When the Australian Taxation Office (ATO) issued Taxpayer Alert 2008/5 in April clarifying the use of borrowing within SMSFs, the fledgling sector catering to the self managed super fund loan market stopped for a moment in its tracks.
The alert, subtitled Certain borrowings by self managed superannuation funds, clearly identified as targets of ATO concern loans that require a personal guarantee from a third party.
The original legislation had stipulated that any loan to a SMSF must be limited in its recourse to the asset for which it was sought.
That is, if the SMSF were to default on the loan requiring the sale of the asset in question, the lender could have no claim on other assets in the SMSF if there was a shortfall between the proceeds from the forced sale and the outstanding loan balance.
Following the issue of the original legislation, a number of lenders brought to market loans specifically tailored to the SMSF sector that required personal guarantees as a way of overcoming the limited recourse nature of the SMSF specific loans.
The alert seemed to be a direct challenge to that practice, spelling out specifically the ATO's concern about arrangements where "a personal guarantee for the borrowing is given by a third party, particularly where the guarantee is given by a member or a related party of the SMSF".
But if the alert prompted some lenders to scurry back to legal departments to determine whether their loan arrangements might be in breach of the rules, most have re-emerged confident that their loan policy has structured the guarantees in such a way that fulfils the requirements of the original legislation.
One of the earliest providers of a loan directly targeted at SMSFs was Westpac. It took its existing business loan and added the requirement that the asset be structured within a security property trust. Since all its business loan products require a personal guarantee, that was included as part of the loan.
"We were confident from our legal advice that the loans, as they were structured, fully complied with the requirements under the legislation," Westpac's Mark Middleton says.
Westpac's loan requires that SMSFs be set up as a corporate trust with the company as trustee.
National Australia Bank (NAB) also requires personal guarantees for the business loans it has revamped to cater for the SMSF market.
"We would normally require access to other assets with our loans, so given the limited recourse nature of this style of loan we definitely require a guarantee to ensure that we were covered in the event of a shortfall," NAB head of business lending Rob Elliot says.
According to Elliot, the bank is confident in the way the contract is drawn up that the loan is structured correctly and in compliance with the legislation.
ANZ has also included the requirement for personal guarantee in its, shortly to be released, loan product aimed at SMSFs.
However, others believe that if there was ever any question over the legitimacy of personal guarantees, the Taxpayer Alert put paid to it.
Macquarie head of Property Lever Joe Micallef is convinced that even the original legislation unquestionably proscribed the use of personal guarantees. Compliance with the legislation was Macquarie's main concern when designing the Property Lever product, the lender's property specific SMSF loan, he says.
"The requirement is that the loan has limited recourse only to that asset [the gearing is for] and arguably if a trustee is providing a guarantee that opens the way to the lender having access to the wider assets in an SMSF," Micallef says.
Calliva, which took its SuperAccess loan to market soon after the original legislation was issued, was also careful to exclude personal guarantees from its requirements right from the start.
Chief executive Vince Scully believes there was never any question that personal guarantees were proscribed by the original legislation and the Taxpayer Alert only vindicated this view.
"What happens if the super fund does default and the lender exercises the guarantee? If the guarantor has to pay up any shortfall to the lender, they have a right to sue the super fund - thus putting other assets within the super fund at risk," Scully says.
Scully says that as a private client advice business servicing the needs of SMSFs it did not make sense to create a product that would put a SMSF's assets at risk.
It is a view shared by Navigator Financial Solutions finance broker Mike Feltscheer, a division of accounting firm Hall Chadwick. Feltscheer believes the legislative requirement is very clear and has governed his choice of lenders to provide to potential clients.
"I know there are a lot of different views, but to me it's straightforward. Lock any claim on assets down this to one property and that's the end of it."
St George head of technical consulting Bryan Ashenden isn't entirely sure whether the legislation specifically prohibits personal guarantees.
"There is a question as to whether it could indirectly give rise to a charge over assets in the fund," he says.
But in any case the lender has decided to approach the issue from a commercial point of view.
"Our thinking is - do we really need to go down the personal guarantee track as a lender?" he says.
Feltscheer says promoting loans that do not require a personal guarantee makes commercial sense in what is a very nervous market.
"Advisers and their clients are already worried about the possibility that the legislation may change in a way that may make funds non-compliant. If anything, we believe that the legislation is likely to tighten up the rules on personal guarantees," he says.
Macquarie is proceeding on a similarly cautious basis. "We are very conscious that we are operating in a highly regulated environment and the feedback that we have received from advisers and administrators is that they are very concerned that any borrowing product be compliant with the legislation," Micallef says.
Micallef believes that with a maximum LVR of 55 per cent, the Property Lever loan provides protection for everyone involved - the lender, the adviser and the trustee.
"We believe that is an adequate level of gearing. We don't believe that aggressive lending has a place in people's retirement nest eggs," Micallef says.
St George is counting on the fact that most of the loans are being made on the advice of financial planners for its protection, on the assumption that advisers will already have assessed with trustees whether borrowing to buy property is an appropriate strategy for the fund, and whether the fund is in a position to be able to pay interest and instalment requirements.
That screening process reduces the need for a personal guarantee, he believes, making the bank's job easier to market the loan to nervous advisers.
Scully says he is somewhat surprised at the rise of products that require personal guarantees.
He says those who are allowing personal guarantees are interpreting the law loosely to mean that the recourse of the lender against the trustee of the super fund means only in their capacity as a trustee rather than as an individual.
Scully says the common law right of a guarantor to sue the entity for which it goes guarantor means the assets of the super funds are fundamentally at risk because of the personal guarantee.
This view is supported by the tax office itself. ATO assistant commissioner of super funds Stuart Forsyth has made it clear the regulator isn't happy about the use of personal guarantees.
"We remain concerned about the potential that the guarantee may be exercised and that a commercial debt may be raised against the fund in the event of a default," Forsyth says.
The worry is that while individual lenders may explicitly exclude the possibility of any recourse to other assets in the fund, there may be an indirect claim under the general law in relation to personal guarantees. The ATO is working on further clarification in regard to personal guarantees for the near future, Forsyth says.
However, some legal experts believe that personal guarantees, properly structured, are not a problem.
Townsends Lawyers principal Peter Townsend says there is nothing intrinsically wrong with personal guarantees as long as the contract spells out that the guarantor won't have the right to recover the money out of the SMSF to compensate or reimburse them for money lost.
The Argyle Partnership financial services partner, Peter Bobbin, agrees.
"Personal guarantees are not a mischief. All the financial learning says that as long as ordinary care is taken and the intent of the borrower is a pure one with the sole purpose of maximising their retirement income, then over the long term they will add to the wealth of an SMSF," Bobbin says.
However, Scully cites the intermingling of entities is another danger in taking out a product that requires a personal guarantee.
If the guarantor loses their job or is made bankrupt, that could theoretically give the lender the right to call in the loan.
In the end the small financial benefit of taking out a product with a Personal Guarantee are far outweighed by the risks of doing so, Scully says.
"To me they are risks you would only take if there was a huge benefit, say 1 or 2 per cent less on the interest rate. But we are talking about 25-50 basis points. Just on a commercial analysis - forgetting all the potential tax issues and SIS (Superannuation Industry Supervisory Act 1993) issues - is that a risk worth taking?" he says.
But Bobbin says it is unlikely lenders would be inclined to call in a loan because of a change in the guarantor's circumstances.
"It is not in their interests to foreclose a loan prematurely. When they've gone to all the trouble of drawing up the loan documents in the first place they don't want to have to call in the loan or foreclose," Bobbin says.
And for borrowers even the small reduction in interest available to those prepared to offer personal guarantees could add up to thousands of dollars over the life of the loan, he says.
But whether or not legal opinion exists to support the use of personal guarantees, the industry's biggest hurdle may be in getting past the anxieties of the intermediaries of the funds themselves - the advisers to SMSFs.
At the National Tax Accountants Association, (NTAA) which represents the majority of small to medium accounting firms which are the main advisers for SMSFs, spokesperson Andrew Gardiner says the association is approaching the new lending regime with caution, if not apprehension.
"There is a lot of uncertainty over whether the arrangements adhere to the rules. The Taxpayer Alert indicates a degree of concern by the tax office over the arrangements, so we are recommending our members adopt a very conservative approach to the products given the potentially catastrophic implications of getting it wrong," Gardiner says.
Gardiner cites the possibility of the fund becoming non-compliant and being required to pay tax at the highest tax rate, or the chance that the arrangement might need to be reversed, requiring the fund to pay back the borrowings, necessitating the reversal of the transaction - possibly involving an emergency sale of the asset.
The problem is that because each of the loan arrangements have subtle variations - each claiming to be compliant with the legislation - it is difficult for a layman to assess whether the product adheres to the rules.
Gardiner believes that the only way the association would be confident to recommend that to members is if the products came with a product ruling from the tax office.
"I think they [the lenders] would be staggered by the demand that would ensue if people had that clarity and certainty on the products," Gardiner says.
Townsend concedes that many advisers and accountants are finding it difficult to understand the full impact of the legislation.
"It is based on instalment warrants and really it was never designed for this end," Townsend says.
He says that it would be in the interests of the industry if the ATO issues further legislation to clarify exactly what is and what is not acceptable.
"I accept that the tax office is concerned in its role as regulator of the prospects of other parts of the super fund being accessed to repay loans," Townsend says.
But he feels that a few "twists and turns" involved in getting the arrangement right does not necessarily mean such an arrangement is dangerous or risky to get into.
"This isn't a scheme being sold by a chap wearing white shoes."
