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SMSFs and Instalment Warrants

SMSFs and Instalment Warrants


by Bill Thompson, Minter Ellison

Released March 2008

ABOUT THIS PROGRAM

Late last year, the Government changed the law to allow super funds, including SMSFs to invest in instalment warrants to remove doubt about their legality.  Instalment warrants are a form of non-recourse borrowing, which have the effect of allowing funds to leverage their investments without breaching the prohibition on borrowing in SIS.  Originally designed to cover listed securities, instalment warrant products for property and collectibles have now appeared on the market, as they too are permissible under the changes.  The incoming government has already expressed some concern over the development.

This program examines the nature of instalment warrants, the types of warrants available in the market, the scope of the changes to the law, and the issues for super funds (including the sole purpose test and the investment strategy) in using them.  The program is very topical given the popularity of these new instruments with controllers of SMSFs.

Current Issues in Investing via an SMSF – Instalment Warrants and Private Unit Trusts

SMSF & Current Issues in Investing

1. Background to Warrants Market

According to information found at the Australian Stock Exchange ('ASX') website, the ASX has operated a warrant market since 1991.  The market began by the trading of equity call warrants.

Warrants can be created over all manner of underlying assets including currency, commodities, shares in listed companies, debt, real estate and various stock market indices.  Short dated share warrants are used for trading type activities and longer dated share warrants are more suited to investing activities.  Longer dated share warrants emerged on the ASX as the market evolved and matured.  They may be either 'call warrants' or 'put warrants'.

'Warrants can be either call warrants or put warrants.  Call warrants benefit from an upwards price movement in the underlying instrument whereas put warrants benefit from a downward trend.  A deliverable call warrant generally gives you the right to buy the underlying instrument (e.g. a share) from the warrant issuer at a particular price on, or before a particular date.  A deliverable put warrant generally gives you the right to sell the underlying instrument to the warrant issuer at a particular price on, or before, a particular date.'1

They have some similarities to exchange traded call and put options.

A number of different types of warrants are available for trading now on the ASX including 'instalment warrants'.  Instalment warrants are a longer dated warrant suited for investment.

The ASX website notes that the ASX 'instalment warrants' have been available for trading for over fifteen years.

'By their nature, instalments (warrants) are considered to have some characteristics of call warrants, giving holders the right to exercise the instalment to acquire the underlying instrument.'2

Warrants are a type of derivative investment as they are contracts which derive their value from an underlying thing (such as a share in a listed company, for ASX traded warrants).

The ASX website notes that instalment warrants are uniquely Australian financial products whose genesis was in the innovative sales of the Commonwealth Bank and Telstra which allowed investors to pay for their shares by two instalments using the instalment receipt mechanism.  Instalment receipts are different from instalment warrants.  Instalment receipts are exchange traded securities which give investors exposure to shares through an initial part payment of the price of the share and a mandatory final payment at a later date.  The amount of the final payment is fixed.

While instalment warrants have some similarities to instalment receipts, they also differ from instalment receipts in that they are instruments created by investment banks specifically for retail investors, rather than instruments created by existing shareholders in a listed company or the listed company itself for the sale of its shares.

Instalment warrants are generally limited to shares in the Top 50 ASX listed companies.

2. Features of Instalment Warrants

An instalment warrant is a contract for the purchase of an underlying ASX listed share by payment of two instalments with a loan from the issuing investment bank to the warrant holder to enable payment of the second instalment.

'In simple terms, instalments are a loan to buy shares, without the obligation to repay the loan nor the risk of receiving margin calls.'3

The first payment (which is roughly half of the share price) is set at an amount which includes the first instalment of the price plus an interest charge in respect of the loan for the second instalment, and fees payable to the issuing investment bank, together with a fee for the purchase of a put option.

The loan from the issuing investment bank is a limited recourse loan in that it is secured only over the share which is the subject of the instalment warrant.  The second instalment is only payable at the election of the warrant holder.  When the second instalment becomes due the warrant holder has a number of choices.  The holder may:

  1. sell the instalment warrant on the secondary market;

  2. 'roll over' the warrant into a new series of instalment warrants over the same shares (if available);

  3. pay the second instalment and acquire the underlying shares;

  4. exercise the put option, in which case the shares will be sold and the proceeds from the share sale applied to repay the loan.  If the share price exceeds the loan amount then the holder receives the excess amount;

  5. do nothing – in which case the shares will be sold and the same result will obtain as if the put option had been exercised.

At the time of purchase of the instalment warrant the issuing investment bank arranges for the purchase of the underlying shares in the name of a security trustee who holds the underlying shares upon trust for the warrant holder.  This creates a trust over the shares under which the warrant holder is a beneficiary, subject to the terms of the warrant. 

A warrant under which the issuer places the underlying instrument in a trust on behalf of the holder is said to be "covered".4

Under the terms of issue of the warrant the issuing investment bank only has recourse to the underlying shares for repayment of the loan amount.  There are now many investment banks in Australia offering instalment warrant products.  The terms of all warrants are specific to the particular instalment warrant.  Not all warrants are the same.  It is necessary to check the terms of the particular instalment warrant being examined to determine the precise terms of the contract between the parties, and, accordingly the precise nature of the legal relationships created by the warrant between the warrant holder, the security trustee and the issuing investment bank.  That is, all warrants are subject to their own terms though they may have broadly similar features.

There are different instalment warrants developed by different issuing investment banks.  They are proprietary to each bank and are sold under different product names.  So, for example, a type of instalment warrant (discussed further below) is a self funding instalment warrant ('SFI').  Broadly, under an SFI, dividends paid on the underlying shares reduce the loan amount and the interest calculation is made on the outstanding loan as reduced by such dividend payments from time to time.  If the holder of the warrant does not quote their tax file number, then, while the amount of the dividend will nevertheless be deducted from the outstanding loan, the withheld amount of tax may become a separate debt due immediately by the warrant holder to the issuing bank.  That separate debt may be a full recourse debt.

The warrant holder, as the beneficiary under the security trust, is entitled to all dividends and attached franking credits in respect of the underlying shares.

3. Comparison of instalment warrants and instalment receipts

The following table sets out the major differences between an instalment warrant and an instalment receipt.

Instalment Warrant

Instalment Receipt

Issuing bank makes a loan equal to the second instalment.  The loan is limited recourse.

The second payment is a debt to the seler of the share.  There is no loan.

The holder acquires a put option to put the shares back to the issuing bank at the greater of the current market price or the amount of the loan at the date of exercise of the put option.

No put option.

Interest on the loan is prepaid annually for the life of the instalment warrant.

There is no loan and therefore no interest payment. 

The payment of the second instalment of the price of the shares is optional.

The second payment is mandatory. 

The underlying share is held on trust for the warrant holder via a security trustee.

The underlying share is held in trust for the holder of the instalment receipt.

The warrant holder is entitled to all dividends and franking credits while the underlying share is held in the security trust.

The holder of the instalment receipt is entitled to all dividends and franking credits in respect of the underlying share while the share is held on trust.

The real difference between instalment warrants and instalment receipts, therefore, may be seen to be in the fact that with an instalment receipt there is no loan made to the holder of the instalment receipt to enable the second payment.  There is simply a debt owed for that amount.

4. Types of Instalment Warrants

4.1 Instalment Warrant Products

Different issuing investment banks have different product names for their different series of instalment warrants.  Each investment bank offers a different series in respect of each of the underlying shares and different warrant features.  The instalment warrants offered by each investment bank will fall into different product categories differentiated by:

  • different levels of gearing – ranging from 30% to 95% of the price of the underlying share;

  • different maturity dates;

  • different loan terms;

  • different underlying shares – for example, some warrants will be in respect of shares in companies providing a high dividend yield and others will be in respect of companies offering high capital growth;

  • self-funding features.

These different features of the different product categories can be observed by visiting the websites of the issuing investment banks or by perusing their product disclosure statements.

4.2 Typical Instalment Warrant – Cash application or issuer application

These are instalment warrants having the features broadly described above and may be distinguished from an instalment warrant offered by way of 'shareholder application'.

4.3 Shareholder application

An instalment warrant by way of shareholder application offers a means for an existing shareholder in a company to extract the equity from those shares without selling the shares.  A further advantage of this is that it does not trigger a CGT event in respect of the shares.

Under an instalment warrant by way of shareholder application a person who already holds shares in a company over which the issuing investment bank is prepared to offer an instalment warrant, will transfer the underlying shares which they own to a security trustee and borrow from the issuer the amount available under the instalment warrant.

Unlike a cash application, where the loan from the issuing investment bank may be used to acquire the underlying shares, the loan in respect of a shareholder application will be used by the warrant holder to invest in additional shares or for other business or investment use.

4.4 Self Funding Instalments ('SFI')

Under a SFI warrant an upfront payment is paid by the warrant holder for the instalment warrant and a loan is obtained from the issuing bank for the balance amount payable in respect of the underlying shares.  This loan will be repayable over a number of years (ranging from 5 to ten years depending on the terms of the SFI).  Under SFI's, the upfront payment may be lower than with other types of instalment warrant due to the period of the loan.

A particular feature of SFI's is that dividends received by the warrant holder during the term of the instalment warrant are retained by the issuer and applied to reduce the loan, with the annual interest payment being calculated on the reducing loan balance.  Franking credits in respect of the dividends continue to flow to the warrant holder.  An objective of warrant holders investing in an SFI will typically be to achieve a positively geared investment by reason of the dividends outstripping the interest payments on the reducing loan balance.

4.5 Rolling Instalment Warrants

'These are a variation on the ordinary instalment structure.  On a periodic basis…the instalment will undergo a reset of the loan amount'.5

'On the annual reset date you may choose to exercise some or all of the instalments and take delivery of the underlying securities, cash out the instalment, roll into the following year (by agreeing to any additional amounts necessary) or do nothing.  If you do nothing you are deemed to have accepted the new exercise price and will automatically roll into the following year.  Conceptually, these instalments can be explained as a series of consecutive ordinary instalments that run back to back with the exercise price being reset on a periodic basis'.6

5. Advantages and Disadvantages of Instalment Warrants

Instalment warrants enable the gearing of an investment into ASX listed shares.  Like any form of gearing, instalment warrants have the ability to magnify returns from the investment but can also magnify losses if the value of the underlying asset declines.

A typical investor in instalment warrants will have a positive view of the likely future value of the underlying shares.

Instalment warrants enable an investment in shares using gearing in a way which ensures that the loan can be repaid. This is achieved by the use of the put option.  The put option is intended as a loan protection feature not a capital protection feature.  That is, the price of the instalment warrant will be set according to the value of the underlying shares agreed for that instalment warrant series at the time the instalment warrant is acquired.  The put option will enable payment to be made of the second instalment (the put option being for the greater of the current market price or the loan) so that the total payment of the originally agreed price can be made.  If the value of the underlying shares declines prior to maturity of the instalment warrant, the first instalment will still have been paid by reference to the agreed higher price of the underlying shares.  In an extreme case, if the value of the underlying share falls to zero, the whole up front payment would be lost.

Instalment warrants enable the warrant holder to receive the cash dividends on the underlying shares and the franking credits attached to those dividends despite the fact that the second instalment has not yet been paid.

The features of instalment warrants enable them to be used to pursue a number of share investment strategies with the benefit of providing more income and more franking credits through the leverage offered by the loan of the second instalment.  Strategies identified on the ASX website which may be pursued using instalment warrants include:

  • lay-by purchase of shares;

  • cash extraction (by the shareholder application method);

  • short term trading;

  • trading for dividends;

  • writing call options using instalment warrants;

  • diversification of share portfolio using instalment warrants;

  • protection strategies using put warrants;

  • hedging a share portfolio in a rising market – by locking in gains using put warrants;

  • leveraging franking credits to offset tax on other income, for example, sheltering contributions and earnings tax in a superannuation fund.

A prospective investor in instalment warrants must assess the terms of the particular instalment warrant.  The cost of the borrowing inherent in an instalment warrant needs to be considered against the investor's view of the performance of the underlying share and any other benefits (including taxation savings) which may be obtained in light of the intended strategy for the use of the instalment warrant.

6. Taxation Treatment of Instalment Warrants

The interest component of the first instalment and of subsequent annual payments of interest (e.g. if using an SFI) may be deductible.  The usual tests of deductibility apply.

To the extent that there is an identifiable payment for the put option then that payment is not deductible7.  If instalment warrants are being used for trading type activities then the cost of the instalment warrant (including the cost of the put option) and the gains on disposal and losses will be on revenue account.

If the instalment warrants are to be used in an investing activity then the capital gains tax rules will apply.

7. Instalment Warrants and Self Managed Superannuation Funds

7.1 Relevant Law

(a) Sole Purpose Test

The starting point in considering the investments which a regulated superannuation fund may make is the definition of 'superannuation fund'.8  A superannuation fund is defined to be a fund, which is indefinitely continuing.

The courts have emphasised the significance of the requirement that a superannuation fund be a 'fund'.

In Scott's Case,9 Windeyer J held that the expression 'fund' means money or investments.  It does not contemplate a business or trading activity or an enterprise in the form of a speculation.  So, in that case, a trust which engaged in real estate developments with a view to profit making by sale, was not a 'fund' and as a result could not be a superannuation fund as then defined under the Income Tax Assessment Act 1936, for tax exemption purposes.  This fundamental definitional issue must be borne steadily in mind when considering the 'sole purpose test' in its current form.

Under section 62 of the Superannuation Industry (Supervision) Act 1993 ('SIS') a trustee of a regulated superannuation fund must ensure that the fund is maintained solely for one or more of the identified core purposes or 'ancillary purposes' as defined in that section.  This means, broadly, that a trustee of a regulated superannuation fund must ensure that the fund is maintained solely for the provision of benefits to a member in the event of retirement, death or disability.

The requirement that the fund be 'maintained' for core or ancillary purposes, means that those purposes must be present on a continuing basis.  Engaging in trading or speculative type activity may be evidence that the fund is not being maintained for a requisite purpose, but for an impermissible collateral purpose, such as tax minimisation or estate planning.

(b) Investment Strategy

Section 52 of SIS prescribes that the governing rules of a superannuation entity are deemed to contain certain covenants described in section 52(2).  Amongst those is a covenant by the trustee:

'to formulate and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including but not limited to the following:

  1. the risk involved in making, holding and realising and the likely return from the entity's investments having regard to its objectives and its expected cash flow requirements;

  2. the composition of the entity's investments as a whole, including the extent to which the investments are diverse or involve the entity in being exposed to risks from inadequate diversification; 

  3. the liquidity of the entity's investments having regard to its expected cash flow requirements;

  4. the ability of the entity to discharge its existing and prospective liabilities;'

(c) No Borrowing

Section 67 of SIS prohibits a trustee of a regulated superannuation fund from borrowing money or maintaining an existing borrowing of money except for certain temporary purposes. 10

(d) In-house  Assets

Part 8 of SIS limits investments by regulated superannuation funds in in-house assets.  Section 71(1) defines an in-house asset of a superannuation fund as including an investment in a 'related trust' of the fund.

The expression 'related trust' is defined in section 10(1) of SIS as:

'…a trust that a member or standard employer sponsor of the fund controls (within the meaning of section 70E) other than an excluded instalment trust of the fund'.

The expression 'excluded instalment trust' in relation to a superannuation fund is defined by section  10(1) of SIS to mean:

'A trust:

  1. that arises because a trustee or investment manager of the superannuation fund makes an investment under which a listed security (within the meaning of subsection 66(5)) (the underlying security) is held in trust until the purchase price of the underlying security is fully paid; 

  2. where the underlying security and property derived from the underlying security is the only trust property;

  3. where an investment in the underlying security held in trust would not be an in-house asset of the superannuation fund.'

(e) No Charges over Assets of Funds

SIS Regulation 13.14 provides that it is a standard applicable to the operation of a regulated superannuation fund and an approved deposit fund that the trustee of the fund must not give a charge over or in relation to an asset of the fund.  The expression 'charge' is defined, by SIS Regulation 13.11 not exhaustively but inclusively.  It includes 'mortgage lien or other encumbrance'.  A 'lien' is a possessory security, for example, a workman's lien on his work until paid.  The expression 'encumbrance' is not defined by the SIS Regulations and therefore has its ordinary meaning in the context of the Act.  The Shorter Oxford Dictionary defines 'encumbrance' in its legal sense as 'a claim, lien, liability attached to property; as a mortgage'.  In Evans v Evans, 11 Lord Cranworth LC held that:

'The word "incumbrance" has no strictly technical meaning; but what is usually understood is, that where a person has a right at his pleasure to charge Ł3,000 upon an estate, that is an incumbrance.  In such a state of things nobody could say he had an estate free from incumbrances while his estate was laible at any time to be charged with such a sum of money.'

The ordinary meaning of the expression 'charge' gives the chargee certain rights to take possession of, or receive payment out of the proceeds of sale of, the charged property. 12  Accordingly, the SIS definition of charge is extended by the inclusion of the words 'mortgage lien or other encumbrance'.

Relevant to a consideration of the use of instalment warrants by superannuation funds, SIS Regulation 13.15A provides that: 

'A trustee may give a charge over or in relation to an asset of a fund if:

  1. the charge is given in relation to a derivatives contract entered into…by or on behalf of the trustee; and

  2. the charge is given in order to comply with the rules of an approved body…that requires the performance of obligations in relation to the derivatives contract to be secured;

  3. the fund has in place a derivatives risk statement that sets out:

  1. policies for the use of derivatives that include an analysis of the risks associated with the use of derivatives within the investment strategy of the fund; 

  1. restrictions and controls on the use of derivatives that take into consideration the expertise of staff;

  2. compliance processes to ensure that the controls are effective (for example reporting procedures, internal and external audits and staff management procedures);

  3. the investment to which the charge relates is made in accordance with the derivatives risk statement.'

The expression 'derivative' in this context is defined to mean:

'a financial asset or liability the value of which depends on or is derived from other assets, liabilities or indices.' 

The expression 'derivatives contract' is defined to mean:

'an options contract or a futures contract relating to any right, liability or thing.'

The reference to an 'approved body' includes the Australian Stock Exchange. 

7.2 Policy of Regulators

(a) Borrowing and Charging Assets

In Superannuation Circular Number II.D.4 'Borrowing by Superannuation Entities' (released by the Australian Prudential Regulation Authority (APRA) in September 1998) APRA sought to explain its interpretation of the borrowing prohibition on regulated superannuation funds.  That Circular remains operative in relation to regulated superannuation funds for which APRA is the responsible regulatory authority.  The Australian Taxation Office (ATO) since assuming responsibility for regulation of self managed superannuation funds (SMSFs) has continued to apply APRA policy as reflected in APRA Circulars.  The Circulars do not represent the law but APRA's view of the law.  At paragraph 16 of Circular II.D.4, APRA noted that:

'Not all liabilities of a superannuation entity will be borrowings within the meaning of section 67…  Whether a particular transaction constitutes a borrowing will depend on the facts and applicable legal principles in any given case.  In general however, a borrowing usually involves receiving a payment from someone in the context of a lender/borrower relationship on the basis that it will be repaid.  A transaction which gives rise to a debtor/creditor relationship does not necessarily give a rise to a lender/borrower relationship and hence may not necessarily represent a borrowing for the purposes of this restriction.'

To that extent, APRA recognises in the Circular the traditional meaning of a borrowing or loan at law as money advanced by one party to another with the intention that it will be repaid. A financing arrangement will not amount to a contract for the repayment of money lent where there is "nothing which could be represented as a lending of money and the promise to repay it".13 

Relevant to a consideration of the character of instalment warrants, at paragraph 19 of the Circular, APRA gave as an example of an amount paid on behalf of or owed by a regulated superannuation fund which would not constitute a borrowing, the following:

'The purchase by a trustee of property where ownership of the property passes to the trustee before the instalments are finalised.  Under this example an investment in endowment warrants or instalment receipts may not be considered borrowings.  It is necessary to check the obligations that lie with the purchaser to meet the instalment(s) as these determine whether the investment is a borrowing.  Where the remaining instalment(s) is not 'compulsory' and the warrant/receipt holder receives the value of the warrant/receipt (less handling or sales costs) on 'default' APRA considers the warrant/receipt does not constitute a borrowing.'

Finally, at paragraph 20 of the Circular, APRA noted that:

'For regulated superannuation funds…there may also be a separate question whether a charge has been given over the entity's property which, subject to certain exceptions, is prohibited under SIS Regulation 13.14.'

It is to be noted that in that Circular, APRA did not refer to 'instalment warrants' but to 'endowment warrants' and 'instalment receipts'. 

'Endowments are long term call warrants typically with a 10 year life.  Endowments are promoted as investment products to be bought by investors and held until expiry. 

The issue price of an endowment is between 30 and 65 percent of the market value of the underlying security at the time of issue.  The exercise price (called the 'outstanding amount' of the endowment) is initially the remaining sum plus other costs.  The outstanding amount varies over the life of the warrant.  In this respect endowment warrants differ from most warrants as they do not have a fixed exercise price.  The outstanding amount is reduced by any dividends that are paid in relation to the underlying security.  However, an interest rate is also applied and the outstanding amount is increased by these interest amounts.  At expiry, if you exercise the warrant and pay the balance of the outstanding amount (if any) the issuer will transfer the underlying securities to you.'14 

It appears that, administratively, both before and after the release of that Circular, both APRA and the ATO took the view that an investment by regulated superannuation funds in instalment warrants did not constitute a prohibited borrowing or a charge over the assets of a superannuation fund. 

However, on 16 December 2002, in a joint media release APRA and the ATO urged superannuation funds to exercise 'extreme caution in the purchase of instalment warrants'.  In guidelines released by the Regulators with that media release, the Regulators noted that they had previously taken the view that a superannuation fund investment in an instalment warrant may not constitute a borrowing under section 67 of SIS.  However, they noted also that the SIS prohibition on borrowing was developed before many of the then currently available geared products had been developed and Regulators had reviewed the position in the light of those products.  They also noted that instalment warrant issuers were now actively targeting superannuation funds with more complex products.

Further, they noted that in some cases instalment warrants could form an appropriate part of a superannuation fund investment strategy in certain situations.

Nevertheless, the conclusion of the Regulators at that time was that an investment in instalment warrants by means of 'shareholder application' would normally involve a charging of a fund asset.  Their conclusion was that:

'Accordingly investment via shareholder application is generally not an appropriate means of implementing any part of a fund's investment strategy and is likely to contravene regulation 13.14.'

They also noted that any superannuation fund trustee considering an investment in instalment warrants must:

  • consider the appropriateness of instalment warrants in the context of the fund's whole investment strategy and be mindful of the trustee covenants under section 52(2) of SIS;

  • ensure that they are familiar with the risks involved in the use of such instruments prior to making such investments;

  • have in place adequate risk management procedures to manage the risks associated with such investments prior to making those investments;

  • ensure that an investment in a particular instalment warrant series does not constitute a borrowing under section 67 or involve charging of an asset in breach of SIS Regulation 13.14.  Instalment warrants do not have standardised terms and the conditions so each product must be examined separately.

Finally, under those 2002 guidelines in the exercise of their administrative powers the regulators granted transitional relief in relation to past investments in instalment warrants by means of shareholder application.

The release of those guidelines was interpreted by the market, and applied in practice by the Regulators, as only prohibiting investments by regulated superannuation funds in instalment warrants which occurred by way of shareholder application, and only on the basis that that involved the giving of a charge over assets of the superannuation fund, not on the basis that the instalment warrant involved a prohibited borrowing, or a breach of the in-house asset rules.

In the light of Circular II.D.4, this was explained by the market on the basis that instalment warrants by way of cash/issuer application not shareholder application did not involve a 'borrowing' because the loan made by the issuer was a limited recourse loan, and, therefore, effectively there was no obligation upon the warrant holder to repay any borrowing.  In the language of paragraph 19 of Circular II.D.4, payment of the remaining instalment(s) was not 'compulsory'.

(b) Regulation of Use of Derivatives

The ISC and subsequently APRA have, issued Guidance Notes and Superannuation Circular II.D.7 on investments by superannuation fund trustees in derivatives, and for licensed registered superannuation entities in relation to the formulation of risk management statements and risk management plans in connection with derivatives.  Those Guidance Notes and Circular discuss what uses of derivatives would normally be seen as appropriate by a regulated superannuation entity (for example, hedging risk, reducing exposures, obtaining better prices than the physical/cash market, adjusting the duration of a fixed interest portfolio and so on15) and what would be an inappropriate use of  derivatives for a trustee (for example speculation or the avoidance of the prohibitions contained in SIS on borrowing16). 

The whole tenor of Superannuation Circular II.D.7 is that an investment in derivatives may be an appropriate supplement of an overall investment strategy to achieve or operate that strategy in a more effective, less risky, optimal (in terms of raising returns and lowering costs) way. 

The Circular clearly does not contemplate a superannuation fund engaging in a purely speculative or trading activity in derivatives: 

'The use of derivatives must be subordinate to the investment strategy and be consistent with the objectives of the strategy.  Thus, for example, the use of derivatives to obtain exposure substantially different to that which could be obtained through physical securities would generally be inappropriate' 17 

This emphasis in Circular II.D.7 upon the subordinate role derivatives may play in an investment strategy is exemplified  by the description of options in the Circular18.  The Circular only discusses the buying of options to insure (hedge) against risk.  There is no consideration of the selling of options to earn premium income.

Trustees should also be able to demonstrate through the trustee's records that they have assessed the risks and benefits of particular investments in derivatives.

While self managed superannuation funds need not meet the requirements of a formal risk management statement and risk management plan as must a licensed registered superannuation entity, it is nonetheless a useful discipline and assistance to the fund auditor for a trustee to have a paper trail setting out a record of the trustee's consideration of such matters in connection with the written investment strategy of the fund and demonstrating that an investment decision, which the trustee is considering, has been properly undertaken.  Further, if a self-managed fund wishes to undertake a derivatives transaction on an Australian or international exchange, and thereby will create a charge over the fund's assets, then the fund must prepare a risk management statement to satisfy SIS Regulation 13.15A19.  Of course, the trustee must be satisfied that the investment is permitted under the fund's trust deed and written investment strategy.

(c) 2006 Announcement and Proposed Legislation

On 3 November 2006 the Minister for Revenue and Assistant Treasurer announced that the Commissioner of Taxation and APRA have 'now concluded that (instalment warrants) entail a borrowing for the purposes of section 67…and are therefore not an allowable investment.'.

The government decided, in order to avoid disruption to markets, that following consultation with the superannuation industry, it would seek amendments to SIS and that pending the change in the law, superannuation funds investing in 'traditional instalment warrants' will not be considered to be non-complying merely because of their investment in those products.

On 22 May 2007, the Minister for Revenue and Assistant Treasurer announced that following the process of consultation with industry, the government would enact legislation 'to allow superannuation funds to invest in instalment warrants of a limited recourse nature over any asset a fund would be permitted to invest in directly.  This will restore the status quo that existed before the ATO and APRA determined that the instalment warrant structure entailed a borrowing.'

The Tax Laws Amendment (2007 Measures Number 4) Bill 2007 ('2007 Bill') has now been introduced into Parliament.  Schedule 3 to that Bill contains the proposed amendments to section 67 of SIS.  In addition there is a proposed amendment to section 71 in relation to the 'in house asset' rules.

The Explanatory Memorandum to the Bill notes that the amendments are seen as necessary as:

  1. the ATO and APRA have come to the view that instalment warrant arrangements constitute a borrowing for the purposes of section 67;

  2. SIS Regulation 13.14 states that a trustee must not give a charge over or in relation to an asset of a fund.  While this does not apply in relation to certain charges specified in regulation 13.15A these relate only to options and futures contracts provided the superannuation fund meets certain conditions;

  3. the ATO has also determined that an investment by a self managed superannuation fund in an instalment warrant is an in-house asset of the fund under section 71 of SIS.

While the apparent change in the interpretation adopted by APRA and the ATO after years of a contrary administrative practice is surprising, the following points may perhaps be noted:

  1. APRA Circular II.D.4 did not actually refer to instalment warrants not constituting a borrowing.  It only referred in that context to instalment receipts and endowment warrants.  This does not appear to have been a distinction relied upon by the Regulators at any time.

  2. The basis upon which shareholder applications were said by APRA in Circular II.D.4 to offend the requirements of SIS was not that they constituted a prohibited borrowing but that they were a charge over the assets of the fund in breach of SIS Regulation 13.14.

  3. APRA did say in Circular II.D.4 that no general statement could be made that an investment by a superannuation fund did not constitute a borrowing. Rather the terms of the investment and the basis on which funds were provided would need to be examined in each case.

  4. It can be seen how, depending upon the terms of an instalment warrant, the investment in the instalment warrant could involve a borrowing by the superannuation fund.  The argument might be made that if upon the exercise of the put option the sale proceeds were to be regarded as the holder's money to be applied at the direction of the holder for the repayment of the loan then that arrangement might readily be construed as a borrowing.  On the other hand, if the terms of the instalment warrant amount to a contract that upon exercise of the put option the issuer would cause the security trustee to sell the underlying shares and simply provide for a payment of any excess of the sale proceeds over the loan amount to be paid to the holder that might simply be a contract for a payment of money rather than for a borrowing and repayment of a loan.  Ultimately the question is, under the terms of the instalment warrant, is the payment of the second instalment truly 'optional' or is it a repayment of a loan at the direction of the borrower?

  5. APRA Circular II.D.4 did not consider the in-house asset rules at all.  The reference in the Explanatory Memorandum to the 2007 Bill to the Commissioner considering that an instalment warrant is an in-house asset is not further explained in the Explanatory Memorandum.  However, the proposed amendment to section 71 contained in the 2007 Bill, suggests that the Commissioner of Taxation must consider that the creation of the security trust arrangement (under which the underlying shares for an instalment warrant are held) constitutes a 'related trust' for the purposes of the in-house asset rules. 

As noted earlier in this paper, a 'related trust' is defined by section 10(1) of SIS to mean a trust, relevantly, that a member of the superannuation fund controls within the meaning of section 70E of SIS.  While it is counter-intuitive to consider that the security trust arrangement under an instalment warrant would be regarded as 'an investment in a related trust of the fund' for the purposes of the in house assets rules, nevertheless the arrangement may fall within the literal meaning of those terms as defined.  Given that the definition of a 'related trust' expressly excludes excluded instalment trusts, the security trust which arises under an exchange traded instalment warrant or under an instalment receipt in respect of ASX listed shares could not be a related trust. 

The amendments proposed by the 2007 Bill are not limited to exchange traded instalment warrants or instalment receipts over ASX listed shares.  It is nevertheless strange that if the ATO has a concern that an investment in instalment warrants may breach the in-house asset rules as described in the Explanatory Memorandum that reference is not made to the existing exception for investments in 'excluded instalment trusts' of a superannuation fund.

7.3 2007 Amendments

By Schedule 3 to the Tax Law Amendment (2007 Measures Number 4) Bill 2007, the Government proposes to amend SIS in two respects namely:

  • to provide in respect of instalment warrants an exception to the prohibition upon borrowings by superannuation funds in section 67;

  • to amend the restrictions on investments in in-house assets to remove the security trust created by an instalment warrant from the meaning of an in-house asset.

(a) Borrowing Exception

The borrowing exception in respect of instalment warrants will be provided by a proposed new section 67(4A) of SIS.  Rather than refer to instalment warrants, the proposed section 67(4A) describes the features which an arrangement must have in order to fall within the proposed borrowing exception.  Those features match typical instalment warrant arrangements.  Specifically, a regulated superannuation fund will not be prohibited from borrowing money or maintaining a borrowing of money:

'…under an arrangement under which

  1. the money is or has been applied for the acquisition of an asset ('the original assets') other than one the RSF Trustee is prohibited by this Act or any other law from acquiring; and: 

  2. the original asset, or another asset ('the replacement') that: 

  1. is an asset replacing the original asset or any other asset that met the conditions in this sub-paragraph and sub-paragraph (ii); and

  2. is not an asset the RSF Trustee is prohibited by this Act or any other law from acquiring;

is held on trust so that the RSF Trustee acquires a beneficial interest in the original asset or the replacement; and

  1. the RSF Trustee has the right to acquire legal ownership of the original asset or the replacement by making one or more payments after acquiring the beneficial interest; and

  2. the rights of the lender against the RSF Trustee for default on the borrowing or on the sum of the borrowing and charges related to the borrowing, are limited to rights relating to the original asset or the replacement; and

  3. if, under the arrangement the RSF Trustee has a right relating to the original asset or the replacement (other than a right described in paragraph (c)) - the rights of the lender against the RSF Trustee for the RSF Trustee's exercise of the RSF Trustee's right are limited to rights relating to the original asset or replacement.'

(b) In-House Assets Exemption

The amendments to the definition of in-house asset will be contained in proposed new subsections 71(8) and (9) as follows:

'(8) if at a time:

  1. an asset (the investment asset) of a superannuation fund is an investment in a related trust of the fund;

  2. the related trust is one described in paragraph 67(4A(b)) in connection with a borrowing by the trustee of the fund that is covered by subsection 67(4A); and

  3. the only property of the related trust is the original asset or replacement described in that subsection;

the investment asset is an in-house asset of the fund at the time only if the original asset or replacement described in subsection 67(4A) would be an in-house asset of the fund if it were an asset of the fund at the time;

(9) Subsections (1),(2) and have effect subject to subsection (8).'

The following comments may be made in respect of these proposed amendments:

7.4 Commentary  

(a) The arrangements described in the proposed amendments to section 67, while describing an instalment warrant typically created over listed company shares, are not limited to listed shares.  In this way, the proposed amendments reflect the policy contained in the announcement by the Minister for Revenue and Assistant Treasurer in May 2007 that superannuation funds will be allowed to invest in instalment warrants of a limited recourse nature over any asset a fund would be permitted to invest in directly.  Proposed paragraph 67(4A)(a)) ensures that assets which would otherwise be in-house assets, for example, may not be the subject of a borrowing within this new exception.

However, any other asset in which a regulated superannuation fund trustee might invest may now be the subject of an instalment warrant borrowing and investment.  Even before the announcement by the Government at the end of November 2006 property investments structured as instalment warrants were being offered by some product providers to the trustees of regulated superannuation funds. 20  It may be expected with the passage of the proposed amendments to section 67 and section 71, a range of product offerings in different asset classes using the instalment warrant structure will become available for superannuation fund trustees to consider.

(b) The proposed amendments to section 71 do not alter the existing definition of a 'related trust' or an 'excluded instalment trust' of a superannuation fund.

(c) Instalment warrant investments by way of shareholder application (cash extraction) are still not permitted.  This arises from the requirement in paragraph 67(4A)(a) that the borrowed money must be 'applied for the acquisition of an asset'.

(d) The loan must be a limited recourse loan (limited to rights relating to the original asset or the replacement asset in respect of the borrowing and charges related to the borrowing).  For reasons explained earlier in this paper a SFI warrant would not satisfy this requirement if part of the loan (or any increased loan) becomes a full recourse debt.

(e) The amendments to section 67 and section 71 will take effect from the date on which the Act receives Royal Assent.  The Explanatory Memorandum notes 21 that existing technical breaches arising by investment in instalment warrants by regulated superannuation fund trustees will be managed through the discretionary powers of the Commissioner of Taxation and APRA.  It will be necessary to consider the previous announcements by the Commissioner and APRA of 16 December 2002 and 3 November 2006 in relation to the exercise of the discretions of those Regulators.

(f) The proposed amendments to section 67 and section 71 do not in any way alter the obligation of the trustee of a regulated superannuation fund in considering of the exercise of the trustee's powers of investment.  Any investment in instalment warrants in any asset class would still require a determination by the Trustee that the investment:

  1. satisfies the sole purpose test; 

  2. is within the investment powers of the trustee under the superannuation fund trust deed; 

  3. is within the investment strategy previously determined by the trustee; 

  4. is in all other respect an appropriate investment for the fund; 

  5. does not breach the in-house asset rules and so on.

(g) The amendments by this Bill and the provisions of the Explanatory Memorandum do not refer to any proposed amendments to the SIS Regulations to clarify the previously expressed concerns of APRA and the ATO that an investment in  instalment warrants or certain types of instalment warrants may constitute a breach of the prohibition in SIS Regulation 13.14 (upon a trustee giving a charge-over or in relation to an asset of the superannuation fund.).  Enquiries made by the writer with the Treasury revealed that the Treasury may enter into a process of consultation with APRA and the industry, following passage of the amending legislation, to determine whether or not any amendments to the SIS Regulations will be made.  While the previously expressed APRA and ATO concerns in relation to the application of SIS Regulation 13.14 were only in relation to instalment warrants by way of shareholder application, it would seem to be desirable that there be a clear statement now in the SIS Regulations that an investment in instalment warrants which otherwise satisfies the requirements of proposed section 67(4A) of SIS would not constitute a breach of SIS Regulation 13.14.

At the time of writing this paper the amending Bill had been passed by the House of Representatives.

8. Unit Trust Issues

8.1 Background

The latest information22 discloses that funds invested in self managed superannuation funds (SMSF's) roughly equals the funds invested in industry funds and corporate superannuation funds combined, and are second only to the amount invested through retail funds.  With the introduction of choice of funds, the removal of the work test for those under 65 the transition to retirement reform, and the Superannuation Simplification reforms, the increasing use of SMSF's is a trend which seems set to continue.

Practical experience shows that the weight of money invested through SMSF's, the desire for diversification of investments, the chase for property assets promising secure returns and capital growth, the opportunities available to private investments in the property market, and the temptation to access cash in an SMSF for that purpose, all feed an ongoing interest by trustee/members of SMSF's in structures which permit them to use cash in SMSF's as 'equity' in direct property plays.

8.2 Corporate Structures

Companies are generally discounted as property investment vehicles.  This is on the basis that the property is being considered as a long term investment and use of a company will not only impose a layer of company tax (30%) on rental income (which may not ultimately be an issue as superannuation fund investors  should recoup excess franking credits through the imputation system) but will also deny a superannuation fund investor in a company access to discounted capital gains.

The aim is for income and capital gains to flow untaxed through a unit trust to the superannuation fund, to be taxed at 15% (or 10% effectively on capital gains) or at 0% if the fund is in pension paying phase.

This result will not be achieved if the unit trust is deemed to be a public trading trust under Division 6C of Part III of the 1936 Act.

The possible application of Division 6C must be considered whenever superannuation funds together hold 20% or more of the units in any unit trust.  In that case, the unit trust will have satisfied the alternative test of a 'public unit trust' in Division 6C.  If the trust is engaged in anything other than principally letting property for rent, or owning securities, it will be a trading trust, and a 'public trading trust'.  A trust engaged in developing land for resale at a profit would be a trading trust.

Public trading trusts are, of course, taxed as companies.

8.3 In-house Asset Rules

Section 83 of SIS requires that a superannuation fund trustee not acquire an in-house asset if the acquisition would result in the ratio of the market value of the fund's in-house assets to the market value of all of its assets exceeding 5%.

Section 71 of SIS defines in-house assets as follows:

'71(1) Basic meaning.  For the purposes of this Part, an in-house asset of a superannuation fund is an asset of the fund that is a loan to, or an investment in, a related party of the fund, an investment in a related trust of the fund, or an asset of the fund subject to a lease or lease arrangement between a trustee of the fund and a related party of the fund, but does not include:

  1. ….

  1. an asset which the Regulator, by written notice given to a trustee of the fund, determines is not an in-house asset of the fund; or

  2. an asset which the Regulator, by written determination, determines is not an in-house asset of:

  1. any fund; or

  2. a class of funds in which the fund is included; or

  1. if the superannuation fund has fewer than 5 members – real property subject to a lease, or to a lease arrangement enforceable by legal proceedings, between a trustee of the fund and a related party of the fund, if, throughout the term of the lease or lease arrangement, the property is business real property of the fund (within the meaning of subsection 66(5)); or 

  2. an investment in a widely held unit trust; or

  3. property owned by the superannuation fund and a related party as tenants in common, other than property subject to a lease or lease arrangement between a trustee of the fund and a related party; or

  4. an asset included in a class of assets specified in the regulation:

  1. not to be in-house assets of any fund; or

  2. not to be in-house assets of a class of funds to which the fund belongs.

For this purpose, a class of assets may consist of, but is not limited to, assets that are investments in entities that undertake, or do not undertake, specified activities'.

Relevantly, for the purposes of this paper, an investment by a superannuation fund in a related trust of the fund, is an in-house asset of the fund.

Section 71(1) of SIS paragraphs (a) to (j) are a list of assets which are excluded as 'in-house assets' of a superannuation fund.  Relevantly for present purposes, an investment in a widely-held unit trust is excluded as an in-house asset.

A trust is a 'widely held unit trust' if:

  1. it is a unit trust in which entities have fixed entitlements to all of the income and capital of the trust, and

  2. it is not a trust in which fewer than 20 entities between them have:

  1. fixed entitlements to 75% or more of the income of the trust; or

  2. fixed entitlements to 75% or more of the capital of the trust. 23

Accessing the 'widely held unit trust' exemption requires some care and attention to the provisions of the Corporations Act.  Consideration would need to be given to whether or not the unit trust must be registered as a managed investment scheme.  Consideration must also be given as to whether or not those involved in promoting the unit trust require appropriate licenses.  The need for product disclosure statements should also be considered. 24

Under section 71(1)(j) the Regulator may determine certain assets not to be in-house assets of a fund.  Conversely under section 71 the Regulator may determine that a loan, investment or an asset subject to a lease which is not otherwise an in-house asset is to be treated as if it was a loan to or an investment in a related party or related trust or an asset subject to a lease between a trustee of the fund and the related party.  This is a wide discretion with no guidance in the SIS legislation as to how it is to be exercised.

The expression 'related trust' is defined 25 in relation to a superannuation fund as a trust that a member or a standard employer sponsor of the fund controls (within the meaning of section 70E) other than an excluded instalment trust of the fund.

Section 70E(2) states that:

'…an entity controls a trust if:

  1. a group in relation to the entity has a fixed entitlement to more than 50% of the capital or income of the trust;

  2. the trustee of the trust or a majority of the trustees of the trust is accustomed or under an obligation (whether formal or informal) or might reasonably be expected to act in accordance with the directions, instructions or wishes of a group in relation to the entity (whether those directions, instructions or wishes are or might reasonably be expected to be communicated directly or through interposed companies, partnerships or trusts);

  3. a group in relation to the entity is able to remove or appoint the trustee or a majority of the trustees of the trust.'

In this context the expression 'group' in relation to the member means the member acting alone or a 'Part 8 associate' of the member acting alone or the member and a Part 8 associate or associates of the member acting together or two or more Part 8 associates of the member acting together.

In relation to a member of a superannuation fund it is necessary to turn to section 70B of SIS to determine who is a 'Part 8 associate' of an individual.  section 70B includes as Part 8 associates of the member, any relative of the member, if the member is a member of a superannuation fund, then each other member of the fund, each director of the corporate trustee and each individual trustee, any partner and any spouse or child of the member's partner, a trustee of any trust which the member controls or a company that is sufficiently influenced by or in which a majority voting interest is held by the member or a Part 8 associate of the member or any two or more entities which are Part 8 associates of the member.

The result of these definitions is that an investment in a unit trust by an SMSF is limited to 5% of the market value of the fund's assets unless entities other than the member or Part 8 associates of the member (relatives, partners, trustees or controlled companies of the member),

  1. hold 50% or more of the units of the trust; or

  2. can direct the actions of the trustee of the unit trust; or

  3. are able to remove or appoint the trustee of the unit trust.

8.4 Unit Trust Gearing Strategies

If those other entities can do that, then the trust in which the superannuation fund invests is not a related trust for the purposes of the in-house asset rules.  It is possible to conceive of unit trust structures in which a number of unrelated superannuation funds and/or other trusts, companies or individuals might invest so that the unit trust would fall outside the definition of a 'related trust' of any one of the investing superannuation funds. 26

Further, subject to the prohibition upon superannuation funds borrowing and the prohibition upon the granting by a superannuation fund of a charge over its assets, it is possible for a unit trust in which a number of superannuation funds invest to borrow to gear up the investments by the unit trust.

If the unit trust borrows from an external financier such as a bank, it is likely that the lender will require security over the assets of the unit trust presumably by way of a first mortgage.  Does the granting of that mortgage by the trustee of a unit trust over its property amount to a 'charge' over the assets of a superannuation fund which invests in or lends money to that unit trust?

Upon first consideration one might think that the giving of a mortgage over the property of the unit trust has nothing to do with the assets of the superannuation fund which invests in the unit trust or lends money to it.  The superannuation fund's assets are units in or a loan to the unit trust by the superannuation fund.  The rights created by the unit holding superannuation fund's investment in or loan to the unit trust must be considered to determine if the charging prohibition is breached.

The nature of a unitholder's interest in a unit trust was recently considered by the High Court of Australia in the CPT Custodian case27.  Prior to the decision in that case, it had been generally accepted following the decision of the High Court in Charles' case28 that a unitholder in a unit trust, unlike a shareholder in a company, had a fixed beneficial interest in the assets of the trust.

It may be seen that if Charles' case did stand for that proposition, then as a unitholder would have a beneficial interest in each unit trust asset, any mortgage given by the trustee over the unit trust assets would be a 'charge' on the unitholder's assets for SIS purposes.

In CPT Custodian, the High Court clarified that Charles' case was not authority for any such general proposition.  Rather, the decision in that case (as was noted in reasons of the High Court in that case) turned upon the specific (and somewhat unusual) terms of the particular trust deed which the court had to consider in that case.  In contrast with the trust deed considered in Charles' case, in the CPT Custodian case the trust deed provided that the unitholders did not have any interest in any particular asset of the trust.  Rather, they had a fixed proportionate entitlement on a winding up of the trust to the surplus remaining after discharge of all of the liabilities of the trustee.  Importantly, those liabilities included the claims of the trustee and manager to their fees and reimbursements.  This would be so even if there was only one unitholder.

In a trust on those terms (which is common in a modern unit trust deed), the nature of the unitholder's interest is closely analogous to the interest of a shareholder in a company. 

Under a trust deed similar to that considered by the High Court in the CPT Custodian case, no  'charge' is imposed upon a unitholder's interest in the trust by reason of there being a charge on the assets of the unit trust.

What if the investment by the superannuation fund in the unit trust is made by way of loan?  The asset which the superannuation fund holds in that instance is not a unit in the unit trust but the loan to the unit trust, or, more precisely, to the trustee of the unit trust.

If the unit trust has obtained funding from an external lender the security for the superannuation fund's loan may be a second mortgage.  The superannuation fund in that instance has an additional asset being the rights under the second mortgage.  Is the subordinated loan made by the superannuation fund to the unit trust 'charged' by the prior loan and mortgage to the bank?  The bank loan and mortgage certainly have priority over the superannuation fund's subordinated loan and second mortgage.  In an extreme case if the value of the property held by the unit trust declines it may be that there is only enough equity remaining in the property to discharge the prior loan to the bank.

Does that mean that the superannuation fund's asset (being the loan and second mortgage) are subject to a charge? 

As noted earlier in this paper, the prohibition upon giving a 'charge' over or in relation to an asset of a regulated superannuation fund, is a broad one, due to the width of meaning of the expression 'charge'.

The argument that the existence of a prior bank loan and mortgage is not a charge on the superannuation fund's loan and second mortgage is simply that those assets of the superannuation fund are not subject to any charge.  Rather it is the asset of the unit trust which is subject to the obligation to repay the bank and discharge the bank's mortgage.

The contrary view is that SIS Regulation 13.14 is not to be read so narrowly and that in the context of the SIS legislation the prohibition on charging a superannuation fund's assets may extend to prior claims which defeat or inhibit or clog the recovery of the superannuation fund's investment.

It is the writer's view that the latter approach would be straining the language of SIS Regulation 13.14.  If the Parliament and the Regulator had intended the prohibition upon charging a superannuation fund's assets to extend so far as to preclude investments which rank with a lower priority to other investments then more appropriate language would have been used than the language of charging assets.  In the writer's view, the investment by a superannuation fund in investments which have a lesser priority, such as second mortgage security, is a question to be determined by reference to the fund's investment powers and strategy not by reference to the prohibition upon charging of fund assets.

In addition, it would be anomalous, if a charge was said to exist upon a superannuation fund's investment in or loan to a unit trust which has a bank loan and prior mortgage, but not upon a superannuation fund's shares in a company which had borrowed and granted a prior mortgage.  Nevertheless, the CPT Custodian case means that, at least in respect of a superannuation fund investment in trust units in a geared unit trust, the unit trust deed must be considered on each occasion.

8.5 Exception for ungeared related trusts

For the purposes of section 71(1)(j) of SIS the Regulator has made regulations (in SIS Regulations 13.22A to 13.22D) which essentially enable the continuation of investments or new investments to be made by superannuation funds in certain related trusts which satisfy the conditions set out in the SIS Regulations.

For unit trusts being created now the relevant regulations are SIS Regulations 13.22C and 13.22D.  Subject to satisfying the conditions in those regulations these unit trusts while not able to borrow, may be used as investment vehicles by SMSF's and related entities.

The requirements which must be satisfied to fall within this exception are:

  1. The superannuation fund must have fewer than five members;

  2. the trustee of the unit trust must not be a party to a lease with a related party of the superannuation fund unless the lease relates to business real property and the lease is legally binding;

  3. the trustee of the unit trust must not have outstanding borrowings;

  4. the assets of the unit trust must not include:

  1. an interest in another entity;

  2. a loan to another entity (except a bank deposit); or

  3. an asset over or in relation to which there is a charge; or

  4. an asset that was required from a related party of the superannuation fund after 11 August 1999 unless the asset was business real property acquired at market value; or

  5. an asset that had been at any time (unless it was business real property acquired by a trustee of the unit trust at market value) an asset of a related party of the superannuation fund since the latter of 11 August 1999 and three years before the day in which the fund first acquired an interest in the unit trust.

  1. The trustee of the unit trust must not conduct a business.

  2. The unit trust must conduct all transactions on an arms length basis.

In the context of the present consideration of superannuation funds investing in unit trusts to undertake direct property investment, the requirement that the unit trust not conduct a business if it is to qualify for the exception to the in-house asset rules in SIS Regulations 13.22C and 13.22D, should be noted.  This effectively precludes reliance on this exception if it was intended to establish a unit trust for which superannuation funds might invest to undertake property development activity.

8.6 Sole purpose test

It is important to begin and end any consideration of an investment by a superannuation fund in a closely held property unit trust by reference to the sole purpose test.  The sole purpose test presents a conceptual difficulty.  While it requires regulated superannuation funds be maintained solely for one or more of the core purposes or the ancillary purposes, (essentially the provision of retirement benefits), it may be said that any investment made within the regulated superannuation fund environment will be for that purpose, as that is the only end to which the investments in the fund may be put pursuant to the terms of the governing rules of the fund and the SIS legislation.

While that is so, it is also apparent from the structure of the SIS legislation with its various limitations on investments by regulated superannuation funds, that the legislature intended that the investments remain available to fund retirement benefits at retirement (or on earlier death or disability).  Further, given the tax concessional treatment of contributions to and investments in and benefits received from regulated superannuation funds the legislation intends that those funds not be used other than solely for the prescribed purposes.  This means, that collateral purposes such as estate planning or tax minimisation if pursued take the trustees of a superannuation fund outside the sole purpose test.

A breach of the sole purpose test is an offence.  Moreover, in the case of a self managed superannuation fund where the members of the fund are the trustees, and vice versa, the breach may cause the trustees to fail the culpability test29 with the result that the fund could become a non complying fund, with its attendant penal tax consequences.30

Whether or not the sole purpose test may be breached by an investment in a closely held property unit trust is a matter which must be decided on the facts of each case.  Certainly, the starting point should be  a consideration of what was said by Windeyer J in Scott's case about the nature of a superannuation fund and the inappropriateness of a superannuation fund engaging in profit making by purchase and resale of property.  To the extent that such activity is not appropriate to a superannuation fund if undertaken directly it also would not be appropriate if undertaken by the fund through interposed entities, except perhaps if the investment was no more than a portfolio investment.

Different considerations apply where the investment in a property unit trust is intended to be a long held investment to derive a secure income stream and eventual capital gains.  One off property investments of a speculative nature through a unit trust, however, would not be in that category.

Finally, it would also be relevant to consider what proportion of the superannuation fund's assets was to be represented by the investment in the property unit trust.  It would be expected that the Regulator would consider the matter closely in circumstances where an investment in the property unit trust is the only investment of the superannuation fund.  It would be relevant in such a case to consider the planned future contributions to the fund and future investment strategy of the fund to determine how significant the initial sole investment might be over the planned duration of the fund.

8.7 Instalment warrants – property

In conclusion, because of the complexities surrounding the in-house asset rules in relation to investments in unit trusts, it may be expected, with the 2007 amendments to permit investments in prescribed instalment warrants, that appropriately structured property instalment warrant products may be well received as a much simpler and less worrisome means of direct property investment for SMSFs.

FOOTNOTES

  1. 'Warrants – Understanding trading and investment warrants' - ASX June 2005

  2. ibid at page 13

  3. 'Warrants – Understanding trading and investment warrants' - ASX June 2005

  4. Note 3 at page 13.

  5. 'Warrants – Understanding trading and investment warrants' - ASX June 2005

  6. 'Warrants – Understanding trading and investment warrants' - ASX June 2005

  7. Refer to the recent amendments to the Income Tax Assessment Act 1997 (Cth) in relation to capital protected borrowings contained in Schedule 7 to the Tax Laws Amendment (2006 Measures No. 7) Act 2007 (Cth)

  8. Section 10 of SIS

  9. Scott v Federal Commissioner of Taxation (1966) 117 CLR 514

  10. A similar prohibition is contained in section 95 in respect of approved deposit funds and in section 97 of SIS in respect of pooled superannuation trusts.

  11. (1853) 22 LJ Ch 785 at 790, CA

  12. Encyclopaedic Australian Legal Dictionary.

  13. Chow Young Hong v Choong Fah Rubber Manufactory [1961] 3 All ER 1163. Also refer to Prime Wheat Association Ltd v Chief Commissioner of Stamp Duties (1996) 42 NSWLR 505 at 511-512; Australia and New Zealand Savings Bank Ltd v Commissioner of Taxation (1993) 42 FCR 535 at 560; NM Superannuation Pty Ltd v Young (1993) 113 ALR 39 at 56-58; Eastern Nitrogen Ltd v Commissioner of Taxation (2001) 108 FCR 27.

  14. 'Warrants – Understanding trading and investment warrants' - ASX June 2005

  15. Circular II.D.7 Appendix 1 Part B.5

  16. Circular II.D.7 paragraph 22

  17. Circular II.D.7 Appendix 1 Part B.4

  18. Circular II.D.7 Appendix 2

  19. Superannuation Circular II.D.7 paragraph 30

  20. for example the Quantum Warrants described in ATO product ruling PR2005/27.

  21. paragraph 3.20

  22. APRA Quarterly Superannuation Performance – March 2007 (issued 28 June 2007).

  23. Section 71(1A) of SIS

  24. C Ketsakidis and J Sudano 'SMSF's and Property development through unit trusts and private companies' Taxation in Australia Issue 39 No. 9 April 2005

  25. Section 10(1) of SIS

  26. Examples of such strategies are provided in a paper by Richard Friend 'The use of unit trusts and other property strategies' Taxation Institute of Australia Superannuation Intensive 17 July 2007.

  27. CPT Custodian Pty Ltd v Commissioner of State Revenue; Commissioner of State Revenue v Karingal 2 Holdings Pty Ltd (2005) 224 CLR 98

  28. Charles v Federal Commissioner of Taxation (1954) 90 CLR 598

  29. Section 42

  30. Previously section 288A in the Income Tax Assessment Act 1936 (Cth), now section 295-325 in the Income Tax Assessment Act 1997 (Cth).

CASE STUDIES

1. What is a traditional instalment warrant?

Bill and Sue as trustees of the ABC Superannuation Fund wish to purchase 2,000 shares in BHP Billiton. However the fund only has available cash this year to allow the purchase of approximately 1,000 shares. The trustees who are the only members of the fund understand that the members plan to contribute sufficient funds in the next year to enable the purchase of another 1,000 shares. 

The investment advisor to the fund suggests the acquisition of 2,000 BHP Billiton instalment warrants, through an instalment warrant product offered by an investment bank. 

The investment bank purchases 2,000 BHP Billiton shares in the name of a security trustee on behalf of the trustees of the fund, and arranges a limited recourse loan to the fund trustees for the second instalment of the price. The trustees pay an initial instalment approximately equal to one half of the price of the 2,000 shares plus interest on a loan for the second instalment of the price, bank charges and a put option fee. 

The trustees acquire a put option to put the shares back to the investment bank at the greater of the current market price or the amount of the loan at the exercise date of the put option. 

The trustees are entitled to all dividends and franking credits in respect of the 2,000 BHP Billiton shares underlying the instalment warrants. 

Upon the payment of the second instalment becoming due, the fund trustees may:

  • Pay the second instalment and acquire the underlying shares;

  • Exercise the put option in which case the shares will be sold and the proceeds from the share sale applied to repay the loan. If the share price exceeds the loan amount then the fund trustees receive the excess amount. 

  • 'Roll over' the warrants into a new series of instalment warrants over the same shares (if available). 

Alternatively the fund trustees may sell the instalment warrants on the secondary market. 

  1. Bill and Sue decide to consult their superannuation advisor before investing in the instalment warrants. The advisor says that until late 2006 it had been commonly understood in the investment advising community that investments in traditional instalment warrants by SMSF's did not involve any breach of the SIS Act or SIS regulations. However on 3 November 2006 the Government announced that the ATO and APRA had concluded that instalment warrants involve a borrowing which breaches the borrowing prohibition of section 67 of SIS. Further the explanatory memorandum to the 2007 amending legislation noted that the ATO also considered that such investments involved an investment in an in-house asset under section 71 of SIS.

The 2007 amendments however, were designed to allow investments not only in traditional instalment warrants by SMSF's but also through instalment purchases using limited recourse loans to invest in any asset a fund could invest in directly. 

  1. The advisor also noted that if the fund trustees had previously invested in traditional instalment warrants before the 2007 amendments took effect on 24 September 2007 then the amendments did not operate retrospectively to rectify any previous breach of SIS by the investment. Rather the explanatory memorandum said that previous breaches would be managed through the discretionary powers of the Commissioner of Taxation and APRA. 

2. What is an instalment warrant by 'Shareholder application'.

Garry and Katrina as trustees of the GK Superannuation fund, own 2,000 shares in Westpac Banking Corporation. The shares have increased significantly in value since the fund acquired them. The trustees wish to access the equity in these shares to leverage an investment by the fund in shares in ANZ Banking Corporation. 

Their investment advisor mentions that an investment bank would be prepared to offer instalment warrants over the Westpac shares held by the fund under which the fund trustees would transfer the Westpac shares to a security trustee who would hold them on behalf of the fund trustees as security for a loan from the investment bank. The loan could be used to purchase the ANZ shares. 

The investment advisor further explains that under this arrangement there is no disposal of the Westpac shares such as would trigger a CGT event and the fund trustees would continue to be entitled to all dividends and franking credits on the Westpac shares. 

Garry and Katrina consult their superannuation advisor. She tells them that on 16 December 2002 APRA and the ATO announce that they considered that investments and instalment warrants by way of shareholder application were generally not regarded as an appropriate means of implementing a funds investment strategy and was likely to contravene the prohibition upon a fund granting a charge over any of its assets, contained in SIS regulation 13.14. 

3. Gearing by SMSF's permitted by 2007 SIS amendments – Traditional Instalment Warrants over ASX listed shares.

The investment in BHP Billiton instalment warrants contemplated in case study 1 above falls within the exception to the prohibition upon borrowing by superannuation funds now contained in section 67 (4A). That new exception is not limited to investments in traditional instalment warrants over ASX listed shares, however. Rather extends to the use of limited recourse loans to acquire an asset (which the SMSF is otherwise permitted to acquire) through making one or more payments under an arrangement where the asset is held in trust for the SMSF until the payments are made and the rights of the lender in the event of default under the loan are limited to rights relating to the asset. 

4. Gearing by SMSF's not permitted by 2007 SIS amendments.

  1. The investment in instalment warrants by way of shareholder application referred to in case study 2 above would not be permitted by the 2007 amendments introducing new section 67 (4A). This is because:

  • the Westpac shares in case study 2 were already owned by the fund. Therefore the borrowing would not be used for the acquisition of an asset by the SMSF. The use of the borrowed monies to acquire an asset is the first requirement to fall within section 67 (4A).

  • further, the instalment warrant arrangement over the existing Westpac shares owned by the fund would involve a charge over the fund assets in breach of SIS regulation 13.14. 

  1. The trustees of the D&N Superannuation fund wish to acquire from Damien, a member of the fund, the residential property which is Damien's home. They have heard of the ability to gear superannuation fund investments under the 2007 amendments and wish to use a limited recourse loan arrangement falling within section 67 (4A) to complete the purchase. They have found a finance company willing to lend money on this basis for this purpose subject to confirmation that the arrangement will not cause the fund to breach the borrowing prohibition in section 67. 

The legal advisors to the fund trustees advise that the exception to the borrowing prohibition in new section 67 (4A) will not be available as the purchase by the fund of Damien's home would involve an acquisition of an asset from a member of the fund. The asset being Damien's home does not fall within the exception for business rule property so that the purchase would breach section 66. As such the asset would be one which the fund is prohibited by SIS from acquiring and outside the exception in section 67 (4A). 

5. Gearing by SMSF's permitted by 2007 SIS amendments.

Chris and David are the trustees of the Maritime Superannuation Fund. They are also the owners of a commercial warehouse and office premises in Brisbane from which their company conducts a marine supplies business. They propose that the purchase of the premises by the fund for lease at a commercial rent back to their company would be a valuable investment and income earner for the fund. 

Their accountant notes that they do not have sufficient available funds in the superannuation fund in order to the make the purchase. With the new contribution limits for contribution to the fund by them it would take years to accumulate the necessary purchase price or pay for the land by instalments. An instalment sale may also raise questions under division 7A of the Tax Act unless the loan is at commercial interest under a division 7A loan agreement. 

The accountant suggests that the trustees investigate whether or not the limited recourse loan borrowing exception in section 67 (4A) of SIS would be available. If so he thought that a bank could be approached to organise the necessary loan. 

  1. The loan monies would be used to buy business real property. On that basis even though the purchase was from a related party the exception in 66 of SIS to the prohibition on purchase of assets from a related party would be available. The asset therefore would not be one the trustees were prohibited from acquiring. 

  2. A security trust arrangement could be created under the loan arrangements for the asset to be held on trust by a custodian for the fund trustees until the asset had been paid for. 

  3. The agreement for sale of the land would provide for the fund trustees to acquire the land by one or more payments after acquiring the beneficial interest under the security trust. 

  4. The rights of the lender in the event of default on the loan by the fund trustees would be limited to rights against the land.

The lawyer for the fund trustees advised that the requirements of section 67 (4A) could be satisfied if the purchase and loan were arranged on that basis. Further the security trust would not be an in-house asset by reason of new section 71(8) and (9) SIS. 

However the lawyer also advised that the following would need to be confirmed:

  1. The funds investment strategy would need to be reviewed to allow for the proposed investment.

  2. The trustees would need to be satisfied that the investment was being made within the sole purpose test.

  3. Did the investment involve the granting of a charge over an asset of the fund? The terms of any mortgage required by the lending bank in relation to the land would need to be considered. For example, does a mortgage given by the security trustee over the land give rise to a charge on assets of the fund? It may be possible to negotiate that a mortgage is not necessarily given the security trust arrangement. 

  4. The sale and all of the loan terms would need to be on an arms length basis to comply with section 109 of SIS.

STUDY POINTS

  1. Explain the key features of a typical instalment warrant.

  2. Under a typical instalment warrant, what choices does the warrant holder have when the second instalment becomes due?

  3. Instalment warrants offered by different investment banks will fall into different product categories differentiated by what?

  4. Explain the purpose and effect of the put option under a typical instalment warrant.

  5. Explain the tax treatment of instalment warrants.

  6. How do the Commissioner of Taxation and the Australian Prudential Regulation Authority view instalment warrants?

  7. Explain the 2 principal reasons why the laws passed in late September 2007 are significant.

  8. Explain the basic provisions for using an instalment warrant laid down in section 67(4A) of SIS.

  9. Given that the usual SIS restrictions will still apply to geared investments contemplated under section 67(4A), what will SMSF trustees need to consider when evaluating instalment warrants?