Gearing in Super Print E-mail
In September last year the Federal Government amended Section 67 of the Superannuation Industry (Supervision) Act (SIS) to widen the ability of Funds to borrow to acquire investment assets.

The amendment was made to clarify that Funds could invest in instalment warrants which have embedded borrowings.

However, the legislation appears to go much further.
  • A simple trust is created with the fund member, or entity controlled by the fund member, as trustee.
  • This trust enters into a simple arrangement with the fund to hold legal ownership of an asset on behalf of the fund and allow the fund a beneficial interest in the asset.
  • The fund then borrows from any lender that will offer a non-recourse loan. The non-recourse loan could be achieved by the fund contributing a significant deposit so that the lender is willing to limit its power of recourse. It may also be possible for a related party to provide the lender with a guarantee that would allow the lender to promise limited recourse to the fund.
  • The fund buys the asset.
  • The fund collects the rent, pays the interest, and pays down capital of the debt to the extent it wants.
  • The fund ultimately sells the asset or pays out the debt and takes legal ownership from the trust.
The amendment is written as an exception to the general prohibition on funds borrowing and is headed "Exemption - Instalment Warrants". However, this is the first and last time instalment warrants are mentioned.

The amendment says that a fund may borrow to buy any investment asset that a fund is ordinarily allowed to buy under SIS, so long as the borrowing is made under an "arrangement" with the following characteristics:
  • The asset is separately held on Trust so that the fund acquires only a beneficial interest in the asset.
  • The fund has a right to acquire legal ownership of the asset by making one or more payments after it acquires the beneficial interest, and
  • The rights of the lender against the fund on default of the borrowing are limited to rights related only to the asset in question.


The legislation does not explain the nature of the "arrangement" that the fund must enter nor, with whom the arrangement should be made. There is no indication of who must be the trustee of the trust that has legal ownership of the asset.

The legislation appears to provide far greater scope for a fund borrowing to acquire assets, than was the Government's stated intention.

 

TAX EFFECTS OF GEARING

Traditionally gearing has been focused on giving up income for future capital gain where there is a significant differential between the after tax cost of the interest and the after tax capital gain. For example, if an individual has a marginal rate of 30% then the interest is subsidised by a tax deduction at 30% and capital gains will be only taxed at 15%, thus to be in front a $1000 gross interest cost needs to produce a gross capital gain of $823
(Net capital gain (100 - 15%) x $823 = $700 = Net interest expense (100-30%) x $1,000).

This does not take into account the time value of money where the interest is paid now but the capital gain is in the future where each dollar has a lower purchasing power.

For a SMSF we can do the same calculation, assuming the fund is in accumulation phase, the results for a $1,000 gross interest cost needs to produce a gross capital gain of $944 to break even. This occurs as the deduction is at the lower tax rate of 15% and the capital gain is taxed at the rate of 10%. If the fund has switched into pension phase after the payment of the interest but prior to the capital gain, then the break even point is $850.

What does make this attractive is when we take into account the income produced by the asset and this exceeds the costs of the borrowing. In that case we end up with a surplus which pays tax at a lower income rate in super than the personal rates. This would suggest that the best outcome for superannuation is where the gearing is "positive" not negative.


Are there any considerations?

Clearly the warrant rules will make those SMSFs that have used closely held non-geared trusts to acquire assets in concert with related parties look at these arrangements. If the outcome is that the SMSF will not increase its holding in these trusts then these current arrangements which can provide the gearing tax breaks at personal marginal rates may stay in favour. If the expectation is that the objective is for the SMSF to acquire total ownership over the asset then the warrant rules will be useful.

We are waiting to see if the ATO will extend its Practice Statement PS LA 2002/2 which waives the tax return requirements for Transparent Trusts (where the investor has absolute indefeasible interest) and Secured purchase Trusts (where the capital is secured by debt but the underlying assets are restricted to listed shares or units). Without an extension to this policy, property or other exotic asset warrants will need to have accounting and tax return services and costs.

There are still some questions to be answered over some of the more interesting strategies being suggested. These include whether a related financier can subsequently forgive the debt to the SMSF (early indications are that in this case the amount would then be treated as a contribution and measured against a contribution cap). Also can a related party financier charge a below market interest rate (again the expectation is that this could trigger some contribution questions and possibly even sole purpose test investigations). Further, whether or not a related party can provide a guarantee to the financier, and, if so, should there be accost charged for this guarantee and in the even of default would the guarantor in an arms length transaction seek recompense from the SMSF for the amount they paid out.

It should be noted that if these become as popular as the pre 1 July 1999 geared trusts were we may end up with more SMSFs that after the final instalment is paid will be the proud owners of a large indivisible illiquid asset that could make paying benefits (which is the primary purpose of superannuation fund) difficult.

Conclusion:

It would appear that while there are clear opportunities for the use of gearing within SMSFs under these new rules, in some respects the choice of which method to use and the mechanics of maintaining the structure need to be considered as carefully as the decision of which asset to gear.

However, given recent pronouncements from the government and ATO, coupled with our view that the new changes seem significantly out of line with the rest of the borrowing restrictions in SIS, which are very restrictive and appear far wider than the government's stated intention for the amending legislation, we advise that the above seems to make borrowing legitimate (but extreme care needs to be undertaken).

We recommend caution. (That is, those that rush in may well have to subsequently amend or update their arrangements).

Tony Martin - Director, Advantage One
 

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