“How to Borrow without Sorrow”

Suzanne BrownSenior Solicitor

LLB (QUT) Hons Div 2A

A crash course in Limited Recourse Borrowings for SMSFs

North Queensland Law Association Conference

21 May, 2011

Can a SMSF borrow?

The Trustee of a SMSF is prohibited from borrowing money except in limited circumstances.

ExceptionsCan borrow for: Maximum 90 days to meet benefit payments due to

members or surcharge liability provided borrowing does not exceed 10% of Fund’s total assets

Short-term borrowing for 7 days to cover settlement of security transactions provided borrowing does not exceed 10% of Fund’s total assets

From 24 September, 2007, s 67 exempts fund borrowings under Limited Recourse Borrowing.

Summary – s 67A

SMSF may enter into a borrowing arrangement where: All general rules relating to SMSF must be complied with – SISA;

SISR Trustee of SMSF borrows money for acquisition of a single

acquirable asset Legal title would be held by a separate trust (aka a ‘Security Trust’) The asset must be held on trust so that the SMSF acquires a

beneficial interest in the trust The Security Trust must have only one (1) asset The SMSF must have a right to acquire the legal ownership of the

asset by making one or more payments The rights of the lender (or other person) against the trustee must

be limited in recourse to only the asset acquired with the borrowed money (ie. must be a limited recourse loan)

Basic Outline of Structure

Gives a Limited Recourse Loan

Pays any repayments

Receives any Income

Purchase Price

Grants any Security Required

Sale of Property

Lender

VendorSMSF Trustee

Security Trust

Compliance with General Rules 1 Has the investment strategy for the SMSF been

complied with? Does the investment strategy comply with s 52(2f) of the

SIS Act? Is the investment the type of investment that a prudent

person would make? Sufficient cash-flow to make the interest payments over

time? Also, if the Fund is in pension mode, then you need to

ensure that the investment will leave enough money in the SMSF to keep paying the pension plus make the interest payments

Compliance with General Rules 2 Does the trust deed have the power to borrow and the

power to make such an investment? Comply with the sole purpose test? Comply with in-house asset rules? Comply with the rules relating to acquisition of assets

from related parties? Is s 109 of the SIS Act (Arms’ Length Transactions)

complied with? Need to limit possession of the property – could cause

breach of SIS Act if related persons are allowed to live in property or if commercial property, non-commercial rates are charged

Review of Trust Deed

To engage in borrowing, need to ensure that SMSF trust deed contains:Power to borrowPower to charge assets and give securityPower to appoint an agent/security trustee

“Do you have the power?”

Security Trust

Could be formed over original asset using the borrowings from the lender or over a settlement sum with the ability to have sub-trusts for each original asset purchased.

Trustee of the SMSF will be the only beneficiary of the Trust.

Must be ability to distribute asset to SMSF upon repayment of the loan

Security Trust - Settlement Sums If settlement sum used to form Security Trust then

possible that original asset will not be the only asset of the Security Trust and in-house asset exemption may not apply.

However, have seen some examples of this used where firms have taken the view that it does not breach the borrowing rules.

Alternatively, could use sub-trust strategy

Example: Although $10 settlement sum will likely be below 5% of Fund’s total assets, the added purchase of an investment property held in the Security Trust would likely push the value of the Security Trust above that 5% threshold. Trustee would then be required to dispose of interest in the Security Trust before end of financial year.

Sub-Trust Strategy Alternative strategy is to allow clients to have one

Security Trust but multiple borrowings without having to have a new Security Trust deed (ie. for investments in shares which may happen more than once).

Allows for settlement sum to be used to create the trust deed

General idea is the security trust is set up and then distinct and separate sub-trusts are created for each purchase with the trustee of the SMSF appointing the security trustee as agent for the purchase of each asset and sub-trusts being named in that document.

Related Security Trust

The s 67A(1)(b) exception contemplates that the SMSF will become a beneficiary in a related trust.

Ordinarily, a “related trust” will be treated as an in-house asset under s 71 SISA

However, when exception introduced for borrowing under s 67A(1), an exception was introduced to the in-house asset test in s 71(8).

Impact of s 71(8) SISA The result of the amendment is that the

investment in the Security Trust will not be taken to be an in-house asset (provided conditions complied with).

If borrowing undertaken by the trustee of the SMSF which does not comply with the rules, then the investment in the security trust will be a breach of the in-house asset rules if the investment is more than 5% of the total value of the SMSF (s 75 SISA)

The Lender

In most cases, the Lender will be a bank or independent financier = complies with ‘arms length’ transaction rule

s 109 prohibits the SMSF from making an investment, unless the investment is at arms length

If involves private companies, then Division 7A ITAA36 may still apply – need commercial terms and rates.

Lender’s fees (ie stamp duty, brokerage or loan establishment costs) can be paid from borrowed funds

Charging Assets

Regulation 13.14 (SISR) prohibits superannuation funds from giving charges over their assets.

Exception for where charges required or implied by SISA or SISR.

While regulations have not been amended to cater for borrowing rules, APRA and ATO have not raised the issue as of concern.

If borrowing rules complied with, then should fall within the exception for charging assets.

Security Instruments

Loan documents should be in the name of the SMSF

Any guarantees should be reviewed to ensure that they do not breach the borrowing rules and that no security is taken over the assets of the SMSF.

Must only be limited recourse loan – security can only be taken over the original asset or replacement asset acquired pursuant to borrowings.

Member Guarantees

Members can give guarantees provided rights against the principal debtor (the SMSF trustee) are limited to rights relating to the asset being acquired under the arrangement.

the recourse of the lender or any other person against the SMSF trustees must be limited to rights relating to the asset that is being acquired under the arrangement.

guarantor must not have general rights of indemnity against the SMSF

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)

Deemed Contributions If a guarantor makes a payment to the lender under an

arrangement where they have foregone their usual rights of indemnity against the SMSF, this is a contribution to the SMSF if it satisfies a liability of the SMSF. E.g. the guarantor paid the borrowing and the acquirable asset was transferred to the SMSF trustee under the arrangement.

However, no contribution if the SMSF trustee has exercised a right to 'walk away' from the arrangement (and has lost the acquirable asset to the lender) and has no further liability, but the lender still exercises a right to call on the guarantee for a shortfall

Loan Drawdown

Borrowing must be for acquisition of an asset Likely that SMSF could not drawdown loan and hold it

pending completion of contract If funds are provided to SMSF who provides them to

Security Trustee to hold on account prior to settlement (gathering interest), then this may itself, breach the borrowing rules as the money would have been applied firstly to the Security Trustee and accrued interest.

Best to have lender fund directly on the day of settlement to the SMSF who can provide the cheque directly to the vendor.

Contract of Sale

On drafting the Contract, the purchaser should be the trustee of the Security Trust;

if not in existence, then need Special Condition allowing rescission and change of buyer entity)

GST

Consider whether Security Trustee needs to be registered for GST – receiving more than $75,000 per year in rent?

Security Trust – separate ABN and GST registration (may not considered bare trust by ATO)

Repairs, Maintenance and Improvements Borrowed monies can be applied towards

maintaining or repairing the acquirable asset

But not expenses incurred in improving the acquirable asset

Impact of recent natural disasters: ImprovementsReplacement asset

Stamp Duty Considerations

May be stamp duty issues on transfer of asset from security trustee to SMSF trustee.

Unsettled Some advisors relying on s 123 and 22(3) Duties

Act It seems that OSR position is that duty is

assessable on transfer.

Questions?

Suzanne BrownSenior SolicitorEmail: sbrown@mckayslaw.comPh: 07 49630820