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04/06/2015 | Stephen Harvey compliance, unit trust, risk, fixed trust

Are You Playing by The Rules With Your Unit Trusts?

Recent case study illustrates potential vulnerabilities
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Sadly, in a recent case that came across my desk, the outcomes from the improper use of unit trusts were particularly adverse for both the accounting firm and their client involved. Although the situation was avoidable, we remain concerned that some practitioners are unaware of the rules applying to the structures they are ordering.

We often notice that practitioners assume a unit trust is a “fixed” trust for tax purposes. As you’ll see from the story below, this is not always the case and the outcome can be disastrous.

Background to the case

Let’s look at a fairly typical situation we come across.

You have set up a company, and its shares are held by a unit trust. The trust cannot, or has not, made a family trust election. Now let’s imagine that the company has been quite successful, and wants to pay a dividend to its investors.

The company then declares and pays a dividend with a franking credit attached. The trust, of course, then distributes the dividend to the individual unit holder. Obviously, the unit holder wants to apply the franking credit to reduce the tax he or she might otherwise have to pay.

Not so fast!

And here’s the rub…Very few unit trust deeds qualify as fixed trusts. In fact, classification as a fixed trust is now less likely following the Federal Court decision in Colonial First State Investments Ltd v Commissioner of Taxation.

Since that decision was handed down, the Commissioner has taken the general view that no trusts are fixed trusts for the purposes of Schedule 2F. Trustees are now left to rely on the exercise of the Commissioner’s discretion to treat the trust as “fixed” in appropriate circumstances. Hardly ideal for your clients!

The Commissioner does, however, seem amendable to an exercise of that discretion where the trust deed has the elements of a fixed trust.

And here’s the technical part - Schedule 2F of the ITAA 1936 defines a fixed trust as one in which: “persons have fixed entitlements to all of the income and capital of the trust”. A non-fixed trust is defined as a trust that is: “not a fixed trust”.

According to Schedule 2F, beneficiaries have a fixed entitlement to the income and capital of the trust where they have a vested and indefeasible interest in a share of the income or capital. Where using a unit trust, units must only be issued or redeemed on the basis of the net asset value of trust assets, according to Australian accounting principles.

Schedule 2F deals with the recoupment of trust tax losses. But it’s also relevant to the ability of the unit holder to access the franking credit. Difficulties arise under the dividend imputation system where a trust is non-fixed.

To claim the benefit of franking credits, section 207-145 ITAA 1997 requires a taxpayer to be a “qualifying person” i.e. the person must hold the relevant shares or interests “at risk” for a continuous period of 45 days.

To work out if shares are held “at risk”, special rules apply to a person who holds an interest in shares as the beneficiary of a trust, including the beneficiary having a fixed interest in the trust. If the unit holder receives a franked dividend from the trust, the unit holder will not gain be able to access the benefit of the franking credit, where the trust is technically not fixed and the Commissioner refuses to treat it as fixed.

Just like the trust loss rules, the imputation rules specify that beneficiaries have a fixed interest where they have a vested and indefeasible interest in a share of the income or capital. Similarly, units can only be issued or redeemed on the basis of the net asset value of the unit trust at the time of the redemption or issue.

Accordingly, if the unit trust is not fixed for the purposes of Schedule 2F loss rules, a unit holder’s interest in that trust will not be fixed for imputation purposes.

The bottom line?

The taxpayer will be assessable on the whole of the dividend at his or her marginal rate, and cannot claim the 30% credit for tax paid by the company.

Two main exceptions are available where:

  • a family trust election has been made in relation to the trust, and the franked distribution is paid to a beneficiary (unit holder) who falls within the family group; or
  • the beneficiary (unit holder) has a fixed interest in the trust.

We often see cases where the franking credits are trapped in the trust because the trust deed does not work like a fixed trust.

Now is the time to review your clients’ trusts. Acis has developed a Unit Trust Checklist to do just that. Download it here or for more information, call us toll-free on 1800 773 477.