How Does a Unit Trust Work?

In order to maximise the benefits available in utilising a unit trust it is necessary to fully understand the nature of the trust, the role of the parties involved and the capabilities of the trust in order to maximise protection of assets and minimise taxation consequences.

What is a Trust?

A trust is a relationship where a person (the Trustee) is under an obligation to hold property for the benefit of other persons (the Beneficiaries). The terms of the obligation are defined by the terms of the Trust Deed entered into between the Trustee and the Settlor.

A trust is not a separate legal entity even though a trust tax return will be required to be lodged with the Australian Taxation Office each year. The Trustee is the legal owner of the trust property and the beneficiaries hold the beneficial interest in the trust property.

What is a Unit Trust?

A unit trust is a trust in which the trust property is divided into a number of defined shares called units. The beneficiaries subscribe for the units in the same way as shareholders in a company subscribe for shares.

In an ordinary unit trust a beneficiary is entitled to the income and capital of the trust in proportion to the number of units held.

A beneficiary of a unit trust has a proprietary interest in all the property of the unit trust.

What are the elements of a Unit Trust?

In determining how a unit trust works the role of each of the five elements of a unit trust should be known. The role of the five elements may be summarised as follows:

1. The Trustee

The trustee is the legal owner of the trust property although not the beneficial owner. The trustee carries out all transactions of the trust in its own name and must sign all documents for and on behalf of the trust. The trustee’s overriding duty is to obey the terms of the trust deed and to act in the best interests of the beneficiaries.

2. The Settlor

The settlor is the person who creates the trust by “settling” a sum of money or item of property on trust for the beneficiaries.

3. The Trust Fund

The trust fund is all the property of the trust including the settlement sum, income accumulated and any other money and property held by the trustee pursuant to the terms of the trust.

4. The Beneficiaries

The beneficiaries are the people (including entities) for whose benefit the trustee holds the trust property. The beneficiaries in a unit trust are entitled to the income and capital of the trust in proportion to the number of units held.

5. The Trust Deed

The trust deed defines the relationship between the trustee and the beneficiaries. The parties to the trust deed are the settlor and the trustee. The trust deed specifically sets out the duties and powers of investment of the trustee.

CONDUCTING A UNIT TRUST

The purpose of this Memorandum is to set out guidelines with regard to the nature and operation of a Unit Trust.

Nature of Trust

A Unit Trust is not a separate legal entity in the same way as an individual or a company, rather it is a relationship which exists whereby a person (Trustee) is compelled to hold property for the benefit of others (Beneficiaries or Unitholders). The relationship is formalised to the extent the units are held by the beneficiaries and the rights attached to such units can be structured in a similar fashion as shares in a company.

The Trust is constituted by the payment to the Trustee of an amount called the Settled Sum which the Trustee agrees to hold, together with any other money paid or property transferred to it, in accordance with the terms and conditions of the Unit Trust Deed executed by the person making the initial donation (the Settlor) and the Trustee at the time that donation is made. The Settled Sum together with any other money paid or property transferred to the Trustee, is called the Trust Fund.

The Trust Deed provides that the Trust is to terminate on a day called the Vesting Day stipulated in the Trust Deed or such earlier date as the Trustee may determine.

On the Vesting Day, the Unitholders are entitled to the whole of the Trust Fund.

The Trustee’s powers of investment of the Trust Fund are specifically set out in the Trust Deed, but basically, the Trustee is authorised to do all things which an individual or a company could do in respect of his or its own property.

Duties of the Trustee

The law imposes upon a Trustee a duty to act in good faith for the benefit of unitholders. The Trustee must administer the trust in accordance with the terms, conditions and powers enumerated in the Trust Deed and implied by law.

Provided that a Trustee acts in accordance with the terms, conditions and powers contained in the Trust Deed and implied by law, the law will protect it from any liability in respect of those actions or any claim by any unitholder, notwithstanding the result of those actions.

All decisions of the Trustee, if a company, in relation to the trust should be made at a meeting of the directors of the Trustee properly constituted in accordance with the provisions of the Trustee’s Constitution. Proper Minutes of each meeting of the directors of the Trustee should be kept.

Similarly, proper accounting records should be maintained by the Trustee. Indeed, the Trustee, if a company, must maintain two sets of financial records - one in respect of its own affairs and the other in respect of its activities as Trustee of the Trust.

If the Trustee’s sole purpose is to act as Trustee of the trust constituted by the Trust Deed, and it will not be engaging in any business on its own account, the books of account and financial records in respect of its own affairs will be extremely simple and should not change from year to year.

It will be necessary for the company generally to comply with its obligations under the Corporations Law, including in relation to notification of changes in directors and share allotments.

The books of account to be maintained by the Trustee in respect of the trust must record all receipts and payments by the Trustee, all distributions of income, etc. A formal balance sheet and profit and loss account should be prepared for the trust in respect of each financial year of its operation, and if the trust has earned income during the period, an income tax return must be lodged with the Commissioner of Taxation.

Distribution of Income

The net trust income is distributed amongst the Unitholders in proportion to the number of units held.

If the whole of the trust income is distributed to adult Unitholders, the amount received by each unitholder is taxable in the hands of the recipient as an addition to the total income of that recipient. Thus, if a particular Unitholder received a distribution of $10,000 from the Trustee and earned salary or wages resulting in a taxable income of $40,000, his total taxable income for the year in question would be $50,000.00 and the tax payable by him would be the amount of tax payable on a total taxable income of $50,000.

When distributing income to unitholders it is possible to separately characterise the amounts concerned. For example, where the trust income includes, say, the receipt of franked dividends, interest income and taxable capital gains then the distribution received by the unitholder can be divided into these three portions. This will be particularly important where, for example, franking credits are to be passed onto unitholders.

Capital Gains Tax

With the introduction of capital gains tax, careful consideration will need to be given to the consequences for the Trust of various types of transactions which may give rise to a taxable capital gain.

If the Trustee sells a trust asset to an arm’s length person and realises a gain on the disposal, the gain will be included in the assessable income of the Trust to be distributed or accumulated as any other income. Capital losses may be subtracted from the gain before a net amount is included as assessable income of the Trust.

Other situations may give rise to deemed capital gains and require careful consideration. For example, if Trust assets are appointed or distributed to any specific beneficiary, the Trustee is regarded as having sold the asset to the beneficiary at its then market value and a capital gain may arise (depending on the cost base of the asset adjusted to take account of inflation).

For capital gains tax purposes, the units in the unit trust will be treated as an “asset”. Accordingly, the disposal of units by a unitholder could give rise to capital gains tax implications. Further, the capital gains tax legislation provides for deemed disposal of units where tax free distributions are made on units and the tax free amounts exceed the so﷓called “indexed cost base” of the units.

For this reason, it is very important that advice is sought prior to entering into major investment transactions using a unit trust structure. In general, any borrowings that need to be undertaken must be entered into by the unitholders. The unitholders would then invest these funds (together with their own capital) on unit capital subscriptions. This will ensure that the “cost base” on units held by a Unitholder are maximised. This could avoid the unitholder from unnecessary tax exposures in future years.

A distribution to a unitholder need not entail a physical payment of the amount distributed to the unitholder. If the Trustee wishes to retain the money which it has decided to distribute to a particular unitholder it may, with the consent of the unitholder, establish a loan account in the books of the trust in the name of that unitholder and credit the amount of the distribution to that loan account. Thereafter, the Trustee can deal with the amount of the loan in accordance with the powers given to it by the Trust Deed, but in the absence of any arrangement to the contrary, the unitholder can call for payment of the amount credited to his account at any time. It should be noted that the amount credited to the new account is nonetheless taxable income of the unitholder.

Winding-Up

On the winding﷓up of the trust on the Vesting Day, or at any time before, the capital of the Trust Fund will be distributed to the unitholders in proportion to the number of units held.

From the Vesting Day, any assets belonging to the trust or constituting the Trust Fund are thereafter held by the Trustee until payment or transfer specifically for the unitholders and in the proportions in which units are held.

The Trustee need not realise the assets of the trust on the Vesting Day, but may transfer those assets to the beneficiaries in specie.

Entering into Contracts

As previously indicated, a trust is represented by the Trustee, which enters into contracts and legal relationships with other persons in its own name.

It is not necessary for the Trustee to disclose to the other party to the dealing that it is acting in its capacity as Trustee of a trust.

Indeed, registers maintained by the Registrar General and company share registers cannot have recorded in them transactions which recognise that a person or company is acting in the capacity as Trustee. However, it should be noted that companies do have the power, under the Corporations Law to obtain information as to the beneficial ownership of their shares.

Documents of transfer should only name the Trustee and should not refer to the capacity in which the Trustee is contracting.

In all circumstances where the Trustee is entering into contracts or dealing with property, it is essential that the decision of the Trustee to contract or deal with the property in its capacity as Trustee should be properly recorded in minutes of a meeting of the directors of the Trustee.

Conducting the Trust Bank Account

The Trustee should conduct a current account in its own name on behalf of the trust if there are a sufficient number of transactions. Alternatively, where only a small number of transactions will take place, a savings or building society account will suffice.

All payments to or by the Trustee should be effected through the Trustee’s account.

Control and Change of Trustees

Most Deeds empower the unitholders to remove any trustee of the trust and appoint a new or additional trustee at any time by instrument in writing.

General

This memorandum has been prepared as a general guideline, and is not intended to be an exhaustive or complete statement concerning the operation of a trust. There are many particular legal and accounting matters which have not been dealt with in this memorandum and clients are urged to discuss any aspect of the operation of the trust not discussed herein with their professional advisers.

FURTHER INFORMATION

This Information Outline is provided courtesy of Craddock Murray Neumann who are experienced in this area of law. They are located at Level 1, 255 Castlereagh Street Sydney NSW 2000 or call them on (02) 9283 4755 if you would like more information on the legal topic, or you wish to obtain formal advice regarding your situation.

Craddock Murray Neumann believe in the ethical practice of law. This means that we strive to protect and advance the legal rights of our clients, whether they are government departments, large corporations or private individuals. This also means that we will not run cases merely for the sake of running up legal costs at your expertise. We try to find practical, cost effective solutions to your problems. If you need to fight we will be there with you. We have set our fair share of precedents but our clients don't always want to make legal history. We will try to achieve what you want.