Practitioners urged to monitor unit trust tax changes

While the draft legislation has not been introduced into Parliament yet, Mr Butler said the main provisions will apply as soon as 1 July 2016 and certain provisions from the date of royal assent.

Mr Butler explained under the current legislation the 20 per cent tracing rule for public trading trusts in division 6C of the Income Tax Assessment Act 1936 (Cth) (‘1936 Tax Act’), broadly specifies that if an exempt entity such as a super fund holds more than 20 per cent on interests in a trust, the unit trust can be a public trading trust and taxed as a company unless the unit trust invests in real estate primarily for rental income.

“At the moment division 6C looks at what is an exempt entity, and an exempt entity includes a complying superannuation fund,” said Mr Butler.

“Now what it says in in chapter eight of the exposure draft Bill is that division 6C will be modified so that membership interests held in a trust by tax exempt entities and complying superannuation entities which are entitled to a refund of franking credits will be disregarded for the purposes of applying the 20 per cent tracing rule that applies to determine whether a trust is a public trading trust,” he said.

The 20 per cent tracing rule he explained determines whether the trust is a public trading trust as s102MD of the 1936 Tax Act currently includes complying superannuation funds in the definition of an exempt entity. However, the revised s102MD in the draft legislation provides:

For the purposes of this Division, treat an exempt institution that is eligible for a refund (within the meaning of the Income Tax Assessment Act 1997) as not being an exempt entity.

Complying superannuation funds that are entitled to a refund of franking credits will therefore no longer be included in the tracing rule. This should result in unit trusts with super fund investors as not invoking div 6C. Therefore, a unit trust that is owned by an SMSF that owns real estate that is not primarily used for rental income will not be taxed as a company when the proposed Bill is finalised as law.

When a unit trust is taxed as a company Mr Butler said the administration involved with the unit trust, its distributions and complying with the franking credit regime becomes considerably more complex.

“If you have a unit trust and the unit trust is not caught up in company taxation, it just distributes and the unitholder, in this instance typically the SMSF accounts for the net income and pays tax to the extent it is not in pension mode – there’s only one layer of tax,” he explained.

“The unit trust then notifies unitholders and the unitholders bring to account the taxable income.”

Mr Butler said under the public trading trust system, however, the unit trust becomes more of an active taxpayer in that it has to pay company tax and comply with the dividend imputation provisions. This means it must frank any distributions with the company tax it pays.

“Once you’re in the company tax system for a while the unit trust generally has to pay that tax quarterly and has to manage its franking accounts,” he said.

The proposed legislation, he said, could therefore have a lot of ramifications and will certainly affect practitioners.

“If your client already has a public trading trust they should start planning their exit as soon as the legislation is finalised. Those clients will need to be very careful because if they’re getting out of a public trading trust and the provisions, then they may have limited time to utilise their available franking credits," said Mr Butler. 

SMSF practitioners will also need to monitor the other potential changes to managed investment trusts, he said.

SMSFs that invest in such trusts such as larger managed fund trusts for example, he said, will be covered by the legislation when finalised. 

"The new provisions will result in significant changes to how managed funds have previously been taxed," said Mr Butler.

The legislation is expected to take effect from mid-2016, he said, but could be subject to further changes before being finalised as law.