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WHAT IS AN INSTALMENT WARRANT
Traditionally, an instalment warrant is a marketed investment product that enables the investor to acquire an asset, normally listed securities. This is achieved through the investor paying an initial instalment together with a borrowing of money to fund the remaining amount required to acquire the asset. The borrowing is repaid by the investor making further instalment payments.
The investor obtains an interest in the underlying asset that provides an entitlement to the income from the asset. The investor’s interest in the asset is provided as security for the borrowing. In the event that the investor defaults on the borrowing, the lender may only have recourse to the asset acquired. The lender has no recourse to any other asset of the investor.
Where the underlying asset is listed securities, the warrant itself is often tradeable on a stock exchange. A tradeable warrant derives its value from the value of the underlying asset.
WHY HAS THE LAW CHANGED
Previously, super funds had been allowed to invest in instalment warrants consistent with longstanding administrative practice.
From September 2007, changes to the law mean that super funds can, providing that certain requirements are strictly met, invest in some instalment warrants or enter into a similarly structured and complying arrangements involving borrowing money to acquire a permitted asset.
DO THE NEW RULES ONLY APPLY TO SMSFs
No. The new laws apply to all regulated funds, not just SMSFs.
IS IT ONLY MARKETED INSTALMENT WARRANT PRODUCTS WHICH ARE ALLOWABLE UNDER THE NEW LAWS.
No. The new laws are not limited to only allowing traditional tradeable instalment warrant products as a means of a super fund borrowing money to acquire an asset.
Such a borrowing may be permitted under any ‘instalment warrant type arrangement’ which is structured and carried out in a way such that it satisfies all of the requirements of the new law.
IS IT ONLY INSTALMENT WARRANT INVESTMENTS OVER LISTED SECURITIES WHICH ARE ALLOWABLE UNDER THE NEW LAWS
No. The new laws are not limited to investments in instalment warrants traditionally offered by financial institutions where the underlying asset is listed securities. Other arrangements or products may also be allowed if they satisfy all of the requirements of the new law.
WHAT CONDITIONS MUST BE MET FOR BORROWINGS TO BE ALLOWABLE
Under the new law a super fund is not prohibited from borrowing money, providing the arrangement entered into satisfy each of the following conditions:
- The borrowed monies are used to acquire an asset which the fund is not otherwise prohibited from acquiring.
- The asset acquired is held on trust so that the fund receives a beneficial interest in the asset.
- The super fund has the right to acquire legal ownership of the asset by making one or more payments after acquiring the beneficial interest.
- Any recourse that the lender has under the arrangement against the super fund is limited to rights relating to the asset acquired. That is, the lender is able to have the right to recover monies where there is a default on the borrowing by repossessing or disposing of the asset acquired, but cannot have the right to recover such monies through recourse to the fund’s other assets.
WHAT ARE THE CONSEQUENCES IF THE INSTALMENT WARRANT ARRANGEMENT DOES NOT SATISFY ALL OF THE REQUIRED CONDITIONS
If the required conditions are not strictly satisfied, borrowing money under an instalment warrant type arrangement will result in a breach of one or more of the super laws. Such a breach may have civil or criminal consequences.
IS A FUND TRUSTEE ALLOWED TO ACQUIRE THE UNDERLYING ASSET FROM A RELATED PARTY VENDOR
The laws which prohibit the acquisition of assets from related parties apply to instalment warrant type arrangements.
However, the exceptions provided for in the rules against acquisition of assets from related parties, such as those allowing for the market value acquisition of listed securities or business real property, continue to apply.
DOES THE REQUIREMENT THAT THE ASSET BE HELD ON TRUST FOR THE FUNDMEAN THAT THE FUND ACQUIRES AN ASSET FROM A RELATED PARTY ON REPAYING THE BORROWING
It is a necessary feature of an arrangement contemplated by the law that the super fund be able to acquire full ownership rights over the underlying asset once the borrowing is repaid.
The security trust which holds the asset underlying an instalment warrant arrangement will be a related party of an SMSF. In these circumstances, the legal interest in the asset may be considered to be acquired from the security trust when the borrowing is repaid.
CAN THE TRUST WHICH HOLDS THE ASSET BE A UNIT TRUST
No. A unit trust cannot be used as the security trust holding the asset underlying an instalment warrant arrangement. The use of a unit trust will result in the fund not meeting the conditions that need to be satisfied under the new laws that allow super funds to borrow.
IS A FUND ALLOWED TO PUT AN EXISTING ASSET INTO AN INSTALMENT WARRANT ARRANGEMENT
No. The requirement that the money borrowed must be applied for the acquisition of an asset (or any replacement) means that instalment warrant investments by way of ‘shareholder application’ or ‘cash extraction’ arrangements are not allowed. The giving of a charge over an existing asset of the fund, as would generally occur under such arrangements, would also result in a contravention of the operating standards that apply to the trustees of super funds.
IS A FUND ALLOWED TO BORROW FROM A RELATED PARTY
The new law does not of itself prohibit the lender from being a related party.
However, super funds must continue to comply with other legislative requirements. For example, the super fund must satisfy the sole purpose test and comply with existing investment restrictions such as those applying to in-house assets and acquiring certain assets from a related party of the fund.
DOES INTEREST ON A BORROWING FROM A RELATED THIRD PARTY NEED TO BE AT COMMERCIAL RATES
A borrowing by a trustee of a super fund from a related party at zero or less than commercial rates of interest may raise concerns as to whether the payment received is not a borrowing but is in fact a contribution.
Further, a borrowing from a related party at a rate of interest exceeding commercial rates may raise concerns as to whether the fund is being maintained solely for the purpose of providing superannuation benefits.
DOES THE ARRANGEMENT ENTERED INTO BY THE FUND TRUSTEE ACTUALLY INVOLVE A BORROWING
It is essential that appropriate documentation clearly reflect that the trustee of a super fund has made a genuine borrowing to acquire an asset.
This is particularly the case where the monies provided to acquire the asset are from a related party. Without adequate documentation to substantiate monies provided by a related party as being by way of a borrowing, it is likely that the monies will to be treated as a contribution received by the fund. This could lead to significant tax consequences should it result in a contributions cap being exceeded.
WILL GRANTING THE LENDER RIGHT OF RECOURSE OVER THE UNDERLYING ASSET LEAD TO A BREACH OF THE PROHIBITION AGAINST CHARGING A FUND ASSET
The granting to the lender of a right of recourse to the underlying asset at the same time that the trustee of a super fund acquires the beneficial interest in the asset is a necessary feature of an arrangement contemplated by the changes to the law.
The Tax Office and APRA are of the common view that the granting of such a right in these circumstances will not of itself contravene the existing prohibition in the law against giving a charge over a fund asset provided that the arrangement complies with all the conditions of the new law.
CAN A FUND TRUSTEE ENTER INTO AN INSTALMENT WARRANT ARRANGEMENT IF ITS GOVERNING RULES DO NOT ALLOW THE FUND TO BORROW
No. The governing rules of a super fund must allow the trustee of the fund to borrow before any instalment warrant type arrangement can be entered into.
CAN A FUND TRUSTEE ENTER INTO AN INSTALMENT WARRANT ARRANGEMENT IF IT IS NOT CONSISTENT WITHE THE FUNDS INVESTMENT STRATEGY
No. A trustee of a super fund can only enter into such an arrangement where this is consistent with the investment strategy formulated in relation to the fund.
HOW DOES MY SMSF PURCHASE A PROPERTY
- The SMSF obtains a loan approval from an accredited lender.
- The SMSF selects the property it wishes to purchase.
- Residential property must be purchased at arm’s length and from a non-related vendor
- Commercial property can be purchased for full value from related parties so long as the property is for business purposes
- A special purpose company is established to act as Trustee for a special purpose Bare Trust.
- An SMSF solicitor/conveyancer is engaged to facilitate the purchase.
- The SMSF pays the deposit
- The balance of the funds required are borrowed by the special purpose company acting as trustee for the Bare Trust.
- The SMSF pays for legal costs, and stamp duty.
- The special purpose company acting as trustee for the Bare trust mortgages the property to the lender
- The SMSF then manages the asset.
CAN AN SMSF TRUSTEE OR MEMBER OCCUPY THE PROPERTY
No. If a member of the SMSF occupies the property the “sole purpose test” would be breached.
WHAT ARE THE NEW RULES THAT PERMIT BORROWING IN AN SMSF
Under the new Section 67 of the SIS Act, SMSF's can borrow providing the following conditions are satisfied;
- The borrowed funds are used to purchase an asset.
- The asset is held in Trust for the SMSF by another entity.
- The SMSF must have the right to acquire legal ownership of the asset
- The lender’s recourse against the SMSF must be limited to the underlying asset and not other assets of the SMSF
- The lender has no right of recourse against any other assets of the SMSF fund
WHO PAYS WHAT AND WHEN
The SMSF is responsible to pay for the following;
- Council Rates, Water Rates, and Land Tax
- Interest and other loan repayments
- Lenders fees
- Repairs
- Property management costs; and
- any insurance premiums & management fees imposed by the Property Trustee
WHAT ABOUT LAND TAX
Land tax is payable by the SMSF only if total land values exceed the prescribed amount.
CAN AN SMSF SELL THE PROPERTY
The SMSF can direct the Property Trustee to sell to any Third Party.
WHAT HAPPENS WHEN THE LOAN IS FULLY REPAID
Subject to future changes in the relevant laws, when the loan is fully repaid, the SMSF is entitled to have the legal title transferred to the SMSF fund. With the correct Trust structure, this transfer will not attract GST or Stamp Duty liabilities as the SMSF will already be the beneficial owner.
WHO CAN BE THE PROPERTY TRUSTEE
The Property Trustee should be an arms length Trustee from the SMSF Trustee and the members of the SMSF. A special purpose trustee company can be established to facilitate this requirement.
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