In December 2013, the Hon Joe Hockey MP announced the final terms of reference for the government’s Financial System Inquiry and the appointment of four members to serve on the inquiry panel, which is being chaired by David Murray AO.
An interim report was released by the inquiry earlier this year. The interim report said: “Direct leverage in superannuation funds is embryonic but growing. The number of SMSFs [self-managed super funds] using geared products grew by more than 11 per cent to 38,000 over the year to April 2014. A number of submissions point to the stabilising influence of the superannuation sector during the GFC [global financial crisis]. The current ability of funds to borrow directly may, over time, erode the superannuation system’s ability to act as a stabilising influence on the financial system during times of stress.
“…If allowed to continue, growth in direct leverage by superannuation funds, although embryonic, may create vulnerabilities for the superannuation
and financial systems.
“…The Inquiry would value views on the costs, benefits and trade-offs of the following policy option or other alternatives:
– Restore the general prohibition on direct leverage of superannuation funds on a prospective basis.”
Accordingly, there is the distinct possibility that SMSF limited recourse borrowing arrangements (LRBAs) might be prohibited.
What the changes might look like
The interim report expressly talked about making changes on a “prospective basis”. Accordingly, any existing arrangement presumably would be grandfathered if limited recourse borrowing arrangements are prohibited.
Certainly this was the case in 2010 when the previous “instalment warrant” laws were repealed and replaced with the less flexible current limited recourse borrowing arrangement laws. More specifically, the amending act provided that its “amendments… apply to an arrangement entered into on or after [July 7, 2010]” (Superannuation Industry (Supervision) Amendment Act 2010 (Cth) sch 1 item 14).
Therefore, it is quite possible that if limited recourse borrowing arrangements are prohibited, any amending act would again provide that the changes (that is, the prohibition) do not apply to an existing arrangement.
This then raises the question of what constitutes an existing arrangement.
There are a number of possibilities as to when an existing arrangement could be said to come into existence, 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 a loan contract with the lender was signed.
Off-the-plan purchases
Based on the above, at the risk of using too much conjecture, there is a danger 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 with off-the-plan purchases, where it is very common to sign a purchase contract even though the property is not built, subdivided and ready to settle for another one to two years. Banks typically will not sign loan contracts until after the property is built, subdivided and ready – that is, one to two years in the future. And again, there is a real possibility that the limited recourse borrowing arrangement exception laws might have been repealed by then.
The strategic opportunity
Of course the simple solution is to sign a loan agreement now, while the limited recourse borrowing arrangement 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 the “line in the sand”, to establish that the arrangement has been entered into. If closer to settlement the LRBA laws still exist, then the SMSF trustee and the related party lender can agree to 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 (for example, the family home) as security.
Naturally, it is also good to get as many of the other documents in place as soon as possible (for example, the bare trust deed) so as to be in the strongest position to say that the agreement has come into existence.
Risks
Naturally, there is a fair amount of conjecture on my part in making this recommendation.
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 Australian Taxation Office (ATO) might follow soon. Therefore, in the meantime, 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.
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.
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.
