National SMSF Conference 2013

Transcription

1 National SMSF Conference September 2013, Melbourne M8 Putting unit trusts in SMSFs under the microscope Presented by: Craig Day Senior Technical Manager Commonwealth Bank of Australia Wealth Management Advice

2 Disclaimer This paper represents the opinion of the author(s) and not necessarily those of The Institute of Chartered Accountants in Australia (the Institute) or its members. The contents are for general information only. They are not intended as professional advice - for that you should consult a Chartered Accountant or other suitably qualified professional. The Institute expressly disclaims all liability for any loss or damage arising from reliance upon any information in these papers. Disclaimer The information contained in this update is based on the understanding Colonial First State Investments Limited ABN , AFS Licence has of the relevant Australian laws as at 1 August As these laws are subject to change you should refer to our website at colonialfirststate.com.au or talk to a professional adviser for the most up-to-date information. The information is for adviser use only and is not a substitute for investors seeking advice. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), no person, including Colonial First State or any other member of the Commonwealth Bank group of companies, accepts responsibility for any loss suffered by any person arising from reliance on this information. This update is not financial product advice and does not take into account any individual s objectives, financial situation or needs. Any examples are for illustrative purposes only and actual risks and benefits will vary depending on each investor s individual circumstances. You should form your own opinion and take your own legal, taxation and financial advice on the application of the information to your business and your clients. 2

3 Introduction One of the perceived advantages of Self-Managed Superannuation Funds (SMSFs) is the level of control and flexibility they offer trustees and members. Importantly, trustees can utilise this additional control to invest the fund s assets into unit trust structures. However, with additional control comes additional responsibility and trustees and their advisers investing an SMSF s assets in a unit trust structure need to understand a range of issues to ensure the fund will continue to comply with the Superannuation Industry (Supervision) Act 1993 (SIS Act) and the Income Tax Assessment Act (ITAA) This paper will examine these issues and explore how unit trust investments can be used in the context of an SMSF. Specific topics discussed will include: The in-house asset rules and related trusts Exceptions to the in-house asset rules Pre 99 trust arrangements and their uses Unit trusts and unpaid present entitlements Taxation of unit trust income 3

4 The in-house asset rules and related trusts Under section 71 of the SIS Act an investment in a related trust is included in the definition of an in-house asset and will therefore be subject to the in-house asset restrictions, unless a specific exemption applies. It is therefore important to understand when a unit trust will be a related trust. Related trusts A related trust is defined in section 10 of the SIS Act to include a trust that a member or standard employersponsor of the fund controls within the meaning of section 70E of the SIS Act. What is a standard-employer sponsor? A standard employer sponsor of a fund is defined in section 16 of the SIS Act as an employer who contributes (or who would contribute) to the fund under an arrangement between the employer and the trustee of the fund. An example of a standard employer sponsored fund would be a corporate super fund. Therefore, unless there is an arrangement between the trustee of an SMSF and an employer who contributes to the fund, an SMSF will generally not have a standard employer sponsor 1. Meaning of control The circumstances in which an entity will control a trust are outlined in section 70E(2) of the SIS Act. These include where: A group in relation to the entity has a fixed entitlement to more than 50% of the capital or income of the trust, or 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), or A group in relation to the entity is able to remove or appoint the trustee, or a majority of the trustees, of the trust. A group in relation to an entity is further defined to include the entity acting alone, or together with one or more of their associates, or two or more associates of the entity acting alone or together. 1 Note - under section 70A of the SIS Act, the ATO can determine a person who is not a standard employer sponsor of a fund to be one. In this situation the ATO must notify the trustee of the fund in writing of that determination. 4

5 Who is an associate? The members of a group in relation to an individual are defined in section 70B of the SIS Act to include 2 : A relative of a member 3 The other members of the SMSF The non member trustee (or non member director of a corporate trustee) of a single member SMSF A partner (and their spouse and child) of a member and a partnership in which the member is a partner 4 A trustee of a trust where the member controls that trust A company that is sufficiently influenced by, or in which a majority voting interest is held by: a member another entity that is an associate of the member two or more associates of a member. Therefore, whether a trust will be a related trust of an SMSF requires a careful examination of the governing rules of the trust as well as the relationship between any persons that have a direct or indirect interest in the trust, or that are able to direct the trustees of the trust. For example, a unit trust would be a related trust of an SMSF where: A member had a fixed entitlement to 55% of the income of the trust A member s spouse had a fixed entitlement to 50% of the capital of the trust and has been appointed as the sole appointer under the trust deed of the trust A member s brother and sister together own 100% of the units in the trust The SMSF had a fixed entitlement to 51% of the income and capital of the trust 5 A discretionary trust, of which the member s spouse is the appointer, owns 65% of the units in the trust 6 A member owned 50% of the units in the trust and the other 50% was owned by a friend of the member who also owned a commercial property as tenants in common with the member The trustee of the trust is under an informal obligation to act in accordance with the directions, instructions or wishes of the members of the SMSF. Restrictions on related trust investments Under section 66(2A) of the SIS Act, a trustee of a complying super fund is prohibited from investing in a related unit trust unless the units were acquired at market value and would not cause the level of the fund s in-house assets to exceed 5% of the market value of the fund s assets. 2 Note if the fund has a standard employer sponsor that is a company or a partnership, the associates of those companies or partnerships are defined in sections 70C and section 70D of the SIS Act. 3 In relation to a member, a relative includes: - parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant or adopted child of the member or of their spouse - the spouse of the member or of any of the above individuals. 4 Partnership is defined in section 70E of the SIS Act to have the same meaning as the ITAA 1997 includes entities that derive income jointly 5 The trustee of an SMSF will generally qualify as an associate of the members and therefore its interest in the trust is included in the control test. 6 I.e. the discretionary trust is an associate of the member as the member is deemed to control the discretionary trust as their spouse is the appointer of the trust. 5

6 Where the trustee of an SMSF has acquired units in a related trust under this rule it must then determine the market value of those units plus any other in-house assets at the end of each financial year. Where the total market value of the fund s in-house assets exceeds 5% of the value of the fund s assets the trustee must then enter into a written plan, and carry out the plan, to dispose of the excess amount by the end of the following financial year. Therefore, a trustee could invest up to 5% of the market value of fund s assets in a related trust. However, this level of investment would generally be impractical in most circumstances and would require ongoing monitoring. Unrelated trusts and their uses Where a unit trust would not otherwise be a related trust of an SMSF under the above definition, an SMSF is able to invest in that trust without the in-house asset rules applying. However, it is important to note that this is subject to any investment restrictions included in the governing rules as well as the other SIS investment rules. For example, while a trustee could generally invest directly in an unrelated trust it could not acquire the units in the trust from a related party, such as a member of the fund, under the acquisition of assets from related party rules unless an exemption applies. Common examples of SMSFs investing in unrelated trusts include: SMSFs investing in public offer managed investment schemes operated via a unit trust structure SMSFs investing in private unit trusts with otherwise unrelated parties as part of a property syndicate. Investments in managed funds Investing in managed funds is probably the most common use of unit trust structures by SMSFs. While it may seem incongruous for SMSF trustees wanting to maintain control over the fund s investment decisions to outsource those decisions to a fund manager there are a number of reasons why this could make sense for an SMSF. These include: Allowing diversification with a small amount where the fund has otherwise invested a large proportion of the fund s assets into a single asset, such as a real property To get the benefit of professional investment management in asset classes that the trustee has limited investment knowledge or experience, such as global shares To access alternative asset classes that are otherwise unavailable to direct investors, such as infrastructure investments and managed futures To get exposure to geared investment returns on Australian and global shares by investing in internally geared managed funds. Managed funds and acquiring assets from related parties Under the superannuation investment rules a trustee of an SMSF will generally be able to invest in a managed fund on the basis that it will not be a related trust. In addition, under section 66(2A) of the SIS Act, a trustee of SMSF is permitted to acquire units in a managed fund from a related party, such as via an in-specie contribution from a member, where the fund satisfies the definition of a widely held trust. 6

7 A widely held trust is defined as a unit trust in which entities have fixed entitlements to all of the income and capital of the trust and no 20 entities between them have fixed entitlements to 75% or more of the capital or income of the trust. For the purposes of the in-house asset definition, an entity and their associates are treated as a single entity. For example, most large retail managed funds would generally qualify as a widely held trust as the top 20 unit holders would generally hold much less than 75% of the units in the trust between them. However, where a member or other related party holds units in a wholesale managed fund, trustees should exercise caution as some wholesale funds may not satisfy the definition. For example, it is not uncommon for a small group of less than 20 institutional investors to hold more than 75% of the units in a particular trust between them. In this situation, a member holding units in that trust would not be able to transfer their units directly to their SMSF, as the widely held trust exemption would not apply. Investments in private unrelated unit trusts The other main use of unit trusts is for an SMSF to directly invest into a private unit trust with a number of other unrelated parties. In this case, so long as the fund did not hold fixed entitlements to more than 50% of the income and capital of the trust, and that none of the members or their associates are able to control the trust, the investment in the trust would be exempt from the in-house asset restrictions. For example, this could allow two or more otherwise unassociated SMSFs to form a syndicate to acquire a property, including via the use of borrowing. Example 1 Un-associated business partners Jake, Lilly and Hanna are all medical specialists in different fields and are not otherwise associates of each other. They each have their own single member SMSF with a sole purpose corporate trustee of which they are the sole shareholder and director. They have decided to pool their collective retirement savings and to borrow to purchase a commercial property. Jake, Lily and Hanna then intend to turn the building into a medical centre and would lease parts of the building back to themselves as well as to other unrelated medical health service providers. Jake, Lilly and Hanna establish a separate unit trust of which they each become a trustee. Under the unit trust s governing rules Jake, Lilly and Hanna each have one vote on any issue and are all appointers of the trust and can only remove and or appoint a trustee by way of a unanimous resolution. Jake, Lilly and Hanna s SMSFs each then invest $250,000 in the trust and are issued two units in the trust each (6 in total). As trustees of the unit trust they then arrange for the unit trust to borrow $250,000 to acquire the commercial property valued at $1 million. An outline of the structure is shown at Diagram 1. 7

8 Diagram 1 the Jake, Lilly and Hanna unit trust 2 units Lilly s SMSF $250k Bank loan $300k Jake s SMSF $250k 2 units JLH Unit Trust $250k 2 units Hanna s SMSF Commercial property $1m In this situation, the JLH unit trust would not be a related trust of any of the SMSFs on the basis that Jake, Lilly and Hanna are not related parties of each other and therefore a group in relation to the members of each fund: Does not hold fixed entitlements to more than 50% of the capital or income of the trust 7 Does not have the ability to effectively control the other trustees of the unit trust Is not able to remove and or appoint the trustee of the unit trust or a majority of the trustees of the unit trust. As a result, the trustees of each SMSF will be permitted to acquire the units in the unit trust and will not be subject to the 5% in-house asset limit. Practical compliance issues Although an investment in an unrelated trust, as outlined in the above example, would not be an in-house asset of the respective SMSFs, the trustees would need to take care with any changes in ownership proportions over time. For example, if Jake decided to sell his SMSF s interest in the trust, the corporate trustee of Lilly and Hanna s SMSFs could each acquire one of Jake s SMSF s units in the trust. In this situation, the trust would still not be a related trust of Lilly and Hanna s SMSFs as a group in relation to either Hanna or Lilly (which would include the corporate trustees of their respective SMSFs) would not have a fixed entitlement to more than 50% of the income or capital of the trust and would not otherwise be able to control the trust. However, if the corporate trustee of Hanna s fund were to acquire both of Jake s SMSF s units in the trust, a group in relation to Hanna (which would include the corporate trustee of her SMSF), would end up holding a fixed entitlement to more than 50% of the trust s income and capital. Therefore, the units in the trust would become an in-house asset of her fund and would be subject to the 5% limit. To avoid these situations it may be 7 Note a group in relation to each member includes the corporate trustee of their respective SMSFs as each member holds 100% of the shares in the corporate trustee. 8

9 beneficial to enter into some formal agreement specifying what is to happen in the event that one of the parties wishes to dispose of their unit in the trust prior to entering into the arrangement. It is also important that any of the un-associated parties involved in an unrelated trust arrangement do not subsequently acquire assets together as either joint tenants or tenants in common as that would cause them to become partners under the tax law 8 and therefore associates of each other. For example, using the above case study, if Lilly and Hanna decided to acquire a property as tenants in common together they would become tax law partners and therefore associates of each other. In this case, the trust would then become a related trust as each corporate trustee s interest in the trust would be combined for the control test. Trustees also need to take care to ensure they invest in the trust by acquiring units directly from the trustees of the trust or from unrelated parties. Where the units in the trust are held by a related party, such as a member of the fund, the SMSF trustee will not be permitted to acquire those units under the acquisition of assets from related party rules unless the trust qualifies as a widely held trust. It is also important to note that such unrelated trust structures can also be used to allow SMSFs to participate in property development activities. However, if the developments activities were undertaken for the purpose generating profits from the eventual sale of the properties and not for the purpose of generating lease income, the unit trust would generally be classed as a public trading trust and would be taxed as a company. See taxation of unit trusts section below. Anti-avoidance provisions It is also important to note that special anti-avoidance provisions are included in section 71(2) of the SIS Act to ensure that the in-house asset rules cannot be avoided through investments in inter-posed entities. For example, an investment in an unrelated trust would be deemed to be an in-house asset where the investment was made as a result of an agreement being entered into which then resulted in an investment being made in a related trust of the fund. Therefore, the ATO will effectively be able to look through any such agreements to deem a trust that would otherwise not be a related trust to be a related trust and therefore an in-house asset of the fund. 8 TR 93/32 Income tax: rental property - division of net income or loss between co-owners 9

10 Exceptions to the in-house asset rules Under section 71 of the SIS Act certain investments by an SMSF in a unit trust are specifically excluded from being an in-house asset. These include: Investments in widely held trusts Investments in a related trusts that meets the requirements as specified in Division 13.3A in the SIS Regulations. Widely held trusts Under section 71(1)(h) an investment in in a trust that was a related trust would be exempt from the in-house asset rules where it was a widely held trust. As previously outlined, a widely held trust is defined as a unit trust in which entities have fixed entitlements to all of the income and capital of the trust and any 20 entities between them do not have fixed entitlements to 75% or more of the capital or income of the trust. For the purposes of the in-house asset rules an entity and their associates are treated as a single entity. Due to the definition of a widely held trust it would be unusual for a trust that was a related trust to also qualify as a widely held trust as it would generally require the fund to have a lot more than 20 members. Note special rules apply to also allow an SMSF to acquire units in a widely held trust from a related party, such as via an in-specie contribution of units from a member. See the restrictions on related trust investments section above. Related trusts that meet the requirements of Division 13.3A in the SIS Regulations Under section 71(1)(h) an investment by an SMSF in a related unit trust will be exempt from the in-house asset rules where the trust satisfies the requirements listed in SIS Regulation: SISR 13.22B where the investment was made prior to 28 June 2000 SISR 13.22C where the investment was made on or after 28 June 2000 Therefore, for an investment in a related unit trust made on or after 28 June 2000 to be exempt from the inhouse asset rules the unit trust must satisfy the requirements of SIS Regulation SISR 13.22C as follows: The trustee of the unit trust must not be party to a lease (or legally binding lease arrangement) with a related party of the fund, unless the lease relates to business real property 9 The trustee of the unit trust must not have any outstanding borrowings The assets of the unit trust must not include: an interest in another entity including a share in a company or a unit in another trust 9 Including both directly and indirectly via a series of interposed entities. 10

11 a loan to another entity unless the loan is a deposit with an authorised deposit-taking institution within the meaning of the Banking Act 1959 an asset over, or in relation to, which there is a charge an asset (other than money) that was acquired from a related party of the fund after 11 August 1999, unless the asset was business real property acquired at market value an asset (other than money) that had (at any time) been owned by a related party of the super in the previous three years, unless the asset was business real property acquired at market value. SIS Regulation SISR 13.22D also confirms that the exemptions in SISR 13.22B and SISR 13.22C will cease to apply where either: The trustee of the unit trust fails any or the requirements in regulation SISR 13.22B or SISR 13.22C (whichever is relevant) The trustee of the unit trust conducts a business The trustee of the unit trust conducts a transaction otherwise than on an arm's length basis The SMSF ends up with more than 4 members due to the admission of additional members. In addition, regulation SISR 13.22D also confirms that once regulation SISR 13.22C ceases to apply, the units in the trust will never again be able to be exempt from the in-house asset rules. For example, where the trustee of the unit trust entered into a transaction that caused the trust to fail the requirements the trustee would not be able to rectify the breach by selling the share. In this case, the SMSF trustee would then be required to treat the units as an in-house asset and may be forced to dispose of them should the fund s level of in-house assets exceed the 5% limit at the end of the financial year. SISR 13.22C trust traps It is important to note that under the SISR 13.22C requirements the trustee of the unit trust must not hold: An interest in another entity or A loan to another entity, unless the loan is a deposit with an authorised deposit-taking institution within the meaning of the Banking Act This means the trustee of the SISR 13.22C trust will generally be limited to holding direct property and money in an Australian bank account only. For example, the ATO has confirmed 10 that where a SISR 13.22C trust acquired a share in a listed company or a unit in a trust, it would hold an interest in another entity and the exemption to the in-house asset rules would cease to apply. Also, given that a deposit to a bank account actually represents a loan to the relevant bank, if a trustee of a SISR 13.22C trust deposited money to a foreign bank account the trust would be deemed to have loaned money in a way that is not permitted under the rules and the exemption would cease to apply. 10 ATO ID 2008/51 - Self managed superannuation fund: Division 13.3A of SIS Regulations - interest in another entity - units in a unit trust and ATO ID 2008/52 - Self managed superannuation fund: Division 13.3A of SIS Regulations - interest in another entity - listed company shares 11

12 The trustee of the SISR 13.22C trust also needs to ensure that it: Conducts all transactions on a commercial arm s length basis Does not carry on any activities that could be considered to involving carrying on a business Does not allow a charge of any kind to be given over an asset of the trust. Uses of SISR 13.22C trusts Under section 66(2A) of the SIS Act a trustee of a complying fund will be permitted to acquire units in a related trust that complies with Regulation SISR 13.22C (a SISR 13.22C trust). This also includes acquiring the units in a SISR 13.22C trust from a related party, such as a member of the fund. Therefore, a trustee of an SMSF can invest up to 100% of the fund s assets in a SISR 13.22C trust. However, given the strict rules and the limitation on holding investments in other entities, a SISR 13.22C trust arrangements can generally only be used as part of a strategy involving property. Some of these strategies are summarised as follows. As an alternative to purchasing assets with a related party as tenants in common Under the SIS investment rules a trustee of an SMSF is permitted to acquire an asset as tenants in common with a related party, so long as the asset is not then leased back to a related party (other than if a business real property). However, acquiring assets as tenants in common with a related party has several disadvantages. These include: Where the SMSF and a related party held property as tenants in common, the trustee of the SMSF would be prohibited from subsequently acquiring the member s interest in the property, unless it was business real property Where the SMSF wished to acquire related party s ownership interest in a business real property, it would need to arrange for a property conveyance for each transfer. Alternatively, the SMSF trustee and related party could arrange acquire units in an interposed SISR 13.22C trust established for the purpose of acquiring the property. In this case, the trustee of the SMSF could then simply acquire the units in the trust. Example 2 Alternative to tenants in common strategy Dean and Kim are the trustees and members of their SMSF. The SMSF has total assets of $800,000 but Dean and Kim have identified a property that they would like to acquire for $1m. Dean and Kim have the cash available and could afford to contribute the additional $200,000 to allow the fund to acquire the asset, however they don t want the $200,000 to be preserved until retirement and they don t want the fund to borrow. In this situation, instead of Dean and Kim acquiring the property as tenants in common with their SMSF they could establish a SISR 13.22C trust and then arrange for their fund and themselves to each invest the required amount to allow the trust to acquire the property. This structure is demonstrated in Diagram 2. 12

13 Diagram 2 Property acquisition via investment in SISR 13.22C trust D&K SMSF $800k SISR 13.22C $200k trust Dean and Kim Property $1million The benefits of this strategy are as follows: It has allowed Dean and Kim to acquire the property without having to borrow and without needing to contribute to the fund and have their contributions preserved until retirement As trustees of their fund Dean and Kim could arrange to acquire their units off themselves as their SMSF could afford to do so regardless of the nature of the property and without needing to change the legal ownership of the property. Alternatively, Dean and Kim could arrange to transfer their units their units to their SMSF as in-specie contributions over time, if they so wished. The strategy would generally be much simpler cheaper to implement than establishing an LRBA. The disadvantage of this strategy is that the whole of the property will not effectively be held within the concessionally taxed superannuation environment, which they could have achieved had their fund acquired the asset using an LRBA. Trustees and members wishing to transfer their units in the trust to their SMSF over time also need to take into account any potential capital gains tax implications as well as any indirect taxes, such as state government stamp duty. For example, landholder duty could apply to the transfer of units in a trust where the trust s assets include property and the acquisition exceeds certain thresholds 11. To facilitate the purchase and improvement of a property In general the trustee of an SMSF is able acquire direct property with the intention of conducting improvements to increase the value of the property. However, depending on the circumstances an SMSF may have insufficient financial resources to do both. In this situation, the trustee could consider borrowing via an LRBA to purchase the property and then using the fund s own cash reserves to improve the property 12. However, this may not be possible where the improvements would result in a fundamental change in the character of the asset and result in a non-allowable replacement asset under the LRBA rules. For example, a trustee would not be permitted to use the fund s own cash resources to subdivide a vacant block of land and construct multiple dwellings on the different blocks 11 For more information on see the stamp duty laws for the relevant state. 12 Note LRBA rules do not allow a borrowing to be used to improve a property acquired with a borrowing 13

14 under an LRBA as this would result in a fundamental change in the character of the original asset from a single block of vacant land to multiple residential properties. Alternatively, the SMSF trustee could arrange to purchase the property via a SISR 13.22C trust arrangement and then arrange for a related party, such as a member, to acquire additional units which would then provide the additional capital to allow the trustee of the unit trust to carry out any improvements or developments. The member could then continue to hold their units or transfer them to their fund over time via either a sale arrangement as their fund could afford to acquire them or as an in-specie contribution. Note this strategy requires the members to have the required funds to be able to invest in the trust. Alternatively, they could arrange to borrow to acquire their units in the trust however they would need to have other assets they could use as security. For example, the lender would not be permitted to take security over the property acquired in the trust as otherwise the trust would fail the SISR 13.22C requirements and the inhouse asset exemption that applies to the units in the trust would cease to apply. To facilitate improvements to a property under an LRBA Under the limited recourse borrowing rules in section 67A of the SIS Act a trustee is will not be permitted to use a borrowing to: Acquire multiple assets unless the assets are distinctly identifiable as a single asset Fund any improvements to the property In these situations, a trustee could consider establishing multiple trust arrangements or using the fund s own cash reserves to improve a property. However, this may not be viable due to the cost of setting up multiple LRBAs or the lack of additional funds which could be used to improve a property. As an alternative, a trustee could establish an LRBA and use the borrowed monies to acquire a collection of units in a SISR 13.22C trust. In this case, the collection of units will qualify as a single acquirable asset where they are purchased and sold as a whole. The trustee of the SISR 13.22C trust could then use the capital of the trust to purchase multiple assets, such as land on multiple titles, or to improve a property. The structure of such a borrowing arrangement is represented in Diagram 3. 14

15 Diagram 3 LRBA used to acquire units in SISR 13.22C trust Multiple properties Cash Lender Security SISR 13.22C Trust Limited recourse loan SMSF Holding (Bare)Trust In this situation, the borrowing would be permitted as the borrowed funds will have been used to acquire a single acquirable asset being the collection of units in a SISR 13.22C trust. Also any changes or improvements to the properties would not create a non-allowable replacement asset under the LRBA rules as the character of the asset acquired with the borrowing, i.e. a collection of units in the SISR 13.22C trust, has not changed. However, from a practical perspective it may be difficult for an SMSF trustee to obtain finance for this type of arrangement as a bank or other third party lender would generally not be willing to take a security over the units in the SISR 13.22C trust. And the trustee of the unit trust would not be permitted to allow a charge over any assets of the trust; otherwise the SISR 13.22C exemption would cease to apply. Alternatively, the ATO has confirmed 13 that an SMSF trustee can borrow from a related party as part of an LRBA and that the fund will not breach the non-arm s length rule in section 109 of the SIS Act where the loan is on terms more favourable to the SMSF. For example, this could allow a member to lend to the fund without needing to take security over any assets. Alternatively, a member could borrow from a third party lender where they have other assets that they can offer as security and then on lend to their SMSF. In addition, the ATO has publically expressed the view 14 that a related party lender could charge a zero or below market interest rate to the fund and that the under payment of interest would not: Give rise to a contribution to the SMSF, or Result in contravention of the SIS Act, or Give rise to non-arm s length income under the ITAA 1997 or invoke Part IVA of the ITAA ATO Interpretative Decision ATO ID 2010/ National Tax Liaison Group meeting December

16 However, to be certain that any under payments of interest would not give rise to any adverse compliance or taxation outcomes in relation to a particular fund s circumstances, the trustees may wish to consider applying for a private ruling to confirm this. Practical issues It is important to note that linking an LRBA arrangement with an investment in a SISR 13.22C trust is complex and involves multiple entities being required to satisfy different sets of very strict rules to be complying. Trustees and their advisers therefore need to have a very good understanding of all the rules involved to ensure they do not enter into any transaction that would otherwise cause the fund to fail the LRBA rules or the SISR 13.22C trust requirements. In addition, it is important to ensure that any property development activities carried on within the trust do not constitute the carrying on of a property development business otherwise the exemption under regulation SISR 13.22C will cease to apply. Finally, where a member of an SMSF borrows and then on lends to their SMSF under an LRBA, the interest will only be deductible to the extent that the loan amount is then used to derive assessable income 15. For example, where a member borrowed from a bank at 6% interest and then on lent the loan amount to their SMSF at a 3% interest rate, only 3% of the member s interest expense would be deductible. 15 Ure v FC of T (1981) 11 ATR

17 Pre 1999 trust investments Prior to August 1999, the definition of an in house asset was limited to a loan to or an investment in, a standard employer sponsor. As a result, there was a perception that many SMSFs were dealing with non arm s length parties, such as members, and that many trustees were investing in related unit trusts to facilitate geared investments. For example, prior to August 1999, a common strategy employed by SMSF members wanting to gear the fund s investments was to set up a separate unit trust with themselves acting as trustee and then to arrange for their SMSF to acquire 100% of the units in that trust. The unit trust would then enter into a geared investment strategy, effectively allowing the fund to circumvent the SIS borrowing restrictions. To close this loop hole the Government introduced legislation on 11 August 1999 to extend the definition of an in house asset to cover a range of transactions with a related party, including investments in controlled companies and trusts. This effectively limited the ability of an SMSF to carry out any investment transactions with a related party, such as to invest in a related unit trust, to a level (5%) that would make them impracticable in most circumstances. However, to avoid the new in house asset definition applying retrospectively to pre-existing arrangements, the Government included a number of grandfathering provisions to exclude certain assets that were not an in-house asset previously from ever being an in-house asset. These included: A share in a company or unit in a unit trust, if the share or unit was acquired on or before 11 August 1999, or that was acquired after 11 August 1999 under a legally binding contract that was entered into before 11 August , and Any additional investments into the company or trust acquired after 11 August 1999 and up to and including 30 June 2009 that represent a reinvestment of trust distributions from the pre 11 August 1999 investment plus any earnings on those reinvestments, or Additional investments in the company or trust acquired after 11 August 1999 and up to and including 30 June 2009 where the additional investment did not exceed the level of debt held by that company or trust as at 11 August It is important to note that under the rules a trustee could elect to reinvest the fund s trust distributions or make additional investments up to the value of the outstanding debt as at 11 August 1999 not both. Where a trustee wished to make additional investments up to the value of the debt in the trust they needed to make an election by 23 December For example, where a trustee of an SMSF held units in a related trust on 11 August 1999, and as at that date the trustee of the unit trust had outstanding borrowings of $100,000, the units held by the trustee of the SMSF in the unit trust are permanently excluded from being an in-house asset of the SMSF, and either: 16 Note - If an SMSF held partly paid shares in a company or units in a unit trust prior to 11 August 1999, the trustee could also pay up any unpaid capital on those shares or units up until 30 June 2009 and those units will also be excluded from being an in-house asset. However, where payments on partly paid shares or units were made after 30 June 2009, the aggregate payments on the share or unit that were made after 30 June 2009 will be in house assets and will count towards the 5% in house asset limit. 17

18 Any additional units acquired after 11 August 1999 and up to (and including) 30 June 2009 from the reinvestment of distributions from those units in the unit trust (plus the reinvestment of earnings from those reinvested earnings) are permanently excluded from being in-house asset of the SMSF, or Any additional units acquired after 11 August 1999 and up to (and including) 30 June 2009 up to the value of $100,000 are permanently excluded from being in-house asset of the SMSF (where the trustee made an election by 23 December 2000 for that to apply) Where a trustee acquired additional units in a related trust in a way not covered by the transitional rules, the additional units will be in-house asset and will be subject to the 5% in-house asset limit. Maintenance of Pre 99 trust arrangements Where the trustee holds units in a Pre 99 related trust that are excluded from the in-house assets rules they can continue to hold those units indefinitely. In addition, where the trust has borrowings it can continue to maintain those borrowings as well as take out additional borrowings where it has sufficient cash flow. However, it is important to remember that the in-house asset rules will apply to any units acquired after 30 June Therefore, SMSF trustees will be restricted from reinvesting any trust distributions after that date. Use of Pre 99 trust assets by related parties The SIS Act does not directly apply to the investment activities carried on by the trustee of a unit trust. Therefore, the trustee may be able to enter into transactions with a related party which would be prohibited if they involved the SMSF directly. For example, the ATO has confirmed 17 that the members of an SMSF are able to lease a residential property from a related Pre 99 trust without causing the fund to contravene the in-house asset rules. In outlining its reasons the ATO cited the fact that the lease between the members of the SMSF and the trustee of the unit trust did not come under the definition of an in-house asset as the property was not an asset of the SMSF. However, despite this, it is important to note that where the trustee of a Pre 99 unit trust entered into a nonarm s length transaction with a related party, the SMSFs trustee s continuing investment in the trust could be considered to breach of a range of regulatory provisions, including: The sole purpose test The non-arm s length rules The prohibition of providing financial assistance to a member or a relative of a member, and The investment strategy covenants. For example, in the case of ZDDD v FCT 18, the ATO issued a notice of non-compliance to an SMSF that held units in a Pre 99 unit trust where an interest free loan was made from the Pre 99 unit trust to a member of the fund on the basis that the fund s continued investment in the trust constituted a breach of: The sole purpose test The non-arm s length rules and 17 ATO Interpretative Decision 2002/388: In-House Assets and leasing property from a Unit Trust. 18 ZDDD v FCT [2011] AATA 3 18

19 The prohibition of providing financial assistance to a member or a relative of a member of the fund. Therefore, any transactions between the related parties of an SMSF and the trustee of a related Pre 99 trust must be conducted on an arm s length basis at all times. 19

20 Unit trusts and unpaid present entitlements An Unpaid Present Entitlement in relation to a unit trust is generally an amount payable by a trustee of the trust from a distribution of trust income. Where there is an UPE owing to an SMSF from a related unit trust for a significant sum and payment has not been sought within a reasonable period, the ATO has outlined in an SMSF ruling 19 that such arrangements could result in a breach of the following: The in-house asset rules The non-arm s length rules The sole purpose test. UPEs and the in-house asset rules In relation to the in-house asset rules, the ATO ruling confirms that where a UPE is owing to an SMSF the amount of the UPE could be considered to be a loan from the SMSF to the related trust and therefore an inhouse asset of the fund where: The trustee of the unit trust and the SMSF agree to bring in place a loan arrangement for the amount of the UPE by executing a loan agreement. Where this occurs the distribution will be considered to have been constructively received by the SMSF and the amount loaned back to the trust The non-payment of the trust distribution results in the provision of credit or financial accommodation to the trust by the SMSF. Alternatively, the trustee of the SMSF may enter into an agreement whereby a UPE is converted into additional units or is added to the capital of the fund to increase the value of the SMSFs units. In these situations the ATO ruling confirms that such arrangements would be an additional investment would therefore be subject to the inhouse asset rules. UPEs and SISR 13.22C trusts Where the related trust satisfies the requirements of SIS Regulation of SISR 13.22C, any additional investment in the trust will be excluded from the in-house asset rules under that exemption. However, where the UPE constitutes a loan to the unit trust, the trust will then fail the SISR 13.22C requirement that the trust does not have any outstanding borrowings. In this case, the exemption to the in-house asset rules would cease to apply and all of the SMSF s units in the trust would become in-house assets. 19 SMSFR 2009/3 Self-Managed Superannuation Funds: application of the Superannuation Industry (Supervision) Act 1993 to unpaid trust distributions payable to a Self-Managed Superannuation Fund 20

21 UPEs and the non-arm s length rule and sole purpose test Where an SMSF holds an investment in a related trust, the trustee must be holding that investment on an arm s length basis and in accordance with the requirements of the sole purpose test. Where a trustee of an SMSF has failed to seek the payment of a substantial amount of unpaid distributions from a related trust without proper compensation being paid i.e. a market rate of interest or the issue of additional units in the trust, the ATO ruling confirms that the trustee of the SMSF would not be considered to be maintaining their investment on an arm s length basis. In addition, where the failure to pay any compensation for the non-payment of distributions effectively resulted in a low cost source of capital for the related trust, the ATO ruling also confirms that fund could be considered to have breached the sole purpose test especially where the SMSF was not the sole beneficiary of the trust. For example, in Montgomery Wools v FCT 20, the Administrative Appeals Tribunal affirmed the ATO s decision to issue a notice of non-compliance to an SMSF on the basis that an unpaid distribution from a related unit trust resulted in: A loan from the SMSF to a related trust which breached the in-house asset rules, and Support being provided to a family business which breached the sole purpose test Timely payment of trust distributions To avoid any potential compliance issues associated with unpaid distributions, trustees should seek payment of any distributions owing as soon as reasonable. As a guide this should generally be as soon as possible after the trust s accounts have been finalised for the year and the SMSF s entitlement to its share of the trust s income has been determined. 20 Montgomery Wools Pty Ltd Super Fund and FCT [2012] AATA 61; 2012 ATC

22 Taxation of unit trust income In general, income distributed from a unit trust will be subject to flow through taxation and will retain its character in the hands of an SMSF. As a result, an SMSF will be eligible for concessional tax treatment on the income and capital gains distributed from the trust. However, in certain situations the income of the trust may be taxed at the top marginal rate where it is non-arm s length income. Alternatively, a trust can also be taxed as a company where it meets the definition of a public trading trust. Non-arm s length income Where an SMSF earns non-arm s length income it will be taxed at the top marginal rate of 45%, instead of the concessional superannuation tax rate of 15%. Under subsection (5) of the ITAA 97, the income derived by a super fund through holding a fixed entitlement to the income of the trust will be non-arm's length income where: The super fund acquired the entitlement under a scheme, or the income was derived under a scheme, the parties to which were not dealing with each other at arm's length, and The amount of the income is more than the amount the entity might have been expected to derive if those parties had been dealing with each other at arm's length. In addition, subsection (4) also confirms that any distribution of income to a trustee of a complying super fund from a trustee of a discretionary trust will be non-arm s length income. To provide further clarity around the circumstances in which a superannuation fund will derive non-arm s length income, the ATO released TR 2006/7 21. The tax ruling provides numerous examples of when the distributions from a fixed unit trust will be non-arm s length income. These include where: An SMSF was issued with units in an unrelated trust that conferred a fixed entitlement to the income of the trust for less than their market value but received distributions of income in proportion to its unit holding An SMSF received distributions of income in proportion to its unit holding in a trust but the trust s income was inflated via the distribution of income from a discretionary trust. It is also important to note that where a fund earns not arm s length income under some scheme or arrangement the whole of the income derived under that arrangement will be non-arm s length income. Therefore, the whole amount will be taxed at 45% and not just the amount above what would have been earned if the parties had been dealing with each other on an arm s length basis. SMSF trustees acquiring units in a related or unrelated unit trust should therefore confirm that under the governing rules of the trust all members will have a fixed entitlement to the income of the trust and that: All units acquired by the fund on an arm s length commercial basis i.e. at market value, and 21 TR 2006/7 Income tax: special income derived by a complying superannuation fund, a complying approved deposit fund or a pooled superannuation trust in relation to the year of income 22

23 That all distributions are paid on an arm s length commercial basis. Public trading trusts Where an SMSF holds fixed entitlements to units in a public trading trust, the trust will be taxed as a company. That is, the trust will be taxed at the corporate tax rate and distributions will be taxed like franked dividends. In relation to an SMSF, a trust would be a public trading trust where it meets both of the following conditions: Complying super funds held fixed entitlements to more than 20% of the income and capital of the trust, and It carries on a business other than just carrying on an eligible investment business An eligible investment business generally involves investing in property to derive rent as well as carrying on other passive investment activities, such as investing in shares, bonds, units, loans and other financial instruments. For example, where three unrelated SMSFs each acquired a 1/3 rd share of the units in a unit trust and the unit trust then carried on a property development business; the trust would be a public trading trust and would be taxed like a company. Note, there is a safe harbour provided at least 75% of the trust s gross revenue is derived from rent as long as the remaining gross revenue is not derived from carrying on a business that is not incidental and relevant to renting land. 23