Preparing Your Unit Trust

Unit Trusts are a popular way of protecting property and managing investment assets. Their popularity has gone up and down over the years, often in response to changes in the law and, in particular, to changes in taxation laws.

In these pages the person who is intending to create a unit trust using the LawOnline system is called "you". You are the reader of these pages.

When you establish a unit trust you are creating a set of rights, duties and powers that can last for many decades. In simple terms, the life of any trust is 80 years, although it can be brought to an end before that. During the lifetime of a trust, society and the laws that society requires, will inevitably change. There are trusts in existence today which were created before the second World War and which are still operating. In that time, we have seen governments come and go, and attitudes to trusts have changed many times. Taxes, including estate or death duty, gift duty, beneficiary's and trustee's taxes and taxes of superannuation have all changed, and in some cases, have come and gone. Things such the law relating to matrimonial property, have changed radically. Over the years, the courts have made decisions and rules that have changed the way that trusts are regulated.

In establishing a trust today, the person drafting the deed can only try to anticipate the changes in the law that may occur, and to draft the trust deed in a way that tries to give the persons whose rights, duties and powers are governed by the deed, as much flexibility as possible. However, the deed is unlikely to be perfect.

A trust is created when a person, who is called the settlor, transfers property to a person, or people or to a company, to hold and manage on behalf of someone else. It is said that the property is "settled on" the trustee or trustees. A person to whom property is transferred in this way is called a trustee. Trustees are obliged by law to use the property for all lawful purposes that the settlor has specified in the trust deed. Usually one of these purposes is to make payments from the trust property to people called beneficiaries. In the case of a unit trust, the beneficiaries are persons or companies who have agreed to hold units in the unit trust. They are called unit holders.

A trust is normally given a name and is often referred to as if it is a separate entity, in the same way that a company is. However, a trust is not a separate legal entity. A trust is a relationship between trustees and beneficiaries which is defined in a trust deed or in a will, which imposes duties on the trustees to deal with the trust property in the best interests of beneficiaries (in the case of a unit trust, the best interests of the unit holders).

Trustees have extensive rights, powers and duties, partly specified in the trust deed, partly in the relevant statute laws (i.e., laws made by Parliament) and partly by the decisions of the courts. Some of the relevant decisions of the courts on trusts were made hundreds of years ago.

The terms and conditions of trusts can differ markedly, depending on the purpose for which the trust concerned has been established.

There are many different types of trusts. These include fixed trusts, unit trusts, constructive trusts, charitable trust, will trusts, bare trusts and discretionary trusts. The information set out in these pages deals only with unit trusts and, while the information may be correct for, and be relevant to, other types of trusts, we do not mean to provide any advice here for any type of trust other than unit trusts.

This type of trust is called a "unit trust" because the beneficiaries of the trust each have a fixed interest in the property of the trust and in the income that is generated. The beneficiaries of a unit trust are usually called "unit holders". The extent of the unit holders's interest is determined by the proportion which the number of units held by the unitholder bears to the total number of units issued by the trustee. For example, if a trustee has issued 100 units in a unit trust and you hold 10 units, then you are entitled to a 10% undivided interest in all of the property held on the trust and to 10% of any distributions of income or capital that are made by the trustee. If a matter is to be voted on by the unit holders, then you have 10% of the votes.

The LawOnline unit trust deed is prepared on a conservative basis. In the creation of trusts, there is a difference between what is possible and what is wise. The LawOnline deed has been prepared taking a cautious approach. That means that it is assumed that you want to have a trust that is more likely than not to protect the assets involved from any challenge. A conservative approach should mean that the trust will be likely to survive any future challenge from a taxing or other government authority, a creditor or a disgruntled beneficiary. However, LawOnline does not guarantee that the unit trust deed will survive any challenge.

One consequence of the conservative approach is that you will have less control over the trust property than some trust founders may wish to have. If you prefer to take a more aggressive approach to the trust, then you should look elsewhere for assistance.

The usual reasons for establishing a unit trust include:

• To try to achieve protection of some assets from creditors, where a risky business venture is being undertaken, in case the business venture fails.
• To enable a commercial venture to be undertaken by a group of people who are not necessarily related as a family.
• To enable different levels of ownership shares of the business venture.
• To change tax liability.

The main parties to a trust are:

• The Initial Unitholder
• The Trustees

The person (people or company) who makes the initial transfer of property to the trustees is called the settlor. In a unit trust the settlor is called the Initial Unit holder. He or she settles the initial property of the trust on the trustee or trustees. By common practice, the initial property which is transferred to the trustees is only a nominal amount. The LawOnline standard unit trust deed provides for the settlor to pay a specified amount to the trustees, for the trustees to hold on the trusts set out in the unit trust deed. We suggest that, unless you have a particular reason for the Initial Unitholder to pay a significant amount to settle the trust, that you simply use the sum of $100. Normally, at a later date, other property is then transferred to the trustees for them to hold on the same trusts.

A unit trust normally has two or more trustees or one company. They should be people, or a company run by people, who will manage the trust wisely.

A person who is forming a unit trust can choose to also be a trustee as well as being a unitholder. However, if you are intending to do that, it is very important that you are not the sole trustee. You must also have an unrelated trustee, who might be a family friend, or a lawyer or an accountant. It is also possible to have a company to be the trustee but, again, it is important that a unitholder is not the sole director of of a company which is the sole trustee of the unit trust.

It is theoretically possible for one person alone to be trustee of a unit trust, while also being one of the unitholders. However, a trust structured in those terms is likely to encounter difficulties. If the unitholders include the sole trustee himself, or herself, it is difficult to see how a sole trustee could exercise the power to distribute income or capital without placing himself, or herself, in a position of conflict of interest. If a distribution is made where there is a conflict of interest, it is likely, if it is challenged, that a court would undo that distribution, and that there may be other adverse outcomes.

For that reason, the LawOnline unit trust deed provides that there will be two trustees, only one of whom can also be a unitholder. It also permits the trustee to be a company. If you use a company as the trustee, please make sure, when you are preparing your trust deed, that if you are to be a unitholder, that you are not the sole director.

In simple terms, any trust cannot exist for longer than 80 years, and the trust deed must set a date by which the trust has to finish. This is known as the date of distribution, or date of final distribution. It is sometimes also called the final vesting date.

Trustees are usually given the power to bring the trust to an end before the date provided for in the trust deed as the date of distribution. Some trust deeds give the trustees a power to extend the distribution date, so long as the total period of the life of the trust does not go beyond 80 years. Both of those provisions are contained in the LawOnline unit trust deed.

The trustees are the legal owners of the trust property and can do the same sorts of things with the trust property that any owner can do. They can hold property, raise mortgages, open and operate bank accounts and generally hold all types of assets and investments, as long as they operate according to the powers set out in the trust deed. The trustee may also appoint a manager to carry out the day to day operation of the unit trust.

It is very important that proper records are kept for the trust, including minutes of decisions made by the trustees, financial records, tax returns and proper documentation for any transactions that the trustees enter into. It is important that if you are not qualified to do these things yourself, that you take proper professional advice from a lawyer and an accountant.

Many people underestimate the cost and effort involved in administering a trust. It is not hard to find situations where a trust has been established, but where everyone involved simply can't be bothered to administer it properly, if at all. There is cost involved in taking proper advice, in keeping proper records and in dealing with all of the day to day issues that arise. Where the value of the property which is held in the trust is not large, some find that the cost and required effort are too much, when compared to the benefits that are gained.

Before a unit trust is established, it is worth while taking the time to investigate all of the possible costs and benefits, before making the decision whether or not to establish the trust. It is important to be clear about what you want to try to achieve, and whether the trust will, or be likely to, succeed in achieving your purpose.

Assets can be transferred into the trust at any time. They can be gifted to the trustees, or sold to them. The initial unitholder, will usually transfer further assets into the trust, or the trustees may acquire the assets from someone else.

Gift duty was an issue until the 1980's, in the transfer of assets to a trustee, but, as the result of State law change then, that is no longer the case.

Any increase in the value of the asset sold to the trust belongs to the trustees, and not to the settlor (or the initial unitholder). Similarly, any income from the trust assets, is usually trustee's income, and not the income of any unitholder.

Generally, the trustees decide which payments are to be made from the trust. In the case of a unit trust the entitlement to a proportion of any payment is in proportion to the number of units held by each unitholder. If, for example, 100 units have been issued and the trustees have decided to make a payment totalling $10,000, then unit holders will receive $100 for each unit that they hold.

Often, assets will be transferred to the trustees, with only part payment of the price, or on the basis that the whole price remains owing. The trustees will acknowledge the outstanding price as a debt, usually in a deed of acknowledgement of debt. The debt is often made payable on demand, and it is normal to make payments in reduction of the outstanding debt, as and when the trustees have available cash to fund the payments. If the debt for the initial purchase of assets is repayable on demand, the vendor of the asset concerned can require payment of all or any part of this debt at any time. Payments of this kind in repayment of a debt, from the trustees to unitholders, will probably be payments of capital rather than income, and will therefore probably be free from income tax. You will be wise to check the tax status of any payment of this sort before it is made.

The taxation of trusts is an area where the law has been subject to regular change and it seems likely that reform will continue.The law relating to income tax, capital gains tax and stamp duties all have an influence on the structuring of trusts and each of those areas of tax are regularly the subject of political debate and change.

Generally, income earned on trust assets will either be taxed in the hands of the trustees as trustee income, or will be taxed in the hands of the unitholders, if the trustees have paid the income to the unitholders. If income is paid or appropriated to a unitholder who is over the age of 18, before the end of the tax year, then it is taxed at the unitholder's personal tax rate, and the tax is paid by the unitholder. Income that is not distributed in this way is taxed as trustee income, at the trustees' rate. The rate at which tax is paid on undistributed trustee income is currently 49%, which is often higher than the rate paid by unitholders. The consequence is that there is an incentive for trustees not to accumulate income.

Where a trustee pays income tax on any part of the income of a trust, no tax will be payable on those moneys when they are later paid to a unitholder. However, the usual effect of available income not being paid to a unitholder, is that the total tax paid by the trustee on the income concerned will be higher than it would be, if the money was paid to a unitholder in the tax year in which it was earned, who then paid tax on it at his or her (usually lower) tax rate.

If the allowable deductions available to the trust exceed its taxable income, a loss will result. Such losses may be carried forward and set off against future income of the trust, but cannot, except in limited circumstances, be "distributed" to the unitholders, to be set off by them against any other income that they might receive.

Where the settlor (i.e., the initial unitholder) or other creator of a trust retains effective control over the trust property, as will be the case where the settlor retains a power to revoke a trust, the settlor will be assessed personally for tax on the trust income. For this reason, where a trust is established by the settlement of some moneys forming the initial trust fund, it is common to ensure that the trust contains no machinery whereby it might be revoked or dismantled by the settlor. This is one of the reasons why, the LawOnline unit trust deed makes no provision for an appointor.

Trusts can provide advantages to the taxpayer, particularly by allowing income to be split among a group of unitholders. This can be done by using a unit trust as a trading trust to enable a trustee to carry on a business, thereby sharing the tax burden at lower marginal rates. The attractiveness of this device for income splitting within families has waned since the introduction of changes to the law relating to the taxation of income of most potential beneficiaries who are below 18 years of age.

Also, the current law and approach of the Commissioner relating to income splitting, where the income arises from the provision of personal services, has reduced the desirablity of many previously used income splitting tactics.

In a publication in 1984 (IT 2121), the Commissioner said;

"...

2. In recent times there has been a significant increase in the creation of family companies and trusts designed to obtain the income tax advantages flowing from the splitting of income derived from the personal exertion of a family member. The practice has extended to most industries and many taxpayers who were formerly deriving income from the rendering of personal services in the mining, computer, insurance, motor vehicle, real estate and entertainment industries are now purporting to be employees of a family company or trust. In a number of cases drawn to the attention of this office a taxpayer has ceased employment on one day and arrived at the former employer's premises the following day to do the same work, not as an employee of the former employer but as an employee of a family trust that has contracted to provide the taxpayer's services to the former employer.

3. A form of the arrangements commonly encountered involves a taxpayer who had been deriving salary and wage income forming a family company of which he and his wife are directors and the company becoming a trustee of a family trust of which the taxpayer's wife and children are beneficiaries. The family company, in the capacity of trustee, engages the taxpayer as an employee. The trustee will then negotiate with the taxpayer's former employer for the provision of the taxpayer's services to the former employer. The amount which would otherwise be paid to the taxpayer as salary and wages will be paid to the trustee who, in turn, will pay the taxpayer a salary which is generally much lower than he had previously received and distribute the balance to family members according to the trust arrangements.

4. In other arrangements of this nature a company will be incorporated with the taxpayer and other family members as shareholders and directors. The taxpayer will become an employee of the company and, thereafter, much the same procedure is followed as in the family trust situation. The company negotiates with the former employer for the provision of the taxpayer's services. The amount which would otherwise be paid to the taxpayer as salary and wages will be paid to the company which will in turn pay the taxpayer a salary - again generally much lower than the taxpayer might otherwise have received - and pay the balance to family members as directors fees, etc.

5. It is a feature of these sorts of arrangements that there is very little, if any, outward sign of change in the method by which the income is derived from the former employer. The taxpayer continues to work for the former employer and performs the same functions for the same overall remuneration. Many of the arrangements of this nature examined in this office indicate that the former employer retains control over the performance of the taxpayer's work, that the taxpayer is required to attend at the former employer's premises during normal working hours, that the former employer has to reimburse the taxpayer for out-of-pocket expenses and that the taxpayer may be absent for periods which might generally be equated with normal annual leave and sick leave entitlements. In many cases the former employer, rather than having a right to terminate the agreement with the family company or trust, retained a direct right of dismissal in relation to the taxpayer.

...

11. In the view of this office all of these arrangements may be characterised as arrangements entered into primarily or principally or predominantly to avoid liability for income tax by means of the splitting of income. They are not explicable as ordinary business or family dealings. To the extent that the arrangements were entered into prior to 28 May 1981 section 260 will operate to nullify them for income tax purposes. The tax benefit arising out of arrangements entered into on or after 28 May 1981 will be removed through the application of Part IVA. In both cases, the practical result will be that the taxpayer doing the work will be liable to tax on the amount paid by the former employer to the interposed entity."

There are often legitimate reasons for using entities such as trusts or companies in many business situations. Therefore the mere use of alternative business structures will not, on its own, amount to a tax avoidance arrangement. Further, the profit generated by the business may not be wholly generated by the individual and there may also be good non-tax reasons as to why the controller of a business receives significantly less of the business profits than would otherwise be the case.

However, where the business involves the provision of services, the Commissioner is likely to examine closely any arrangement where the individual service provider (usually the real owner or owners or controllers of the business) is not receiving a significant portion of the profits derived from the business. This is particularly so where there is an absence of other business profit drivers and other non-tax reasons do not justify the level of remuneration received by the individual.

You should take good advice before you use a trust structure for income splitting purposes to reduce taxation.

Trusts are subject to various legal constraints and there are several provisions in the law that allow property in a trust to be "clawed back". "Clawing back" in these circumstances, means that the process by which the asset has been transferred to the trustees was invalid. The result is that the property is brought back into the ownership of, and belongs to, the person who tried to transfer it, making it available to the creditors, a matrimonial property claimant or the taxing authority. This inevitably defeats the purpose for which the trust was set up in the first place. An example of a clawed back transfer is where someone sets up a trust, and transfers property to the trust, but later becomes bankrupt. The previous transaction may be invalid. This is can be the case if the transfer occurred as long ago as 10 years prior to the challenge to the transfer.

A court may set aside transfers of assets that were made with the intention of defeating the rights of creditors, or the rights of a spouse or partner under the law relating to matrimonial property. If a couple's relationship property has been transferred into a trust, and that transfer has the effect of defeating the rights of one of the partners under the legislation, the court may order the other partner to compensate the partner whose rights are defeated.

You should assess whether a trust is a suitable vehicle to meet your objectives. You should weigh up the advantages and disadvantages of your various options, including the on-going management and compliance costs of each. Your lawyer and accountant will be able to help you determine what is required to meet your needs.

The law relating to trusts is to be found in the general law as decided by the courts, and in the statutes that have been enacted in each State and Territory. The law in each State and Territory differs from the others in subtle, but sometimes important ways.

The preparation of the LawOnline Trust Deed allows you to choose which State or Territory law applies. In most cases, it is sensible to simply choose the State or Territory where the trustees and most of the potential beneficiaries live. If the trustees are to hold real property (land and buildings) on the trust, then it is normal to specify the law of the State or Territory where that property, or where there is more than 1 property, then where most of them are located.

However, if you have a particular reason for choosing the law of one of the other States or Territories, then you are free to do so.

It is unwise to base your choice of applicable law simply to avoid the requirement to pay the large amount of stamp duty that is payable in NSW. However, it is not unusual for the makers of trust deeds to choose the law of the ACT as a suitable legal system to apply, and where there is no stamp duty payable on the creation of a trust. See the Stamp Duty section of the advice on this point.

To be a valid trust, which the courts will recognise and enforce (if required), and which can be used to hold real property, trust deeds must be stamped, if the applicable law requires stamping. This means presenting one signed copy, or as many extra copies (counterparts) as you wish to have stamped, to the State or Territory taxing authority within a specified period, and paying the amount of stamp duty required. Each State and Territory has its own rules and rates.

You can write to the relevant authority and send the signed deed with your letter. Or you can go to the office of the revenue authority to make the payment over the counter. Simply ask for stamp duty to be assessed on the trust deed. You will receive a reply telling you how to pay the duty and, once it is paid, a stamp will be endorsed on your deed recording the payment, and the deed will be posted back to you.

The deadline for stamping is calculated from the day when the first person signs the deed.