Is borrowing through SMSF safe from the chopping block?


The recent Financial System Inquiry recommended banning SMSFs from borrowing to invest in property. What would this mean for you as an investor, and what’s the likelihood it will materialise? Neil Howard explains.

Prior to 24 September 2007, self-managed superannuation funds (SMSFs) were prohibited from borrowing, with only very minor exceptions.

These exceptions were to enable SMSFs to pay a benefit or a surcharge liability or to settle contracts to acquire certain investments. The amounts that could be borrowed were restricted and the terms of the borrowings were short. These exceptions still exist.

On 24 September 2007, a further exception to the prohibition was introduced. This exception enabled SMSFs to enter limited recourse borrowing arrangements (LRBAs) that met certain conditions, commonly found in instalment warrants.

The conditions that needed to be met included:
  •  The borrowed money was applied to acquire an asset that the SMSF was not otherwise prohibited from acquiring;
  •  The asset was held on trust (in a holding trust), so that the SMSF only received a beneficial interest in the asset acquired;
  •  The SMSF had the right to acquire legal ownership of the asset by making one or more payments after acquiring the beneficial interest; and
  •  The recourse of the lender under the LRBA against the SMSF was limited to rights relating only to the asset held in the holding trust.
These conditions were contained in s67(4A) of the Superannuation Industry (Supervision) Act 1993 (SIS). This section was repealed on 7 July 2010 and replaced in SIS by s67A and s67B. These new sections contained many of the previous rules, including the conditions listed above. However, they also provided clarification in respect of the use of personal guarantees to underwrite the lender’s risk, restrictions on the acquisition of multiple assets, and the replacement of the asset subject to the borrowing.

LRBAs have been used to acquire shareholdings and both residential and commercial property.

Between 2007 and 2010, SMSFs made very little use of the ability to borrow, largely due to the uncertainty that existed regarding the practical application of some of the rules. Since 2010, the use of LRBAs by SMSFs has increased significantly, albeit from a small base, but this still only represents a very small percentage of the assets of the SMSF sector.

Financial institutions were very slow to offer LRBA loans, due to the uncertainties that existed. Most financial institutions now offer LRBA loans, but they are very conservative in their approach. Lower-than-normal loan-to-value ratios (LVRs) are offered, higher-than-normal interest rates are charged, and personal guarantees are usually sought. This conservative approach by the institutions has resulted in the growth in the use of related party loans in LRBAs.

A related party is a member, an employer-sponsor or a Part 8 Associate of either. The definitions are contained in s70 of SIS and are very broad.

Concerns about LRBAs

Over the years, a number of concerns have been raised in respect of LRBAs:
  •  There was a concern that the use of related party loans which were ‘favourable’ to SMSFs would be considered as a contribution, possibly giving rise to excess contributions tax problems. The ATO has since stated that a saving in interest expense (due to a favourable interest rate) would not be viewed as a contribution. The ATO says this merely reduces an SMSF’s obligations to meet a liability, rather than adding to the corpus of SMSFs.
  •  There was also a concern that favourable related party loans would fail the arm’s length rules in s109 of SIS. However, in ATO ID 2010/162, the ATO took the view that, provided the loan favoured the SMSF and not the related party, s109 would not be contravened.
  •  The most recent concern has been that related party loans that favour SMSFs would give rise to non-arm’s length income (NALI). NALI is taxed in SMSFs at the rate of 45% (plus the current 2% budget repair levy), compared to the normal rate of 15% (or 0% if the SMSF is in pension phase). In December 2014, the ATO released ATO ID 2014/39 and ATO ID 2014/40 to provide some clarification on when NALI may be an issue under related party loans. In short, the totality of the loan must be considered, rather than just the interest rate charged.
  •  In December 2014, the Financial System Inquiry (FSI), chaired by David Murray, handed down its final report. The report stated that Australia’s superannuation system had acted as a buffer to the downturn that followed the GFC and played a vital role in supporting Australia’s economy. It added that allowing (increasing) leverage in superannuation could undermine the system’s ability to act as such a buffer in the future. The FSI recommended that borrowings in the superannuation system under LRBAs be banned and that the borrowing rules revert to the rules that existed prior to 24 September 2007.
  •  In recent times, a number of bodies connected to the real estate industry have stated that the use of LRBAs by SMSFs to purchase residential property has contributed to the growth in prices in that market.
As a result of all of the foregoing issues and concerns, there is much speculation in the superannuation industry about the future of LRBAs.

Potential changes to SMSF rules

So, what would be the government’s options if changes to the borrowing rules were to be made? These would include:
  • A total ban on LRBAs and reversion to the pre 24 September 2007 rules, as recommended by the FSI. In my view, this would be a gross overreaction. While quickly increasing in both numbers and dollar values, LRBAs still represent only a very small percentage of the assets held by SMSFs.
  • A ban on the use of LRBAs to purchase residential property, although SMSFs would still have the ability to purchase other assets, such as shareholdings and commercial property. Using LRBAs to purchase residential property represents only a tiny part of the overall residential market, and residential property has been a favourite investment both inside and outside the superannuation system. This type of ban would just be another restriction on the investment decisions able to be made by SMSF trustees.
  • A ban on the use of related party loans under LRBAs. As mentioned earlier, financial institutions have been relatively conservative in the loans that they offer under LRBAs. The recent ATO IDs should result in all related party loans being made on terms that are not too dissimilar to those offered by independent third parties.
  • Impose further restrictions on LRBAs, such as reducing (or limiting) the LVRs that can be used. Such restrictions could have the impact of distorting competition in the market.
If changes are to be made, the government’s track record of no retrospectivity in respect of negative changes to the system should protect SMSFs that have an existing LRBA in place.

I believe it is inevitable that changes will be made to the borrowing rules in SIS. All the options listed above would reduce the ability of SMSFs to invest in the property market, but this is not likely to have a major impact on that market.

However, my personal view is that no changes are needed at the current time.

Neil Howard is a senior manager, superannuation, at mid-tier accounting firm HLB Mann Judd in Melbourne.


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