Should our SMSF have kept its Principal Employer?

MissingPiece

Last month’s piece Lost SMSF trust deed replacement deeds – are they a scam? is my exposé of SMSF (self managed superannuation fund) trust deed variation techniques revealed as dodgy in the light of high Australian legal authority there set out.

So my exposé can be better appreciated and understood: this month I turn to some typical dilemmas faced by a SMSF trustee trying to update SMSF trust terms to:

  • keep them up to date with changing superannuation and tax laws; and
  • introduce capabilities so that opportunities presented by current regimes impacting superannuation funds can be effectively used.

To bring in the new, keep the old

One can see from my exposé that, to introduce new SMSF trust terms to a SMSF, a trustee needs to paradoxically keep the old.

Possibly no starker reminder of this are older SMSFs where the power of vary trust terms in the original trust deed (OTD) unconditionally requires the Principal Employer (or the “Employer” or the “Founding Employer”  – descriptions of this substantially similar role from the days of employer-sponsored superannuation vary) to initiate or consent to update trust terms of the SMSF.

My exposé further explains:

  • aside from in the narrowest of exceptions, a valid deed to vary SMSF trust terms requires a rigid adherence to the requirements of the power to vary trust terms contained in the OTD of the SMSF; and
  • an update or change to the power to vary in a SMSF OTD made on a misunderstanding that the power to vary allows amendment of the power to vary itself, when it doesn’t, is ineffective.

Invalid replacement of the power to vary

Say:

On that misunderstanding by a deed provider (unfortunately I can’t say deed lawyer here because, due to regulatory failings, SMSF legal documents with these errors are often supplied by non-lawyer outfits these days), the deed provider supplies a deed to vary SMSF trust terms by which the trustee purports to replace, among other trust terms, the power to vary in the OTD which power is replaced with the deed provider’s own contemporary take on an apt power to vary.

The SMSF trustee then considers the “replaced” power to vary which no longer requires the trustee to:

  • obtain the consent of the Principal Employer to vary trust terms; or
  • to take direction on the varied trust terms from the Principal Employer;

and decides that the redundant office of Principal Employer, no longer necessary with the evolution from employer-sponsored superannuation to self managed superannuation, can cease. The Principal Employer, say a company, is then de-registered and the office of Principal Employer under the SMSF lapses.

Marooned without a Principal Employer

As the “replaced” power to vary is of no effect this leaves the trustee unable to vary the SMSF trust terms further in future where there is no Principal Employer who can act under the power to vary from the OTD of the SMSF.

A question also arises whether the deed inserting the “replaced” power to vary also fails in its entirety where it contains an invalid replacement of the power to vary in the OTD. The answer to that question may vary case to case.

One can be more certain that deeds purporting to vary SMSF trust terms non-compliant with the power to vary in the OTD unconditionally requiring the consent etc. of the Principal Employer, will fail.

Other dated requirements in the power to vary

In retrospect many of the provisos which providers of SMSF OTDs included in powers to vary in SMSF OTDs seem unwise. Examples include provisos in powers to vary in OTDs that the trustee obtain the approval of:

  • the Commissioner of Taxation; or
  • the Insurance and Superannuation Commission;

to amendment of trust terms of the SMSF. These days the Commissioner of Taxation as the regulator of SMSFs is loathe to give such approval, which is not required by legislation, and the office of Insurance and Superannuation Commissioner no longer exists.

Unfortunately some old SMSF OTDs have these kinds of provisions and some way to deal with them needs to be worked out so that amendment compliant with the power to vary can take effect.

The right “applicable law”?

Powers to vary in SMSF OTDs frequently refer to an “applicable law”, or similar, broadly being the law that applied to SMSFs when the OTD was prepared. “Applicable law”, or whatever it may be, is usually defined in the OTD separately from the power to vary. When SMSF trust terms are generally updated, years later, the varied terms are understandably predicated on a different updated “applicable law”.

In my reckoning this means a deed varying SMSF trust terms probably needs to recognise and define two kinds of “applicable law” where compliance with “applicable law” is a proviso of the power to vary in the OTD:

  • firstly the statutes, regulations etc. that are apply to the SMSF under its updated terms; and
  • secondly the older laws prescribed as “applicable law” in the OTD, which may be redundant or repealed, which the trustee of the SMSF must nevertheless comply with to effectuate an update of trust terms in accordance with the power to vary in the OTD. The power to vary should then specifically refer to this second variety of “applicable law”. Restatement of these older laws can get complicated. For instance the Occupational Superannuation Standards Act 1987, which is often justifiably included as a component of “applicable law” in older superannuation OTDs, has been progressively renamed to the Superannuation Entities (Taxation) Act 1987,  the Superannuation (Excluded Funds) Taxation Act 1987 and the Superannuation (Self Managed Superannuation Funds) Taxation Act 1987.

An alternative view is that one stipulation of “applicable law” can suffice for the other on a reasonable interpretation of the OTD a court or tribunal may accept. That may be somewhat tenable if the OTD contains a interpretative provision contemplating amendments and re-enactments of statutes.

Still it is discomforting to rely on that interpretation of “applicable law” when the OTD specifically and restrictively defines what “applicable law” is and makes compliance with such “applicable law” a proviso to the power to vary. Adoption of multiple concepts of “applicable law” being:

  • one to support updated trust terms; and
  • the other to ground variations of the deed using the power to vary;

is a safer course in a deed to vary trust terms where “applicable law” is a proviso built into the power to vary in the OTD.

Challenges!

Proactive management of a SMSF with timely and effective amendment of SMSF trust terms to support that management can be a much more demanding and technical task then many will appreciate. It may pay for a SMSF trustee to carefully consider what the SMSF power to vary requirements in the OTD are, and what service the SMSF will be getting, rather than expecting that some plain vanilla SMSF deed amendment service is going to work.

Lost SMSF trust deed replacement deeds – are they a scam?

The writer has been reading about opportunity to replace lost trust deeds with a replacement deed from professional suppliers of replacement trust deeds, in SMSF Adviser and in other places. The writer is unconvinced that these replacement deeds are going to be legally effective particularly in relation to trust deeds to which the law in New South Wales applies.

Trust deeds lost in SA – Jowill Nominees Pty Ltd v. Cooper

On 2 July 2021 SMSF Adviser suggested that the South Australian case Jowill Nominees Pty Ltd v. Cooper [2021] SASC 76 provides an insight into issues a court will consider when a trust deed has been lost. This case concerned how trust rules of a trust governed by South Australian law can be varied by the SA Supreme Court on the application of the trustee pursuant to section 59C of the Trustee Act (SA) 1936. In the writer’s view this decision says nothing about variation of trust rules beyond the confine of a SA Supreme Court section 59C application.

Section 59C differs from the Trustee Acts to similar effect in other Australian jurisdictions including section 81 of the Trustee Act (NSW) 1925.

Regularity supports that there is a SMSF where its deed is lost

Where a trust, such as a self managed superannuation fund (SMSF), has been running for some time the trustee may be able to rely on the presumption of regularity to support the operation of the trust where the trust deed is lost.

The presumption of regularity is an evidentiary rule. It can apply where there is a gap in evidence about a prior act but where later acts and circumstances indicate likelihood that the prior act was performed. So in:

  • Sutherland v. Woods [2011] NSWSC 13 the NSW Supreme Court accepted that a SMSF trust deed and resolutions of a trustee of an active SMSF were signed on balance of probability although signed versions of these documents were missing from the evidence in the case; and
  • Re Thomson [2015] VSC 370 the Victorian Supreme Court treated a SMSF as operative in conformity with trust rules in a supposed later deed of variation even though an earlier deed of variation of the trust deed of the SMSF was lost and only an unexecuted version of the later deed of variation of the trust deed was available in evidence. Probabilities, and the surrounding facts such as the ongoing acceptance of the accounts of the SMSF based on the supposed later deed of variation, indicated likelihood that these deeds of variation had been completed and executed.

It is clear from the cases where the presumption of regularity is sought to be relied on that a court or tribunal will presume to aid a trustee unable to produce a missing deed only after an exhaustive search by the trustee for it:

He cannot presume in his own favour that things are rightly done if inquiry that he ought to make would tell him that they were wrongly done. 

Lord Simons in  Morris v. Kanssen  [1946] AC 459 at p. 475

Where a trustee of a trust, that has lost the trust deed of the trust, finds itself in dispute with the Commissioner of Taxation the presumption of regularity can counter the burden of proving the establishment of the trust on the trustee imposed by Part IVC of the Taxation Administration Act (C’th) 1953. See our post The burden of proof in a tax objection

The presumption of regularity is of procedural and not of substantive aid to establishing that a trust has been operating for some time in conformity with a valid and effective trust deed containing trust terms consistent with that operation where the trust deed cannot be produced. In the absence of evidence of the precise terms of a power of amendment, which is an exceptional power that can’t be presumed, the presumption of regularity, though, gives no substantial basis for amendment of trust terms to bring the terms of a SMSF trust deed back to terms that can be produced:

94. Variation of the terms of a trust (including by way of conferral of some new power on the trustee) is not something within the ordinary and natural province of a trustee. It is not something that it is “expedient” that a trustee should do; nor, fundamentally, is it something that is done “in the management or administration of” trust property. A trustee’s function is to take the trusts as it finds them and to administer them as they stand. The trustee is not concerned to question the terms of the trust or seek to improve them. I venture to say that, even where the trust instrument itself gives the trustee a power of variation, exercise of that power is not something that occurs “in the management or administration of” trust property. It occurs in order that the scheme of fiduciary administration of the property may somehow be reshaped.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at para 94

It follows that the presumption of regularity gives the trustee latitude to administer a trust on a presumed generic basis consistent with how that trust has been administered since inception where the trustee cannot produce the trust deed containing the trust terms. That presumption, though, would not ground alteration of trust terms where terms of a power of amendment which may not exist at all, cannot be specifically drawn on from the original trust instrument and complied with.

Law on amending lost trust deeds

How terms of a trust governed by the laws of New South Wales can be varied was considered by the Court of Appeal in Re Dion Investments Pty. Ltd. [2014] NSWCA 367. Re Dion Investments concerned an application to the Supreme Court to vary a trust deed of a trust by modernising its provisions for the benefit of the beneficiaries of the trust. In the writer’s view it is this Court of Appeal decision (by Barrett JA, whose decision Beazley P and Gleeson JA agreed with), not Jowill Nominees Pty Ltd v. Cooper, that gives insights into issues courts and tribunals, especially those in NSW, will consider when the effectiveness of instruments to amend trust terms:

  • where the trust deed of the trust has been lost and the power of amendment is not precisely known; or
  • in other circumstances where the variation to trust terms sought is not supported by, or are beyond, the power of amendment contained in the trust instrument such as in Re Dion Investments;

is to be considered.

Alteration of a trust by its founders

In the absence of a reserved power of amendment in a trust deed, can the trustee and the founders of a trust take action by a subsequent deed to vary an original trust deed (OTD)? The NSW Court of Appeal in Re Dion Investments indicates not. Barrett JA dispels this possibility where trusts and powers of the trust have been “defined” in an OTD:

41. Where an express trust is established in that way by a deed made between a settlor and the initial trustee to which the settled property is transferred, rights of the beneficiaries arise immediately the deed takes effect. The beneficiaries are not parties to the deed and, to the extent that it embodies covenants given by its parties to one another, the beneficiaries are strangers to those covenants and cannot sue at law for breach of them. The beneficiaries’ rights are equitable rights arising from the circumstance that the trustee has accepted the office of trustee and, therefore, the duties and obligations with respect to the trust property (and otherwise) that that office carries with it.

42. Any subsequent action of the settlor and the original trustee to vary the provisions of the deed made by them will not be effective to affect either the rights and interests of the beneficiaries or the duties, obligations and powers of the trustee. Those two parties have no ability to deprive the beneficiaries of those rights and interests or to vary either the terms of the trust that the trustee is bound to execute and uphold or the powers that are available to the trustee in order to do so. The terms of the trust have, in the eyes of equity, an existence that is independent of the provisions of the deed that define them.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at paras 41 to 42

Barrett JA then illustrates the point by this example:

43. Let it be assumed that on Monday the settlor and the trustee execute and deliver the trust deed (at which point the settled sum changes hands) and that on Tuesday they execute a deed revoking the original deed and stating that their rights and obligations are as if it had never existed. Unless some power of revocation of the trusts has been reserved, the subsequent action does not change the fact that the trustee holds the settled sum for the benefit of beneficiaries named in the original deed and upon the trusts stated in that deed. The covenants of a deed may be discharged or varied by another deed between the same parties (West v Blakeway (1841) 2 Man & G 751; 133 ER 940) but the equitable rights and interests of a beneficiary cannot be taken away or varied by anyone unless the terms of the trust itself (or statute) so allow.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at para 43

Alteration of a trust by all beneficiaries of a trust

SMSF Adviser and some SMSF deed suppliers express the view that persons who can compel the due administration of the trust can complete a replacement deed that varies and replaces a lost SMSF trust deed.

This view relies on a rule of equity from Saunders v. Vautier (1841) [1841] EWHC J82, 4 Beav 115, 49 ER 282. The rule is that where all of the beneficiaries of a trust are sui juris (of adult age and under no legal disability), the beneficiaries may require the trustee to transfer the trust property to them and terminate the trust. In Re Dion Investments, Barrett JA. recognises that this rule can entitle beneficiaries relying on the rule to require that the trustee hold the trust property on varied trusts:

but, if they do so require, the situation may in truth be one of resettlement upon new trusts rather than variation of the pre-existing trusts (and the trustee may not be compellable to accept and perform those new trusts: see CPT Custodian Pty Ltd v Commissioner of State Revenue [2005] HCA 53; 224 CLR 98 at [44]).

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at para 46

For a trust that is a SMSF impediments to and implications of variation by the force of using the rule from Saunders v. Vautier are:

  • relatives and other dependants beyond the members of a SMSF, being all of the beneficiaries, must consent to using the rule from Saunders v. Vautier. Children, and others lacking legal capacity, who cannot consent to using the rule, are beneficiaries who can complicate use of the rule to vary a SMSF trust: Kafataris v. Deputy Commissioner of Taxation [2008] FCA 1454; and
  • if the beneficiaries do apply the rule from Saunders v. Vautier, resettlement of a SMSF trust on taking that action gives rise to:
    • CGT event E1 or E2 for each of the CGT assets of the SMSF under Part 3-1 of the Income Tax Assessment Act 1997. It follows that action taken by SMSF beneficiaries in reliance on the rule from Saunders v. Vautier will have comparable capital gains tax consequences to a transfer of all members’ benefits to a newly established SMSF; and
    • prospect that a new ABN and election to become a regulated superannuation fund for a new resettled SMSF will by required by the regulator.

Much reliance is placed by SMSF Adviser and by deed suppliers’ websites promoting replacement deed services on Re Bowmil Nominees Pty. Ltd. [2004] NSWSC 161. In Re Bowmil Nominees Pty. Ltd. . Hamilton J of the NSW Supreme Court, as a matter of expediency, allowed beneficiaries to vary a SMSF trust deed beyond limitations in the amendment power in the trust deed utilising the rule in Saunders v. Vautier on this basis:

20. Since it is appropriate that the trustee act upon the informed consent of beneficiaries who are sui juris and unnecessary applications to the Court for empowerment are not to be encouraged, I propose to adopt the course followed by Baragwanath J in the New Zealand case. I do not propose to make an order under s 81 of the TA empowering the making of the amendment, although I have expressed the view that the Court has power to do so and would be prepared to do so if it were necessary. Rather, I shall make an appropriate declaratory order to the effect that it is expedient that the proposed deed of amendment be entered into and that it will be appropriate for the trustee to act in accordance with it.

Re Bowmil Nominees Pty. Ltd. [2004] NSWSC 161 at para. 20

Update of trust terms by a court

The Court of Appeal in Re Dion Investments agreed with Young AJ, the primary judge, that post-1997 court decisions, including Re Bowmil Nominees Pty. Ltd., which relied on a misunderstanding of the extent of court power to vary trust deeds, particularly in relation to the statutory powers of a court to alter the terms of the trust viz. the aforementioned section 81 in NSW and section 59C in SA, which misunderstanding originated from this obiter dicta of Baragwanath J in Re Philips New Zealand Ltd [1997] 1 NZLR 93

The Court will not willingly construe a deed so as to stultify the ability of trustees, having proper consents, to amend a deed to bring it into line with changing conditions.

Re Philips New Zealand Ltd [1997] 1 NZLR 93 at page 99

were not correctly decided. Barrett JA said:

100. For these reasons, I share the opinion of the primary judge that the post-1997 decisions that have proceeded on the basis that variation of the terms of a trust is, of itself, a “transaction” within the contemplation of s 81(1) rest on an unsound foundation. The court is not empowered by the section to grant power to the trustee to amend the trust instrument or the terms of the trust. It may only grant specific powers related to the management and administration of the trust property, being powers that co-exist with (and, to the extent of any inconsistency, override) those conferred by the trust instrument or by law.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at para 100

In particular. the decision in Re Bowmil Nominees Pty. Ltd. and the other post-1997 decisions referred to in Re Dion Investments cannot be reconciled with the Court of Appeal decision in Re Dion Investments where Barrett JA found:

96. In such cases, however, the creation of what is, in terms, a power of the trustee to amend the trust instrument is a superfluous and meaningless step. When the court, acting under s 81(1), confers on a trustee power to undertake a particular dealing (or dealings of a particular kind), “it must be taken to have done it as though the power which is being put into operation had been inserted in the trust instrument as an overriding power”: Re Mair [1935] Ch 562 at 565 per Farwell J. The substantive power that the court gives comes into existence by virtue of the court’s order. It does not have its source in the terms of the trust. There is no addition to the content of the trust instrument. That content is supplemented and overridden “as though” some addition had been made to it. The terms of the trust are reshaped accordingly.

97. Conferral of specific new powers pursuant to s 81(1) should not be by way of purported grant of authority to amend the trust instrument so that it provides for the new powers. Rather, the court’s order should directly confer (and be the sole and direct source of) the powers which then supplement and, as necessary, override the content of the trust instrument. And, of course, the only specific powers that can be conferred in that direct way are those that fall within the s 81(1) description concerned with management and administration of trust property.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at paras 96-97

A variation relying on a power of amendment in trust terms is not a variation of a trust deed but a variation of trust terms contained in a trust deed. Barrett JA explained this in Re Dion Investments:

44. It is, of course, commonplace to speak of the variation of a trust instrument as such when referring to what is, in truth, variation of the terms upon which trust property is held under the trusts created or evidenced by the instrument. A provision of a trust instrument that lays down procedures by which it may be varied is, of its nature, concerned with variation of the terms of the trust, not variation of the content of the instrument, although the fact that it is the instrument that sets out the terms of the trust does, in an imprecise way, make it sensible to speak of amendment of the instrument when the reference is in truth to amendment of the terms of the trust.

45. Where the trust instrument contains a provision allowing variation by a particular process, the situation is one in which the settlor, in declaring the trust and defining its terms, has specified that those terms are not immutable and that the original terms will be superseded by varied terms if the specified process of variation (entailing, in concept, a power of appointment or a power of revocation or both) is undertaken. The varied terms are in that way traceable to the settlor’s intention as communicated to the original trustee.

Barrett JA in Re Dion Investments Pty. Ltd. [2014] NSWCA 367 at paras 44-45

Significance of the power of amendment as expressed in an OTD

A power of amendment of a SMSF, or any other express trust, is a precise reflection of the settlor’s (founder’s) intention of conditions for amendment of the trust communicated in the trust terms in the OTD and supplies the only lawful way trust rules in a trust deed, otherwise immutable, can be amended aside from narrow exceptions:

  • where beneficiaries can invoke the rule in Saunders v. Vautier and, by doing so, resettle the SMSF on a new trust; or
  • by court order to vary trust terms or, in NSW, to allow dealings of a particular kind despite trust terms, in accordance with a state or territory Trustee Acts such as section 59C of the Trustee Act (SA) 1936 and section 81 of the Trustee Act (NSW) 1925;

as considered above.

Amendment practice

It follows that a power of amendment in an OTD of a trust:

  • needs to remain, as it was in the OTD, as a term of the trust unless the power of amendment itself can be amended, should that be possible and has so been amended; and
  • is best extracted, repeated and given prominence in a deed of variation which replaces the other trust terms of a trust so that trust terms are clear and traceable on an ongoing basis.

Extraction and repeat of a reserved power of amendment from an OTD is not always just a matter of extracting the paragraph or paragraphs in the OTD containing the power of amendment. In the writer’s experience powers of amendment in older SMSF OTDs are frequently premised on laws and practices that prevailed when the superannuation trust was established e.g. such as in the former Occupational Superannuation Standards Act (C’th) 1987 and practices relating to now redundant regimes of employer sponsored superannuation. To remain traceable to the settlor’s (founder’s) intention as communicated to the original trustee, conditions specified for amendment in a power of amendment based on laws and practices, even where those laws and practices have evolved or become redundant since establishment of the trust; need to be complied with and reflected cogently in the extraction and repeat of the power of amendment in a deed of variation, within reason, if the power of amendment is to remain as a trust term in an exercisable form in the deed of variation.

When can a power of amendment in an OTD itself be amended?

Amendment of the power of amendment itself may be possible but unlikely if the amendment provision in the OTD itself does not expressly permit it. In Jenkins v. Ellett [2007] QSC 154, Douglas J. stated:

The scope of powers of amendment of a trust deed is discussed in an illuminating fashion in Thomas on Powers (1st ed., 1998) at pp. 585-586, paras 14-31 to 14-32 in these terms:

“In all cases, the scope of the relevant power is determined by the construction of the words in which it is couched, in accordance with the surrounding context and also of such extrinsic evidence (if any) as may be properly admissible. A power of amendment or variation in a trust instrument ought not to be construed in a narrow or unreal way. It will have been created in order to provide flexibility, whether in relation to specific matters or more generally. Such a power ought, therefore, to be construed liberally so as to permit any amendment which is not prohibited by an express direction to the contrary or by some necessary implication, provided always that any such amendment does not derogate from the fundamental purposes for which the power was created ….It does not follow, of course, that the power of amendment itself can be amended in this way. Indeed, it is probably the case that there is an implied (albeit rebuttable) presumption, in the absence of an express direction to that effect, that a power of amendment (like any other kind of power) cannot be used to extend its own scope or amend its own terms. Moreover, a power of amendment is not likely to be held to extend to varying the trust in a way which would destroy its ‘substratum’. The underlying purpose for the furtherance of which the power was initially created or conferred will obviously be paramount.”

Jenkins v. Ellett [2007] QSC 154 Douglas J. at paragraph 15

One can see the parity between what was said in Jenkins v. Ellett and in Thomas on Powers and in paragraph 94 in Re Dion Investments Pty. Ltd., as set out above, about a trustee’s proper role not being concerned to question or improve trust terms. See the writer’s article Redoing the deed https://wp.me/P6T4vg-3x#rtd

Update of the power of amendment?

The writer sees confusion among SMSF deed suppliers over the difference between the OTD and the trust terms in the OTD and who consequently fall into the trap of treating the power to amend as updatable by the same power to amend.

So instead of relocating the power of amendment in the OTD to updated trust terms, suppliers simply replace that power with their own take on an apt power of amendment departing from Barrett JA’s dictum that it is not for the trustee, far less a variation deed supplier, to “question the terms of the trust or seek to improve them”. Following Re Dion Investments and Jenkins v. Ellett a replacement of a power of amendment that is not amendable is a deviation from the power of amendment prone to be:

  • beyond the power of:
    • the parties entrusted with the power of amendment; and
    • a court, even if an order of the court for the replacement power had been sought; and
  • thus void.

Later deeds of variation of SMSFs based on a deviation

As in Re Thomson trust deeds of SMSFs will likely be varied more than once so that trust terms (governing rules) can better reflect evolving law and practice with SMSFs. An unlawful replacement of a power of amendment which deviates from the power of amendment in the OTD of a SMSF lays a trap when a trustee seeks to make a further amendment to the trust terms of the SMSF: Based on the above authorities a further deed of variation reliant on the “updated” power of amendment in an earlier deed of variation, rather than the power of variation in the even earlier OTD of the SMSF, will fail and be void unless the updated power of amendment in the earlier deed of variation is in conformity with the power of amendment in the OTD.

So are replacement SMSF trust deeds a scam?

The writer suspects many SMSF deed suppliers who supply replacement SMSF deeds don’t understand or follow the implications of Re Dion Investments. As a considered NSW Court of Appeal decision Re Dion Investments is binding legal precedent that rejects the authority of first instance NSW Supreme Court decisions referred to and discussed by the Court of Appeal, including Re Bowmil Nominees Pty. Ltd., that rest on an “unsound foundation” .

It is unfortunate that these cases are still being used as spurious authority on the websites of SMSF deed suppliers in support of claims that lost SMSF deed replacement deeds are of greater efficacy as variations of a trust deed than courts and tribunals, especially NSW courts, will be prepared to accept or order following Re Dion Investments. The writer wouldn’t say these claims are a scam necessarily because, as this post shows, the present state of law is complicated, difficult and more restrictive than understood by courts in the post-1997 cases referred to in Re Dion Investments.

The current law appears to be that if a trustee wants to vary a SMSF trust deed, which is “not something within the ordinary and natural province of a trustee” especially in NSW, the parties given power to amend under a power of amendment must locate, have and rely on that power in or derived from the OTD to successfully amend terms of a SMSF trust without resettling it.

Other solutions, aside from supreme court applications allowed under:

  • section 81 of the Trustee Act (NSW) 1925, as pursued in Re Dion Investments
  • section 59C of the Trustee Act (SA) 1936, as pursued in Jowill Nominees Pty Ltd v. Cooper; or
  • comparable legislation in other Australian states and territories;

which are expensive litigation, are unlikely to be legally effective.

It follows that every effort should be made to find trust terms in an OTD so that the power of amendment in the deed will be carefully complied with when an amendment of a trust deed is to be undertaken. That includes where there have been earlier deeds of variation of the trust terms of a SMSF whose validity also rests on, and must be derived from the reserved amendment power defined in the OTD.

ACKNOWLEDGEMENTS

The author acknowledges the articles:

  • A matter of trusts – Presumption of regularity to the rescue? Milton Louca and Phil Broderick, Taxation in Australia March 2018 at page 436
  • The powers of a Court to vary the terms of a trust A consideration of in Re Dion Investments Pty. Ltd. (2014) 87 NSWLR 753 A paper presented to the Society of Trust and Estates Practitioners – NSW Branch Wednesday 21 October 2015 by Denis Barlin of counsel (who appeared as counsel for the section 81 applicant in the case)

that were useful in preparing this post and which contain greater detail on the issues discussed. The author also expresses his gratitude that these articles have been made available openly online.

Why the weird donation trust beneficiary qualification?

Donation

I was recently asked why a trust deed for a family discretionary trust (FDT) contained this somewhat unusual means of qualifying as a discretionary beneficiary (DB) of the FDT:

any person who makes a donation of (some minimum amount) to …

As the questioner rightly observed, this mechanism readily allows someone outside of a family specified as the DBs, in the main, of a FDT to become a DB. Wouldn’t that mean that a FDT with this mechanism is not or can’t be a family trust?

The answer to this depends on what is meant by family trust.

Certainty of objects necessary for validity of a trust

The thinking behind this kind of provision is that a trust deploying a beneficiary by donation mechanism such as above in its trust deed will be valid.

Certainty of objects is essential for validity of a trust in Australia: Kinsela v. Caldwell (1975) HCA 10. Objects, that is who are or what are to benefit from the trust, being:

  • beneficiaries; or
  • charitable purposes;

must be certain in a valid trust.

It is clear law that a trust (other than a charitable trust) must be for ascertainable beneficiaries.

Re Vandervell’s Trusts (No 2) [1974] Ch 239 at 319 per Lord Denning

When DBs are specifically named or family members qualify by virtue of specified family relationships in a trust deed of a FDT, who qualifies as a beneficiary under the FDT generally presents no uncertainty. It is where classes of beneficiaries are wider and looser that problems of certainty arise and can cause a trust to fail for invalidity. For instance, in R. v District Auditor exparte West Yorkshire Metropolitan County Council (1986) 1 RVR 24, an English Court found a trust, where the class of beneficiaries was expressed as 2½ million inhabitants of West Yorkshire, was invalid as the class was too large and was thus uncertain.

Donations

It follows that a beneficiary by donation mechanism for DBs in a trust deed of a FDT can readily meet the certainty of objects requirement. A person either has or has not made the requisite donation and so the trustee can perfunctorily ascertain that the person is a DB under the mechanism once the person has made the specified donation. Similarly every person who:

  1. has not made the specified donation;
  2. is not named as a DB; or
  3. is not in any other class of DB;

under the trust deed can be categorised not as a DB of the FDT with certainty.

There are limits to this though.

Or just a gift?

Where the beneficiary by donation mechanism in the trust deed is to a charity then the trustee can observe a donation by the prospective beneficiary. Sometimes I have seen trust deeds where the beneficiary by donation mechanism is a minimum donation not to a charity but to a beneficiary of the trust! A question arises here whether a payment of the minimum amount to qualify as a beneficiary under the mechanism is a donation, or is simply a gift (or perhaps a reimbursement agreement! see below), because the recipient beneficiary is not in need. A donation may need to be both a gift and a gift made to a recipient understood by the donor to be in need based on what a donation is commonly understood to be. Beneficiaries of private trusts in Australia are often well-heeled and are clearly not in need.

It may then follow that the donor does not qualify as a beneficiary of the trust because the donor has not made a donation.

Family trust?

Understanding then that an appropriately constructed beneficiary by donation mechanism for DBs in a FDT, which DBs are not necessarily members of the specified DB family in the trust deed, will not compromise the validity of the FDT as a trust, is it still fair to say that a FDT with this mechanism is still a family trust, that is a trust for a family, in substance?

FDTs as matter of course include charities as objects either so:

  • the trustee with discretion to choose who takes trust property can favour a charity as well as or instead of named beneficiaries and their family members; or
  • FDT income or capital does not become bona vacantia. That is before trust property reverts to the state as ownerless when the trustee doesn’t, can’t or doesn’t wish to exercise its discretion to distribute the property to a DB of the FDT, a charity or often a wide range of charities are able to take trust property under the trust deed of a FDT either by exercise of the trustee’s discretion or on default of that exercise without offending the certainty of objects requirement.

So clearly a FDT can still be a “family trust” in substance even though charities beyond the family can also benefit from the largesse of an FDT.

From that perspective it can be seen that a beneficiary by donation mechanism in the trust deed of a FDT, particularly if it is sparingly used by a trustee of a FDT to benefit non-family beneficiaries, is unlikely to make a FDT any less a family trust.

The point of a donation qualification mechanism in a FDT is to ensure the trust is/remains valid even if a person becomes a beneficiary of the trust using the mechanism who is not within the family or other class of who is a beneficiary in the trust deed. Whether a trust is a family trust or not is not pertinent to that.

Schedule 2F (trust tax losses etc.) family trusts

A “family trust” (2FFT) for the purposes of the (trust loss measures in) Schedule 2F of the Income Tax Assessment Act 1936 is a different matter. Sections 272-90 and 272-95 of Schedule 2F include certain specified relations of a test individual as members of a family group. Although distributions to individuals outside of the family group are liable to family trust distributions tax (FTDT) under Division 271 of Schedule 2F at the highest marginal income tax rate imposed on the trustee, trust distributions by a 2FFT to those individuals are not precluded by Schedule 2F either by law or in practice.

It can be seen that, unlike with state stamp duty and land tax surcharge measures which impacted who can be a DB of a FDT, the family trust and FTDT regimes in Schedule 2F do not impact on who can be a beneficiary of a FDT. Where a FDT elects to become a 2FFT, no FTDT arises until the 2FFT makes a distribution to an outsider outside of the family group. It matters not under Schedule 2F who qualifies as a DB of a 2FFT but does not receive a distribution.

If Schedule 2F had instead tax penalised 2FFTs with DBs outside of the family group whether or not distributions were made to them we would have seen the range of beneficiaries of FDTs reduce back to family groups and beneficiary by donation mechanisms superseded.

Reimbursement agreements

Another serious fetter on a trustee of a FDT exercising their discretion to distribute trust income to a DB who qualifies as a DB by using a beneficiary by donation mechanism is the high risk and potential that the Commissioner of Taxation may impose section 100A of the ITAA 1936 to tax the distribution on the trustee also at the highest marginal income tax rate.

A discretionary distribution by a trustee of a FDT to a person who is not a member of the family designated for benefit under the FDT begs the question why the distribution is being made outside of the family to this person. It is unusual that a trustee of FDT would seek to benefit someone outside of that family without the family receiving a quid pro quo in some form.

A quid pro quo grounds a reimbursement agreement which triggers section 100A.

A true gift to the non-family DB and the absence of a quid pro quo are facts the trustee and the family would need to prove, to resist a section 100A reimbursement agreement assessment on the trustee of the FDT. Situations where distributions to DBs who are not members of the family are more likely to be accepted by the Commissioner as not involving a reimbursement agreement include where:

  • the DB is a relation of a family member who is narrowly outside the class of family included as beneficiaries under the FDT;
  • the designated family may have few if any surviving family members; or
  • the DB is a person in need;

or a mix of those circumstances and then a beneficiary by donation mechanism in a trust deed of a FDT that is not a 2FFT may be usable without draconian tax consequences.

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The tax burden of handing over business assets to trust beneficiaries

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Business assets of GST registered entities, including business assets of a business carried on in a trust, attract significant tax concessions and advantages including:

  • income tax deductibility – generally either in the income year when they cost money: notably on purchase, or across their effective life in the case of depreciation; and
  • goods and services tax (GST) credits on GST creditable acquisitions.

It is to be expected that there are clawbacks under the taxation law when a business asset, that has attracted concessions and advantages under the taxation system in anticipation of its productive business use, is transferred to a beneficiary of a business trust that owns the asset for the beneficiary’s private use.

Trading stock taken out of a business for private use

It can be seen with business trading stock, for example, that a strictly market value disposition is taken to occur for income tax purposes when trading stock is taken for private use without regard to the money that may have changed hands. This treatment contrasts with the more flexible choice of actual cost, replacement cost and market selling value that is allowed to a business in determining trading stock on hand: section 70-45 of the Income Tax Assessment Act (ITAA) 1997.

Section 70-90 of the ITAA 1997 includes the market value of trading stock in income assessable to income tax when it is disposed of outside of the ordinary course of business. Section 70-100 can also include the market value of trading stock in the same income where the item, though not disposed of, has ceased to be trading stock.

Handing over depreciable equipment

The balancing charge or adjustment which is assessable to income tax on the disposal of an item of depreciable plant and equipment, such as a car used in the business of a trust, is determined based on its termination value. Where a business (taxpayer) stops holding the item under a non-arm’s length dealing for less than market value, then the item’s termination value is taken to be the market value of the item just before that dealing under item 6 in the table in section 40-300 of the ITAA 1997.

Where business equipment being depreciated by a trust is used privately by a beneficiary of the trust without being disposed of to the beneficiary the item will precipitate a non-deductible private use proportion of use of the equipment. When the item is eventually sold or otherwise disposed of for more than its cost, a capital gain under CGT event K7 attributable to the private use component can arise to the trustee of the trust.

Taxable GST supply without consideration

Generally a supply of property, goods or services by a business that is registered or required to be registered for GST for consideration is a taxable supply. Under section 72-5 of the A New Tax System (Goods And Services Tax) Act 1999 a supply to an associate:

  • not registered or required to be registered for GST; or
  • where the associate acquires the thing supplied otherwise than for a solely creditable purpose;

is treated as taxable supply even when there is no consideration for the supply. The value of a section 72-5 taxable supply without consideration (a price) is the GST exclusive market value of the supply: section 72-10.

Not worth the tax and accounting trouble

It can be seen from the above that taxation consistently based on market value substitution applies to non-arm’s length provision of business assets to beneficiaries of business trusts for the beneficiary’s private use.

The in specie distribution of a business asset of a GST registered trust to a trust beneficiary for no consideration, or an inadequate consideration, (price) is thus discouraged by the clawbacks. There is no apparent tax advantage to a trust in giving an asset to a beneficiary of the trust when the gift is compared to a sale of the asset. A sale raises far fewer tax compliance challenges!

How getting the business asset to the beneficiary might be done?

A less problematic way to achieve the same thing would be for the trustee to simply sell the business asset in the ordinary course of its business to the beneficiary for its market value (plus GST in the case of a sale by a GST registered business trust) and, concurrently make a capital distribution to the beneficiary to cover the price. Then the clawbacks would not need to be endured.

Uneven sharing of the partnership pie – OK for tax?

pie

Anecdotally one hears that many partners of business partnerships, especially husband and wife partnerships, don’t bother with a deed or agreement to record their partnership. These partnerships run some risk that the Commissioner of Taxation won’t accept that a partnership exists and then the onus of proof will be on the “partners” to show that the Commissioner is wrong and that the partnership between them is real.

Demonstrating the partnership

The burden of proof (see our blog post at https://wp.me/p6T4vg-W ) then moves on to the taxpayers asserting their partnership to prove their contribution and involvement in a partnership and their conduct of a business as a partnership. If the supposed partners don’t meet this onus on them, the partnership fails for tax.

The Commissioner usually won’t dismiss a business partnership asserted in a partnership income tax return without a reason for doing so. But lack of a written partnership agreement can be a major driver in cases where the Commissioner does do that.

Income tax effective features of a partnerships accepted for tax

A partner in a tax partnership can broadly offset a loss from the partnership against non-partnership income of the partner for income tax though that capability is now constrained by the non-commercial loss rules in Division 35 of the Income Tax Assessment Act (ITAA) 1997 which apply to both individuals and partnerships.

The ability of partners to share income and losses from a partnership unevenly is both a commercially useful flexibility and a tax effective feature of a partnership.

Uneven shares of tax partnership income and losses

Section 92 of the ITAA 1936 brings to tax a partner’s share of their “individual interest” in the net income of the partnership in an income year. If the agreed split of partnership income and losses between two partners of a partnership is say 75%/25% by agreement between the partners then this can be thus accepted for tax, all else being in order.

In order?

State and Territory partnership legislation provides that:

all partners share equally in the capital and profits of the business, and must contribute equally towards the losses, whether of capital or otherwise, sustained by the partnership

from paragraph 24 of Taxation Ruling TR 2005/7 [footnoting Section 24(I) of the Partnership Act 1892 (NSW); section 28(1) of the Partnership Act 1958 (Vic); section 27(1) of the Partnership Act 1891 (Qld); section 24(I) of the Partnership Act 1891 (SA); section 34(1) of the Partnership Act 1895 (WA); section 29(a) of the Partnership Act 1891 (Tas); section 29(1) of the Partnership Act 1963 (ACT) ]

To achieve an unequal split of income or losses between the partners, the partners must produce an agreement contracting out of this statutory prescribed equal share which applies effectively by default. An obvious instance where this is necessary is when partners have made unequal capital contributions to the partnership and seek to adjust quantum rights to:

  • partnership income and losses; and
  • returns of partnership capital;

accordingly.

Where partners pursuing unequal partnership income/loss entitlements seek:

  • to prove those entitlements to the Commissioner; or
  • to avoid disagreement and dispute with other partners about their share of partnership income or losses;

a written form of the deal setting out the terms of the partnership is essential.

Partner salary

Taxation Ruling TR 2005/7 concerns the taxation implications of ‘partnership salary’. The ruling explains:

 A ‘partnership salary’ is not truly a salary, nor is it an expense of the partnership, but instead is a distribution of partnership profits to the recipient partner. Thus, the payment of a ‘partnership salary’ to a partner, whether or not for personal services provided by the partner, is not taken into account as an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997…

Paragraph 7 of TR 2005/7

At paragraph 10 of TR 2005/7 the Commissioner further states that, to be effective for tax purposes, an agreement to pay a partnership salary must be entered into before the end of the income year in which a claimed partnership salary is drawn.

TR 2005/7 has a number of useful examples of how accounting for a partnership salary can be done in a way that will be acceptable for tax by the Commissioner.

Fights with other partners over entitlements

A partner in receipt of a partnership salary for personal services should thus be mindful that a partnership deed may or will be vital to showing he or she received a partnership salary, as agreed, for those services in fact and that amounts received by the partners were additional, as salary, to and not an advance or drawings of the partner’s statutory equal share of income.

Other problems with partnerships that are not in order for tax

Not partnership salary issues and so not addressed in TR 2005/7 are:

  • where the Commissioner may adjust partnership income of a partner where a partner does not have real or effective control of or of disposal of partnership income using the uncontrolled partnership income provision in section 94 of the ITAA 1936; and
  • where the Commissioner asserts a partnership is a sham: that is, the partnership is without legal effect despite documentation, such as an purported agreement, of it.

Conclusions

It is an imperative that partnerships where a partner or partners:

  • are to receive a partnership salary; or
  • are to participate unequally in income and losses with the other partners for any other reason, including due to disparity in contributions of capital to the partnership of to facilitate partnership salaries;

document the terms of the partnership. A partnership deed or agreement is usually inexpensive and a small price to protect against the above calamities. It is especially important to complete a deed or agreement where there is possibility of dispute between partners as to what their shares of partnership income and losses are to be.

A partnership deed also shows the Commissioner that the partnership is most likely a real structure carrying on a business and that the shares of income and losses partners say they share in and take from the partnership matches what the partners believe them to be and will so return in their partnership income tax returns.

Tax risks of low or zero interest loans to private companies

zero %

Low or zero interest loans (LOZILs) to companies by their shareholders are generally not a tax problem in themselves.

Total Holdings

The well-regarded 1979 Full Federal Court decision in F.C. of T. v. Total Holdings (Australia) Pty. Ltd. [1979] FCA 53 allowed a tax deduction to a holding company for its interest costs of borrowing despite the holding company on-lending the borrowing to its operating subsidiary at zero interest.

The deduction for the whole of interest paid on the borrowing was allowed to the holding company as it could show its purpose in using the money borrowed was to improve the profitability of the subsidiary. That improvement meant an increased likelihood of the holding company deriving assessable dividend or interest income from the subsidiary company.

No Division 7A deemed dividend

When a LOZIL is by a private company to another private company who may either be:

  1. a shareholder of the lender; or
  2. associated with a shareholder of the lender;

the question of whether the LOZIL could be treated as a deemed dividend under Division 7A of Part III of the Income Tax Assessment Act (ITAA) 1936 arises. A LOZIL would not be immune from deemed dividend treatment under section 109M in Division 7A as it would be:

  1. neither a loan in the ordinary course of the business of the lender;
  2. nor on the usual terms on which the lender makes loans to other parties at arm’s length.

However section 109K excludes loans to standalone private companies that are not trustees of trusts from deemed dividend treatment under Division 7A:

A private company is not taken under section 109C or 109D to pay a dividend because of a payment or loan the private company makes to another company.

Note: This does not apply to a payment or loan to a company in its capacity as trustee. (See section 109ZE.)

Section 109K of the ITAA 1936

The protrusive LOZIL

Despite the above low or zero interest marks a LOZIL as uncommercial and potentially attracts greater scrutiny of:

  • the reason for the LOZIL; and
  • the transactions of a taxpayer to which the LOZIL relates;

by the Commissioner of Taxation.

From a company lender’s or a company borrower’s perspectives it is generally preferable that interest is charged and paid to as close to a commercial rate as possible if the Commissioner’s (See my blog “Only a loan? Impugnable loans, proving them for tax and shams” https://wp.me/p6T4vg-8a), non-loan party shareholder’s and creditor’s (interested parties) scrutiny of the loan is not to be attracted.

If, after that, a LOZIL to a company is still thought worthwhile to make then the company should carefully record the purpose of the loan to reduce opportunity for interested parties to allege the LOZIL was made for nefarious or unacceptable purposes to benefit the recipient.

LOZILs as de facto shareholder capital funding

LOZILs are commonly used by shareholders as de facto capital to fund private companies. A LOZIL has the disadvantage that it is not counted in the cost base of the shareholder’s shares for capital gains tax purposes. A LOZIL can complicate the position for shareholders either:

  • looking to sell their shares; or
  • to project a clean balance sheet of the company when the company is looking for more funding.

A tidying up of ad hoc and lazy LOZIL arrangements is frequently a feature of private company funding and restructuring deals.

Loans at will

These LOZILs are typically at will, that is with no set terms either for the payment of interest on the loan or the repayment of principal. They arise often in the void where a private company receiving shareholder funding has omitted to perform a routine share capital issue to the shareholders in exchange for the funding.

When might a LOZIL be a tax problem?

It is not possible to be definitive about when a LOZIL may be a tax problem without understanding the wider context, especially tax avoidance or illegal contexts, of why a LOZIL is being made. Usually LOZILs attract greater scrutiny from the ATO because of their uncommercial character, as stated. A LOZIL often needs to be put in place with some care so what the LOZIL is intended to achieve is above board.

Here are some specific situations where a LOZIL to a company will give rise to tax problems (definitely not an exhaustive list! – this is a list I may add to):

  • a LOZIL by an employer or associate of the employer to a company that is an associate of an employee subject to fringe benefits tax;
  • a LOZIL to a company as trustee of a trust by an outsider to the trust where the LOZIL is productive of scheme assessable income which cannot be applied to reduce trust losses: Division 270 of Schedule 2F to the ITAA 1936; and
  • where there may be cross-border transfer pricing see Draft Practical Compliance Guideline PCG 2017/4DC2.

ZBFF v. C. of T. – AAT finds no loophole at the heart of capital gains tax

… must be one of Wilde’s …

OscarWilde

Oscar Wilde’s quip “no good deed goes unpunished” opened Deputy President McCabe’s decision in the 2 February 2021 Administrative Appeals Tribunal (AAT) case of ZBFF v. Commissioner of Taxation [2021] AATA 275. It prefaced his introduction to the matter at hand in ZBFF: whether a good deed will go untaxed. ZBFF is an insight into the possibility of loophole, or lack of symmetry between assessable proceeds and tax allowable costs, at the heart of the capital gains tax (CGT) provisions of the Income Tax Assessment Act (ITAA) 1997. Lawyers for the taxpayer endeavoured to find what turned out to be elusive before this AAT.

A good deed for an old friend going through a divorce

The good deed for an old friend, whom the AAT referred to by the pseudonym of Mr. Green, was done by the taxpayer (the appellant), a wealthy businessman, who was willing and able to help out Mr. Green on his divorce in 2006. Rather than see Mr. Green lose his home in a divorce settlement, the taxpayer arranged for the taxpayer’s family trust (TFT):

  1. to purchase Mr. Green’s home from Mr. Green for its (2006) value; and
  2. to allow Mr. Green a right of occupancy so he could continue to occupy the home after the TFT’s purchase.

2016 sale of the home for a profit

The TFT sold the home in 2016 and the net proceeds of sale, being the sale price less the TFT’s cost of acquisition and its holding costs, were all paid over to Mr. Green.

The taxpayer and the TFT took nothing and sought to take nothing for their beneficence to Mr. Green.

Mr. Green not taxed on his windfall?

The decision doesn’t say as much, as the case did not concern Mr. Green’s affairs, but it might be presumed that Mr. Green wasn’t taxable or taxed on the proceeds of the 2016 sale (the Net Proceeds) paid over by the TFT to Mr. Green: going untaxed by virtue of the good deed:

Why might Mr. Green escape tax on the Net Proceeds he received? Mr. Green had no property interest or CGT asset in the home from 2006, and it would seem (presumption again) that the Commissioner sought not to assess Mr. Green on a capital gain based on the Net Proceeds he received from the TFT from the standpoint of either or both of CGT event D1 or CGT event H2 occurring. If there had been a capital gain the CGT main residence exemption could not have been applied by Mr. Green in the absence of his ownership interest in the home made out under section 118-130 of the ITAA 1997 from that time.

Instead the taxpayer, as the beneficiary of the TFT entitled, was assessed on an assessable capital gain on the 2016 sale.

In the dispute over this assessment of the taxpayer before the AAT the taxpayer was required to establish the terms of the arrangement with Mr. Green:

  1. which was only partly in writing, having been put to writing sometime after the arrangement was entered into, and otherwise oral; and
  2. the terms of which were contested by the Commissioner.

The AAT accepted that there was an agreement between the taxpayer and Mr. Green as contended for by the taxpayer.

Downside of leaving Mr. Green without rights to the Net Proceeds

Still the absence of a clear term in the arrangement as to what the TFT would do with the Net Proceeds (if any), after already paying the purchase price to Mr. Green back in 2006, a term that may enable the Commissioner to tax Mr. Green on his receipt of the gain; prejudiced the taxpayer who was left with a hard road to establish that the taxpayer, as a beneficiary of the TFT, wasn’t taxable on the Net Proceeds to the TFT unreduced.

The evidence before the AAT was that Mr. Green was willing to let the TFT retain the profits on a later sale, viz. retain the Net Proceeds, but, in the event in 2016, the TFT opted not to retain them. It could be inferred that the payment over of the Net Proceeds to Mr. Green following the sale in due course was a gift to Mr. Green of an amount the TFT was otherwise entitled to keep.

The hard road

Still the taxpayer contended before the AAT that the payment of the Net Proceeds to Mr. Green was a cost to the TFT which:

  • increased the TFT’s cost base of the home;
  • reduced the capital proceeds to the TFT from the 2016 sale; and/or
  • caused the TFT to make an off-setting capital loss;

or, alternatively was a cost to which a deduction under section 40-880 of the ITAA 1997 could be applied by the TFT.

The taxpayer asserted that the payment of the Net Proceeds was fifth element expenditure “to preserve or defend your ownership of, or rights to” the CGT asset which could be included in the CGT asset’s cost base in accord with sub-section 110-25(6) of the ITAA 1997. A difficulty for the taxpayer with his fifth element argument was that the danger identified, supposedly necessitating that the TFT defend its title to the CGT asset, was the equitable interest in the CGT asset Mr. Green might have or assert under his arrangement/agreement with the taxpayer. The AAT rejected this argument as the taxpayer could not establish any interest in the home that Mr. Green might plausibly have.

The AAT disposed of the taxpayer’s other technical arguments that somehow the payment of the Net Proceeds should be allowed to/offset by the TFT to reduce the net capital gain. Some arguments of the taxpayer relied on the taxpayer’s questionable position, given the context of the good deed, that the taxpayer was dealing with Mr. Green at arm’s length.

The arm’s length obstacle

The AAT preferred the Commissioner’s contention that the parties were not dealing at arm’s length, with paragraph 112-20(1)(c) of the ITAA 1997 applicable to include market value, rather than amounts actually paid to Mr. Green, in the TFT’s cost base of the home.

The taxpayer’s contention that section 40-880 applied failed as the taxpayer could not establish, from evidence put to the AAT, that the TFT was carrying on a business and that there was any nexus between the payment of the Net Proceeds and that business.

Symmetry prevails

The taxpayer was hopeful for a mismatch or lack of symmetry between:

  1. those provisions relating to CGT events in the ITAA 1997 that bring capital proceeds into net capital gains and into assessable income in section 102-5 of the ITAA 1997 and then to tax that presumably did not apply to Mr. Green’s receipt of the Net Proceeds on the one hand; and
  2. the provisions which would reduce the assessable capital gain to the TFT on the other hand;

in pursuit of a reduction in the amount of the Net Proceeds assessable to him as a net capital gain by the amount of the TFT’s payment of the Net Proceeds.

According to the AAT in ZBFF the symmetry holds. The payment of the Net Proceeds by the TFT was indistinguishable from a gift by the TFT to Mr. Green in the tax law analysis. Mr. Green may not have been assessable on the gain reflected by the Net Proceeds but the taxpayer/TFT was.

Will the taxpayer, a wealthy businessman who can afford to appeal, appeal to the Full Federal Court?

Determining the AAT fee on a tax appeal to the AAT

The applicable fees to appeal

Unless a taxpayer is disadvantaged and qualifies for a concessional $100 fee – see our blog post: Small business now has its own dedicated taxation division of the AAT at https://wp.me/p6T4vg-dx, fees for review of the Commissioner of Taxation’s decisions reviewable by the AAT are now:

  • $952 for review by the Taxation & Commercial Division; and
  • $511 for for review by the Small Business Taxation Division (SBTD).

These fees have gone up since our blog post in March 2019.

Who can appeal to the SBDT?

As explained in our earlier blog post, appeal to the SBTD is available where the appellant is a small business entity under section 328-110 of the Income Tax Assessment Act (ITAA) (C’th) 1997.  A small business entity is an entity (see section 960-100 of the ITAA 1997) carrying on business with an aggregated turnover of less than $10 million in an income year.

Multiple decisions – single fee on an applicant

Where the appeal is against more than one decision that relates to the appellant, the AAT can allow appeals to be dealt with together so only one fee applies. For instance, if a taxpayer is appealing against decisions to disallow a series of objections against multiple assessments of tax across multiple tax periods then the AAT can apply a single fee.

The AAT also allows for a single fee to be imposed on an “organisation” rather than separately on each of the members of the organisation applying to appeal.

Partnership CGT SBDT appeal

We have a client seeking review of objections against multiple assessments of income tax in the SBTD. The client is a partnership under State law (viz. a general law partnership carrying on business) and is a section 328-110 small business entity eligible to appeal to the SBTD.

The appeal concerns decisions by the Commissioner to disallow objections by the partners against income tax assessments seeking reduction in amounts included as assessable net capital gains to the partners in a series of income years.

Net capital gains made on partnership assets are assessed as income to the partners individually in a partnership. That is capital gains on partnership assets are not included in partnership income nor are they included in a partnership’s income tax return.

Soon after the introduction of capital gains tax (CGT) in September 1985 to include capital gains in assessable income it became apparent that it was impractical to assess partnership capital gains as partnership income to partnerships. Not only is a partnership not a legal owner of partnership property, and thus not apparent as the entity against which to assess a gain on a CGT asset, partnership property is often not owned by partners in the same names or proportions as partners share in the income and losses of the partnership.

Should a single fee have applied to the partnership?

The treatment of a partnership as an entity for some purposes, but not for others, can be confusing. It is via the small business entity regime that our client, a partnership, qualifies as a small business entity and this also impacts how the capital gains on partnership assets in dispute are assessed to the partners. The partnership is an “organisation”. Should a single fee apply to appeals by all of the partners of the partnership relating to the partnership asset CGT issues which are in common to all of the partners?

For the moment the AAT Registry say no. The AAT Registry has sought the $511 fee from each of the partners and has raised the appeals as separate cases (at odds with how the Australian Taxation Office dealt with binding private ruling applications and objections from the client in substance). The AAT Registry have raised the prospect that partners can seek to have their cases combined into one case and can seek a refund of the further instances of the $511 fee at a later point in the proceedings.

If the client is successful in obtaining a refund of the additional $511 fees we will update this story with a comment below.

Offshoring of non-resident capital gains – the India experience of Vodafone and Cairn Energy

LotsOfRupees

Two Indian tax cases that have now largely run their course illustrate difficulties faced by countries determined to tax major economic activity in their own territory by non-residents.

India stands out as a rare jurisdiction determined to tax major foreign investors that greatly gain from economic activity there.

The cases show how difficult it can be to prevent profit shifting to tax havens, such as the Cayman Islands which features in each of the cases considered in this blog. The Cayman Islands is a haven of financial secrecy with no direct resident taxation of companies that can attain Cayman resident status.

The Indian cases have comparable facts and have followed a similar course:

Vodafone

In 2007 Vodafone Group PLC (British) sought to re-organise its nationwide telecommunications business in India. So Vodafone International Holdings BV (VIHBV) acquired the share capital of a Cayman Islands holding company from Hutchison Telecommunication International Ltd giving Vodafone Group PLC 67% control of Hutch Essar, an Indian joint venture company that owned the business’s Indian telecommunications licences.

A “crore” is 107. The Indian Income Tax Department sought to tax VIHBV on a capital gain of around Rs 12,000 crore with penalties on the transfer of telecommunications licences, the capital assets of the Indian business, re-organised between non-residents.

Cairn

In 2006-7 Cairn Energy PLC (British) re-organised the largest privately owned oil and gas business in India by transferring its shares in Cairn India Holdings, a Cayman Islands company to Cairn India, an Indian company.

In 2011 Cairn India merged with Vedanta Resources, another Indian mining conglomerate. The Indian Income Tax Department sought to tax a capital gain of around Rs 24,500 crore on these transfers of the capital assets of the Cairn India business.

Source taxation

The capital gains reflected growth and the increase in value in Indian-based business assets. India sought to subject these Indian-based gains to taxation based on their source in India.

Vodafone contested their assessment and was successful before the Supreme Court of India. The Supreme Court found that the Indian Tax Department couldn’t tax VIHBV, a non-resident, on gains it realised in the Vodafone re-organisation as there was no relevant capital asset of VIHBV of, or facilitation of a look-through to a capital asset in, the Indian Income-tax Act 1961 in its pre-amendment version.

Following that loss in the Supreme Court the Indian government amended the Income-tax Act 1961 with the Finance Act 2012 to retrospectively target indirect gains made by non-residents on realisation of Indian capital assets. Section 9(1)(i) of the Income-tax Act 1961, with retrospective effect from 1961, treats income in the nature of capital gains from the direct or indirect transfers of Indian capital assets between non-residents as Indian-sourced income.

The retrospectivity was justified as a “clarification” of how the Indian tax law is to apply but the impact of the amendment suggest this government descriptor was euphemistic.

Comparison with Australian tax on indirect gains on non-residents’ assets

There is no comparable between Section 9(1)(i) of the Income-tax Act 1961 of India and the Australian and most other taxation systems where source taxation of gains on moveable assets made by non-residents is generally not pursued unless the non-resident has a direct interest in an asset used in a local business permanent establishment.

Australia has conformed with OECD model treaty conventions, and so most Australian treaties are based on, or are comparable to the OECD model convention which provides:

4. Gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State.

Article 13(4) of the OECD model convention

This substantially confines when Australia and these other places will tax non-residents on their disposals of shares in companies. That is the source country only taxes gains on shares of a non-resident who is resident of the other treaty state where shares reflect immovable interests such as in real estate, mines, forests, fisheries etc.

The rationale of the confinement, as I understand it, is to avoid double and multiple taxation arising when countries tax dealings by non-residents outside of, or with no connection to, their own country especially understanding the country where a person is resident is expected to tax the person on their worldwide income. But the confinement in Article 13(4) and the like excludes the right to tax indirect gains enjoyed by non-residents on movable property that does have a true connection with the country such as the movable business property in India of Vodafone and Cairn owned by Cayman Islands companies.

So these treaties don’t concede rights to countries to tax a non-resident to gains on shares reflecting growth in capital assets used in a local business realised indirectly through a sale of company shares of the non-resident. Instead that right to tax is ceded to the treaty partner where the owner of the shares is tax resident in that other country.

Comparison with taxes on business profits under OECD-like treaties

This is in contrast to business profits with a source in, say, Australia where Australia has first right to tax non-residents under OECD model-like articles when a non-resident, though tax resident in the other treaty country, has a permanent establishment in Australia.

In other words Australia, like many other countries but unlike India, generally does not pursue source income taxation of gains on Australian assets of non-residents made outside of a business permanent establishment. Capital gains on Australian assets realised by non-residents, and not just treaty partner residents, that are not Taxable Australian Property (I capitalise this defined term in the Income Tax Assessment Act (ITAA) 1997) are not subjected to the Australian CGT regime under Division 855 of the ITAA 1997 though capital gains of non-residents made on Taxable Australian Property which extends to:

  1. immovable real estate, mines, etc. and interests in them – see section 855-25 of the ITAA 1997: that is, indirect interests in these too are Taxable Australian Property, and options to acquire them; and
  2. assets that are business assets used in permanent establishment though:
    • inclusion of permanent establishment business assets in Taxable Australian Property can be subject to treaty constraints; and
    • indirect interests in business assets used in permanent establishment are not included in Taxable Australian Property;

(see the table in section 855-15 of the ITAA 1997;)

are subject to Australian CGT.

The limits on non-residents relying on treaty protection to resist Australian tax on indirect capital gains are also evident in Australia in Resource Capital Fund IV LP v Commissioner of Taxation [2019] FCAFC 51 which again featured the Cayman Islands. The Full Federal Court found that a Cayman Islands limited partnership with U.S. resident limited partners could not invoke Article 13 in the Australia USA Double Tax Treaty to prevent Australia taxing capital gains on sales of shares in a limited partnership (treated as a company under Australian tax law) which held interests in immovable mining assets in Australia.

Australian opportunities for non-residents and tax havens

Where Australian shares or other business assets aren’t or don’t reflect interests in immovable property or direct interests in permanent establishment assets (other than Taxable Australian Assets in Australia’s case) then Australia and other OECD member states generally don’t look to tax non-residents on gains on them say by imposing withholding taxes to assure collection from non-residents.

It follows that these countries give non-residents based in low-tax jurisdictions, or non-residents who structure their holdings through tax havens, much opportunity to invest in movable Australian assets including brands, digital assets, designs, licences, other intellectual property and goodwill on a virtual CGT free basis.

It is known that the rather extreme minimal or zero tax outcomes these non-residents can access by offshoring their interests are a principal driver of “private equity” opportunities where restructure into, or using, either genuine or contrived non-resident ownership is a common feature.

Desirable destinations for foreign investment

Australia and other OECD nations supposedly encourage and compete for foreign investment by their light touch of capital gains on moveable property connected to local business which non-residents can realise their interests in offshore. Patent boxes, conduit foreign income exemptions, CGT participation exemptions come to mind as light touches on non-residents onshore.

Clearly, and rather dramatically, the Indian government is not so willing to give up the huge tax revenue at stake although there is awareness in India about the impact of their policy of pursuing non-residents for taxes on India-generated capital gains on India as a desirable destination for foreign investment.

The retrospectivity stumbling block

India also tried to introduce General Anti Abuse Rules (GAAR) in 2012 to retrospectively attack the Vodafone and Cairn arrangements however India was not able to implement their GAAR until 2018-19.

The retrospective elements of Section 9(1)(i) of the Income-tax Act 1961 and the proposed GAAR are controversial and the retrospective application of Section 9(1)(i) by the Indian Tax Department, especially with the imposition of penalty, now appears to be its stumbling block in its pursuit of Vodafone and Cairn.

Both Vodafone and Cairn have lately been able to rely on international treaties (not tax treaties) to resist Indian taxation under the retrospective law on the basis that imposition of the retrospective law was unfair and inequitable.

Treaty arbitration

India and the Netherlands entered into a Bilateral Investment Treaty in 1995. In the Vodafone case VIHBV obtained an order against the Indian government for violation of the treaty at the Permanent Court of Arbitration (The Hague, Singapore seat) as the tax, interest and penalties assessed to VIHBV under retrospective legislation violated the fair and equitable treatment of Dutch investment required under the treaty. Simply stated VIHBV was held to account against a tax law that was not in place at the time it undertook Vodafone India re-organisation and when VIHBV would have returned its income in India.

In December 2020, three months after the Vodafone arbitration, Cairn obtained a similar arbitrated order under a similar Bilateral Investment Treaty between the UK and India.

The Indian government can still pursue rights under these treaties to appeal to the High Court in Singapore however they will be aware that this court will be reluctant to disturb Permanent Court of Arbitration findings. Nevertheless it is surprising that both arbitrations treated the Vodafone investment as Dutch and the Cairn investment as British respectively even though the investments in India in both cases were by Cayman Islands entities presumably outside of the coverage of these bilateral investment treaties.

Conclusion

It seems clear enough that countries with the will and fortitude to do so, like India, can impose tax laws which bring gains on offshore holdings of non-residents which indirectly reflect or look through to gains on onshore capital assets used in local businesses to local tax. However these countries will be pitted against powerful interests willing to structure through tax havens and keen to resist taxes relying on any weakness in the imposition of their tax collecting law.

In that context legislation that takes effect retrospectively, even where effective under local law, is a serious flaw in the international treaty domain. Further, like in the Vodafone and Cairn cases, these countries may find tax pursuit of non-residents stymied by:

  1. treaty commitments;
  2. international norms largely set and dominated by the OECD nations; and
  3. reputational risk that the country does not welcome foreign investment;

with tax havens like the Cayman Islands and others ever ready to facilitate offshore realisation of gains effectively tax free for their clients.

Avoiding the igloo – land sold for a GST-inclusive or GST-exclusive price?

AvoidIgloo

A local sale of goods or a supply of services by a GST-registered business will usually be:

  • for a GST-inclusive price/fee; and
  • accompanied by a tax invoice confirming the GST-inclusive price and the 10% (1/11th) GST included in the price/fee.

When to look out for GST on land sales

The price and GST on a sale of real estate in Australia can be far less clear. Although a majority of sales of residential property are not subject to GST, sales broadly of:

  1. new residential premises (where not tenanted for at least five years);
  2. vacant land that can be used for residential development; and
  3. commercial residential premises;

are generally (GST) taxable supplies at settlement where the sale is by a seller who is either registered or required to be registered (perhaps solely required to register due to the sale). There are some exceptions.

Unanticipated GST and reducing GST with the margin scheme

Sometimes the parties can be caught unaware of a GST liability on the land sale or of an opportunity to apply the margin scheme to a sale of residential land under Division 75 of the A New Tax System (Goods And Services Tax) Act 1999 so a GST rate lower than 10% can be applied. A margin scheme rate lower than the 10% rate (or 1/11th of the GST inclusive price) will suit:

  • a purchaser:
    • not entitled to claim a GST credit (purchaser credits are not available when the margin scheme is applied to the purchase) ; and
    • liable for stamp duty calculated ad valorem based on the (lower) purchase price plus GST; and
  • the vendor who receives a higher nett price.

GST-inclusive or GST-exclusive price in the contract?

Normally a price for land is GST-inclusive under a contract in NSW.

Still, a purchaser should be vigilant when purchasing real estate where GST could apply. The current 2019 Law Society NSW and Real Estate Institute NSW contract of sale of land (the NSW contract) now has a number of checkboxes and GST residential withholding details which should indicate if GST is to apply when a proposed contract is received from the vendor. However where vendor agents and conveyancers are unaware or unsure about whether GST applies these can be left unchecked or incomplete when they should be proposed checked and completed.

The general conditions in the NSW Contract state that:

Normally, if a party must pay the price or any other amount to the other party under this contract, GST is not to be added to the price or amount. (Emphasis added)

General condition 13.2

That normal case thus matches a GST-inclusive price one is used to seeing on a tax invoice for goods or services from a supplier. However beware a contract which reveals that the purchaser must pay the price “plus GST” (so the price is GST-exclusive and general condition 13.2 is thus overridden) in a special condition even where less than obviously so: see Booth v Cityrose Trading Pty Ltd [2011] VCAT 278.

The importance of the terms of the contract, and the imperative to pick up an exceptional GST-exclusive special condition, is apparent from the NSW Court of Appeal decision in Igloo Homes Pty Ltd v Sammut Constructions Pty Ltd [2005] NSWCA 280. In that case a price plus GST (GST exclusive) provision in a 2000 edition NSW contract permitted the vendor to recover an additional amount of $250,000 on account of GST even though a series of misunderstandings (or worse) indicated that:

  1. the vendor had put the properties on the market at a price inclusive of GST;
  2. the purchaser had intended the price it offered to be inclusive of GST;
  3. the selling estate agent had intended the price agreed upon to be inclusive of GST;
  4. the selling estate agent was the vendor’s agent for the purpose of negotiating the sale and the price;
  5. the selling estate agent had given written advice to the vendor of the terms agreed;
  6. the vendor’s directors had intended the price to be the price agreed plus $90,909 on account of GST applying the margin scheme;
  7. neither party had intended the price to be the price agreed plus $250,000 on account of GST;
  8. the vendor had settled the sale even though GST of any amount and other amounts due at settlement hadn’t been paid by the purchaser;
  9. at settlement the vendor had accepted the price agreed and undertook to provide a tax invoice; and
  10. the purchaser’s mistake as to the effect of the contract was induced by the vendor’s agent who knew of and intended that outcome.

Contract could not be rectified

The evidence in the case showed that the purchaser did not understand GST and the margin scheme and had not examined the contract to identify the GST-exclusive special condition. It was found that the vendor’s conveyancer’s and the agent’s conduct described above was not so wrongful that the “rectification” of the contract sought on appeal was justified: a rewriting of the contract by the courts to reset the price as GST-inclusive.

Add the GST inclusive amount in the box to avoid an “Igloo”

The 2019 NSW contract includes a box on the front page:

The price includes GST of: $ _________

however the box is marked “optional”. It is in a purchaser’s interests to ensure this box is completed before contracts are exchanged so a purchaser’s liability for a “plus GST” amount above the agreed contract price can be countered for whatever reason.

The margin scheme and the price

One reason the parties may not complete this box is that the parties do or would seek to apply the margin scheme where GST must be charged. Eligibility for the margin scheme and thus a GST rate lower than 1/11th of the sale price is limited – see Eligibility to use the margin scheme at the ATO website. A GST liability under the margin scheme needs to be calculated by the vendor and the vendor may not have performed the calculation in time for the exchange of contracts. A further requirement of using the margin scheme is that the parties must agree to apply it under their contract (another checkbox on the NSW contract).

Under the consideration method for applying the margin scheme, which will usually be the only method applicable to property acquired on or after 1 July 2000, a margin scheme GST is 1/11th of the margin viz. the margin is the difference between the property’s selling price and the original purchase price. That is, the sale price less the purchase price equals the margin.

The GST residential withholding amount when the margin scheme applies

The margin scheme GST and rate differs from the flat 7% GST residential withholding amount which a purchaser must usually withhold at settlement based on the vendor’s notification that margin scheme GST applies on the contract.  GST residential withholding was introduced in 2018 to require a purchaser to withhold an amount to meet the GST on the sale (taxable supply) of residential land at settlement. The GSTRW amount is paid by the purchaser to the Australian Taxation Office at settlement as an approximation of the margin scheme GST with credit given to the vendor for the payment.

The 7% GST residential withholding amount is presently set by sub-sections 14-250(6)-(8) of Schedule 1 to the Taxation Administration Act 1953. Under sub-section 14-250(7) the 7% rate is applied to the “contract price” to determine the amount that must be withheld. It is to be remembered that the 7% is not the GST payable by the purchaser so a calculation treating a notionally GST-exclusive price as the price in the 7% calculation  viz.

notGSTRWcalc

viz. 6.542056075% of the contract price on a supposed GST-inclusive basis withheld as GST residential withholding is not compliant either with this author’s understanding of sub-sections 14-250(6)-(8) or with the ATO website guidance on withholding on GST at Settlement. It should be 7% x Price.