A guide to SMSFs and limited recourse borrowing arrangements

Gemma Dale outlines the implications recent legislation could have for SMSF trustees who want to use limited recourse borrowing arrangements to acquire allowable assets.

Section 67 of the Superannuation Industry (Supervision) Act (SIS) prohibits the trustees of regulated super funds from borrowing money (or maintaining a borrowing) subject to some specific exceptions.

One of these exceptions, introduced with the original amendments on 24 September 2007, allows trustees to borrow money on a limited recourse basis to acquire an allowable asset — provided certain other conditions are met.

This is typically done through using an ‘instalment warrant type arrangement’.

On 26 May 2010, SIS Amendment Bill 2010 was introduced into the House of Representatives to resolve some uncertainties and reduce the risk of losses to fund assets for super fund trustees when using these arrangements.

The Bill received Royal Assent on 6 July 2010 and the amended law will apply to new arrangements entered into (and pre-existing arrangements that are refinanced in certain circumstances) after this date.

What are the Government’s key concerns?

Since the previous exemption allowing the use of ‘instalment warrant type arrangements’ was introduced, the Government’s view is that certain practices have emerged that raise prudential concerns. These include:

• The use of personal guarantees provided by the super fund trustees to underwrite the lender’s risk in the borrowing arrangement;
• Borrowing arrangements held over multiple assets that can potentially allow the lender to select which assets are sold in the event of a loan default; and
• Arrangements where the asset subject to the borrowing can be replaced at the super fund trustee’s or lender’s discretion.

The key changes are discussed below.

The definition of ‘asset’

While the previous exemption referred to the term asset in the singular, it was possible to interpret the meaning to include the plural. The amended law ensures the term should be read in the singular, but does permit borrowing over a collection of assets that are identical and have the same market value.

Examples of a single ‘acquirable asset’ include a collection of:

• Shares of the same type in a single company (eg, ordinary shares in X Ltd);
• Units in a unit trust that have the same fixed rights attached to them; and
• Economically equal and identical commodities (such as gold bars, irrespective of whether or not, for example, they have different serial numbers).
• Examples of assets that would not be allowable include a collection of:
• Shares in a single company with different rights (eg, ordinary and preference shares);
• Shares in different entities;
• Units in a unit trust of different classes that have different rights attached to them, or are potentially subject to differing trustee discretion; and
• Buildings where each is held under separate strata title, irrespective of whether they are substantially the same at acquisition time.

In the case of a real property purchase, a single title for land and the accompanying property would be considered a single acquirable asset.

However, additional items such as furnishings would not be allowed to be purchased through the same limited recourse borrowing arrangement. Finally, the definition of acquirable asset excludes money (ie, Australian or foreign currency).

Refinancing and related expenses

The new law clarifies that super fund trustees can refinance an existing limited recourse borrowing. This may allow them to minimise the risk of default on a borrowing resulting from a temporary inability to meet a repayment.

Furthermore, the new law:

• Won’t apply if the refinancing involves a renegotiation of the borrowing with the same lender that is simply a variation of a loan contract that continues to exist;
• Will apply if the refinance involves the rescission or replacement of the original loan contract, or a change is made to the arrangement’s terms and conditions that fundamentally alter the character of the arrangement; and
• Confirms the borrowing amount can include expenses that are considered to be intrinsically linked to the purchase of the acquirable asset (eg, conveyancing fees, stamp duty, brokerage and loan establishment costs).

Replacement assets

The previous exemption allowed the original asset held on trust to be replaced at the super fund trustee’s or lender’s discretion.

The new law ensures the original asset can only be replaced in very limited circumstances. For instance, if the original asset is a share in a company, it can only be replaced with a share in the same company.

In broad terms, the replacement provisions for securities are predominantly limited to corporate action type activity (eg, scrip for scrip transactions and mergers/reconstructions).

Examples of scenarios not permitting the replacement of an asset include:

• Securities liquidated or traded or both for different assets as a consequence of implementing an investment strategy;
• Money or cash is not eligible as a replacement under any circumstances. This includes situations where the original asset is replaced with an eligible replacement asset plus cash (eg, where shares in Y Ltd are replaced by shares in Z Ltd and a pool of cash, as a result of a takeover of Y by Z Ltd);
• A replacement asset arising from an insurance claim covering the loss to the original asset;
• A replacement by way of improvement to a real property;
• A series of titles over land replacing a single title over land that has been subdivided; and
• The replacement of a title over real property as a result of Government action, such as the resumption of all or part of a property rezoning.

Personal guarantees and related borrowings

The new law provides that the recourse of the lender and of any other person against the super fund trustees for default on the borrowing is limited to the rights relating to the acquirable asset.

A personal guarantee granted by the super fund trustees will not be effective in securing the lender’s interest in that asset.

It’s very important that super fund trustees are familiar with the changes, as a breach of the laws could result in civil or criminal penalties.

Note: This article is current as at 22 July, 2010.

Gemma Dale is head of technical services at MLC/360.