Part 2: Case studies of trading SMSF assets (and replacement assets) bought under an instalment warrant arrangement

Christopher Balmford, MD

(For Part 1 on this topic, see the post on 16 September, 2009.)

Since the original blog post below, the law on SMSF borrowing - and the replacement assets issue - has been clarified. In particular, there are some useful comments in the Explanatory Memorandum issued with the Bill. The changes to the law were passed in late June 2010. They will receive Royal Assent in early July 2010.


You can download a copy of the bill and the Explanatory Memorandum here

Cleardocs reports on the changes, and on related developments, in ClearLaw articles here

Orginal post

How the legal documents might be affected under the options outlined in Part 1

If the SMSF trustee(s):

· trade in the normal way without repaying any of the loan (Option 1 in earlier post), then I think the instalment warrant documents continue as they are. But there are two main issues — a legal one and a practical one:

o The legal issue Is it OK for the SMSF trustee(s) to treat the newly purchased shares as "replacement assets"? and

o The practical issue Are the SMSF trustee(s) complying with their LVR limits? (See, Part 1 about LVRs.)

· repay all of the loan and keep the remaining proceeds of sale in cash or use it to buy
another asset (Option 2 in earlier post), then I think the instalment warrant arrangement comes to an end; and

· combine the proceeds of sale with money from a new loan to acquire another asset (Option 3 in earlier post), then we need to think hard about what happens to
the paper work for the instalment warrant arrangement.

Do you have any alternate views? It would be interesting to know the ATO’s views.

Also, as I said in Part 1:

· Maybe this topic is one that you might ask the ATO about under the new system that allows SMSF trustee(s) to applyfor a private ATO tax ruling on planned activities, see the ATO website here. If you do learn anything from the ATO (that you are allowed to disclose) about all this, we’d be delighted to learn about it; and

· These comments are preliminary thinking about what the answers might look like. So this
blog post is me sharing my thinking. Feel free to share this post with your colleagues, advisors etc. But you need to form your own view. And your colleagues, advisors etc. need to form their own views too.

Case studies of trading shares under SMSF borrowing — how it might work

Let’s look at some case studies to illustrate our discussion. Before we do, 2 thoughts:

· Generally, the case studies below are the same regardless of whether the lender is a bank
or a party related to the SMSF trustee(s); and

· Generally, the case studies below are the same for each of the assets in the narrow range of assets allowed to be acquired through SMSF borrowing — those assets are, primarily: commercial property, shares in a company (listed, or unlisted), units in a trust, fund or managed investment scheme (listed, or unlisted, and whether registered with ASIC or not). The facts in the case studies change if the asset is commercial property — as commercial property cannot be traded like shares or units. Even so, in each case study, the impact on the instalment warrant paperwork is the same if the asset is commercial property.

Facts for the case studies

For each of the case studies, let’s assume the SMSF’s trustee(s):

· have $50,000 cash to invest;

· borrow $100,000 through an instalment warrant arrangement; and

· buy $150,000 worth of shares in ABC Limited.

Case study for Option 1 — Buy and sell (and trade generally) in the usual way

	What the SMSF trustee does	The instalment warrant paperwork involved
Case study 1	· Sells some shares in ABC Limited · Uses the proceeds of sale to buy shares in XYZ Limited (but does not use any new borrowed money) · Continues to hold any remaining shares in ABC Limited	The instalment warrant arrangement can continue as is — as long as the value of the ABC Limited shares satisfies the lender’s LVR. However, if the ABC Limited shares don’t satisfy the lender’s LVR, then: · perhaps a lender (especially if it’s a bank) will handle this in the same way it handles the similar situation in a margin lending arrangement; and · the meaning of the word "replacement” in the law may become relevant. Perhaps, the “replacement” asset the legislation refers to is (in this situation) the shares in XYZ Limited. What do you think?
Case study 2	· Sells all of its shares in ABC Limited · Uses the proceeds of sale to buy shares in XYZ Limited (but does not use any new borrowed money)	Same as above for Case study 1.

Case studies for Option 2 — Repay the loan

	What the SMSF trustee does	The instalment warrant paperwork involved
Case study 3	· Sells all of the shares — and the proceeds of sale are more than the amount owing under the loan · Repays the full amount owing under the loan · Either keeps the remaining proceeds of sale in cash or uses them to buy another asset	The instalment warrant arrangement comes to an end. In that case, the paper work is fairly straightforward: · the loan agreement ends, · the mortgage or charge is discharged; and · the custodian trust (or bare trust) can be wound up or it may (if the deed allows — as the Cleardocs deed generally does) remain to be used later for another transaction.
Case study 4	· Sells the number of shares required to produce proceeds of sale equal to the amount owing under the loan · Repays the amount owing under the loan · Continues to hold its remaining shares in ABC Limited	Same as above for Case study 3
Case study 5	· Sells some of the shares — but the proceeds of sale are not enough to repay the full amount owing under the loan · Repays some of the amount owing under the loan · Continues to hold any remaining shares in ABC Limited	The SMSF trustee must observe LVR limits. Assuming the LVR limits are observed, then the instalment warrant arrangement continues as is. But the amount of the loan is reduced by the amount repaid from the proceeds of sale.
Case study 6	· Sells all of the shares — but the proceeds of sale are not enough to repay the full amount owing under the loan ! Hang on, … this one is tricky, and the situation is unlikely to happen. After all, if the SMSF trustee(s) try to sell the shares for less than the amount owing under the loan, then (depending on who the lender is) the lender is unlikely to release its security over the shares. In fact, if things are that bad, the lender may have already started to enforce its rights to recover the amount owing.	… The lender (depending on who the lender is) is likely to already be enforcing its rights: · under the charge over the shares; and · under any guarantee it has over assets outside the SMSF that are owned by the SMSF trustee(s) or anyone else. For more information on guarantees as part of SMSF borrowing, see here. http://www.cleardocs.com/clearlaw/superannuation/smsf-borrowing-risks.html

Case studies for Option 3 — Arrange a new loan and combine the amounts

	What the SMSF trustee does	The instalment warrant paperwork involved
Case study 7	· Sells some of the shares · Borrows another $100,000 from a bank under an instalment warrant arrangement · Combines the proceeds of sale and the second loan to buy shares in XYZ Limited	For the first loan, the instalment warrant arrangement continues as is — as long as the SMSF trustee(s) observe LVR limits. For the second loan, the SMSF trustee(s): · need a new loan document and a new security document (mortgage or charge); but · can add the new asset into the existing Declaration of Custody Trust — as long as: o this is allowed under the terms of that trust (it generally is under the Cleardocs deed); and o it is acceptable to the lender.
Case study 8	Same as Case study 7 in row above — except that the SMSF trustee(s) sell all of the shares	For the first loan, the instalment warrant arrangements ends as if the SMSF trustee(s) sell all the shares, then they must pay-out the first loan with the sale proceeds. For the second loan, … same as Case study 7 in the row above. ! But maybe it would be better to pay out the first loan, and then arrange one new loan and instalment warrant arrangement. What do you think?

More information, any questions

Let us know if you have any questions:

· comment below

· call 1300 307 343, if your questions are legal, we can refer you to the free legal helpline
at our lawyers, Maddocks

· email support@cleardocs.com

· read about the Cleardocs instalment warrant document packages for SMSF borrowing from a bank or from a party related to the SMSF trustee(s) http://www.cleardocs.com/products-smsf-borrowing-bank.html

· visit www.cleardocs.com

Comments welcome

That’s my preliminary thinking about all this. I welcome your comments below.

No advice Lastly, these are just my personal views. Neither Cleardocs nor I provide, or are licensed or authorised to provide, legal, commercial, financial, or taxation advice. You must obtain your own advice.