Unit trusts have long been popular property investment vehicles, especially where multiple owners are involved. Similar to shareholders owning shares in a company, unit holders can indirectly own their proportionate interests in an underlying property held by a unit trust, which is a reasonably simple structure for people to understand, notwithstanding that unit trusts and companies are fundamentally very different things at law.
Tax benefits of unit trusts as property investment vehicles
Unit trusts are generally preferred when it comes to investment property ownership over companies because they have the ability to pass on any net cash profit from the property that represents non-cash depreciation and capital works deductions to the unit holders. Such cash distributions, also known as ‘non-assessable amounts’, made by a unit trust will generally reduce the cost base of the units and do not give rise to any immediate tax consequences.
However, when the cumulative non-assessable amounts exceed the entire cost base of the units, any excess will give rise to a taxable capital gain. Provided that the underlying units on which the distributions are made have been held by the relevant unit holder for at least 12 months and the unit holder is either an individual or a trust, the capital gain will be halved under the 50% capital gains tax (CGT) discount (if the unit holder is a complying superannuation fund, the CGT discount is 33.33%).
In contrast, if this kind of distribution is made by a company to a shareholder, it will generally be treated as an assessable dividend upfront, which may give rise to an immediate tax liability.
Unit trusts also shine in comparison with companies when an investment property is eventually sold and a capital gain is made. Provided that the property has been held for at least 12 months, any capital gain derived on the property by a unit trust will qualify for the 50% CGT discount; assuming that the relevant unit holder to whom the capital gain is distributed is paying tax at a marginal tax rate of 49% inclusive of the Medicare Levy and temporary Budget Repair Levy, the effective tax rate on the discount capital gain will be 49% x 50% = 24.5%.
On the other hand, if the capital gain is derived by a company instead, no CGT discount will be available and the capital gain will be taxed at 30%. If a dividend attributable to the capital gain is eventually distributed to an individual shareholder who is paying tax at the highest marginal tax rate of 49% as a franked dividend, the capital gain would ultimately be subject to an overall effective tax rate of 49% after the franking credits are utilised by the individual shareholder.
Given these differences in tax treatment, it is not difficult to understand why unit trusts are generally preferred as property investment vehicles over companies. Having said that, taxation should only be one of the many factors to consider in any structuring decision. Other factors will also need to be considered to evaluate the merit and appropriateness of using unit trusts in different circumstances, eg, the stamp duty treatment for the transfer of units and shares may be significantly different, depending on the relevant jurisdiction in which the dutiable transaction is effected.
Tax problems of unit trusts as property investment vehicles
Notwithstanding the above, many property investors are not aware that there are some less well-publicised technical tax problems associated with using unit trusts as property investment vehicles, even though some of these problems may potentially have far reaching taxation implications.
Potential double taxation
The current tax rules contain a cost base reduction mechanism known as ‘CGT event E4’ and a ‘capital works deduction clawback’ that may inadvertently give rise to double taxation.
Consider an innocuous situation where a sole unit holder of a unit trust contributes $1M to acquire units in the trust. The trust subsequently spends the $1M to acquire an investment property.
Disregarding other rental income and expenses, assume that the unit trust claims a capital works deduction of $5K in the first year and distributes the cash representing the deduction to the unit holder as a non-assessable amount (because the deduction is not a cash expense and the income of the trust sheltered by this deduction is excluded from the assessable income of the trust but is distributed to the unit holder) – the non-assessable amount will trigger CGT event E4, which requires the tax cost base of the units held by the unit holder to be reduced to $1M - $5K = $995K. As discussed above, the cost base reduction does not in itself trigger a tax liability upfront.
If the trust sells the property immediately at the end of the year for, say, $1.2M, the taxable capital gain derived by the trust, ignoring the effect of the 50% CGT discount for simplicity, is calculated as follows:
The $205K are distributed to the unit holder as a taxable capital gain, even though the cash representing the capital gain distributed to the unit holder is only $200K as the $5K capital works deduction clawback is only a tax adjustment.
At some stage, when the units held by the unit holder are either redeemed or cancelled, the capital proceeds on the disposal of the units will still be $1M, even though the cost base of the units is $995K due to the previous operation of CGT event E4. Therefore, the disposal will give rise to a taxable capital gain in the unit holder’s hands of $1M - $995K = $5K.
Pulling all of the components above together, the unit holder has derived an overall economic benefit as follows:
However, the total amount taxable in the hands of the unit holder is:
In other words, the $5K attributable to the capital works deduction have effectively been taxed twice!While the above double taxation issue has been a known problem for a long time, it still exists today and investors generally either accept it as a commercial trade-off or are not aware of it altogether.
Potential inability to recoup tax losses
Perhaps a bigger ‘time bomb’ regarding the use of unit trusts as property investment vehicles is the technical issue regarding whether any unit trust can be a ‘fixed trust’ in Australia. Among a number of taxation provisions that may be affected by this ‘fixed trust’ issue are the trust loss provisions’, which govern the ability of a unit trust to recoup carried forward tax losses.
Putting the issue in simplistic terms, the trust loss provisions will generally permit fixed trusts to recoup tax losses if the majority unit holders of the relevant trust continue to own the units of the trust since the tax losses were incurred. Therefore, whether the unit trust is a ‘fixed trust’ is critical in determining if it is allowed to recoup tax losses; if the unit trust is not a fixed trust, it will need to pass a set of more stringent trust loss recoupment tests before the tax losses can be recouped.
For quite some time, it was assumed that most unit trusts are in fact fixed trusts until a number of relatively recent legal precedents suggest that it is extremely difficult, from a technical point of view, for any unit trust in Australia to qualify as a fixed trust. As a consequence of these cases, there is now an increasing risk that unit trusts with carried forward tax losses would not have been or will not be able to recoup those tax losses. While it does not appear that the Commissioner of Taxation has been actively pursuing this issue to date, it is not inconceivable that he may take advantage of the technical glitch and challenge taxpayers who have used unit trusts for various purposes, including property investment and development.
To that end, anecdotal evidence seems to suggest that people and their advisers who continue to use unit trusts and may potentially be confronted with this technical issue are either not aware of it or are cognisant of the issue but ignoring it. There are also others who believe that the court decisions were wrong and live in the hope that the law may retrospectively be amended at some stage in the future to restore the original intention of the law.
Regardless of your views and approach, notwithstanding that this issue may eventually be resolved one way or another, doing nothing is not really a good option and there may well be practical steps to take that may minimise your risk exposure to put you in at least a reasonably arguable position.
For more information please contact Eddie Chung, Partner, Tax and Advisory, Property and Construction, BDO Australia +61 7 3237 5927
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. This article is provided on the terms and understanding that the author and BDO (QLD) Pty Ltd are not responsible for the results of any actions taken on the basis of information in this article, nor for any error in or omission from this article. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.