Back in September 2007, at the stroke of the legislator’s pen, superannuation law was amended to enable trustees of superannuation funds to borrow for investment purposes. Many trustees, particularly in the SMSF sector, have been captivated by the thought of gearing into direct property investments through their SMSF.
From time to time, trustees may need to consult a number of professional advisers (lawyers, accountants, financial planners) as they progress through the journey of establishing an LRBA for their SMSF.
When a professional adviser is involved in conversations concerning gearing through an SMSF, there is a plethora of issues that need to be taken into account to ensure that any advice is delivered in a responsible and compliant manner.
First and foremost, a professional adviser must consider whether they have the necessary skills, experience and licensing or authorisation needed to appropriately execute the brief they are undertaking. This is not the time for a professional adviser to be posturing about their infallibility and be all things to all people.
Following that, consider the adequacy of your current professional indemnity insurance arrangements to ensure that, in the unlikely event that something goes wrong, protection is available. There is no doubt that LRBAs are complex, and with many different aspects to manage, errors will unfortunately occur from time to time. And they may be very expensive to fix.
Once this self-assessment has been completed and you are comfortable with undertaking the assignment, there are several specific considerations that need to be taken into account regarding the SMSF.
The following questions should always be considered when discussing an LRBA:
1. Review the fund’s trust deed. Does it allow the trustees to borrow under an LRBA? If not, a deed upgrade may be necessary.
2. Review the trusteeship of the SMSF. Is each member a trustee, and each trustee a member? If the fund has a corporate trustee, is each director a member, and each member a director? Some commercial lenders may require the SMSF to have a corporate trustee before they will provide financing under an LRBA.
3. Review the fund’s investment strategy. Does it cater for the proposed investment that will be subject to the LRBA, taking into account all the aspects that must be considered by the trustees when developing an investment strategy.
4. Consider the most appropriate structure for holding the proposed investment. In some cases, owning the asset in personal names, through a family trust or another entity may be more appropriate, in the long term, to holding the investment through an SMSF. Just because an SMSF can borrow, doesn’t always mean it should!
5. Conduct detailed cash flow analysis to ensure the SMSF can service its loan obligations. Has the loan been 'stress tested' to determine if the SMSF sufficient cash flow can continue servicing the loan in the event of a rise in interest rates?
6. Consider the composition of the fund's membership, including age of members, individual account balances and whether the member accounts are in accumulation or pension phase. If in accumulation phase, at what point are members likely to transfer to the pension phase?
7. How liquid is the asset to be acquired under the LRBA, and what proportion of the total fund assets will it represent? In the event of a need to sell the asset, can it be readily disposed of?
8. Should insurance be considered for the life of one or more members of the fund?
9. What are the trigger events that will allow the lender to review and potentially call in the loan (for example, a member leaving the fund; the death or disablement of a member; a member commencing a pension)? Each lender will have their own criteria or review events.
10. Does the lender require the SMSF and/or the holding trust to have a corporate trustee? In some cases, lenders have their own holding trust arrangement which may be used by SMSFs to hold the title of the property whilst the debt remains. Where the trust arrangement has been established by the lender and their legal advisers, consideration needs to be given to whether there is a conflict of interest between the lender and the borrower.
11. Has the person or firm arranging the establishment of the LRBA, documentation, and settlement of the underlying asset the skills required to successfully execute a compliant LRBA? This may be more relevant in cases where a related party is providing the finance to the SMSF.
12. If the asset subject to the borrowings is to be leased to a related party, will this be arranged on an arm’s length basis and will an enforceable lease agreement be in place?
13. Has due consideration been given to the appropriateness of holding the geared asset in an SMSF and does the proposed LRBA compromise the trustees' ability to meet the sole purpose test (e.g. has the SMSF been used since it is the only structure with sufficient cash to fund the deposit)? The trustees must be able to demonstrate that the purpose of the investment is to provide benefits to the members of the fund for their retirement, or for their dependents in the event of a member’s death before retirement.
14. Is the proposed asset to be acquired with one or more other parties as tenants in common? If so, the LRBA may fail.
15. If the fund has, or is likely to pay pensions to members before the loan if discharged, will the asset subject to the LRBA be segregated to the pension phase? Have the implications arising from TD 2013/D7 been considered, including the potential for the Australian Taxation Office to invoke the anti-avoidance provisions where an asset has been segregated to the pension phase just prior to disposal?
Unfortunately, the first time a professional adviser may become involved in an LRBA is after the decision has been made by the SMSF trustee to embark on this strategy. Often the property may have already been selected and a contract signed.
It then becomes a case of the professional adviser structuring their advice to 'make it fit' the decisions that have already been made. This will challenge the professional integrity of any adviser and may result in an outcome that is not in the client’s best interest.
Only time will tell whether LRBAs are the next train crash waiting to happen.
Peter Kelly, manager - technical advice, Centrepoint Alliance