Auditing Investments in Related Pre-August 1999 Unit Trust

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SMSF Audit Technical Issues Series

In this blog series, CaseWare’s SMSF Audit expert and content provider Sharlene Anderson, outlines common technical SMSF issues, and what auditors need to consider for each. This is the fourth issue of six.

Auditing Investments in Related Pre-August 1999 Unit Trust

When auditing an SMSF with an investment in a pre-August 1999 related unit trust the fundamental requirements for the auditor are to:

  1. Test the investment is correctly owned by the fund
  2. Test the investments are recorded at market value in the fund financials
  3. Form an opinion on the funds compliance with the requirements of SISA and SISR in relation to the investment in the unit trust
Documents initially required for audit

As a starting point the documentation on the audit file should include:

  1. Unit Trust Deed A complete signed copy of the Trust Deed is required to confirm date of establishment of the trust as pre 11 August 1999. The Deed will also confirm details of the trustee for use in testing ownership and rights and obligations in relation to the assets and liabilities of the Trust. The Deed also includes the rules governing the trust which should be reviewed, at minimum, to ensure the Trust is a fixed trust. It may be necessary to further review the governing rules to ensure compliance when, for example, units are redeemed or issued, or in relation to payment of distributions.
  2. Unit Register and evidence as to whether sections 71A and 71D or 71E apply to investments between 11 August 1999 and 30 June 2009

The Unit register will act as evidence that the fund held an investment in the trust pre August 1999 along with any Unit Certificates that may be available. The Unit Register will also show the amount of any unit issues (or redemptions) between 11 August 1999 and 30 June 2009.

Historically, some investments in related unit trusts were used to avoid the borrowing restrictions of SISA. The SMSF would invest in a trust which would then borrow to acquire assets. The introduction to SISA of Part 8 closed this loophole but included transitional provisions to allow time and a certain amount of further investment to be able to repay the borrowings.

Section 71A of SISA is the grandfathering provision which basically permits investments in related trusts held before 11 August 1999 to not be included as in house assets of the fund. The trustee of the fund was at the time able to make a written election that section 71E was to apply to further investments. Section 71E is often referred to as the ‘debt election’ and allowed for the fund to make further investments in the unit trust between 11 August 1999 and 30 June 2009 up to the total of debt owed by the trust to entities other than the fund at 11 August 1999.

Where section 71E is elected the audit file would include a copy of the written election made at the time and evidence of the level of debt at 11 August 1999 such as loan agreements, loan statements or at minimum the trust financial statements prepared closest to that date. The unit register should be reviewed to ensure that the purchase price of investments between 11 August 1999 and 30 June 2009 did not exceed the debt level. Any excess would be included as an in-house asset of the fund.

If section 71E is not elected, the alternative and default transitional provisions are contained in section 71A and 71D of SISA which are not mutually exclusive and allowed the fund to both reinvest distributions and pay calls on partly paid units held at 11 August 1999 between that date and 30 June 2009. Where section 71A and 71D of SISA are taken to apply the unit register should be reviewed to test the reasonableness of any reinvestments and where possible obtain corresponding financial statements for the trust disclosing distributions made.

When the auditor has been the auditor of the fund for the 2000 financial year onwards it would be expected that each year any further investment was checked for compliance with the relevant sections and any breaches reported appropriately. Any in-house assets created by exceeding the relevant permitted amounts should be carried forward each year in the compliance section of the audit report until the matter is rectified.

However, we are now conducting audits for the year ended 30 June 2016 and are auditing funds for the first time with such investments that have changed auditors. It is not enough to simply rely on the prior year audit report as confirmation that all investments in the trust are in accordance with Part 8. We still obtain a copy of the unit register, 71E election if applicable and supporting evidence to satisfy ourselves of compliance. As the unit trust is only required to keep accounting records for 5 years this can be troublesome. (The written section 71E election was required to be maintained for 10 years under SISA).

We have seen more than one example of large investments in the 2008 and 2009 years which exceeded the relevant transitional limits and were not identified by the then incumbent auditor. ATO audits of these funds following lodgement of a contravention report resulted in enforceable undertakings to rectify the breaches. These rectifications several years after the breach occurred have proved to be expensive.

We have also seen an example where the accountant purported that significant investment in a trust by a fund during the 2006 and 2007 financial years represented calls on partly paid units held at 11 August 1999 in accordance with section 71A of SISA. Documents were provided indicating that at 11 August 1999 the fund held one thousand units with a value of five thousand dollars each that were paid up to one dollar. Professional scepticism caused the validity of the documents to be questioned.

The transitional provisions ceased on 30 June 2009. Any further investment in a related unit trust after that time is prima facie an in-house asset of the fund. The possible exception is reliance on that post 30 June 2009 investment being a regulation 13.22C trust investment. The conversion of pre August 1999 trusts to regulation 13.22C trusts is discussed in a separate section below.

  1. Signed Confirmation of Units Held at 30 June year of audit

We require signed confirmation from the trustee of the trust as to the number of units held by the fund and the holding name. We agree the number of units to the unit trust accounts, the fund accounts and the unit register. This evidence goes to ownership of the investment by the fund and compliance with regulation 4.09A SISR.

  1. Complete set of financial statements for the Unit Trust

SMSF auditors are not necessarily required to audit the unit trust financials. However, to confirm ownership by the fund, market value of the fund investment and fund compliance with SISA in relation to the investment in the trust an audit is effectively performed. The following section will cover audit procedures and evidence required in this regard.

Review of Trust Financials and additional audit documentation

Completion of the procedures described above goes to confirming that previous investments in the trust have not placed the fund in breach of Part 8. It is then necessary to perform procedures to ensure the fund is not in breach of SISA or SISR in relation to the fund investment in the trust in the current year of audit. Whereas SISA and SISR do not directly apply to the unit trust the fund can find potentially find itself in breach of sections 65(1)(b) of SISA (using the resources of the fund to give financial assistance to a member or relative), section 62 of SISA (the sole purpose test) and section 109 of SISA if the trustee of the fund is not dealing at arm’s length with the trustee of the trust.

We review the assets and liabilities of the trust and obtain supporting documentation to confirm ownership and market value of a sample of the investments. Our sample size may vary depending on the overall materiality of the fund investment in the trust. Investment types such as listed securities and managed funds are the easier types of investments to support with adequate documentation and external confirmations accessible. Bank accounts and bank borrowings can also be easily supported with bank statements to evidence the closing balances and interest received or paid. Loans to the trust by related parties should be supported by current loan agreements.

Real Property Investments

Real property is the most common type of investment held by related unit trusts and indirectly usually represents a significant portion of the fund’s total assets. If correct ownership of the property by the unit trust cannot be established the auditor must consider including a financial qualification on the fund’s audit report and possible compliance issues if for example the property has been sold and sale proceeds have not been received by the trust. We obtain the same level of audit evidence as we would if the property was held directly by the fund. This includes:

  1. Copy of purchase contract to confirm the property was correctly purchased in the name of the trust.
  2. Copy of relevant dealing search (for Queensland properties) to test that that property is correctly registered in the name of the trustee as trustee for the trust.
  3. Copy of post 30 June title search for each year of audit to confirm the property continues to be registered in the name of the trustee of the trust. The title search will also disclose any mortgages over the property.

An issue that arose in the Montgomery Wools case1 was that property held in the associated unit trust in which the fund invested was used as a security for a borrowing by a family trust. Ultimately, when the property was sold the proceeds were used to repay the debt by the family trust and a corresponding loan to the family trust was raised in the financials of the associated unit trust.

We have encountered several other instances where associated unit trust properties are used as security for borrowings by other related entities. Such practice would likely also constitute a breach of section 65(1)(b) of SISA where ultimately the resources of the fund as being used to provide financial assistance to relatives. If there is a registered mortgage which does not correspond to a liability in the unit trust financials further questions must be asked.

 Commonly, the mortgage relates to an earlier unit trust borrowing which has been repaid but the facility left open in case further borrowings are required. If this assertion is made by trustees the auditor should either sight evidence of release of the mortgage or obtain evidence from the bank that no borrowings were secured by the mortgage during the current year of audit.

  1. Copy of lease agreement valid for the year of audit. This is required to establish that the property is leased on arm’s length terms and that the unit trust is receiving the correct rent. Where the tenant is a related party we would be more inclined to obtain all unit trust bank statements for the year to test whether rent was received in regular instalments. Single deposits of annual rent in arrears at year end may not represent commercial terms and may constitute a breach of section 65(1)(b) of SISA. (Annual rent in arrears is likely to be acceptable for agricultural properties as commercial practice dictates). A breach would also occur if a related party had use of the property either rent free or at a rate of rent below a reasonable market rate.
  2. Evidence that the property is adequately insured in the name of the trust. Absence of adequate insurance indirectly puts the fund assets at risk and may result in a financial qualification on the audit report.
  3. Evidence of current market value. We would require the same level of evidence to support the market
    value of real property held by the unit trust as we would if the property was directly held by the fund. We would apply relevant audit standards to ensure sufficient appropriate evidence of market value is obtained.
Loans by Unit Trust to fund members

Our review of the assets in the unit trust financials includes close inspection of debtor, receivable or loan accounts to determine whether the unit trust has loaned monies to related parties. We also suggest reviewing unit trust bank statements to identify any loans made and repaid during a financial year and beneficiary accounts to check if related party investors have been paid distributions in excess of present entitlement.

S65 of SISA prohibits a fund from lending money to members or relatives. Subsection 65 (1)(b) extends this to prohibit the fund from giving any other financial assistance using the resources of the fund to members or relatives. Section 62 of SISA contains the sole purpose test for the fund. It is important to remember that SISA governs the fund and not the unit trust. The fund may be in breach of SISA but the unit trust itself will not be.

Where a unit trust lends monies to a related party of the fund relevant loan agreements should be obtained to evidence ownership of the asset by the trust and applicable interest rates. However, the relevant question is whether the fund has, by investing in an associated unit trust that lends money to a fund member, used the resources of the fund to provide financial assistance and or is the investment in the unit trust in breach of s62 as the sole purpose of the investment may not necessarily be to provide retirement benefits but also to lend monies to the member.

The Montgomery Wools case[2], SMSFR 2008/1[3]  (paragraphs 18 to 20, 78 and 79), ESAT case study 4.06.06, Taxpayer alert 2010/5[4]  and even comments in SMSF News – edition 23[5]  indicate that where a fund invests in a trust which lends money to related parties a breach of the act may occur.

A factor in the Montgomery wools case appears to be distributions went unpaid and that the unit trust was receiving no interest on the loans and the principal could not be repaid. This may be distinguished from a case where there are no unpaid distributions between the unit trust and the fund and interest is being received by the unit trust at a market rate and principal is being repaid in accordance with a loan agreement.

Paragraphs 18 to 20 of SMSFR 2008/1 and the ESAT case study appear to be circumstances where the fund invests in a unit trust which immediately uses those fund resources to lend monies to related parties. Again this may be distinguished from a case where the unit trust had surplus cash and made the decision to make loans rather than reducing debt which secured a rate of return for the unit trust higher than the cost of the borrowings and provides greater distributions to the fund and provides better for old age benefits.

The overriding question is: does a breach of 62 / 65(1)(b) occur every time a unit trust in which a fund invests lends money to related parties or are there certain circumstances where a breach will not occur?

It may be that the ATO would consider the facts in each case and matters such as:

  • Did the unit trust also make loans to other unrelated parties?
  • Did those loans on the same terms as the loans to the member?
  • Are the loans actually being repaid with interest at the specified rate?
  • Would the member have been able to obtain the loan, on the same terms from an unrelated third party?

However, the overall weight of authority would suggest that a fund is in breach of section 65(1)(b) and probably section 62 when an associated unit trust in which the fund invests lends monies to a member.

S129 of SISA requires the auditor who forms an opinion that it is likely a contravention may have occurred or may be occurring to report to the ATO (if the matter is specified in the ATO Auditor Contravention Report).

Accordingly, even if the auditor is not certain a breach has occurred the matter should be reported as it is likely it may have occurred. The ATO can then review the case on its individual merits and take action as it considers appropriate.

It should also be noted that in certain situations when a fund invests in an unrelated unit trust the fund will also be in breach of the act if the unrelated unit trust makes loans to a related party (Taxpayer Alert 2010/5).

Payment of Distributions

Audit procedures relating to unit trust distributions should commence with testing net profit to be distributed. Income can usually be supported by lease agreements, dividend statements, bank statements for interest received and so forth. Expenses can likewise by simply tested by agreeing a sample to supporting documentation. If the unit trust financials are prepared at market value the auditor should check that unrealized gains have not been included as income on the Operating Statement as this will result in net income to be distributed including an unrealized amount that can usually not be paid, giving the appearance of unpaid distributions. Such movements should be booked to equity accounts.

The transitional provisions provided an opportunity for SMSFs to invest sufficient amounts to clear the debt from the unit trust. Funds that have failed to take this opportunity may encounter problems if the unit trust continues to maintain loans that have a principal and interest component. Repayment of the principal amount may result in the trust having insufficient funds to pay distributions. Non-payment of distributions for this reason or any other reason may result in a compliance breach.

SMSFR 2009/3 – Self Managed Superannuation Funds: application of the Superannuation Industry (Supervision) Act 1993 to unpaid trust distributions payable to a Self Managed Superannuation Fund[6] is the relevant ATO ruling regarding unpaid trust distributions.

Example 2 in the ruling describes a situation where distribution of current year net income is unpaid at the year end. The amount is paid in May of the next financial year one month after the unit trust financials were prepared and the amount of distribution ascertained. All unit holders were paid at the same time. In these circumstances the unpaid distribution does not constitute a further investment in the trust or a breach of section 109 of SISA.

However, in other circumstances unpaid distributions may represent a breach of section 109 of SISA and/or constitute a further investment in the trust which would be included as an in-house asset of the fund unless an exemption applied.

The ruling identifies that where distributions remain unpaid a breach of section 109 will occur unless a loan agreement for the distribution or a consensual arrangement meeting the section 10 SISA definition of a loan is in place and the terms of such loan or agreement are on an arm’s length basis.

The mere possibility of receiving greater distributions from the trust in future due to the provision of low cost capital (the unpaid distribution) would not be adequate compensation where the SMSF is not the sole beneficiary of the trust. Where the fund is the sole beneficiary the Commissioner’s view is that the SMSF may be able to validate a view that the non-payment of a trust distribution was undertaken at arm’s length and such a consensual arrangement would meet the definition of a loan to and thereby an investment in the trust.

A breach of section 109 can therefore be avoided with a loan or consensual agreement on arm’s length terms. However, the ruling also states that where such a loan or agreement is entered into the amount will constitute an investment in the trust and will be included in the in-house assets of the fund unless any of the exclusions in sections 71 to 71E of SISA apply.

Auditors should determine the amount of distributions that have remained unpaid for greater than 12 months and establish whether any loan or arrangement has been entered into. If no arm’s length arrangement is in place the auditor should consider a compliance qualification for breach of section 109 and lodging an Auditor Contravention Report (ACR) dependent upon the quantum involved and other ACR reporting requirements.

Where an arrangement is in place on arm’s length terms the auditor should determine whether any exclusions in sections 71 to 71E apply to this additional investment in the trust. If not, the amount will be an in-house asset. If the amount by itself or with other in-house assets held by the fund exceeds 5% of total fund assets the auditor should again consider a compliance qualification for breach of Part 8 and lodging an ACR.

Further issues may arise if the fund is not the sole beneficiary of the trust. If, for example, the fund and a related entity each hold 50% of the unit capital the auditor should be reviewing all beneficiary accounts in the trust financials to establish whether each beneficiary is receiving distributions on the same terms. Starting with a calculation to ensure each beneficiary receives 50% of the net income and then checking that amounts are being paid equally. If the related party is being paid distributions whilst the fund distributions accrue additional breaches of section 109 should be considered. Instances have also been seen where the related parties’ beneficiary account is overpaid in excess of present entitlement. This then constitutes a loan by the trust to the related party and the auditor should consider a breach of section 65 of SISA.

Converting Pre-August 1999 Trusts to 13.22C Trusts

Section 71(j) of the SIS Act exempts from in-house assets investments in related trusts or companies that meet the strict criteria specified in a regulation. The relevant regulations are in Division 13.3A of the SIS Regulations being regulations 13.22A to 13.22D. The criteria which must be met by these entities are strict and onerous and auditors should carefully read these regulations to understand the requirements.

In some instances pre August 1999 trusts have paid down all borrowings, removed charges from property titles and divested all other investments other than bank accounts and real property and may appear to meet the definition of a 13.22C trust. This is possible and then allows the fund to make further investments in that trust that will be excluded from fund in house assets. However, whilst it is possible it is difficult to accurately ascertain the nature of all of the transactions and ensure that a 13.22D event has not occurred and this provides a challenge for the auditor.

Firstly, there have been instances, mainly toward the end of the 2009 financial year where funds made significant investments in pre August 1999 trusts and instantaneously paid of the remaining debt in that trust attempting to rely on regulation 13.22C.  However, at the time of the investment the debt was still there meaning that the conditions of regulation 13.22C were not satisfied and the investment constituted an in-house asset of the fund other than amounts available under sections 71A and 71D or 71E of SISA.

Secondly, there are cases to the present day where funds make investments in pre August 1999 trusts which genuinely satisfy the conditions of regulation 13.22C at the time of the investment. However, the ATO view is that this by itself is not enough. ATO ID 2012/53 – Self Managed Superannuation Fund: in-house assets – additional investment in a related trust – trust borrowings at 28 June 2000 increased and discharged prior to additional investment in the related trust[7] provides the ATO view that where a regulation 13.22D event has occurred in the unit trust after 28 June 2000 this excludes any other investment in that trust being excluded as regulation 13.22C investments. The determination describes an example where a pre August 1999 unit trust makes further borrowings on or after 28 June 2000. All outstanding borrowings are repaid before the fund later makes a further investment relying on regulation 13.22C of SISR. The determination states that 13.22C does not apply as a result of the 13.22D event previously occurring notwithstanding that at the time of the investment all conditions of 13.22C are met and that the fund has never before relied on 13.22B or 13.22C of SISR for investments in the trust.

Extension of this example means that any 13.22D event occurring in a pre-August 1999 unit trust after 28 June 2000 will prevent any further investment in that trust being excluded from in house assets of the fund under regulation 13.22C. Given that we are now auditing the year ended 30 June 2016 and that unit trusts would only be required to keep records for 5 years the problem for the auditor, and the ATO in fact, will be evidencing whether or not a 13.22D event has occurred between 28 June 2000 and the date of the additional investment by the fund. Remembering that 13.22D events are extensive, including holding an interest in another entity, making a loan, leasing residential property to a related party, not having a legally binding lease agreement for business real property leased to a related party, conducting a transaction otherwise than on an arm’s length basis and borrowing money which would include overdrawing a bank account.

When a fund has exceeded permitted investments in a pre-August 1999 related trust or a fund holds an investment in a regulation 13.22C trust in which a 13.22D event has occurred there is at least hope that the auditor has identified the contravention, reported the matter and carried forward any breaches in the audit report. However, there would have been no direct requirement for the auditor to consider 13.22D events when auditing a fund that held an investment in a pre-August 1999 trust which did not rely on the 13.22B or 13.22C provisions. Accordingly, there would be no reporting of these events in the audit report and no matters carried forward to assist future years of audit.

Faced with such a predicament, the auditor should make all necessary enquiry and obtain as much evidence as is available to confirm no 13.22D event occurred between 28 June 2000 and the date of the investment under 13.22C. This is most likely to be inconclusive. The remaining option is for the auditor to qualify the audit report and lodge an ACR describing an inability to form an opinion on compliance with in-house asset rules.

Market Value of Related Unit Trust Investments in the Fund Financials

Regulation 8.02B of SISR requires the fund financials to record assets at market value. For related unit trust investments, we accept that net assets per unit based on market value of assets as an appropriate market valuation method for the fund financials. Commonly unit trust financials are prepared at cost. If so, it is necessary to obtain reconciliation between the market value reported by the fund and the net assets at cost of the unit trust, to test the calculations and obtain evidence of the market values of assets in the trust. Alternatively, the unit trust financials may be prepared at market value with unrealized gains (or losses) booked to the equity account. In these cases the auditor can simply obtain evidence that the assets are correctly recorded at market value. Whether the financials are prepared at cost or market value we strongly suggest the auditor checks that any unpaid distribution account is not double booked by the fund.


[1]Decision Impact Statement Re MONTGOMERY WOOLS PTY LTD (AS TRUSTEE FOR MONTGOMERY WOOLS PTY LTD SUPER FUND) v FC of T http://law.ato.gov.au/atolaw/view.htm?DocID=LIT/ICD/2009/3486/00001

Full report at: http://law.ato.gov.au/atolaw/view.htm?locid=’JUD/2012ATC10-233’&PiT=99991231235958

[2]http://law.ato.gov.au/atolaw/view.htm?locid=’JUD/2012ATC10-233’&PiT=99991231235958,
http://law.ato.gov.au/atolaw/view.htm?DocID=LIT/ICD/2009/3486/00001
[3]http://law.ato.gov.au/atolaw/view.htm?dbwidetocone=06%3AATO%20Rulings%20and%20Determinations%20(Including%20GST%20Bulletins)%3ABy%20Type%3ARulings%3ASelf%20Managed%20Superannuation%20Funds%3A2008%3A%2304920010000%23SMSFR%202008%2F1%20-%20Self%20Managed%20Superannuation%20Funds%26c%20giving%20financial%20assistance%20using%20the%20reso…%3B

[4]http://law.ato.gov.au/atolaw/view.htm?dbwidetocone=03%3ATPA%3A2010%3A%2300005%23TA%202010%2F5%20-%20The%20use%20of%20an%20unrelated%20trust%20to%20circumvent%20superannuation%20lending%20restrictions%3B

[5]http://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/News/SMSF-News/SMSF-News—edition-23/?default=&page=19#Related_pre_1999_unit_trusts

[6]http://law.ato.gov.au/atolaw/view.htm?dbwidetocone=06%3AATO%20Rulings%20and%20Determinations%20(Including%20GST%20Bulletins)%3ABy%20Type%3ARulings%3ASelf%20Managed%20Superannuation%20Funds%3A2009%3A%2304910030000%23SMSFR%202009%2F3%20-%20Self%20Managed%20Superannuation%20Funds%26c%20application%20of%20the%20Superannuation%20Industry…%3B

[7]http://law.ato.gov.au/atolaw/view.htm?dbwidetocone=05%3AATO%20Interpretative%20Decisions%3ABy%20Topic%3ASuperannuation%20Entities%3ASelf%20managed%20superannuation%20funds%3A%2304880053%23ATO%20ID%202012%2F53%20-%20Self%20Managed%20Superannuation%20Fund%26c%20in-house%20assets%20-%20additional%20investment%20in%20a%20related%20trust%20-%20trust%20borrowings%20at%2028%20June%202000%20increased%20and%20discharged%20prior%20to%20additional%20investment%20in%20the%20related%20trust%3B