As a business owner, choosing the right business structure for your business is one of the most crucial decisions that you can make. One structure that is growing in popularity is a unit trust. A unit trust is a structure where third parties operate a business with the aim of using it as a vehicle for investment. If you are currently operating a unit trust, you may be re-assessing whether a it is suitable to fulfil your:
- commercial purposes; and
- tax purposes.
This article considers the operational issues that you should assess when deciding whether a unit trust is the right structure for your business. It also provides tips on how best to manage these different issues.
What is a Unit Trust?
A good way to understand a unit trust is to consider the key players involved in its operation.
A trustee is a person or company appointed to manage the assets held in the trust. The trustee legally owns the assets and holds them on behalf of and in the interest of beneficiaries (known as unitholders). The trustee is subject to various controls and duties under the trust deed and the general law.
Beneficiaries generally set up the trust and entrust their assets to the trustee. For a unit trust, beneficiaries (or unitholders) receive distributions that are proportionate to their unit holding.
Do You Want to Raise Funds or Take Out a Loan?
If you are seeking financing from investors or for minimising debt, investors and lenders may be reluctant to place funds into a unit trust.
Large scale investors like venture capital firms generally prefer to invest in companies rather than unit trusts. Companies are a more familiar structure than a unit trust and investors are more comfortable with a company’s operation.
Issuing or transferring shares is an easier and more standard process as the Corporations Act regulates it. In comparison, each individual trust deed dictates the issuing of units in a unit trust.
For financing debt, lenders are also more familiar with companies. In addition, any income that hasn’t been distributed from the trust by the end of the financial year is taxed at the highest marginal income tax rate. This means that most trustees distribute all income during each financial year. As a result, it can be difficult to save funds to make repayments on a loan.
If you need to pay off debts, you may wish to consider transitioning from a unit trust to a company. We strongly recommend seeking tax advice before proceeding as this can trigger tax consequences unless specific rollover relief is available.
Have There Been Disputes Between Unitholders?
Electing to structure your business as a unit trust over a discretionary trust tends to limit disputes since distributions are proportional to unitholders’ investment. Disputes may arise where unitholders sell units to a third party or where the trustee issues units. To avoid these disputes, many trusts have a unitholders agreement that dictates how the trustee should manage these events.
Have There Been Any Disputes With the Trustee?
Unitholders may wish to challenge the trustee if the trustee has not fulfilled their legal duties. A trust deed specifies these duties and other powers of a trustee. The law subjects trustees to:
- act honestly;
- be reasonable;
- act in good faith; and
- avoid conflicts of interest.
Given that most trustees are corporate trustees and beneficiaries make up the board, disputes between unitholders and the trustee are relatively rare.
Are You Meeting Your Tax Objectives?
A trust does not generally pay tax. Rather, the beneficiaries are taxed on their share of the trust’s income. However, any income that is undistributed from the trust by the end of each financial year is subject to the highest marginal income tax rate. This is a flat 45%, excluding levies. Therefore, most trustees distribute all trust income each year.
One of the key benefits of structuring as a unit trust rather than a company is its eligibility for the 50% capital gains tax (CGT) discount. Under this, assets that are held in the trust for at least 12 months receive 50% of the asset sale price tax-free.
As for unitholders, the discount capital gain is ‘grossed up’ to its original amount, and the unit holders then apply any losses and re-assess eligibility for the 50% CGT discount. That is, a discounted capital gain must find its way into the hands of an individual beneficiary to retain the benefit of the 50% CGT discount.
Are Unitholders Benefiting From Franking Credits?
Franking credits are the tax credits generated when a company pays tax. Companies can attach these franking credits to the cash component of a dividend. A cash dividend is the money paid to investors as part of the corporation’s current earnings or accumulated profits. Franking credits can significantly reduce a unitholder’s tax bill.
The franking system aims to prevent the double taxation of a ‘classical’ corporate tax system. This is where both a company and its shareholders are taxed on their net income without gaining credits for the corporate tax that has already paid.
Franking credits are only available to a unit trust if it is a ‘fixed trust’ for tax purposes. Unfortunately, many unit trust deeds that are ‘fixed’ from a commercial perspective do not meet the very rigid definition of a ‘fixed trust’ for tax purposes. A trust is a fixed trust for tax purposes where unitholders have fixed entitlements to all of the income and capital of the trust.
Non-Arm’s Length Income Rules
Separate from the fixed trust definition above, there is also another definition of ‘fixed’ for the purposes of the non-arm’s length income rules (NALI). Under the NALI rules, self-managed superannuation funds (SMSF) are taxed at the top marginal tax rate. This is in comparison to the usual concessional 15% tax rate. These NALI rules include trust distributions (other than those arising from a fixed entitlement). In turn, a fixed entitlement is vested and indefeasible. This broadly means that a current interest cannot be taken away.
Therefore, if an SMSF invests in a unit trust that does not give rise to fixed interest, it will be taxed at 45%.
Whether your trust qualifies as a fixed trust will largely depend on how your trust deed has been prepared. You can amend your trust deed to make it a fixed unit trust. However, this may trigger resettlement issues.
Having established your unit trust, it is important to make sure that you are receiving its intended benefits. If not, some short-term solutions include:
- preparing a unitholders agreement to limit disputes;
- assessing your eligibility for the 50% CGT discount;
- amending your trust deed to receive franking credits; or
- transitioning to a company structure to access financing from third parties.
If you have any questions about unit trusts, get in touch with LegalVision’s business lawyers on 1300 544 755 or fill out the form on this page.
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