One of the main reasons to have an SMSF is the flexibility it provides with investments. Many funds invest directly in more traditional investments such as listed shares and trusts, bonds, cash and property. However, did you know they are also able to invest in private companies and trusts which have a link to those associated with the fund? We often receive enquiries about superannuation funds investing in trusts and whether it is possible.
Whether SMSFs can invest in private trusts and the amount they can invest or lend to the trust depends on the circumstances. In some situations, an SMSF can invest in a unit trust without any restrictions, but limits may apply in other cases. In one particular type of trust, it is certainly not worthwhile for the superannuation fund to be a beneficiary as penalty tax rates will apply, but more about that later.
Unit trusts are established under a trust deed that sets out the rights and obligations of the trustee, beneficiaries and anyone who transacts with the trust. The trust will usually issue units to the beneficiaries, such as the superannuation fund, at a cost so that the amount received from the sale of units can be invested as permitted under the terms of the trust deed. Any income earned by the trust can be distributed to the beneficiaries, such as the superannuation fund.
The amount an SMSF can invest in the unit trust depends on a number of factors, such as the proportion of the units that are held in the unit trust, including any units held by related parties. Related parties include members and trustees of the fund, their relatives and companies and trust that they have majority control. Where the fund and related parties hold greater than 50% of the units in the unit trust in total or can control the appointment and removal of trustees, or are able to effectively control the trust, there is a limit to the amount the fund can invest in or loan to the trust. This is referred to as the in-house asset test, which restricts the fund from investing more than 5% of the total value of its investments and loan in all in-house assets.
The Mitchell Family Superannuation Fund (Mitchell Fund) has purchased 3000 units in the Mitch and Family Unit Trust, which are valued at $9,000 and are 1/3rd of the trust's units. Dan Mitchell, who is a member of the fund, has also purchased 3000 units in the Unit Trust, which are also 1/3rd of the trust's units. The other 3000 units in the trust are owned by an unrelated third party.
As the Mitchell Fund and Dan Mitchell own a total of 2/3rds of the trust units, they can control the trust. The units owned by the Mitchell Fund are in-house assets, and the trustees must ensure that the fund's total in-house assets do not exceed 5% of the fund investments at market value.
There are some exceptions to the in-house asset test, which allow an SMSF to acquire all of the units in a unit trust providing the trust complies with some very tight rules that must be adhered to at all times. That is, the unit trust that meets the exceptions cannot have any gearing, such as borrowing or mortgaging any of its investments or making any investments in other entities apart from having a bank account. These unit trusts are called 13.22C unit trusts, and it is worthwhile to seek specialist professional advice before the fund purchasing units in the trust because of the complex rules that apply.
The advantage of an ungeared unit trust is that the fund or other parties can buy and sell units as they wish without being caught by the in-house asset rules.
The Robyn Family Superannuation Fund owns all of the units in a unit trust which has a factory. The factory is leased to the family company at commercial rates and meets all the requirements of the superannuation legislation for ungeared unit trusts. The fund’s investment in the unit trust will not be included in the value of its in-house assets.
In contrast to the rules which limit the amount that the SMSF can invest, it is possible for the fund and related parties to invest no more than 50% of the units in unit trust with very few restrictions. In these circumstances, the unit trust is not considered to be controlled for superannuation purposes. This ownership structure allows a deal of flexibility and allows the unit trust to borrow and invest in other entities, subject to the fund’s trust deed. The main issue is that the unit trust is required to have unrelated third-party unit holders, which may place some limitations and controls over the operation of the unit trust.
The Deb Family Superannuation Fund owns 2000 units in the Country Life Unit Trust which are 20% of its units. Bob Deb owns 2500 units in the Country Life Trust which means the total units owned by the fund and Bob are 45% of the total units in the trust. As the units held by the fund and Bob are no more than 50% of the units in the trust it is not controlled. Therefore the fund will not be required to include the value of the units as part of its in-house assets holding.
There are usually few restrictions on the underlying investments that a unit trust can invest in. The trustees of the SMSF have the responsibility to ensure that the investment it makes in the unit trust is sound and will provide returns for the retirement benefits of members. If this can be established and the investment in the unit trust is consistent with the fund’s investment strategy as well as the fund’s trust deed then there should be no compliance problems.
However, there is one red warning light in relation to investing in unit trusts. It applies to units that the superannuation fund may acquire at ‘mates rates’ or where expenses of the underlying unit trust may be discounted and distributions made to the superannuation fund are inflated. It is possible that in these situations, the investment in the unit trust or the distributions made to the superannuation fund are treated as ‘non-arm’s length income’ (NALI) and taxed at penalty rates. NALI occurs where income or capital gains received by the superannuation fund is greater than if the same transaction had been conducted on an arm’s length basis. The penalty rate of tax paid on NALI is 45%.
In an unusual situation, an SMSF may become the recipient of income from a discretionary trust; the NALI legislation will tax the whole amount received by the fund at 45%, irrespective of whether it may be allocated to the accumulation or pension phase income of the fund.
SMSFs that invest or lend to a unit trust are able to use the flexibility of the units and benefit from their underlying investments. However, the superannuation legislation does place some limits on the amount the fund is able to invest in the unit trust, but this depends on the control that can be exercised by the fund and related parties.