On 14 September 2011, the ATO released a draft SMSF ruling clarifying the rules applying to limited recourse borrowing arrangements. The draft ruling deals mainly with real estate and SMSF borrowing. The good news for many SMSF investors is that the ATO’s interpretation of what SMSF trustees can do to maintain properties subject to a LRBA provides greater investment opportunities. For example, the ATO has clarified that it is possible to borrow via a LRBA and invest in an older investment property, and to renovate (but not ‘improve’) this property using borrowed money under the existing LRBA, under certain circumstances.

SMSF borrowing rules

Before the release of the ATO draft ruling, the ATO’s position stated that if your SMSF uses a LRBA to purchase an asset, then the arrangement must satisfy the following conditions:

• The SMSF uses the borrowed monies to purchase a single asset, or a collection of identical assets that the same market value
• The SMSF can’t use the LRBA monies to improve a purchased asset
• The SMSF trustees receive the beneficial interest in the purchased asset but the legal ownership of the asset is held on trust (the holding trust)
• The SMSF trustees have the right to acquire the legal ownership of the asset by making one or more payments
• Any recourse that the lender has under the LRBA against the SMSF trustees is limited to the single fund asset (including rights to income). Lenders can legally demand an individual to provide a personal guarantee against personal assets
• Replacing the asset subject to the LRBA is possible only in very specific circumstances.

The conditions listed above remain in place but in a welcome example of pragmatism, the ATO’s Draft SMSF ruling, SMSFR 2011/D1: ‘Self-managed superannuation funds: limited recourse borrowing arrangements – application of key concepts’ outlines, inter alia, the meaning of the following terms:

• a ‘single acquirable asset’
• maintaining or repairing (which is OK)
• improving (which is not OK)
• a replacement asset

You can read the ruling at your leisure by clicking on the link above, but as a quick reference I list some of the property investing scenarios that the ATO says is OK when using a LRBA, and the scenarios that are NOT OK when using a LRBA.

Note: If you wish to comment on the draft SMSF ruling, you have until 28 October 2011 to make a submission. When the ruling is finalised it is proposed to apply to arrangements entered into on or after 7 July 2010 (including any arrangement that involves a refinancing since 7 July 2010).

Investment scenarios: what’s OK and NOT OK?

The following scenarios outline when an existing LRBA will continue to apply to an asset, based on the ATO’s draft SMSF ruling. For example, if a repair is completed on an asset subject to an LRBA, that arrangement has not changed which means the existing LRBA can continue to be in place.

1.   Repair and maintenance (OK) vs improvement (Not OK)

Source: SMSFR 2011/D1 (www.ato.gov.au)

2.   Retain asset identity (OK) vs Becomes different asset (NOT OK)

Source: SMSFR 2011/D1 (www.ato.gov.au)

3.   Single asset (OK) vs Multiple assets (NOT OK)

Source: SMSFR 2011/D1 (www.ato.gov.au)

4.   More examples of repair or maintenance (OK) vs Improvement (NOT OK)

Source: SMSFR 2011/D1 (www.ato.gov.au)

5.   More examples of retain asset identity (OK) vs Becomes different asset (NOT OK)

Source: SMSFR 2011/D1 (www.ato.gov.au)

For more information on the ATO’s latest views on SMSF borrowing check out the draft SMSF ruling (SMSR 2011/D1)

Related posts:

1. Limited recourse borrowing: What you can and can’t do under the new super rules
2. SMSF investment: Buying commercial property, and borrowing options
3. Cooper Review: Government flags ‘bye bye’ to SMSF borrowing

The Government recommends undertaking a review of leverage in two years time, covering all superannuation funds across the industry, and determining whether such arrangements should be permitted to continue.

The key words from the Government’s response are: “…whether borrowing by superannuation funds has become excessive, placing fund assets at risk…”

Although the Government doesn’t explicitly state that the borrowing rules will be removed in two years’ time, the wording of the recommendation hints strongly that major concerns are held within Government at the use of debt strategies within concessionally taxed investment vehicles.

Quoting directly from the ‘Stronger Super’ website (the website publishing the Government’s response to the Cooper Review):

Recommendation 8.10 (from the Cooper Report)

The 2007 relaxation of the borrowing provisions and the consumer protection measures that have recently been announced should be reviewed by government in two years’ time to ensure that borrowing has not become, and does not look like becoming, a significant focus of superannuation funds.

Government response

Support

The Government agrees with this recommendation. However, a broader review of leverage will be undertaken that includes all superannuation funds across the industry. Leverage poses a risk to superannuation fund assets in both SMSFs and APRA-regulated funds because it can magnify investment losses and reduce liquidity. The review will enable consideration of whether borrowing by superannuation funds has become excessive, placing fund assets at risk, and whether such investments should be permitted to continue.

SMSF investment-related recommendations

The Government also published the following SMSF investment-related recommendations:

• In-house assets. Retain in-house asset investment provisions (and 5% limit)
• Related-party purchases and sales. Where SMSF trustees buy or sell assets from related parties, that the relevant transaction occurs via an underlying market. Where an underlying market doesn’t exist, then the transaction must be supported by a valuation from a suitably qualified independent valuer.
• Collectibles and personal use assets. Introduction of tightened legislative standards for storage, to apply to new investments from 1 July 2011, and existing holdings from 1 July 2016.
• Net market value. SMSF trustees should value fund assets at net market value.
• Valuation guidelines. The ATO should publish valuation guidelines for SMSF trustees.
• Deed simplification. The Government intends to amend the SIS Act to deem that anything permitted by the legislation is deemed to be permitted by SMSF trust deeds.
• Keeping personal/employer assets separate from fund assets. Convert this trustee covenant into a full-blown SIS operating standard.
• Investment strategy. SMSF trustees should be required to consider life and TPD insurance as part of the investment strategy.

You can read about the Federal Government’s broader response to the Cooper Review report in our article Cooper Review: Our Government’s four-pronged response, other SMSF-related recommendations in our article SMSF supervisory levy to increase from 2010/2011 year, or you can access the full report on the Stronger Super website (www.strongersuper.treasury.gov.au).

Related posts:

1. Cooper Review: Our Government’s four-pronged response
2. Cooper Review: Top 10 recommendations from final report
3. SMSFs: Nothing exotic or personal says Cooper review

It appears that the primary reason for this levy hike is: Larger super funds have sloppy processes that have enabled scamsters to withdraw the super savings of innocent account-holders and take it out of the system. The scamsters pretended they were fund members wanting to be SMSF trustees, and the ATO and the large funds didn’t pick this up. What this now means is that the ATO and the large funds have to lift their game and monitor these transactions. Naively, I hoped they were already doing this.

Quoting directly from the ‘Stronger Super’ website (the website publishing the Government’s response to the Cooper Review):

The SMSF registration and rollover processes will be amended to reduce the incidence of funds being illegally released from SMSFs. Proof of identity checks will be required for all people joining an SMSF, whether they are establishing a new fund or joining an existing fund. Identification measures will not apply retrospectively except for existing SMSFs wishing to organise rollovers from an APRA-regulated fund.

Someone has to pay so, sorry guys, it’s got to be you! The large funds have antiquated paper-base processing systems (the reason behind the ‘SuperStream’ recommendation – see article Cooper Review: Our Government’s four-pronged response) and SMSF trustees now have to pay for the two decades of inactivity.

You may recall that this annual supervisory levy was trebled to $150 (from $45) from the 2007/2008 year to cover just this type of “improvement” in regulation, although I hasten to add the ATO has enhanced its information services to SMSF trustees since this levy increase. At the same time however, the number of SMSFs has increased beyond all industry projections which means money is pouring into the Government coffers from the 400,000-odd SMSFs in existence.

I again quote directly from the Stronger Super website, justifying this increase:

The implementation of reforms to the SMSF sector will necessarily involve some costs to the ATO and ASIC. These costs will be offset by an increase to the annual SMSF levy with effect from the 2010-11 financial year. The increase to the SMSF levy will be determined once the total costs of implementation are known.

Much of the cost related to the reforms associated with the SMSF sector relate to governance issues of large funds when verifying the identity of fund members, and improving the quality of services provided by SMSF service providers.

SMSF-related recommendations

In response to the Cooper Review, the Federal Government makes the following SMSF-related recommendations (taking effect from 1 July 2012 unless otherwise stated):

• New SMSF registration process from 1 July 2014. The SMSF registration and rollover processes to be amended to stop illegal access to money held in SMSFs. Proof of identity checks required for all people joining an SMSF, whether they are establishing a new fund or joining an existing fund.
• New penalties for illegal early release from 1 July 2012. Criminal and civil sanctions to be introduced for illegal early release scheme promoters and amounts illegally released early will be taxed at the superannuation non-complying tax rate, with an additional penalty that takes into account the individual circumstances. Also, the ATO will be given powers to force SMSF assets to be separated from personal or employer assets.
• New regulatory powers. The ATO to be become more powerful against naughty SMSF trustees. A sliding scale of administrative penalties to be introduced for less serious cases of non-compliance and will be personally payable by the trustee (not by the SMSF).
• Rectification orders and mandatory SMSF trustee education. The ATO to be given the power to issue trustees with a direction to rectify contraventions within a specified timeframe. The ATO to be given power to enforce mandatory education for trustees where there is non-compliance with the superannuation legislation, particularly less serious non-compliance.
• Knowledge and competency requirements for SMSF service providers. ASIC to develop a mandatory SMSF specialist knowledge component of Regulatory Guide 146 to impose minimum training requirements on financial advisers providing services to SMSFs.
• ASIC to be registration body for SMSF approved auditors. ASIC to determine the qualifications and minimum ongoing competency and knowledge standards required for eligibility to be registered, taking into account existing professional competencies and knowledge standards. The ATO will continue to monitor compliance with the approved auditor standards.
• Independence standards for approved auditors. ASIC will examine existing auditor independence standards that may be applied and, if necessary, develop new independence standards.
• Review of leverage in two years’ time. The Government to undertake a review of leverage in two years time, covering all superannuation funds across the industry, and whether such arrangements should be permitted to continue. I comment on this recommendation in our article Government flags ‘bye bye’ to SMSF borrowing.
• Collectibles and personal use assets. Introduction of tightened legislative standards for storage, to apply to new investments from 1 July 2011, and existing holdings from 1 July 2016.

You can read about the Federal Government’s broader response to the Cooper Review report in our article Cooper Review: Our Government’s four-pronged response, or you can access the full report on the Stronger Super website (www.strongersuper.treasury.gov.au).

Related posts:

1. SMSFs: 20% jump in ATO supervisory levy
2. Cooper Review: Government flags ‘bye bye’ to SMSF borrowing
3. Cooper Review: Our Government’s four-pronged response

Any LRBA must satisfy special conditions

According to the ATO, if your super fund chooses to use a limited recourse borrowing arrangement (LRBA), then the arrangement must satisfy the following conditions:

• The fund uses the borrowed monies to purchase a single asset, or a collection of identical assets that have the same market value. For example, presumably, the intent of this rule is that you can borrow to purchase the shares in one company, but you would need to take out another LRBA if you intend to borrow to purchase shares in another company.
• The fund cannot use the LRBA monies improve a purchased asset.
• The SMSF trustees receive the beneficial interest in the purchased asset but the legal ownership of the asset is held on trust (the holding trust)
• The SMSF trustees have the right to acquire the legal ownership of the asset my making one or more payments
• Any recourse that the lender (or other party) has under the LRBA against the SMSF trustee is limited to the single fund asset (including rights to income). Note that lenders can legally demand an individual to guarantee a loan against personal assets. More on that issue later in the article.
• Replacing the asset subject to the LRBA is possible in very select circumstances. For example, if a company undertakes a share split or unit split, or there is a company takeover or merger.

Note: If cash is received as part of the share split or company takeover, then the replacement asset doesn’t satisfy the pre-existing LRBA conditions. Subdividing a single title into a series of titles also doesn’t satisfy the LRBA conditions.

Q & As – courtesy of the ATO

The ATO has kindly produced a batch of Q &As for SMSF trustees on LRBAs. The document is well worth a read. I have included a sample of the Q & As below, but you can read the entire ATO document by clicking on this link.

1. Are only marketed instalment warrant products allowable for SMSFs under the limited recourse borrowing rules?

The ATO says: “No. Borrowing is allowed under any arrangement that meets the requirements of the super law, not just financial products marketed as instalment warrants. Conversely, it does not automatically follow that a product marketed as an instalment warrant meets the conditions of the super law.”

2. Are only instalment warrant investments over listed securities allowable for SMSFs under the limited recourse borrowing rules?

The ATO says: “No. The rules allowing limited recourse borrowing are not limited to investments in instalment warrants traditionally offered by financial institutions where the underlying asset is a listed security. Other arrangements or products are allowed if they satisfy all of the requirements of the super law.”

3. Can an SMSF trustee refinance a limited recourse borrowing without contravening the super law?

The ATO says: “Yes, provided the re-financed arrangement meets the requirements of section 67A of the SISA. Section 67A explicitly allows re-financing of a borrowing (including any accrued interest) under an arrangement if the new borrowing arrangement is over the acquirable asset from the first arrangement (including an asset from the first arrangement that is a replacement asset under section 67B of the SISA) and no other acquirable asset. Where a new trust is created to hold the asset, SMSF trustees must ensure that the asset is transferred directly to that new trust and that the SMSF does not temporarily obtain title to the asset at that time, otherwise a contravention of the super law will occur. “

The ATO also deals with LRBAs in place before 7 July 2010 (when the new laws were introduced). If you have a LRBA that was in place before 7 July 2010 then I strongly recommend you read the ATO’s Q & A document. Click here to access the document.

4. Is an SMSF allowed to borrow from a related party?

The ATO says: “The law does not prohibit the lender from being a related party. However, SMSFs must continue to comply with other legislative requirements. For example, the SMSF must satisfy the sole purpose test and comply with existing investment restrictions such as those applying to in-house assets and prohibitions on acquiring certain assets from a related party of the fund. For more information on acquisitions from a related party, refer to self-managed super funds ruling SMSFR 2010/1 Self-Managed Superannuation Funds: the application of subsection 66(1) of the Superannuation Industry (Supervision) Act 1993 to the acquisition of an asset by a self managed superannuation fund from a related party.

5. Can a related party borrow on a full recourse basis and on-lend the money to the SMSF under a limited recourse borrowing arrangement at a higher rate of interest?

The ATO says: “Yes, provided:

• the limited recourse loan to the SMSF by the related party is appropriately documented
• the SMSF is not charged higher than an arm’s length rate of interest for borrowing
• the arrangement under which the SMSF borrows from the related party otherwise meets the requirements of the super law.

For arrangements entered into on or after 7 July 2010, the super law specifically prohibits the asset being acquired by the SMSF trustee under the arrangement from being used as security for the borrowing of the related party.”

6. Does an arrangement that permits capitalisation of interest or other borrowing charges satisfy the super laws?

The ATO says: “Yes. The super law (specifically, subparagraph 67A(1)(a)(i) of the SISA) applying to these arrangements explicitly provides that, under a limited recourse borrowing arrangement, the SMSF trustee can apply borrowed money towards expenses incurred in connection with the borrowing.

• Example: Dividend income to reduce loan principal. Under an arrangement that otherwise meets the requirements of the super law, any dividend income on the underlying share is applied first in reducing the loan principal amount. At one point in the year, the loan principal amount is increased by the capitalisation of the interest amount. This is permitted under subsection 67(4A) applying to arrangements entered into before 7 July 2010, because each amount so drawn down is applied as a cost of acquiring the underlying share. It is also permitted under section 67A applying to arrangements entered into on or after 7 July 2010.
• Example: Dividend income paid to the investor. Under an arrangement that otherwise meets the requirements of the super law, all dividend income on the underlying share is paid to the investor. The loan is drawn down annually and applied to pay the interest amount. This is permitted under subsection 67(4A) applying to arrangements entered into before 7 July 2010, because each amount so drawn down is applied as a cost of acquiring the underlying share. It is also permitted under section 67A applying to arrangements entered into on or after 7 July 2010.”

7. Can an SMSF member provide a personal guarantee to the lender in a limited recourse borrowing arrangement?

The ATO says: “Yes, provided the guarantors rights against the principal debtor (the SMSF trustee) are limited to rights relating to the asset being acquired under the arrangement.

Under the super law applying to these arrangements, the recourse of the lender or any other person against the SMSF trustees in connection with, or as a result of, a default on the borrowing (either directly or indirectly) must be limited to rights relating to the asset that is being acquired under the arrangement. This means, for example, that for an arrangement to meet the requirements of the super law, any guarantor must not have general rights of indemnity against the principal debtor (the SMSF trustee) that might crystallise in the event of a call on the guarantee. However, the guarantor may have rights of subrogation of the lender’s rights (that is, the right to exercise the lender’s limited rights of recourse to the asset being acquired under the arrangement) that might crystallise in the event of a call on the guarantee.”

8. Can an SMSF trustee borrow under a limited recourse borrowing arrangement to build a house on vacant land owned by the fund?

The ATO says: “No. An existing SMSF asset cannot be put into a limited recourse borrowing arrangement. The giving of a charge over an existing asset of the fund (the vacant land), as would generally occur under such arrangements, would contravene the super law.”

9. Can shares issued under a dividend reinvestment plan be retained in the arrangement?

The ATO says: “No. For an arrangement over a collection of shares, if additional or bonus shares are issued in respect of that collection of shares, they cannot simply be added to the collection as that is not a permitted replacement asset. If the arrangement is to continue, the additional shares need to be transferred out of the arrangement – for example, in a similar way that a cash dividend might be.”

Note: The Q & As listed above are just a sample of the Q&As you can find on the ATO website. If your fund is considering a LRBA then I encourage you to check out the ATO material. If you have a pre-existing LRBA (in place before 7 July 2010), then you must check out the Q&As because slightly different rules apply to LRBAs in place before 7 July 2010. Click on this link to access the Q &As.

Other useful ATO documents on LRBA

The ATO has also produced four other useful documents on LRBAs. Click on the links below for access:

• ATO ID 2010/162 (Self managed Superannuation Fund: limited recourse borrowing arrangement – borrowing from a related party on terms favourable to the self managed superannuation fund)
• ATO ID 2010/169 (Self managed superannuation fund: limited recourse borrowing arrangement – refinancing)
• ATO ID 2010/170 (Self managed superannuation fund: limited recourse borrowing arrangement – third party guarantee)
• ATO ID 2010/172 (Self managed superannuation fund: limited recourse borrowing arrangement – joint investors)

Important announcements from the Government

On 10 March 2010, the Minister for Financial Services, Superannuation and Corporate Law, Chris Bowen MP announced two proposed changes to the limited recourse borrowing rules in relation to superannuation:

• Only licensed advisers will be able to recommend and implement limited recourse borrowing arrangements.
• A superannuation trustee who enters into a limited recourse borrowing arrangement to purchase an asset, as permitted under the SIS Act, will be treated as the owner of the asset for income tax purposes, thereby averting the triggering of the capital gains tax rules when paying the final instalment.

The Government has subsequently released a discussion paper on these two proposed changes, and an exposure draft of the proposed legislation for these additional changes will soon be available.

Related posts:

1. What is the difference between a limited recourse borrowing arrangement and a non-recourse loan?
2. SMSF borrowing: What’s the difference between a non-recourse and limited recourse loan?
3. SMSF property: ATO ‘relaxes’ borrowing rules (what’s OK and NOT OK)

Many of you will already be aware of my previously published views on the ‘hysteria’ surrounding the most recent versions of the SMSF limited recourse borrowing products.

Over the years, I have spoken to thousands of Australians about super and finance and they share their stories with me about good and bad investments. I’ll share one horror story with you about the misunderstandings that sometimes follow the fascination with packaged borrowing products.

During the months following the GFC, a woman in her fifties explained to me that she had a margin loan and it hadn’t performed that well. (A margin loan is a borrowing arrangement to purchase shares, and the shares are used as security for the loan. SMSFs cannot use margin loans.)

My investment alarm bell was ringing loudly in my head when I asked her what she had invested in with her borrowed money. She responded: “A margin loan of course. I always wanted to have a margin loan”.

It seems that her adviser either didn’t tell her what shares she had purchased, or she didn’t listen to him, or she didn’t understand what he was saying. As it turned out, her money was invested in one shareholding and after some digging we discovered that she had invested in one of those companies that imploded during late 2008.

The woman has nothing to show for her so-called investment, and she had to take out a larger mortgage on her house to repay the margin loan. The horror wasn’t that she lost her money, although that was bad enough, the horror was that she thought the loan was the investment and had no idea what she had invested in. The financial tragedy for this woman is that she now has a bigger mortgage because of her financial misunderstanding.

The moral of this tale is to understand the financing and investment decisions that you make.

Superannuation funds have always been able to buy direct property but the problem for most super funds is that the fund didn’t have sufficient cash to purchase the property outright. The ability to indirectly borrow money has opened up the possibility of direct property investment.

If you do your research and focus on the underlying investment rather than becoming distracted about being involved in the latest ‘hot’ product offering, then gearing and super can be relatively happy marriage.

The following is an extract from my book DIY Super For Dummies, explaining my views on gearing and borrowing within super:

Using borrowed money to invest can be a popular way to accelerate wealth accumulation. Borrowing to invest is also known as gearing, and involves an individual borrowing money to buy an income-producing asset. The income earned from the geared asset is then used to cover the expenses in purchasing and maintaining the asset, including repaying the loan. If the costs of investing, including interest payments, are greater than the income earned on the asset, individual taxpayers can then offset other income with the loss on the geared investment.

Borrowing to invest is a higher-risk strategy that relies on the investment returns or tax benefits associated with such a strategy outweighing the interest costs. Any loan that you take out still has to be repaid, which means the returns and tax benefits on that geared investment would at least have to deliver the costs of borrowing money to make the strategy worthwhile.

A major advantage of gearing is the ability to invest in more investments, or in an asset that is worth a greater amount of money, because you have more money to invest. Taking such an aggressive approach can increase your investment earnings if the value of your investment portfolio increases. A distinct drawback of gearing, however, is that using such a strategy can dramatically increase your losses when the value of the investment portfolio falls.

When borrowing to invest, the assets that you invest in are usually used as security for the loan, which means the bank has an interest in the investment. If you can’t repay your loan, then the bank can claim the property or shareholding, and can potentially demand more money from you if the sale of the asset delivers less money than the amount borrowed.

… You’re going to hear a lot of puff about [limited recourse borrowing arrangements]. Despite the hype, a [limited recourse borrowing arrangement] isn’t a magic pill that miraculously delivers you a stupendous property investment. The arrangement is simply that — an arrangement, rather than an investment. You, or the product promoter offering the borrowing product, have to select a suitable property investment for your fund. The borrowing arrangement then enables that investment to take place.

For example, you may be able to access a product that enables your SMSF to invest in residential property, provided you have 25 per cent of the purchase price plus enough cash to cover buying costs, including stamp duty. Another product on the market allows a SMSF to buy commercial property, provided the SMSF can cover 45 per cent of the purchase price plus buying costs.

Purchasing property (or any type of asset permitted by the super rules) by using a limited recourse borrowing arrangement can be a legitimate option for SMSF investors. When property values are rising, geared products enable to you to accumulate wealth at a much faster rate because you have access to the returns on more assets. In falling markets, however, your losses are also greater when you borrow to invest.

What matters when investing, whether you use borrowed money or not, is the quality of the underlying property investment. You also need to be mindful of the costs of such an arrangement. As a SMSF trustee, you need to ask yourself whether the expected returns on the investment justify the costs of the borrowing arrangement. The property products aren’t necessarily cheap, and you may discover you’re being charged several levels of fees.

… My view of limited recourse borrowing within SMSFs is that just because you can, doesn’t mean that you should. You can expect to read a lot of hype and hoopla about gearing within SMSFs, as if the act of gearing is an investment in itself. My reservations about some of the limited recourse borrowing products on the market is that investing in this way is expensive and you have to do your sums about the net benefit of such an investment approach. Don’t get distracted by the complicated structure of such products. You need to ask: Is the expected return on the property behind the borrowing arrangement going to exceed the annual interest costs, any management charges, and any additional establishment and add-on costs that the product promoter is going to charge?

The extracts above have been reproduced with slight amendments, from Trish Power’s book DIY Super For Dummies (Wiley) ($39.95) Reproduced with permission.

Related posts:

1. SMSF borrowing: What’s the difference between a non-recourse and limited recourse loan?
2. What is the difference between a limited recourse borrowing arrangement and a non-recourse loan?
3. SMSF basics: Can my DIY super fund borrow money?

Borrowing directly in two scenarios only

Your fund can’t directly borrow money, except in two instances: if you need cash to pay a member’s benefit, or if you need cash urgently to settle a share transaction.

1. Borrow to pay a super benefit

A SMSF can borrow money to pay a benefit to a fund member if the loan satisfies the following conditions:

• SMSF member’s benefit payment is required by law, or by the fund’s trust deed
• SMSF trustee can’t pay the benefit unless the fund can borrow money
• Loan is for no more than 90 days
• Total loan is for no more than 10% of the value of the SMSF’s assets.

2. Settle a share transaction

A SMSF can also borrow money directly for up to 7 days to settle a share transaction. A super fund trustee can only borrow money to settle a share purchase if:

• At the time the investment was made, it was likely that the borrowing would not be needed.
• The period of the loan is no more than 7 days.
• The total amount borrowed can’t exceed 10% of the fund’s assets.

Note: The super laws also permit the tax commissioner to make written determinations exempting certain share purchase borrowings.

Borrowing indirectly is the latest trend

Your super fund can also indirectly borrow money. A SMSF can invest in managed funds that borrow money (geared managed funds), or even invest in instalment warrants, warrants, options or contracts for differences (CFDs). I write about options and CFDs in the article SMSFs: Purchasing options is OK, and even sometimes CFDs.

The latest ‘hot’ trend in the SMSF world is the opportunity for a SMSF to indirectly borrow to purchase fund assets using a limited recourse borrowing arrangement.

In plain English, such an arrangement enables your fund to purchase an asset using borrowed funds. Your fund makes an initial payment, your fund then pays interest and after a period of time, the fund has the option to eventually repay the full amount and received full ownership of the asset. The super fund secures beneficial ownership of the asset from the very start.

You can read more about limited recourse borrowing arrangements in other articles on the SuperGuide website.

For more detailed information on the general borrowing rules, you can refer to the ATO SMSF ruling, SMSFR 2009/2,  which provides guidance on the borrowing ban and the exceptions that apply using case studies. Click here to access the ruling.

Related posts:

1. SMSF investment: Can my DIY super fund invest in direct property?
2. SMSF basics: Is there a minimum or maximum age for starting a DIY super fund? (2 questions)
3. SMSF borrowing: What’s the difference between a non-recourse and limited recourse loan?

Trish’s response: Before I answer your question, I need to clarify your comment about now being able to use a super fund to purchase real estate. Superannuation funds, including self-managed super funds (SMSF), have always been able to invest in direct property. The big change is that the Government now permits SMSFs to use a special type of gearing structure to invest in property which means in certain circumstances, a SMSF doesn’t need the full purchase price to invest in real estate, or to invest in any other allowable investment.

A SMSF can in invest in all types of property such as indirect property investments, direct property (residential, commercial, industrial and rural) and property located overseas.

Anyone considering such an investment should seek out professional advice and if a SMSF is considering a particularly complex strategy, then perhaps a call to the technical experts at the ATO may be in order.

In theory there are no special rules applicable to direct overseas property but a few issues come to mind, including the following:

• Documentary evidence that a SMSF owns the overseas property, and that the fund ownership is recognised in the country where the asset is located.
• Any investment must still be consistent with the sole purpose test, which means, for example, a residential property located in the United States could not be leased to a fund member or relative of a fund member
• Any investment needs to be considered against the potential risk and return of the investment, and the cash flow needs of the fund. For example, a viable return for such an investment would also need to take into account the cost of any flights to inspect the property, and consider the risk that such overseas trips may be more closely investigated by the ATO as a possible breach of the sole purpose test.
• A fund’s auditor may need special documentation to verify the existence and ownership of the asset

You also ask for some information on the process to purchase overseas property and the entities necessary to proceed with such an investment. At this stage, our website cannot provide you with a list of overseas property specialists that are located in Australia, or located overseas. As a preliminary step, I suggest you speak with a financial adviser or accountant who knows a lot about SMSFs to confirm that your fund is in a position to consider such an investment, and the compliance process involved from a SMSF point of view.

Related posts:

1. SMSF investment: Can my DIY super fund invest in direct property?
2. SMSF investment: Buying commercial property, and borrowing options
3. SMSF basics: Can my fund buy my residential investment property?

NEWS UPDATE: On 10 March 2010, the Minister for Financial Services, Superannuation and Corporate Law, Chris Bowen MP announced two changes to the instalment warrant rules in relation to superannuation:

• Only licensed advisers can recommend and implement instalment warrant arrangements.
• A superannuation trustee who enters into a limited recourse borrowing arrangement to purchase an asset, as permitted under subsection 67 (4A) of the SIS Act (instalment warrant provisions), will be treated as the owner of the asset for income tax purposes, thereby averting the triggering of the capital gains tax rules when paying the final instalment.

Certain borrowing arrangements by superannuation fund trustees which are permitted by the Superannuation Industry (Supervision) Act 1993 (the SIS Act) will now be financial products under the Corporations Act 2001. What this means is that only licensed financial services providers can offer these arrangements to superannuation funds, which cuts out accountant, mortgage brokers and property spruikers (unless they also hold an Australian Financial Services Licence). The Regulations formalising this change will take effect three months after being made.

According to Minister Bowen, the second change, relating to ownership of the underlying assets for tax purposes, ensures that trustees of superannuation funds who have entered into permitted limited recourse borrowing arrangements will not face capital gains tax obligations at the time the last instalments are paid. The changes to the ownership status will apply for income tax assessments from 2007/2008 year onwards.

Minister Bowen also flagged that due to some areas of uncertainty in relation to the borrowing arrangements permitted by super funds, there may be further announcements in relation to instalment warrants.

The following text is an edited extract from Trish Power’s book DIY Super For Dummies ($39.95, Wiley). Reproduced with permission.

Instalment warrants – the basics

Instalment warrants are becoming increasingly popular with SMSF trustees seeking to gear an investment portfolio without breaking super’s ‘no borrowing’ rules.

An instalment warrant is similar to a hire purchase plan — a third party purchases, say, a shareholding in a company. You pay an instalment now on the purchased shareholding, and then pay interest every year; and, after a period of time, you have the option to repay the rest and receive full ownership of the asset. For example, say you own shares in the Bigger And Better Building Company (BBB) and you receive dividends from those shares. A BBB company share costs $10 and is currently paying a dividend of 50 cents a share, whereas a BBB instalment warrant costs $5. If you have $1,000 to invest in BBB, you can buy 100 shares or 200 instalment warrants; plus, you receive an extra $50 a year in dividends by buying the warrants.

A SMSF can invest in an instalment warrant issued over any asset that a SMSF can invest in directly. For example, a product provider may offer an instalment warrant over property, Australian shares, overseas shares, managed funds, private equity investment or even collectibles.

Not everyone in the superannuation industry supports the use of gearing within super funds. Some experts believe that gearing places super savings at too much risk, while others argue that if SMSF trustees can invest in geared managed funds and highly geared listed companies, then using instalment warrants is also legitimate.

The risk of investing in derivatives, such as instalment warrants, is that because you only pay a portion of the full value of the asset, you can buy more instalment warrants compared with what you buy of the underlying asset, with the same amount of money, and it can expose the fund to greater losses if the share price drops substantially. A derivative is a financial asset or liability whose value is linked to an underlying asset such as shares.

The government and the ATO have expressed concerns about the appropriateness of some types of instalment warrants for SMSFs. An instalment warrant with a limited recourse arrangement that gives the product provider recourse only to the asset attached to the instalment warrant (rather than other fund assets) has been given the ATO tick of approval. Limited recourse means the maximum that you can lose is your original capital investment.

Taking the risk of a limited loss, on trust

Before legislation was passed in late 2007, SMSFs only invested in instalment warrants issued over shares. Since the introduction of new rules in September 2007, a SMSF trustee can ‘borrow’ money under an instalment warrant arrangement over most types of assets when the geared product holds the following features:

• Held on trust. The borrowing is used to buy an asset that is held on trust, and the SMSF trustee receives the beneficial interest and a right to purchase the underlying asset.
• Limited recourse. Limited recourse means that the maximum your fund can lose is the original capital investment: Your fund can’t lose more than the original amount invested (including amount borrowed). The lender (product provider) only has recourse to the asset in question if your fund defaults on the loan, rather than recourse to other fund assets. If you don’t make a payment, the asset held in trust is sold on-market and the proceeds of the sale are offset against the final instalment payable. And, if the final payment outstanding is greater than the sale proceeds, then your fund isn’t required to pay the difference because the product included loan insurance.
• Allowable investment. The underlying asset is the type of asset that a SMSF trustee can invest in directly. For example, a SMSF trustee can’t purchase a residential investment property owned by a fund member under such an instalment arrangement because such an asset can’t be purchased directly by a SMSF. If the residential property is bought from an unrelated party, however, then such an arrangement is possible. Unlike residential property, business-related property such as an office or warehouse can be bought from related parties.

Note: SMSF trustees must still comply with other superannuation rules. You must have drafted, and follow, a derivative risk statement if your fund invests in instalment warrants or any other derivative product such as options. Your derivative risk statement must explain your policies when using derivatives, including the risk analysis of using such an approach and the controls you have in place to manage these investments. Your fund’s auditor must sign off on this document each year.

What matters is the quality of the underlying investment

Purchasing property (or any type of asset permitted by the super rules) by using instalment arrangements is a legitimate option for SMSF investors but such an investment approach involves borrowing, commonly known as gearing. When property values are rising, geared products enable to you to accumulate wealth at a much faster rate because you have access to the returns on more assets. In falling markets, however, your losses are also greater when you borrow to invest.

What matters when investing, whether you use borrowed money or not, is the quality of the underlying property investment. You also need to be mindful of the costs of such an arrangement. As a SMSF trustee, you need to ask yourself whether the expected returns on the investment justify the costs of the instalment arrangement. The property warrant products aren’t necessarily cheap, and you may discover you’re being charged several levels of fees.

Note: You need to fully understand that this ‘borrowing’ caper isn’t a regular arrangement, and can be relatively expensive to set up and to maintain over time. Your instalment arrangement must also meet special conditions (refer earlier).

Source: Edited extract from Trish Power’s book DIY Super For Dummies ($39.95, Wiley). Reproduced with permission.

Related posts:

1. SMSF borrowing: What’s the difference between a non-recourse and limited recourse loan?
2. Using unit trusts for purchasing property through your SMSF
3. SMSF investment: Can my DIY super fund invest in direct property?