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.
Background — SMSFs borrowing money through instalment Warrants
To find out more about the general position on SMSFs borrowing money to acquire assets, see Part 2 of this article below.
Part 1 — Using instalment warrants to develop real property
The fundamental issue about whether an SMSF can use an instalment warrant arrangement to develop real property is that the law requires the borrowed money to be used to 'acquire' an asset. Even so there appears to be a way it can be done.
First, let's look at a solution that will work in some circumstances. Then we can look at how the law prevents some other possibilities.
Solution: funding through a partnership arrangement
An SMSF can co-develop real property in partnership with a third party external funder. In partnership:
- the SMSF would acquire the undeveloped land under an instalment warrant arrangement; and
- the third party would contribute 100% (or most of) the development finance to the partnership. This contribution would most likely be unsecured, but see next heading. (If this loan were to be directly secured, then the security could not involve taking security over the SMSF's assets).
How would the third party's loan "to develop" be secured?
The third party funder would, through an Instalment Warrant arrangement, fund both the acquisition and the development. As part of the loan to acquire the site, the third party could:
- take limited-recourse security over the site, and
- be granted full rights over whatever is constructed on the site.
In this way, the loan "to develop" is secured by the lender having rights over what is to be built.
There are obvious complexities involved with such an arrangement (including a consideration of in-house asset rules and ensuring such enterprises are carried out in accordance with the sole purpose test, see Part 2 below). But in some cases this may be an option worth exploring.
Why are other more obvious and simple arrangements not possible?
The law allows SMSFs to use Instalment Warrant arrangements to "acquire" assets. Constructing an asset through development is not "acquiring" an asset but rather it is "creating" an asset.
The new rules do not specifically address the possibility of anything other than "acquiring". Nor has the Australia Taxation Office specifically addressed the issue in any of its recent releases.
Is there an argument that development equates to 'acquiring' an asset?
An SMSF may argue that developing a property through construction still means the SMSF acquires the building, it is just that it does so over time. However, this presents two primary difficulties:
- First, an external lender is unlikely to be prepared to lend on this basis (at least in the absence of further security — which could not include any other assets of the SMSF). That is, an external lender is unlikely to provide a capital loan which will be used both for acquiring and developing land, which is secured (at least in the beginning) only by an undeveloped parcel of land; and
- Second, because immediately after the acquisition the only asset is undeveloped land, most of the borrowing actually relates to service fees such as construction costs. The new rules require the borrowing to be applied to purchase an 'asset' but these services are not 'assets' and are arguably separate from the tangible asset that will be brought into existence through the construction process.
So it would seem that a borrowing to 'acquire' is ruled out.
Can an SMSF self-fund a development and then refinance?
If an SMSF has the capital to self-fund construction of a development on undeveloped land, then we need to consider whether, after the completion of the development, it can refinance its new asset through an instalment warrant arrangement.
The problem with this strategy, however, is that the SMSF would already own the asset that would form the basis of the instalment warrant arrangement. Therefore, money borrowed under the instalment warrant arrangement would not be used to 'acquire' a new asset.
Part 2 — SMSFs borrowing to acquire assets through Instalment Warrant arrangements
What is an 'instalment warrant' arrangement?
Instalment warrant arrangements under superannuation law are structured products or lending arrangements that enable an SMSF (or any super fund) to acquire an asset through a series of agreed instalment payments.
Under the warrant an SMSF:
- makes an initial upfront payment of part only of the purchase price of an asset (say 20%);
- the unpaid balance of the purchase price is effectively lent to the SMSF (or any super fund) by the issuer of the warrant (that is, by the lender); and
- this borrowing (plus interest) is progressively repaid by the SMSF 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 (being the issuer of the warrant) is entitled to interest on the loan and is protected via security over the asset the subject of 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.
Because a SMSF is only required to fund the initial upfront payment, instalment warrants:
- 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 all or most to the purchase of a single asset.
What assets can be acquired using an 'instalment warrant' arrangement?
Potentially any asset that a SMSF is permitted to invest in directly can be acquired using an instalment warrant arrangement. Historically, instalment warrant arrangements 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 (or issuer of the warrant)?
After the September 2007 changes to the law, there are no restrictions on who may lend the money and issue the warrant. Indeed, the lender may even be the SMSF's members.
What are the restrictions?
Instalment warrant arrangements must take a specific form in order to comply with the new rules:
- The borrowed money must be used to acquire an asset which the SMSF is not otherwise prohibited from acquiring;
- The asset acquired must be held on trust (that is, a trust separate from the SMSF) so that the SMSF receives only a beneficial interest in the asset;
- The SMSF must have a right to acquire legal ownership of the asset by making one or more payments after acquiring the beneficial interest; and
- 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 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.
In addition, an SMSF must continue to comply with other legislative requirements — including: the sole purpose test, investment restrictions that apply to in-house assets, and restrictions that apply to assets acquired from a related party.
If the required conditions are not strictly satisfied, then borrowing money through an instalment warrant arrangement will result in a breach of one or more of the super laws. The breach may have civil or criminal consequences for a fund trustee.
Using instalment warrants to acquire real property
Instalments warrant arrangements can be used by a SMSF 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;2 or
- the asset, when acquired by the SMSF, must not offend the in-house asset rules.3
- 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.
- The lender (who effectively issues the warrant) could either be the existing owner of the property, a third party financial institution or a related party of the SMSF.
- If the SMSF obtains a loan from 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.
Questions & Further 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.