Instalment warrants and super funds

Scope and purpose of this document

This document provides general guidance on the Tax Office’s current views regarding the application of the superannuation law (specifically the Superannuation Industry (Supervision) Act 1993 and related superannuation rules) to instalment warrant type arrangements, certain borrowings by self managed superannuation funds. These views have been developed in consultation with the Australian Prudential Regulatory Authority (APRA). This document does not deal with tax issues other than those relating to the application of the superannuation law.

Matters trustees should take into account

Trustees should always consider the quality of the investment they are making and whether their fund can meet all of the future obligations under the arrangement.

For more information about Trustee/Member obligations please read Role and Responsibilities of Trustees (NAT 11032).

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 (e.g. dividends in the case of shares). The investor’s interest in the asset is provided as security for the borrowing the investor has made. 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 (for example, the Australian 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. More recently the Tax Office and APRA concluded that instalment warrant products involve a borrowing and as such were not an allowable investment. The Tax Office also considered that an investment by a super fund in the security trust holding the acquired asset is an in-house asset. The Government subsequently announced in the Minister for Revenue and Assistant Treasurer’s Press Release No. 78 of 2006 (3 November 2006) that they would legislate to allow the longstanding practice of super funds investing in instalment warrants.

From 24 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. Arrangements must meet the conditions stipulated by the law.

Do the new rules apply only to Self Managed Superannuation Funds (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 a borrowing to be allowable?

Under the new law a super fund is not prohibited from borrowing money, or maintaining a borrowing of money, providing the arrangement entered into satisfies 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 (or a replacement asset) 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 (or, if applicable, the replacement 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 (or, if applicable, the replacement asset). 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.

It may also be necessary for the asset to be the only property of the trust in which it is held at the times that the fund only has a beneficial interest in the asset. The Tax Office does not yet have a formal view on this matter. This publication will be updated when the Tax Office’s view is settled.

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.

What is the purpose of the changes made to the in-house asset rules?

Changes to the law have been made to ensure that an instalment warrant type arrangement entered into by an SMSF which meets the other requirements of the new law will not automatically result in an in-house asset arising from the investment made in the security trust.

These changes ensure that such an investment will only be an in-house asset where the underlying asset would itself be an in-house asset of the fund if held directly.

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.

This question is different to that where the legal ownership of the asset is transferred from the security trust to the super fund on repaying the borrowing once all the instalments are paid.

Does the requirement that the asset be held on trust for the fund mean 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 (and possibly also of other super funds). In these circumstances, the legal interest in the asset may be considered to be acquired from the security trust when the borrowing is repaid. The Tax Office considers the intent of the new laws is that this would not of itself contravene the existing prohibition on acquiring assets from related parties.

This question is different to that where the original vendor of the asset is a related party.

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.

There are also other broader issues relating to security trust requirements which the Tax Office is considering. This publication will be updated when the Tax Office’s views on such matters are settled.

Is a fund allowed to put an existing fund 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 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 a 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 with the fund’s 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.

Other issues under consideration

There are issues, listed below, in respect of which the Tax Office does not yet have a formal view. To the extent that these issues arise under a given arrangement, there may be concerns whether the arrangement complies with the law. These issues are:

• Does an arrangement where a borrowing is guaranteed by a third party satisfy the new laws, particularly where the personal guarantee is provided by a member or a related party?
• Does an arrangement that permits re-financing satisfy the new laws?
• Does an arrangement that permits capitalisation of interest satisfy the new laws?
• Can multiple drawdowns from a single loan facility satisfy the new laws?

Other issues that are still being considered include:

• What constitutes an ‘original asset’ and a ‘replacement asset’ for the purposes of the new law?
• What constitutes ‘maintaining a borrowing of money’?

This publication will be updated when the Tax Office’s view is settled.

How is the Tax Office dealing with those SMSFs that invested in instalment warrant products before 24 September 2007?

If you are a trustee or director of a SMSF and you invested before 24 September 2007 in an instalment warrant that the new law allows, we will not issue a notice stating your fund is a non-complying fund solely on the basis of this investment.

However, if you invested in an instalment warrant product before 24 September 2007 that breaches the new law, we will decide on a case-by-case basis what you must do to become compliant. For example, we may impose a penalty, or where possible, require you to rectify the contravention.

What Tax Office assistance is available to clarify the law?

This question and answer publication deals with issues that have presently been identified in relation to the application of the Superannuation Industry (Supervision) Act 1993 and other related superannuation laws to instalment warrant type arrangements.

The identification and prioritisation of other technical issues for further clarification by the Tax Office will occur in consultation with the NTLG Superannuation Technical Sub-group. The Tax Office will continue to consult with members of this forum in resolving these issues, including determining the most appropriate manner of publicising the Tax Office view.