You may be considering a unit trust to operate your business or as a vehicle for investment. You may also be considering a unit trust structure because of their tax benefits. Therefore, it is important to understand:
- the tax advantages of unit trusts; and
- how to benefit from these advantages.
This article explains all the important tax considerations of a unit trust, so you make an informed decision on how to proceed with a trust and prepare the trust deed.
What is a Unit Trust?
A trust is the relationship between a trustee and beneficiaries that is governed by the trust deed. Beneficiaries are typically people who set up the trust and entrust assets to the trustee. A trustee legally owns assets and holds them for the benefit of the beneficiaries. The trustee can be either an individual or a company with a board of directors that is typically made up of beneficiaries.
A trust can be either a:
- discretionary trust, where the trustee distributes income at its discretion; or
- unit trust, where beneficiaries (often called unitholders) hold a fixed entitlement to the trust’s income. They receive distributions proportionally to their unit holding.
A unit trust is typically where unrelated parties:
- wish to invest in securities or real property; or
- operate a business and do not intend to raise significant capital from third parties.
The trust and unitholders are separate and are taxed separately.
How is the Unit Trust Taxed?
A unit trust is not generally taxed at all. Instead, the unitholders are taxed on their share of the trust’s income. However, sometimes there is trust income that no unitholder is entitled to. In this circumstance, the trustee is taxed at the highest marginal tax rate (45%).
For this reason, trustees typically distribute all income to the unitholders every financial year. This can be disadvantageous if the trust is seeking to fund expansion or is seeking to pay a loan.
If the trust disposes of all assets, it is generally subject to capital gains tax (CGT). Broadly, you calculate CGT on the difference between the asset sale price and the price paid for its acquisition.
The trust may be eligible for the 50% CGT discount if you hold the asset in the trust for 12 months or more. This means that 50% of the sale price is tax-free and only the remaining 50% is subject to tax.
How Does This Affect Unitholders?
As a unit trust is generally a flow-through vehicle, it is usually the unitholders who are ultimately taxed on trust distributions. As not all types of entities are eligible for the 50% CGT discount, special rules operate to effectively gross-up any discount capital gain in the hands of a unitholder. They can then:
- apply any capital losses they have against the gain;
- re-determine eligibility for the 50% CGT discount at their level; and
- apply any revenue losses they may have.
This procedure can be fairly complicated to understand, so a hypothetical example of this process is explained below.
A trust purchased an asset for a purchase price of $100,000. It sells the asset for $200,000 and makes a capital gain of $100,000. If it is eligible for the 50% CGT discount, the trust will only include $50,000 in its net income.
One of the unitholders, Sam, holds one of ten units and receives a distribution of $10,000 from the disposal of the asset. If Sam is eligible for the 50% CGT discount, he will only pay tax on a discount capital gain of $5,000 (the first $5,000 being completely tax-free).
One of the unitholders is Company A and holds one of ten units. It also receives a distribution of $10,000, representing the capital gain from the disposal of the asset. As a company, Company A is not eligible for the 50% discount, and it will pay tax on the full $10,000 even though the unit trust was eligible for the discount.
How are Unitholders Taxed?
As a general rule, any income received from the trust forms part of unitholders’ assessable income and is subject to their marginal tax rate. In addition, they may receive franking credits if the trust qualifies as a fixed trust.
How Do Franking Credits Work?
Franking credits are generated when a company pays tax. Companies can then attach franking credits to the cash component of a dividend. Shareholders then must include both the cash component and the value of the franking credit in their assessable income. The dividend (including the value of the franking credits) is taxed at the relevant marginal tax rate. The tax otherwise payable is reduced on a dollar-for-dollar basis by the franking credits attached to the dividend.
When Can Unitholders Receive Franking Credits?
Unitholders can generally only obtain the benefit of franking credits if the trust is a fixed trust. A fixed trust is defined in different ways for different purposes throughout tax law. To benefit from franking credits, draft the trust deed with these purposes and definitions in mind. However, this comes at the expense of flexibility. Therefore, a trust deed is often a compromise based on what the trust will invest in and what the beneficiaries are looking for.
After establishing the trust, it can be difficult to amend it for fixed trust purposes. Unitholders must have fixed entitlements to all of the income and capital of the trust. This will ensure that the unit trust can facilitate the flow-through of franking credits.
The Safe Harbour Compliance Approach
The Australian Tax Office (ATO) has the discretion to treat a non-fixed trust as fixed trust for tax purposes. The ATO published guidelines that explains how it exercises its discretion to provide a safe harbour compliance approach. A safe harbour approach is a regulation where certain conduct that is normally not allowed will be allowed in a particular circumstance. In practice, this allows taxpayers to self-assess their trust in certain circumstances.
If a unitholder is a Self-Managed Super Fund (SMSF), the unit trust must be a fixed trust for non-arm’s length income (NALI) purposes. This will allow the SMSF to access the concessional 15% tax rate. A trust distribution is NALI unless you derive it from a fixed interest. Interest is fixed if it is a present that cannot be taken away, including by the exercise of any discretion.
Trusts are not normally taxed at all. Rather, the unitholders are taxed on their share of the trust income. Unit trusts can access the 50% CGT discount, but the unitholder must be an eligible entity to retain that concession. Franking credits will generally only pass through a unit trust if it meets the rigid definition of a fixed trust’. If you have any questions about unit trust taxes, get in touch with LegalVision’s tax lawyers on 1300 544 755 or fill out the form on this page.
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