Explanatory Memorandum(Circulated by authority of the Assistant Treasurer, the Rod Kemp)
Regulation Impact Statement
The operation of the superannuation investment rules needs to be considered in the context of the size and importance of the superannuation industry: at March 1999, superannuation funds held assets of around $390 billion. This includes around 180,000 excluded funds (funds with fewer than 5 members) with assets of around $50 billion. Superannuation receives tax concessions of some billions of dollars a year.
The Superannuation Industry (Supervision) Act 1993 (the SIS Act) contains a number of rules governing investment activities by superannuation funds. Collectively, these rules are designed to limit the risks associated with superannuation fund investments and to ensure that superannuation savings are preserved until retirement and not accessed for current use. These reflect the objectives of the Governments retirement incomes policy. The investment rules in the existing legislation include:
- A superannuation fund is limited to holding no more than a specified percentage of fund assets in the form of in-house assets. An in-house asset is currently defined as a loan to, or an investment in, an employer-sponsor or an associate of an employer-sponsor. The 1993 legislation reduces the limit to 5 per cent of the market value of fund assets from the end of 2000-01 (the 5 per cent limit already applies to new investments). This rule limits the risk to superannuation savings from investment in an employer-sponsor or associate.
- Superannuation funds are generally not permitted to borrow in their own right. This is designed to reduce the risk to retirement income from funds gearing their assets.
- Superannuation funds are not permitted to acquire assets from members and their relatives, except for listed securities and - for a fund with fewer than 5 members - up to 40 per cent of assets being used to acquire business real property. This is designed to limit the scope for non-arms length transactions with related parties that result in early access to superannuation savings for non-retirement purposes.
- Superannuation funds are prohibited from lending or providing other financial assistance to members and relatives. This is to prevent the use of superannuation savings as a means of providing current day financial support to members.
- There is a general requirement that superannuation funds make investments on arms length terms. Essentially, this means that investments should be entered into, and maintained, on commercial terms. This has the objective of limiting non-arms length transactions that result in early access to superannuation savings for non-retirement purposes.
In early 1997, the then superannuation regulator, the Insurance and Superannuation Commission (ISC) undertook a random survey of around 1,000 excluded funds. The survey did not include funds with assets of less than $30,000 nor funds where all assets were in life insurance policies.
Findings of the survey included:
- Around 20 per cent of excluded funds were investing in unit trusts that were effectively controlled by the fund members or the employer. It appears that around one half of these unit trusts were undertaking geared investments (that is, gearing up money received from the superannuation funds).
- Around 13 per cent of superannuation funds were leasing or renting assets to associated parties (such as members or employers).
More detailed survey field work examined around 100 selected funds. These provided examples of superannuation funds investing in unit trusts, which in turn invested in the employer-sponsor, made loans to members and employer-sponsors and leased assets to members and employer-sponsors.
The practices identified by the ISC survey and field work affect the integrity of the investment rules.
- Superannuation savings are being transferred into related trusts that are not subject to the investment rules or other SIS regulation, and which are controlled by an employer-sponsor or member. Even if permitted by legislation, it would be complex and resource intensive for the regulators to apply the investment rules to superannuation funds on the basis of activities undertaken by an increasing number of unregulated, related entities. The task would become increasingly difficult. By way of illustration, at March 1999 there were around 186,000 superannuation funds, compared with around 100,000 funds in June 1995.
- If a superannuation fund invests in a related trust, the employer or member is able to use the assets in a geared investment, which the superannuation fund could not undertake directly. This circumvents the rule that prevents borrowing by a superannuation fund.
- Assets are being leased to an employer-sponsor or member, either through a unit trust or directly by a superannuation fund. This results in the funds assets being committed to the employers business or being accessed for current day use by members.
These practices undermine the effectiveness of the existing investment rules that are designed to reduce the risks of superannuation investments and ensure that superannuation savings are preserved for retirement purposes. The use of these practices can be expected to increase over time. This can be expected to have a cumulative, long term effect, over a period of decades, on superannuation savings available for retirement income.
Concerns about the effectiveness of the existing investment rules need to be considered in the context of the billions of dollars of superannuation tax concessions provided to encourage superannuation savings. If superannuation savings are not available for retirement income purposes, the tax concessions will not have achieved their purpose and Age Pension outlays would be higher in the longer term as a result.
The primary policy objective is to ensure that the investment practices of superannuation funds are consistent with the Governments retirement incomes policy. That is, superannuation savings should be invested prudently, consistent with the SIS requirements, for the purpose of providing retirement income and not for providing current day benefits.
Identification of Alternatives
Option 1 Implement the changes to the superannuation investment rules set out in the Bill.
Option 2 Do not proceed with the changes.
The following groups will be affected by the proposed changes to the superannuation investment rules.
Option 1: The changes are designed to ensure that members superannuation savings are preserved for retirement income.
The changes will restrict the use of superannuation savings on assets leased to employer-sponsors and members (either directly or through investments in related entities). There will be an exception for business real property leased directly by a superannuation fund with fewer than 5 members. Transitional rules will also apply (see below, under Costs and Benefits, Option 1 ).
Employer-sponsors and their associates will generally not be able to sell assets to their superannuation funds (see below, under Costs and Benefits, Option 1 for exceptions).
Option 2: Members and employer-sponsors will not face the changes under Option 1. The practices that would be prevented under the new legislation could continue to expand.
Option 1: Superannuation fund trustees will need to ensure that they do not exceed the in-house asset limits under the new provisions.
Superannuation fund trustees will also need to ensure that they do not acquire assets from employers and associates in a manner that would be contrary to the new provisions.
Option 2: Trustees will be able to continue and to expand the types of activities that are not prohibited by the existing legislation.
Option 1: Administering the new investment rules will have some resource implications for the ATO and APRA. This will include administering the transitional rules.
Option 2: The ATO and APRA will need to administer the rules that existed before the Budget announcement.
The cumulative effect of allowing these types of transactions to continue and to expand over a period of years could be expected to impact on Budget outlays in the longer term, including Age Pension outlays.
Costs and Benefits of the Proposed Options
Option 1 - Implement Changes to the Superannuation Investment Rules
In the 1998-99 Budget, the Government announced that the in-house asset rules would be extended to cover investments in, and loans to, members and associates. The in-house limits will also cover investments in trusts that are controlled by an employer-sponsor or a member of the fund. Assets leased by a superannuation fund to a related party will also be treated as in-house assets.
An exception is that a superannuation fund with fewer than 5 members can have up to 100 per cent of its assets in business real property leased to a related party.
The transitional arrangements ensure that investments and loans made before 12 May 1998 are grandfathered (that is, permanently exempted from the changes). Assets leased before 12 May 1998 are also covered by grandfathering arrangements. For investments made between Budget night and the date of Royal Assent for the legislation, funds will have until 30 June 2001 to comply.
Grandfathering also applies to investments, loans and leases covered by a pre-12 May 1998 contract. There are also provisions to allow further payments on partly paid shares and units and to allow reinvestment of income received from a related entity until 30 June 2009.
As an alternative to other transitional arrangements, grandfathering arrangements allow small funds to make additional investments into a related entity until 30 June 2009, up to the amount of the outstanding debt of the related entity at 12 May 1998.
The anti-avoidance rule preventing the circumvention of the in-house asset rules by investing via a non-related entity has also been strengthened.
In addition, the provisions preventing a superannuation fund from acquiring an asset from a member or relative will be extended to cover the acquisition of assets from an employer-sponsor and other related parties. For a fund with fewer than 5 members, the previous 40 per cent limit on acquisition of business real property from a member has been increased to 100 per cent of fund assets. The exception for listed securities remains.
Proceeding with the investment rule changes will limit the ability of funds to transfer assets to related entities that are not regulated by the SIS provisions. The changes will also limit the ability of funds to lease assets to related parties. The changes have the objective of ensuring that superannuation savings are safeguarded in the manner that was originally intended by the SIS investment rules and preserved for retirement purposes. Failure to ensure this can be expected to impact on longer term Budget outlays.
The risks from not implementing the changes will increase as the superannuation sector grows and matures. If the changes do not proceed, it will open the way to a major expansion of the practices that they address. An assessment of the impact needs to take account not only of the current level of particular practices but also the long term cumulative effect of allowing such practices to expand and continue over a long period of time.
The rules concerning the acquisition of assets from related parties and leasing assets to related parties have exceptions for business real property. While there are risks involved in providing exceptions to the general rules, these exceptions have the benefit of allowing small business owners to use their superannuation savings to invest in their own business premises. The exceptions recognise that land and buildings generally have an underlying value independent of the employer-sponsors business.
Option 1 will prevent some transactions being undertaken between superannuation funds, related trusts and employer-sponsors. Employer-sponsors that would otherwise have leased assets financed by superannuation savings will need to access other sources of funds (unless the business real property or other exceptions cover these assets). However, this should not involve additional costs if the superannuation savings were being accessed on commercial terms.
Investments and loans that were made before 12 May 1998 and assets that were first leased by a superannuation fund before then and continue to be leased will be covered by transitional rules.
Trustees and related parties will face some additional costs in understanding and complying with the new provisions. These include the application of the in-house rules to transactions involving members and associates. However, superannuation funds are already required to comply with the existing in-house asset rules. For large funds, the 5 per cent of fund assets limit applies separately for unrelated employer-sponsors. Moreover, the obligation on fund trustees is limited to the requirement to take all reasonable steps to comply with the in-house asset provisions.
To take advantage of the transitional rules, trustees will need to identify pre-Budget and post-Budget assets and liabilities and monitor future investments and flow of funds. However, it will be a matter of choice whether to use particular transitional arrangements.
The compliance costs for funds will depend on the investment practices of particular funds. The 1997 ISC survey indicated that around 20 per cent of surveyed excluded funds invested in related trusts and around 13 per cent of funds leased assets to related parties. The transitional arrangements mean that pre-Budget investments will not need to be unwound. The new rules will limit future transactions of this kind. It is therefore unclear what proportion of funds would consider making a new investment that may potentially be subject to the new rules and therefore involve costs in determining the status of particular transactions under the new rules.
Funds will also need to comply with the changed rules preventing a superannuation fund from acquiring assets from an employer-sponsor or associate (the rules currently apply only to members and associates).
The ATO and APRA will have costs in administering the rules, including the transitional rules. However, they will avoid the need to monitor the use of superannuation savings in an increasing number of non-regulated trusts controlled by employer-sponsors and members.
Option 2 - Not Proceeding with the Legislative Changes
This option would allow funds and members to undertake transactions that are not prohibited by the existing SIS provisions, including unlimited investments into related trusts.
This would avoid the compliance and other costs as outlined above in option 1.
If the legislative changes do not proceed, superannuation savings will not be safeguarded in the manner that was originally intended by the SIS legislation. Superannuation funds could continue to transfer superannuation savings into non-regulated entities controlled by employer-sponsors or members. Investments in related trusts could continue to be used as a means of circumventing the borrowing restriction that applies to superannuation funds. There would be no provision preventing a superannuation fund from leasing assets to employer-sponsors and members. Superannuation funds could continue to acquire assets from employer-sponsors and associates.
The decision to change the investment rules was announced in the 1998-99 Budget. A number of representations were received prior to the release of the draft legislation. An exposure draft of the legislation was released on 22 April 1999 for public comment. Submissions were received from a range of organisations and individuals.
Views expressed included that the legislation is not needed and that reliance should be placed instead on the existing arms length requirement. It was also argued that funds should be able to make geared investments through related entities, that the changes would affect the supply of finance to small business, and that transitional arrangements should be provided to allow further superannuation fund investments in related trusts in order to pay off existing debt. Concern was also expressed about the compliance costs for large funds.
However, if the legislation does not proceed, it will continue to be possible for a superannuation fund to undertake the practices outlined above.
The business real property exceptions will be available to small funds. Transitional arrangements have been included in the revised legislation to allow repayment of existing debt of related entities.
With regard to compliance costs, large funds already have to meet the existing in-house asset rules. The requirement on trustees will be to take all reasonable steps to comply with the new rules. For large funds, the 5 per cent of fund assets limit applies separately for unrelated employer-sponsors.
The legislation is necessary to maintain the effectiveness of the investment rules that have been in the SIS Act since its introduction in 1993. A decision not to maintain the effectiveness of the investment rules can be expected to have an adverse long term, cumulative impact on superannuation savings.
Implementation and Review
The changes will be administered by the ATO and APRA after the passage of legislation. Monitoring the effectiveness of the new investment rules will be part of the ongoing monitoring of the superannuation sector by the ATO and APRA.