset is real property, someone will need to manage and maintain the property and its leasing. That could perhaps be the instalment trustee or some entity engaged by it to perform those services. Either way, regard needs to be had to the commerciality of the arrangement and whether it might affect the smsf trustee s ability to meet the SIS arm s length tests. (refs include: s109 SIS) Are there other requirements which may be relevant for smsf trustees? As with any superannuation investment, there are other considerations which need to be covered off by an smsf trustee before entering an instalment arrangement, such as the requirements to comply with the SIS sole purpose test and to act in the best interests of members. However, these will not be discussed because in many cases it is not expected that the structure of the instalment arrangement of itself would be a cause of concern in this regard. (refs include: s52 & s62 SIS, general trust law) Are there alternative ways of acquiring the asset by instalments which would better suit the smsf? An arrangement of the type described here is one way of an smsf trustee acquiring full ownership of an asset by instalments. If the asset is business real property, for example, other ways include: acquiring part of it as a tenant-in-common with a related party and subsequently acquiring that party s interest; acquiring some (and perhaps ultimately all) units in a unit trust which holds the business real property unencumbered. Alternative arrangements such as these also demand careful consideration of SIS and other regulatory requirements and tax law. ********* Disclaimer: Macquarie Investment Management Limited (MIML) is not an authorised deposit-taking institution for the purposes of the Banking Act (Cth) 1959, and MIML s obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542. Macquarie Bank Limited does not guarantee or otherwise provide assurance in respect of the obligations of MIML. This information is provided for the use of licensed financial advisers only. In no circumstances is it to be used by a potential investor for the purposes of making a decision about a financial product or class of products. The information provided is not personal advice. It does not take into account the investment objectives, financial situation or needs of any particular investor and should not be relied upon as advice. Any examples are illustrations only and any similarities to any readers circumstances are purely coincidental. While the information provided here is given in good faith and is believed to be accurate and reliable as at 29 January 2008, it is provided by Macquarie for information only. Macquarie will not be liable for any losses arising from reliance on this information. Macquarie recommends investors seek independent advice including taxation advice. Copyright 2008 Macquarie Investment Management Limited ABN 66 002 867 003. Instalment Warrants & SMSFs: Regulatory Issues Checklist Page 7 of 7