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SMSF limited recourse borrowing arrangements as financial products

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There is an undercurrent of change currently impacting SMSF limited recourse borrowing arrangements (or SMSF Instalment Warrants) and for those who will be able to advise on these arrangements moving forward.

In March 2010, Minister Chris Bowen announced changes to Corporations Regulations to regulate certain borrowings by super funds as financial products. Earlier this month (June 2010), we have seen the issue of an exposure draft which proposes to amend the Corporations Regulations to provide that:

  • limited recourse borrowing arrangements are financial products when acquired by superannuation funds;
  • limited recourse borrowing arrangements are not a credit facility when acquired by superannuation funds (therefore caught under licensing requirements); and
  • an Australian Financial Services Licence covering derivatives is taken to also cover limited recourse borrowing arrangements (i.e. section 67(4A) arrangements are classified derivatives, regardless of the underlying asset being shares, units or property).

The Government’s rationale for these proposed changes are to address concerns about their growing use in the market.  The explanatory memorandum outlines that:

  • Government has concerns that SMSFs may be investing in assets through borrowing without fully understanding the risks involved;
  • SMSFs may be receiving inappropriate advice when purchasing instalment warrants from unlicensed and unqualified advisers.
  • As a result of the above, when purchasing from unqualified sources, SMSFs are without access to appropriate consumer protections, such as product disclosure, indemnity insurance or dispute resolution mechanisms

Calling these arrangements a “derivative”?

The government has decided to amend Corporations Regulation 7.1.04 to include instalment warrant arrangements undertaken by fund trustees.  This appears to be in line with their view that instalment warrants constitute a “derivative” in accordance with section 761D of the Corporations Act 2001.

Impact for Advisers & Accountants

These proposed changes may impact many advisers who currently do not have the ability to deal in derivatives under their Australian Financial Services License (AFSL).  For those advisers that already do (can provide advice on derivatives), the government has announced that these limited recourse borrowing arrangements are covered under the existing derivatives requirements.

For accountants, this simply becomes a licensing issue… without appropriate licensing, providing any advice in this area becomes fraught with danger!!

The approach the government has taken appears a little heavy-handed in my view; not in regards with the licensing requirements, but more with capturing all arrangements under section 67(4A) as derivatives, without considering the underlying security.  I’m not sure how a commercial property purchase using a “BYO” limited recourse borrowing arrangement can be a derivative in the same context as swaps, futures and options.  It may have made more sense to have created a new class or kind of financial product to deal with these arrangements.  But it appears that the government is trying very hard to limit the amount of activity within this area…

Will this impact future growth of limited recourse borrowing arrangements?

Yes, somewhat.  However, many things within the SMSF environment are ‘purchased’ by trustees rather than sold by accountants or advisers[1].   I believe there will continue to be activity in this area driven by clients who understand their benefits of these arrangements, but also are aware of the risks.  With reduction in contribution caps and long-term investment horizons, the legislative impost may not entirely achieve its desired effect.

Submissions can be made on this issue to Treasury up until 25 June 2010 to comment of the draft regulations.  It will be interesting to view responses from some of the large financial institutions currently offering these types of loan arrangements to Fund Trustees.

Do you think these proposed changes are reasonable?  Click here to vote.


[1] This was supported by research provided by CPA Australia in their submission to the Super System Review (Cooper Review) on SMSFs.

Comments

comments

2 thoughts on “SMSF limited recourse borrowing arrangements as financial products

  1. in respect to non recourse lending. Is is at present legal for two three or more SMSF’s to pool their funds to purchase a commercial property?

    • Hi Mark,

      No, you cannot have multiple funds enter into a limited recourse borrowing arrangement to acquire property. The single acquirable asset must only be purchased by one fund.
      An alternate strategy may be to use a geared unit trust, but this is dependent on the number of unit holders involved and their relationship to each other.

      Regards,
      Aaron

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