Property development and SMSFs - Part 2: Investing through a unit trust
In the first instalment of the four part series on self managed superannuation fund trustees developing property, we considered the tricks and traps for fund trustees developing property directly.
In this update, we consider the commercial and superannuation law issues associated with developing property through a related or unrelated unit trust structure.
Can a related unit trust undertake a property development?
An option for structuring property development projects is for the fund trustee to invest in a unit trust that holds the development land by subscribing for units in the unit trust. Importantly, where the unit trust is a related party of the fund, the investment will be an in-house asset under section 71 of the Superannuation Industry (Supervision) Act 1993 (SIS Act) unless the requirements of regulation 13.22C of the Superannuation Industry (Supervision) Regulations 1994 (SIS Regulations) are complied with as follows:
- the trustee of the unit trust is not a party to a lease with a related party of the fund unless the lease relates to business real property;
- the trustee of the unit trust does not borrow;
- the assets of the unit trust do not include an investment in another entity (except an approved deposit-taking institution);
- the trustee has not given a charge over the trust assets;
- the trustee has not made a loan to another entity;
- assets acquired from related parties of the fund after 11 August 1999 are business real property acquired at market value;
- the trustee does not conduct a business; and
- transactions are on arm's length terms.
In practical terms, this means that the unit trust must be a passive investment vehicle that only invests in real property. The trustee for the unit trust will also be prohibited from borrowing to fund the development. Importantly, the trustee for the unit trust should not conduct a business of property development. Thus, depending on the size and scale of the development, the trustee should consider engaging a third party to develop the land for a fee.
When is a unit trust a related party?
The unit trust will be a related party of a fund where the fund trustee controls the trust as follows:
- the fund trustee and/or its associates have a fixed entitlement to more than 50% of the income or capital of the trust;
- the fund trustee and/or its associates have the power to influence the trustee for the unit trust, either directly or indirectly within the meaning of section 70E(1) of the SIS Act (Sufficient Influence); or
- the fund trustee and/or its associates have the power to appoint or remove the trustee for the unit trust.
An associate of a fund for the purposes of section 71 of the SIS Act includes the members, members' relatives (ie spouse, children, parents and extended family), the partners of a member (ie partners in a law firm), companies a member and/or their relative(s) control and trusts the member and/or their relative(s) control.
A related party also includes a standard employer-sponsor of the Fund (section 10 of the SIS Act). An employer that contributes to a fund on behalf of a member is not automatically a standard employer-sponsor. A standard employer-sponsor is defined in section 16(2) of the SIS Act as an employer that contributes to the fund pursuant to an agreement between the trustee and the employer. An arrangement between the employer and member is not sufficient.
Where a fund trustee invests in a related unit trust in which a related or unrelated party also invests, the fund trustee may acquire the units held by the other party over time, subject to complying with the provisions of the SIS Act. Keep in mind that here could be capital gains tax implications and where the unit trust is land rich, there may be a corresponding stamp duty liability.
Can a fund trustee invest in an unrelated unit trust?
Where the fund trustee invests in an unrelated or widely held unit trust (ie the entitlements are fixed and fewer than 20 entities do not have a fixed entitlement to 75% or more of the income and/or capital of the trust), the trustee for the unit trust is not required to comply with the requirements of regulation 13.22C of the SIS Regulations. This means that the trustee for the unit trust can borrow to fund the land development without the fund trustee breaching the in-house asset rules in section 71 of the SIS Act.
The unit trust will be unrelated if the fund trustee and its associates do not:
- have a fixed entitlement to more than 50% of the income and capital of the unit trust. This means that the fund trustee could hold 50% of the units without the unit trust being a related party of the fund;
- exercise Sufficient Influence; or
- have the power to remove or appoint the trustee for the unit trust.
If a fund is a related party of another investor in the unit trust and any of the above criteria are satisfied in aggregate (ie the sum of all interests held by related parties of the fund equal a fixed entitlement to more than 50% of the capital and/or income of the unit trust etc), the unit trust will be a related party of the fund.
From a practical perspective, it is important that the units in the unit trust carry equal rights to income and capital such that the fund trustee and/or its associates do not have disproportionate income rights that give a fund trustee effective control of the unit trust. Disproportion income rights could also trigger the non arm's length income provisions under section 295-550 of the Income Tax Assessment Act 1997 (1997 Act).
Whether a fund trustee and or its associates exercise Sufficient Influence is a question of fact to be determined in all the circumstances.
The Commissioner has not elaborated on the meaning of Sufficient Influence in a superannuation law context and the Explanatory Memorandum to the SIS Act does not provide any guidance. The factors likely to evidence Sufficient Influence include the nature of the relationship between the trustee for the unit trust and the fund trustee or one or more associates, such as a family or financial relationship or common directors or shareholders (ie the controlling minds are the same) and whether any inferences can be drawn from events, transactions or patterns of behaviour which show that the entity is able to direct or influence the trustee's behaviour.
Generally, it is difficult to establish Sufficient Influence between unrelated parties dealing on commercial terms because a business relationship usually does not have the same degree of mutual trust and guidance present in personal relationships. However, this is ultimately a question of fact for the fund trustee to determine based on all the circumstances and the relationship between the relevant parties.
Even where two unrelated fund trustees each hold 50% of the units in the unit trust, it is important that the trust operates on a 50/50 basis. It should be evident that decisions are made jointly. There is no room for the silent director. For example, both parties should approve or sign any important documents and both should be signatories to the bank account.
Power to appoint or remove the trustee
Whether a fund trustee and/or its associates have the power to appoint or remove the trustee for the unit trust will depend on the terms of the trust deed for the unit trust and the constitution of the corporate trustee for the unit trust.
From a practical perspective, it is important that the units in the unit trust carry equal rights such that the fund trustee and/or its associates do not have disproportionate voting rights that give the fund trustee effective control of the unit trust.
The constitution of the trustee for the unit trust should be reviewed to ensure that the fund trustee and/or its associates do not have the power to control the trustee by effectively having the power to appoint and remove the trustee for the unit trust by reason that they hold a majority of the shares in the trustee. Generally, each ordinary share in the trustee should entitle the shareholder to one vote. Further, it is important that the chair does not have a second or casting vote where the chair is a representative of the fund trustee and/or its associates.
Can a pre 11 August 1999 unit trust undertake a property development?
Where the fund trustee has invested in a grandfathered pre 11 August 1999 unit trust, a property could be developed within the pre 11 August 1999 unit trust on the basis that the fund trustee's investment in the unit trust continues to satisfy the prudential requirements of the SIS Act. Importantly, the trustee of a pre 11 August 1999 unit trust is not restricted in the investments it is permitted to make under the SIS Act, for example the trustee can borrow, charge its investments, invest in another entity and conduct a business.
As the transitional period ended on 30 June 2009, the fund trustee cannot reinvest distributions and subscribe for additional units without the additional investment being treated as an in-house asset under section 71 of the SIS Act. Further, all distributions must be physically paid to the fund trustee. Therefore, it is important that the unit trust has sufficient cash flow to enter into and fund the transaction without additional investment by the fund trustee.
The trustee for the unit trust must also consider whether the land development is consistent with the terms of the trust deed for the unit trust and an appropriate investment.
Will any distributions to the fund trustee be non-arm's length income?
Where the fund trustee invests by way of a unit trust structure, any income received by the fund trustee may be treated as non arm's length income and taxed at 45% under section 292-550 of the 1997 Act, where:
- the parties are not dealing at arm's length terms; and
- the fund trustee receives an amount it would not otherwise have received if the parties were dealing on arm's length terms.
Similarly, income the fund trustee derives as a beneficiary of the trust, other than because of a fixed entitlement to income, will be treated as non arm's length income and taxed at 45%. Therefore, it is important to ensure that the unit trust is a fixed trust, meaning that the entitlement of unit holders to receive income and/or capital from the unit trust is fixed and indefeasible.
On the basis of the recent case of Colonial First State Investments Limited v Commissioner of Taxation  FCA 16, it may be necessary to ensure the power to amend the trust deed for the unit trust does not extent to reducing or varying the rights of unit holders to receive income and/or capital distributions from the unit trust.
Stay tuned for Part 3 where we consider the commercial and superannuation law issues associated with borrowing to develop property and the importance of properly documenting a property development arrangement.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.