Tag Archives: unit trusts

Investing in real estate with a SMSF – traps & entanglement

There is more to investing in real estate together with a self managed superannuation fund (SMSF) than meets the eye. It can be fraught and illegal under SMSF rules. This blog looks at why.

Joint tenancy ownership compared to ownership by tenants-in-common

The title of this blog piece does not refer to investing jointly with a SMSF and this is deliberate. Co-ownership of land can be joint: viz. as joint tenants, where a surviving joint owner or owners take the interest of a joint owner who dies, or can be as tenant/s-in-common (TsIC) where each co-owner owns a discrete co-ownership interest in a fixed proportion of the whole outright ownership interest in the land which, in the case of an individual on his or her demise, will form a part of his or her estate just as an interest in land owned by a sole individual owner would.

Which type of ownership works where a (trustee of a) SMSF is a co-owner?

Joint tenancy is usually only appropriate for life partners. Investing in a joint tenancy can also work for joint trustees of a trust where, on the death of a trustee, it is appropriate that the property be legally owned by surviving trustee/s.

The point here is joint tenancy is inapt and inappropriate investing between a member of a SMSF and the SMSF obliged to deal on arm’s length basis under section 109 of the Superannuation Industry (Supervision) Act (C’th) 1993 (SIS Act) with all parties including the member when co-ownership of an asset is under contemplation. A SMSF needs to acquire assets at arm’s length and assets acquired need to have a discrete integrity which joint tenancy ownership doesn’t give.

So, if there is to be co-ownership between members or related parties and a SMSF investing in land, it needs to be as TsIC.

Related parties of a SMSF include:

relatives of the Members (spouse, children, siblings, etc.);
the (business) partners (Partners) of the Members;
the spouse and children of the Partners;
companies (Companies) controlled by the Members or any of the above (Associates);
the members of the SMSF (Members) themselves; or
trusts controlled by the Members, Associates and Companies.

(See Part 8 associates in Sub-division B of Part 8 of the SIS Act.)

Co-ownership of land between SMSF members and the SMSF as tenants-in-common

There is a further trap where SMSF members or other related parties and a SMSF contemplate co-ownership of land as TsIC where the land is residential property (RP):

Prohibition on acquisition of assets from superannuation fund members and related parties

With very limited exceptions, real estate with a residence cannot be business real property (BRP): see Self Managed Superannuation Funds Ruling SMSFR 2009/1 Self Managed Superannuation Funds: business real property for the purposes of the Superannuation Industry (Supervision) Act 1993. A SMSF cannot acquire an asset from a related party of the SMSF (section 66(1) of the SIS Act) unless an exception applies such as the exception for BRP (permitted under para 66(2)(b) of the SIS Act).

A breach by a trustee of a SMSF of section 66 can result in criminal prosecution and imprisonment of the individual trustee/s or director/s of the trustee (TEsDRs), as the case may be, for up to one year (sub-section 66(4) of the SIS Act).

It follows that the trustee of a SMSF cannot, or likely cannot, lawfully acquire RP already owned by a member/related party of the SMSF unless the RP is BRP. This prohibition works in substance as schemes that have the result that RP of a member/related party of a SMSF is acquired by a SMSF, say indirectly via sale to the SMSF and then purchase back by the SMSF from an intermediary unrelated to the SMSF, are also caught by section 66 and are similarly prohibited: sub-section 66(3).

Implications for related co-owners who own RP as tenants-in-common with a SMSF

This has further implication when RP is acquired and co-owned where a SMSF is an established co-owner: let us say where the RP is purchased in an arm’s length sale on the open market.

The SMSF owns a part of the RP as a TsIC but section 66 prohibits the SMSF from buying more of the RP from the related TsIC who is now a co-owner too. That further purchase would be acquisition of an asset from a member/related party. The same anti-scheme rule in sub-section 66(3) again applies to prevent the SMSF acquiring a further interest owned by a related party as a TsIC indirectly through a scheme.

An unsatisfactory entanglement

So the entanglement of a related party in the ownership of RP effectively prevents the SMSF from ever owning the whole of a RP it invests in as TsIC with a related party. This bears on, or should have borne on, the investment decision of the SMSF trustee to invest in the RP in the first place.

Entanglement gets worse when a SMSF has individual trustees and these individual trustees are members of the SMSF with whom the SMSF co-invests in RP. Under land law in most Australian states and territories only these individuals appear on title as registered owners of the RP. Without further steps, such as registering a caveat, the trustees of the SMSF, obliged to act at arm’s length from themselves, are poorly placed to assert co-ownership of the RP by the SMSF and to comply with mandatory covenants applicable to a SMSF including:

(b)   to exercise, in relation to all matters affecting the fund, the same degree of care, skill and diligence as an ordinary prudent person would exercise in dealing with property of another for whom the person felt morally bound to provide;

…

(d)   to keep the money and other assets of the fund separate from any money and assets, respectively:

(i)   that are held by the trustee personally; or

(ii)   that are money or assets, as the case may be, of a standard employer – sponsor, or an associate of a standard employer – sponsor, of the fund;

(e)   not to enter into any contract, or do anything else, that would prevent the trustee from, or hinder the trustee in, properly performing or exercising the trustee’s functions and powers;
from sub-section 52B(2) of the SIS Act

Entanglement disrupting sale of the TsIC interest by a SMSF

An investment in an asset which is not discretely saleable raises further section 52B covenant difficulty. The section 52B covenants continue:

(f)   to formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the fund including, but not limited to, the following:

(i)   the risk involved in making, holding and realising, and the likely return from, the fund’s investments, having regard to its objectives and its expected cash flow requirements;

(ii)   the composition of the fund’s investments as a whole including the extent to which the investments are diverse or involve the fund in being exposed to risks from inadequate diversification;

(iii)   the liquidity of the fund’s investments, having regard to its expected cash flow requirements;

(iv)   the ability of the fund to discharge its existing and prospective liabilities;
paragraph 52B(2)(f) of the SIS Act

Investing in a marooned asset

So does a trustee of a SMSF who invests in a asset that is marooned, because it can’t be readily sold without the co-operation of a co-owner or co-owners also selling, adequately deal with the risks referred to in paragraph 52B(2)(f)? Assumption that a related party TsIC will always co-operate with a co-owner trustee of a SMSF TsIC is incompatible with the section 109 of the SIS Act obligation of the trustee to act an arm’s length basis in its dealings including dealings with related parties.

Based on the section 52B covenants and section 109 the trustee/s of a SMSF should establish proper motive for making an investment as a co-owner in RP. To do that there likely needs to be either an exchange of:

tag along drag along rights; or
rights to require other TsICs to buy each other out of their interests;

so the SMSF can realise its investment in a TsIC investment interest in RP when it needs to meet its s52B(2)(f) covenants without being marooned in the investment.

The mandatory covenants in section 52B on trustees of SMSFs are between the trustee/s of the SMSF and the members of the SMSF. When they are the same people there are only occasional cases where a member would sue trustees for breach. The covenants are not civil penalty provisions.

Civil penalty provisions

In the SIS Act civil penalty provisions have these potential consequences for SMSFs:

breach can lead to the Australian Taxation Office as SMSF regulator (ATO as R) issuing a notice of non-compliance (NONC) to a SMSF so it is no longer a complying superannuation fund where:
1. non-complying superannuation funds pay 45% income tax on their assessable income; and
2. the assessable income of a fund that becomes a non-complying superannuation fund under a NONC must include the value of the assets of the fund, less undeducted contributions, at the beginning of the income year when the fund becomes non-complying. This is a significant penalty as it effectively taxes the fund’s accumulated assets at the 45% rate: see Subdivision 295-E of the Income Tax Assessment Act 1997.
intentional breach can result in criminal prosecution of TEsDRs: section 202 of the SIS Act;
administrative penalties on TEsDRs (in less serious cases taken not to warrant the above): s166 of the SIS Act; and
the ATO as R can give the TEsDRs directions to rectify (section 159 of the SIS Act) the breach or educational directions (section 160 of the SIS Act).
Consequences 1 to 3 don’t apply to a breach that is solely or simply a breach of the section 52B mandatory covenants. Consequences 4 can happen though: the ATO as R can give TEsDRs a direction to rectify requiring sale of a marooned TsIC interest acquired in RP in breach of the covenants in paragraph 52B(2)(f).

Sole purpose fails

Even where the RP is let out under a lease entirely at arm’s length to an arm’s length tenant there could still be a sole purpose civil penalty provision problem under section 62 of the SIS Act where the purpose of an investment by the SMSF in RP was not so much to generate returns to the SMSF, or to assist a SMSF to fund the payment of SMSF benefits to members, but rather to finance SMSF member acquisition of an investment property. Not bothering to arrange the above rights for the SMSF amplifies the prospect that a SMSF auditor or the ATO as R will reach that conclusion about the illicit purpose of the trustee/s of the SMSF.

Where the RP is acquired for a member or related party of the SMSF to live in then breach of the section 62 civil penalty provision will be yet more serious and clear cut.

Entanglement of financing

The need for a SMSF member and SMSF co-investors in RP as TsIC to co-operate extends further. The SMSF member borrowing with recourse or security over the property can amount to a charge over the property breaching SIS Regulations 13.14 and 13.15 and, where the recourse or security is called in, the SMSF might find itself co-investing with a financier eager to sell up the RP. In June 2011 the Commissioner and tax professionals considered these issues which were reported in National Tax Liason Group technical minutes. These can be difficult to locate on the somewhat dynamic Australian Taxation Office website so we have uploaded a copy here

It follows that a mortgage can’t be given to the financier of the co-owning member/s of the SMSF over the RP co-owned by the SMSF. Giving security over the TsIC interest only of the member/s of the SMSF who borrow only may be possible but that security needs to be carefully target only the borrower’s TsIC interest so that it has no reach to impact or to give any recourse against the TsIC interest of the SMSF in the RP.

Unit trust alternative?

Investment of more than 5% of a superannuation fund in in-house assets under Part 8 of the SIS Act can give rise to breach of a civil penalty provision with the potential Consequences 1-4 described above: section 84 of the SIS Act.

In 1999 the meaning of in house asset was widened to curtail significant investment by SMSFs in particular in related unit trusts. A popular strategy, to establish a unit trust to hold RP in which SMSFs and their related parties could hold units, could no longer be used without running into an in house asset problem. A carve-out to in house asset treatment was extended in Division 13.3A–In-house assets of superannuation funds of the SIS Regulations for companies and unit trusts that:
- are continuously non-geared, that is never have liabilities;
- have assets that are not investments in other entities;
- do not conduct a business; and
- neither lend nor borrow
so that SMSFs could invest in shares or units in them without these being in house assets.

An exception in sub-paragraph 66(2A)(a)(iv) of the SIS Act means that investment in say a SIS Regulation 13.22C non-geared unit trust to hold RP is not only excluded from being an in-house asset under paragraph 71(1)(j), but its acquisition from a related party is not prohibited under sub-section 66(1).

Non-geared unit trust compared to co-investing in residential property as tenants-in-common

This is a significant advantage over investing in an interest as a TsIC in RP. So a SIS Regulation 13.22C non-geared vehicle should be seriously considered as an alternative to investing with a related party in RP as a TsIC. Still a SIS Regulation 13.22C non-geared unit trust is nevertheless a challenging structure for indirect SMSF investing in RP as:
1. the compliance requirements, especially those that cause abrupt loss of the in house asset exclusion in SIS Regulation 13.22D are daunting (albeit the problems with investing as a TsIC in RP are covertly so and are all across the SIS Act , as this post illustrates); and
2. units in a non-geared unit trust that don’t amount to all of the units in the trust still have the same propensity to be marooned assets of the SMSF unless the investing SMSF can compel all other unit holders to buy or drag along when the SMSF needs to realise its investment.

Fixed trust present entitlement – a land tax trap?

Trusts and land tax in NSW

To protect the integrity of land tax:

so no advantage is given to trust owned land that can’t be treated as owned by a taxable person viz. an individual or a company; and
by means now also similarly adopted in other jurisdictions, notably Victoria (trust surcharge rate applicable mainly to land acquired by a trust after 31 December 2005 Land tax and trusts | State Revenue Office Victoria https://t.ly/ex6Jw );

New South Wales taxes a trust that owns NSW land not entitled to concessional tax treatment at an ample land tax rate as a special trust without threshold allowed to an outright individual or a company owner of land viz. not subject to a trust: see section 25A of the Land Tax Management Act (NSW) 1956 (LTMA).

Photo by Jon Tyson on Unsplash

Fixed trusts

A key concession where the special trust rate will not apply is where a trust is a fixed trust:

the equitable estate in all of the land that is the subject of the trust is owned by a person or persons who are owners of the land for land tax purposes …

and the trust won’t then be a special trust: sub-sections 3A(1) and 3A(2) of the LTMA.

Where a trust is a fixed trust the trustee is not separately taxed for persons, who are owners of the equitable estate in the land:

are taken to be owners for land tax purposes;
are liable for land tax as if they were the legal owners of the land: section 25 of the LTMA; and
unlike the trustee of a special trust who can’t apply threshold, these land tax owners can apply their remaining threshold and thereby access or potentially access a lower land tax rate.

Usually, as this term of art is understood in trust law, a fixed trust will be a fixed trust under section 3A of the LTMA. It doesn’t follow that a unit trust will usually be a fixed trust.

When can a unit trust be a fixed trust?

Whether or not a unit trust is a (section 3A) fixed trust will vary case by case as some unit trusts meet the above formulation of a fixed trust in sub-section 3A(2) and some, likely most, do not.

The demarcation was authoritatively considered by the High Court in CPT Custodian Pty Ltd v Commissioner of State Revenue; Commissioner of State Revenue v Karingal 2 Holdings Pty Ltd [2005] HCA 53. CPT Custodian Pty Ltd was a Victorian land tax case where unit holders of a unit trust where found not to have an equitable estate in the property of the trust. It followed that the unit holders could not be treated as having a fixed interest in the property of the trust and so they could not be treated as owners of the land of the trust for Victorian land tax purposes.

CPT Custodian Pty Ltd distinguished the earlier decision of the High Court in Charles v. Federal Commissioner of Taxation (1954) HCA 16 where, unlike in CPT Custodian, unit holders were conferred equitable proprietary interests in the property of the unit trust in the proportions in which they held units under the terms of the trust deed of the relevant trust in Charles, the Second Provident Unit Trust.

The LTMA approach

If what is a fixed trust under the LTMA ended with the sub-section 3A(2) formulation as enunciated in CPT Custodian Pty Ltd then a fixed trust under the LTMA would be conceptually clear and land tax integrity aims would be achieved. But sub-section 3A(2) and CPT Custodian Pty Ltd are either:

somehow not enough assurance of the integrity of the distinction to the legislator; or
unintelligible to or incapable of ready application by Revenue NSW officers;

and so the LTMA proffers additional relevant criteria viz. guidelines for what is a fixed trust viz. when the “relevant” criteria are met, a trust will be taken to be a fixed trust with owners taken to have the required equitable estate in the land of the trust: section 3A(3A) of the LTMA.

Safe harbour?

In other words the relevant criteria are a safe harbour viz. where the relevant criteria are satisfied by a trust then it will be notionally unnecessary to separately apply the principles enunciated in CPT Custodian to ascertain whether the equitable estate in the subject land under the trust is wholly owned by a person or persons who are owners of the land for land tax purposes.

The relevant criteria are:

(a) the trust deed specifically provides that the beneficiaries of the trust–

        (i) are presently entitled to the income of the trust, subject only to payment of proper expenses by and of the trustee relating to the administration of the trust, and

        (ii) are presently entitled to the capital of the trust, and may require the trustee to wind up the trust and distribute the trust property or the net proceeds of the trust property,

    (b) the entitlements referred to in paragraph (a) cannot be removed, restricted or otherwise affected by the exercise of any discretion, or by a failure to exercise any discretion, conferred on a person by the trust deed,

    (c) if the trust is a unit trust–

        (i) there must be only one class of units issued, and

        (ii) the proportion of trust capital to which a unit holder is entitled on a winding up or surrender of units must be fixed and must be the same as the proportion of income of the trust to which the unit holder is entitled.
section 3A(3B) of the LTMA (emphasis added)

But what safety is there in the safe harbour?

So if you are establishing a unit trust to hold NSW land that is to be treated as a fixed trust, or you are the lawyer acting for prospective NSW land owners setting up a unit trust what do you do? Should you simply include the relevant criteria so a Revenue NSW officer can give the trust a sign off on the safe harbour for a fixed trust under section 3A(3A) so the trustee won’t be taxed on the land on a special trust basis?

Discretions and classes of units

Section 3A(3A)’s relevant criteria concerning discretions shouldn’t present a difficulty. A unit trust that meets the principles in CPT Custodian and is comparable to the Second Provident Unit Trust in Charles doesn’t give discretions to any person to distribute, redirect or accumulate income or to distribute or redirect capital to beneficiaries other to the unit holder who holds the so fixed proportion of the equitable estate of the trust. Similarly there would be no point to more than one class of units, as prescribed by the relevant criteria, when designing a trust with fixed proportions of the equitable estate in property of the trust referable to each unit as in Charles.

However present entitlements proposed by Section 3A(3A)’s relevant criteria for a fixed trust are a different matter:

Present entitlements are inapt

Present entitlement as a measure in the relevant criteria is drawn from sub-section 97(1) of the Income Tax Assessment Act (C’th) 1936 (C’th ITAA 36) which speaks of “a beneficiary of a trust estate” who is “presently entitled to a share of the income of the trust estate” and is understood to have a corresponding meaning in the relevant criteria.

Under Division 6 of Part III of the C’th ITAA 36 (Division 6) a beneficiary is presently entitled if, and only if:

the beneficiary has an interest in the income which is both vested in interest and vested in possession; and
the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment.

[Federal Commissioner of Taxation v. Whiting (1943) 68 CLR 199, at pp 215-216, 219-220; Taylor v. Federal Commissioner of Taxation (1970) 119 CLR 444, at pp 450-452; Harmer v. Federal Commissioner of Taxation [1991] HCA 51 at para. 8 and Commissioner of Taxation v. Bamford & Ors, Bamford & Ors v. Commissioner of Taxation [2010] HCA 10 at para. 37.]

Present entitlement is an evaluative state at a particular point of time which is applied under Division 6 to retrospectively determine income tax liability at the end of either an income year or some other period of a trust in practice. In that context present entitlement is not used as a means to define estates or interests in trusts in succession prospectively by a preparer of a trust deed. It is instead used as a determinant of tax liability turning on whether a person is presently entitled to income of a trust. Despite that the relevant criteria in sub-section 3A(3B) agitate specific trust deed provisions that beneficiaries of a trust “are presently entitled” to income and capital of a fixed trust to attract the safe harbour.

Temporal fail

This doesn’t work as even a fixed trust with fixed correlation between the income and capital of the unit holders as holders of the equitable estate in the property of the trust can’t always achieve present entitlement in a time continuum, and certainly not at the outset of the trust when a trust deed of a trust may likely be drafted to potentially include the relevant criteria and executed, and the trust is yet to acquire property to which the beneficiaries may become presently entitled to income and capital but not “are” yet.

The relevant criteria oblige that beneficiaries are presently entitled seemingly to all income and capital of the trust through its existence. Beneficiaries can’t be presently entitled to income and capital in property of a trust that the trust is yet to acquire or to income of future periods or to capital on dates in the future of the trust. Beneficiaries are not presently entitled to income and capital from property that is yet to be property of the trust and a provision to the contrary in a trust deed to the effect that they are makes no sense.

Senseless provisions in a trust deeds unhinge the effectiveness of their other provisions and the trust itself.

Present entitlement when a unit holder dies?

Further Division 6 contains failsafes that apply where no beneficiary is presently entitled viz. sections 99 and 99A. Section 99 dealing with deceased estate cases is of particular significance as it could be that a unit holder in a unit trust with provisions in its trust deed to comply with the relevant criteria and to gain the safe harbour dies. From the moments after death until full administration of the deceased estate of the deceased unit holder, if that occurs, there is no owner of an equitable estate in the property of the trust reflecting the interest of the deceased who is presently entitled to the income of the property such as the fixed trust interest in the deceased estate: see Taxation Ruling IT 2622 Income tax: present entitlement during the stages of administration of deceased estates.

Until a legal personal representative obtains probate or letters of administration no equitable owner has standing to require the trustee of the fixed trust to require the trustee to transfer the property reflecting the interest of the deceased over to them.

But that is contrary to and in breach of a trust deed that obliges continual present entitlement, viz. that beneficiaries remain “are” presently entitled to the income and capital in land in succession.

Present entitlement when a unit holder is an infant or lacks legal capacity?

It could be that units in a unitised fixed trust that has adopted the relevant criteria come be to owned by an infant or a beneficiary subject to a disability who cannot be presently entitled to income or capital of the trust. In Taylor v. Federal Commissioner of Taxation (1970) 119 CLR 444, at pp 450-452 Kitto. J was able to deal with how section 98 can apply to these beneficiaries at para. 11 as follows:

Notwithstanding a passage in the joint judgment of Latham C.J. and Williams J. (Federal Commissioner of Taxation v. Whiting (1943) 68 CLR, at pp 214-215 ) which I must own I do not altogether understand in view of the recognition by s. 98 that a beneficiary may be “presently entitled” to income notwithstanding that by reason of a legal disability he has no right to obtain immediate payment, the tenor of the judgments is, I think, that “presently entitled” refers to an interest in possession in an amount of income that is legally ready for distribution so that the beneficiary would have a right to obtain payment of it if he were not under a disability.
(at p452)

but sub-section 3A(3B)(a) of the LTMA, unlike section 98 in Division 6, is neither qualified nor focused on application to a beneficiary under a legal disability who has no right to immediate payment of the amount such that the beneficiary can be considered presently entitled to income and capital of the trust so there is no reason why present entitlement of an infant unit holder, who can’t demand payment of trust income to him or her, for instance, should be inferred under sub-section 3A(3B)(a) of the LTMA based on Taylor.

Companies that “are” presently entitled – more likely to work

Unlike individuals, companies have perpetual succession and so, when they are beneficiaries of a fixed trust they can likely sustain continual present entitlement to the income and capital of a trust.

Is the inference thus to be drawn that a trust deed of a trust that includes the “are” presently entitled conditions to meet the relevant criteria and attract the safe harbour precludes individuals from becoming beneficiaries because an individual cannot necessarily sustain continual present entitlement such that they always are presently entitled because they may die, lose or never have legal capacity?

Lawyer’s quandary

How is a drafter of a deed for a fixed trust to deal with sub-section 3A(3A)’s relevant criteria in sub-section 3A(3B) then? I can’t follow what legitimate concern it is of the NSW legislature in a taxation statute or Revenue NSW to dictate trust terms to lawyers tasked with defining fixed interests in estates in succession but clearly blind adoption of the relevant criteria gives a tempting assurance to a drafter of a trust deed that a trust will be a fixed trust not land taxed as a special trust.

But inclusion of the relevant criteria which shouldn’t be strictly necessary has unintended consequences. A lawyer drafting a trust deed for a client is obliged to ensure that the drafting of a trust:

does not have adverse implications for the client such as precluding individuals who can be taxable owners for land tax from being unit holders; and
needs be wary of including trust deed terms that make no sense for which the lawyer, and not the legislator, is professionally responsible to the client.

Of further concern is that, despite the primary notion of the definition of fixed trust in section 3A(2), my recent experience is that Revenue NSW is obliging trustees to meet section 3A(3A)’s relevant criteria as if it is on those criteria, rather than the actual definition of fixed trust in section 3A(2), on which a fixed trust characterisation under the LTMA will turn. Without express inclusion of the are presently entitled stipulations of beneficiary interests in the trust deed of the trust Revenue NSW is treating a fixed trust that meets the CPT Custodian principles and so makes out as a fixed trust under section 3A(2) as a special trust. Officers at Revenue NSW don’t appear to follow or recognise that sub-sections 3A(3A) and (3B) are a safe harbor for the fixed trust notion specifically defined in sub-section 3A(2) of the LTMA.

Land tax assessments arising due to this approach by Revenue NSW should be challenged and disputed.

Australian non-fixed trust liable for CGT on non-TAP gains given to a foreign resident: Peter Greensill Family Co Pty Ltd

A mirror of the general principle of source and residence taxation broadly setting the parameters of international taxation, and reflected in Australia’s income tax law, is that income of a foreign resident not from sources in the state is not taxable in the state (in this post called the Mirror Principle). In Australia:

interests in real property in Australia and related interests; and
interests in assets used in business in permanent establishments in Australia:

are designated “Taxable Australian Property” (TAP) (see Division 855 of the Income Tax Assessment Act (ITAA) 1997). TAP is used in Australian income tax law to apply the Mirror Principle.

Foreign resident capital gains from non-TAP disregarded

Property which is not TAP, that is, property not taken to be connected to Australia for income tax purposes in the hands of foreign residents includes shares and securities as opposed to property interests in or related to Australian land or of permanent establishments carrying on enterprises in Australia which are TAP.

Capital gains made by foreign residents from non-TAP assets are disregarded for tax purposes: section 855-10.

Trouble pinpointing trusts as foreign or not

Trusts are elusive and create enormous difficulties in the international tax system see Trusts – Weapons of Mass Injustice. Trusts can detach beneficiaries who benefit from property who may be in one state from:

the trustee of the trust, in whose name the property is held, who may be in another state; and
the activities of trust which may be in yet another state.

Apt taxation of those activities in line with Mirror Principle thus poses a significant challenge to governments. States are justified imposing laws to counter offshoring with trusts to ensure the integrity of their tax systems.

Some states don’t recognise trusts.

In Australia trusts are mainstream. Some types of trusts are considered tax benign and conducive to legitimate business, investment and prudential activity. Fixed trusts are often treated transparently for Australian income tax purposes so that a fixed trust interest holder is:

taxed similarly to a regular taxpayer or investor; and
no worse off, tax wise, than a taxpayer or investor who owns the property outright rather than by way of a trust beneficial interest.

So, consistent with the Mirror Principle that a foreign resident owner of non-TAP who makes a gain on the non-TAP shouldn’t be taxable on the gain, a foreign resident beneficiary (FRB) of a fixed trust can disregard a capital gain made in relation to their interest in a fixed trust: section 855-40.

Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation

In the Federal Court case Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation [2020] FCA 559 this week the issue arose whether an Australian resident family discretionary trust – a non-fixed trust, was entitled to rely on section 855-10 and the Mirror Principle to disregard capital gains distributed to a FRB, a beneficiary based in London, of the trust from realisation by the trust of shares in a private company, GCPL, which were non-TAP of the trust.

Detachment of capital gains from the workings of trust CGT tax rules

The capital gains of a trustee are distant from the capital gains of a beneficiary under the ITAA 1936 and the ITAA 1997. Transparent treatment or look through to the capital gains of the trustee as capital gains of the beneficiary/ies became even more remote following changes to Sub-division 115-C of the ITAA 1997 including the introduction of Division 6E of Part III of the ITAA 1936.

These changes brought in distinct treatment of capital gains and franked distributions of a trust from other trust income following the High Court decision in Commissioner of Taxation v Bamford [2010] HCA 10 and the clarification of taxation of trust income in that case.

Legislation unsupportive of transparent treatment

In Greensill Thawley J. analysed the provisions in Sub-division 115-C and Division 6E to deconstruct the applicant’s case to disregard capital gains using Division 855.

Section 855-40 specifically allows a FRB of a fixed trust to disregard non-TAP capital gains. The absence of an equivalent exemption for FRBs of non-fixed trusts is telling unless section 855-40 is otiose or represents an abundance of caution. Thawley J. did not follow that line. As the applicant in Greensill could not disregard the capital gains using section 855-40 in the case of non-fixed trust, or section 855-10, the capital gains were taxable in Australia.

Unless there is an appeal to the Full Federal Court the Commissioner can finalise his draft taxation determination TD 2019/D6 Income tax: does Subdivision 855-A (or subsection 768-915(1)) of the Income Tax Assessment Act 1997 disregard a capital gain that a foreign resident (or temporary resident) beneficiary of a resident non-fixed trust makes because of subsection 115-215(3)? as the Federal Court has accepted the view in it.

The discretionary capital distribution – it’s a CGT free gift!

Annual income distributions by family discretionary trusts (FDTs) are routine for trustees for apparent Australian income tax reasons but trustees of FDTs can be reluctant to distribute trust capital. What would be the reason for that reluctance? Why don’t trustees of FDTs make capital distributions more often?

The trust deed

The regime in a FDT deed typically centres on distribution of capital on the vesting of the FDT. However even older and archaic FDT deeds usually expressly allow for interim distribution of capital, that is, distribution of trust capital before the FDT vests and winds up. Interim distribution of capital to beneficiaries, rather than holding it for them until the vesting day, is often conditional on the distribution being for the “maintenance education advancement in life or benefit” either for infant beneficiaries or for beneficiaries generally – see Fischer v Nemeske Pty. Ltd. [2016] HCA 11: a condition which, in ordinary family dealings, can readily be met.

Purpose of a FDT

A FDT is, in its essence, an arrangement to benefit family members. A FDT can be seen as a pool set aside to gift to family members. But is a distribution to a family beneficiary from a FDT treated the same for tax as a family gift to a family member?

It is useful to think about differences between a FDT and other types of entities before answering that:

Difference to a proprietary company

A proprietary company has the legal status of a separate person and the release of company capital to a shareholder of a company is subject to a number of corporations law and tax technicalities. A company can have wide objects but giving its value away to other persons would not usually be one of them. Under tax rules the enrichment of a shareholder’s family member from a company’s capital is likely dividend income assessable to income tax either directly or as a “payment” under section 109C of the Income Tax Assessment Act 1936.

Difference to a unit trust

A trustee of a genuine unit trust would generally be required to make capital distributions in equal proportions based on the unit holdings of unit holders. If capital distributions from a unit trust are feasible the capital gains tax (CGT) rules can discourage the trustee from making these distributions before vesting. CGT event E4 applies to distributions of capital of a unit trust which are not in connection with the disposal of the units to reduce the cost base of the unit holder by the amount of the distribution and, to the extent the cost base doesn’t cover the amount of the distribution, the excess is a capital gain assessable to unit holders.

How CGT applies to distributions of capital by FDTs

CGT event E4 does not apply to non-assessable capital distributions from a FDT. In Taxation Determination TD 2003/28 Income tax: capital gains: does CGT event E4 in section 104-70 of the Income Tax Assessment Act 1997 happen if the trustee of a discretionary trust makes a non-assessable payment to: (a) a mere object; or (b) a default beneficiary? the Commissioner of Taxation confirms his longstanding view and practice, since the introduction of CGT in 1986, that CGT event E4 does not happen if a trustee of a discretionary trust makes a non-assessable payment to a mere object. That is, a mere discretionary beneficiary where the entitlement to the payment arose because the trustee exercised its discretion in the beneficiary’s favour and the interest was not acquired by the beneficiary for consideration or by way of assignment.

The CGT similarity of FDT cash distributions and cash gifts

The enrichment of a family beneficiary of a FDT by an interim distribution of the capital of a FDT is not, of itself, subject to CGT based on TD 2003/28 i.e. there is no CGT on a distribution of cash to a beneficiary from the capital of a FDT. If there is a distribution of a CGT asset from the capital of a FDT to a beneficiary that is a different story. CGT events E5 and E7 can apply to subject the realisation of the CGT asset by the FDT to a family beneficiary to CGT (see sub-sections 104-75(3) and 104-85(3) respectively of the Income Tax Assessment Act 1997 which visits the CGT event on the the trustee of the trust – sub-sections 104-75(6) and 104-85(6) generally enable the beneficiary of a FDT to disregard a capital gain or capital loss under either of these CGT events where the beneficiary acquired the asset within the trust without incurring expenditure viz. on a capital distribution by the trustee the beneficiary is treated only as the acquirer of the asset for CGT purposes).

But there is no fundamental difference between a distribution of a CGT asset from the capital of a FDT, and the CGT events that apply to it, and how a family gift of a CGT asset by an individual is treated for CGT. That is, a gift of cash is CGT free and a gift in the form of property that is a CGT asset is subjected to CGT: not because of the gift but because a CGT asset is being realised and the CGT regime brings gains in value on a CGT asset to tax on a change of ownership.

So cash distributions of capital by a FDT, where permissible under a trust deed of a FDT, can generally occur, either with income year end income distributions or at other times during the currency of a FDT, without income tax consequences.

However there is a problematic exception:

Small business CGT concessions participation percentage

Under item 2 in the table in section 152-70 of the Income Tax Assessment Act 1997 the “small business participation percentage” of a beneficiary of a FDT is the smaller of the percentages of the beneficiary’s entitlement to income and the beneficiary’s entitlement to capital in an income year if both income distributions and capital distributions are made in that year. Generally beneficiaries are better off qualifying for a sufficient small business participation percentage to qualify for the concessions if no distribution of capital, or no divergent distribution of capital (bearing in mind that a capital gain on an active asset distributed by a FDT is likely to have a capital component), has been made in the income year the relevant capital gain has been made in to some other beneficiary.

So if a capital gain arises to a FDT in an income year which can attract the small business CGT concessions in Division 152 of that Act, then a distribution of the income in that income year substantially to family member A, including entitlement to a capital gain, may not count or count sufficiently in the measurement of small business participation percentage where a cash distribution of capital has been made to family member B and not family member A who is left with a “smaller” participation percentage. It could be that family member A may thus not qualify as a significant individual or as a CGT concession stakeholder without the sufficient interest in capital distributions of the FDT in the relevant income year in which the capital gain was made.

So a trustee of FDT needs to be wary of cash distributions of capital from a FDT and, indeed, the streaming of capital gains where there has been a capital gain that can attract the small business CGT concessions to ensure that the desired beneficiaries have sufficient entitlements to capital that can attract the concessions. If the small business CGT concessions participation percentage is not in issue a cash distribution from from the capital of a FDT to a beneficiary can be a tax benign.

Bringing trusts to a timely ending

Ending a trust is straight forward, isn’t it? Vest all interests in the trust in beneficiaries and make the right accounting entries and the trust is terminated? Not quite.

That word “vest”. What does it mean? Vest is a technical legal term. Broadly it means to imbue with ownership of property. So, when a trust ends and the property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.

But not all trusts end that way. For instance a unit trust or an unpaid present entitlement may already be vested in a beneficiary or beneficiaries. Clearly something other than vesting is needed to bring trusts of that type to an end. In those cases property that has already vested in beneficiaries may need to be paid to or put in the possession of the beneficiaries too for the trust to end.

Ending is all in the timing

In most states and territories of Australia trusts must vest within a statutory perpetuity period, typically 80 years. From this point this post relates to jurisdictions where a statutory perpetuity period applies.

Trusts that are fully vested, such as bare trusts, fixed trusts, some sorts of unit trusts and “indefinitely continuing” superannuation funds may continue for longer than the perpetuity period. A discretionary trust must vest no later than the perpetuity period, that is, discretions to distribute all income and capital of the trust must be taken and sunset once the time for vesting has been reached otherwise it will be too late and the formula for distribution for “takers-in-default” set out in the trust deed will apply to the property then left in the trust. The divesting of those interests, which are then held by the trustee outright for those beneficiaries, by payment over to, or at the direction of, the beneficiaries, can happen later after the expiry of the perpetuity period.

Bringing forward the ending of a trust

The trust deed should also set out how the time for vesting can be brought forward from the expiry of the perpetuity period. That time of expiry will usually be the “default” time for vesting, or a time just before it, (the last vesting time) in a well-crafted discretionary trust deed.

An objective of winding up a trust is to satisfy all parties with interests, in the wider sense, in the trust, including creditors, trustees, beneficiaries and the Commissioner of Taxation.

Failure to address these interests of the parties interested, or the trust deed requirements and formalities for the bring forward of the time of vesting, can mean that the trust, or its aftermath, will remain a matter in contention or dispute which is diametrically not what a trustee will want to occur following their effort to bring the trust to an end. A trustee can face difficulty in the converse case too where a trust is inadvertently brought to an end prematurely. In other words trustees can face problems where a trust has a mistimed ending either way. A trust may go on longer than planned or it may be inadvertently brought to an end before the trust should end. An example of the latter is to be found in trust deeds which set an inexplicably early time for vesting many years prior to the expiry of the perpetuity period.

Ending by depletion and merger

Depletion and merger are two other ways a trust may be brought to an end even where the intent of the trustee and beneficiaries is, and the trust deed may suggest that, the trust is to go on for longer.

Depletion is where the trustee no longer holds property on trust. If trust property is depleted and the trustee acquires more property on trust, the arrangement is treated as a new and separate trust. A “resettlement” occurs as well as likely confusion about which trust is which. Hence the device of a “settled sum” for a discretionary trust, which remains as trust property, to ensure continuity of the (original) trust even where the trust is in deficiency and has no other identifiable property.

Merger also brings a trust to an end in an untimely and premature way. Merger occurs where the trustee and the beneficiary are or become the same person. In the case of a merger the trust obligation of the trustee under the terms of the trust is no longer owed to the beneficiary so the trust does not continue.

Merger and SMSFs with individual trustees

Merger can be an interesting issue in the case of a self managed superannuation fund with individual trustees. There is no merger while the fund has two trustees: Trustee A has trust obligations to member B and trustee B has trust obligations to member A. However if a trustee/member dies and the surviving sole trustee is also the sole member of the fund with a fully vested beneficiary account of the entirety of the fund, the fund likely merges. It follows that the fund is no longer a trust. The Commissioner of Taxation has not addressed how the doctrine of merger may apply in these cases, and, as I understand it, the Commissioner treats a fund in this situation as continuing on as a matter of administrative convenience. If the Commissioner’s approach, which may be tantamount to a recognition of a self managed superannuation fund that is not a trust, came before the courts, it is unclear how it might be explained or permitted.

Some starting points

Trusts that require winding up usually commence by and are governed by a trust deed. I am not writing here of testamentary trusts. A trust deed will usually state the requirements to wind up the trust including how the time of vesting must be brought forward. A trust deed may also provide for other things which complicate vesting or winding up, or both. The trust deed may require that a party’s consent is required before either can happen. There may be other forerunner steps which haven’t been taken which must be taken before the trust can vest under the deed. A grasp of the design or method of the trust provisions in the trust deed will build confidence that all requirements for a winding up raised in a trust deed have been identified and addressed.

If the accounts of the trust have been correctly prepared then the current balance sheet, in particular, gives a list of activity to be addressed before the trust can be wound up. For a company liquidation, liabilities need to be satisfied with the balance of assets (property) distributed to owners. Trusts are no different. The more assets have been converted to cash and liabilities have been met the simpler the contemporary balance sheet and the winding up will be.

Tax planning

The conversion of assets to cash can give rise to taxable capital gains and assessable balancing charges but the alternative, their distribution to beneficiaries on a winding up inevitably does so too. It is generally simpler or more tax effective, or both, if these CGT events are contemporaneous with the trust coming to an end. In the cases of a fixed trust or a unit trust CGT event E4 can occur where a non-assessable part of a capital gain is distributed to a beneficiary when the interest of the beneficiary in the capital of the trust persists.

Errors frustrate the ending

Correct accounting in the trust will follow correct treatment of interests, assets or liabilities in the trust by the trustee. But correct treatment of interests, assets or liabilities doesn’t always happen. Notable examples where correct treatment doesn’t happen include:

the elimination of entitlements of family beneficiaries in the course of a winding up. Trustees of discretionary trusts distribute trust income to family members on lower tax rates (A) which remains unpaid and which is treated in the accounts of the trust as an unpaid present entitlement under terms in the trust deed. On winding up the distribution may revert to or may be paid to the principals of the family (B) instead without explanation. That suggests that the present entitlement of beneficiaries to former income of the trust was a sham or misunderstood with potential tax liability for the trustee;
distribution in the course of a winding up to individuals where the trust holds money or property sourced from a private company to which Division 7A of the Income Tax Assessment Act 1936 applies. This may be inconsistent with repayment of the money or property to the relevant company and could trigger a “deemed dividend” tax liability; and
backdating and forgiveness of loans – it can be tempting for a trustee to purge debts to related parties in the accounts of a trust but the purge is unlikely to be legally effective. A more nuanced treatment, which actually addresses the nature of the original transaction, is more likely to be accepted.

The Commissioner of Taxation investigates, audits and challenges trusts and the parties involved in these kinds of errors including after a winding up.

Conclusion

The affairs of trusts vary greatly and some have deeply intransigent issues. Getting a trust ready to wind up, and executing that wind up at a custom desired point in time may pose a number of challenges which should be considered and addressed in the process. The legal, accounting, business and practical attributes of the trust and possible errors should be considered through the due diligence process so that a non-contentious consignment of the trust to history can be effectively documented.

Minority SMSF investors and related unit trusts

A popular pro-active SMSF strategy is to skirt the boundaries of the associate rules in Part 8 of the Superannuation Industry (Supervision) Act 1993 (SISA) with minority SMSF investors taking units in a unit trust with no apparent majority controller with other unrelated SMSF or non-SMSF investors. The object of the minority strategy is that the minority SMSF investor and associates have a less than 50% entitlement to income and capital of the unit trust and so the unit trust will not be a related trust of the SMSF automatically. This is an alternative strategy to investing in a non-geared unit trust which complies with Regulation 13.22C of the Superannuation Industry (Supervision) Regulations.

If the minority strategy doesn’t work

If the unit trust is, or becomes, a related trust of the SMSF the consequences can be severe. The investment in the related trust by the SMSF is taken to be an in-house asset. A SMSF that fails to remedy an investment of more than 5% of its assets in in-house assets faces loss of complying status potentially causing:

tax at 47% on its current income; and
loss of almost half of the assets of the SMSF in a one-off additional tax bill in the year in which the SMSF becomes non-complying; or
prosecution for civil or criminal breach of a civil penalty provision under the SISA.

An investment in a non-geared unit trust which complies with Regulation 13.22C is specifically excluded from being an in-house asset. The minority strategy does not give the same assurance to a SMSF investor in units in a unit trust which is not Regulation 13.22C compliant.

Control of a trust

The more than 50% entitlement to income and capital test is one of the tests of control of a trust in sub-section 70E(2) of the SISA which determine whether or not a trust is controlled and is thus an associate and, by that, a related trust. An alternate test in paragraph 70E(2)(b), sometimes overlooked by users of the minority strategy, is the directions, instructions or wishes test which is an alternative test of control of a trust. Its formulation:

an entity controls a trust if:

… (b) 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);

is based on a similar formulation in sub-section 318(6) of the Income Tax Assessment Act 1936 which deals with associates under the income tax controlled foreign corporations (CFC) rules.

MWYS v. Commissioner of Taxation

The directions, instructions or wishes test in paragraph 318(6)(b) in the CFC rules was recently considered by the Administrative Appeals Tribunal in MWYS v. Commissioner of Taxation [2017] AATA 3037 (22 December 2017) and the companies in dispute with the Commissioner in that case were found not to be associated even though the companies concerned had the same directors.

Deputy President Logan found that, despite the unanimity of the directors of the companies involved, the companies were not associates as it could not be concluded, on the evidence, that the directors of one company, acting in that capacity, would influence themselves acting in their capacity as directors of the other company. Deputy President Logan observed that the arrangements between the companies involved: an Australian listed company and a UK publicly listed company which enabled them to dual list on the ASX and the London Stock Exchange, were for the purpose of compliance with dual listing requirements but, within that framework, the companies were structured with similarity to unrelated joint venturers. No inference could be drawn about one company acting on the directions of the other.

Moreover the strict governance which applied to both of the listed companies actually helped the companies to establish that the directors were acting independently and at arms length from the other company even where the directors were directors of the other company too. Short of a sham, or a cipher, as arose in Bywater Investments Ltd v Federal Commissioner of Taxation [2016] HCA 45 (see our blog -Why setting up offshore companies for Australians is a tricky business), the AAT was prepared to rely on the meticulous corporate documents which set out the distinct responsibilities of the directors of the companies they separately served.

Directors in common

It is certainly clear from MWYS that commonality of directors of a company, or in the case of paragraph 70E(2)(b) of the SISA, commonality of directors of a corporate trustee is not enough, in itself, to amount to a reasonable expectation that one company will act in accordance with the directions, instructions or wishes of the other company or of a group including it.

Is MWYS good news for SMSFs using the minority strategy?

Is the decision in MWYS a relief to minority SMSF investors in unit trusts concerned about paragraph 70E(2)(b) of the SISA? Maybe not. Documents of SMSF trustees and of unit trusts, in which they invest, are far less likely to be as meticulous at keeping the affairs of entities being examined for control apart. A unit trust deed is more likely than, say, a joint venture arrangement to show that the trustee of a unit trust might act in accordance with the directions, instructions or wishes of a unitholder, albeit a minority unitholder.

Frequently, under unit trust deeds, minority unitholders have the right to vote on resolutions which bind the trustee of the unit trust to act. A minority unitholder may not have the votes, alone, to so bind the trustee; but the question posed by the test is whether the trustee is accustomed to act, or whether there is a reasonable expectation that the trustee of the unit trust will act, in accordance with the directions, instructions or wishes of a minority unitholder. The answer in fact is equivocal – yes, if the minority unitholder votes are in the majority and no, if not. So yes, a part of the time or on some occasions. So the minority SMSF investor and the trustee of the unit trust are associated?

What will facts show under scrutiny?

The concern for SMSF users of the minority strategy is: will their position, that the unit trust they invest in is not a related trust, become less defensible under scrutiny from the Commissioner? From the activities of the SMSF investor, its associates and the trustee of the unit trust the Commissioner can gauge how the trustee of the unit trust has reached decisions, which may not have been in accord with documents, whether sound or not, and form a view as to how likely the trustee of the unit trust is likely to have acted on directions, instructions or wishes of the SMSF investor and its associates.

Until the circumstances of a SMSF using a minority strategy, including the relevant documents, are considered it can be uncertain whether a SMSF minority unitholder may “control” a unit trust and cause it to be a related trust.

SMSFs getting practical to invest in land with others

The force of the superannuation law is that investment in land by a SMSF needs to be prudent. An investment needs to be considered in a business-like way.

Limited recourse borrowing is one way to fund investment in real estate. SMSF principals may prefer to arrange equity investment from private connections outside of the SMSF.

Investment as a tenant-in-common?

I am frequently asked about SMSFs participating in land investments as a tenant-in-common with related and unrelated entities of the principals of the SMSF. It is apparent from the NTLG Superannuation sub-committee technical minutes of June 2011, released by the Australian Taxation Office, that tenants in common arrangements for SMSFs are not going to be prudent for the SMSF without careful and restrictive implementation. Wherever other tenants in common could borrow, or use or risk their interest as security, the SMSF tenant-in-common is exposed to uncontrolled risks which would bring into question, for instance, whether the SMSF:

1. has acted prudently pursuing the investment for members for whom it is bound to provide;

2. has breached regulations which prevent charges, or the potential for them, being taken over SMSF property; or

3. has satisfied the sole purpose test.

Investment through a trust?

The tenant-in-common option is frequently turned to because of the restrictive regime that has applied in relation to the investment by SMSFs in related trusts since 1999. Shortly stated, a post 1999 investment by a SMSF in a trust, which is related to the principals of the SMSF, a “related trust”, is treated as an “in-house asset” and more than 5% of the assets of a SMSF in in-house assets can leave the SMSF non-complying.

Non-geared unit trust – expressly relieved from being a related trust

The SIS Regulations provide an express exception. A superannuation fund can invest in a non-geared unit trust (NGUT) to which Regulation 13.22C applies without the NGUT being taken to be a “related trust” and thus the investment isn’t taken to be an investment in an “in-house asset”.

This express exception is especially limited and, aside from relief from “related trust” treatment causing in-house asset difficulty, offers no expansion in the kind of investment that can be pursued with superannuation money. In other words, the investment still needs to address 1 to 3 above, for instance.

The Regulation 13.22C and 13.22D requirements and restrictions on NGUTs essentially mirror the restrictions on regulated superannuation funds. NGUTs cannot borrow and they can only “lend” to operate a bank account. They cannot secure or charge their assets. (A non-SMSF unit holder in a NGUT could give a security over his, her or its units but security could not be given over the assets of the NGUT.) A NGUT cannot run a business – unlike with superannuation funds, this is a direct requirement. Loss of NGUT status, so that the NGUT becomes a related trust triggering in-house asset difficulties follows the merest breach under Regulation 13.22D which can put complying status of a SMSF investor at the mercy of the ATO.

Practicalities

1. Nevertheless a carefully implemented NGUT can be the most practical way to pursue unitised investment in land by related parties and unrelated parties of a SMSF with the SMSF.

2. Compliance with the regulations needs to be closely monitored as stated. Any debtor or creditor, aside from a bank for the (credit only) trust bank account, potentially causes loss of protection from related trust status. Funding of, and money flow to and from, the NGUT without breaching the rules is thus practically challenging. The trustee needs to raise equity (unit) funding whenever any extra funding is required. From a practical and paperwork burden perspective, using partly-paid units is a strategy that might be considered wherever the trust needs a flexible equity facility.

3. The activity of the NGUT that invests in land also needs to be monitored and carefully planned and structured. It is possible for real estate activity by trustees to be considered the carrying on of a business under tax rules. As stated a NGUT cannot carry on a business under the NGUT regulations nor, if it has a trust deed to suit, under its trust deed.

4. Under the special trust rules in NSW, a special trust pays land tax at the highest land tax rate without a threshold. A SMSF can attract a better land tax rate. A NGUT will not automatically qualify for the rate for a SMSF to the extent a SMSF invests in it. However if the NGUT is a “fixed trust” under the land tax rules then a better rate than the special trust rate can be achieved. Hence there can be advantage to structuring a NGUT with a trust deed so that the NGUT can be treated as a fixed trust under the land tax rules.

5. A carefully crafted trust deed can be very useful to assist the trustees of a SMSF and a NGUT to keep within the express requirements and restrictions on NGUTs.

Australia is now tracking & surcharging foreign buyers of land

Turning missing demographics into tax revenue

Hats off to Australian governments who have turned an imperative into a revenue opportunity. The Australian federal government regulator, the Foreign Investment Review Board (the FIRB), has not been well placed to track foreign purchases of real estate to date. The FIRB has been reliant on disclosure, and if prospective foreign buyers didn’t voluntarily disclose their planned land acquisitions, the FIRB has been none the wiser. There has been no register of (foreign) beneficial ownership of buyer entities which the FIRB can go and check even in the case of foreign real estate acquisitions completely prohibited under the foreign acquisitions law: the Foreign Acquisitions and Takeovers Act (C’th) 1975.

That has all changed. Buyers now need to demonstrate that they are not foreign to avoid hiked stamp duty in New South Wales, Victoria and Queensland. Foreigners who buy and sell Australian real estate are now under great scrutiny at both the buyer and seller ends of the land sale especially if the sale is for more than $750,000.

Big city real estate markets are buoyant, prices are high and foreign buyers are not exactly welcome by those looking to buy the same city real estate. The community has been surprised to learn that foreign purchases of Australian land have not been closely monitored. So, politically, it has been an opportune time to introduce these changes. Time will tell if they will be successful. They may well be. They will be a boon to the FIRB, but Australian buyers too will get caught up in the ramp up of imposts on foreign buyers. Why?

Buyers of Australian land

This is the bit for the FIRB. The New South Wales, Victorian and Queensland governments have just introduced hefty stamp duty and land tax surcharges on foreigners. From 21 June, 2016 a sworn Purchaser Declaration (“PD”) is now required from buyers, whether foreign or not, buying real estate in New South Wales. The PD is required along with stamp duty at the band the PD establishes that the buyer should pay to complete the conveyancing of a land sale. If the buyer of land in New South Wales is a foreign person (entity):

a 8% SURCHARGE (for the 2018 tax year, it was 4% for the 2017 tax year) on the stamp duty (i.e. extra) applies (it’s a 7% surcharge in Victoria);
the buyer is not entitled to the 12 month deferral for the payment of stamp duty for off-the-plan purchases of residential property; and
the buyer faces 2% SURCHARGE (for the 2018 tax year, it was 0.75% for the 2017 tax year) on land tax (i.e. extra).

It’s plain on the PD that the information is going to the ATO – it asks for the FIRB application number for the purchase. This will let the Australian Taxation Office (“ATO”) and the FIRB gather comprehensive data on foreign land acquisitions. Coupled with significantly increased penalties for breach of the foreign acquisitions rules, the availability of this information to the ATO and to the FIRB will give the federal government real capability to penalise unlawful real property acquisitions by foreigners.

Where an Australian buyer will be caught out too – example of a buyer that is an Australian-based family discretionary trust

It is notable that the PD doesn’t seek the confidential tax file number (understandable as the ATO can’t get the States to collect those) or the Australian Business Number (if any) of a buyer trust. It relies on the name of the buyer trust and a copy of the trust deed of the buyer trust with all amendments must be included with the PD.

If a foreign individual, company or trust is a potential beneficiary of the usual style of Australian family discretionary trust that is a New South Wales land buyer then, usually, the trustee can distribute 20% or more (Victoria – more than 50%) of the income and capital to that foreign person. That gives the foreign person a “significant interest” in the trust enough to cause the trust to be a foreign trust under these rules to whom the foreign stamp duty and land tax surcharges apply.

So if the copy trust deed supplied with the PD indicates that a remoter family member, who is not an Australian citizen or an Australian permanent resident, but is a foreigner who is a potential beneficiary of an (otherwise) Australian family discretionary trust ABLE to receive 20% of income or capital (more than 50% in Victoria), even if that remoter family member/foreigner may not have:

any current or past entitlement to income or capital of the trust; nor
any strong likelihood of participating in income or capital of the trust;

his or her eligibility under the trust deed exposes the trust to foreign trust/person status and liability for the stamp duty and land tax surcharges under these rules accordingly.

Sellers of Australian land

The ATO has had a problem collecting capital gains tax from sellers who are offshore after the sale of Australian land. Under tax treaties worldwide rights to tax interests in land are almost universally reserved to the governments where the land is. As other forms of assets and activity are moveable and relocatable taxation based on place is not so reserved because it is less effective than taxation based on residence and/or makes less sense.

So, frequently, when a non-resident sells land and makes a capital gain taxable in Australia, the ATO has no interaction with the non-resident, aside from due to their Australian landholding. This has often left the ATO with little leverage to assist them to collect tax debts arising from CGT on disposals of Australian land by non-residents ceasing investment in land in Australia.

The solution is the tried and trusted withholding tax model. From 1 July, 2016, the non-resident capital gains tax withholding tax (“NCGTWHT”) is an obligation on the buyer (statistically likely to be a resident) to pay a non-final withholding tax to cover capital gains tax (likely to be) owing by the non-resident seller.

The NCGTWHT broadly applies as a non-final tax on sales of land worth more than $750,000 (from 1 July 2017, was $2m from 1 July 2016 to 30 June 2017). If the buyer does not receive an ATO clearance certificate from the seller then the buyer must withhold 12.5% (from 1 July 2017, was 10% from 1 July 2016 to 30 June 2017) of the value of the property (so 12.5% of the price for the land if it is an arms length sale, 12.5% of the “first element of the cost base” of the land to the acquirer if a CGT market value substitution rule applies in a non-arms length transaction).

Where an Australian seller will be caught out too – a non-final 12.5% tax

It is of no consequence that the seller is, or might be, an Australian resident/tax resident and the buyer is assured of this. There is no “reason to believe the seller is an Australian resident” exception for sales of freehold interests in land. Even the seller could be wrong – tax residence can a vexed question which is frequently litigated in tax cases.

The liability to the ATO is on the buyer unless the seller can obtain and provide a clearance certificate from the ATO to the buyer no later than settlement of the land sale so, if the seller does not return and pay the CGT on the seller for the sale, the NCGTWHT paid by the buyer on the seller’s behalf won’t be refunded.

Template contracts for the sale of land across Australia have been hastily adjusted to include conditions confirming that, where the land is worth more than $750,000:

the buyer can contractually withhold the NCGTWHT from the price if the clearance certificate is not provided; and
the seller can be assured that the NCGTWHT will be paid immediately by the buyer to the ATO to the credit of the seller.

Is a family trust a good way for setting up a new franchisor business?

A family discretionary trust structure is a slightly more complicated and costly structure but it has more flexibility than a holding company structure for distributing income tax effectively while also being capable of having limited liability protection for the franchisor along with potential access to the company tax rate through a beneficiary company.

But is one trust enough?

For asset protection and management reasons it may be multiple structures are desirable into the future to separately hold IP and property interests (including lease interests to be sub-let).

Trust a conduit to beneficiaries

A family trust can distribute business profits as trust distributions as a conduit of taxable income to adult resident beneficiaries.

Division 7A would not usually apply

A significant advantage with a family trust structure is that Division 7A does not apply to loans from the trust to associated parties (where companies are not involved) to treat them as taxable/unfrankable deemed dividends.

Capital gains tax advantages

The adult resident beneficiaries of a family trust can also use the CGT discount if the trust makes a capital gain. Sometimes a trust is a more difficult structure than a company if a new franchise venture makes losses (say due to difficulties finding and keeping franchisees on good terms).

Bringing in new equity

A family trust isn’t as good as a unit trust or a company for bringing in new equity participants however it appears that, with the new small business restructure CGT rollover relief, a later conversion to a unit trust structure can be done for a low cost.

CGT discount and small business CGT concessions

Capital gains made by a family trust structure could attract the CGT discount and the small business concessions (a company can only get the latter), such as the 50% active assets reduction. A family trust structure has the tax advantage over a company structure if CGT assets of the business, including goodwill, are at some stage sold for a capital gain by the trust.