A unit trust is a popular structure for holding property and other investments and this article examines numerous methods of how an SMSF may invest in a range of unit trusts.
Many publicly offered managed investment funds are structured as unit trusts to allow multiple investors to invest in a diversified investment portfolio. Typically, the units in the trust reflect each investor’s proportionate equity or interest in the trust. The concept of owning a unit in a unit trust is a similar but different concept to owning a share in a company.
While an SMSF investing in a larger unit trust may not have any influence on the trustee or have much opportunity to make any change to the unit trust documents, our firm has acted for numerous SMSFs over the years where we have negotiated changes to reduce regulatory or legal risk.
Closely held unit trusts
On a smaller scale, unit trusts are also popular for SMSFs to invest in, especially to acquire real estate. One or more SMSFs and/or other investors can combine their finances to acquire an investment property via a unit trust structure. In some cases, this may allow each investor access to a better property with considerably more upside potential compared to investing alone.
In particular, an SMSF may only want to hold a proportionate interest in a unit trust to minimise risk. There may be one or more related or other investors who also participate in the same unit trust. Each investor invests in units, which, in turn, are used to finance the unit trust’s acquisition of property.
However, an SMSF has to be very careful to ensure it complies with the raft of superannuation rules before investing in a unit trust. Moreover, the quality of the unit trust deed and constitution of the corporate trustee are important to an SMSF’s complying status.
Related unit trusts
An SMSF is restricted to investing no more than 5 per cent of the market value of the SMSF’s assets in ‘in-house assets’ (IHA). The Superannuation Industry (Supervision) (SIS) Act 1993 specifies that IHAs include an investment in a related trust of the SMSF.
A related party is broadly defined and includes an SMSF member, a standard employer-sponsor of the SMSF, the member’s relatives, a partner in a partnership and a company or trust that is controlled or significantly influenced by an SMSF member and their associates.
A related trust includes a unit trust where an SMSF member, a standard employer-sponsor or their associates hold more than 50 per cent equity in the unit trust, exercise significant influence in relation to the trust or can remove or appoint the trustee.
Therefore, an SMSF with $1 million of assets could not, subject to section 66 of the SIS Act, invest more than $50,000 (that is, 5 per cent) in IHAs (including any related trust). Such a unit trust could invest in a real estate property where the remaining units were held by others, including related parties such as family members, relatives or a related family discretionary trust.
This may not be attractive to an SMSF where it’s likely the 5 per cent limit will be exceeded. For instance, if an SMSF invested more than 5 per cent, this would contravene the SIS Act and significant penalties could be imposed on an SMSF by the ATO.
Accordingly, to ensure this test is met it is necessary to identify which assets are considered to be IHAs and then determine the market value of all assets to ensure the 5 per cent limit is not exceeded. The acquisition of a new IHA where the fund is already at the 5 per cent limit is an immediate contravention. Additionally, where the fund is not over the 5 per cent limit, the acquisition of an IHA that would itself cause the fund to exceed the 5 per cent limit is also an immediate contravention.
There is, however, a possible exception discussed below that allows an SMSF to invest in a related unit trust.
Non-geared unit trust
A related unit trust, often referred to as a non-geared unit trust (NGUT), allows for one or more related investors to come together to invest in property. An NGUT allows an SMSF to hold up to 100 per cent of the units issued in that ‘related’ unit trust. This is permitted provided the unit trust complies with the strict criteria in the SIS Regulations 1994 and continues to comply with those strict criteria on an ongoing basis. Failure to comply can result in the units becoming IHAs.
As discussed above, an SMSF cannot hold IHAs that exceed more than 5 per cent of the value of the fund’s assets and may therefore need to dispose of the asset causing the SMSF to exceed this limit. Such a disposal could give rise to substantial transaction costs.
Broadly, an NGUT may be a suitable structure for holding real estate with no borrowings secured on the title to that property and to overcome the IHA prohibition. This is because the strict criteria in the SIS Regulations require the trust must, among other things, not:
- have any borrowings or charges (for example, a mortgage) on the trust’s assets,
- lease any property to a related party apart from business real property,
- invest in any other entity (for example, the trust must not own shares in a company), or
- conduct a business such as property development.
An SMSF may also be permitted to acquire further units in an NGUT from a related party without infringing section 66 of the SIS Act provided certain criteria are satisfied.
There may also be stamp duty savings on the transfer of units if the value of the property owned by the unit trust falls below the landholder threshold of the relevant state or territory (for example, $2 million in New South Wales and $1 million in Victoria).
However, care needs to be taken to ensure the unit trust continuously complies with the SIS Regulations. Units in an NGUT can readily become an IHA if the strict regulation criteria are not complied with.
Unrelated unit trust
If an SMSF invests in a unit trust that is not a related trust, the SMSF is not limited in how much of the fund’s assets could be invested in such a trust.
For example, an SMSF with $1 million of assets could acquire a 35 per cent unit holding in an unrelated trust, investing the entire $1 million in that unit trust as the trust is not a related party. (The SMSF’s investment strategy must still allow for cash flow and liquidity and may therefore hold some of its assets in cash or deposits to pay for ongoing costs of pension payments, for example.) Under this scenario, the SMSF would not have control, nor significant influence in respect of the unit trust and therefore the 5 per cent IHA limit should not apply.
It may also be possible to structure an investment in property that involves two unrelated SMSFs (where each family is not related nor in a close business relationship such as a partnership, for example) so that each SMSF holds exactly 50 per cent of the units. The ATO has confirmed that a 50 per cent/50 per cent unitholding arrangement would not, by itself, give rise to a related trust relationship.
It should be noted, however, that the ATO has broad powers and unless this type of 50-50 arrangement is carefully implemented and documented, it could result in a contravention of the SIS Act with significant penalties. The constitution of the corporate trustee may, for example, provide a casting vote to a chairperson, which can give rise to a related trust relationship. For this reason, it is generally much safer to have, for example, three unrelated SMSFs undertaking such an investment with, say, 33.3 per cent of units each.
Thus, where, say, two or more unrelated investors wish to combine their investments in a common structure such as a unit trust, this could provide a suitable structure for aggregating such investments between two or more SMSFs that are not ‘grouped’ together under the IHA rules.
One example may be three SMSFs with $333,334 each combining together to invest in a unit trust to acquire a $1 million investment property.
Unit trusts are generally not subject to tax provided the trustee of the relevant unit trust distributes all its net income (including any net capital gain) prior to 30 June each financial year. Trusts therefore are often referred to as flow-through structures.
To the extent a trustee of a unit trust fails to distribute its net income prior to 30 June, the trustee of the unit trust will generally be taxed at the top personal marginal tax rate (currently, in the 2020 financial year, 45 per cent plus applicable levies).
When setting up a unit trust that SMSFs propose to invest in, it is important to select a unit trust that will qualify as a ‘fixed trust’. Broadly, a fixed unit trust has less compliance issues compared to a non-fixed unit trust, which may be required to consider, among other things, a family trust election or interposed entity election.
The unit trust deed should also cover a range of other matters that regulate what happens on the admission or departure of a unitholder and how disputes are to be resolved between the parties. A very important point to note here is unitholders can be exposed and liable for the liabilities of the unit trust, including any damages or losses incurred by the trustee. Carefully drafted limitation of liability provisions are required to ensure unitholders, including any SMSFs, are not placed at risk from obtaining inferior documents.
We also recommend a suitable buy-sell agreement should be considered where there is more than one unitholder, even if that unitholder is a related party, to ensure the parties are dealing at arm’s length.
The stamp duty implications of transferring, issuing and redeeming units in each relevant state or territory also need to be carefully managed. We are also aware of numerous unit trusts that have been set up that have incurred considerable extra stamp duty on the acquisition of property as the unit trusts had not been set up before the purchase or a change in unitholders occurred after the purchase contract had been executed.
Unit trusts are a popular structure for SMSFs to invest in. It is important the various rules are clearly understood to ensure each investment by an SMSF in a unit trust is compliant and effective. Moreover, there are considerable legal and related risks, including the tax effectiveness of the trust and stamp duty costs, that need to be carefully managed.
Dan Butler is the director of DBA Lawyers.