Borrowing by superannuation funds

The Superannuation Industry (Supervision) Act 1993 (SIS Act) has been amended to allow superannuation fund trustees to borrow money to acquire assets in particular circumstances.  There are also a number of other issues which need to be considered.

Superannuation fund trustees can borrow money to acquire assets where:

• the borrowing is limited recourse ie from the fund’s perspective, the lender’s only security is the property;
  


• the fund could acquire the asset directly; and
  


• a third party (security trustee) holds legal title to the asset on trust for the fund trustee, who has a beneficial interest and a right to call for a transfer of the legal title when the loan is repaid and the mortgage is discharged.

An investment in a related trust is excluded from being an in-house asset where the asset could be acquired by the fund trustee directly.
The amendments allow residential property to be acquired from, and leased to, an unrelated third party. However, where residential property is acquired from, or leased to, a related party such as a member, relative or Part 8 associate of a member, the investment will be an in-house asset.

A fund trustee wanting to borrow must ensure that:

• the loan complies with the SIS Act;
  


• the fund has sufficient cash flow to repay the interest and principal (without relying on member contributions);
  


• the fund deed allows the fund trustee to borrow, acquire the relevant asset and invest in derivatives (where the asset is acquired under an instalment warrant);
  


• the purchase of the asset with borrowed funds is consistent with the fund’s investment and risk management strategy and the prudential requirements of the SIS Act ie the investment is in the best interest of members and the benefits and risks have been considered;
  


• a declaration of trust is executed between the security trustee and the fund trustee; and
  


• the fund auditor is satisfied that the structure of the transaction and the investment complies with the SIS Act.

Example:  A fund trustee with $500,000 cash borrows a further $500,000 from a bank or related entity to buy residential property for $1,000,000 from an unrelated third party. The parties to the loan agreement are the fund trustee, related entity (lender) and third party security trustee.
The trustee needs to be mindful of the arms length rules in the SIS Act and the Tax Act. For example, excessive rent charged to a related party tenant would be treated as special income and taxed at 45%.

If the lender is a related company, the loan should be Division 7A compliant. If there is no Division 7A compliance issue eg the lender is a family trust, the interest rate should be arm’s length, bearing in mind it is a limited recourse loan. If the interest rate is excessive, the fund’s complying status may be at risk. If the rate is less than market, the difference could be treated as an excessive contribution.

The fund trustee signs the contract of purchase and nominates the security trustee as the purchaser prior to settlement. The fund trustee and security trustee enter into a declaration of trust on the day of nomination. The security trustee enters into a lease with an unrelated third party. The lender takes a mortgage over the property. The fund trustee receives all rent.

If the fund trustee defaults on the loan, the lender can sell the property. If the property is sold for $900,000 and no principal repayments have been made, the lender will take $500,000 plus any interest and costs incurred and pay the balance to the security trustee. The lender cannot recover from the fund’s other assets if the sale price is insufficient.

Superannuation fund deed:  The fund deed must allow an investment in the property and derivatives (if necessary), borrowing in accordance with the SIS Act and a nominee to hold legal title.

Where the deed does not include these terms, we can update the deed for $220 (inclusive of GST).

Investment strategy:  The fund trustee must ensure the purchase and borrowing is consistent with the fund’s investment and risk management strategy and is an appropriate investment in light of the prudential requirements of the SIS Act, such as the sole purpose test, which requires an asset to be maintained for the purpose of providing retirement benefits to members or death benefits to members’ dependants.

When considering whether the investment is appropriate, the fund trustee must consider the:

• risks involved in borrowing and acquiring the asset as well as the likely return and cash flow requirements;
  


• diversification of the fund’s assets and the risks of inadequate diversification;
  


• liquidity of the fund’s investments and the ability to pay member benefits when required; and
  


• ability to discharge existing and prospective liabilities.

Property:  The fund trustee signs the contract of purchase ‘and/ or nominee’ and nominates the security trustee as purchaser prior to settlement.

The deposit is paid by the fund trustee and the balance by the lender. The lender takes a mortgage over the property and if it requires additional security, the member or a related party could provide a guarantee or other security.

The security trustee enters into the lease with the tenant on behalf of the fund trustee. The fund trustee can control all aspects of the property management, including sourcing tenants and determining the rent, controlling the capital expenditure, undertaking repairs and maintenance and paying the rates, taxes and insurance. The fund trustee could also arrange for the security trustee or a third party to manage the property.
The security trustee’s activities should be limited to holding the property and perhaps managing the property. It should not be involved in any trading activities where it may be exposed to outside risks. It can hold multiple assets on separate trusts.

The fund trustee is prohibited from gearing an existing asset as the SIS Act requires the fund trustee to use the loan to buy a new asset.

Income tax:  For income tax purposes, the Commissioner considers that a mortgage or security arrangement will not prevent the fund trustee from having an absolute indefeasible interest in the capital and income of the property. The security trustee will not need to lodge an income tax return.

The fund trustee receives the rent, which is taxed at 15% where the fund is in accumulation phase, or tax free where the fund is in pension phase.

Interest on the loan should be deductible when the fund is in accumulation phase. However, it should be clear that the property will have a positive return in the foreseeable future. If the property is negatively geared and the only likely profit is from the ultimate sale of the property, the interest will only be deductible up to the amount of the rent. The balance will be capitalised into the cost base. If it is anticipated that the property will not be sold during the accumulation phase and it is negatively geared during the accumulation phase, the interest in excess of the rent will not be deductible or capitalised into the cost base.

Stamp duty:  The fund trustee will pay stamp duty on the purchase of the property.

The subsequent transfer of the legal title to the fund trustee will be exempt from stamp duty under section 34 of the Duties Act 2000 (Vic) where a declaration of trust is made by the security trustee (apparent purchaser), which states that the property is held on trust for the fund trustee (real purchaser) (s34(1)(a)). The fund trustee must provide all of the money for the purchase.

Section 35 of the Duties Act 2000 (Vic) also provides an exemption where there is no change in the beneficial ownership of the property.
It is important to remember that the stamp duty provisions vary from state to state and the structure of the arrangement will need to be tailored accordingly.

CGT:  There will be no CGT payable as there is no change in the beneficial ownership of the property when the fund trustee takes legal title (section 104-10(2)(a) of the Income Tax Assessment Act 1997).

Land tax:  The Land Tax Act 2005 (Vic) provides that land held on trust is subject to a higher rate of land tax. Land tax is payable by the security trustee as the legal owner of the property. The security trustee can lodge a notification of beneficial interest in land with the Commissioner of State Revenue, which means that:

• the fund trustee is deemed to be an owner of the property in addition to the security trustee;
  


• land tax is levied at standard rates rather than at surcharge rates; and
  


• any land owned by the security trustee in any other capacity will be excluded from the calculation of any land tax liability.

The security trustee will be assessed on any land tax payable and should be indemnified by the fund trustee.

GST:  Where the fund does not exceed the $75,000 registration threshold in the course of its enterprise, the fund is not required to be registered for GST, but may elect to register. Where the fund is registered for GST, GST must be remitted on the leasing of commercial properties.

The leasing of residential premises is input taxed, meaning that GST is not charged on this supply. Input tax credits cannot be claimed for purchases relating to input taxed supplies ie costs associated with maintaining the residential property.

The fund trustee must quote its ABN when making any supplies or ABN withholding will apply where commercial premises are being leased. If the property being rented is residential premises, there is an exception to the ABN withholding provisions.

Where the fund trustee directs the security trustee to transfer legal title to it, no GST will be payable where both parties are registered for GST as it is not a taxable supply as no consideration will be paid.

Where the security trustee is not registered for GST, no GST will be payable as the transfer of the legal title will not be a taxable supply.

There may be other tax related issues that need to be considered depending on the specific circumstances.

Australian financial services licence (AFSL):  The lender will be exempt from the licensing and disclosure obligations under Chapter 7 of the Corporations Act 2001 (Act) where the loan is a credit facility (which is specifically excluded from being a financial product under the Act), instead of an instalment warrant (which is a derivative and therefore a financial product).

Agreements:  The following agreements will need to be entered into: a loan agreement between the lender, the fund trustee and the security trustee setting out the rights and obligations of the parties in respect of the loan; and a declaration of trust executed by the fund trustee and the security trustee setting out the terms upon which the security trustee will hold the property for the fund trustee.

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