Trust Structures Targeted by the Tax Office and Property Investment Rules Change
Property investment is a great way to minimise your tax obligations because all of the costs of owning and maintaining the property can be used as a tax deduction at the end of the year. Some property investors are able to take the management of their investments to the next level by investing using trust structures which can not only reduce tax obligations, but also reduce personal risk if investing for business for example.
For anyone who uses trust structures or is involved in property investment, an important ruling was issued by the Commission of Taxation in December 2009 which is known as TR 2010/3 because the way trusts pay their beneficiaries has been significantly affected.
How are Trusts Structured?
Many property investors will use a discretionary trust to own a property and investors who own a business will use a discretionary trust to hold the property which is their business premises to help protect it from business risks. The aim then is to protect assets, for example if the business is sued, then the property where it operates from is owned by a different entity and cannot be used to fulfil the business’ liabilities.
A discretionary trust means that if the trust generates a net profit in a year, the trustee has the discretion to distribute some or all of the profits to different beneficiaries of the trust, to optimise the tax position for the owner’s family group. For example, if a spouse does not complete paid work in a year but their partner is paying tax at a high rate, the trustee – who is usually one or both of the spouses – can distribute the profit from the trust to the non-working spouse and benefit from their lower marginal tax rate.
It is common for trustees to also make distributions of profits to a corporate beneficiary which could be a private company which was set up for the sole purpose of receiving income from the trust however, the actual cash is retained by the trust. The trust distribution is taxed at the corporate tax rate of 30% in the hands of the corporate beneficiary, which means the trust can no reinvest the after-tax income which has now been taxed at the corporate rate. The trust can then use the funds to pay down a loan on a property, cover the property’s running costs or make new investments. As a result, the cash profit is retained and reinvested by the trust and cannot be accessed by individual trustees.
The Trust Owes its Beneficiaries
The trust retains the actual cash which represents the distributions to its corporate beneficiaries, and that amount is called an Unpaid Beneficiary Entitlement. A UPE is not a loan by law and simply represents the cash which is yet to be paid by the trust to the corporate beneficiary, satisfying the distribution made by the trust on paper.
This practice is commonly known as Division 7A and treats outstanding loans owned by a shareholder or their associate to a private company at the end of the year as an unfranked dividend. That is, unless certain remedial actions are taken such as commercialising the loan by written agreement. An associate often encompasses most entities related to the shareholder.
Legally, Division 7A does not apply directly to a UPE which is owed by a trust in favour of a corporate beneficiary, even though the trust will be an associate of a shareholder of the corporate beneficiary in most cases. As a result, there are provisions which will apply only if the trust has a UPE in favour of a corporate beneficiary, and an individual owes money to the trust.
While the Commissioner of Taxation has previously been aware of how corporate beneficiaries and UPEs were being used under Division 7A, a reinterpretation of the practice can affect this structure.
New Tax Ruling
The Commissioner of Taxation is now arguing that a UPE may be converted to a loan in certain circumstances, which will then be subject to Division 7A. Alternatively, a UPE can also be viewed as a provision for financial accommodation as there is an implied acquiesce between the trust and the corporate beneficiary for the trust to use the funds, and this will also be subject to Division 7A.
If you can show that a UPE is neither a loan, nor financial accommodation, the Commissioner of Taxation views the UPE balance as legally representing a sub-trust and any income which is derived from the main trust and is attributable to the UPE balance belongs to the corporate beneficiary and should therefore be distributed to the corporate beneficiary.
New Tax Implications
This small change can have significant implications for trusts structured with a UPE which is owed by a corporate beneficiary. For example, if the UPE is converted to a loan or is proved to be financial accommodation, it will be subject to Division 7A and must be repaid in full or repaid over seven years if the loan is formalised or 25 years if it is secured against a property.
However, if the UPE is deemed to be a sub-trust Division 7A does not apply and the main trust must make payments to the corporate beneficiary to represent the income derived from the funds attributable to the UPE.
The requirement to repay funds could severely affect a property investor’s investment strategy, because it had been originally designed based on the previous interpretation of the tax rules. This could mean an investor has to add years to their plan, to reach the same goals.
Plus, thanks to the decline in property values after the GFC, it could be difficult for a trust to refinance their lending, and as a result, they would not have the cash available to pay out a corporate beneficiary. The trust would then be forced to pay tax at a higher rate.
Every property investor with a trust structure will need to reassess their tax obligations and their investment plans to ensure they are still on track to achieve their goals, and all their obligations are met.
Related posts:
- How to get an Investment Loan For a Trust
- Discretionary Trust Home Loans
- Using a Trust to Own Your Property – Definition, Function, Benefits
- Home Loan For Unit Trust
- Which expenses can I prepay for my investment property
- Home Loan Using Property Investor Trust
- Westpac Fixed Rate Investment Property Loan Interest Only in Advance
- Investment Property Cash Flow
- Investment Property Tips & Guides
- Investment Property Tax Deductions
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