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SMSFs with units in unit trusts and NALI –– review and action may be needed

NALI –– unit trusts and draft LCR 2019/D3

There are a considerable number of SMSFs that invest in private unit trusts. These unit trusts may include pre-99 unit trusts, unrelated unit trusts and non-geared unit trusts (under div 13.3A of the Superannuation Industry (Supervision) Regulations 1994 (Cth) (SISR)).

The ATO’s Law Companion Ruling 2021/2 (LCR 2021/2) outlines, among other things, the ATO’s view in relation to when a loss, outgoing or expense (‘Expense’) invokes non-arm’s length income (NALI) in relation to non-arm’s length dealings with fixed or unit trusts. In particular, this article focuses on paragraphs (b) and (c) of s 295-550(5) of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997).

Where a lower than arm’s length Expense gives rise to NALI, this is commonly referred to as NALE (ie, a non-arm’s length expense). There is not much guidance relating to how NALE applies to unit trusts and this article is designed to bridge this gap.

All references are to the ITAA 1997 unless otherwise stated.

NALI –– fixed entitlements to trust income

From 1 July 2018 an important change occurred to s 295-550(5) by the addition of paragraphs (b) and (c). Broadly, these paragraphs assess distributions from fixed trusts or unit trusts as NALI where a lower (or nil) Expense is incurred in relation to acquiring the entitlement in the trust or producing the income from the trust.

Section 295-550(5) states:

Other income *derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is non-arm’s length income of the entity if, as a result of a *scheme the parties to which were not dealing with each other at *arm’s length in relation to the scheme, one or more of the following applies:

  • the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm’s length in relation to the scheme;
  • in acquiring the entitlement or in gaining or producing the income, the entity incurs a loss, outgoing or expenditure of an amount that is less than the amount of a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme;
  • in acquiring the entitlement or in gaining or producing the income, the entity does not incur a loss, outgoing or expenditure that the entity might have been expected to incur if those parties had been dealing with each other at arm’s length in relation to the scheme.

Section 295-550(b) –– NALE –– lower than arm’s length Expense:

Broadly, for a distribution to be assessed as NALI under s 295-550(5)(b) the following criteria must typically be satisfied:

  • The SMSF derives income as a beneficiary of a fixed trust, eg, by holding a fixed entitlement.
  • The parties were not dealing with each other at arm’s length in relation to the scheme.
  • In acquiring the entitlement or in gaining or producing the income, the SMSF incurs an Expense that is less than an arm’s length amount. The acquisition of the entitlement would be in relation to the SMSF acquiring the units. The words ‘in gaining or producing the income’ should be read in similar light that the income being produced is the distribution from the trust.

Section 295-550(c) –– NALE –– nil Expense:

The key difference between paragraph (c) and (b) is that paragraph (c) is invoked where the SMSF does not incur any Expense. In contrast, paragraph (b) is invoked where the SMSF incurs an Expense that is lower than an arm’s length amount.

Given the similarity between paragraphs (b) and (c), we will not discuss paragraph (c) any further and will focus on paragraphs (a) and (b) for the remainder of this article.

Section 295-550(a) –– NALI –– lower than arm’s length Expense:

This is a good time to discuss s 295-550(5)(a) and contrast it with paragraph (b).

Broadly, for a distribution to be assessed as NALI under s 295-550(5)(a) the following criteria must typically be satisfied:

  • The SMSF derives income as a beneficiary of a fixed trust, eg, by holding a fixed entitlement.
  • The parties were not dealing with each other at arm’s length in relation to the scheme.
  • The SMSF derives more income from the trust as a result of the parties not dealing at arm’s length. Two typical examples that would invoke NALI under paragraph (a) include:
    • A related party tenant agreed to pay a higher rent for the business real property held by the trust compared to its arm’s length value.
    • A related party provided a loan to the trust that did not incur interest and was not on arm’s length terms.

Paragraph (a) has been law for a considerable period and was in place well before the 1 July 2018 changes. As noted above, paragraphs (b) and (c) were only introduced as law from 1 July 2018 but have retroactive effect (as they apply regardless of when the ‘scheme’ was entered into).

Unit trust example from LCR 2021/2

Example 12 of LCR 2021/2 involves Scott’s SMSF acquiring $50,000 of units in a stock exchange listed unit trust at market value with a flexible related party limited recourse borrowing arrangement (LRBA). The loan is interest free, the loan is repayable in 25 years and the loan has a 100% loan to valuation ratio (ie, 100% geared). The unit trust distributes $8,000 to Scott’s SMSF for FY2019.

The ATO conclude that, in addition to distributions of income being assessed as NALI, any capital gain from a CGT event relating to a disposal of the units will also be assessed as NALI to Scott’s SMSF.

This example is the only example relating to a unit trust in LCR 2021/2 and relates to an SMSF ‘acquiring the entitlement’ to units in a unit trust at market value.

LCR 2021/2 therefore provides limited guidance in relation to how paragraphs (b) and (c) apply to unit trusts. Further, the ATO do not provide any analysis on why any capital gain derived by Scott’s SMSF should be subject to NALI once a CGT event occurs in relation to the units which may occur many years after the loan has been repaid.

Indeed, query whether there is a sufficient relevant nexus between any future capital gain that may eventually arise in respect of the disposal of the units (which are listed on the stock exchange) and the flexible LRBA provided to acquire the units. For instance, the flexible loan may only last for several years, whereas the units may be held for many more years after that loan is repaid; why should the entire capital gain for the entire holding period be tainted? Moreover, one would think that any capital gain that may eventually arise has no strong connection to the flexible LRBA given that the capital gain is entirely subject to the vagaries and volatility of the stock exchange for this type of investment.

However, on the other hand, a relevant nexus would exist where the eventual capital gain would not have arisen if Scott’s SMSF would not have had the fund’s to acquire the units at the relevant time but for the flexible related party loan. This view is based on the argument that the fund would not have derived any income or capital gain from the units but for the (flexible LRBA) scheme.

What if an SMSF trustee/director provides services to a unit trust?

One important point which is not dealt with in LCR 2021/2 is what is the status if an SMSF trustee/director provides services to a unit trust. For example, consider an SMSF that is invested in a non-geared unit trust that owned a factory and the SMSF trustee/director oversaw the collection of rent and dealings with the tenant (which may be a related party where the property constitutes business real property), attended to bookkeeping and instructed the accountant regarding the trust’s annual financial statements.

First, it is worthwhile noting here that ss 17A and 17B of the Superannuation Industry (Supervision) Act 1993 (Cth) do not apply to a unit trust.

Broadly, s 17A precludes an SMSF trustee/director from being remunerated for trustee duties in respect of an SMSF and s 17B authorises an SMSF trustee/director to be remunerated for non-SMSF trustee/director duties subject to certain criteria (eg, the person is qualified/licensed, the person carries on a business of providing such services to the public and the remuneration is arm’s length). Thus, ss 17A and 17B only apply at the SMSF level.

The position relating to remuneration for a trustee/director of a unit trust that an SMSF invests in depends on a range of factors including the unit trust’s governing rules (eg, the unit trust deed and the constitution of the corporate trustee of the unit trust).

The ATO acknowledges in relation to a trustee or director of a corporate trustee of an SMSF that:

  • A trustee or a director of a corporate trustee of an SMSF will be required to perform particular actions in order to satisfy a range of obligations imposed on them, eg, any conditions imposed by statute as well as fiduciary duties and obligations (see paragraph 44 of LCR 2021/2).
  • The trust deed may also provide a trustee or director of a corporate trustee the power to perform certain actions (see paragraph 45 of LCR 2021/2).
  • An individual’s business, profession, life experiences or employment may result in the individual having skills and knowledge that can assist the individual to perform their duties in their capacity as trustee, or as a director of a corporate trustee, of a SMSF. Utilising such skills and knowledge of itself does not indicate that the individual is not acting in their capacity as trustee or as a director of a corporate trustee (see paragraph 46 of LCR 2021/2).

While the three points referred to above relate to the trustee or director of a corporate trustee of an SMSF, there appears to be no reason why these same principles should not also apply to a trustee of a unit trust, eg, a director of a corporate trustee of a unit trust is required to perform a range of obligations both at law and under the trust deed. Such a director may also possess special skills and knowledge.

The Compendium issued with LCR 2021/2 provides responses to comments received on draft Law Companion Ruling LCR 2019/D3 (which was finalised as LCR 2021/2). The following is a relevant extract in relation to services which are provided by a related party at the unit trust level.

Issue number Issue raised

 

ATO response

 

 

23

Further clarification is needed for SMSFs that invest in unit trusts as the guidance provided so far is not sufficient.

 

The draft Ruling does not provide any examples where an SMSF trustee is assisting with managing the activities of a unit trust that owns real estate. We query whether these would be treated in a similar manner to the situation where the trustee provides internal or trustee type services directly to a SMSF.

We consider the Ruling provides sufficient guidance on the key principles to assist trustees to determine how the provisions apply.

 

Trustees may seek certainty on their specific circumstances through the private ruling process.

Thus, the ATO did not use LCR 2021/2 as the opportunity to clarify this topic. The ATO has suggested that trustees may wish to seek a private binding ruling instead.

However, given that paragraphs (b) and (c) in s 295-550(5) appear to relate to the SMSF acquiring the entitlement or in gaining or producing the income from the units in the unit trust, it would appear that any services provided by an SMSF trustee/director in relation to a unit trust would need to be considered under paragraph (a). That is, if the SMSF trustee/director has provided services for lower than market value or for free in relation to the unit trust, then that would appear to be a scheme that could result in more income flowing to the unit trust and, then ultimately the SMSF.

This issue may relate to a number of SMSFs with investments in unit trusts, particularly closely held and unlisted unit trusts where some services are provided. Not many have turned their minds to this NALE risk. Indeed, the penny has not yet dropped for many advisers on this point. A careful consideration should therefore be given to the types of services that might give rise to a NALI risk and these services might include the provision of financial support to the unit trust’s activities in the form of guarantees in respect of borrowings by the trustee of a unit trust. In short, careful consideration should be given to ensuring there is appropriate remuneration for services provided in relation to a unit trust where an SMSF holds units.

However, there may be certain formalities that need to be satisfied before remuneration can be paid to a trustee/director including ensuring there is express power in the unit trust’s deed that authorises payment.

Conclusions

SMSFs that invest in unit trusts, especially closely held unit trusts, need to carefully monitor the impact of LCR 2021/2 and make necessary changes to minimise NALI risks. Some unit trusts may need to outsource some of their activities moving forward, eg, appoint a real estate agent to manage the property owned by the unit trust, which may currently be undertaken by the SMSF trustee/directors free of charge. Expert advice should be obtained if there is any doubt.

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This article is for general information only and should not be relied upon without first seeking advice from an appropriately qualified professional.

By Daniel Butler ([email protected]), Director, DBA Lawyers and Bryce Figot ([email protected]), Special Counsel, DBA Lawyers.

DBA LAWYERS

3 August 2021

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