Graphic of SMSF trustee(s) borrowing to acquire assets — emerging learning on instalment warrant arrangements
With the banks having lent money for about 1,000 SMSF instalment warrant arrangements (according to John Wasiliev in "The Australian Financial Review", 27 May 2009), some of the patterns and issues are becoming clear. This article uses a diagram to tell the story of Instalment Warrant Arrangements: how they work, the documents involved, the 'asset's journey' to the SMSF trustee(s), and some of the emerging issues.
By the way, some banks are still coming to grips with how to make limited recourse loans for instalment warrant arrangements.
Julian Smith and Paul Ellis
The law about SMSF Borrowing has changed since this article was written. The article on this page has not been updated.
You can link to the changes from the short note at the top of this page.
The article below analyses instalment warrant arrangements. An interactive graphic overview here tells the story visually. There is considerable overlap between the graphic overview and the article
The best place to start is the graphic overview which includes:
- A diagram of How Instalment Warrants work for SMSF borrowing
- the parties involved
- the documents involved
- the asset's journey to the SMSF Trustee(s)
- each document's role
- The 2 alternate Cleardocs document packages: for a loan from a "bank lender", or a "non-bank lender"
- More information and next steps
Background — SMSF trustee(s) can now borrow to invest in their SMSF
Although SMSF trustee(s) traditionally were not allowed to borrow to invest in their SMSF, that changed in September 2007. The law was amended then to allow SMSF trustee(s) to make certain investments in their SMSFs using borrowed money. The relevant borrowing arrangements are known as 'instalment warrant arrangements'.
SMSF trustee(s) can now enter into an arrangement under which they have a right — but not an obligation — to acquire the legal ownership of an asset acquired with borrowed money as long as:
- Normal asset restrictions the asset is one that the trustee(s) are permitted to acquire and hold directly under the other SISA investment restrictions — for example, the 'sole purpose' test and limitations regarding related party asset acquisitions etc. must be satisfied; and
- 'Limited recourse' loan the only security the lender may have in relation to the loan is over the asset bought with the loan money. In this way, the lender's rights to recover are limited to that asset. However, for instalment warrant arrangements, some (but not all) banks will require guarantees from the SMSF trustee(s) (or members) as additional security. To comply with the 'limited recourse' restrictions, these guarantors must disclaim any rights to recover from the SMSF if they have to pay under the guarantee.
What is an instalment warrant arrangement?
Instalment warrant arrangements under superannuation law are lending arrangements that enable an SMSF (or any super fund) to acquire an asset through a series of agreed instalment payments.
Under the instalment warrant arrangement, an SMSF:
- makes an initial upfront payment of part only of the purchase price of an asset (say 20%);
- borrows the balance of the purchase price from a lender; and
- progressively repays the borrowing (plus interest) through instalments until the asset is paid for in full.
For the period of the loan, the SMSF obtains an interest in the underlying asset and is entitled to all income from the asset. The lender is entitled to interest on the loan and is protected by security over the asset being acquired through the instalment warrant arrangement.
If the SMSF defaults on the borrowing, then the lender may have recourse to the underlying asset only — that is, the lender will have no recourse to any of the SMSF's other assets.
Instalment warrant arrangements:
- are an effective means of SMSFs leveraging the purchase of an asset; and
- enable the SMSF to use its capital to acquire several assets rather than committing to the purchase of a single asset.
What assets can be acquired using an instalment warrant arrangement?
Any asset that an SMSF is permitted to invest in directly can be acquired using an instalment warrant arrangement. Historically, instalment warrants have been offered by financial institutions as a means for investors to acquire listed securities.
However, after changes in the law in late 20071, any asset may be acquired provided that:
- it satisfies all the requirements of superannuation law; and
- it is permitted by the SMSF's governing rules.
Obvious assets that can be acquired are real property and shares.
Who may be the lender?
After the September 2007 changes to the law, there are no restrictions on who may lend the money.
The Lender can be any of:
- a financial services organisation — for example, a bank
- a person or company etc. known to the SMSF trustee(s)
- the SMSF trustee(s) or member(s) — in their 'non-trustee' or 'non-member' capacity.
What are the requirements for SMSFs to borrow through instalment warrant arrangements?
Instalment warrant arrangements must be structured as follows:
- Asset The borrowed money must be used to acquire an asset which the SMSF is not otherwise prohibited from acquiring. That is, the SMSF must continue to comply with other legislative requirements — including: the sole purpose test, and the restrictions that apply to in-house assets and to assets acquired from a related party.
- Custodian Trust or 'Bare Trust' Until the loan is repaid, the SMSF may receive only a beneficial interest in the asset being acquired. To achieve that, the asset must be held on trust (that is, in a trust separate from the SMSF). The trustee of that trust is known as the Custodian. The Custodian can be any of a person or company (etc.) known to the SMSF trustee(s) — subject to the rules below. Some banks may require the Custodian to be a company.
If the SMSF has:
- a company trustee, then one or all of the directors of the trustee company can be the Custodian but not the Company trustee itself. The director(s) would hold the asset on trust for the company as SMSF trustee. (If the company was the Custodian, then it would be holding the asset on trust for itself (which is invalid).)
- individual trustees, then some (but NOT all) of the trustees can be the Custodian — in their "non-trustee" capacity. (If all of the trustees were the Custodian, then they would be holding the asset on trust for themselves (which is invalid).)
- Right to acquire legal title The SMSF must have a right to acquire legal ownership of the asset by making one or more payments after acquiring the beneficial interest.
- Limited recourse Any recourse that the lender has against the SMSF must be limited to rights relating to the asset acquired. That is, if the SMSF defaults on the borrowing, then:
- the lender's right to recover money from the rights and interests held by the SMSF must be limited to repossessing, or disposing of, the asset acquired; and
- the lender cannot have the right to recover money through recourse to the fund's other assets.
If a lender requires the SMSF trustee(s) or members to guarantee the loan in relation to the arrangement, then those guarantors must disclaim any rights to recover from the SMSF if they have to pay under the guarantee.
If these conditions are not satisfied, then borrowing money through an instalment warrant arrangement will result in a breach of one or more of the superannuation laws. The breach:
- may mean the SMSF is not complying — which has punishing tax consequences; and
- may have civil or criminal consequences for a fund's trustee(s).
What is required for an SMSF trustee to borrow to acquire real property?
SMSF trustee(s) can use instalment warrant arrangements to acquire real property. There are a number of relevant considerations:
- If the SMSF acquires real property from a related party, then:
- the real property must be commercial property acquired at market value; and
- the asset, when acquired by the SMSF, must not offend the in-house asset rules.
- Stamp duty will be payable in the ordinary way when the SMSF acquires the real property — although certain contributions of real property to a SMSF do not attract duty.
- If the lender is a related party of the SMSF, then the interest rate needs to reflect commercial rates.
- If the real property is a development site, then the purchase price of the site may be funded through an instalment warrant arrangement.
What happens when the asset is sold?
When the asset is sold, the SMSF trustee(s) must use the proceeds of sale to repay the loan.
The balance of the proceeds of sale can then be kept in cash or used to buy another asset.
However, the existing loan cannot be used (by, say, redrawing on the loan) to buy another asset.
Can the trustee borrow more to acquire another asset with the proceeds of sale?
The trustee(s) can combine the proceeds with money from a new loan to acquire another asset. If they do that then:
- they will need a new loan document and a new security document (mortgage or charge); but
- subject to their bank's requirements and the terms of their Declaration of Custody Trust (also known as a "Bare Trust"), the new asset can be added into that existing Custody Trust.
What do SMSF trustee(s) and their advisers need to be wary of?
As SMSF borrowing is still a new concept, the superannuation industry, the banks, and even the regulators are still coming to grips with the issues.
Some issues to be wary of are:
- the loan must be on commercial terms — so for members in their 50s, a 30 year loan may look uncommercial to the ATO as regulator (though some banks are offering 30 year loans)
- 100% of the loan must be used to pay the asset's price — that is, the loan money cannot be used to pay any fees, stamp duty, etc.
- the ATO is of the view that the loans cannot be refinanced in the usual way — because there would be a new borrowing of money but the newly borrowed money would not be applied to the purchase of a new asset (which you will recall is required by SISA).
Questions & more information
For questions or more information about SMSFs, taxation or instalment warrants, call Maddocks in Melbourne (03 9288 0666) or Sydney (02 8223 4100) and ask for a member of the Maddocks Tax and Revenue Team or Superannuation Team.