Are we coming to the end of Super Fund Borrowing?

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1 ISSUE January 2015 THE NEW YEAR AHEAD. Are we coming to the end of Super Fund Borrowing? On Sunday, 7th December last year the long-awaited Financial System Inquiry Report handed down by David Murray caused enormous industry and media speculation effectively signing the death warrant for super fund borrowing, known more accurately as limited recourse borrowing. Now that the dust has settled and we are into the New Year we examine briefly the implications of this report and for ourselves speculate on whether limited recourse borrowing for self managed superannuation funds will continue to the future. It is fair to say that media speculation on the subject of limited recourse borrowing has, in our opinion, overstated both the process of the report and its outcomes. The report which is some 350 pages in length deals with a whole range of financial services issues and proposed reforms that are recommended to the government. As such they are not government proposals and there is no guarantee that any of the reforms recommended in relation to the financial services industry will in fact be adopted by the government as part of any legislative reform; as we have seen earlier with the Cooper review and the Wallis report. At present, the report is being circulated for industry comment to be received by 31 st March next before the government will make any decisions on any of the report s recommendations. In summary the report states the government should restore the general prohibition on direct borrowing by superannuation funds by removing section 67A of the SIS Act on a prospective basis. The basis for this recommendation is made on two grounds. The first is that poor lending practices and the risk associated with borrowing has or will put super fund assets at risk contrary to the general

2 theme of the superannuation law which prohibits any form of borrowing other than in very limited circumstances. The report also commented on the fact that banks and lending institutions generally require personal guarantees from Trustees which introduces or spreads the risk of borrowing to nonsuperannuation assets in addition to other debt that members may already hold. The second basis is the apparent contribution that superannuation borrowing has made to the inflated property market and the risk of a property bubble burst and the economic consequences of such a fallout. However, both of these views have become under criticism by many leading industry experts, including SPAA, as having no substance or basis. At the very least the FSI views and concerns are overstated particularly in relation to the amount of super fund borrowing as a percentage of overall borrowing throughout Australia. Despite speculation however, the government have a number of options in relation to the recommendations if they are persuaded by any of the arguments or recommendations that the report makes. We summarise these options as Hill Legal views them as follows:- 1. Ban on limited recourse borrowing Given Australian s love affair with property and the rise and growth in self managed super fund assets this option is of course open to be adopted by the government but, in our view, is unlikely to occur for all of the reasons set out below with the alternate options. 2. No changes to limited recourse borrowing It is possible the government may take the view that if there is any evidence that super fund borrowing has contributed to the spike in property across the country the ban on limited recourse borrowing could cause the demise of the property market with negative economic consequences being suffered to an economy which is already fragile and suffering from low economic growth. Alternatively, if it believes that there is not enough evidence that limited recourse borrowing has contributed to the property spike in any significant way there is no reason to change the current super fund borrowing rules which have been the subject of ongoing clarification and quasi judicial interpretation by the ATO. The government may also take the view that super fund borrowing adds to the wealth of Australians because super fund borrowing typically involves the acquisition of property

3 assets which have and will continue to grow in value. This will reduce the cost and risk to government funding and supporting an ageing baby boomer generation as well as contribute to economic growth. 3. Restriction or ban on related party loans If the government were going to give lip service to the report and if there was evidence that related party lending was a major or growing feature of super fund borrowing the government may either ban or restrict the ability of a fund to borrow money from a related party. Related party loans are popular with super fund members who are young, cannot access their superannuation benefits for many years and who have other assets outside the super fund which they can borrow against in order to lend money to the fund. A related party loan allows the member to withdraw money out of the superannuation fund and access any additional cash flow coming out of the fund in order to reduce debt quicker or to be able to use the fund s cash flow for other purposes. At present there is an anomaly in the superannuation rules. The superannuation contribution rules restrict money going into the fund by way of contributions. There is a maximum of $180,000 per annum per member for non-concessional contributions (or $540,000 with the 3 year bring forward rule) and $25,000 or $35,000 (depending on age) for concessional (tax deductible) contributions. However there are no restrictions on the amount that the fund can borrow to contribute into the fund. A fund could, for example, borrow $1 million to acquire a property asset but a member is only able to contribute a maximum of $540,000 into the fund. Restricting or banning related party loans would close this anomaly if the government were inclined to restrict the borrowing rules in some form or manner. 4. Create an LVR limitsay 50% If the government were concerned at the potential risk of members borrowing excessive amounts of money and any potential impact that this would have on the economy it could introduce a loan to valuation restriction such that the fund could only borrow a maximum of say 50% of the purchase price of the asset either from a related party or from a bank. In our view this is a more likely scenario if the government wanted to adopt some of the recommendations in the FSI report. This approach would address the reports concerned about the apparent unnecessary build up of risk in the superannuation system

4 but still allow the super fund to purchase direct property outright that would provide a passive income to the fund s members in retirement and potentially cool the overheated property market. 5. Phase-out and grandfathering The government may potentially take the view that any immediate changes to superannuation borrowing may destabilise either the financial services industry or the economy particularly around the time of any change when transactions are underway or being contemplated. Take for example a super fund that enters into a contract to purchase an off the plan apartment with the intention of borrowing money when that apartment is constructed say in 12 months time. What is to happen with such an arrangement if the government makes a change to the rules? A grandfathering policy could see the government phase-out super fund borrowing altogether but over an extended period of time. A grandfathering policy would acknowledge the benefit that super fund borrowing has created but mitigate its problems by phasing it out over an extended time which would reduce the impact on the economy and the financial services industry generally. Such a policy however would nevertheless cause a rush in property acquisitions before the grandfathering became effective, cause inequality to funds that are established and restricted in borrowing after the grandfathering dates and could potentially negate the objectives of the policy by funds ramping up their risk in purchase of property assets prior to the introduction of the grandfathering dates. Such a policy could also see the collapse of self managed superannuation funds which contribute to approximately 1/3 of superannuation assets in Australia. While we are yet to see the government s comments and response to the report it is likely in our view that there will either be no changes to the super fund borrowing rules or the government will be inclined to adopt a restrictive LVR policy as outlined in 4 above. Either way we have seen anecdotally in the last month since the FSI report an increase in interest in super fund borrowing ahead of any changes that may be made by the government. If you are inclined to consider either establishing a self managed superannuation fund or using your existing fund to borrow money to acquire assets we would encourage you to discuss your intentions with us as soon as convenient. If, for example you are contemplating entering into a limited recourse

5 borrowing arrangement with an off the plan purchase that may not settle for an extended period of time we would recommend that the borrowing documents be created and established as soon as possible to take advantage of any grandfathering that is likely to be associated with any rule changes. Watershed New ATO rulings Restrict Related Party Loans On the 12 December last year the ATO issued two interpretive decisions (1) Clarifying widespread industry speculation arising out of an earlier private ruling concerning the taxation consequences of a related party loan which carried a zero interest rate. Loans to a superannuation fund by a related party carrying a nil or low interest rate have become popular as a result of an ATO interpretive decision in September 2010 which stated that a super fund can borrow money on terms from a related party at less than a rate that a lender might lend and not breach section 109 of the SIS Act providing the fund was paying interest no more favourable to the related party than if the parties had been dealing with each other at an arm s length. Further, this view gained more traction when the ATO met with industry participants in June 2012 (2) During that dialogue the ATO was asked can a SMSF enter into a borrowing arrangement under section 67A of the superannuation industry supervision Act 1993 with a related party if a zero rate of interest is charged by the related party lender and only principal repayments with no imputed interest are made throughout the loan term in accordance with the loan agreement. In response the ATO said that such an arrangement does not breach the SIS Act. It did not increase the capital of the fund and the interest-free component of the loan will not be deemed to be a contribution. The ATO also said that a lower than market interest rate by a loan to the Trustee by related party will not prevent the arrangement from being a borrowing for the purposes of the SIS Act. The ATO noted that the non-payment of interest did not negate a borrowing arrangement and the ATO referred to the 2010 interpretive decision by citing the example noted therein that refinancing the original loan at an interest-free rate does not cause a contravention of section 109 of the SIS Act. Despite these views the ATO have now stated from the new rulings that while a related party loan carrying a zero interest rate may not breach the SIS Act requirements for super fund borrowing purposes the income

6 from the asset acquired from the borrowing will be treated as non-arm slength income and will be taxed in accordance with section of the Income Tax Assessment Act with the result that the fund will have to pay tax on this income at a rate of 45% not at its concessional tax rate of 10%. The rulings separately deal with the acquisition by the fund of listed shares and real property. In respect of the property acquisition the following facts arose: The fund had a corporate Trustee and the 2 members were the directors of the Trustee company; The members were also the directors of the Holding Trustee company; The fund purchase commercial property at $625,000 The members lent the fund $500,000 personally for loan term of 15 years at a zero interest rate The loan agreement specified periodic monthly repayments to ensure that the loan was repaid at the end of the loan term. The ATO stated that such an arrangement resulted in the fund receiving non-arm slength income in accordance with section of the Income Tax Assessment Act. It came to this view on the basis that in accordance with this section of the Tax Act it was an arrangement or scheme with the result that the parties were not dealing with each other at arm s length in relation to the scheme because the members of the fund, the directors of the Holding Trustee and the lenders were all related to each other and the loan was for an amount at 80%, higher than what a bank would normally offer and at a zero interest rate which would not be commercially available. The ATO stated that had the parties been dealing with each other at arm s length a commercial lender would not lend any amount to the fund on these terms and without the loan on these terms there would be no investment in the asset and so therefore income from that asset namely the rent from the property will be treated as nonarm s-length income and taxed at the highest marginal tax rate of 45%. The other ruling involved the fund borrowing several million dollars over a loan term of 20 years at a zero interest rate being 100% of the purchase price of the asset without any personal guarantees given to acquire a parcel of listed shares. In those circumstances the income from the shares was treated as nonarm s-length income and also taxed at the 45% tax rate.

7 Important Lessons The lessons from these rulings in relation to related party loans can be summarised as follows:- 1. A loan of 100% of the purchase price of the asset is not likely be accepted as commercial and therefore the income from the asset taxed at 45% 2. The LVR ratio of the loan should approximate what a bank or lending institution might offer; 3. The interest rate on the related party loan should approximate what might be available commercially and evidence of what is a commercial rate should be sourced and held on file; 3. A related party loan should be secured by mortgage with personal guarantees particularly if the LVR of the loan is likely to be higher than a bank funded loan; 4. A zero interest rate loan may be permissible from the point of view of the SIS Act but it is most likely that the income from the asset being acquired will be treated as non-arm s-length income and taxed accordingly; 5. There is now a higher requirement to properly document such a loan transaction; 6. The ATO will examine the regularity and frequency of principal repayments; 7. Interest only loans for the duration of the term may be questioned; These two rulings which were made just before Christmas have serious and significant implications for members who have made related party loans to their super fund that have not been properly documented or structured. Take for example a commercial property valued at $1 million that is purchased by the fund with the assistance of an $800,000 loan by the members at say a nominal rate of interest. Such an arrangement, based on the recent rulings, could result in the income from the property being declared as nonarm s-length income. If the rental income from the property was $70,000pa the tax applicable would be $31,500pa instead of $7000pa (or Nil if the fund was in pension mode) if the income was ordinary income of the fund. This tax impost would occur whilst the non-arm s-length income is being received by the fund. In these circumstances the member would need to refinance the loan with a commercial loan which may not be available. Further the super fund borrowing rules only permit the refinancing of the original loan for the original loan amount which might not be available. If you have any concerns about your own related party loan arrangements we would encourage you to seek our advice to

8 review the structure of the loan with the view to avoiding any non-arm slength income issues arising from the transaction. Typically an auditor may sign off on the transaction simply because your loan arrangement may comply with the SIS Act requirements however your auditor may not be concerned about the adverse taxation consequences of such an arrangement. January 2015 LL.B; B.Juris; Dip.FP; CFP; TEP; LIV Accredited Specialist; SMSF Specialist Advisor Principal Hill Legal Lawyers and Consultants Notes: (1) ATOID 2014 /39 and 2014 /40 (2) ATOID 2010/162 (3) Superannuation Technical Minutes of Meeting June 2012 Disclaimer The material contained in this publication is general reading only information and does not constitute advice on the subject matter. While every effort has been made to ensure accuracy you should not rely on the information provided without seeking professional specialist SMSF advice on your individual needs and circumstances and the relevance and appropriateness of the ideas and strategies mentioned. No representation is given, warranty made or responsibility taken as to the accuracy, timeliness or completeness of any information or recommendation contained in this publication and Hill Legal, lawyers and consultants will not be liable to the reader in contract or tort (including for negligence) or otherwise for any loss or damage arising as a result of the reader acting upon any such information or recommendation. Page 1