Treasury has issued two releases to address some of the speculation about borrowing by super funds:
- the first is a proposals paper released by the Assistant Treasurer, Nick Sherry, outlining proposed amendments to confirm the existing ATO practice in relation to the income tax treatment of borrowings by superannuation funds; and
- the second, a media release by the Minister for Financial Services and Superannuation, Chris Bowen, foreshadowing changes to the Corporations Regulations to regulate certain borrowings by superannuation fund trustees as financial products.
The significant changes foreshadowed in the releases are:
- limited recourse borrowing arrangements involving super funds are to be regulated as financial products; and
- tax law will be amended to bring the taxation of limited recourse borrowings into line with the current approach taken by the Commissioner of Taxation.
Distinguishing between instalment warrants and limited recourse borrowings
The release from Chris Bowen states that 'the Government proposes to amend the Corporations Regulations 2001 to provide that certain borrowing arrangements by superannuation fund trustees permitted by the Superannuation Industry (Supervision) Act 1993 (the SIS Act) are financial products under the Corporations Act 2001 (the Corporations Act).' It then goes on: 'The amendments will extend the Government's consumer protection framework to cover certain superannuation borrowing arrangements such as instalment warrants and thereby help protect the savings of fund members.'
The Bowen release does not go into any detail about what types of limited recourse arrangements the Corporations Regulations amendments will target, but the taxation proposals paper distinguishes between:
- traditional instalment warrants (warrants over shares);
- the types of structured products offered by institutions whereby an investor borrows to invest in an asset, such as a share (being the underlying asset); and
- non-traditional instalment warrants (warrants over real property) which a fund trustee might invest in pursuant to section 67(4A) of the SIS Act.
The material released so far doesn't indicate whether the Government will regulate all limited recourse loans entered into by fund trustees as financial products, or only instalment warrant arrangements. It is therefore not clear whether the limited recourse loans that banks have made to SMSFs to purchase real property will be regulated as financial products (and therefore regulated under the licensing and disclosure provisions of Chapter 7 of the Corporations Act) or credit products (which are specifically exempted from regulation under Chapter 7 of the Corporations Act). We would expect there to be a significant backlash from banks and other non-bank lending institutions if simple limited recourse loans are covered by the changes, as this would require the lender to comply with the licensing and disclosure provisions in Chapter 7 of the Corporations Act in relation to such products when they are specifically exempted from doing so in relation to any other loan.
Instalment warrants as financial products
There is no detail as yet about how the Government intends to bring limited recourse borrowing arrangements within the regulatory framework as financial products, but there are two possible mechanisms: declaring products in the nature of instalment warrants issued to superannuation fund trustees as a new class or kind of financial product pursuant to section 761CA of the Corporations Act, or extending the definition of what constitutes a derivative in Corporations Regulation 7.1.04 to include instalment warrants issued to superannuation fund trustees.
In the proposals paper, Treasury describes instalment warrants as 'a form of derivative or financial product', suggesting that Treasury has taken the view (as have many in the industry) that instalment warrants fall within the definition of a derivative in section 761D of the Corporations Act. It is more likely that the Government will simply amend the definition of a derivative through the Corporations Regulations to specifically include instalment warrants (whether the underlying asset is a share or real property), given many of the institutions that offer instalment warrants will already have an Australian financial services licence (AFSL) that allows them to issue derivatives, so there would be no need for those institutions to seek variations to their AFSL to offer these products.
Is this the end of DIY borrowing in SMSFs?
Until the legislation is released, it is difficult to assess the extent to which DIY limited recourse borrowing arrangements (ie where the lender is a related party of the SMSF rather than a bank or other financial institution) will be affected by these changes. It will largely depend on whether the Government seeks to capture all limited recourse borrowing arrangements involving fund trustees, or only arrangements which have the features of an instalment warrant. As discussed above, if the changes clearly distinguish between instalment warrants, which will be regulated as financial products, and limited recourse loans offered by banks or other lenders to SMSFs, which are regulated as credit products, there may be some capacity for the DIY instalment warrant market to continue.
Also, regulation under Chapter 7 of the Corporations Act hinges around whether a 'financial services business' is being conducted by the issuer of the product or the adviser. Even if all limited recourse borrowing arrangements entered into by fund trustees are regulated as financial products, there may be an argument that a fund trustee can enter into such an arrangement as it is not doing so as part of a 'financial services business'. However, unlicensed advisers such as accountants would have to be careful about giving advice about such arrangements because it may constitute financial product advice if all limited recourse borrowing arrangements are regulated as financial products.
Clarifying taxation of instalment warrants and limited recourse borrowings
The taxation proposals paper suggests that the Commissioner of Taxation takes the view that income tax law as it currently stands is inconsistent with the accepted practice for the taxation of traditional instalment warrants. The trustee of the instalment trust (which is required for the borrowing to comply with superannuation law) is the legal owner of the underlying asset in the trust, but if the investor is entitled to all the income of the trust, the Commissioner assesses the investor on the net income of the instalment warrant trust, which includes any income derived by the trustee (together with any franking credits if the 'qualified person rules' are satisfied).
The potential CGT issues associated with the creation and maintenance of the instalment warrant trust include:
- a CGT liability may arise when the investor pays the final instalment (CGT event E5), which brings forward the CGT taxing point in comparison to current practice. A possible outcome is that the investor may have to sell the asset to meet any tax liability.
- the instalment warrant itself is a CGT asset as it is an interest in a trust, which means:
- if the asset has increased in value, the investor may make a capital gain on the instalment warrant (separate to any capital gain made by the trustee). However, the anti-overlap rule is likely to apply to prevent double taxation on the gain made by the trustee; and
- if the asset has fallen in value, the investor may make a capital loss on the instalment warrant. This allows the investor to claim a capital loss notwithstanding that the loss the trustee makes on the underlying asset is trapped in the trust.
However, the Commissioner currently treats the investor as the owner of the underlying asset held pursuant to an instalment warrant trust, so the investor:
is entitled to any distributions and accompanying franking credits relating to the underlying asset;
- takes possession of the underlying asset without incurring a CGT liability on the investor making the final instalment under the warrant; and
- inherits a cost base for the underlying asset that reflects the amounts paid to acquire the underlying asset (excluding fees) and not the market value when the investor becomes the legal owner of the underlying asset.
What are the proposed changes?
The owner of an instalment warrant over a single exchange traded security in a company, trust or stapled entity will be treated as the owner of the security for income tax purposes. The effect is that the legislation will 'look through' instalment warrant trusts for income tax purposes. This means that there will be no CGT consequences for the trustee or investor on the investor paying the final instalment or the trustee transferring the asset to the investor.
A superannuation fund trustee who enters into a non-recourse borrowing arrangement pursuant to section 67(4A) of the SIS Act, will be treated as the owner of the asset for income tax purposes. The fund trustee will be assessed on any income earned on the underlying asset, such as rental income and will be entitled to claim any applicable deductions.
The taxation changes will bring tax law into line with the Commissioner's treatment of these types of borrowing arrangements. However, although the investor in the instalment warrant will be treated as the 'owner' for income tax purposes, the trustee may be treated as the economic owner or holder of the asset under other provisions of tax law, for example, the depreciating assets provisions in section 40-40 and Divisions 243 and 250 of the Income Tax Assessment Act 1997. Broadly, these provisions might act to deny or reduce capital allowance deductions for the investor where they are not the economic owner of the asset and/or do not bear the economic loss of the depreciation.
Treasury has called for submissions and asked for the following questions to be considered:
- How to define an instalment warrant trust as distinct from other trusts?
- How does the 'look-through' treatment affect the obligations of the trustee (such as the need to file a tax return and the information the trustee must provide to the beneficiary)?
- Do any other areas of tax law impact on the suggested amendments?
- Are there transitional issues that need addressing?