This article was originally written by Eddie Chung in a blog post titled: The Tax Issues Experienced by a Unit Trust as a Property Investment Medium
Unit trusts have been popular property investment channels for a long time, particularly if several owners are participating. Much like shareholders owning stocks in a business, unit holders can indirectly own their proportionate shares in an underlying property managed by a unit trust, which is a fairly easy concept to understand, though companies and unit trusts are basically different according to the law.
Tax breaks of unit trusts as property investment channels
In terms of investment property ownership, unit trusts are generally favoured over companies as they can pass on whatever net cash profit from the property that embodies non-cash depreciation and capital works deductions to the unit owners. These cash distributions, or “non-assessable amounts,” generated by a unit trust will normally lower the units’ cost base and do not bring about instant tax implications.
But in the case where the cumulative non-assessable sums surpass the units’ overall cost base, any surplus will generate a taxable capital gain. As long as the underlying units have been owned by the unit holder for a minimum of 12 months and the unit holder is either a trust or an individual, the capital gain will be split under the 50% capital gains tax (CGT) discount (unit holders who are a complying superannuation fund are entitled to a 33.33% CGT discount).
In comparison, if a company made this type of distribution to a share owner, it will be typically considered as an assessable dividend straight away, which may result in an immediate tax liability.
Unit trusts are also preferred over companies when a capital gain is generated as a result of selling the investment property. As long as the property has been owned for no less than 12 months, whatever capital gain made by the unit trust will be covered by a 50% CGT discount. For example if the unit holder that gets the capital gain is paying tax at a marginal tax rate of 49% including the temporary Budget Repair levy and the Medicare levy. The discount capital gain’s effective tax rate will be 49% x 50% = 24.5%.
On the other hand, if a company made the capital gain, there is no CGT discount and a 30% tax will be levied on the capital gain. In the case of a divided ascribed to the capital gain being issued to an individual shareholder who is paying tax of 49% (the highest tax rate) as a franked dividend, the capital gain would have an effective tax rate of 49% after the individual shareholder has used the franking credits.
With these dissimilarities in tax application, it’s easy to appreciate the reason for unit trusts being generally favoured as property investment channels over companies. With that said, taxation is not the only factor that you should take into accounting when you make any structuring decision. For example, you have to consider that the treatment of stamp duty relating to the allocation of shares and units may be considerably dissimilar, depending on the area where the dutiable transaction took place.
Tax issues encountered by unit trusts as property investment channels
There are some less well known technical tax issues with regards to utilising unit trusts as property investment channels that property investors are unaware of. There may be far reaching tax implications with some of these problems.
Possible double taxation
Double taxation may inadvertently occur because the existing tax regulations include a cost base reduction system called “CGT event E4” and a “capital works deduction drawback.”
Imagine an innocent scenario where a single unit owner of a unit trust makes a contribution of $1M to purchase units in the trust. Subsequently, the unit uses the money to buy an investment property.
Ignoring other rental expenditures and income, let’s say the unit trust claims $5k in capital works deduction during the first year and issues the cash attributable to the deduction to the unit owner as a non-assessable sum (since the deduction isn’t a cash expenditure and the trust’s income covered by the deduction is not exempt from the trust’s assessable income but is issued to the unit owner) – the non-assessable sum will activate the “CGT event E4,” which will entail the tax cost base of the units maintained by the unit holder to be trimmed down to $1M – $5k = $995k. As stated above, the cost base reduction alone does not activate a tax liability directly.
If the property is sold by the trust at year’s end for $1.2 M, for example, the assessable capital gain earned by the trust, disregarding the impact of the 50% CGT discount to make things simple, is computed as:
Capital proceeds $1.2M
Original cost of property $1M
Less: Cumulative non-assessable amounts clawbacks ($5K) ($905K)
Taxable capital gain $205K
The unit holder will receive the $205 as a taxable capital gain, although the cash attributable to the capital gain issued to the unit holder is just $200k since the capital works deduction clawback amounting to $5k is just a tax correction.
When the time comes that the units held by the unit holder are either cancelled or claimed, the capital proceeds on the sale of the units will remain at $1M, although the units have a cost base of $995K because of the past activation of CGT event E4. Thus, a taxable capital gain of $1M – $995K = $5K will be made to the unit holder as a result of the sale of the property.
Combining all the elements above together, the following is the economic benefit that is due to the unit holder:
Non-assessable amount sheltered from tax $5K
Actual capital gain in cash1 $200K
Total overall economic benefit $205K
But the taxable amount all in all for the unit holder is:
Taxable capital gain distributed by trust $205K
Taxable capital gain on disposal of units $5K
Total capital gain that is taxable $210K
This means the capital works deduction of $5K underwent double taxation!
The double taxation problem was discovered a long time ago, but it still happens today, and investors either don’t know about it or just consider it a trade-off for doing business.
Probability of not recouping tax losses
A more major concern in using unit trusts as property investment channels is the technical problem that relates to the possibility of transforming any unit trust into a “fixed trust” in Australia. There are many taxation policies that may be impacted by the matter of “fixed trust.” One of these is trust loss policies, which cover the capability of a unit trust to recover carried forward tax losses.
To put it simply, the trust loss policies, in general, allow fixed trusts to recover tax losses provided most of the unit holders of the applicable trust remain the owners of the units of the trust from the time the tax losses were acquired. Thus, a unit trust can in allowed to recover its tax losses if it is a “fixed trust”. If it is not, it must pass a series of more difficult trust loss recovery tests before it can recoup its tax losses.
It was believed, for quite a while, that a significant number of unit trusts are really fixed trusts. This changed when several fairly new legal precedents implied that it is very hard, from a technical standpoint, for an Australian unit trust to be eligible as a fixed trust. As a result of these instances, the risk is now greater that unit trusts with carried forward tax losses will not to be able to recoup tax losses.
It seems that the Commissioner of Taxation has been active in tackling this problem, but it is not far fetched for him to exploit the technical issue and dare taxpayers who have utilised unit trust for different reasons, including property development and investment.
Considering all of these issues, circumstantial evidence appears to imply that individuals and their advisers who still utilise unit trusts and may likely face this technical problem are either ignorant of its existence or are aware of the problem but paying no attention to it. There are also people who think that the court decisions were erroneous and continue to hope that regulations will be changed sometime in the future to right the wrong.
Whatever your views and approach are, and in spite of the fact that a resolution will be found eventually, doing nothing is a bad idea as there may be practical actions that you can do to lessen your exposure to risk.
For tax advice or guidance, contact PJS Accountants. We offer expertise in managing your tax affairs with a full range of compliance, corporate and individual tax services, whether you are a large company, SME, family business or individual. Tax laws and requirements change constantly, potentially putting you or your businesses at risk. Have a chat with one of our expert advisers now and significantly minimise your exposure to financial risks.