Speaking in a recent webinar, DBA Lawyers senior associate Shaun Backhaus explained that sometimes where SMSFs invest in unit trust, unpaid present entitlements (UPEs) can arise.
The ATO released a ruling relating to SMSFs and UPEs in 2009, SMSFR 2009/3.
“In this ruling, the Commissioner’s view is that where an SMSF is entitled to distributions from a related trust which are not paid to the SMSF, this can result in a number of superannuation law contraventions which include the arm’s length rules, sole purpose tests, and in-house assets from being a loan because there’s something owing from the unit trust,” said Mr Backhaus.
However, this particular ruling only discusses a related trust — it doesn’t talk about situations involving an unrelated trust, he noted.
Where there is an unrelated trust involved, the ATO’s position on this is less clear, he said.
“[Even where it is an unrelated trust], there would need to be some good reasons why those UPEs were there,” he said.
Mr Backhaus said there may be a reason for having unpaid present entitlements such as cash flow being tight with a property development, for example.
“Sometimes they can make sense, but you need to make that clear and record it and pay it when you can,” he explained.
“The UPEs would definitely need to be proportionate; you couldn’t just have the SMSF having UPEs — that would look weird. You also wouldn’t want them to be outstanding for too long either as that may raise questions.”
Mr Backhaus said the SMSF professionals and their clients would also need to evaluate whether the UPEs are in line with normal commercial operations.
The ATO previously clarified in ATO ID 2012/74 that if UPEs are kept proportionate then no loan will arise for Division 7A purposes, he noted.
“So, we have a bit of a position on that,” he said.
It also seems to be common when setting up unrelated trust investments, to issue initial units only to the investors (including SMSFs) then “loan” the balance of the investments into the unit trust. Presumably this less paperwork than issuing further units, particularly if there is disparity in the timing of receiving the capital, and possibly avoids stamp duty issues in some States.
The problem from an SMSF perspective is that typically there is no loan agreement, no scheduled repayments, security or documented interest rate. Such a loan can’t be considered to be at arms length as required by SIS Section 109.
The SMSF trustee often believes they have only an investment in a unit trust, when in fact the majority of it is a loan.
Such shortcuts in not issuing additional units may be acceptable for most investors, but not SMSFs.
What is the big deal about a proportionate UPE? It is exactly the same as a DRP in a pblicly listed company!