Woes of a beneficiary of a discretionary trust in getting a tax deduction for interest: Chadbourne v. C of T.

CarWoes

In the recent Administrative Appeals Tribunal case Chadbourne and Commissioner of Taxation (Taxation) [2020] AATA 2441 (10 July 2020) the AAT confirmed the disallowance of tax deductions to Mr. D. Chadbourne (the Applicant).

The Applicant was a beneficiary of the D & M Chadbourne Family Trust (DMCFT) and the Applicant was denied deductions for:

  • interest on money borrowed by the Applicant to fund the acquisition of real estate and shares by the DMCFT; and
  • other expenses incurred by the Applicant expended;

so the DMCFT could earn income.

The discretionary trust

The DMCFT was a discretionary trust. In Chadbourne Deputy President Britten-Jones usefully described a discretionary trust:

I note that the meaning of the term ‘discretionary trust’ is disclosed by a consideration of usage rather than doctrine, and the usage is descriptive rather than normative. It is used to identify a species of express trust, one where the entitlement of beneficiaries to income, or to corpus, or both, is not immediately ascertainable; rather, the beneficiaries are selected from a nominated class by the trustee or some other person and this power (which may be a special or hybrid power) may be exercisable once or from time to time.

Chadbourne at paragraph 8

The mere expectancy of a beneficiary of a discretionary trust

Because the beneficiaries of a discretionary trust are not immediately ascertainable and are to be selected, a prospective beneficiary only has an expectancy of earning trust income unless and until the beneficiary is so selected by the trustee to take income:

Unless and until the Trustee of the discretionary trust exercises the discretion to distribute a share of the income of the trust estate to the applicant, the applicant’s interest in the income of the discretionary trust is a mere expectancy. It is neither vested in interest nor vested in possession, and the applicant has no right to demand and receive payment of it.

Chadbourne at paragraph 57

or in the case of a beneficiary who takes in default of exercise of discretion they have no more than a similar expectancy.

The Applicant was a beneficiary of the DMCFT with an expectancy interest.

The available tax deduction

The Applicant could not satisfy the first limb of the general deduction provision, now in the Income Tax Assessment Act (ITAA) 1997, which allows an income tax deduction for a loss or outgoing to the extent:

it is incurred in gaining or producing your assessable income 

paragraph 8-1(1)(a) of the ITAA 1997 (emphasis added)

In Chadbourne the Applicant’s expenditure was incurred to gain or produce income for the trustee of the DMCFT, a separate legal entity. Applying authority including Federal Commissioner of Taxation v Munro (1926) 38 CLR 153, Antonopoulos and FCT [2011] AATA 431; 84 ATR 311, Case M36 (1980) 80 ATC 280,  Commissioner of Taxation v Roberts and Smith (1992) 37 FCR 246, where Hill J. referred to Ure v Federal Commissioner of Taxation (1981) 50 FLR 219, Fletcher v Commissioner of Taxation (1991) 173 CLR 1 and other cases, the AAT required a nexus between loss or outgoings of the Applicant and the assessable income of the Applicant; not the DMCFT. Although the Applicant stood to earn income indirectly as the likely beneficiary of the DMCFT the AAT found:

The Trust is a discretionary trust the terms of which require the Trustee to exercise a discretion as to whom a distribution of net income is to be made.  It is an inherent requirement of the exercise of that discretion that it be given real and genuine consideration. There must be ‘the exercise of an active discretion’. There were numerous beneficiaries in the Trust.  There was no certainty provided by the terms of the Trust that the Trustee would exercise its discretionary power of appointment in favour of the applicant.

Chadbourne at paragraph 53

and the Applicant thus had not incurred the expenditure in gaining or producing the assessable income of the Applicant.

Why did the Applicant run the AAT appeal?

The Applicant in Chadbourne was self-represented. With the benefit of professional advice or assistance the Applicant may have:

  • more readily foreseen the outcome of his appeal to the AAT which, in the light of the authority applied by Deputy President Britten-Jones, could be seen as inevitable; or
  • moreover, arranged the loan to achieve the required section 8-1 nexus between the outgoings and the assessable income of a taxpayer.

Safer alternative 1 – trustee loan

The most obvious alternative would have been for the trustee of the trust to have been the borrower and to have directly incurred the relevant expenses though those actions would have been different commercial arrangements to those that were done.

These actions may have been more complicated and expensive to arrange: not the least because the financier may have required the Applicant to personally guarantee repayment of the loan by the trustee of the trust which was a corporate trustee with limited liability. Nonetheless these precautions would have ensured section 8-1 deductions were available to the trustee of the trust.

(Somewhat) safer alternative 2 – on-loan to the trustee

The other and perhaps commercially easier alternative would have been an on-loan of the borrowed funds by the Applicant to the trust.

The Applicant in Chadbourne may have belatedly considered an on-loan solution. At paragraph 11 of the AAT decision it was observed that the Applicant had abandoned a contention that there was a “written funding agreement” between the Applicant and the trustee of the DMCFT which the Commissioner had suggested was an invention to assist the Applicant in the appeal.

In the event of a genuine on-loan the trustee of the trust would hold the borrowed funds as loan funds with a clarity as to whom interest and principal is to be repaid rather than as a capital contribution or gift to the trust without that clarity.

On-loan – interest free

Clearly the on-loan by the Applicant to the trustee of the trust should not be interest free as the Applicant then faces the Chadbourne problem of having no assessable income with which to justify a section 8-1 deduction. In the words of Taxation Determination TD 2018/9 Income tax: deductibility of interest expenses incurred by a beneficiary of a discretionary trust on borrowings on-lent interest-free to the trustee:

A beneficiary of a discretionary trust who borrows money, and on-lends all or part of that money to the trustee of the discretionary trust interest-free, is usually not entitled to a deduction for any interest expenditure incurred by the beneficiary in relation to the borrowed money on-lent to the trustee under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)…  

TD 2018/9 – paragraph 1

On-loan – at low interest

An on-loan at low interest was arranged in Ure v. Federal Commissioner of Taxation (1981) 11 ATR 484. In Ure the borrower borrowed funds at up to 12.5% p.a. interest and on-lent the funds to his wife and his discretionary trust at 1% p.a. The Full Federal Court found that the deduction Mr. Ure could claim under the first limb of the general deduction provision, sub-section 51(1) of the ITAA 1936, was limited to the 1% p.a. by which the interest income earned by Mr. Ure from his on-loan was confined.

On loan – at equivalent interest

It thus follows from TD 2018/9, Ure and Chadbourne that, to achieve deductibility in full for interest on funds borrowed and on-lent to a related discretionary trust, the interest earned by the beneficiary/on-lender on the on-loan should be the interest payable by the on-lender on the loan from the financier. This should leave the beneficiary/borrower in a tax neutral position on his or her loan on-loaned with assessable interest earned under the on-loan equalling deductible interest paid on the loan.

Related loan issues

As the on-loan is a related loan there are further considerations which will attract the scrutiny of the Commissioner:

A related on-loan should ideally be carefully documented and it should be clarified that the beneficiary/on-lender has an indefeasible right to the interest even though the on-lender is a related party of the borrower. It is also important that commitments in the on-loan agreement are met and generally interest due to the beneficiary/on-lender shouldn’t be capitalised and, especially, shouldn’t be aggregated with unpaid present entitlements due to the beneficiary.

The Commissioner could take these positions:

  • that the on-loan with interest is inadequately documented and can’t be proved so accounting entries capitalising interest shouldn’t be considered conclusive; or
  • the on-loan may be documented but it is a sham and the failure of the trust to pay interest when due shows this.

See my blog post at this site “Only a loan? Impugnable loans, proving them for tax and shams” https://wp.me/p6T4vg-8a which shows the fallibility of related party loans when these questions are contested with the Commissioner.

Woes with hybrid trusts

A hybrid trust, also a descriptive rather than a normative structure, can also fit the Deputy President Britten-Jones formulation of a discretionary trust where the entitlement of beneficiaries of the hybrid trust to income is not immediately ascertainable and is subject to the exercise of a discretion. It has been recognised,  including in the Commissioner’s Taxpayer Alert TA 2008/3 Uncommercial use of certain trusts that the considerations of the AAT in Chadbourne can similarly apply to deny a section 8-1 deduction to the holder of an interest in a hybrid trust who incurs expenditure to earn income through a hybrid trust structure.

In passing I note my wariness of hybrid trusts which are typically aggressive and sometimes tax abusive arrangements. The Commissioner’s Tax Alerts are particularly directed against tax aggressive activity.

That said, the trust in the case of Forrest v Commissioner of Taxation [2010] FCAFC 6, which was referred to in a citation (sic.) in Chadbourne, appears to have been an instance of a hybrid trust where entitlement of unit holders to ordinary income was ascertainable and not subject to a discretion. On appeal to the Full Federal Court, the unit holders in Forrest could establish a nexus between borrowing expenditure incurred and assessable income.

Controlling who gets death benefits from a SMSF

A widower nominated his son and daughter to take equal shares of his superannuation benefits on his death on a basis not binding on the trustee. The daughter, who was the surviving trustee of her father’s self managed superannuation fund (SMSF) after his death, appointed her husband as the new co-trustee and excluded the son from control of the SMSF. The daughter refused to pay the son the equal share of death benefits based on the father’s non-binding death benefit nomination (DBN). The son unsuccessfully challenged the daughter’s conduct in the NSW Supreme Court: Katz v. Grossman [2005] NSWSC 934.

Dilemma – the SMSF trustee’s control over where death benefits go

Katz v. Grossman reveals a dilemma with SMSFs: whoever survives a member as trustee of a SMSF generally has significant autonomy as to whom death benefits of a deceased member will be paid to by default unless the member:

  • has taken effective steps to ensure the DBN is a valid binding DBN (BDBN) to bind the trustee to pay his or her benefits to:
    • dependant/s nominated by the member; or
    • the member’s estate by nominating the member’s legal personal representative (LPR); or
  • the member has made his or her pension reversionary to their chosen dependant: although a reversionary pensioner generally cannot be an adult child as only death benefits dependants contemplated by section 302-195 of the Income Tax Assessment Act 1997 can receive pension, including reversionary pension, death benefits.

(Exceptions)

The challenge of directing death benefits to dependants

Member control of superannuation is all well and good but selection of dependants to receive death benefits, either by member’s DBN or by the trustee of the fund, is fraught and is just as prone to dispute between disgruntled family beneficiaries as disputes over wills (Wills) and deceased estates are.

With superannuation funds generally, and especially SMSFs, it is a challenge for a member to:

  • maintain an up to date expression of where he or she wants his or her benefits to go on his or her death; and
  • to effect those wishes by way of a DBN.

In many cases this will be inconsequential such as where a surviving spouse of a deceased member is the surviving trustee, or controls the trustee, and is the obvious dependant of the member to take death benefits. But where dependants are next generation, or where a member has a blended family, surviving trustee decisions to pay death benefits of the deceased may not align with the deceased member’s wishes or their DBN especially where trusteeship of the SMSF passes into unexpected and unprofessional trustee hands on their demise.

Section 17A of the Superannuation Industry (Supervision) Act 1993 (the SIS Act) limits who can be or control a trustee of a SMSF to:

  • the members of the SMSF; or
  • their enduring attorneys;

unless the fund is a single member fund and, in any case, trustees of a SMSF must be unremunerated in their role as trustee: paragraph 17A(2)(c) of the SIS Act. Member controlled superannuation by a SMSF can be a control vacuum isolated from professional trustee expertise following the death of a SMSF member unless a professional is involved in the limited ways possible under sections 17A and 17B.

Does a SMSF member need to control where their death benefits go?

Is it desirable that the member controls where he or she wants his or her benefits to go in any case? Superannuation is explicitly to provide for a member’s dependants when the member dies. The SIS Act defines a dependant:

“dependant”, in relation to a person, includes the spouse of the person, any child of the person and any person with whom the person has an interdependency relationship.

Section 10 of the SIS Act

A deceased member may nominate a dependant by a DBN that is not the dependant of the member most truly dependent or most in need of the member’s death benefits. That is why it is doubly desirable to have a competent and trustworthy person succeed the member as trustee who will genuinely assess these needs. It is on the assumption that such a trustee will survive the member as SMSF trustee that superannuation fund governing rules (SFGRs) generally give the surviving trustee an open discretion to select the dependant of the deceased member to take the member’s benefits unless one of the Exceptions applies.

So even with the guidance of a non-binding DBN (NDBN), which expresses a deceased’s wishes as to whom his or her benefits are to be paid, SFGRs, the SIS Act and trust law typically give a superannuation trustee a power to pay benefits to dependants the trustee chooses in the trustee’s discretion contrary to and despite a NDBN as occurred in Katz v. Grossman.

The binding death benefit nomination

To immunise a DBN from a wrong choice of trustee, who may select a dependant in their discretion at odds with the member’s wishes, a member can use a BDBN. A widow or widower in circumstances similar to Katz v. Grossman can prevent override of their wishes as to who is to be their superannuation dependant to take their death benefits by force of a BDBN to bind the trustee to pay to that dependant.

The BDBN obstacle course

A SMSF member seeking to impose a BDBN to control his or her superannuation needs to be sure it will take effect. There are numerous contingencies. Consider these:

  • is the capability in SFGRs allowing BDBNs effective and does it have integrity? Does the member appreciate that BDBN forms and arrangements differ from trust deed to trust deed? Not all BDBN arrangements in trust deeds are rigorous;
  • will the BDBN be validly completed? (Wareham v. Marsella discussed below is an instance of invalid completion of a BDBN);
  • if the BDBN is stated to be non-lapsing will it take effect as non-lapsing? That is: will the BDBN continue to bind the trustee more than three years after it is made? In the recent case Re SB; Ex parte AC [2020] QSC 139 a non-lapsing BDBN was accepted by the Supreme Court of Queensland. Non-lapsing BDBNs are understood to be feasible for SMSFs following:
    • Donovan v. Donovan [2009] QSC 26; and
    • Self Managed Superannuation Funds Determination SMSFD 2008/3 Self Managed Superannuation Funds: is there any restriction in the Superannuation Industry (Supervision) legislation on a self managed superannuation fund trustee accepting from a member a binding nomination of the recipients of any benefits payable in the event of the member’s death?
  • what if the member marries, divorces or commences a reversionary pension after making a BDBN?
  • will the BDBN have a fraud risk? Who needs to witness completion of a BDBN form by a member under the SFGRs? Depending on arrangements and the regime in the SFGRs for safe custody and verification of a BDBN, is there a risk that a BDBN may be altered by a dishonest successor trustee or a trustee in a conflict of interest with other dependants or “lost” so the BDBN won’t take effect as intended by the member? and
  • what if the SFGRs are subsequently amended so that a BDBN made under former SFGRs of a SMSF no longer comply with the later SFGRs?

So a member looking to rely on a BDBN to direct who will take their superannuation faces a veritable obstacle course turning on:

  • the SFGRs in the trust deed of the fund;
  • the member’s domestic circumstances; and
  • the security integrity of the BDBN arrangements;

in his or her quest to have a BDBN complied with by the trustee of the SMSF when the member is no longer around.

Better for a BDBN to be in a member’s Will?

Although a payment of death benefits is not a testamentary disposition:  McFadden v Public Trustee for Victoria [1981] 1 NSWLR 15, it is desirable that a BDBN should be set out in, or, in the least, kept with, the Will of a SMSF member to avoid some of the above contingencies.

Generally speaking Wills are:

  • subject to strict witnessing and other evidentiary requirements under state laws which reduce the prospect of fraud. By inclusion of a BDBN in a Will the BDBN can attract the same protections; and
  • revoked on marriage and, depending on state laws, altered by divorce. A dependant nominated in a BDBN may pre-decease the member. On any of these events BDBNs are ideally revisited and, in that context, a non-lapsing BDBN is especially fraught after a situation where a long-dated BDBN should have been updated to reflect changes in a member’s domestic situation. If a BDBN is in a Will there is a greater likelihood that desirable update of a BDBN will not be overlooked.

There is also the advantage of consolidated consideration and expression of the member’s wishes for his or her property and financial resources substantially in a single document. Superannuation death benefits of deceased superannuation members now frequently exceed deceased estate property governed by their Wills in value.

To include a BDBN in a Will there needs to be a basis or regime for making a BDBN in a member’s Will in the SFGRs (in the trust deed) of a SMSF. Ordinarily SFGRs/SMSF trust deeds do not provide for BDBNs to be set out in a Will and instead require the BDBN to be in a discrete BDBN form.

When there is no BDBN

When:

  1. a BDBN fails;
  2. there is a NDBN but no BDBN; or
  3. no DBN at all;

what assurance does a member have that a trustee will act in the interests of and fairly to the prospective dependants of the member?

There is initially the issue with the first and third cases that there is no satisfactory expression of what the member wishes. This situation arose in the recent Victorian Supreme Court Appeal decision in Wareham v. Marsella [2020] VSCA 92.

Wareham v. Marsella

In Wareham v. Marsella the dependants of the deceased member of a SMSF included:

  1. the deceased’s daughter from her earlier marriage, Mrs. Wareham; and
  2. her husband of 32 years up to her death, Mr Marsella.

The deceased had made a BDBN in favour of her grandchildren at the inception of the SMSF but her grandchildren were not her superannuation dependants (see the definition in section 10 of the SIS Act above) so the BDBN was invalid.

Mrs. Wareham was the deceased member’s surviving trustee. Relations between her and the husband, Mr. Marsella, were strained. Mrs. Wareham appointed her husband Mr. Wareham as co-trustee. The trustees paid all of the deceased’s SMSF death benefits to Mrs. Wareham wholly excluding Mr. Marsella.

At first instance McMillan J. held that Mr and Mrs Wareham had exercised their discretion as trustees without giving real and genuine consideration to the interests of the dependants of the SMSF and:

  • set aside the exercise of their trustees’ discretion to favour themselves; and
  • removed Mr and Mrs Wareham as trustees of the SMSF.

This result was upheld on appeal to the Court of Appeal.

The court confirmed the wide autonomy the trustees of the SMSF had to select a dependant to take death benefits:

Apart from cases where trustees disclose their reasons, the exercise of an absolute and unfettered discretion is examinable only as to good faith, real and genuine consideration and absence of ulterior purpose, and not as to the method and manner of its exercise.

from Karger v Paul [1984] VicRP 13

Mr and Mrs Wareham did not give reasons for their decision to distribute all of the death benefits to Mrs. Wareham which meant that Mr. Marsella needed to establish:

  • bad faith;
  • lack of real and genuine consideration by; and/or
  • an ulterior purpose of

the trustees in making the decision (the Challengeable Grounds).  These are all matters that are challenging to prove before a court particularly where there are no expressed reasons of the trustees for making the decision. However in this exceptional case the Supreme Court could focus on:

  • the erroneous response by the trustees’ lawyers in correspondence with Mr. Marsella over his claim to participate as a dependant. From that it could be shown that the trustees misconceived their obligation to give Mr. Marsella’s claim a real and genuine consideration. For instance, the trustees’ lawyers had asserted in the correspondence that “Mr. Marsella was not a beneficiary or dependant and had no interest in the fund”; and
  • the bad faith of the trustees. The court observed that “the decision to pay no part of the death benefit to the deceased’s husband of more than 30 years was, at least, remarkable” and the “grotesquely unreasonable” nature of the decision to exclude him was enough to establish bad faith. As there was actual conflict between Mrs. Wareham, a trustee, and Mr. Marsella the court observed that it may remove a trustee in its discretion.

Balanced against that was:

  • the trustees’ resolution to pay Mrs. Wareham which did not reveal errors that establish any of Challengeable Grounds;
  • the power of the trustees to pay death benefits to a dependant who is a trustee despite the conflict of interest; and
  • the trustees did not give evidence and so where not examined about their consideration of Mr. Marsella’s claims as a dependant;

An exceptional case

So even though Mr. Marsella was successful the case was appealed and hard fought. The trustees’ lawyer’s unlikely lapses in the correspondence and the extreme outcome and treatment of a husband of more than 30 years were vital to the result especially where SFGRs expressly permit a trustee to favour themselves in death benefits discretionary decisions despite their conflict of interest with other potential dependants that could receive those death benefits.

Where a trustee is more cautious and opaque in the course of:

  • their decision to pay death benefits to their own benefit, despite their conflict of interest; and
  • in related correspondence;

the trustee will reveal little which will give a disgruntled dependant Challengeable Grounds to challenge the trustee’s exercise of discretion.

In that respect Katz v. Grossman more likely reflects the reality facing most disgruntled family members who miss out on death benefits, especially those who are not a spouse or in an interdependency relationship. In Katz v. Grossman Mr. Katz may not have been in a position to establish the Challengeable Grounds even though:

  • his father had nominated him on a non-binding basis to take an equal share of his death benefits; and
  • his sister and her husband as trustees of the SMSF instead distributed all of the death benefits of the father to his sister.

Conclusion

It follows that the authority of Wareham v. Marsella may only assist a spouse or interdependency dependant highly deserving of death benefits as dependants in compelling cases where:

  • a SMSF’s trustee makes identifiable error in the process of discretionary decision-making to pay death benefits to himself or herself despite their conflict of interest with the deceased’s spouse or interdependency dependant; and
  • where that spouse or interdependency dependant can endure legal action to challenge the decision based on the Challengeable Grounds.

Otherwise SMSF members need to ensure the right person or people are their successor trustee of their SMSF if a Katz v. Grossman or other situation where a dependant favoured by the member misses out on death benefits is to be avoided. A valid or current expression of wishes either in a NDBN or better:

  • in a BDBN, rigorously backed by SFGRs, included in or with the Will of the member to ensure its integrity, reducing the likelihood that a payment of death benefits will be made to the exclusion of a desired or deserving family member especially where, due to the confines of the SIS Act, the member can’t be confident that their successor SMSF trustee won’t use the opportunity to favour their own benefit; or
  • where a member foresees that their dependants will be in potential conflict, in next generation or blended family circumstances, by taking steps in accordance with the SFGRs to remove trustee autonomy to make the death benefits payment decision and to instead mandate that death benefits are to be paid to the LPR of the member in compliance with core purposes of superannuation which allow payment of death benefits to the LPR under section 62 of the SIS Act. In that case the member can set out how death benefits are to be left in his or her Will.

The AAT applies Bamford to rubbery number trust income distributions in Donkin – or does it?

RubberyNumbers

In Donkin & Others v. Federal Commissioner of Taxation [2019] AATA 6746, a recently published decision of the Administrative Appeals Tribunal (AAT), the AAT considered how section 97 of the Income Tax Assessment Act (ITAA) 1936 applied to distributions by the trustee of a family discretionary trust (FDT).

Distributions of income were made to up to five beneficiaries (the Participating Beneficiaries) by resolution of the trustee of the Joshline Family Trust (the JFT), a FDT, for the 2010 to 2013 income years (the Years).

Tax audit – taxable income of the JFT increased

Following an audit of the first Participating Beneficiary, Mr Donkin, and his associated entities the Commissioner of Taxation (Commissioner):

  • disallowed deductions to the JFT increasing the taxable income of the JFT for the Years; and so
  • increased the taxable income of the JFT.

Before the AAT the Participating Beneficiaries contended that:

  • on the increase in the taxable income of the JFT the respective shares of taxable income of the Participating Beneficiaries should remain constant (unaltered); with
  • the increase in JFT taxable income taxable to (another) residuary beneficiary Joshline (understood to be a company taxable at no more than 30%).

The Commissioner contended that, based on the High Court authority in Commissioner of Taxation v. Bamford [2010] HCA 10 (Bamford), the proportionate approach should be applied to proportionately increase the taxable income of the Participating Beneficiaries under section 97 from their shares of taxable income on which they were originally assessed.

AAT decides – aligns with Commissioner

The AAT accepted the Commissioner’s contentions and increased the taxable income of:

  • the Participating Beneficiaries where section 97 applied; and
  • the trustee in respect of Participating Beneficiaries where section 98 applied.

The residuary beneficiary Joshline was not assessed to any of the increase.

Opaque expression of distributable income

The resolutions of the JFT during the Years were odd in that they expressed or specified distributions as amounts of assessable income to which (“trust law”) income (unspecified) was to equate to. The trust deed of the JFT supported this novel approach which was directed to tax planning and, in particular, to certainty of assessable income that each Participating Beneficiary would receive.

These resolutions did not specify distributable income and so obliged a backwards calculation from shares of “assessable income” of the JFT to ascertain the distributable income and the share of it each Participating Beneficiary was entitled to.

How distributable income can be distributed

“Trust law” income, referred to in the legislation as “a share of the income of the trust estate”, considered by the High Court in Bamford to be “distributable income” is, and was described in Bamford as:

income ascertained by the trustee according to appropriate accounting principles and the trust instrument

Bamford at paragraph 45

which can be distributed and which the trustee distributes to beneficiaries and by which the respective shares of assessable income of beneficiaries, and trustees on behalf of other beneficiaries of a trust, is determined under sections 97 and 98 respectively.

If, on a 30 June at the end of an income year (30 June), the trustee has a specified a prescription for the distribution of income of a FDT whether it be:

  • an amount (from);
  • a set proportion, say expressed in percentage terms; or
  • a residue or remaining amount;

of distributable income then that can be accepted understanding that, almost universally, the trustee will not have had the opportunity, by 30 June, to ascertain the distributable income of the FDT to a final figure or amount.

Timing of present entitlement to distributable income

Nevertheless:

  • distributions are FDT trustee decisions that need to be made by 30 June if the distributions are to confer present entitlement on beneficiaries in the year of income; and
  • beneficiaries must be presently entitled to a share of the distributable income for either of section 97 or section 98 to apply.

Section 99A will apply to a FDT to tax the income to which no beneficiary is presently entitled by 30 June to the trustee at the highest marginal income tax rate. See my post (My Lewski Post) about Lewski v. Commissioner of Taxation [2017] FCAFC 145 where that happened. Lewski was referred to by the AAT in Donkin: Full Federal Court pinpoints year end trust resolutions that fail https://wp.me/p6T4vg-8s

Setting distributable income by 30 June

It follows that to effectively confer present entitlement a trustee decision to distribute trust income under a discretion needs to determine the share of distributable income of each beneficiary by 30 June. That determination of the trustee is confirmed and applied when the trustee prepares accounts for trust purposes in accordance with the terms of the trust deed and, if beneficiaries are entitled to a proportion or a residue of distributable income rather than a fixed amount of distributable income, those entitlements can then be ascertained from distributable income or the remaining distributable income numerically.

Distributable income not set in Donkin

However, in Donkin, the Participating Beneficiaries had entitlements to a proportion of “assessable income” (viz. taxable income or “net income” for the purposes of sub-section 95(1) of the ITAA 1936) (Taxable Income).  For instance, under the resolutions Mr. Donkin was entitled to 70.11% of the Taxable Income, not distributable income, of the JFT for the 2013 income year. So in the Commissioner’s contention, as accepted by the AAT, Mr. Donkin was taxable under section 97 on:

  • $262,659 being 70.11% of the Taxable Income of the JFT for the 2013 year when an original assessment was raised on Mr. Donkin’s share of trust Taxable Income returned by the trustee of the trust; and then
  • $304,137 being 70.11% of the Taxable Income of the JFT for the 2013 year following the amendment of the assessments following the audit.

It can be inferred from and is consistent with the Commissioner’s contention that, on the amendment of Mr Donkin’s 2013 assessment in or around 2015, the distributable income of Mr. Donkin was increased at that later time – the proportion of Taxable Income, 70.11%, did not change.

But how can distributable income of a trust increase after 30 June income year end?

Understanding that the trustee of the JFT determined the distributable income of the JFT and Mr. Donkin’s share of it by 30 June 2013 by mechanisms in the trust deed fixing and thus making Mr. Donkin presently entitled to a share of income confirmable and confirmed when 2013 accounts of the JFT were taken, how can a 2015 amendment to Taxable Income of the JFT alter the 2013 distributable income of the JFT and the present entitlement of Mr. Donkin to it at 30 June 2013?

It seems to me that the AAT has set out good reasons why the Commissioner’s contentions to:

  • alter distributable income; and
  • increase the present entitlement of each Participating Beneficiary supposedly by the end of the relevant June 30;

should not have been accepted and there should have been no change in distributable income of the Participating Beneficiaries in the Years. In paragraphs 42 and 43 of the AAT’s decision, in a response to different propositions put by the Applicants, the AAT stated:

42. It seems to us that on the Applicants’ construction of the resolutions their alternative submission would be correct. That is to say, the resolutions would be ineffective to confer a present entitlement on the individual beneficiaries because they involved a contingency.

43. They would depend on the occurrence of an event which may or may not happen, in particular, the Respondent disallowing a deduction and including an additional amount in assessable income. It follows that the individual beneficiaries would not be “presently entitled” under ss 97 or 98 of the ITAA36 to a share of the income of the JFT.

Donkin & Others v. Federal Commissioner of Taxation [2019] AATA 6746 paragraphs 42-43

These findings do resonate against the Commissioner’s and the AAT’s construction of the resolutions and the trust deed too.

Construing trust income resolutions applying Bamford

The High Court in Bamford stated:

The opening words of s 97(1) speak of “a beneficiary of a trust estate” who is “presently entitled to a share of the income of the trust estate”. The language of present entitlement is that of the general law of trusts, but adapted to the operation of the 1936 Act upon distinct years of income. The effect of the authorities dealing with the phrase “presently entitled” was considered in Harmer v Federal Commissioner of Taxation where it was accepted that a beneficiary would be so entitled if, and only if,

“(a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and (b) the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment.”

Bamford at paragraph 37

So in whatever way the trust deed of the trust allows the trustee to ascertain distributable income, the trustee must identify distributable income, or use a method which enables identification of distributable income not subject to contingency, by 30 June to confer present entitlement by 30 June. Without that a beneficiary has no present legal right to demand and receive payment of their share of income by 30 June.

It is that identification of distributable income referred to in Zeta Force Pty Ltd v Commissioner of Taxation  (1998) 84 FCR 70 at 74‑75 to which the High Court in Bamford refers where the High Court cites Sundberg J. with approval:

The words ‘income of the trust estate’ in the opening part of s 97(1) refer to distributable income, that is to say income ascertained by the trustee according to appropriate accounting principles and the trust instrument. That the words have this meaning is confirmed by the use elsewhere in Div 6 of the contrasting expression ‘net income of the trust estate’. The beneficiary’s ‘share’ is his share of the distributable income.”

….

“Having identified the share of the distributable income to which the beneficiary is presently entitled, s 97(1) requires one to ascertain ‘that share of the net income of the trust estate’. That share is included in the beneficiary’s assessable income.”

….

from Bamford at paragraph 45

It is respectfully suggested that the later part of Sundberg J.’s findings cited by the High Court:

Once the share of the distributable income to which the beneficiary is presently entitled is worked out, the notion of present entitlement has served its purpose, and the beneficiary is to be taxed on that share (or proportion) of the taxable ncome of the trust estate.

from Bamford at paragraph 45

does not mean that the distributable income of a FDT is to be or can be derived from Taxable Income of the FDT unless that proportion must be quantified or quantifiable, maybe by backwards calculation, by 30 June. For instance, the trustee’s own estimate of Taxable Income on or before 30 June, which could be supported by evidence after the fact, could be a parameter of distributable income which must be fixed if not ascertained by 30 June to achieve present entitlement.

Distributable income at 30 June is then routinely reflected in the accounts of a FDT at 30 June and other evidence which later demonstates what the trustee fixed as distributable income at 30 June.

Why was there no distributable income calculation for each 30 June in Donkin?

The Commissioner too could have worked out the amount of, or the figure for, distributable income of the JFT consistent with resolutions and accounts for the Years and other evidence. including trust tax returns, prepared and lodged later. It is implausible that the trustee of the JFT took into account the 2015 inclusions in Taxable Income in its 2010 to 2013 decisions which the AAT correctly observed was a contingency at the each of the 30 Junes through the Years.

Section 99A should have applied

In my understanding:

  • the Participating Beneficiaries in Donkin were not presently entitled in the Years to a proportion of amounts first included in Taxable Income in around 2015 following the Commissioner’s audit and amendment of assessments: and
  • section 99A should thus have been applied to these proportions when they became Taxable Income in 2015.

Distributable income – no place for a variable parameter

The AAT appears to have accepted that distributable income can be a variable parameter which can fluctuate after 30 June; the Commissioner and the AAT accepted a distribution method in Donkin based on a set proportion of Taxable Income, a variable parameter, which, in their view, caused distributable income to vary after 30 June when assessments were varied following audit. This sanctioned the use of rubbery numbers for ascertaining shares of distributable income, which the trust deed of the JFT contemplated for opaque tax reasons, without applying section 99A which, in my understanding and based on this analysis, should have applied.

That is disappointing, especially on the urging of the Commissioner, as the AAT decisions may influence future practice and encourage rubbery distributions of distributable income and the use of contorted trust deed provisions that facilitate them.

Income equalisation clauses

Family discretionary trust deeds I have prepared for over thirty years, and deeds drawn by many other preparers, have long based distributions of distributable income on an income equalisation clause. I suggest that an income equalisation clause is, and has always been, a more conventional mechanism for practically dealing with the divergence between distributable income and Taxable Income in section 97 of the ITAA 1936 than the mechanisms contained in the trust deed of the JFT.

An income equalisation clause is a provision in a FDT trust deed which allows the trustee to align the distributable income of a FDT to Taxable Income.

The above analysis is also relevant to how an income equalisation clause using Taxable Income, a parameter that can change after a 30 June year end, should be construed. I addressed this question in My Lewski Post. There I concluded, based on the Full Federal Court’s views of how trust deeds and resolutions are to be construed, that Taxable Income in an income equalisation clause should be construed as Taxable Income based on knowledge of the trustee, informing the trustee’s decision at the time of the distribution, which is confirmed when accounts of the FDT for the relevant income year are taken and the mechanisms from the trust deed for determining distributable income are applied. On that construction Taxable Income is or should be fixed and present entitlement of beneficiaries to shares of distributable income of a FDT at 30 June can thus be attained.

Australian non-fixed trust liable for CGT on non-TAP gains given to a foreign resident: Peter Greensill Family Co Pty Ltd

BigBen

A mirror of the general principle of source and residence taxation broadly setting the parameters of international taxation, and reflected in Australia’s income tax law, is that income of a foreign resident not from sources in the state is not taxable in the state (in this post called the Mirror Principle). In Australia:

  • interests in real property in Australia and related interests; and
  • interests in assets used in business in permanent establishments in Australia:

are designated “Taxable Australian Property” (TAP) (see Division 855 of the Income Tax Assessment Act (ITAA) 1997). TAP is used in Australian income tax law to apply the Mirror Principle.

Foreign resident capital gains from non-TAP disregarded

Property which is not TAP, that is, property not taken to be connected to Australia for income tax purposes in the hands of foreign residents includes shares and securities as opposed to property interests in or related to Australian land or of permanent establishments carrying on enterprises in Australia which are TAP.

Capital gains made by foreign residents from non-TAP assets are disregarded for tax purposes: section 855-10.

Trouble pinpointing trusts as foreign or not

Trusts are elusive and create enormous difficulties in the international tax system see Trusts – Weapons of Mass Injustice. Trusts can detach beneficiaries who benefit from property who may be in one state from:

  • the trustee of the trust, in whose name the property is held, who may be in another state; and
  • the activities of trust which may be in yet another state.

Apt taxation of those activities in line with Mirror Principle thus poses a significant challenge to governments. States are justified imposing laws to counter offshoring with trusts to ensure the integrity of their tax systems.

Some states don’t recognise trusts.

In Australia trusts are mainstream. Some types of trusts are considered tax benign and conducive to legitimate business, investment and prudential activity. Fixed trusts are often treated transparently for Australian income tax purposes so that a fixed trust interest holder is:

  • taxed similarly to a regular taxpayer or investor; and
  • no worse off, tax wise, than a taxpayer or investor who owns the property outright rather than by way of a trust beneficial interest.

So, consistent with the Mirror Principle that a foreign resident owner of non-TAP who makes a gain on the non-TAP shouldn’t be taxable on the gain, a foreign resident beneficiary (FRB) of a fixed trust can disregard a capital gain made in relation to their interest in a fixed trust: section 855-40.

Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation

In the Federal Court case Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation [2020] FCA 559 this week the issue arose whether an Australian resident family discretionary trust – a non-fixed trust, was entitled to rely on section 855-10 and the Mirror Principle to disregard capital gains distributed to a FRB, a beneficiary based in London, of the trust from realisation by the trust of shares in a private company, GCPL, which were non-TAP of the trust.

Detachment of capital gains from the workings of trust CGT tax rules

The capital gains of a trustee are distant from the capital gains of a beneficiary under the ITAA 1936 and the ITAA 1997. Transparent treatment or look through to the capital gains of the trustee as capital gains of the beneficiary/ies became even more remote following changes to Sub-division 115-C of the ITAA 1997 including the introduction of Division 6E of Part III of the ITAA 1936.

These changes brought in distinct treatment of capital gains and franked distributions of a trust from other trust income following the High Court decision in Commissioner of Taxation v Bamford [2010] HCA 10 and the clarification of taxation of trust income in that case.

Legislation unsupportive of transparent treatment

In Greensill Thawley J. analysed the provisions in Sub-division 115-C and Division 6E to deconstruct the applicant’s case to disregard capital gains using Division 855. 

Section 855-40 specifically allows a FRB of a fixed trust to disregard non-TAP capital gains. The absence of an equivalent exemption for FRBs of non-fixed trusts is telling unless section 855-40 is otiose or represents an abundance of caution. Thawley J. did not follow that line. As the applicant in Greensill could not disregard the capital gains using section 855-40 in the case of non-fixed trust, or section 855-10, the capital gains were taxable in Australia.

Unless there is an appeal to the Full Federal Court the Commissioner can finalise his draft taxation determination TD 2019/D6 Income tax: does Subdivision 855-A (or subsection 768-915(1)) of the Income Tax Assessment Act 1997 disregard a capital gain that a foreign resident (or temporary resident) beneficiary of a resident non-fixed trust makes because of subsection 115-215(3)? as the Federal Court has accepted the view in it.

Deep pockets couldn’t overturn tax resident and evasion decision

Full Wallet

Plenty was spent by Malaysian multinational timber tycoon Yii Ann Hii unsuccessfully fighting $A 64m in income tax. This tax litigation looks like it has just ended with Hii v Commissioner of Taxation (No 2) [2020] FCA 345 in March 2020.

The litigation

Although the litigation with the Commissioner of Taxation was about whether the taxpayer was a resident of Australia between 30 June 2001 to 30 June 2009 (the relevant years), this issue never came to be decided in the litigation with the Commissioner which included:

  • a tax appeal to the Federal Court from objection decisions;
  • an appeal to the Administrative Appeals Tribunal for administrative review in relation to penalty assessments for the relevant years;
  • proceedings under section 39B of Judiciary Act 1903 collaterally taken in the Federal Court: Hii v Commissioner of Taxation [2015] FCA 375 before Collier J.;
  • an original proceeding in the High Court under sub-section 75(5) of the Constitution seeking writs of certiorari and mandamus; and
  • further proceedings under section 39B of Judiciary Act taken in the Federal Court seeking to quash an audit decision and an objection decision: Hii v Commissioner of Taxation (No 2) [2020] FCA 345 before Logan J.

An insight into the Australian tax system

Although the litigation never came to decide whether the Commissioner was correct in finding that the taxpayer was a resident taxable on worldwide income during the relevant years there is something to be drawn from these cases about the operation of Australia’s tax system.

Forum to fight the Commissioner

As we have said before on this blog in Is an objection needed to amend a tax assessment?, proceedings against the Commissioner other than under Part IVC (of the Taxation Administration Act 1953) where taxpayers can object against assessments of tax and appeal against the objection decisions arising, are expensive and are prone to failure. In Hii No. 1 Collier J. applied the High Court’s decision in Federal Commissioner of Taxation v Futuris Corporation Ltd (2008) 237 CLR 146 where it was held, by virtue of section 175 and section 177 of the Income Tax Assessment Act (ITAA) 1936, that judicial review under section 39B of the Judiciary Act 1903 is limited to where:

  • an assessment is tentative or provisional; or
  • where conscious maladministration by the Commissioner has occurred.

There were no allegations of tentativeness or bad faith of the Commissioner amounting to maladministration by the taxpayer in Hii No. 1; the taxpayer’s counsel instead sought to establish that the principles from Futuris did not apply to the taxpayer.

The taxpayer did not succeed. The Federal Courts in Hii No. 1  and in Hii No. 2 applied the principles from Futuris and decided for the Commissioner.

Getting advice or legal help in tax disputes

It would appear that the taxpayer was selective about taking or, alternatively, following counsel. It appears that the taxpayer conducted the section 39B proceedings in Hii No. 2 from Malaysia seemingly without Australian legal representation. The Federal Court found his action in Hii No. 2 to be an abuse of process. Moreover a vexatious proceedings order was made against the taxpayer preventing the taxpayer taking further action in the court in relation to these disputes.

In contrast, through the earlier litigation, the taxpayer engaged experienced senior and other counsel. In the appeal against the objection decisions the Commissioner obtained an order for security for costs in the Federal Court against the taxpayer who is a citizen of Malaysia and who had, by then, left Australia. The taxpayer never complied with the order nor sought any extension of time to do so. One can only assume his counsel would have advised him of the risk that he would lose his rights to contest the tax bills by not engaging with the security for costs order.

The subsequent litigation shows that is what happened. The Part IVC appeal was struck out because security for costs was not given to the Commissioner.  From then the taxpayer was unable to get his tax residence issue, or any review of the Commissioner’s decisions to treat him as a resident, before the courts at all despite his numerous and expensive efforts to do so.

Commissioner’s residency findings

As stated the courts were never able to get to the residence issue in the litigation. In the transcript of the High Court refusing an extension of time to apply to the High Court to the taxpayer the Commissioner’s findings of fact about the taxpayer nonetheless appear:

(i) the plaintiff was granted a permanent residency visa on 20 March 1992;

(ii) the plaintiff was granted a five year resident return visa on 27 February 1995, which allows current or former Australian permanent residents to re-enter Australia after travelling overseas and to maintain status as a permanent resident on return to Australia;

(iii) the plaintiff was issued a Queensland Drivers Licence on 6 February 1996, and his most recent Queensland Drivers Licence had effective dates of 23 December 2005 to 30 January 2011, with a Queensland address listed by the plaintiff;

(iv) the plaintiff applied on 6 September 2005 to alter his credit card limit with the National Australia Bank, listing the same Queensland address for his contact details;

(v) the plaintiff and his wife purchased the property at that Queensland address on 2 April 2001 for $6.5 million and more than six gigabytes of documents pertaining to the plaintiff’s business interests were found at that Queensland address and another property owned by companies controlled by the plaintiff;

(vi) the plaintiff’s immediate family, his wife and six children, resided in Australia as permanent residents of Australia, the plaintiff’s extended family lived in Brisbane, and his brothers lived in Victoria;

(vii) all the plaintiff’s children undertook their schooling at Queensland schools, and several children attended the University of Queensland and Queensland University of Technology; (viii) the plaintiff held in his own name 15 separate Australian bank accounts in the relevant years;

(ix) the plaintiff stayed at seven different hotels between 2002 and 2007 on his visits to Malaysia, but there was no evidence of any hotel stays when he was in Brisbane;

(x) As at 21 January 2009, the plaintiff had a number of vehicles registered to him or his wife in Australia for which insurance was obtained listing either him or his wife, or both, as the main driver, including a Lamborghini Murcielago, a Rolls Royce Phantom, a Ferrari Coupe, and a Bentley Continental;

(xi) in the relevant years, the plaintiff departed Australia 85 times, of which 84 departure cards were located on each of which the plaintiff indicated that he was an “Australian resident departing temporarily”;

(xii) the plaintiff spent between 65 and 189 days in Australia in each of the relevant years with 6 to 125 in Malaysia for the years known;

(xiii) the plaintiff was a director of seven Australian companies with registered offices in Queensland (in six of which the plaintiff held between 35% and 90% of the shares) during the relevant income years; and

(xiv) the plaintiff wrote a letter dated 12 March 2009 to the Australian Department of Immigration which he signed on behalf of one of the companies in which he was a director, which included his statement that “My family currently resides permanently in Brisbane since our first landing in 1993 … Due to the nature of my business I am forced to regularly travel overseas, because of other business interests”.

Did the taxpayer get advice about tax residency?

If these findings are plausible then, without even expressing a view on whether the Commissioner should have determined that the taxpayer was a tax resident of Australia as no Australian tribunal or court did, it can be inferred that the taxpayer was desultory in either taking or, if he took it, following advice on how to avoid being treated by the Commissioner as a tax resident of Australia.

A journalist’s report https://is.gd/KWH9jj suggests that the taxpayer may have over relied on the 183 day test (in the definition of “resident” or “resident of Australia” in sub-section 6(1) of the ITAA1936) but that report is unconfirmed. Could it be that the taxpayer did not take advice during the relevant years about the risks of his activities and circumstances possibly leading to him being treated as a tax resident of Australia either:

  • under ordinary concepts?; or
  • due to adopting Australia as a domicile of choice?

(See our blog from February 2020 When 183 days is not enough to make you an Australian tax resident )

It is through the relevant years in particular that advice or legal assistance to the taxpayer acted on by the taxpayer may have really counted.

Evasion and the resident determination

A further grievance of the taxpayer in the litigation was that in those years of the relevant years where the Commissioner raised original assessments based on the taxpayer’s non-resident returns, the Commissioner was out of time to amend the assessments raised under section 170 of the ITAA 1936.

Amended assessments were there raised by the Commissioner on a footing of evasion under Item 5 of sub-section 170(1).

Is getting tax residence wrong evasion?

One would think that an error by a taxpayer on the frequently nuanced and complex question of whether or not the taxpayer is a resident of Australia does not amount to evasion. However once the question of tax residence is investigated under audit by the Commissioner it is then more awkward to hide behind that simple proposition. In Hii No. 1 it is stated that the Commissioner justified his evasion determination on the following acts of the taxpayer:

  a.           Listing a Singapore business address on his Australian tax return as his residential address

  b.           Providing different reasons as to why various addresses are used in each country [during the course of the audit]

    c.           Not providing details of his offshore income and assets when requested [during the course of the audit]

    d.           Failing to provide full and complete details of foreign entities he controls [during the course of the audit]

    e.           Omitting foreign source income from his Australian tax returns; and

    f.            Failing to pay appropriate tax in Australia.

(see paragraphs 12 and 28)

Viewed skeptically one could suggest that facts e. and f. could happen when a taxpayer innocently believes they are a tax non-resident and may not be evasion. Facts  a. to b. more strongly can support an evasion finding.

Evasion & co-operating with an audit

From c. and d. it can be inferred that full co-operation with the Commissioner in the course of an audit is an imperative where a taxpayer is contesting an amended assessment which would be out of time in the absence of fraud or evasion.

The question again arises, did the taxpayer get or follow advice this time about what information to provide to the Commissioner’s auditors? Based on c. and d. the withholding of information from the auditors prejudiced the taxpayer’s position on the evasion issue.

When 183 days is not enough to make you an Australian tax resident

The recent AAT case of Schiele v. Commissioner of Taxation [2020] AATA 286 (24 February 2020) illustrates when 183 days presence in Australia in an income year is not enough to make someone a resident for tax purposes.

Background

Mr Schiele:

  • is a German citizen;
  • lived with his parents prior to coming to Australia;
  • obtained a working holiday visa for the year ended 30 June 2016;
  • arrived in Australia on 30 October 2015 and departed Australia on 18 July 2016;
  • left his personal belongings and furniture with his parents in Germany while in Australia;
  • did not leave Australia between 30 October 2015 and 18 July 2016;
  • stayed on a farm between 1 December 2015 and 5 June 2016 where he did farm work between 22 March 2016 and 4 June 2016, and travelled to visit friends and to see the country in his remaining time while in Australia;
  • did not become a member of any community groups, churches, clubs or organisations while in Australia; and
  • returned to live with his parents in Germany after departing Australia.

Before the AAT the taxpayer contended he was an Australian tax resident for the 2016 income year. The taxpayer was looking for the tax free threshold that applies to an Australian tax resident’s taxable income.

A visitor

From the above facts the AAT found that the taxpayer was a visitor to Australia.

What makes an individual an Australian tax resident?

The relevant passages of the taxation legislation in the case are from the definition “resident” or “resident of Australia”:

  (a)  a person, other than a company, who resides in Australia and includes a person:

    (i)  whose domicile is in Australia, unless the Commissioner is satisfied that the person’s permanent place of abode is outside Australia; or

    (ii)  who has actually been in Australia, continuously or intermittently, during more than one-half of the year of income, unless the Commissioner is satisfied that the person’s usual place of abode is outside Australia and that the person does not intend to take up residence in Australia;

from sub-section 6(1) of the Income Tax Assessment Act 1936

If the taxpayer could satisfy any of the phrase in paragraph (a), or either of sub-paragraphs (i) or (ii), then the taxpayer would be a tax resident. It is to be noted that both sub-paragraphs (i) and (ii) have prominent conditions (after the word “unless”).

paragraph (a) resides – resident according to ordinary concepts

The term resides in Australia in paragraph (a) is the legal parameter of residence (in Australia) according to ordinary concepts. Residence according to ordinary concepts has been developed in the common law in tax court cases each typically involving a controversy about where a person resides. The AAT approved of a summary of case authority on residence according to ordinary concepts submitted by the Commissioner. To keep this extract brief I extract the Australian High Court cases so summarised in paragraph 24 of the AAT decision:

…. Determination of a person’s residence is a “question of degree and …fact”; ….

Federal Commissioner of Taxation v Miller [1946] HCA 23; (1946) 73 CLR 93, 103

… “a person does not necessarily cease to be a resident there because he or she is physically absent. The test is whether the person has retained a continuity of association with the place … together with an intention to return to that place and an attitude that the place remains “home””; ….


Koitaki Para Rubber Estates Limited v The Federal Commissioner of Taxation [1941] HCA 13; (1941) 64 C.L.R. 241 at p.249

The AAT found that the taxpayer did not reside in Australia and was not a resident according to ordinary concepts as a matter of fact and degree. The AAT found no persuasive evidence that the taxpayer intended to dwell permanently or for a considerable time in Australia. His presence in Australia for 7 months did not make him a resident on its own.

sub-paragraph (i) – the domicile test

Domicile is another technical legal test governed by the Domicile Act (C’th) 1992. Shortly stated a domicile is most often in the country where a person is born, or based on the nationality the person is born with which is taken to be where he or she intends to live indefinitely (domicile of origin) . Domicile of origin is intractable but can be changed: where the person can demonstrate his or her intention to make his or her home in another place indefinitely. Without a quest for a permanent right to live in a country no change to that country as a domicile of choice is evident. Clearly in the taxpayer’s case, the taxpayer has a domicile which remains his domicile of origin in Germany.

The condition to domicile in Australia concerning the permanent place of abode of the taxpayer is not enlivened because the taxpayer does not have a domicile in Australia.

sub-paragraph (ii) – the 183 day (half year) test

The 183 day test was the test on which the taxpayer sought to qualify as an Australian resident. The taxpayer was present in Australia for over 183 days and sought to correct immigration records that suggested to the contrary through the course of the case.

However the taxpayer’s difficulty in the case was not with his presence in Australia for more than 183 days, which the AAT accepted, but with the condition to the 183 day test of residence. The Commissioner and the AAT were satisfied that the taxpayer’s usual place of abode was in Germany so the condition to sub-paragraph (ii) was both enlivened and satisfied. The taxpayer was not an Australian tax resident because his usual place of abode was not in Australia despite his presence in Australia of more than 183 days.

Does a SMSF that holds only life insurance satisfy the sole purpose test?

LifeInsurance

I was recently asked if a SMSF whose only assets are an insurance policy and cash topped up by contributions used to meet premiums on the policy would comply with the sole purpose requirement in the Superannuation Industry (Supervision) Act 1993.

It depends. It will depend on the terms of the life policy and significantly on the age of the member:

The sole purpose test in sub-section 62(1) is structured as follows:

(1) Each trustee of a regulated superannuation fund must ensure that the fund is maintained solely:

(a) for one or more of the following purposes (the core purposes ):

… or

(b) for one or more of the core purposes and for one or more of the following purposes (the ancillary purposes ):

….

In other words a fund maintained for any of the listed core purposes complies with the sole purpose test. A fund maintained for an ancillary purpose or purposes also complies with the sole purpose test so long as it is also maintained for a core purpose or purposes.

The life insurance policy in question would need to be considered. Will the policy pay out insurance proceeds to the trustee of the fund on the death of the member to be used by the trustee to pay death benefits?

Pursuing a core purpose

If the policy would indemnify the trustee on the death of the member before the member:

  • ceases gainful employment; or
  • reaches age 65;

the trustee of the fund would appear to pursue core purposes either in sub-paragraph 62(1)(iv) or (iv) which are:

(iv)  the provision of benefits in respect of each member of the fund on or after the member’s death, if:

(A)  the death occurred before the member’s retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged; and

(B)  the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;

(v)  the provision of benefits in respect of each member of the fund on or after the member’s death, if:

(A)  the death occurred before the member attained the age (65) prescribed for the purposes of subparagraph (ii); and

(B)  the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;

by taking out life cover to fund these death benefits.

Pursuing an ancillary purpose

If the life cover in the policy:

  • is in respect of the life of a member who is over age 65 and who has ceased gainful employment; or
  • only extends cover following both of those events;

then the fund is only maintained for ancillary purposes in sub-paragraph 62(2)(iii) and (iv) which are:

(iii) the provision of benefits in respect of each member of the fund on or after the member’s death, if:

(A) the death occurred after the member’s retirement from any business, trade, profession, vocation, calling, occupation or employment in which the member was engaged (whether the member’s retirement occurred before, or occurred after, the member joined the fund); and 

(B) the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;

(iv) the provision of benefits in respect of each member of the fund on or after the member’s death, if: 

(A) the death occurred after the member attained the age prescribed for the purposes of subparagraph (a)(ii); and 

(B) the benefits are provided to the member’s legal personal representative, to any or all of the member’s dependants, or to both;

and the fund is not maintained for core purposes and so the fund does not comply with the sole purpose requirement in sub-section 62(1).

Summary

To reiterate: where the member has both:

  • reached the age of 65; and
  • ceased gainful employment;

or the policy doesn’t fund death benefits before either case then core purposes in sub-paragraph 62(1)(iv) and (iv) don’t apply to life cover taken out by the fund and the sole purpose test in section 62 could be breached for failure to pursue a core purpose in addition to an ancillary purpose or purposes.

Tax residence – is it administrable after Pike?

passportsIn the recent case of Pike v Commissioner of Taxation [2019] FCA 2185 Federal Court judge Logan J. noted:

This is the third in a succession of taxation appeals in the original jurisdiction entailing a taxation residence issue, the others being Stockton v Commissioner of Taxation [2019] FCA 1679 (Stockton) and Addy v Commissioner of Taxation [2019] FCA 1768 (Addy), which have fallen for determination by me since the Full Court’s judgment in Harding v Commissioner of Taxation (2019) 365 ALR 286 (Harding).

The Commissioner’s losses

In each of the cases, the Federal Court overturned decisions of the Commissioner of Taxation that each of the protagonists were residents of Australia for tax purposes, and found that they were non-residents. Addy and Stockton were “working holiday” cases. In Pike too Logan J. overturned an objection decision of the Commissioner that Mr. Pike was a resident for the 2009 to 2014 income years but the Pike case raises wider questions about the income tax residence rules and indeed, Pike differs from the Full Federal Court decision (special leave to appeal to the High Court refused) in Harding too as it concerned a taxpayer whose spouse and children lived in Australia during the income years in dispute and was especially borderline. How that perhaps perplexing outcome could come about is the concern of this post.

Dissatisfaction with the residency rules already

In 2016 the Board of Taxation initiated a review into income tax residence rules which considered:

  • whether the existing Australian individual income tax residency rules that are largely unchanged since enactment in 1930:
    • are sufficiently robust to meet the requirements of the modern workforce;
    • address the policy criteria of simplicity, efficiency, equity (fairness) and integrity;
  • integrity concerns;
  • the increase in litigation relating to the residency rules since 2009; and
  • any changes that could be adopted to improve the residency rules.

The Board reported a core finding that the current individual tax residency rules are no longer appropriate and require modernisation and simplification but the Board also noted that any change has inherent integrity risks such that high net worth individuals in particular could become citizens of nowhere.

Pike – applying the existing tests

The curious and complex aspects of the existing Australian individual income tax residency rules where comprehensively considered and applied by Logan J. in Pike. Mr. Pike, even in the submission of the Commissioner, was a dual resident of Australia and Thailand during the relevant years. This meant that Logan. J needed to look to the “tie-breaker” provisions in the Australia Thailand Double Tax Agreement (the DTA) to determine which of Australia or Thailand could treat Mr. Pike as a tax resident of their jurisdiction during those years.

The domicile test

In the residency tests in the definition of “resident” or “resident of Australia” in sub-section 6(1) of the Income Tax Assessment Act (ITAA) 1936 there is an interplay between ordinary residence with the test in paragraph (a)(i) where the “domicile” of the taxpayer is relevant. Under that definition in the ITAA a “resident” or “resident of Australia”means:

(a)  a person, other than a company, who resides in Australia and includes a person:

(i)  whose domicile is in Australia, unless the Commissioner is satisfied that the person’s permanent place of abode is outside Australia; …

And so Logan J. needed to consider the evidence in Pike to understand whether Mr. Pike had a domicile in Australia during the relevant years.

Principal facts relating to the domicile test in Pike

In the context of Mr. Pike’s domicile the principal facts in Pike were:

  1. Mr. Pike was a native of Zimbabwe.
  2. Mr. Pike and his de facto, Ms. Thornicroft, with whom Mr. Pike had children, left Zimbabwe. Ms. Thornicroft obtained a position with Ernst & Young in Brisbane however Mr. Pike’s skills and career were in the tobacco industry and he had to relocate elsewhere. In the event he relocated alone to Thailand, and after 2014, to Tanzania and to the United Arab Emirates to use his skills and pursue his career in the tobacco industry.
  3. Ms. Thornicroft and their children became Australian citizens in 2010. Mr Pike applied to become an Australian citizen in 2013 and, initially, he was rejected presumably with the Department of Immigration taking into account the paucity of time Mr Pike was physically in Australia and his Thailand connections:
Income year Days spent in Australia Percentage of time spent in Australia
2008 76 20%
2009 155 42%
2010 97 27%
2011 109 30%
2012 102 28%
2013 86 23%
2014 123 33%
(2015) 32 8%
(2016) 44 12%
(2017) 77 21%
  1. Despite those Mr. Pike did eventually become an Australian citizen in 2014.

These principal facts are but a snapshot and simplification of the factual matrix in Pike all of which beared on, in varying degrees, the questions of residence and domicile at issue in the case. Resolution of these questions based on these facts plainly justified the full remittance of penalties by the Commissioner which the Commissioner conceded to Mr. Pike at the objection stage.

Domicile of origin of Mr. Pike

Logan J. observed that Mr. Pike had sought to become and became an Australian citizen though somewhat as a matter of convenience to overcome the complications for an international businessman travelling on a Zimbabwean passport. Logan J. found that Mr. Pike clearly had a domicile of origin in Zimbabwe and applied legal reasoning and learning to understand when Mr. Pike may have acquired Australian domicile as a domicile of choice. Even though the evidence was far from conclusive Logan J. stated that there were sufficient signals from Mr. Pike’s activity to conclude that Mr. Pike did not have a domicile of choice in Australia before 2014.

Thus Logan J. found that Mr. Pike was not a “resident of Australia” due to the operation of the domicile test in paragraph (a)(i) of the definition in sub-section 6(1) even should the Commissioner have reason not be satisfied that Mr. Pike had a permanent place of abode in Thailand.

Dual resident

Logan J. explained with reference to applicable authority including Dixon J. in Gregory v D.F.C.T. (W.A.) [1937] HCA 57; 57 CLR 774 at p.777-778 that an individual can be ordinarily resident in two places. In Pike further principal facts relating to Mr. Pike’s ordinary residence included:

  1. Ms. Thornicroft and their children opted not to move to Thailand so that the children’s schooling could be in Australia and could continue undisrupted.
  2. Despite their living apart the Federal Court was impressed by Mr. Pike’s commitment to his de facto, children and his wider family including his full economic support of Ms. Thornicroft and the children after Ms. Thornicroft ceased earning an income from her employment in 2011 after sustaining an injury.
  3. Although Mr. Pike and Ms. Thornicroft had purchased a vacant block in Brisbane in the hope of building a home, the block was sold undeveloped for a loss in 2014. Ms. Thornicroft, the children, and Mr. Pike when in Australia, thus always occupied rental accommodation in Australia.
  4. Mr. Pike too rented a succession of apartments and cottages in Chaing Mai, Thailand which accommodated the family when Ms. Thornicroft and their children visited Mr. Pike in Thailand; and
  5. Mr. Pike was keen on sports, both as a participant as a spectator and was a member of a number of sports clubs in Thailand. Logan. J. accepted evidence of Mr. Pike and Ms. Thornicroft that Mr. Pike had his own “life abroad” for the long periods he was present in Thailand for his work commitments.

As stated, the Commissioner too had accepted that Mr. Pike was an ordinary resident of both Australia and Thailand. Thus the Federal Court needed to apply the “tie-breaker” tests in the DTA.

The paramount DTA

Logan J. explained how the DTA is paramount over the ITAA  in cases where the DTA applies. Thus an individual who is, or could be a resident of, Australia under the ITAA definition in sub-section 6(1) could nevertheless come to be treated as a resident of Thailand and not a resident of Australia under the DTA. That is the outcome under sections 5 and 4 of the International Tax Agreements Act 1953 if, under the DTA, the “tie-breaker” provisions of the DTA apply to treat a dual resident as a resident of Thailand.

The DTA tie-breakers

However like with the domicile test considered above, the tie breaker tests in the DTA were not so readily capable of application to resolve Mr. Pike’s circumstances.

The first tie-breaker under Article 4.3(a) of the DTA is:

the person shall be deemed to be a resident solely of the Contracting State in which a permanent home is available to the person;

Based on relevant authorities and OECD commentary Logan J. found that a rented home, albeit a family home occupied as such for the foreseeable future, is not a permanent home in this context. Similarly Mr. Pike’s various accommodations in Thailand also did not amount to any permanent home. So this tie-break was of no assistance to the Federal Court to resolve the question of Mr. Pike’s tax residence.

The second tie-breaker is in Article 4.3(b) of the DTA:

if a permanent home is available to the person in both Contracting States, or in neither of them, the person shall be deemed to be a resident solely of the Contracting State in which the person has a habitual abode;

which also turns on the availability of a permanent home to Mr. Pike was similarly to no avail.

The third tie-breaker in Article 4.3(c) of the DTA is:

if the person has a habitual abode in both Contracting States, or in neither of them, the person shall be deemed to be a resident solely of the Contracting State with which the person’s personal and economic relations are closer.

was applied by Logan J. Logan J. analysed Mr. Pike personal relations to Australia which included the presence of his de facto wife and children in Australia and the availability of a not so permanent home which he occupied in Australia when he was living with his family. Those were clearly of greater significance, as personal relations, than his sporting and social activity in Thailand to him in his personal space. Against that Logan J. considered Mr. Pike’s economic relations to Thailand which gave rise to all of his income which, from 2011, was the income which sustained both Mr. Pike and his family in Australia.

Although Mr. Pike spent considerably more days each year between 2009 and 2014 in Thailand due to work than in Australia Logan J. stated:

I do not accept Mr Pike’s submission that habitual abode ought to be determined just by length of residence such that Mr Pike’s greater length of residence in Thailand in each year meant that, between the 2009 and 2014 income years, only in Thailand could be said to have a habitual abode.

Although it was something of an oranges versus apples comparison Logan J. broadly found that Mr. Pike’s relations (in the main, economic) to Thailand were closer than Mr. Pikes relations (in the main, personal) to Australia.

Hence Logan J. found that, under the DTA tie breaker in Article 4.3(c), Mr. Pike was a resident of Thailand and a non-resident of Australia between the 2009 and 2014 income years.

How then to change the residency rules?

At the outset of this post I raised the Board of Taxation’s recommendation that the residency rules should be modernised and simplified. In the context of Pike and how that case ultimately turned it is not so easy to formulate how the residency rules could be changed to avoid the perhaps arbitrary application of overly simple and ineffective DTA tie-breakers based on OECD settled model provisions which change may put Australia out of alignment with international norms.

Or is Pike too unusual to worry about?

That said the facts in Pike seem exceptional to the wisdom that tax residence will generally be at the habitual place of abode a taxpayer has with his or her spouse and children. In Pike the following factors, which were somewhat unusual, appear to have given rise to a different outcome:

  • Mr. Pike had a foreign history and never seemed to really settle with his family in Australia before 2014;
  • Mr. Pike and Ms. Thornicroft never purchased a home in Australia and the family lived in a succession of rented homes; and
  • Mr. Pike and Ms. Thornicroft were unusually credible and convincing witnesses who were able to establish to the Federal Court that they really had reasons for and had a believable distance though stable family relationship.

Commissioner hamstrung by equivocal residency rules

Still unusual residential arrangements abound and, for many taxpayers, this means wide surveys of their facts and background of their residency will need to be undertaken and presented to the Commissioner. The Commissioner does not have the benefit of laws fit for purpose to assist the Commissioner to administer the law and clearly resolve the question of tax residence even when fully appraised of assiduously supplied facts. This ultimately can lead to administration challenges for the Commissioner and to expensive disputes with taxpayers over tax residency which will be as impenetrable as Pike was to resolve.

Closely held trusts, “family trusts” and circular trust distributions – a tax net nuanced again for the compliance burden

trusts guardrail

In Australia the income taxation of trusts is based on the trust being a conduit with look-through to beneficiaries of the trust who are presently entitled to the income of the trust. In the standard case of an adult resident beneficiary of a trust, the beneficiary is taxed on trust income and the trust is broadly treated as a transparent entity and isn’t taxed.

Even where a beneficiary is:

  • not an adult; or
  • not a tax resident;

the trustee of the trust pays tax though ostensibly on behalf of the beneficiary entitled to trust income at the rate applicable to the beneficiary and the beneficiary is entitled to a credit for tax paid on that income should the beneficiary file his, her or its own tax return.

Tax capture when no beneficiary entitled to the income

Look-through taxation of income doesn’t work when there is no beneficiary presently entitled to income of the trust to look through to. Under the Australian system, in these cases, the trustee of a trust pays tax at the highest marginal rate on income plus applicable levies including medicare levy. That is where no beneficiary is presently entitled to the income of a trust under section 99A of the Income Tax Assessment Act 1936.

The trustee beneficiary complication

Trusts can be beneficiaries of other trusts. These beneficiaries are “trustee beneficiaries” of a trust.

Example

  • The trustee of trust B is a beneficiary and so is a trustee beneficiary of trust A.
  • C, a beneficiary of trust B, takes (is presently entitled to) a share of the income of trust A.
  • C may be an individual or a company, viz. an ultimate beneficiary, or may be a further trust – a further trustee beneficiary.

It is then necessary to trace trust income of trust A through trustee beneficiaries to find if there is an ultimate individual or company beneficiary entitled to that income. There may be no ultimate beneficiary entitled to income and the case of a “circular” trust distribution is a case in point.

The circular trust distribution by trusts

A definitive example of a circular trust distribution of income is where:

  • trust X distributes income of trust X to trust Y; and
  • trust Y distributes its income (back) to trust X.

There is thus no ultimate individual or company beneficiary. The income is in a state of flux.  Nonetheless it is clear no beneficiary is presently entitled to the income and the highest marginal rate and applicable levies imposed under section 99A should be applicable to a circular trust distribution of income under the regime so far described.

That is a fair point in principle but a circular trust distribution, or any distribution to a trustee beneficiary that isn’t on-distributed to an ultimate beneficiary, is not necessarily readily traceable and identifiable as income to which no beneficiary is entitled. That is especially so where a labyrinthine structure of numerous trusts is used to conceal who is entitled to trust income and that there is no ultimate beneficiary who is not a trustee beneficiary entitled to trust income.

The legislative countermeasures

Countermeasures in the below legislation apply to support the integrity of flow through taxation of trusts. These countermeasures were introduced in Division 6D of Part III of the Income Tax Assessment Act 1936 which has lead to these new taxes:

  • firstly, the ultimate beneficiary non-disclosure tax when introduced with the A New Tax System (Closely Held Trusts) Act 1999 (see below); and
  • currently the trustee beneficiary non-disclosure tax as introduced to reform the ultimate beneficiary non-disclosure tax under the Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No. 1) 2007 and the Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No. 2) 2007.

These taxes were or are in substance proxies for tax on the trustee under section 99A for presumed lack of present entitlement of an ultimate beneficiary to ensure that income of a trust does not escape income tax either:

  • for want of an ultimate beneficiary entitled to the income; or
  • because of the opaque lack of an ultimate beneficiary where a trustee beneficiary may seem to be an ultimate beneficiary in the tax return of the trust.

Like the rate that applies under section 99A the rate of trustee beneficiary non-disclosure tax is the highest marginal rate plus applicable levies including the medicare levy.

The countermeasures also include a concept of “trustee” group which expands liability for trustee beneficiary non-disclosure tax to corporate directors of trustees of closely held trusts personally: an impost beyond the section 99A impost for falling under the purview of these anti-avoidance provisions.

A New Tax System (Closely Held Trusts) Act 1999

The first legislation to grapple with the tracing problem was in the A New Tax System (Closely Held Trusts) Act 1999 which introduced a wide and indiscriminate ultimate beneficiary statement reporting obligation on all closely held trusts.

Closely held trusts

A trust is a closely held trust if it:

  • is a discretionary trust, or
  • has up to 20 individuals who, between them, directly or indirectly, and for their own benefit, have fixed entitlements to a 75% or more share of the income or a 75% or more share of the capital of the trust;

where the trust is not an excluded trust. Examples of excluded trusts are complying superannuation funds and, for their first five years, deceased estates.

Reset of the closely held trust compliance burden

In response to sustained complaints from many trustees of trusts which did not distribute to trustee beneficiaries and their advisers, the federal government came to amend the regime in 2007 so that only trustees of closely held trusts which distribute income to:

  • trustee beneficiaries;
  • where the distribution includes an “untaxed part”;

have reporting obligations to file a trustee beneficiary (TB) statement. TB statements need to be filed with a tax return and, in the case of resident trustee beneficiaries, need to disclose the following about the trustee beneficiary:

  • name,
  • tax file number,
  • the untaxed part of their share of trust income; and
  • their share of tax preferred amounts;

and to withhold trustee beneficiary non-disclosure tax and to pay it to the Commissioner of Taxation where the relevant trustee beneficiary fails to provide the information for the TB statement when it is sought by the (distributor) closely held trust.

This more nuanced or targeted solution imposes a less onerous compliance burden on closely held trusts than the 1999 measures did.

Further, in accord with policy to treat “family trusts” viz. trusts that have

  • a valid family trust election; or
  • a valid interposed entity election;

in force or that otherwise forms part of a “family group” less onerously, family trusts were excluded trusts to which the closely held trusts regime did not apply following the 2007 reform.

2018-19 Budget changes to closely held trusts

Following an announcement in the 2018-19 Federal Budget, the closely held trust arrangements have been further tweaked by the Treasury Laws Amendment (2019 Tax Integrity and Other Measures No. 1) Act 2019. Under these changes it is still the case that family trusts still do not have to comply with the TB statement reporting requirements however family trusts are no longer excluded trusts.

That means that a family trust that is a closely held trust (which will often be the case) must now comply with the closely held trust obligations but a family trust remains relieved from the obligation to file TB statements and pay trustee beneficiary non-disclosure tax on omission to file a TB statement. Despite that a family trust is now liable for trustee beneficiary non-disclosure tax on circular trust distributions under section 102UM of the Income Tax Assessment Act 1936 but not on distributions received from other trusts (which are not circular and to which section 102UM does not apply).

How will compliance with the changes work?

It is perhaps unusual that the changed closely held trusts regime relieves a family trust, no longer an excluded trust and that distributes income to a trustee beneficiary, from filing a TB statement. The Commissioner of Taxation will have no TB statement to aid detection of a taxable circular distribution back to the family trust. Further, in the case of family trusts, the Commissioner won’t obtain TB statement level information about distributions by family trusts to trustee beneficiaries that are not circular or the opportunity to impose the trustee beneficiary non-disclosure tax on those distributions as a matter of course on the omission to file a TB statement.

Nevertheless the Commissioner of Taxation will have trustee beneficiary contact details and perhaps a tax file number, or will be alerted by the absence of a tax file number; from the tax return of a closely held trust family trust. The Commissioner can trace a distribution and ascertain when a circular trust distribution by a family trust occurs by investigative activity. Further, risk of family trust distributions tax liability under Schedule 2F of the Income Tax Assessment Act 1936 makes it less likely that a family trust will make a distribution liable to that tax, particularly a distribution of a tax preferred amount, to a trustee beneficiary that is:

  • outside of the family group; and
  • where that trustee beneficiary’s tax file number is not known by the trustee of the trust and reported in the trust tax return.

Income from private company investments – the tax scourge of SMSFs

increase

A self managed superannuation fund (SMSF) is generally a low tax entity, particularly when in pension phase where a nil rate can apply and a low 15% rate can apply when not. Still the taxable income of a complying superannuation fund (SF) can be split into a non-arm’s length component and a low tax component under section 295-545 of the Income Tax Assessment Act (ITAA) 1997. The non-arm’s length component is taxed at the highest individual marginal rate which is 45% in the 2019-20 income year.

Non-arm’s length income

The non-arm’s length component for an income year is the complying SF’s “non-arm’s length income” (NALI) for that year less any deductions to the extent that they are attributable to that income.

NALI picked up on audit – even higher tax

The recent case in GYBW v. Commissioner of Taxation [2019] AATA 4262 (GYBW) is a cogent reminder of how NALI taxed at the highest marginal rate can arise in a SMSF. In GYBW a tax shortfall arose as the NALI not returned by the SMSF was detected in an audit by the Commissioner of Taxation. Hence even higher taxes applied including shortfall interest and penalties. There was a reduction in penalties on appeal to the AAT from “reckless” to “failure to take reasonable care” level.

NALI

Section 295-550 is one of a number of superannuation rules designed to protect the integrity of the low tax complying SF regime by combatting income shifting arrangements where income, that might be taxed elsewhere to another type of taxpayer at higher rates, is non-commercially shifted to a complying SF that attracts a low rate of tax.

Section 295-550 is directed at non-arm’s length dealings where complying SFs (and other superannuation entities) earn income from an arrangement which exceeds the income that the complying SF might have been expected to derive from the arrangement if the parties to the arrangement had been dealing with each other at arm’s length.

Where section 295-550 is enlivened all of the income from the arrangement is NALI taxed at the highest rate.

Private companies dividends prone to be NALI

At the forefront of NALI is dividend income from investment by complying SFs in private companies.

In GYBW Senior Member McCabe identified an objective test in sub-section 295-550(2) which looks at a question of fact: is a dividend paid by a private company to a complying SF consistent with an arm’s length dealing? A private company dividend paid to a SMSF is NALI to the SMSF if it is not. This objective test replaced the former provisions in Part IX of the ITAA 1936 under which private company dividends were treated as special income (the forerunner to NALI) as a matter of course. That is, unless the Commissioner exercised a discretion that it was unreasonable to treat the private company dividend as special income where the Commissioner became satisfied that the income was earned at arm’s length.

Sub-section 295-550(3) sets out factors to be considered in applying the objective test.

The facts and findings in GYBW

In GYBW, the SMSF was the SMSF of a partner in an accounting practice with the pseudonym D. His client and connection pseudonym K had volatile and valuable business interests which could earn significant income from Department of Defence contracts.

D retired from his accounting practice to become the chief financial officer of the B Group.

The various partnership and corporate dealings of K are complex and supporting evidence of them before the AAT was “difficult” and incomplete. The AAT did not accept:

  • that the evidence, though involving non-related parties D, K, K’s trust and the other partners and former partners of K; and
  • that legal advice received before the SMSF invested in B Holdings;

supported a finding that the shares in pseudonym B Holdings acquired by D’s SMSF were acquired on terms where dividends would be earned from the shares consistently with an arm’s length dealing.

Senior Member McCabe observed how parties at arm’s length from each other can engage in an non-arm’s length dealing just as non-arm’s length parties can engage in an arm’s length dealing. For instance, in the latter case, a family member of the seller acquiring stock exchange listed shares of the seller on a stock exchange. Section 295-550 is directed to the dealing viz. how the SMSF came to earn the private company dividends it earned, not to the relationship of the parties to the arrangement. The AAT was therefore sceptical about the acquisition by D’s SMSF of ordinary shares in B Holdings on its formation for a nominal sum where B Holdings was also able to obtain and exploit K’s business interests a day later which D contended had negligible value then.

That AAT observed that “Fortune shined on the business” of B Holdings and B Holdings earned more than $10 million over four years which likely explains why it was picked up for an audit by the Commissioner.

Darrelen applicable

After looking at the Explanatory Memorandum with which section 295-550 was introduced Senior Member McCabe concluded that the purpose of the section did not change nor was there any change to the factors to which regard was to be had. Therefore the Full Federal Court decision in Darrelen Pty Ltd v Federal Commissioner of Taxation (2010) 183 FCR 237, which concerned the former provisions in Part IX of the ITAA 1936, remained authoritative in Senior Member McCabe’s view. In Darrelen the court had held that dividends paid by a private company were special income. In the case the SMSF had acquired its four shares in that company for a cost far less than their market value in an earlier year of income notwithstanding that the same dividend amount was paid on all 100 shares in the income year it was paid.

The cost to the SMSF of the shares on which the dividend was paid

The cost to the SMSF of the shares on which dividends were paid is a specific factor that can be taken into account under paragraph 295-550(3)(b) in determining whether their payment is consistent with an arm’s length dealing. In applying the objective test Senior Member McCabe referred to Commissioner of Succession Duties (SA) v Executor Trustee and Agency Co of South Australia Ltd (Clifford’s Case) where the High Court set out its views on how to value shares in a company:

The main items to be taken into account in estimating the value of shares are the earning power of the company and the value of the capital assets in which the shareholder’s money is invested. But a prudent purchaser does not buy shares in a company which is a going concern with a view to winding it up, so that the more important item is the determination of the probable profit which the company may be reasonably expected to make in the future, because dividends can only be paid out of profits and a prudent purchaser would be interested mainly in the future dividends which he could reasonably expect to receive on his investment. Further, a prudent purchaser would reasonably expect to receive dividends which would be commensurate with the risk, so that the more speculative the class of business in which the company is engaged the greater the rate of dividend he would reasonably require. In order to estimate the probable future profits of a company it is necessary to examine its past history, particularly the accounts of those years which are most likely to afford a guide for this purpose. In order to estimate the rate of dividend that a prudent purchaser could reasonably require on his investment it is necessary to examine the nature of the business and the risks involved and to seek the evidence of business men, particularly members of the stock exchange and experienced accountants, who can testify to the appropriate rate from the prices paid for shares in companies carrying on a similar business listed on the stock exchange or from private sales of shares in such companies or from their general business experience.

[1947] HCA 10; (1947) 74 CLR 358 at p.362

and with the benefit of hindsight, and omissions in the evidence supporting D’s SMSF’s case about how the SMSF and B Holdings came to benefit in K’s business interests, the AAT found that dividends were not consistent with arm’s length dealing as they arose from shares acquired for less than their value so evaluated. The AAT found that the dividends received by D’s SMSF from B Holdings were NALI.

NALI rules extended to expenses

The NALI rules have extended to losses, outgoing or expenditures that are less than expected to the complying SF by the Treasury Laws Amendment (2018 Superannuation Measures No. 1) Act 2019 in Schedule 2.

Conclusion

Unless GYBW is overturned on appeal SMSF investment in a private company of a related party or in a private company of the connections of the SMSF seem destined for NALI high tax treatment. So SMSFs should be wary of investment in private companies generally: SMSF investment in a private company carries the suspicion that the investment is an opportunity to shift income from a higher taxed entity to a concessionally taxed SMSF.

It follows that the trustee of a SMSF looking to sustain concessional tax treatment needs to adequately document its dealings with and investment in private companies so the arm’s length character of the investment can be verified and, where need be, independent valuation supporting consistency with arm’s length dealing should be sought.