On Sunday 7 December 2014, the Financial System Inquiry (FSI), chaired by former Commonwealth Bank CEO David Murray, released their final report (Report) urging the government to prohibit certain SMSF borrowing arrangements.
The FSI has recommended a general prohibition on direct borrowing for limited recourse borrowing arrangements by SMSFs.
Since that time there has been a lot of speculation about the future of limited recourse borrowing arrangements (LRBAs). Although not government policy, the FSI recommendations may lead to new legal restrictions on LRBAs and subsequent transitional arrangements which SMSFs may need to be mindful of in the near future.
What does superannuation law currently allow?
Currently, the SIS Act1 allows SMSFs to borrow directly using LRBAs.
Under such an arrangement:
- an SMSF can use the borrowed monies to purchase a single asset, or a collection of identical assets that have the same market value
- the SMSF trustees receive the beneficial interest in the purchased asset but the legal ownership of the asset is held on trust
- the SMSF trustees have the right to acquire the legal ownership of the asset by making repayments
- any recourse that the lender has under a LRBA against the SMSF trustees is limited to the acquired asset (including rights to income).
What does the Report suggest?
The Report states that LRBAs should be prohibited. However it acknowledges that the exception of temporary borrowing by SMSFs for short-term liquidity management purposes (as set out in the SIS Act2) should remain.
While the FSI acknowledged the level of borrowing is currently relatively small, the Report suggested if direct borrowing by SMSFs continues at current growth rates, it could pose a risk to the financial system. The Report stated this recommendation seeks to prevent the unnecessary build-up of risk in the superannuation system and the financial system more broadly.
The Report noted that lenders can charge higher interest rates because of the higher risks associated with limited recourse lending, and ‘frequently’ require personal guarantees from trustees. The Report articulates concerns as to whether LRBAs are genuinely ‘limited recourse’ by nature, particularly where the SMSF’s repayment obligations are supported by personal guarantees.
What has been the reaction of the industry?
Industry speculation in relation to the future of LRBAs is rife. Although this has been triggered by the release of the Report, it is also because the industry remembers the propensity of the government to announce changes to the superannuation law on federal budget night – some of which take immediate effect.
By way of example, prior to the 2004 budget, an SMSF was able to pay to members a defined benefit pension. On budget night, being Tuesday 11 May 2004, the government announced that SMSFs were no longer able to provide a new defined benefit pension, unless:
- the SMSF was established before 12 May 2004
- the governing rules of the SMSF have not been amended on or after 12 May 2004 to provide for the payment of such a pension.
Under the transitional arrangements, an SMSF was only able to continue to pay a defined benefit pension where the term of the pension had commenced or where the entitlement to the pension had been established before 12 May 2004.
Subsequently, there is concern amongst the industry as to what needs to be in place in order to be prepared for the changes which may take immediate effect on budget night 2015, or whenever else government may make any announcement.
What might come next?
The answer is decisively ‘who knows’? We must wait for the government to make the relevant announcements and, given the obvious fiscal impact, you would expect any announcements to be made on budget night.
The key question is how the government will respond to the FSI’s recommendations. Will it:
- Completely remove the scope for LRBAs?
- Place constraints on such borrowings?
- Make no changes?
FSI submissions of various industry stakeholders suggested constraints on LRBAs such as:
- prohibiting personal guarantees
- limiting loan-to-value ratios or the amount that could be borrowed by an SMSF
- requiring the terms of all loans to be completely commercial (which is not currently required by the SIS Act3)
- imposing consumer protection requirements on relevant licensees offering advice and products, along the lines originally proposed as part of the previous government’s Stronger Super package.
Although the timing of any changes to the LRBAs or new constraints is unknown, it is unlikely the government will make any announcement before it has received submissions responding to the FSI. Submissions need to be lodged by 31 March 2015.
Can planning be done?
Should the government ultimately decide to impose constraints on, or remove the scope for, LRBAs, it is reasonable to assume transitional arrangements will be put in place in relation to existing arrangements, as recommended by the FSI.
Ideally, the loan documentation would be completed, money borrowed and asset purchased. However, at a minimum, we would think the transitional arrangements must deal with:
- SMSFs which have used, or plan to use, LBRAs to purchase off the plan
- SMSFs which have entered into a contract to acquire a single acquirable asset and which will need to borrow in the future to complete such a purchase, in particular:
- We consider it likely that such arrangements will be limited to where the SMSF or relevant custody trust is bound by the contract.
- SMSFs should ensure they are not relying on a nomination of contract to evidence the SMSF being bound by the contract – this is because a nominee under a contract is often not bound to perform under the original contract as against the vendor. Accordingly, the custodian or SMSF trustee should be a party to the original contract. This approach is also consistent with statements made by the ATO which raise concerns with situations where the custodian and custody trust are not in existence when the original contract is signed4.
- SMSFs which are party to existing LRBAs
- the ability to refinance existing debt given this was an unnecessary constraint under the original LRBA rules.