Practitioners are often asked whether SMSFs can carry out property development projects. Whilst the ATO has indicated that there is nothing in the legislation that specifically prohibits a complying superannuation fund from carrying on a business, it is not entirely clear how a SMSF could actively operate a business without breaching the sole purpose test, especially if other assets of the fund are being put at risk.
To alleviate this risk, an option often proposed for structuring property development projects is for a SMSF to invest in a unit trust that holds the real estate. However, where the unit trust qualifies as a related trust, the SMSF will need to consider (amongst other things) whether its investment in the related unit trust is within the 5% in-house assets threshold. This limit does not apply to a related unit trust that is not geared. However, there are restrictions placed on a non-geared related unit trust including the trust being prohibited from conducting a business (which would include property development projects even a one-off isolated property development).
Nonetheless, a unit trust structure continues to be a popular vehicle for property development projects between unrelated investors wishing to combine their investments through their respective SMSFs. Whilst unit trusts are often referred to as flow through structures, prior to 1 July 2016, by virtue of the rules in Division 6C of the Income Tax Assessment Act 1936, a unit trust that undertakes a property development business will be treated as a public trading trust and taxed on a similar basis to a company if more than 20% of its units are owned by SMSF. Similar to a company, tax paid by a unit trust that is a public trading trust can be passed to its unit holder(s) by way of franking credits attached to dividend distributions.
Division 6C was recently modified as part of the new tax system for managed investment trusts. Effective from 1 July 2016, complying superannuation funds and exempt entities that are entitled to a refund of excess franking credits will now be exempt from the 20% tracing rule with the consequence a unit trust that is carrying on a business (e.g., a property development project) will no longer qualify as a public trading trust just because more than 20% of its units are held by SMSFs.
As a result of this modification to Division 6C, some unit trusts will cease to be taxed as corporate entities effective from 1 July 2016. If the unit trust has significant surplus in its franking account, it will no longer be able to pass the franking credits to its unitholders when it exits the corporate tax system. To overcome this problem, under the transitional rules, a unit trust that ceases to be a public trading trust will have until 30 June 2018 to use any surplus in its franking account. Where applicable, practitioners should review the franking accounts of unit trusts that are affected by the amendments to Division 6C to ensure the benefits of any franking surplus can be effectively passed on to their SMSFs unitholders prior to 30 June 2018. Trust distributions made subsequent to 30 June 2018 can no longer be franked.
Whilst changes to Division 6C may make unit trusts an even more attractive investment vehicle for property development projects, income derived by SMSFs from their unit trust investments may still be exposed to the non-arm’s length income provisions of section 295-550 of the Income Tax Assessment Act 1997. It is generally assumed where a trust is a unit trust the unit holders has a fixed entitlement to income such that income derived by a SMSF will only be considered non-arm’s length income if it falls within subsection 295-550(5). This occurs if the income derived by the SMSF or the units owned by the SMSF was acquired under a non-arm’s length dealing and the amount of income is more than the amount that the SMSF might have been expected to derive under an arm’s length dealing.
The issue of fixed entitlement in the context of section 295-550 has been considered by the ATO in various edited versions of private binding rulings and is based on the view expressed in Taxation Ruling TR 2006/7 – i.e.,
trust distribution to a complying superannuation fund will fall within subsection 295-550(5) of the ITAA 1997 rather than subsection 295-550(4) of the ITAA 1997 only if the fund’s entitlement to the distribution does not depend upon the exercise of the trustee’s, or any other person’s discretion, that is, if the fund holds a fixed entitlement to the income of the trust.
An example that comes to mind is a hybrid trust, such as the one in Taxation Alert TA 2008/4. We note the treatment of public trading trusts analogous to companies is only for certain purposes of the Act. As such, there are many purposes of the Act for which public trading trusts will still be treated as trusts. We consider the non-arm’s length income provisions is one of those provisions for which the unit trust is treated as a trust. Where the entitlement to income of a unit trust is not fixed, distributions derived by the SMSF from its unit trust investment will be non-arm’s length income and assessed to the trustee at the highest marginal rate even if the SMSF is in pension phase.
Accordingly, for SMSFs with investments in unit trusts it would be appropriate for practitioners to conduct a review of the relevant unit trust deed as part of their due diligence process.