By Domenic Festa (Accredited Tax Specialist and Chartered Tax Adviser)
When considering a suitable investment strategy (particularly for assets that are held outside of superannuation) alternatives for gearing, both in relation to the acquisition of the asset and improvements to the asset, are often considered.
These options are generally not available to superannuation funds because of the prohibition against borrowing.
Limited Recourse Borrowing Arrangements
From September 2007 an exception from the borrowing prohibition was introduced in the form of limited recourse borrowing arrangements. The rules relating to these arrangements were later clarified from 1 July 2010.
Such arrangements are subject to a number of restrictions. Some of the restrictions are:
- The borrowing must be limited recourse, namely, the lender’s right of recourse is limited to the underlying assets subject to the borrowing – the lender does not have any recourse against the other assets of the superannuation fund. In some circumstances, this causes the bank to require a lower LVR or higher interest rate;
- Borrowings are permitted for the acquisition of an asset and for making repairs to the asset, but cannot be applied to make improvements to an asset;
- Where borrowings are applied to acquire an asset, the superannuation fund cannot make significant improvements to the asset, even if making those improvements with cash reserves (that is, not borrowing for the improvements).
There are other conditions that must be satisfied for limited recourse borrowing arrangements, but they are not the focus of this article.
Options for consideration.
Option 1: Ungeared Trust as an alternative to limited recourse borrowing arrangements
A client may be looking at alternatives to a limited recourse borrowing arrangement, perhaps because their own bank does not offer those arrangements or imposes stringent conditions.
Nevertheless, they may have a sum of money in their superannuation fund which they wish to utilise for the acquisition and would also like the option of the superannuation fund increasing its interest over time.
The legislation generally prohibits superannuation funds from investing in closely held trusts. One of the exceptions from this prohibition is an investment in what might be termed Ungeared Trusts, namely trusts that satisfy conditions that are set out in the regulations.
This exception would allow the superannuation fund to invest its funds by acquiring units in the Ungeared Trust and a related party to invest the remaining funds that are required for the acquisition (those funds may be financed by fully recourse bank loans to the related party provided the asset to be acquired is not required as security for those borrowings). If, at a later time, it is desirable for the superannuation fund to increase its interests, the superannuation fund may acquire units from the related party (the acquisition of those units is excepted from the prohibition against acquiring assets from related parties).
Option 2: Ungeared Trust to overcome restrictions against improvements
Where it is proposed to acquire an asset and make significant improvements to that asset subsequent to acquisition, and borrowings are required for the acquisition or improvement, or both, a limited recourse borrowing arrangement may be considered in conjunction with an Ungeared Trust.
In essence, there is an investment by the superannuation fund in the Ungeared Trust, whether or not involving borrowings (if it involves borrowings, the unit holder will be the Warrant Trust under the limited recourse borrowing arrangement).
When it is necessary to make improvements, the superannuation fund can obtain a borrowing under a limited recourse borrowing arrangement to fund an acquisition of a second tranche of units. The underlying asset cannot be used as security for the borrowing. Provided security outside of superannuation is available, the borrowing could be applied by the superannuation fund to acquire further units in the Ungeared Trust, and the funds from that investment could be applied by the trustee of the Ungeared Trust to make the improvement. The borrowing has been applied to acquire a separate asset, namely units in the Trust. The restriction against improvements does not apply because the asset of the superannuation fund is the units in the Ungeared Trust and the improvements are not made to that asset.
The same process can be applied if it is proposed to split the asset into several assets (for example, a subdivision or the removal of a structure overlapping 2 separate titles which has the effect that the asset ceases to be a single acquirable asset – another condition of limited recourse borrowing arrangements).
Option 3: Unrelated Trusts
Whilst the legislation generally prohibits an investment in closely held trusts, that only applies where the closely held trust is controlled by a group relating to the superannuation fund in one of the three ways set out in the legislation.
What that means is that where an acquisition involves two or more unrelated family groups (for example two or more business associates not related by blood), their superannuation funds may invest in a unit trust that is structured in a way that the group associated with any one superannuation fund does not control the trust in one of the three ways.
Where the unrelated family groups are business associates, the structure of the business must also be considered.
The advantage of this kind of trust is that it is not subject to the restrictions that apply to superannuation funds. Importantly, they are not subject to limited recourse borrowing arrangements. They are therefore able to borrow on full recourse terms, are able to borrow to make improvements and are able to borrow on the security of other assets held in the unit trust. They therefore provide a more flexible means of gearing the acquisition and improvement of an asset. In addition, in certain circumstances it is possible for one of the superannuation funds to provide additional monies by way of loan directly to the unit trust, provided it is made on arm’s-length terms.
Key Points
- Most of the advisers when considering acquisitions by superannuation funds focus on limited recourse borrowing arrangements.
- In many circumstances, the restrictions applying to those arrangements make them unsuitable.
- There are often other options that can be considered to achieve your objective.