Many SMSF clients have invested in private unit trusts – such as pre-August 1999 trusts, ‘unrelated’ unit trusts or non-geared unit trusts that meet specific legislative requirements. In this article, I discuss how the ATO’s views on non-arm’s length income could impact on these investments.
In my experience, practitioners typically focus on the following SIS compliance issues when dealing with SMSF unit trust investments:
- Ensuring that the initial SMSF unit trust investment is not caught as an in-house asset. This is crucial where the parties are connected (such as being in business together) and wish to ensure that neither party controls the trust.
- Confirming that the unit trust is not providing financial benefits to a related party (eg, loans).
Often overlooked however, is that in-bound financial or other support to a pre-August 1999 or unrelated trust could lead to adverse tax consequences arising for the SMSF. More specifically, if a party (usually a related party) provides financial or other benefits to the unit trust on a non-commercial basis (such as interest free loans), this could result in trust distributions to the SMSF being taxed at 47%.
Furthermore, the ATO considers that non-arm’s length transactions at trust level ‘taint’ the trust distribution – resulting in the entire distribution being taxed at 47% to the SMSF, not merely the non-commercial component. The ATO made this point clear in ATO IDs 2014/39 and 40, where it concluded that ‘nil interest rate’ related party loans resulted in the trust distribution being treated as non-arm’s length income.
Note, this issue does not usually arise for a 13.22B or C trust because of the strict legislative requirements they operate under (e.g., these trusts cannot borrow).
EXAMPLE – Non-arm’s length income
The ABC SMSF has an existing investment in a pre-August 1999 unit trust. The unit trust has substantial investments, generating net income of $350,000 per year. Roger, a fund member, lends $5,000 interest free to the unit trust.
Will the trust income of $350,000 be treated as non-arm’s length income?
Yes, the ATO will argue that the entire trust distribution is non-arm’s length income.
What should you do as a practitioner?
In ATO IDs 2014/39 and 40, the ATO considered all loan features, including the existence of any personal guarantees, security provided, interest rate, level of principal repayments and loan to value ratios in considering whether the distribution was arm’s length.
Therefore, to ensure that unit trust distributions are not taxed at 47% to SMSF clients, all transactions should be reviewed to ensure that they are arm’s length, including:
- Applying commercial terms to trust loans.
- Physically paying all trust distributions within a reasonable period of time (refer to SMSFR 2009/3).
- Ensuring that free services are not provided to the unit trust from related parties.
- Making sure that SMSFs have invested in the trust at market value.
- Checking that transactions are conducted by the unit trust on commercial terms (e, trust assets are acquired at market value).
This minimises the risk of seemingly innocuous transactions leading to trust income being taxed to the fund at punitive rates – even though most transactions at trust level may occur on commercial terms.
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This article was submitted by Darren Wynen on behalf of TaxBanter. Darren is a passionate trainer who for the last 12 years, has focused heavily on taxation law for SMSFs and has become well known in the SMSF field through his presentations for a number of high profiled membership bodies and training organisations.
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