SME owners looking at gearing of their business premises through super are likely to react positively to the government’s rejection of the Financial System inquiry’s recommendation to prospectively prohibit super funds from directly borrowing using limited recourse loans.
However, the Council of Financial Regulators and the Australian Tax Office, as the regulator of self-managed super, will monitor the risk of SMSF borrowing and report back to the government in three years.
Some SME owners will interpret the rejection of the inquiry’s recommendation as a signal that the present government, at least, is unlikely to bar SMSFs from using limited recourse loans for at least three years – if at all.
Leigh Mansell, technical services manager for Heffron SMSF Solutions, and Daniel Butler, director of DBA Lawyers, are among the self-managed super specialists now expecting more SME owners to arrange for their self-managed funds to gear their business premises.
Mansell and Butler believe a number of SME owners who had been considering whether their SMSFs should acquire and directly gear their business premises will feel a greater degree of comfort about proceeding with the transaction.
Butler says this may be particularly the position for SME owners who had been thinking about acquiring off-the-plan business premises through their SMSFs. Some of these business owners have held back from the proceeding because of their uncertainty about whether SMSFs would be barred from taking new limited recourse loans before the purchase was settled.
Interestingly, Mansell expects the Financial System Inquiry’s attention to limited recourse loans and the announcement of the three-year monitoring program may influence some SME owners to examine alternative ways of financing their business premises through their SMSFs.
The state of play
Since September 2007, super funds have been permitted to borrow to invest – as an exemption to the general bar on borrowing – using limited recourse borrowing arrangements. The geared asset must be held in a holding trust until the loan is repaid and creditors cannot make claims against a super fund’s assets other than the geared asset.
SME owners are believed to be among the biggest users of limited recourse borrowing arrangements to gear investments – typically to their own business premises – through their SMSFs.
Significantly, business property is one the few types of assets SMSFs are allowed to acquire from their members and other related parties. As well, business property is one of the few types of assets that funds can lease to related parties, including the members’ businesses, without being limited by the in-house asset rules in superannuation law.
In light of the government’s response to the Financial System Inquiry regarding limited recourse loans, here are four factors to think about for SME owners who are considering how their self-managed fund can acquire their business premises:
1. Don’t overlook that SMSF borrowing through limited recourse loans is being monitored over the next three years
Some SME owners are likely to try to ensure any transaction to acquire and directly gear their business premises through their self-managed funds is concluded within the three-year monitoring period.
According to Stuart Jones, senior superannuation and tax editor with Thomson Reuters, the government’s rejection of the inquiry’s recommendation means that the use of limited resource loans by SMSFs is “safe – at least for the next three years”.
2. Take specialist financial planning advice about whether a gearing strategy is appropriate for your SMSF
The fact the government has rejected a recommendation to bar SMSFs from using limited recourse loans doesn’t, of course, mean that it is an appropriate strategy for your fund and its members.
Further, SMSF trustees should only accept investment advice from holders of an Australian financial services licence – not from property spruikers targeting SMSFs.
3. Ensure the acquisition of geared business premises through your SMSF complies with its mandatory investment strategy
Under superannuation law, SMSF trustees must prepare, implement and regularly review an investment strategy that has regard to the whole circumstances of their fund. These circumstances include investment risks, likely returns, liquidity, investment diversity, risks of inadequate diversity and ability to pay member benefits.
While fund trustees must consider diversification when preparing an investment strategy, they are not legally required to diversify their portfolios.
In fact, some fund trustees specifically decide to have SMSF portfolios holding a single property asset, such as the premises of their businesses, perhaps after considering the diversification of their other super and non-super investments.
4. Consider an alternative way for your SMSF to acquire your business premises other than using a limited recourse loan
Meg Heffron, co-principal of Heffron SMSF Solutions, describes ungeared trusts and companies as a “much-underutilised” and “poorly understood” means for SMSFs to progressively buy assets, including their members’ business premises.
A typical strategy would involve the members of an SMSF and the SMSF itself owning units in the ungeared trust that acquires the business premises.
The SMSF would then progressively acquire more units to eventually gain full ownership. Although the trust is ungeared, the law does not prohibit SMSF members from personal borrowing to acquire units in the trust.
With limited recourse loan arrangements, the geared business premises (or whatever other asset is being acquired) provide security for the loan whereas with a typical ungeared trust arrangement, SMSF members often borrow against the equity in their homes.
On the face of it, with limited recourse loan arrangements, the geared business premises would be at risk if the investment did not succeed. Whereas with the typical ungeared trust arrangement, fund members would have typically borrowed against the family home and therefore the family home would be at stake. In practice, however, the contrast is not so clear cut.
Although with limited recourse loan arrangements, a financier can only make a claim against the geared asset, SMSFs often use almost all of their assets to pay the deposit or initial instalments on the investment. And lenders often require SMSF members to provide a personal guarantee, which typically means that their homes may also be at risk.
Another point to consider is underexisting law, SMSFs using a limited recourse loan arrangement can only drawdown on the loan to make repairs not improvements to a geared property. This applies to arrangements entered into after July 7, 2010.
Heffron says this bar on using money borrowed under limited recourse loan arrangements may make ungeared trusts more appropriate for an SME wanting to acquire business premises through their SMSFs and then to make significant improvements. Much depends on the circumstances, including professional advice received.