Demystifying Unit Trusts: Your Ultimate Guide

Introduction to Unit Trusts

A unit trust lets investors pool money to invest in assets like shares, bonds, and property.

In Australia, investors often use unit trusts for property investments. They pool their money to purchase real estate, earning income from rent or through the sale of the property.

Unit trusts are popular in Australia because they offer a number of benefits, including:

Tax advantages because a unit trust doesn’t pay tax itself. The beneficiary has to pay income tax on the proportion of income they receive.
Minimising liability protecting unitholders’ assets from lawsuits against the trust.
Easier compliance as a trust isn’t as heavily regulated as a company.

In this guide, we explore unit trusts and their benefits. We’ll also cover who manages them and critical factors to consider when setting one up.

How Does a Unit Trust Work?

A trust deed, which sets out the terms and conditions of the trust, creates unit trusts. A trustee manages the trust deed and ensures the trust complies with these terms and conditions.

Investors in a unit trust are called unitholders. Unitholders purchase units in the trust, representing a share in the trust’s underlying assets. The value of the underlying assets determines the price of a unit.

Unitholders possess a set interest in all property under the trust. Unlike in a discretionary trust, where the trustee has the power to decide the distribution of income and capital, in a unit trust, beneficiaries have defined rights to these assets.

A unit trust lasts for a certain time, usually up to 80 years. This information is in the trust deed. When this time ends, they sell everything the trust owns. The unitholders receive this money.

Understanding Fixed Trusts and Unit Trusts

Unit trusts often seem like they should be fixed trusts, as entitlements are typically associated with units. However, tax regulations complicate this assumption.

The principle of ‘fixed entitlement’ defines fixed trusts in tax legislation. According to section 272-65 of Schedule 2F:

A trust is a fixed trust if persons have fixed entitlements to all of the income and capital of the trust.

Therefore, a unit trust can only be classified as a fixed trust when all unitholders have a fixed entitlement to all income and capital of the trust.

Why Some Unit Trusts are not Fixed Trusts

Despite the definitions, not all unit trusts qualify as fixed trusts. A breach in fixed entitlement to all income and capital often disqualifies them.

For instance, if a trustee has discretion concerning some income or capital distribution, it compromises the fixed entitlement.

Examples include if the trust deed permits:

Different classes of units
Amendment without all unitholders agreeing.
Gifting of assets by the trustee
Transferring assets between trusts with the same trustee and same trust interests
A change in the number of units in the trust at prices that aren’t in line with market values.

The Hybrid Trust

A unit trust gives the unitholders a guaranteed share of the income or capital. However, if the trust allows the trustee to make decisions about some of the income or capital, it changes. This type of unit trust is called a hybrid trust.

These trusts have clauses defining fixed entitlement and clauses granting trustee discretion, leading to their hybrid classification.

Why the Classification Matters

Three major reasons underline the importance of distinguishing whether a unit trust is a fixed trust.

First, unit trusts failing to meet the fixed trust criteria can’t be treated as such under trust loss provisions, potentially affecting the availability of prior-year tax losses.
Second, not being a fixed trust influences the transfer of franking credits to beneficiaries.
Lastly, it can impact the continuity of ownership test. This tax rule checks if the same owners have continuously held more than 50% of a company’s shares over a certain period. It’s important because if a company fails this test, it might be unable to use its past losses to lower its future tax.

Advantages of Unit Trusts

Ease of adding new partners as they can simply buy units to join.
Less regulation as unit trusts are easier to manage than companies or individual investments, making them attractive.
Tax benefits as unit trusts can access tax concessions for small businesses, potentially saving unit holders money.
Flexibility as unit trusts can have various units, with some having voting rights while others do not. The trust deed outlines these details.
Simple termination that mainly involves selling the assets and distributing the money.

Disadvantages of Unit Trusts

Cost base adjustments could lead to significant capital gains, which may increase tax liabilities.
Complex trust loss provisions can be challenging to understand and manage.
Potentially high costs as unit trusts can be more expensive and complex than being a sole trader or running a company.
Understanding the trust deed. This legal document is often filled with jargon, making it challenging for clients to comprehend. Check out my guide on What is a Trust Deed.
Difficulties in varying trust terms which can be tricky and might yield undesirable results.
Limited asset protection. If the trust encounters financial trouble, the assets may be at risk.

Summary

Unit trusts are an attractive investment vehicle in Australia, especially for property. They bring benefits like tax advantages and asset protection. Additionally, they’re not as heavily regulated as companies.

However, understanding unit trusts requires grasping key concepts, such as the principle of ‘fixed entitlement’. This is crucial in differentiating unit trusts from fixed trusts. Disruption to this fixed entitlement, typically due to trustee discretion, can result in a unit trust evolving into a hybrid trust. This shift has impacts on tax implications, franking credit distribution, and the continuity of ownership test.

While unit trusts present several benefits, they also pose specific challenges. These include the potential for substantial capital gains tax and complexity in trust loss provisions. There may also be high costs involved, and understanding legal language in trust deeds can be daunting.

Furthermore, the level of asset protection offered might not be as robust as expected. Hence, a thorough understanding of these factors is important when considering a unit trust as an investment structure.