The Financial System Inquiry’s final report — chaired by David Murray — was recently released.
As expected, it has recommended that limited recourse borrowing arrangements (‘LRBAs’) in superannuation funds be banned.
This gives rise to a certain window of opportunity.
What the FSI final report actually said
The final report recommended that the government:
Remove the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements by superannuation funds.
More specifically, it states:
Government should restore the general prohibition on direct borrowing by superannuation funds by removing Section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS Act) on a prospective basis. [Emphasis added.]
The final report describes the problem that it seeks to address as follows:
… growth in superannuation funds’ direct borrowing would, over time, increase risk in the financial system … the Inquiry notes an emerging trend of superannuation funds using LRBAs to purchase assets. Over the past five years, the amount of funds borrowed using LRBAs increased almost 18 times, from $497 million in June 2009 to $8.7 billion in June 2014.
Although the limited recourse nature of LRBAs is supposed to limit risk, the report is sceptical, stating:
Because of the higher risks associated with limited recourse lending, lenders can charge higher interest rates and frequently require personal guarantees from trustees. In a scenario where there has been a significant reduction in the valuation of an asset that was purchased using a loan, trustees are likely to sell other assets of the fund to repay a lender, particularly if a personal guarantee is involved. As a result, LRBAs are generally unlikely to be effective in limiting losses on one asset from flowing through to other assets, either inside or outside the fund. In addition, borrowing by superannuation funds implicitly transfers some of the downside risk to taxpayers, who underwrite adverse outcomes in the superannuation system through the provision of the Age Pension.
What does this mean in practice?
So far, the final report does not mean anything. The Financial System Inquiry is not a law making body and its recommendations do not constitute law.
However, the Financial System Inquiry was essentially commissioned by the government. Accordingly, there is a fair chance the government will take it seriously and pass an Act that implements at least some of its recommendations. The government has previously acted on similar reports and which recommendations eventually become reflected in law depend on numerous factors.
The next federal budget night is a logical time. Accordingly, it is possible that trustees of superannuation funds will be able to enter into LRBAs until at least May 2015.
However, the government could make an announcement either sooner or later that it will prohibit LRBAs.
Naturally, it is unlikely that an announcement by the government would be immediately accompanied by the Act that implements it. Rather, it is more likely that the effect of the Act will be backdated to the day of the government announcement.
Might a ban on LRBAs be backdated to the FSI’s release of the final report?
It would be unlikely and inconsistent with good legislation making practices for the government to make an Act that has retrospective effect to the date of the Financial System Inquiry’s release of the final report.
What grandfathering can we expect?
The final report recommends grandfathering, stating:
In implementing this recommendation, funds with existing borrowings should be permitted to maintain those borrowings. Funds disposing of assets purchased via direct borrowing would be required to extinguish the associated debt at the same time.
What is the critical action?
Naturally, those who want to engage in LRBAs should do so as soon as possible so that they have an ‘existing borrowing’ as soon as possible in order to maximise their chance of qualifying for grandfathering.
This then raises the question of what constitutes an existing borrowing.
There are a number of different possible points in time that might be thought of as important in the commencement of an LRBA, such as:
- when the purchase contract is signed
- when the deposit is paid
- when the bare trust deed is signed
- when any supplementary deed is signed
- when a loan contract with the lender is signed
- when the loan is drawn down
- when the property settles.
At the risk of oversimplifying, in respect of the 2010 changes, the arrangement was typically viewed as coming into existence when the when a loan contract with the lender was signed. This time, the grandfathering language seems even clearer, with the Inquiry using the term ‘existing borrowing’ rather than just ‘existing arrangement’.
In short, I suspect the critical deadline to qualify for grandfathering will be when the loan contract is made.
The danger … especially for off-the-plan purchases
Based on the above, there is a risk for SMSF trustees who have currently signed (or shortly will sign) purchase contracts but have not signed loan contracts with lenders. The danger is that the law might change before the loan contract is signed meaning that they might not be able to borrow to settle the property.
This could cause difficulties if the SMSF trustee was relying on borrowing to fund the settlement!
This is a particular concern for off-the-plan purchases. Naturally, with off-the-plan purchases it is very common to sign a purchase contract yet the property is not built, subdivided and ready to settle for another 1¬–2 years. Banks typically will typically not approve finance and then sign loan contracts until after the property is substantially built, subdivided and ready … that is, 1–2 years in the future and again, there is a real possibility that the LRBA laws might have been repealed by then.
The strategic opportunity
Of course the simple solution is to sign a loan agreement now, while the LRBA laws still exist.
However, again, banks might not be willing to sign the loan agreement now.
Therefore, SMSF trustees might consider signing a loan agreement with a related party as soon as possible. This helps draw a ‘line in the sand’ to establish that the ‘existing borrowing’ has been entered into. If closer to settlement the LRBA laws still exist, then the SMSF trustee and the related party lender may agree to refinance with a bank lender or rescind the loan contract without ever having drawn down any money. However, if closer to settlement the LRBA laws have been repealed, hopefully the SMSF trustee could still borrow from the related party lender. The related party might itself look to borrow from, say, a bank using non-SMSF assets (eg, the family home) as security.
Naturally, it is also good to get as many of the other documents in place as well as soon as possible (eg, the bare trust deed) so as to be in the strongest position to say that the borrowing has come into existence.
Risks
Naturally, there is a fair amount of conjecture on my part in the above strategy. As a lawyer, I must ensure any announcement has been passed as law before providing advice. As you may well recall, in late 2013 the current government reviewed a backlog of 64 announced but unlegislated tax and superannuation measures and decided that only 16 measures would proceed and 48 were scrapped.
Also, when setting the terms of any related party loan, recall the controversy regarding related party loans and non-arm’s length income. This controversy is yet to be settled, although I understand further information from the ATO should follow soon. Therefore, in the meanwhile particular care should be taken to ensure that the terms of any related party loan agreement would not result in the SMSF deriving more income than it would have had it been at arm’s length. Broadly, this requires the terms and conditions of each related party loan to be benchmarked with an arm’s length supplier (especially, the interest rate, LVR and security arrangements).
Finally, care should be taken to ensure that any related party loans do not constitute deemed dividends under div 7A of the Income Tax Assessment Act 1936 (Cth). This is typically relevant where the lender is a private company or the trustee of a family trust that has unpaid present entitlements owing to a private company.
Conclusion
Where an SMSF trustee signs a purchase contract with a view to later settle the purchase using borrowings, they should consider signing a related party loan agreement now … even if they currently intend to ultimately borrow from a bank.
* * *
This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.
