SMSF borrowing – friend or foe?

The use of leverage in self-managed superannuation funds (SMSFs) to finance asset purchases has been on the rise.  This special type of borrowing became viable in 2007, when SMSFs were permitted to use limited recourse borrowing arrangements (LRBAs) as an exception under the Superannuation Industry (Supervision) Act 1993 (Cth).

How does it work?

Broadly, SMSFs can be used for the purpose of borrowing money from lenders (banks or other financial institutions) to buy a single asset, usually residential or commercial property, which will be held in a separate holding trust by a “custodian”.  The loan itself can be made directly with the lender, or indirectly through fund members, who may also have a discrete full recourse loan with a lender.

The effect of this is that:

  • the SMSF trustee provides its own monies for the asset purchase in addition to repaying the loan funds;
  • the legal ownership of the asset is held on trust (as a bare trust) by the custodian for the benefit of the SMSF trustee;
  • the SMSF trustee acquires a beneficial interest in the asset; and
  • investment returns earned from the asset are received by the SMSF trustee (as trustee for the SMSF).

If the SMSF trustee defaults under the loan facility, the lender is limited to enforcing over the relevant asset only.

Recent developments and debate

In recent years the government has undertaken a Financial System Inquiry (FSI) to examine how the Australian financial system can be best positioned to meet the nation’s evolving needs and support economic growth.  In November 2014, the FSI Final Report was published and one of the recommendations was that there be a prohibition on direct borrowing by SMSFs using LRBAs.1  There were concerns over the risks involved for SMSF trustees, the financial industry and Australia broadly, arguing that borrowing with LRBAs magnifies any gains and losses from fluctuations in the prices of the assets held in funds, increasing the possibility of large losses.

Lenders often require guarantees to support limited recourse lending. However, if the asset significantly diminishes in value, it is likely the guarantor may need to liquidate other assets of the fund or other assets outside of the fund to repay the lender.  The main concern expressed in the FSI Final Report is that this may decrease the ability of the SMSF to act as a savings vehicle for retirement income.  This may mean that it will fall back on the government to fund retirement through taxation.

 

Another potential effect of LRBAs is that SMSFs may become heavily weighted in real estate, and SMSFs trustees may be selling other assets of the fund to repay lenders, cover losses or concentrating the asset mix of funds towards property. The FSI Final Report suggested this may reduce the benefits of diversification and further increase the amount of risk in a fund’s portfolio of assets. However, others argue that the move away from more traditional exposed asset classes, such as listed securities and cash, towards the stability of real estate, may lower systemic risk.

In the context of the public debate on these issues, the government is expected to provide its official decision on the recommendations of the FSI Final Report in August, following consultations with industry and consumers. We will provide our comment on these developments in a future edition of the Finance Update..

What about the current economic climate?

The ultimate decision on LRBAs may in fact depend on the government’s future economic outlook. Presently, the superannuation system is largely unleveraged with low levels of borrowing.  During or about 2009 to2011 there were rapid changes in asset prices globally, however the losses in SMSFs were fairly curbed.  This allowed the superannuation system to have a stabilising effect on the broader financial system and the economy more generally. Therefore, if the current level of borrowing continues, the government will need to consider whether there is any risk that significant growth in LRBAs will create any vulnerability in the financial system.

Approach of lenders

Lenders at the institutional level have taken a diligent approach in creating SMSF lending products and policies that safeguard SMSF trustees and beneficiaries, while also maximising successful outcomes for SMSF trustees.  Most major lenders require SMSF trustees to provide financial advice certificates from financial advisors or accountants to ensure that the lending is in their best interests and appropriate to their circumstances.  Some lenders have also taken a cautious approach by restricting loans to established properties (as opposed to off-the-plan purchases) and restricting their dealings to commercial, rather than residential, properties.  This is in addition to tightening lending criteria, which tend to require property valuations, as well as instituting maximum loan to value ratios to help maintain SMSF cash flows.

Lavan Legal comment

Before committing to a superannuation investment using a LRBA individuals should assess whether the investment is consistent with their SMSF investment strategy and the risk profile of their fund. It is recommended that both financial and legal advice be sought before a loan application is even considered.

Other factors that should be kept in mind include the high costs of establishing and maintaining LRBAs, the complex compliance requirements, the liquidity of the SMSF and its ability to meet loan repayments and the restrictions on using borrowed funds to improve property.

Tax implications are also an important consideration.  On 19 January 2015, the Department of Treasury released draft legislation in relation to income taxes that will impact on LRBA2.  The draft legislation adopts a “look through” approach whereby the SMSF trustee should be treated as the owner of the asset of the holding trust, rather than the custodian. This treatment will likely have flow on effects in relation to interest deductions, capital gains tax events, dividends and franking credits.

Overall, LRBAs have the potential to present individuals with a viable mechanism to invest in assets, particularly property, in a manner which is able to limit losses and may yield stable capital growth as well as an income stream.

However, there are risks which remain for investors, particularly where personal guarantees are required, or where the use of LRBAs results in a reduced asset mix within a fund’s portfolio of investments.

Once further guidance is provided by the government, it will become clearer whether LRBAs are a friend or foe for investors.

1 Full details are available at http://fsi.gov.au/publications/final-report/

2 See Exposure Draft and Explanatory Memorandum for Tax and Superannuation Laws Amendment (2015 Measures No. 2) Bill 2015: Instalment warrants.