Self managed superannuation funds (SMSFs) are known for their use of bare trusts in the context of limited recourse borrowing arrangements (LRBAs), but there are other ways in which SMSFs could use bare trusts as part of their asset structure. This article looks at the use of non-LRBA bare trusts by SMSFs, and whether that could cause issues from an in-house asset perspective.
What is a bare trust?
"Bare trusts" or "holding trusts" are commonly used as part of LRBAs, with s 67A of the Superannuation Industry (Supervision) Act 1993 (Cth) (SIS Act) providing an exception to the general prohibition against borrowing by SMSF trustees. Under s 67A, an SMSF trustee may borrow money where that money is applied for the acquisition of a single acquirable asset, and where the acquirable asset is held on trust so that the SMSF trustee acquires a beneficial interest in the asset.
While not defined in the SIS Act, bare trust is generally understood to exhibit the following characteristics (see Herdegen v FCT [1988] FCA 419):
the trustee holds property without any interest therein, other than that existing by reason of the office and the legal title as trustee; and
the trustee has no discretion and no active duties, other than to convey the trust property on demand to the beneficiary or beneficiaries or as directed by them.
Section 67A does not strictly require a bare trust relationship. It could, for example, include a fixed trust that is not a bare trust. However, many LRBA trusts are established as bare trusts.
In addition, there are other ways in which an SMSF might invest via a bare trust, which are outside of an LRBA context.
This could be, for example:
to protect the SMSF from claims (asset protection);
commercial efficiency reasons (for example, a desire to have one entity holding legal title as bare trustee for multiple entities as beneficiaries, which could include SMSF beneficiaries);
privacy reasons (so the vendor or the world at large is not aware that the SMSF is the beneficial owner);
a bare trustee does not necessarily need all (or any) of the members of the SMSF to be the bare trustee or director of the corporate bare trustee.
In-house asset rules
An SMSF is typically restricted to investing no more than 5% of the market value of the SMSF's assets in "in-house assets". "In-house asset" is defined in s 71(1) SIS Act as:
... an asset of the fund that is a loan to, or an investment in, a related party of the fund, an investment in a related trust of the fund, or an asset of the fund subject to a lease or lease arrangement between a trustee of the fund and a related party of the fund ...
For the purposes of the in-house asset provisions, a related trust includes a trust where the SMSF has an entitlement to the majority of the income from the trust.
Bare trust = related trust?
A trust under an LRBA is typically a related trust of the SMSF because the SMSF trustee has an entitlement to all of the income from the trust. The interest of the SMSF in the LRBA trust therefore represents an investment in that trust for the purposes of the in-house asset rules. An express legislative carve-out is contained in s 71(8) and (9) SIS Act which provide that an SMSF's investment in the LRBA trust is not an in-house asset, provided that certain conditions are satisfied (including that the LRBA meets all of the requirements set out under s 67A SIS Act).
However, the operation of s 71(8) and (9) is limited to trusts used as part of LRBAs which meet the requirements set out under s 67A SISA. These provisions do not apply more broadly to trusts (including bare trusts).
A similar carve-out for instalment trusts is provided in s 10(1) SIS Act which defines "related trust" as:
... a trust that a member or a standard employer-sponsor of the fund controls (within the meaning of section 70E), other than an excluded instalment trust of the fund.
"Excluded instalment trust" is defined in s 10(1) SIS Act as a trust which arises when the fund trustee makes an investment under which a listed security, being the only trust property, is held in trust until the purchase price of the underlying security is fully paid, and where the investment in the underlying security held in trust would not be an in-house asset of the fund.
These two examples appear to be the only exceptions expressly provided for by the SIS Act. The SIS Act does not contemplate a scenario where an SMSF has an interest in a bare trust, where that bare trust is not part of an LRBA.
In that instance, would the SMSF's interest in the bare trust count as an investment in a related trust for the purposes of the in-house asset provisions? Or, given the "bare" nature of the trust, should the SMSF's interest in the bare trust be more properly characterised as an interest in the underlying asset? That is, should the bare trust be "looked through" for the purposes of the in-house asset provisions?
SMSFR 2009/4 discusses the Commissioner's view on the meaning of "investment in" for the purposes of the in-house asset provisions but does not specifically discuss investment in a non-LRBA bare trust.
Bare trusts and look-through treatment
There is a widespread taxpayer practice where bare trusts are not recognised for income tax purposes, i.e. the bare trust is generally looked through or disregarded. Beneficiaries are taken to derive income and incur losses directly as though no trust exists. However, this practice is not expressly supported by Div 6 of Pt III of the Income Tax Assessment Act 1936 (Cth) for most types of bare trusts, in that Div 6 does not express a distinction between bare trusts and other trusts. The practice is arguably only maintained by an ongoing administrative approach from the Commissioner (see GSTR 2008/3, PS LA 2000/2, and the Commissioner's comments in his Colonial First State Investments Ltd v FCT [2011] FCA 16 and Howard v FCT [2012] FCAFC 149 decision impact statements).
In its June 2017 report to the Minister for Revenue and Financial Services (Board of Taxation, Review of the tax treatment of bare trusts and similar arrangements, 2017), the Board of Taxation expressed concern that this general taxpayer practice appears not to be supported at law, which inevitably gives rise to uncertain outcomes. The Board made a number of recommendations, arguing that the current administrative approach be given express legislative support. However, these recommendations have not yet translated to legislative reform.
The Income Tax Assessment Act 1997 (Cth) (ITAA97) provides express legislative support for the look-through approach in certain circumstances, including:
s 106-50 ITAA97: a beneficiary will be treated for CGT purposes as if it owns a CGT asset to which it is absolutely entitled as against the trustee (the concept of "absolute entitlement" in this context was examined in TR 2004/D25);
s 235-820 ITAA97: if an entity (the investor) has a beneficial interest in an instalment trust asset under an instalment trust, the asset is treated as being the investor's asset (instead of being an asset of the trust); and
s 235-840 ITAA97: the look-through treatment in s 235-820 applies to bare trusts used as part of SMSF LRBAs.
The "look-through" approach to bare trusts is also reflected in the ATO's administration of the tax system, for example:
GSTR 2008/3 permits registration at the beneficiary level rather than the bare trustee level, therefore allowing for the beneficiary to account for the GST; and
PS LA 2000/2 exempts bare trusts that are "transparent trusts" from lodging tax returns, permitting the income and expenses of the bare trust to be accounted for at the beneficiary level.
Absolute entitlement = look-through treatment?
In TR 2004/D25, the look-through treatment of bare trusts in the context of the CGT provisions turned largely on the concept of "absolute entitlement".
The Commissioner's view in TR 2004/D25 is that absolute entitlement to an asset as against a trustee is the ability of a beneficiary to call for a trust asset to be transferred to them at their discretion where the beneficiary has a vested and indefeasible interest in the entire asset.
The Commissioner further confirmed that the most straightforward application of the core principle of "absolutely entitled" is one where a single beneficiary has all of the interests in the trust asset.
Arguably then, if the SMSF trustee is the sole beneficiary under a bare trust and has all of the interests in the trust asset, the SMSF trustee is absolutely entitled to the asset in the same way that a beneficiary is as described under s 106-50 ITAA97. It follows that the "look-through" treatment described in TR 2005/D25 should also apply to this scenario.
This argument is bolstered by the fact that s 235-840 ITAA97 recognises look-through treatment specifically in the context of bare trusts in LRBAs. By analogy, this treatment should also apply to SMSFs and non-LRBA bare trusts, where the SMSF trustee is the sole beneficiary and has all of the interests in the trust asset.
To take it one step further, if the "look-through" treatment applies for tax purposes, could it also apply for in-house asset purposes? That is, the bare trust is looked through or disregarded, and the interest of the SMSF trustee is in the underlying trust asset, rather than an interest in the trust. Accordingly, there would be no "investment in a related trust of the fund" for the purposes of the in-house asset provisions and, so long as the underlying asset does not fall within the definition of in-house asset for other reasons, no issues from an in-house perspective.
While the above reasoning makes practical sense, it is untested and relies on an analogy with non-SMSF provisions and ATO materials. The application of TR 2004/D25 is limited to the CGT provisions, and comments made by the Commissioner in the ruling cannot be applied with certainty in an SMSF context. It is also important to note that the ATO has a broad discretion to deem an SMSF trustee's investment to be an in-house asset, even if it does not constitute an in-house asset under the usual rules.
More specific commentary from the ATO as to how it will interpret and apply the in-house asset provisions in the context of bare trusts under the in-house asset rules will be needed before SMSF trustees can proceed with certainty. In the meantime, SMSF trustees with bare trust arrangements (other than those relating to LRBAs) may have to infer a look-through approach under the SIS Act by way of the ATO's general administrative practices relating to bare trusts.
Phil Broderick
Principal
T +61 3 9611 0163 l M +61 419 512 801
E pbroderick@sladen.com.au
Philippa Briglia
Special Counsel
T +61 3 9611 0174 | M +61 449 404 801
E: pbriglia@sladen.com.au
Jan Harnischmacher
Associate
T +61 3 9611 0158
E joh@sladen.com.au
Andrea Lin
Lawyer
T +61 3 9611 0189
E alin@sladen.com.au