A unit trust is a very common feature in Australia. Most widely held trusts are unit trusts. But when are unit trusts fixed trusts for tax purposes?
When are Unit Trusts Fixed Trusts?
You would think that a unit trust is a kind of fixed trust. After all entitlements are linked to units. And in the normal world this is how it works. But nothing is normal in tax land. And so you are right about the units but not necessarily right about the fixed trust.
Fixed Trust
Schedule 2F defines a fixed trust.
s272-65: A trust is a fixed trust if persons have fixed entitlements to all of the income and capital of the trust.
And there you have the key word it all depends on: Fixed Entitlement. That is the all deciding factor.
And the ATO confirms the approach in Practical Compliance Guideline PCG 2016/16. A unit trust only qualifies as a fixed trust, when all unit holders have a fixed entitlement to all income and capital of the trust.
As a result most unit trusts (even when referred to as a fixed trust) will not qualify as a fixed trust because something breaks the fixed entitlement to all income and capital. The trustee has some discretion regarding the distribution of some income or capital.
Fixed Entitlement
There is a long list of set ups that will break the fixed entitlement. But they all come down to the trustee having some discretion about something. As soon as the trustee has discretion, a beneficiary’s entitlement is no longer fixed.
In the case of partly paid units the trustee can decide when to call in the rest of the payments, hence influence the amount of capital that a beneficiary can put a claim on.
When the trust deed allows for different classes of units, then a beneficiary’s entitlement will depend on the exercise of this discretion.
When the trustee deed allows its amendment without the unanimous approval of unit holders, then a change in the trust deed can change a unit holder’s entitlement.
The same applies if the trustee deed allows the trustee to make gifts, transfer assets with trust cloning power or issue new units or redeem existing units other than at market value.
Any of these will change a unit holder’s interest and hence make the entitlement no longer fixed.
Hybrid Trust
A unit trust that gives its unit holders a fixed entitlement to some part of income or capital but then also gives its trustee discretion over some part of income or capital is a hybrid trust.
An example would be a clause in the trust deed that says, ” Trust income is the same as net income per s95 ITAA36. The owner of a unit is presently entitled to a pro rata amount of the trust income at 11:59 pm on 30 June each year. The trustee has no power to distributed trust income contrary to this automatic, pro rata distribution.” So that is a fixed entitlement. The trustee had no discretion. And if this all there was, this unit trust would be a fixed trust.
But then there is another clause that says, “The trustee can apply capital at the trustee’s discretion.” So there it is – at the discretion of the trustee. This is not a fixed entitlement. So the trust is now a hybrid trust.
Relevance
Why is this relevant? Why does it matter whether a unit trust is a fixed trust or not? There are three reasons.
1) If a unit trust doesn’t qualify as a fixed trust, then you obviously can’t treat it as a fixed trust under the trust loss provisions in Schedule 2F. And that might affect the availability of prior year tax losses under these trust loss provisions.
2) Not being a fixed trust will affect the passing on of franking credits to beneficiaries. And a family trust election or interposed entity election won’t fix this issue, since those are only available to discretionary trusts.
3) Not being a fixed trust can affect the continuity of ownership test.
Practical Compliance Guideline PCG 2016/16
Where a unit trust does not satisfy all conditions for a fixed trust, the Commissioner has the discretion to deem entitlements as fixed.
The PCG 2016/16 provides a list of relevant factors that ATO will look at when considering whether to exercise this discretion.
But the ATO’s discretion is not something you want to rely on when designing a business structure. But so the safe harbour rules listed in the PCG are really important.
The PCG provides a number of safe harbours setting out scenarios where the ATO will accept that entitlements are deemed to be fixed – without the need to apply for the exercise of the discretion.
Safe Harbours
PCG 2016/16 outlines six safe harbours but only two will apply to private unit trusts. Safe harbours 5 and 6.
Safe harbour 5 only applies where the unitholders are individuals, listed trusts or managed investment schemes.
And so Safe harbour 6 will have wider application and will be the relevant benchmark for most private unit trusts.
Safe Harbour 6
Safe harbour 6 applies if all units on issue have the same rights to income and capital and there are no issued discretionary units, which give the trustee the discretionary power to distribute income or capital.
The trustee can’t have any discretion in relation to the distribution of income or capital between the unitholders; and the trustee has never exercised any discretion to distribute income or capital other than in proportion to the unit holdings.
And the trust also can’t have any power to gift any assets of the unit trust; or hold the assets of the trust on the terms of another trust.
If a private unit trust meets these conditions, it is deemed to be a fixed trust. And so the trust loss provisions in Schedule 2F for fixed trusts apply.
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