SMSFs investing in unit trusts

October 16, 2015

SMSF InvestingA unit trust is a popular structure to hold property and other investments.

Many publicly offered managed investments fund are structured as a unit trust to allow multiple investors to invest in a diversified investment portfolio. Typically, large managed investments funds invest in shares, property and a range of securities. The units in the trust reflect each investor’s proportionate equity or interest in the trust. The concept of owning a unit in a unit trust is a similar but different concept to owning a share in a company.

On a smaller scale, unit trusts are also popular for self managed superannuation funds (‘SMSF’) to invest in especially to acquire real estate. One or more SMSFs and/or other investors can combine their finances to acquire an investment property via a unit trust structure. In some cases, this may allow each investor access to a better property with considerably more upside potential compared to investing alone.

In particular, an SMSF may only want to hold a proportionate interest in a unit trust to minimise risk. There may be one or more related or other investors that also participate in the same unit trust. Each investor invests in units which, in turn, is used to finance the unit trust’s acquisition of property.

However, an SMSF has to be very careful to ensure it complies with the raft of superannuation rules before investing in a unit trust. We examine some of the key rules below.

Related unit trusts
An SMSF is restricted to investing no more than 5% in ‘in-house assets’ (‘IHA’) which includes investments in related parties and related trusts.

A related party is, broadly, a close family member, a partner in a partnership and a company or trust that is controlled or significantly influenced by an SMSF member and his or her associates.

A related trust includes a unit trust where an SMSF member and his or her associates hold more than 50% equity in the unit trust, exercises significant influence in relation to the trust or who can hire or fire the trustee.

Therefore, an SMSF with $1,000,000 of assets could not invest more than $50,000 (ie, 5%) in IHAs (including any related trust). Such a unit trust could invest in a real estate property where the remaining units were held by others including related parties such as family members, relatives or a related family discretionary trust.

This may not be attractive to an SMSF where it’s likely the 5% limit will be exceeded. For instance, if an SMSF invested more than 5%, this would contravene the Superannuation Industry (Supervision) Act 1993 (Cth) (‘SISA’) and significant penalties could be imposed on an SMSF by the ATO.

There is an exception discussed below; involving non-geared unit trusts (‘NGUT’) that allows an SMSF to invest in a related unit trust.

Non-geared unit trust
A NGUT allows an SMSF to hold up to 100% of the units issued in that ‘related’ unit trust. This is permitted provided the unit trust complies with the strict criteria in the Superannuation Industry (Supervision) Regulations 1994 (Cth) (‘SIS Regulations’) and continues to comply with that strict criteria. Failure to comply can result in the units becoming IHAs. As discussed above, an SMSF cannot hold IHAs that exceed more than 5% of the value of the fund’s assets.

Broadly, a NGUT is an ideal structure for holding real estate with no borrowings secured on the title to that property. This is because, the strict criteria in the SIS Regulations requires the trust must not:
• have any borrowings or charges (eg, a mortgage) on the trust’s assets;
• lease any property to a related party apart from business real property; or
• invest in any other entity (eg, the trust must not own shares in a company).

An SMSF can also acquire further units in a unit trust from a related party without infringing s 66 of SISA provided the exception in s 66(2A) is satisfied. There may also be stamp duty savings on the transfer of units if the value of the property owned by the unit trust falls below the landholder threshold of the relevant State or territory (eg, $2 million in NSW and $1 million in Victoria).

However, care needs to be taken to ensure the unit trust complies with SIS Regulation 13.22C and an event that is in SIS Regulation 13.22D is not invoked. An event in SIS Regulation 13.22D can result in the units becoming IHAs. Broadly, where the regulations are contravened by a NGUT (eg, the NGUT borrows money or buys shares in a company), the asset (being the units) owned by the SMSF will typically need to be disposed of by the SMSF within 12 months of the end of the financial year to the extent the units cause the SMSF to exceed the 5% IHA limit. Such a disposal may not always be ideal and could give rise to significant transaction costs.

Broadly, a NGUT is a specific structure recognised by SIS Regulations which will overcome the IHA prohibition in SISA as it is expressly permitted under s 71(1)(j) and SIS Reg 13.22C, provided the following conditions are satisfied and continue to be satisfied on an ongoing basis (SIS Regulation 13.22C and 13.22D):
• The SMSF has fewer than 5 members.
• The NGUT must not borrow or have any loans to other parties or any unpaid present entitlements (‘UPEs’) – the ATO considers that a UPE owing to a unitholder constitutes a borrowing by the unit trust trustee (refer to SMSFR 2009/3). In particular, each UPE should be paid within 9-10 months of the end of each financial year).
• The NGUT generally must not be involved directly or indirectly in a lease with a related party of the SMSF unless the lease is in relation to business real property, reflects arm’s length terms and is legally binding.
• The NGUT must not conduct a business and must not hold trading stock. Where a NGUT is undertaking a property development, this test can easily be contravened if the unit trust develops and sells a property in a short-time frame and regularly undertakes similar activities. Even a one-off isolated development can constitute a business.

Unrelated unit trust
If an SMSF invests in a unit trust that is not a related trust, the SMSF is not limited in how much of the fund’s assets could be invested in such a trust.
For example, an SMSF with a $1,000,000 of assets could invest the entire $1,000,000 in an unrelated unit trust as the trust is not a related party. (The SMSF’s investment strategy must still allow for cash flow and liquidity and may therefore hold some of its assets in cash or deposits to pay for ongoing costs of pension payments, etc). Under this scenario, the SMSF would not have control, nor significant influence in respect of the unit trust and therefore the 5% IHA limit would not apply.
It is possible to structure an investment in property that involves two unrelated SMSFs (where each family are not related nor in a close business relationship such as a partnership) so that each fund holds exactly 50% of the units. The ATO has confirmed that a 50%/50% unitholding arrangement would nit, by itself, give rise to a related trust relationship.
It should be noted, however, that the ATO has broad powers and unless this type of 50%/50% arrangement was carefully implemented and documented, it could result in a contravention of SISA with significant penalties. The constitution of the corporate trustee may, for instance, provide a casting vote to a chairperson that can give rise to a related trust relationship. For this reason, it is generally much safer to have, for example, three unrelated SMSFs undertaking such an investment with, say 33.3% units each. This would not give rise to a related trust relationship.
Thus, where say two or more unrelated investors wish to combine their investments in a common structure such as a unit trust, this could provide a good structure for aggregating such investments between two or more SMSFs that are not ‘grouped’ together under the IHA rules in part 8 of the SISA.
One example, may be three SMSFs with $333,334 each combining together to invest in a unit trust to acquire a $1,000,000 investment property.

Tax treatment
Unit trusts are generally not subject to tax provided the trustee of the relevant unit trust distributes all its net income (including any net capital gain) prior to 30 June each financial year. Trusts therefore are often referred to as flow through structures.

However, if a unit trust is not investing in property primarily for rental, then the unit trust can be taxed on a similar basis to a company. Broadly, a company is taxed at a 30% tax rate and the tax paid by the company can be passed on to a shareholder by way of a franking credit offset. Individual shareholders and SMSFs can offset these ‘franking credits’ against their tax payable. In the case of an SMSF in pension mode, an SMSF trustee can also obtain a refund of franking credits.  Thus, even though a unit trust may be taxed as a company, there may be no significant loss of tax efficiency but the timing of the tax payable and cash flow to an investor changes.

An example where a unit trust is typically taxed as a company is where a unit trust is conducting a property development activity and more than 20% of units in that trust are owned by an SMSF. In the case of a unit trust conducting a property development to sell its apartments for profit, the unit trust is not investing in land primarily for rental. Thus, the tax rules tax the trustee of the unit trust on a similar basis as the corporate tax system.

Proposed changes to this tax treatment however are under way. Exposure draft Tax Laws Amendment (New Tax System for Managed Investment Trusts) Bill 2015 (‘ED Bill’) will impact on the tax treatment of unit trusts that are currently taxed as companies under div 6C of the Income Tax Assessment Act 1936 (Cth) (‘ITAA 1936’).

Currently, under div 6C, the 20% tracing rule for public trading trusts broadly specifies that if exempt entities (such as an SMSFs) holds more than 20% interests in a trust, the unit trust can be a public trading trust (‘PTT’) and taxed as a company unless the unit trust invests in real estate primarily for rental income or a range of passive investments such as financial instruments and securities.

The ED Bill will amend div 6C so that membership interests held in a trust by tax exempt entities and complying superannuation entities which are entitled to a refund of franking credits will be disregarded for the purposes of applying the 20% tracing rule. In particular, s 102MD of the ITAA 1936 currently includes complying superannuation funds in the definition of an exempt entity. However, the revised s102MD in the draft legislation provides:

For the purposes of this Division, treat an exempt institution that is eligible for a refund (within the meaning of the Income Tax Assessment Act 1997) as not being an exempt entity.

Thus, SMSFs will no longer be included in the tracing rule once the ED Bill is passed as law. This should result in unit trusts with SMSF investors not invoking div 6C. Therefore, for example, a unit trust that is owned by an SMSF that owns real estate that is primarily used for development purposes (rather than only rental income) will not be taxed as a company when the proposed ED Bill is finalised as law.

The ED Bill will have a number of ramifications as some existing PTTs will exit the corporate tax environment shortly after the legislation is finalised and there may be limited transitional time to utilise available franking offsets.

The changes once enacted will also reduce the need for SMSFs to claim refunds of franking offsets where PTT distributions are received by an SMSF in pension mode.

This will make unit trusts an even more attractive investment structure given that there are many other areas to refine.

Unit trusts are a popular structure for holding investments in. There are a number of unit trust strategies that allow SMSFs to invest in. It is important that the various rules are clearly understood to make sure any investment by an SMSF in a unit trust is compliant and effective.

This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.

For more advice on Self Managed Super Funds, contact us at Leenane Templeton on 02 4926 2300

Article provided by Daniel Butler DBA Lawyers

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