The Superannuation Industry (Supervision) Regulations 1994 (Regulations) prohibit the capital value of a pension and the income from it, from being used as security for a borrowing. It is not clear whether this restriction operates against the member of the SMSF, the trustee of the SMSF, or both.
If the restriction is found to operate against trustees of SMSFs, and a trustee fails to comply with it by granting security over a pension asset, then the trustee would be in breach of their trustee obligations. Depending on the severity of the breach, the ATO may take action to protect the assets of the fund and impose regulatory penalties and sanctions on the trustee.
If the restriction applies only to members, then the consequences of a breach are likely to be less significant — at least in terms of the assets of the SMSF.
Section 67A of the Superannuation Industry (Supervision) Act 1993 (SISA) permits the trustee of an SMSF to borrow money to acquire an asset under a limited recourse borrowing arrangement. In these circumstances, the lender's right of recourse if the borrower defaults, is limited to rights in the underlying asset. The law allows the trustee to provide security to the lender, on the condition that the security is restricted to the asset which is the subject of the borrowing arrangement.
There are no legislative documents showing Parliament's precise intention about the restriction in the Regulations. So the words about the restriction should arguably be given their ordinary meaning. On the face of it, this means the Regulations would be read as limiting both the SMSF trustee and the member from using current pension assets as security for borrowing.
But two additional considerations are relevant:
1. The ATO in a release related to the introduction of the account based pension impliedly expressed its view that the restriction operates against the SMSF member only (and not the trustee). Indeed, there is no reference to the SMSF trustee. You can read a copy of this ATO release here. Although this is not conclusive, as the ATO's release was made in the context of an account based pension, it is arguable that the ATO would take a similar view on how the provisions apply to other types of pensions.
2. Before the September 2007 amendments to the SISA and the Income Tax Assessment Act 1997 (ITAA97), SMSF trustees where prohibited (subject to limited exceptions) from borrowing to acquire assets for the SMSF. For this reason, it was unnecessary for Parliament in 1994 when introducing the relevant Regulations, to state specifically that the trustee could not use the capital value of a pension (and income from it), as security for a borrowing.
These observations lend support to the argument that the law applies only to the SMSF member.
When an SMSF pension begins, the SMSF is likely to have segregated and non-segregated pools of assets.
Commonly, the trustee and the members of the SMSF agree between themselves (and in accordance with the SMSF's deed) as to which assets of the fund they wish to segregate. Segregated assets are then invested, held in reserve, or otherwise dealt with for the sole purpose of discharging pension liabilities in respect of members' superannuation income stream benefits from the SMSF.
Under the ITAA97, income and capital gains from segregated current pension assets are exempt from tax. For this reason, members may elect to segregate pension assets to qualify for these tax advantages.
Assets not specifically included in a pension account balance (for an allocated pension, a market-linked pension or an account-based pension) will not be considered as segregated current pension assets. This means that income derived from these assets will not be exempt from tax.
If the SMSF (through a custodian of a custody trust) has entered into, or intends to enter into, a limited recourse borrowing arrangement to acquire an asset for the SMSF, then trustee should ensure that any security provided is not over an asset that comprises part of the 'capital value' of the pension being paid to the members. This avoids the tension between the two requirements the law sets. This is critical because if the borrower defaults in its obligations to the lender, then the lender may be entitled to call on its security. If this property that formed all or part of the security is sold to repay the lender, then the member has lost the asset funding their pension. In that case, it is arguable that if the security applied in that way, the SMSF has breached the Regulations by granting the security.
So, if an SMSF uses the segregated assets method to fund its pension, then any asset acquired under a limited recourse borrowing arrangement could be allocated to the non-pension accumulation asset pool. The security could then be granted over that non segregated asset.
Maddocks will shortly apply to the ATO for interpretive advice on the Regulations to clarify whether the restriction discussed in this article operates against a member, the trustee, or both of them. Once the position is clear we will publish a Cleardocs update on the matter.
For more information, contact Maddocks on (03) 9288 0555 and ask for a member of the Maddocks Superannuation Team.
You can read earlier ClearLaw articles on a wide range of SMSF topics here.
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 See regulations 1.06(1) and then 1.06(2)(h), 1.06(7)(k), 1.06(8)(h), 1.06(9A)(d) of the Superannuation Industry (Supervision) Regulations 1994.
 See section 298-385.
Qualifications: LLB (Hons), BCom, University of Melbourne
Andrew is a Partner in Maddocks Tax and Structuring team. He has significant experience in advising Australian and multinational companies, high net worth individuals, accountants and financial advisers on all areas of taxation law.
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His advice covers both direct and indirect tax considerations.
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