Can a family discretionary trust distribute income to its corporate trustee?

Businesswoman piggybank desk

A family discretionary trust (FDT) often has a corporate trustee (TCo) for limited liability and other reasons. With a private company able to access a 30% or lower tax rate on an income distribution received from a FDT, distribution to a private company such as TCo can be a way to access a lower company income rate for a family that does not own or control a private company aside from TCo out of thrift.

But is it a good idea?

Distribution by a FDT to its corporate trustee, TCo, as a “bucket company”, is not necessarily allowable or advisable.

It needs to be understood that FDT deed terms, quality of the FDT deed and FDT set up, including attention to who is a beneficiary of the FDT, vary widely across Australia.

TCo needs to be a beneficiary of the FDT

FDT distributions can only be made to beneficiaries of the FDT. It follows that TCo would need to be entitled in its own right as a beneficiary to a distribution under the terms of the FDT deed. TCo may or may not be a named discretionary beneficiary under the FDT deed.

Many FDT deeds provide for a class of discretionary beneficiary which includes companies owned or controlled by a (some other) beneficiary of the FDT. Sometimes this class is referred to as “eligible corporations” which the FDT deed terms state become beneficiaries of the FDT. These provisions in FDT deeds, if they exist, vary too. Sometimes qualification within a corporate class of discretionary beneficiary turns on someone who qualifies as a beneficiary in the deed:

  • owning shares in the company; or
  • being a director of the company;

and it can be just one or the other and not necessarily both.

It can’t be assumed that:

  • beneficiary qualification in these ways is possible; or
  • that TCo meets these beneficiary qualifications;

without checking the FDT deed.

Consequences of distributing income to a non-beneficiary

Consequences of a FDT distributing trust income to a person or company who is not a beneficiary under the deed of a FDT can be:

  • failure of the distribution for legal and tax purposes so that the trustee of the FDT is assessed under section 99A of the Income Tax Assessment Act (ITAA) 1936 with income tax at the highest marginal rate; and/or
  • treatment of the FDT and distributions from the FDT as a sham by the Australian Taxation Office, other government departments, creditors or others.

Even where TCo may appear to qualify as a beneficiary due to the above, many FDT deeds have overriding exclusionary provisions which exclude persons and companies otherwise specified as beneficiaries from being beneficiaries for various reasons:

Excluded beneficiaries – conflict of interest

Frequently a trustee of a FDT is excluded from being a beneficiary because the trustee, which can exercise the discretion to select discretionary beneficiaries, is in a position of conflict of interest and so TCo, despite qualification as a beneficiary otherwise, is ultimately excluded from being a beneficiary of the FDT. More commonly FDT deeds contain other means which allow a family to control who becomes and acts as a trustee which displaces or should displace inapt conflict of interest considerations as a control redundancy within the deed.

Excluded beneficiaries – stamp duty

But even then a trustee, such as TCo, that may otherwise have qualified as a beneficiary, may still be excluded as a beneficiary by the FDT deed for stamp duty reasons. In New South Wales, in particular, an entitlement to concessional duty under sub-section 54(3) of the Duties Act (NSW) 1997 on a change of trustee of a trust that owns dutiable property can be lost where the a trustee can participate as a beneficiary of the trust.

The consequence of that is a change of trustee of a FDT, say by deed, is treated as a fully ad valorem dutiable transfer of all of the NSW dutiable property of the FDT to the new trustee/s.

Although this limitation of a duty concession varies from other exemptions and concessions applicable to changes of trustee of trusts in states and territories other than NSW, FDT deeds frequently exclude trustees from being beneficiaries out of an abundance of caution that this or a similar stamp duty concession may be lost where the trustee of the FDT is not excluded.

TCo can qualify as a beneficiary  – but what then?

If it can be confirmed that TCo does qualify as a beneficiary and is not ultimately excluded as a beneficiary under the trust deed of a FDT, distribution to TCo, rather than another discrete company is still not necessarily a good idea.

Managing TCo’s asset mix

Should TCo receive income from a FDT, and so come to have assets in its own right, TCo will need to manage its assets to ensure that property it holds in its own right and property TCo holds for the FDT are not mixed. A trustee of a trust has a fiduciary duty not to mix trust property with property held not on that trust. This trustee duty is often explicitly set out in FDT deeds.

In terms of title, property distributed to TCo in its own right will be indistinguishable so, without careful accounting and administration of TCo’s activities to ensure trust property isn’t mixed with non-trust property, there is the prospect that a family in control of a FDT may lose track of in which capacity the TCo is owning property and doing things. It will often fall to the accountant of the FDT to sort this out unless the FDT has a very capable and aware functionary administering the FDT for the trustee.

Serious tax risk of losing track of how TCo owns what

Tax risks of unpaid present entitlements (UPE) of TCo in its own right are also high following the recent Draft Taxation Determination TD 2022/D1 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of ‘financial accommodation’? – see our blog post – Draft ATO reimbursement agreement suite out in the wake of Guardian AIT https://wp.me/p6T4vg-q6. Under that draft determination a UPE of a FDT to a private company not detected and promptly repaid (has TCo repaid TCo?) or dealt with under a section 109N of the ITAA 1936 loan agreement, by the time the tax return of the company beneficiary for the income year in which the UPE arises is due, will likely precipitate a deemed and unfrankable dividend to the FDT.

Understanding a company can’t enter into a legally enforceable agreement with itself how could TCo even comply with section 109N as a way to avoid a deemed dividend?

Is distributing to TCo worth it?

Despite the above distribution by FDTs to their corporate trustee as a bucket company is commonplace but done without a keen appreciation of the risks of doing so. I don’t encourage FDTs to distribute to their own trustee even when I am familiar with the trust deed of the FDT. I appreciate there is a cost saving but the costs of running a separate “bucket company”, including the setup and annual ASIC fees and accounting costs, are or should be relatively low so be wary that multi-purposing of TCo can be a false economy for many families with FDTs when the above is taken into account.

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Statutory exemptions for a trust and containment

ContainedCube

Duty on transfer to a discretionary testamentary trust beneficiary

According to Revenue NSW section 63 of the Duties Act (NSW) 1997 does not extend concessional relief to the transfer of dutiable property by a testamentary trust (TT) trustee to a beneficiary.

Concessional duty of $50 applies to:

(a) a transfer of dutiable property by the legal personal representative of a deceased person to a beneficiary, being–

    (i) a transfer made under and in conformity with the trusts contained in the will of the deceased person or arising on an intestacy, or …

under sub-paragraph 63(1)(a)(i) of the Duties Act (NSW) 1007

Accepting that a TT trustee is a LPR of a deceased person, or at least disregarding cases where it is not the case, a transfer of NSW real estate by a TT trustee to a TT beneficiary named in the will of the deceased person (Will) in conformity with a TT in the Will appears to make out the requirement of the concession. But Revenue NSW differs.

In Revenue Ruling DUT 46 – Deceased Estates, Revenue NSW states at paragraph 30:

Testamentary trusts

30. Often a will may establish a trust with a named trustee and beneficiaries, with a gift to the trustee of that trust. A transfer from the legal personal representative to a beneficiary of the testamentary trust will not obtain the benefit of the section 63 concession, however, a transfer to the trustee of the testamentary trust will be liable to duty of $50 under sub-paragraph 63(1)(a)(i).

Revenue Ruling DUT 46 – Deceased Estates, Revenue NSW states at paragraph 30

Denial of concession explained?

There is no explanation in DUT 46 as to:

  • why a transfer to a beneficiary seemingly in conformity with the section 63 concession doesn’t attract the concession; or
  • how sub-paragraph 63(1)(a)(i) may apply where a beneficiary of a TT has an absolute or indefeasible interest in dutiable property under the TT in the Will.

Scope of statutory exemptions (concessions)

An adage and exhortation about stamp duty, statutory exemptions to duty and those who seek to rely on an exemption is:

find an exemption and get within it

could be trite.

A corollary of no lesser importance is that where a situation doesn’t meet all requirements of an exemption there will be no exemption.

Figuring out what Revenue NSW mean

I understand Revenue NSW to be saying that not all requirements of the formulation:

in conformity with the trusts contained in the will of the deceased person

are met in the case of transfer of dutiable property by a LPR to a TT beneficiary.

Some indication of what Revenue NSW means is at paragraph 7 of DUT 046 which states:

7. The transfer must be made both under and in conformity with the trusts of the will or arising on intestacy. It is not sufficient that the transfer not be inconsistent with those trusts.

with Sanders v Chief Commissioner of State Revenue [2003] NSWADTAP 22 cited in support.

Paragraph 7 hints at the problem an LPR or a TT trustee of a discretionary TT in a Will may have with the section 63 concession. A transfer to a specific discretionary beneficiary in a class of beneficiaries under a discretionary TT is not a stipulation of the testator contained in the Will. The transfer occurs instead because someone other than the testator has been given a power beyond the Will to decide who among the class of TT beneficiaries is to receive the dutiable property.

That exercise of discretion by a living person is extraneous to the Will but is authorised by the Will. Yet, because a discretionary TT beneficiary doesn’t take the dutiable property by direction of the testator and the Will, Revenue NSW seem to say that the transfer is not in conformity with the trusts contained in the Will. That is an undeniably strict interpretation of section 63 bearing in mind that a transfer to an identifiable discretionary beneficiary of a TT to give effect to a valid gift to the beneficiary in the Will is entirely within, anticipated by and “in conformity with” the wishes of a testator expressed in his or her Will.

To describe a transfer made in pursuance of a Will-reposed discretion to gift property among a class of named discretionary beneficiaries as a mere consistency with the Will is somehow inadequate.

Testamentary trust planning

An ongoing discretionary TT included in a Will by a testator may not necessarily be of use to or in the interests of TT beneficiaries who are to take the testator’s property. So a collapsible TT can be desirable and useful to a testator’s survivors instead. Broadly a collapsible TT is where a LPR, TT trustee or appointor is given ability under a Will to collapse a discretionary TT and take the TT property as if the Will had made a gift of the property bypassing holding the property on the TT.

Based on the above such a gift on collapse of a discretionary TT to a named beneficiary is or should be wholly in conformity with a stated gift in the Will and so should attract concessional duty under sub-paragraph 63(1)(a)(i). It follows that a collapsible TT can lead to a duty saving where:

  • the TT is over property including dutiable property;
  • the TT is collapsed, bypassed and doesn’t take effect as a TT; and
  • the dutiable property that was to be held on the TT is instead transferred to the named beneficiary expressly under the terms of the Will and the sub-paragraph 63(1)(a)(i) exemption can thus be made out.

Containment

So to achieve a stamp duty exemption in conformity with the trusts contained in the Will under the Revenue NSW regime no actions extraneous to the Will, such as the exercise of a Will-based discretion to distribute dutiable property to a TT beneficiary, are “within” the concession. That is: the gift pathway of the dutiable property from testator to beneficiary needs to be wholly contained in the Will.

Perpetuities

There is a curious comparison between the approach of Revenue NSW to duty on transfer by a LPR to a discretionary TT beneficiary and the approach of the Federal Court to the rule against perpetuities.

In an earlier blog How perpetuities law limits can impact trust distributions to other trusts I considered the “wait and see” rule as it applies to the perpetuities following the Federal Court decision in Federal Court in Nemesis Australia Pty Ltd v Commissioner of Taxation [2005] FCA 1273. What would the outcome in that case have been if such a narrow or strict approach to the “wait and see” rule, which is effectively an exemption from the common law rule against perpetuities now codified by statute in most states (the Perpetuities Rule), been taken?

All jurisdictions except South Australia have retained the Perpetuities Rule.

Uneasiness

I am uneasy about the Nemesis Australia decision as the last words in my blog suggest. If Nemesis Australia is later found by a court to be incorrectly decided then the consequences will be severe for trusts impacted: where the Perpetuities Rule applies to a trust, the trust is void and treated as if it was never valid. This harshness was the reason for the introduction of “wait and see” rule, under which dispositions of property under a trust, that would otherwise be void under the Perpetuities Rule, are not void from the outset and the parties can “wait and see” whether the disposition of property under the trust will vest within the applicable perpetuity period. Only where the property does not so vest is the trust then invalidated by the Perpetuities Rule.

Policy to prevent remoteness of vesting

The policy of the Perpetuities Rule (the Policy) is:

  • to prohibit lengthy remoteness of vesting of property interests in private hands and indestructible private trusts;
  • to limit property owners’ capacity to restrict free alienation of property ; and
  • to limit the control of property by trust founders or testators to a reasonable period.

The Perpetuities Rule applies to private trusts aside from charitable trusts and superannuation funds to achieve this Policy.

Significance of a trust discretion

The Nemesis Australia decision turned on the significance of an exercise of a discretion: it was found that the “wait and see” rule could be applied because the trustee of Trust B had a discretion to bring forward the vesting day and the parties could then “wait and see” whether the vesting day of Trust B will be brought forward by exercise of discretion to the earlier vesting date of Trust A. Should that happen property from Trust A, received into Trust B as a distribution from Trust A, would not vest outside of the Perpetuities Rule perpetuity period for property vested in Trust A. (See my blog  How perpetuities law limits can impact trust distributions to other trusts )

Disparity of approach to statutory exemptions

There is a disparity between how the “wait and see” rule was interpreted in Nemesis Australia where a discretion, whose exercise is not dictated by the terms of a trust, was acceptable to invoke the “wait and see” rule and Revenue NSW’s rejection of exercise of a Will-based discretion not dictated by a Will as not being in conformity with the trusts in a Will for section 63 of the Duties Act 1997 purposes.

There are a number of principles of statutory interpretation that can be applied to exemptions which were not considered in Nemesis Australia. These principles do not support a construction of the “wait and see” rule that saves a trust from being void under the Perpetuities Rule where the parties wait to see if a trust terms-based discretion will be exercised to bring forward the vesting date of the trust:

  • an interpretation of a statute which will permit a person to take advantage of his or her own wrong is to be resisted (Resistance); and
  • an interpretation of a statute that promotes the purpose of a statute is to be preferred to a literal construction (Preference).

Resistance

An instance of a Resistance given in Pearce & Geddes “Statutory Interpretation” 7th ed. is in Holden v. Nuttall (1945) VLR 171 where, on an application for possession of leased premises, a court was required by statute to take into account whether an order for possession would cause the lessee “hardship”. Evidence showed that the lessee had acted in a manner contrived by the lessee to enable him to take the benefit of the hardship exception. Herring CJ found that the meaning of “hardship” should be limited so that no injustice would be brought about by allowing a person to benefit from his or her own wrong.

This is comparable to where a trust is established with say a last vesting date of 160 years which is well beyond perpetuity periods allowed under Perpetuity Rules. (See also the similar hypothetical raised by the Respondent referred to in paragraph 43 in the judgement in Nemesis Australia.) This differs much from a case of say, a trust where when property may vest turns on a genuine and unplanned contingency or contingencies that may or may not occur within the perpetuity period, such as how long a beneficiary of a trust may live for, which is the type of contingency the “wait and see” rule ordinarily contemplates.

Still trust terms may allow a trustee, or some other person; a discretion to bring forward the vesting day as in Nemesis Australia, or even in the absence of a term allowing the bring forward of the vesting date of the trust, state law may allow a trustee to apply to a state court for a vesting order prior to expiry of the applicable perpetuity period. If Nemesis Australia is correctly decided the parties to the trust may then “wait and see” whether a vesting order is applied for and vesting happens within the perpetuity period of a trust flagrantly in breach of the Perpetuity Rule and the Purpose and, in the meantime, the trust would be valid.

But a 160 year last vesting date for a trust may be a wrong, such as considered in Holden v. Nuttall, by the founder of a trust. That is a wrong that is contrary to the Policy when considered in the context of the Policy. Shouldn’t a trust established on the premise of that wrong, if it is a wrong, be considered:

  • contrived to take advantage of the “wait and see” rule?; and
  • beyond what is meant as a “wait and see” under the “wait and see” rule?;

and denied “wait and see” exemption from the Perpetuities Rule?

Preference

The construction of the “wait and see” rule in Nemesis Australia is literal. The Preference, as Pearce & Geddes explain, is that an interpretation of a statutory provision under section 15AA of the Acts Interpretation Act (C’th) 1901 and comparable state and territory legislation should promote a construction of a statute based on the purpose of a statute as preferable to a literal construction.

Pearce & Geddes also refer to the explanation of Dawson J. in Mills v. Meeking (1990) HCA 6 at para. 19 as follows:

19. However, the literal rule of construction, whatever the qualifications with which it is expressed, must give way to a statutory injunction to prefer a construction which would promote the purpose of an Act to one which would not, especially where that purpose is set out in the Act. Section 35 of the Interpretation of Legislation Act must, I think, mean that the purposes stated in Pt 5 of the Road Safety Act are to be taken into account in construing the provisions of that Part, not only where those provisions on their face offer more than one construction, but also in determining whether more than one construction is open. The requirement that a court look to the purpose or object of the Act is thus more than an instruction to adopt the traditional mischief or purpose rule in preference to the literal rule of construction. The mischief or purpose rule required an ambiguity or inconsistency before a court could have regard to purpose: Miller v. The Commonwealth (1904) 1 CLR 668 at p 674; Wacal Developments Pty. Ltd. v. Realty Developments Pty. Ltd. (1978) 140 CLR 503 at p 513. The approach required by s.35 needs no ambiguity or inconsistency; it allows a court to consider the purposes of an Act in determining whether there is more than one possible construction. Reference to the purposes may reveal that the draftsman has inadvertently overlooked something which he would have dealt with had his attention been drawn to it and if it is possible as a matter of construction to repair the defect, then this must be done. However, if the literal meaning of a provision is to be modified by reference to the purposes of the Act, the modification must be precisely identifiable as that which is necessary to effectuate those purposes and it must be consistent with the wording otherwise adopted by the draftsman. Section 35 requires a court to construe an Act, not to rewrite it, in the light of its purposes.

Dawson J. in Mills v. Meeking (1990) HCA 6 at para. 19

The purpose of the Perpetuities Rule is the Policy. The Policy is defeated where a contingency that a trustee could apply for a vesting order prior to the expiry of the perpetuity period applicable to the trust prevents the Perpetuities Rule from taking effect in an abundance of cases. The Respondent’s submission referred to in paragraph 43 in the Nemesis Australia judgement cogently establishes why the Policy fails where the “wait and see” rule is applied literally but the Federal Court in the Nemesis Australia seemed to gives minimal credence or importance to the Policy as the legislative intent of the Perpetuities Rule.

Conclusion

All requirements to make use of a statutory exemption from a law need to be met. Occasionally exemptions, including exemptions which are not clearly expressed, will be construed strictly perhaps to unanticipated standards. Equivocally drafted statutory exemptions can lead to unexpected outcomes so, where much turns on whether or not an exemption is available, caution should be exercised and a conservative approach taken.

Hopefully Revenue NSW’s view in paragraph 30 of Revenue Ruling DUT 46 on duty on transfers of dutiable property to a beneficiary of a testamentary trust will eventually be tested and explained in a reported court decision.

With regard to perpetuities, the Perpetuities Rule and the “wait and see” rule I suggest that appropriate fail safes should be included in discretionary trust deeds so that the Perpetuities Rule can be complied with and the trust will remain valid, just in case Nemesis Australia doesn’t persist as the accepted Australian understanding of how the “wait and see” rule applies on some basis I have or haven’t anticipated.

The capital gains tax main residence exemption, affordable housing and caps

CGT beginnings

With wage and salary earners taxable on virtually every dollar they earn from their work, sources from the Asprey Report (1975) through to the tax summit of 1985 identified the lack of a capital gains tax as a tax regressive unfairness in the Australian income tax system which then relied on a narrower tax base. Before the CGT, gains on investments made by their owners escaped income tax and allowed already wealthier people to step up their wealth untaxed where less wealthy typically working people who paid their taxes could not.

Still it would have been near unthinkable for the Hawke Keating government of 1985 to have introduced the capital gains tax, which then was a partisan political and controversial proposal, into the Australian income tax system without CGT relief on the family home following the tax summit.

In those days a greater proportion of working people and middle Australia owned their own homes. So the exemption now legislated as the CGT main residence (MR) exemption in Division 118 of the Income Tax Assessment Act (ITAA) 1997, then not thought especially regressive, was a political price the government then had to pay to have a constituency-supported capital gains tax in the Australian income tax mix at all.

The uncontained housing tax exemption

But the breadth of the CGT MR exemption has made the CGT MR exemption itself regressive.

The CGT MR exemption is unlimited and especially generous when compared to CGT relief given in other countries.

The CGT MR exemption has these characteristics:

  • generally, where there is no income-earning use of a home and a taxpayer is or is taken to have occupied the home as their main residence while he or she has owned it, any capital gain on the home is fully exempted from the Australian CGT;
  • there is no qualifying length of ownership period to wait before the CGT MR exemption can be applied to exempt CGT on sale of an Australian home – the owner can live there for a month, rent the property out for five years, go overseas, come back and sell the (former) home and claim the full exemption – see section 118-145 of the ITAA 1997; and
  • a taxpayer can turnover any number of homes and keep claiming the exemption from CGT on every successive capital gain. In other words there are no limits on the amount of, or numbers of tax free step ups in, wealth a taxpayer can achieve with no taxation by selling each of their successive and possibly more expensive homes.

This has made Australian home ownership an incomparably attractive investment for tax reasons. This frustrates wider social housing objectives such as opportunity and ability for the populace to securely house themselves when they cannot afford to compete in the housing market especially as long term renting in Australia is not so secure either.

Sources of unaffordable housing

The CGT MR exemption has indisputably contributed to unaffordible housing both as a tax shelter, as a driver of demand for real estate and as an improver of the financial case to own an expensive home. To what extent is not for a tax lawyer, who is no econometrician, to judge. The CGT MR exemption may not even be the greatest contributor to unaffordable housing in Australia. Housing markets around the world are elevated due to the abundance of money injected into major economies by quantitative easing. But in Australia add:

  • dark money laundered through Australian real estate attributable to persisting slack regulation of money flows into Australia, including continuing failure by government to commence the 2007 AML/CTF measures to expand the range of oversight of AUSTRAC to non-financial businesses and professions including the legal, accounting and real estate professions: see my 2017 blog – Sluggish anti-money laundering reform in Australia https://wp.me/p6T4vg-6J and The Lucky Laundry by Nathan Lynch https://cutt.ly/JCwVAyK;
  • housing financialisation; and
  • light and regressive taxation of housing in Australia;

to the reasons why Australian residential property prices have reached the unaffordable levels they have.

The wrong culprit

Light taxation has been widely canvassed in the media as a contributor to unaffordable housing but journalists and commentators frequently focus on the 50% CGT discount for investors and negative gearing as the tax system causes of unaffordable housing unfortunately ignoring the CGT MR exemption or even the various land tax exemptions that Australian state and territory governments extend which shelter owner-occupied homes from state taxation too.

The 50% CGT discount was an inexplicable 1999 adjustment to sound original design of the CGT in 1986. It replaced the indexation of cost (base) which was to ensure an investor paid tax only on a real capital gain after adjusting for inflation but at ordinary income tax rates so the CGT could work fairly and progressively as designed. The 50% CGT discount instead effectively and regressively reduced the income tax rate on investment capital gains made by property investors, as it turned out, during a period of negligible inflation which the 50% discount was meant to overtly but more crudely counter. Now inflation is back so a nuanced policy response may be to scrap the 50% CGT discount and to revert back to the 1986 indexation of cost which should never have been altered in the first place.

In contrast to the CGT MR exemption, the 50% CGT discount has a waiting period, 12 months – see section 115-25 of the ITAA 1997, which is not much, and is limited to 50% as a highest discount to individuals. Like the CGT MR exemption, availability is not limited or capped to those who qualify and this is a boon to investors in the property market although major investors and developers need to be tax wary that their property investment activity is not treated by the Commissioner of Taxation as a business of profit-making by sale with the consequences that:

  • proceeds of sale of investment in housing become taxable as ordinary income;
  • thus CGT relief, such as the 50% CGT discount, is unavailable – see section 118-20 of the Income Tax Assessment Act (ITAA) 1997; and
  • their activities become an enterprise where they must charge the goods and services tax (GST) to buyers for reasons set out in Miscellaneous Taxation Ruling MT 2006/1.

Tax relief saving for a home?

The CGT MR exemption is of no benefit to someone who is saving for a home, but does not have a home yet, whom one would think would be the focus of a real and progressive tax exemption to house. Capital gains made on investments by someone saving for a home are not exempt from tax, and get no better than the 50% CGT discount I have maligned in this post, which is odd when it is understood the tax system gives already housed wealthier citizens, who may turnover a series of homes of increasing value and for increasing gains, full tax relief on each gain made on their homes through the CGT MR exemption.

For the CGT MR exemption to be fairer, and to discourage home buyers from taking on higher mortgages to get into the housing market where ruin may be more likely than gain, could the CGT MR exemption extend to capital gains made by persons who are saving for a home or who are yet to own home on portfolio assets set aside to buy a home they hold in the interim? Clearly the former First Home Saver’s Account scheme, which was an utter failure and repealed in 2014, was not ambitious enough and was a false move to help those accumulating what they need to buy a home.

A cap on the CGT main residence exemption?

A limit or cap could be put on the CGT MR exemption that a taxpayer can use to exempt capital gains on his or her home during their lifetime. This would take heat out of the housing market.

An arguably generous lifetime cap of $A 1 million would still bring in substantial additional CGT revenue that could fund social and universal housing and reduce the CGT MR exemption rort by those who take large or multiple full exemptions on their turnover of increasingly expensive homes. The CGT system already uses a lifetime limit in the small business CGT retirement exemption rules in Subdivision 152-D of the ITAA 1997 and caps now limit contributions that can be put into tax concessional superannuation on tax fairness and equity grounds.

A home turnover limitation?

In many countries in Europe a holding period of less than five years can cause capital gains on assets including the family home to be taxable. Tax relief cuts in where an asset is held for longer. Are their approaches something Australia should also consider when looking at tax exemptions and concessions for housing?

Challenge

There is no doubt changes that really improve Australian housing affordability and address inequitable and fiscally disastrous untethered tax exemptions will be politically fraught especially when there are so many interests vested in the present tax system who may lose with change. In the bigger picture lightly taxed property gains and unquarantined negative gearing deductions can be seen as scourges when proper taxation, orthodox monetary policy and extended oversight of criminal money flows could be used to re-balance the housing investment market with the social housing needs of Australia’s citizens.

The member’s say over where their SMSF death benefits are to go

On 15 June 2022 the High Court in Hill v Zuda Pty Ltd [2022] HCA 21 ruled against a challenge to earlier court decisions that a binding death benefits nomination (BDBN) made under the governing rules (GRs) [trust deed] of a self managed superannuation fund (SMSF) need not lapse after three years of the nomination as a comparable nomination made under a retail or industry superannuation fund must under Regulation 6.17A(7) of the Superannuation Industry (Supervision) Regulations.

Non-lapsing SMSF BDBNs confirmed

The High Court’s decision confirmed that this regulation, which operates under the force of sub-section 59(1A) of the Superannuation Industry (Supervision) Act 1993 (SIS Act), did not apply to or limit the effectiveness of a BDBN made as non-lapsing more than three years earlier by a member of a SMSF under GRs of the SMSF that allowed for non-lapsing BDBNs.

External discretions and directions

It follows that other limitations in section 59 and Regulation 6.17A also have no application to a SMSF. Among them is the original rule in sub-section 59(1) which broadly, with exceptions, invalidates GRs that allow a person other than the trustee to exercise a discretion under the GRs of a fund. A related provision, which is similarly confined to retail and industry funds, and especially clearly so, following Hill v. Zuda; is section 58 of the SIS Act which broadly, with exceptions, invalidates a GR under which a person may direct the trustee (to act or not act in a certain way in the conduct of the fund).

Implications for death benefits directions

Without the reservation for superannuation funds other than retail and industry funds it would be thought that death benefits agreements or “SMSF wills” included in, or which took effect under, the GRs of a SMSF which prevailed over, or overrode, a power or discretion of a trustee to decide on which dependant of a deceased member was to take death benefits of the member would fail. It seems indisputable now that trustees of SMSFs and Small APRA Funds, can be effectively directed and bound by members on where their death benefits are to go under valid GRs whether that is by nomination, direction or in some other way .

It follows that SMSF GRs are free to allow for members, either not as or not acting in their capacity of trustees or as directors of a trustee, to control decisions over to whom their death benefits are to be paid. This is starkly different to a retail or industry fund that cannot outsource the duties and obligations of its trustee to determine who is take the benefits of a deceased member unless the BDBN requirements in Regulation 6.17A are strictly complied with.

Too much latitude to a SMSF then?

Many SMSF GRs are and will be unconstrained or vague in setting out process of where death benefits of a deceased member are to go without the stricture of Regulation 6.17A. Accordingly SMSF GRs that give a member a binding and final say over to whom their death benefits are to be paid need to be carefully considered when a death benefits decision is to controlled by a member in any way.  A reckoning should be taken as to whether the SMSF GRs, that give a member this autonomy over their benefits; is workable, predictable and will limit opportunity for fraud on the member and the member’s family.

Foreign income tax offsets and discount capital gains – the Burton effect

HalfDollar

Non-residents* no longer have entitlement to the 50% capital gains tax discount (the Discount) on their Australian capital gains, save grandfathering, but the inverse isn’t true: Residents* can apply the Discount to foreign capital gains that meet the requirements of the Discount in their Australian tax.

The CGT discount

Obtaining the Discount principally requires:

  • the entity who made the gain being an individual either directly or as the beneficiary of a trust [50% discount] or a superannuation fund [33⅓% discount] : section 115-100 of the Income Tax Assessment Act [ITAA] 1997). That is the entity is not a company. Companies are ineligible for the Discount;
  • the CGT asset on which the gain is made was held for at least twelve months: section 115-25; and
  • the gain made is not otherwise treated income under the ITAA 1997. So where a gain is both assessable income and a capital gain under the ITAA 1997 the gain is not taxed as a capital gain and so the Discount cannot apply too: section 118-20.

How taxation of foreign income works

Broadly foreign capital gains are included in the Australian assessable income of a resident just as domestic capital gains are. Resident taxpayers are taxed on income from all worldwide sources: sections 6-5 and 6-10. Notable exceptions are foreign income of companies from:

  • their foreign branches with an permanent establishment in those foreign places: section 23AH of the ITAA 1936; and
  • foreign subsidiaries of Australian resident companies or where a company has non-portfolio (at least 10%) holding in a foreign company: section 768-5 of the ITAA 1997.

Foreign income, including of capital gains, of a resident is separately taxed (or exempted) under Australian tax rules even where the foreign income has been, or is to be, taxed under a foreign regime. To address the prospect of double (foreign and domestic) taxation of foreign income a foreign income tax offset (FITO) is available: Division 770 of the ITAA 1997. Australian tax on foreign income can be offset by a FITO for the foreign tax a resident taxpayer has paid, as a non-resident typically but dual tax residence is possible, in the foreign place the foreign income came from.

Double tax and double tax treaties

Australia has double (bilateral) tax treaties with many countries including all large countries and major trading partners which:

  • mutually allow source taxation of income of non-residents of each country (jurisdiction) at tax rates lower than both non-treaty rates and domestic rates on some forms of foreign income – this reduces foreign tax and, consequently the FITO needed to offset that foreign tax; and
  • provide a structure to alter domestic tax law, if need be, to prevent situations where taxpayers will be taxed in both places (double tax) on the same income.

The tax treaties reserve rights to a treaty partner to tax real estate where a taxpayer is resident in the other jurisdiction and taxation of capital gains made on the realisation of real estate, unlike typically interest, dividends and royalties, is not capped at lower rates in the treaties. Broadly this means Australian residents, as non-resident taxpayers, pay foreign capital gains taxes at rates comparable to, or even higher than, the taxes locals pay on capital gains made on foreign real estate.

It follows that foreign capital gains tax can be significant. Can this foreign tax payment be used as a FITO to offset the CGT on an Australian Discount capital gain? The FITO available to offset Discount capital gains on real estate and other investments was considered by the Full Federal Court in Burton v Commissioner of Taxation [2019] FCAFC 141.

Burton v Commissioner of Taxation

In Burton v Commissioner of Taxation it was found that 50% only of US tax paid on a capital gain made on US investments by an Australian resident individual taxpayer was offsettable against the individual’s Australian tax as a FITO.

The reason for this finding is technical but can be understood as follows:

In essence a FITO under section 770-10 of the ITAA 1997 is strictly confined to foreign income that is subject to foreign tax. Under the Discount regime in Division 115 and under section 102-5 of the ITAA 1997 only the net capital gain after applying the Discount, which is 50% in the case of a resident individual, is included in assessable income. It follows that a component of a capital gain taxed as a foreign capital gain is not taxed in Australia where the capital gain is a discount capital gain under Division 115. That is a Discount capital gain to an Australian resident individual taxable on their worldwide income that arises from a capital gain made in the US is made up of:

  • 50% that is taxed in the US which is included in Australia assessable income as net capital gain; and
  • 50% that is taxed in the US but which is not included in assessable income in Australia viz. it is exempt from tax in Australia.

The Full Federal Court confirmed that a FITO is only available in relation to the first of these 50% categories. Logan J. stated at paragraphs 84 and 86:

84. Read in context, the text of s 770-10 is, in my view, fatal to the success of the alternative foundation of Mr Burton’s appeal, grounds 1 to 4 of which challenge the correctness of the conclusion adverse to him reached by the learned primary judge in relation to the allowance of foreign tax offsets under s 770-10 of the 1997 Act. An amount of foreign tax paid only counts towards a tax offset if it was paid “in respect of an amount that is all or part of an amount included in your assessable income for the year”.

….

86. Section 770-10 looks to “an amount that is all or part of an amount included in your assessable income for the year”. The term “assessable income” is defined in s 995-1 of the 1997 Act, which is not the same as “income” as understood for the purposes of the Convention. As defined in the 1997 Act, assessable income includes “ordinary income” (s 6-5) and, materially, what is termed “statutory income” (s 6-10). One form of statutory income included in assessable income is a net capital gain included pursuant to s 102-5(1) of the 1997 Act. As a matter of ordinary language flowing from the text of s 770-10 and, in turn, s 102-5(1), it is only the net capital gain which is, in each instance, included in Mr Burton’s assessable income. Regard to ss 6-5, 6-10 and 102-5 highlights that the phraseology “included in your assessable income” is pervasive in the 1997 Act. There is no contextual warrant for construing “included in” as extending to an amount which is used for computation of an amount that is included in assessable income. The learned primary judge (at [113] – [114]) reached just such a conclusion. That conclusion was correct, for the reasons given by his Honour.

Burton v Commissioner of Taxation [2019] FCAFC 141 at paras. 84 and 86

Repercussions

This outcome is quirky and is entirely due to the laboured statutory drafting of the CGT provisions which is in part consequence of laudable efforts to rewrite and improve the Australian legislation with the advent of the ITAA 1997. If, instead, the taxation of discount capital gains had been governed by a rate set in less intelligible and obscure fine print in the Income Tax Rates Act 1986 as say 50% of the rate otherwise applicable, with that net rate to apply to the whole capital gain; then the whole of the US tax paid on the capital gain could have been offsettable as a FITO. In other words a half of the FITO would not have been lost to Mr. Burton due to the clash of legislative style with treaty terms.

But that is not the case. Accordingly Australian residents with Discount capital gains which are foreign capital gains need to ensure FITO claims in their Australian income tax return reduce the foreign tax claimed by the discount percentage to ensure no FITOs are claimed for the non-assessable/exempt component of the foreign capital gain that technically arises under the Australian CGT legislation.

*In this post resident and non-resident respectively mean resident and non-resident for tax purposes: see “resident of Australia” defined in sub-section 6(1) of the ITAA 1936.

Used the wrong/ trustee’s ABN for a new trust? How to fix …

WrongBox

A common mistake, misstep or omission on setting up a family discretionary trust (FDT) or other kinds of trusts is to use the Australian Business Number (ABN) of the trustee of the trust, typically a proprietary company, rather than to obtain and use a separate ABN after the trust has been established to run a business or enterprise.

Situations where this can happen include:

  • an ABN application form is completed incorrectly for the company without correctly identifying the FDT as the entity to which the application applies;
  • early application for the ABN is made by the company for an ABN, say so the company can say, open a bank account before the trust formation; or
  • the company is already doing other things and has an ABN already.

In each of these situations a client of an accountant can be tempted to use the ABN already to hand for the FDT. A client so tempted may well think – my accountant can sort this out later!

ABN for the wrong entity

It’s a clear mistake as a trust is clearly a separate entity to the company. An entity that can obtain an ABN under the A New Tax System (Australian Business Number) Act 1999 is equivalent to an entity as defined under the companion GST legislation which is:

(1)  Entity means any of the following:

(a) an individual;

(b) a body corporate;

(c) a corporation sole;

(d) a body politic;

(e) a partnership;

(f) any other unincorporated association or body of persons;

(g) a trust;

(h) a superannuation fund.

Note: The term entity is used in a number of different but related senses. It covers all kinds of legal persons. It also covers groups of legal persons, and other things, that in practice are treated as having a separate identity in the same way as a legal person does.

sub-section 184-1(1) of the A New Tax System (Goods And Services Tax) Act 1999

which also conforms with other definitions of entity in the Income Tax Assessment Acts (ITAAs). Its clear that a company can have an ABN and a trust with a company as its trustee can and should separately obtain another ABN where the trust is to carry on an enterprise requiring an ABN.

The usual trust implementation

The usual implementation of an asset protected FDT is to set up the FDT with a corporate trustee with limited liability where the company is to be a dormant company. That is the company will have modest nominal share capital so it can register as a proprietary company with the Australian Securities and Investments Commission (ASIC) but the company will not have business or other substantive assets or liabilities on its own behalf as all intended activity of the FDT will be as the trustee of the FDT.

The company must have a right to be indemnified out of the property of the FDT so that the directors will not be personally liable for the debts of the trust under section 197 of the Corporations Act 2001 but, in terms of the balance sheet of the corporate trustee of a FDT, that right and the share capital are about the only few assets the company needs in the role of trustee of a FDT.

Impact of the wrong ABN

But if an ABN for the company is quoted on bank accounts and on invoices then the Australian Taxation Office (ATO) and all others concerned with the business are informed that transactions thought to be made by the FDT for its business are made by the company in its own right. The accountant for the FDT will have little choice but to record the transactions as transactions of the company in its own right and prepare the accounts of the company accordingly. Significant penalties can apply if the company persists with a position that it was quoting the ABN of the company for activity of an entity without an ABN rather than for activity in its own right.

So instead of the accounts of the company being dormant and those of the FDT being active, the business transactions will go to the accounts of the company and nothing will happen on FDT accounts and the implementation of the trust to operate the business will misfire.

If the business is being run under a business name, where the ABN of the company was used to apply for and obtain the business name, then the ATO and all others concerned with the business will view and treat the business name as a business name of the company and not the FDT.

Fixing the problem – reverting to the trust structure

This is one of those problems that can’t be fixed retrospectively without penalty trouble – the ABN has been quoted and relied on, but the problem can be fixed going forward.

Get the right ABN

The FDT can belatedly apply for an ABN. It is possible for an ABN to have retrospective application viz. the ABN can take effect from a date nominated by the applicant some time prior to the time of the application. But the ABN taking earlier effect won’t cure the problem of where the wrong ABN has been quoted since then.

Restore the company balance sheet

The company shouldn’t need to be voluntarily liquidated but a comparable internal process can be done to transfer the assets and liabilities in the accounts of the company to the FDT and to restore the balance sheet of the company to the modest assets described under The usual trust implementation above from a set fix or changeover date. If the problem is picked up early enough – it should be! –significant income tax profit and capital gains tax exposures of transferring assets to the FDT that may require remedy such as the small business restructure rollover in Division 328-G of the ITAA 1997 may not necessarily be needed to reset the company balance sheet.

Coping with the administrative consequences of changeover

If a client of an accountant has put itself into this sort of tangle it is likely that the client will struggle with this remedial action too which presents some administrative challenges as the client is now dealing with, effectively, two discrete businesses before and after the changeover day: The business initially carried on by the company with its ABN and then the business carried on by the FDT with its ABN from the changeover day.

It is important that the accounting and administrative team of the client (the Team) can pinpoint company period transactions before the changeover date and FDT period transactions that happen after the changeover day.

So a further element of the fix proposed here is to change the name of the company and for the Team to be meticulous about changing processes and stationery etc. to the new company name once the changeover day happens and the FDT period is underway.

There is an ASIC cost to change the name of the company and stationery etc., and time of the Team to manage all of this, but that cost should be considered in the context of alternatives that are costlier such as to voluntarily liquidate the company, to start afresh with an entirely new business structure to get the ABN process right or to abandon plans to use the FDT structure altogether.

A common technique for a name change for a company running a business, when a name change isn’t really wanted for public facing reasons; is to change NameOfCompany Pty. Ltd. to say NameOfCompany (Aust.) Pty. Ltd. This can help the Team and its customers to apply the right ABN and to get the accounting right (e.g. sales put through the right books of the two distinct entities NameOfCompany Pty. Ltd. to NameOfCompany (Aust.) Pty. Ltd (as trustee for the FDT) in this example for before and after changeover day transactions.

Unless something like this is done the Team and customers of the business might get very confused and might not manage the transition to the FDT as sought all along.

Impact of name change on the appointed FDT trustee

Unlike a liquidation of the company, after which a new trustee of the trust would need to be set up and appointed, a name change won’t affect the position of the company as the trustee of the trust.

Keeping the CGT main residence exemption when working from home

home

Only a partial exemption from capital gains tax (CGT) is available to the extent a main residence is used for an income-producing use: section 118-190 of the Income Tax Assessment Act (ITAA) 1997.

As the CGT main residence exemption is, or can be, so valuable – there is often no bigger tax break to an individual in their lifetime; an individual working in their business or their employment from a home they own will be looking to preserve the full CGT main residence exemption (MRE) where they can.

Setting the scene

For most taxpayers opportunity to claim the full CGT MRE will be straight forward. The Australian Taxation Office (ATO) website

Home-based business and CGT implications | Australian Taxation Office https://cutt.ly/ZDOjOWt

re-assures a home owner simply working from home from a desk, chair and a computer that a full CGT MRE will be available where the ATO states:

Generally, when you sell your home CGT doesn’t apply. However, if you used any part of your home for business purposes, you may have to pay CGT. CGT won’t apply if any of the following occurred with your home-based business:

– You operated your business from a rented home.

– You didn’t have an area specifically set aside for your business activities.

– You operated your business through a company or trust.

You only have to pay CGT for periods when you used your home for your business.

Home-based business and CGT implications | Australian Taxation Office https://cutt.ly/ZDOjOWt

But the ATO’s page isn’t the whole story. The ATO’s first dot point is so obvious that it shouldn’t be in the list but is helpful to any renters that may happen on to this page of course. The ATO’s second dot point is reassuring especially as all that is physically needed by many workers working from home is that chair, desk and computer. This derives from the distinction between homes with a place of business and those not with a place of business and how they are treated for the CGT MRE considered later in this blog. The third dot point is partly right. What about, though, where a related company or trust, which is a separate entity to an individual owning his or her home:

  • pays rent to the owner for the use of the home?; or
  • meets or helps meet the expenses of the owner of the home?

Separate entity – related company or trust

Let’s say Fred owns his own home and Fred has a related company from which Fred conducts his business from home. If the company rents a room in the home then the CGT MRE is reduced to a partial CGT exemption when Fred sells his home as:

  • Fred has earned rental income from the company, a separate legal entity; and
  • Fred will either have deducted, or could have deducted, interest on money borrowed put to the home, if any – see paragraph 118-190(1)(c) and sub-section 118-190(2);

as section 118-190 then applies.

Don’t charge rent

If Fred is the sole owner of his company then an obvious first measure of tax planning to ensure Fred keeps the full CGT MRE is for Fred not to charge rent to the company.

But where Fred charges no rent to the company this has implications for expenses like heating and cooling and other expenses Fred incurs, and has no rent to cover, when the company occupies his home for no charge and carries on its business from there remembering:

  • Fred is not entitled to deduction for the expenses of his company which is a separate entity to him and which are essentially private to him; and
  • the company is not entitled to a deduction for expenses for which Fred, rather than the company, is responsible even where the company pays those expenses (without considering fringe benefits tax implications where Fred is also an employee of the company as well as a shareholder).

Can the company instead reimburse Fred, sustain deductions for the expenses of the home it meets as business expenses and not disturb the CGT MRE position of Fred?

Legalities – a licence!

Firstly the company is, as stated, a separate legal entity to Fred. To clarify its basis for using Fred’s home, the company and Fred should document what the company can do at his home.

Secondly a document between Fred and the company under which the company can enter and use Fred’s home to run its business without paying rent to Fred is likely not a lease. It is a licence to enter the home granted by Fred and to do the things at the home which Fred allows the company to do under the licence.

Thirdly the licence terms can specify and delimit the home expenses of Fred which the company will reimburse to Fred.

Running expenses vs. occupancy expenses

The Commissioner of Taxation’s Taxation Ruling TR 93/30 Income tax: deductions for home office expenses explains two significant dichotomies:

Firstly TR 93/30 distinguishes between running expenses, being the costs of living at a home, and occupancy expenses which are the costs of owning a home. These examples are given:

Occupancy expenses –  relating to ownership or use of a home which are not affected by the taxpayer’s income earning activities (i.e., occupancy expenses). These include rent, mortgage interest, municipal and water rates, land taxes and house insurance premiums.

Running expenses – relating to the use of facilities within the home. These include electricity charges for heating/cooling, lighting, cleaning costs, depreciation, leasing charges and the cost of repairs on items of furniture and furnishings in the office.

Paragraph 6 of TR 93/30

Secondly, from the tax cases on the issue, TR 93/30 draws a distinction between an area of a home to be treated as a place of business and an area of a home which is not to be so treated. This ties back to the ATO observation in the second dot point on Home-based business and CGT implications about a part of a home specifically set aside for business activities.

Safe harbour for a full CGT MRE

To my mind a CGT MRE safe harbour for Fred would be for the licence:

  • to allow Fred reimbursement by the company for running expenses related to the use of the home by the company for business purposes; and
  • to preclude reimbursement by the company for occupancy expenses;

to Fred. Then the ATO would have no reason to treat payments by the company to Fred or payments by the company to meet expenses of the home on Fred’s behalf as either rent or as contributions to Fred’s occupancy expenses so that the CGT MRE of Fred then diminishes to a partial exemption where these payments do not exceed the applicable running expenses that Fred can recover under the licence.

On the other hand a reimbursement of occupancy expenses to Fred is an indicator to the ATO that Fred is allowing a physical part of the home itself, whether or not that part is a place of business or not based on the indicators of a place of business described in TR 93/30 (see below), to be used by the company in its business to earn income and a notional apportionment between use as a main residence and income earning leading to a diminished partial CGT MRE under section 118-195 might then follow.

Sole trader or partnership

Where the owner of the home is a sole trader, or where the owners of the home are carrying on a business in partnership, then the issue of licence to enter and use the home and reimbursement of home expenses to owners as separate entities won’t arise.

In those cases closely abiding by TR 93/30 can give home owners working from home safe harbour from a partial CGT MRE so long as:

1. the home has no place of business viz like:

the area is clearly identifiable as a place of business;

the area is not readily suitable or adaptable for use for private or domestic purposes in association with the home generally;

the area is used exclusively or almost exclusively for carrying on a business; or

the area is used regularly for visits of clients or customers.

from paragraph 5 of TR 93/30. A home-based doctor’s surgery is given as an example of a place of business in paragraph 4 of TR 93/30.

2. tax deduction claims by the sole trader or partnership are constrained to running expenses and occupancy expenses are excluded from those tax deduction claims.

Draft ATO reimbursement agreement suite out in the wake of Guardian AIT

In my blog post 100A trust reimbursement agreement not the tool to fix the bucket company dividend washing machine last month I looked at reimbursement agreements following Guardian AIT Pty Ltd ATF Australian Investment Trust v. Commissioner of Taxation [2021] FCA 1619 (Guardian AIT).

The Commissioner acts

In the meantime the Commissioner has appealed Logan J.’s decision in Guardian AIT to the Full Federal Court. The Commissioner has also released a suite of “draft products” which set out the compliance approach of the Commissioner relating to reimbursement agreements under section 100A of the Income Tax Assessment Act (ITAA) 1936:

  • Draft Taxation Ruling TR 2022/D1 Income tax: section 100A reimbursement agreements
  • Draft Practical Compliance Guideline PCG 2022/D1 Section 100A reimbursement agreements – ATO compliance approach
  • Draft Taxation Determination TD 2022/D1 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of ‘financial accommodation’?
  • Taxpayer Alert TA 2022/1 Trusts: parents benefitting from the trust entitlements of their children over 18 years of age 

Evolution of the draft products

The suite clearly evolves from a similar suite finalised nearly twelve years ago which included Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements and Practice Statement Law Administration PS LA 2010/4 Division 7A: trust entitlements which focused on unpaid present entitlements of private companies, deemed loans and sub trusts. The Commissioner now takes a tougher line, prospectively, on what is a financial accommodation and thus a deemed loan for the purposes of Division 7A of the ITAA 1936 in TD 2022/D1. A company will need to demand immediate payment when it becomes aware of and has an unpaid present entitlement (UPE) to income of a trust. There will still be a financial accommodation, despite arrangement to pay a commercial rate of interest, which will be enough to be deemed loan and potentially a deemed dividend. Section 109N of the ITAA 1936 complying loan terms are needed so that UPE will not trigger a deemed dividend under section 109D.

This does not appear to be a relevant matter in Full Federal Court appeal in Guardian AIT in relation to the the bucket company dividend washing machine (BCDWS) arrangement used in that case. Under that BCDWS a dividend was declared by the bucket company back to the Australian Investment Trust (AIT) in the window allowed for a private company debit loan before the income tax return for the bucket company was due. That declaration is a prompt if not immediate action to extinguish any financial accommodation by the bucket company to the AIT.

Staying red?

The dividend washing machine arrangement comes up as Red zone scenario 2 in paragraphs 33 to 36 of PCG 2022/D1 where red zone activity in PCG 2022/D1 is activity at high risk for ATO action with compliance resources. It is not expected that, even if the Commissioner is unsuccessful in the Full Federal Court case in Guardian AIT, the BCDWS will be reclassified out of the red zone and will become an acceptable tax practice.

Repercussions of Guardian AIT?

It remains to be seen whether section 100A risks addressed in the draft products will align with Guardian AIT following the Commissioner’s appeal. Will higher courts adopt Logan J.’s understanding of the facts which accepted the BCDWS as an ordinary family or commercial dealing?

Perhaps more problematic for the Commissioner will be to convince a higher court that there was a reimbursement agreement at all in Guardian AIT. Logan J.’s findings that there was no timely reimbursement agreement for the bucket company to pay dividends to the Australian Investment Trust, and no plausible counterfactual as to whom otherwise the trustee of the Australian Investment Trust would have distributed income of that trust had it not been distributed to the Australian Investment Trust, meant the Commissioner could not make out a reimbursement agreement to which section 100A could apply.

In running the appeal the Commissioner may run the risk that the Full Federal Court will establish authority that section 100A cannot readily apply where the impugned distributions to which the Commissioner seeks to apply section 100A is made to immediate family members such as Simon and Sam in Example 7 in paragraphs 85 to 92 of PCG 2022/D1.

Example 7 – amounts provided to the parent in respect of expenses incurred before the beneficiary turns 18 years of age

85. Brown Trust’s beneficiaries include the members of the Brown Family. Brown Co is the trustee of Brown Trust, and Bronwyn Brown is the sole shareholder and director of the trustee.

86. Bronwyn is the parent of three adult children; Sandra (aged 26), Simon (aged 21) and Sam (aged 19).

87. During the 2022-23 income year, Sandra is self-employed and has a taxable income of $90,000. Simon and Sam study full-time and derive no income during the income year. Bronwyn’s children live at home with her at all times throughout the income year.

88. During the 2022-23 income year, Brown Trust derives $240,000 in income (the trust’s net income is also $240,000). Throughout that year, Brown Co makes regular payments totalling $240,000 into Bronwyn’s bank account. Those payments are recorded as a ‘beneficiary loan’ in the accounts of Brown Trust. Bronwyn uses these amounts throughout the year to meet her personal living expenses and those of the household.

89. On 30 June 2023, Brown Co resolves to make Simon and Sam each presently entitled to $120,000 of the Brown Trust income.

90. Brown Co applies their entitlements against the beneficiary loan owed by Bronwyn. The entitlements of Simon and Sam are each recorded as having been fully paid in the accounts of Brown Trust. Bronwyn assists in the preparation of Simon and Sam’s tax returns and pays the tax liability arising in relation to their entitlements from her personal funds.

91. The entitlements of Simon and Sam are applied in this manner because they each purportedly have an outstanding debt owed to Bronwyn in respect of education expenses and their share of the Brown household expenses that Bronwyn paid before they each turned 18.

92. Diagram 10 of this Guideline illustrates the circumstances in this example.

Example 7 in PCG 2022/D1

Under sub-section 100(8) an agreement is carved out from being a reimbursement agreement unless there is what the Commissioner refers to as the tax reduction purpose.

Even though a distribution in that Example 7 to Bronwyn was a “lawful possibility” why “would have” distributions made to Simon and Sam (assuming the distributions were real and genuine) who are equally family beneficiaries with Bronwyn have been made to Bronwyn? Isn’t the true issue that the trust distributions to Simon and Sam are a sham and that Simon and Sam did not have a real entitlement and so are not presently entitled to the distributions in the first place?

The Commissioner appears to be reliant on the Full Federal Court agreeing with the construction of sub-section 100A(8) expressed in paragraphs 156 to 158 of Draft Taxation Ruling TR 2022/D1 Income tax: section 100A reimbursement agreements rather than the construction of that sub-section preferred by Logan J.

100A trust reimbursement agreement not the tool to fix the bucket company dividend washing machine

WashingMachine

This blog post is about tax avoidance. That is not apparent from the odd title of this blog which I should explain:

Bucket companies

A bucket company is a private company included as a beneficiary of a trust and is used to receive income of a trust. It is a popular discretionary trust strategy for a trust to distribute trust income to a bucket company as a beneficiary of the trust when, as at present, company income tax rates are lower than income tax rates:

  • for beneficiaries who are individuals typically on significant incomes (individual beneficiaries); and
  • the (can be even higher – highest marginal) rate generally paid when no beneficiary receives (technically: is distributed or becomes presently entitled to) the income of the trust;

(the Higher Rates).

Thus the “bucket” takes the overflow of trust income which the trustee or trust doesn’t wish:

  • to flow to high income individual beneficiaries; and
  • to be taxed at their higher rates.

Not considered tax avoidance

The Commissioner of Taxation (Commissioner) doesn’t view the simple use of a bucket company as a beneficiary of a trust as tax avoidance. That is the case even though less tax will be collected from a trust’s trustee and beneficiaries when the Higher Rates won’t be paid by the trustee and the beneficiaries of the trust when a BC beneficiary is used. There are measures in place: notably the deemed dividend anti-avoidance rules in Division 7A of Part III of the Income Tax Assessment Act (ITAA) 1936 (Div 7A), which generally give the Commissioner assurance that:

  • a private company is a no mere lowly taxed conduit or way for high income individual individuals to receive trust income; and so
  • value either within and distributed to a private company stay within the company or are otherwise treated as non-frankable shareholder/associate dividends they are deemed to receive and to be taxable on.

The washing machine

The bucket company dividend washing machine (BCDWS) though pushes the Commissioner’s tolerance for the bucket company tax strategy.

The BCDWS is like this:

  1. A family discretionary trust (FDT) makes a substantial distribution of trust income (Distribution 1) to a bucket company (BC) in Year 1.
  2. Distribution 1 is not paid and thus becomes an unpaid present entitlement owed to BC by FDT to be paid later.
  3. BC is taxable on Distribution 1 in Year 1 at the company rate which is lower than the Higher Rates.
  4. In Year 2, but in the window before the income tax return for BC is due, and thus before Div 7A treats Distribution 1 to BC to be a deemed dividend based on the analysis of when unpaid present entitlements, including unpaid present entitlements of companies in trust income, can be loans and deemed dividends in Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements; the bucket company declares and pays a dividend to cover Distribution 1.
  5. BC has franking credits to frank the dividend from the payment of tax as a beneficiary on Distribution 1.
  6. The sole shareholder of BC entitled to the dividends is the (trustee of) FDT which has been set up as the owner of the shares in BC that can participate in these dividends.
  7. No actual payment is required as Distribution 1 has gone around the washing machine and has come back to FDT in Year 2 as dividends fully franked by BC.
  8. So in Year 2 the trustee of FDT distributes Distribution 2 of the same amount as Distribution 1 to BC again. It is again unpaid until early in Year 3. The distribution is fully franked which is how the dividends were received from BC so there is no further tax for BC to pay.
  9. The arrangement can be repeated on and on.

By using a concession in Div 7A, the BCDWS in effect enables BC to access a lower company income tax rate for an amount which is not actually paid over or intended to be paid over to a beneficiary but circulates back to the trustee.

Income tax rate integrity problem

So it’s like the trustee is accumulating the income and never having to pay it to a beneficiary but paying less tax as if the income had been paid to a company.

Understandably the Commissioner is concerned with the integrity of income tax rates, and the particularly the integrity of the Higher Rates including the highest marginal rate applicable where no beneficiary is presently entitled to income under section 99A of the ITAA 1936. The Commissioner would like to see that the BCDWS will have the same rate outcome. It does if a BCDWS is a trust reimbursement agreement: a share of trust income arising from a section 100A reimbursement agreement is deemed to be income to which no beneficiary is presently entitled: sub-section 100A(1).

So it is that, at the ATO website, https://www.ato.gov.au/General/Trusts/In-detail/Distributions/Trust-taxation—reimbursement-agreement/ where, at example 5, the Commissioner observes that the trust reimbursement agreement provisions in section 100A of the ITAA 1936 apply to a BCDWS arrangement.

Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation

The Commissioner’s observation in example 5 is put into doubt by the December 2021 Federal Court case Guardian AIT Pty Ltd ATF Australian Investment Trust v. Commissioner of Taxation [2021] FCA 1619. In that case the Commissioner was unsuccessful assessing a BCDWS using anti-avoidance tax laws including section 100A. The taxpayer’s appeal to the Federal Court concerned the Commissioner’s assessments applying the anti-avoidance provisions in section 100A and, alternatively, based on the general anti-avoidance provisions in Part IVA of the ITAA 1936.

Logan J. found that there was no reimbursement agreement and that Part IVA didn’t apply.

The Commissioner had at least these significant difficulties in making out that the BCDWS in the case was a reimbursement agreement:

  1. firstly, that there was any agreement to which sub-section 100A(7) and (8) could apply, and particularly establishing a counterfactual as to whether Mr. Springer, who controlled Guardian AIT Pty Ltd, would have been liable to pay income tax had the “agreement” not been implemented;
  2. secondly, that there was provision of “payment of money or the transfer of property to, or the provision of services or other benefits for, a person or persons other than the beneficiary …” under that agreement: sub-section 100A(7); and
  3. thirdly, that the agreement was not an ordinary family or commercial dealing: sub-section 100A(13).
·        agreement

Mr. Springer was wealthy and conducted a well prepared case before the Federal Court in which the taxpayer was able to establish that the BC, Guardian AIT Pty Ltd, had not been set up with the intent, understanding or expectation that the BC would pay dividends back to the Australian Investment Trust (the FDT). That is what eventually transpired though, and a BCDWS, largely as described above and in the Commissioner’s example 5 happened.

There must be an agreement first

Logan J. accepted that even though it was legally possible for the BC to pay the dividends to the FDT there was no evidence of any timely agreement or plan (my words) to do so. To make out a section 100A reimbursement agreement the Commissioner had to make out that there was “agreement” (though widely defined) between the FDT and its beneficiary/ies before BC started paying dividends to the FDT to make the income tax saving.

Counterfactual not accepted

Logan J. found the Commissioner’s counterfactual under the section 100A(8) “would have been” hypothetical: that Mr. Springer personally would have been liable to pay income tax, that is Mr. Springer would presumably have to have been the beneficiary presently entitled to the income distributed to the BC rather than the BC, had it not been for the reimbursement agreement, could not be reconciled with the evidence in the case.

·        payment, transfer etc.

Logan J. did not accept that there has provision for a payment , transfer etc. to another beneficiary…. The BC was a related entity of Mr. Springer that was a beneficiary of the FDT and a part of the family structure in its own right (that incidentally happened to be on a lower tax rate as an income beneficiary).

Unlike with a unrelated entity that takes, say, a payment to be made a beneficiary of trust income in a trust stripping, which is the use of trusts abuse to which section 100A is directed; the BC in this case can be seen as a beneficiary related to and having no reason for such arm’s length like dealing with Mr. Springer or other members of his family.

·        ordinary family or commercial dealing

Section 100A was introduced to combat trust stripping typically involving unrelated parties (see Federal Commissioner of Taxation v Prestige Motors Pty Ltd (1998) 82 FCR 195) and “specially introduced beneficiaries having a fiscally advantageous status” particularly. Logan J. did not accept that this characterisation applied to the BC, Guardian AIT Pty Ltd. From the evidence Logan J. found that the implementation and use of Guardian AIT Pty Ltd as a “clean” (for instance, no carry forward losses or other utilisable positive tax attributes) company beneficiary of the FDT, Australian Investment Trust, was an ordinary family dealing.

Observations

Guardian AIT confirms that a reimbursement agreement contains a number of technical elements that the Commissioner can be hard pressed to establish where a taxpayer produces facts contrary to the Commissioner’s position on them. These elements can make section 100A, as a tool in the anti-tax avoidance armoury of the Commissioner, ill-suited to enforce the integrity of the Higher Rates applicable to trust income and the rate applicable under section 99A of the ITAA 1936 where there is no beneficiary presently entitled to income in particular. That is not to say that the Commissioner should not endeavour to enforce that integrity.

Based on authority referred to in Guardian AIT Logan J. was unwilling to accept that the reimbursement agreement rules in section 100A, directed as they are to the contrived introduction of specially introduced beneficiaries with a fiscally advantageous status, had application to a clean company introduced within Mr. Springer’s family structure despite the overtly unplanned tax arbitrage Mr. Springer could achieve due to the lower company income tax rate.

There is the prospect that the Commissioner will appeal to the Full Federal Court. The government could better protect the integrity of the trust tax rates with specific amendment so that circulating BCDWS distributions, which do or must have some aspect of artificiality or contrivance by virtue or their circularity or non-distribution, attracted the highest marginal rate of tax without the Commissioner having to contest assessments based on section 100A and Part IVA attack or sham characterisation which are more costly, fraught and complicated for the Commissioner to prosecute.

A dentist might be better than the cheapest guy with a drill

drill

Proprietary company setups are not all the same. The $512 ASIC registration fee doesn’t get you a constitution for your company. Company constitutions vary and are on a quality spectrum and quality can count just like with any product.

Is a company constitution worth having?

A company set up without a constitution gets a one size fits call called the replaceable rules which gives a bare bones way for the company, and those involved in it, to operate. One size fits all can lead to a unintended outcomes. For instance an often unforeseen, easy to trip, requirement is to notify other directors of a conflict of interest between a director and the company. A properly tailored company constitution can modify conflict of interest rules away from the one size fits all to suit a company where only mum and dad are directors. Failure to do this can get weaponised like, say, when directors get divorced. And don’t think that this is the only reason why the replaceable rules may be a poor fit for your company.

Getting a capital structure of a company right

I do work sorting out situations made worse because companies are not understood by those setting them up. A company’s ideal capital structure is a big issue when a company is acting in its own right and not a trustee. Unless you understand the impact of s112-20 of the ITAA 1997 on the issue of shares in the company you’re a big chance to pay more capital gains tax that you might have when you sell or exit out of a company that has grown.

Company capital structure fails can lead to unnecessary loss of small business CGT concessions for small business which can amount to a big economic cost where a company ends up being a good business.

Getting “my” money out of a company

Shareholders try to get “their” money out of a company following a poorly executed lawyer free setup is another world of grief which can ironically bring in the lawyers, the ATO and expensive insolvency specialists.

A reckoning on death

Lots of problems don’t show up until a shareholder dies. This is often when the problem comes to my desk. It is sad when a family is tied in knots because their company establishment going way back was stuffed up. Any company setup, whichever way, might seem the same through times of smooth sailing. Why bother with the pesky paperwork at all? Wait, too, until the shareholders divorce, a fight amongst shareholders ensues or there is trading or tax trouble with the company: a sudden turn of interest, then, in the company’s capital, structure and records.

The “professional services” industry – escape for profit

Most of the non-legal providers on the internet are suss. They are derived from the offshore tax haven shell company “professional services” industry or use their business model. ICIJ media gives you an idea of their ethics https://cutt.ly/oUO7bvW and how they help their customers deal with local rules and commitments (not). Their model is to hide and escape from them.

Company constitutions, trust and SMSF deeds and partnership agreements are legal documents, and these providers are there to help you escape from having to get them from a lawyer charging a fee who is ethically obliged to professionally prepare them and whose work is covered by a professional indemnity/negligence insurance to protect you. And what about these rights? What a solicitor must tell you https://go.ly/P0jLU Worth having?

Their model is often something like this: we are not lawyers, so we give you escape from lawyers with this service. But we offer documents which are (based on) documents authored by a lawyer.

Reality check on unqualified legal practice

However you take this double-think pitch on the merits of avoiding lawyers, a reality is that the model is illegal: see the Federal Court case of Australian Competition & Consumer Commission v. Murray [2002] FCA 1252 https://jade.io/article/106192 to appreciate how documents supplied this way is from an unqualified legal practice source.

Ah! lawyers

There is a misconception that lawyers in this space are not worth the fees. I, for one, reckon my operation is lean and mean. And there are others like me. Sure my company and trust setup services cost a little more because my setups involve me thinking about and taking responsibility for what I am asked to do, and guiding clients on their setup choices based on what I know about them and thirty-five years’ experience of the ever changing traps – and that can’t be done by AI, yet.

What you get

So I can’t “compete” with a non-thinking service which gives you a company, trust of SMSF setup from a sausage cutter: documents all done and delivered instantaneously, with your credit card charged just as fast. But you get my drift: this blindingly impressive service just may be just too fast, hassle-free and brain-free. Look at the fine print (hello accountants) about who takes responsibility for loss if anything, including data inputs for which the inputter is made fully responsible, turn out not quite right.

So I agree. It could be better to go to a dentist than the cheapest guy with a drill.

This post is actually from a post I made to another blog.  I think it’s worth another post on this blog even though it’s a more unruly and uncompromising than my usual posts here!