Technical issues involving pre August 12 1999 unit trusts and the 30 June 2009 deadline
Issue raised
Technical issues involving pre 12 August 1999 unit trusts and the 30 June 2009 deadline
1. If a SMSF doesn't have the financial capacity to make the remaining payments on partly paid units before the 30June 2009 cut off, does the unpaid component constitute a 'loan' for the purposes of the SISAct?
2. Can a SMSF utilise the aggregate total of the amount required to pay up the partly paid units AND the amount allowable under the reinvestment rule to determine the maximum level of investment in the unit trust before 1July2009?
3. (a) For unit trusts required to be wound up for practical reasons where the trust property includes one or more assets which would otherwise breach the related party acquisition rule (for example, residential property), would the transfer of the capital asset to the SMSF contravene section66?
(b) If so, could the Tax Office provide a definitive statement regarding whether it would grant a Regulator's Exemption under section66(2)(d)?
4. In the event of units being transferred to a non-member spouse's SMSF on marital breakdown, could the Tax Office provide a definitive statement that the transferred units would be granted a regulators exemption under section71(1)(e) or(f) and circumstances in which one may or may not be granted?
5. Does an 'unpaid distribution' result in a breach of section71-109 where the unit trust is locked into principal and interest fixed rate loan arrangement which absorbs the cash reserves of the unit trust?
6. Small Independent Superannuation Funds Australia (SISFA) also wishes to provide some practical statements/observations regarding agenda item5.2 of 23March2009 NTLGSTS concerning the section71D reinvestment calculation.
Background information
1. Many SMSFs experiencing cash flow difficulties may not be able to make the remaining payments on their partly paid units. This brings into play whether the unpaid amount could be treated as a loan for the purposes of section65 or section71 since there would be no ability (beyond 5% threshold) to pay up these units beyond 30June2009.
2. It is widely accepted and clear in law that trustees cannot aggregate the section71E threshold with the other investment thresholds potentially available under section71A(2) and section71D. However, the question relates to whether the section71A(2) and71D thresholds can be aggregated for the purposes of calculating the maximum pre 1July2009 investment threshold.
3. Many unit trusts are currently experiencing cash flow difficulties and may be facing situations where they have to decide to between selling an assets at the bottom of the market (in forced sale situation), or otherwise endeavour to retain the asset within super system with the view of providing better returns for the future. An issue they face is whether the capital distribution of an asset (such as residential property, art, plant and equipment etc) to the SMSF would breach section66. Two fundamental issues emerging from this: The first is whether or not the vesting of assets is the unit trust means the SMSF is taken to 'acquire an asset' for the purposes of section66. The second is whether the principles arising from Charles and Lock cases could apply to exempt the transfer:
The Courts have held that that holders of units in a unit trust may have an equitable proprietary interest in the underlying assets of the trust (Charles v. Federal Commissioner of Taxation (1954)90CLR598; (1954)10ATD328; (1954)6AITR85, Lock v. Commissioner of Taxation (2003)129FCR1; (2003)52ATR575; [2003]FCA309 although this may not always be the case depending on the terms of the trust deed (CPT Custodian Pty Ltd v. Commissioner of State Revenue (Vic) [2005]HCA53; (2005)224CLR98; 2005ATC4925; (2005)60ATR371. Source:ATOID2008/51.
In other words, could the Charles and Lock principles be applied to exclude the SMSF from the application of section66 where the SMSF owns 100% of the units and the trust deed confers an equitable interest in the underlying property? Overlaying these technical issues is whether or not the Tax Office could provide some certainty in these situations by providing a regulator's exemption under section66(2)(d).
4. An unintended consequence of the existing legislation is that in the event of separation, the units in a unit trust can be transferred to the non-member spouse's SMSF without triggering capital gains tax (CGT) consequences and there is also an exemption provided under section66. However, there I no corresponding in-house assets exemption available unless a regulators exemption is granted by the Tax Office.
5. Take the following as an example. A fixed rate principal and interest loan was entered into 2008-09 income year. The expected 2009-10 income and expenses are as follows:
Expenses 2009-10 / AmountInterest repayments / $10,000
Principal repayments / $8,000
Running costs / $2,000
Income 2009-10
Gross income / $20,000
Net income (taxable in SMSF) / $8,000
Unpaid distribution / $8,000
This position would be broadly replicated for the remaining term of the loan. The SMSF owns 100% of the units in the unit trust.
Up to 30June2009, the unpaid distribution may have been dealt with under section71A-E of the SISAct. From 1July2009, that option is no longer available (other than investing up to 5% in-house asset limit) so the client is left with an unpaid entitlement.
If this arrangement is considered to be in breach of the SISAct, the client has the choice of incurring substantial 'break fees' or entering into a forced sale situation in a depressed market.
Industry view/suggested treatment
1. No, provided there is no compulsion under the trust deed of the unit trust for the SMSF to fully pay up the units, there ought to be no 'loan' as defined in section10 of the SISAct.
2. Yes, it is possible for an SMSF to invest up to the sum of the reinvestment thresholds provided under section71D AND the amount required to make the units held fully paid under section71A(2).
3. Depending on the specific arrangements, it would appear there would always be some risk the transfer of assets on closure/vesting of the unit trust might contravene section66. The only way for the asset to be retained within super system with certainty rather than sell out is to apply for and be granted a regulator's exemption under section66(2)(d).
4. The only way for the units to be retained by the new fund would be when regulators exemption under section71(1)(e) or (f) has been granted. This matter has been raised at the NTLG previously. In our view this issue has become more relevant in current economic environment with increasing divorce rate.
5. The unpaid distribution is an amount owing bet not necessarily a 'loan'. Most unit trusts hold these amounts on a separate trust for the SMSF. Hence there is no creditor/borrower relationship. The unpaid amount may not be an investment. An investment is an amount paid for the purposes of obtaining a pecuniary return. The unpaid distribution is not paid from the SMSF.
6. Clarification of agenda item5.2 - Calculation of section71D threshold from meeting of June2007.
SISFA endorses the Tax Office analysis provided in response to agenda item5.2 of the NTLGSTS meeting of 5June2007 such that the reinvestment threshold should only reflect the sum of post test time distributions derived from the original investment ($10,000x10years=$100,000 in example) AND the distributions relating to further investments of post test time distributions derived from the original investment ($20,000x$0.10=$2,000x8years=$16,000).
The practical issue is that the amount counted as in-house assets in June 2001 may exceed the 5%IHAlimit which means at least part of the investment ought to be unwound over the following income year (unless the fund has over $1.6million of assets to stay within 5%limit). Should the threshold have been exceeded in the 2000/2001 income year the trustees are required to enter into a plan to dispose of the excess in-house assets to within the 5% limit. No further re-investments can be made until such a time as the excess in-house assets have been disposed of.
Technical reference
o Section 66 SISAct
o Section 71A-71E SISAct
o NTLG STS - agenda item 5.2 - 5 June 2007
o SISFA submission - R. Jeremiah - 20 August 2007
o SMSFR 2008/D1
Impact on clients
o Legislative uncertainty concerning pre 12 August 1999 units trusts.
o Legislative inconsistency following introduction of section 67(4A).
o Compliance risks leading up to 30 June 2009 and beyond.
o Inadvertent breaches of the SISAct.
o Forced sales and increased costs.
Priority of issue where ATO view is required
High - 30 June 2009 deadline.
Has previous advice been sought from the Tax Office?
It is understood advice has been sought on questions 3 and 4.
Tax Office initial response
o If a SMSF doesn't have the financial capacity to make the remaining payments on partly paid units before the 30June 2009 cut off, does the unpaid component constitute a 'loan' for the purposes of the SISAct?
Section 65 prohibits an SMSF from lending money of the fund to a member or a relative of a member. Where the SMSF has not fully paid for a unit in a related unit trust, this amount cannot represent a loan of the money of the fund as it represents a potential liability of the SMSF. That is, if any 'loan' were to arise from this unpaid amount, it would be a loan from the unit trust to the SMSF. Such a loan is not prohibited by section65.
Likewise, the relevant part of the definition of an in-house asset in subsection71(1) requires that a 'loan' to a related party is an asset of the fund. As any unpaid part of a partly paid unit represents a potential liability of the SMSF, it cannot be an in-house asset of the fund.
It has also been questioned as to whether the unpaid amounts on the partly paid units represent a borrowing by the SMSF from the unit trust. 'Borrowing' (unlike 'loan') is not defined in the SISAct and takes on its ordinary meaning. As explained in SMSFR2009/2 the prohibition and exceptions in section67 only apply to borrowings of money. Therefore, for the purposes of section67, a borrowing is an arrangement that exhibits two necessary characteristics:
o a temporary transfer of an amount of money from one entity (the lender) to another (the borrower), and
o an obligation or an intention on the part of the borrower to repay that amount to the lender (which may be satisfied by the provision of an asset).
An amount left unpaid on the partly paid shares would not fit within the requirements for it to be a borrowing of money. Please refer to SMSFR2009/2 for further information.
o Can a SMSF utilise the aggregate total of the amount required to pay up the partly paid units AND the amount allowable under the reinvestment rule to determine the maximum level of investment in the unit trust before 1July2009?
Section 71A excludes shares or units in a unit trust acquired before 12August 1999 (or under a contract entered into before 12August 1999) from the in-house assets of the SMSF where those shares or units would not have been in-house asset prior to that date. Further payments on those shares or units between 12August1999 and 30June2009 will not prevent section71A from excluding these shares from the in-house assets of the SMSF.
Section 71D excludes from the in-house assets of an SMSF, new investments made in a company or unit trust between 12August 1999 and 30June 2009 where such an investment would have not been an in-house asset if held prior to 12August 1999. The investments excluded under this section are reinvestments of dividends or trust distributions received by the SMSF from that entity. Correspondingly, the total amount invested in the entity during that time must not exceed the sum of the amounts received by the SMSF as dividends or trust distributions derived from the original investment and re-investments during that same period.
Section 71D only applies to investments that are not covered by section71A (see paragraph71D(b)). Therefore, there will not be any overlap between section71D and section71A. The limit on making new investments under section71D will not be affected by payments on the original shares or units covered by section71A. It will be a question of fact as to whether a particular payment is:
o a further payment on an existing share or unit (section 71A)
o a new investment through the issue of new units (section 71D), or
o a new investment through the acquisition of units from an existing unit holder (section71D) subject of course to the acquisition rules in section 66.
o For unit trusts required to be wound up for practical reasons where the trust property includes one or more assets which would otherwise breach the related party acquisitions rule (for example, residential property), would the transfer of the capital asset to the SMSF contravene section66? If so, could the Tax Office provide a definitive statement regarding whether it would grant a regulator's exemption under section66(2)(d)?
Where an SMSF has a pre-12August 1999 investment in a related unit trust and that unit trust winds up, any transfer of capital assets will be an acquisition of an asset from a related party under subsection66(1). This is because the terms 'acquire' and 'asset' in the context of section66 have a wide meaning. The term 'acquire' means 'obtain', 'gain' or 'receive' (see paragraph39 of SMSFR2008/D2). The term 'asset' is defined in subsection10(1) of the SISAct to mean 'any form of property'. The phrase 'any form of property' has a wide meaning and includes every type of right, interest, or thing of value that is legally capable of ownership and can be alienated or transferred to an SMSF (see paragraph48 of SMSFR2008/D2).