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.
To find out more about the general position on SMSFs borrowing money to acquire assets, see Part 2 of this article below.
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.
An SMSF can co-develop real property in partnership with a third party external funder. In partnership:
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:
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.
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:
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.
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:
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:
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:
Obvious assets that can be acquired are real property and shares.
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.
Instalment warrant arrangements must take a specific form in order to comply with the new rules:
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.
Instalments warrant arrangements can be used by a SMSF to acquire real property. There are a number of relevant considerations:
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.
Andrew is a lawyer in the Maddocks Tax & Revenue team.
Andrew provides advice on:
His advice covers both direct and indirect tax considerations.
Prior to joining Maddocks, Andrew was a tax consultant at a Big 4 Chartered Accounting Firm.
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For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of their team.