Problems vaguely adding beneficiaries to a trust

I admit to trepidation when I find a trust deed for a family discretionary trust (FDT) has a power allowing the trustee to add anyone as beneficiary of the trust – an add anyone power (AAOP). Why should this be of concern?

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The three certainties

The essentials of a valid trust are certainty of:

1. intention to create the trust;

2. subject matter (trust property); and

3. objects.

Certainty of objects means certainty of beneficiaries of the trust. Potentially a power like an AAOP is not only invalid itself but can invalidate the whole trust causing the trust to fail. In the case of a FDT that means the property is not held for beneficiaries as set out in the deed but is instead returned, or held for return, to whoever gave property on trust to, or settled trust property on, the trustee.

The risk that trust terms of a FDT meant to delineate its beneficiaries may themselves fail can be opaque.

When a trust has certainty of objects

Traditionally, to comply with the certainty of objects essential for a trust, a trustee of supposed trust needed to satisfy the complete list test. That is, for a trust to be valid , the trustee, or a court, had to be able to compile a complete and exhaustive list of all beneficiaries of the trust.

Under the complete list test, a trustee or court needs to able to:

identify all beneficiaries within each class of beneficiary with certainty; and
ensure that no potential beneficiary was omitted or left indeterminate.

A trust with an AAOP clearly fails the complete list test.

The complete list test generally remains critical to trusts including fixed trusts in determining whether a trust has certainty of objects needed for a valid trust.

A dovetail

However, in the latter half of the last century, English courts were confronted with trust terms for discretionary trusts with large or diffuse classes of beneficiaries. These beneficiaries were only to participate in the property of the trust on the exercise of a discretion in their favour. These were not FDTs but discretionary trusts with a wider range of potential beneficiaries whom the founder sought to benefit selectively.

In these cases it was realised that complete list certainty worked well for fixed trusts but worked less well as a way to scope who may be benefit under these kinds of discretionary trusts. There was a tension between the complete list test, and giving wide flexibility in the selection of beneficiaries to take, where a precision more appropriate to fixed trusts was required.

McPhail v. Doulton – the is or is not test adopted in England

So in McPhail v. Doulton [1970] UKHL 1, the House of Lords relaxed the complete list requirement for certainty of objects of a discretionary trust and found that beneficiaries of the trust were sufficiently certain where an is or is not test could be satisfied. That is, a discretionary trust can be valid where it is possible for the trustee of a court to determine if any given person is or is not a beneficiary within the trust terms. This wasn’t an original formulation but drew on the same test applicable to the validity of trust powers which by then had been expressed in Re Gulbenkian’s Settlement Trusts (No 1) | [1968] UKHL 5.

Thus the court in McPhail v. Doulton recognised that a discretionary trust should not simply be treated as a trust but as an exceptional mix of a trust and power/s with the is or is not test relevant to ascertain whether powers granted in trust terms meet certainty of objects standards.

The is or is not test itself needed further elaboration in McPhail v. Doulton. On the remand of the case, in Re Baden’s Deed Trusts (No 2) [1972] EWCA Civ 10, the UK Court of Appeal demarcated between conceptual uncertainty, where it is uncertain a person is a beneficiary under terms, and evidential uncertainty where it is uncertain that a person is beneficiary because it cannot be proven that he, she or it is a member of a conceptually sound class of beneficiaries. It was found that a discretionary trust will fail under the is or is not test in the case of conceptual uncertainty but will not fail in the case of evidential uncertainty unless that uncertainty makes administration of the discretionary trust impracticable.

Applying the is or is not test to an AAOP in a FDT

Where someone can only be a discretionary beneficiary of a FDT on the later exercise of a AAOP by a trustee of a FDT it is impossible to tell, just from the FDT terms, whether or not the person is or is not a beneficiary. It follows that a FDT with these terms fails the is or is not test.

But since McPhail v. Doulton courts have taken a piecemeal approach to the is or is not test focusing on the kind of power the donee of the power can exercise within the framework of the discretionary trust. The focus is then on whether a power or powers within trust terms have sufficient certainty of objects with the level of certainty required depending on the kind of power concerned.

The certainty of objects for different kinds of powers to appoint i.e. give or benefit beneficiaries with trust capital or trust income within a discretionary trust is now generally understood to be:

Power Type	Definition	Key Features
Special Power	A power to appoint property to a defined and limited group of beneficiaries.	Restricted to specific individuals or groups (e.g., “my children”). Requires certainty of class members viz. strict conceptual certainty.
Intermediate (Hybrid) Power	A power to appoint property to a broad class of beneficiaries, subject to exclusions.	Broad, but excludes certain groups (e.g., “anyone except family members”). Requires broad rather than strict conceptual certainty which is enough to establish that a beneficiary is outside of the exclusions. Upheld unless administratively unworkable or legally problematic.
General Power	A power to appoint property to anyone, including the donee of the power.	Unrestricted in scope, effectively ownership rights. No specific exclusions or limitations.

From this table it is evident that where a purely general power of the trustee or other donee can be isolated certainty of objects requirements are even more relaxed to no requirement at all viz. no requirement even to apply the is or is not test which is akin to the unlimited rights an absolute owner of property enjoys.

Extent of invalidation

Does it follow that, in the case of a FDT with an AAOP, the AAOP is a power that can be isolated and considered separately from other powers of the trustee under a FDT? Other powers usually found in a FDT where the is or is not test does apply include the power to appoint income at the end of an income year and the power to appoint capital on the vesting of the FDT to a particular discretionary beneficiary. Further, in the case of an uncertain power, it could be that only the supposed power itself, and not all trust terms, that will be invalid and won’t be exercisable where only the power is uncertain. That is the approach that appears to have been taken in Evans v. Commissioner of Taxation (1988) 19 ATR 1784, (1988) 88 ATC 4771.

In Evans v. Commissioner of Taxation a deed of a FDT gave the trustee a power to add beneficiaries of the FDT in clause 10 of the trust deed in these terms:

At any time prior to the vesting date, the Trustee may, …, by deed … vary any of the trusts, powers, discretion, or duties herein set forth in any manner whatsoever, including … enlarging any category of eligible beneficiaries and adding a further class of eligible beneficiaries, PROVIDED HOWEVER that no exercise of this power of variation shall be capable of conferring any interest in the trust fund upon the Settlor, and any alteration which would otherwise do so shall, to that extent, be ineffective.

Fisher J. of the Federal Court identified the power to add beneficiaries as a hybrid or intermediate power which, without the exclusion of the settlor of the FDT, only slightly differing from a general power which was found not be invalid for these reasons:

On the assumption that the purported addition of Orebody Investments as an eligible beneficiary was prima facie an effective exercise of power under clause 10, counsel contended that the clause was void for uncertainty. He described the clause as conferring a power which was a “hybrid or intermediate power” and was administratively unworkable. He cited McPhail v Doulton [1971] AC 424, especially at 457, and Re Hay’s Settlement Trusts [1982] 1 WLR 202 at 213 as authority for this proposition.

A contrary authority is Re Manisty’s Settlement [1974] Ch 17, a decision of Templeman J (as he then was), which counsel for the Commissioner contended was either distinguishable or ought not to be followed in Australia. In that matter, his Lordship had to consider a power to add to the class of beneficiaries which was said to be an intermediate power and wider than any special power as it was practically unlimited. Thus, it was contended that the power was too wide, uncertain, and invalid. However, he declined to apply the requirement of class certainty to mere powers as opposed to trust powers.

This case and its reasoning have been approved in Australia by the authors of Jacobs’ Law of Trusts in Australia (5th ed, p 345, para 258), and by Professor R. P. Austin in an article entitled “A Survey of Recent Cases in the Law of Trusts.” Likewise, Megarry VC applied Re Manisty’s Settlement in Re Hay’s Settlement Trusts, where at 212 the Vice-Chancellor said:

Nor do I see how the power in the present case could be invalidated as being too vague, a possible ground of invalidity considered in Re Manisty’s Settlement, at 24. Of course, if there is some real vice in a power, and there are real problems of administration or execution, the court may have to hold the power invalid: but I think that the court should be slow to do this. Dispositions ought, if possible, to be upheld, and the court ought not to be astute to find grounds upon which a power can be invalidated. Naturally, if it is shown that a power offends against some rule of law or equity, then it will be held to be void: but a power should not be held void upon a peradventure. In my judgment, the power conferred by clause 4 of the settlement is valid.

It is my opinion that I should refrain from declaring clause 10 void for uncertainty in these proceedings, as sought by the Commissioner, not only because I find in his favour on this aspect of the appeals on another ground but also because the matter was not argued in depth. Furthermore, any such finding could have an impact upon persons not before the court, even though they would not be bound by the finding. I am not considering the matter as a court of construction and hearing all parties interested in various possible interpretations.

Can a trustee of a FDT rely on Evans v. Commissioner of Taxation?

So Evans v. Commissioner of Taxation, a decision of a single judge of the Federal Court, does not purport to be immutable authority on the issue of uncertainty of a wide intermediate or hybrid power was not isolated from the or a general power, such as an AAOP, in a FDT. Further, the correctness of the decision is open to doubt as the intermediate or hybrid power of the trustee: the appoint anyone other than the settlor power in clause 10 of the trust deed, was not isolated from other trust powers/duties of the trustee to which the is or is not test does apply. That is the appoint anyone other than the settlor power in clause 10 cannot be decoupled from the other trust terms which uncertain alteration of who can be a beneficiary impacts including in Evans v. Commissioner of Taxation:

the power to appoint income at the end of an income year: sub-clause 3(a); and
the power to appoint capital on the vesting of the FDT: clause 4;

which were trust duties of the trustee to perform under the deed which each need to comply with the is or is not test and, further, core trust duties on which the validity of the whole trust stands.

Impact of takers-in-default of appointment on a trust power to appoint

My questioning of the decision in Evans v. Commissioner of Taxation relies on an understanding that the power to appoint income at the end of an income year and the power to appoint capital on the vesting of the FDT are trust powers/duties that significantly differ from a general power or a wide intermediate or hybrid power. In an Australian FDT this distinction can be fine because powers to appoint income or capital on vesting in a FDT will generally specify takers-in-default of appointment. However, generally in a FDT, as in McPhail v. Doulton, the presence of gifts over in default of appointment does not eliminate the duty or obligation on the trustee to perform its obligation: that is, to exercise its discretion and select beneficiaries to take. A gift over in default of appointment acts no more than as a failsafe in the event that the trustee fails to exercise its discretion, say in breach of trust. That is a gift over in default gives no liberty to the trustee of a FDT not to exercise their discretion like an absolute owner of property has.

If I am correct and an AAOP with uncertain objects cannot be isolated from obligatory trust powers to appoint income at the end of an income year and the power to appoint capital then it may be possible to manage the certainty of objects by having the trustee (donee) leaving an impugned AAOP dormant. By desisting to use the AAOP the trustee can ensure that beneficiaries selected under the appointment powers continue to meet the is or is not test despite the presence of the AAOP in the trust terms. Perhaps a additional beneficiary or beneficiaries could be added to the FDT is some other way? With the aid of the principle on which Evans v. Commissioner of Taxation, ultimately relies viz.

Dispositions ought, if possible, to be upheld, and the court ought not to be astute to find grounds upon which a power can be invalidated.
supra.

desisiting from exercising the impugned AAOP to add a person as a beneficiary and appointing income or capital to that person may save a trust from invalidity.

Conclusion

It follows that, despite Evans v. Commissioner of Taxation, an AAOP in the trust terms of a FDT may run risk of being invalid with chaotic outcomes where the trust that so fails was thought to hold significant property. Thank kind of clause appears reckless and unnecessary when parameter or parameters of a trust class can be readily designed so that beneficiaries can be added to a trust within the wide certainty that the is or is not test allows.

Some warning about discretionary distribution of trust income to a deceased estate

The principal and controller of a family discretionary trust (FDT) may have died. The trustee of the FDT (Trustee) may be inclined to distribute income of the trust at financial year end (ITFYE) to his or her deceased estate (DE) for two apparent reasons nevertheless:

the Trustee may seek to broadly maintain, at least in transition, the same pattern of distribution of ITFYE to family beneficiaries where the deceased had been a major discretionary beneficiary of the FDT prior to his or her death; and
the Trustee may believe that the DE, as an Australian tax resident DE, has or is expected to have the tax advantage of income tax at rates equivalent to an adult resident individual including the tax free threshold available for three years following death in Schedule 10 of the Income Tax Rates Act (C’th) (ITRA) 1986 (Schedule 10).

But will this distribution of ITFYE to the DE be effective?

A distribution of income of the FDT made both before death and, where permitted by the trust deed of the FDT, the end of the financial year say to a terminally ill beneficiary:

does not give rise the difficulties considered in this blog post; and
can be income of the DE under sub-section 101A(1) of the Income Tax Assessment Act (ITAA) 1936 where the entitlement to ITFYE arose before death (with evidence of a resolution to distribute then) where the beneficiary dies later before the end of the financial year.

However a trustee of FDT may not follow, may not utilise or have the opportunity afforded by a trust deed to distribute current year income of the FDT on a timely basis before the beneficiary dies.

The beneficiary after death?

After the death of a deceased beneficiary:

the deceased is no longer a person, both physically and legally;
the DE arises as a separate entity, including, for income tax purposes: as a trust: paragraph 960-100(1)(f) of the ITAA 1997 and by the inclusion of executors and administrators (of DEs – in the view of the Commissioner of Taxation – ;see below) in the definition of trustee in sub-section 6(1) of the ITAA 1936;
property belonging to the deceased, including any property that would have been due to them after the date of death had he or she survived, constitutes property of the DE; and
that separate entity, the DE, is not ordinarily a beneficiary of the FDT.

The implications of these parameters, and their interplay with the income tax rules relating to distributions of ITFYE of FDTs in particular, need to be examined to better understand whether or not a distribution of ITFYE can be made to a DE.

1. BENEFICIARY NO LONGER LEGALLY A PERSON

In essence a discretionary distribution from a FDT is a gift by the trustee in exercise of a discretion to appoint income or capital of the FDT to a discretionary beneficiary of the FDT. It is fundamental that a deceased person cannot receive a gift. Lord Parker formulated when a gift can be valid this way:

I think, well to bear in mind certain general and perhaps somewhat elementary principles. At common law the conditions essential to the validity of a gift are reasonably clear. The subject-matter must be certain; the donor must have the necessary disposing power over, and must employ the means recognized by common law as sufficient for the transfer of, the subject-matter; and, finally, the donee must be capable of acquiring the subject-matter. If these conditions be fulfilled, the property in the subject-matter of the gift passes to the donee, and he becomes the absolute owner thereof and can deal with the same as he thinks fit. The common law takes no notice whatever of the donor’s motive in making the gift or of the purposes for which he intends the property to be applied by the donee, or of any condition or direction purporting to affect its free disposition in the hands of the donee. It is immaterial that the gift is intended to be applied for a purpose actually illegal – as, for example, in trade with the King’s enemies – or in a manner contrary to the policy of the law – as, for example, in paying the fines of persons convicted of poaching. In either case, the essential conditions being fulfilled, the gift is complete, the property has passed, and there is an end of the matter. A gift at common law is never executory in the sense that it requires the intervention of the Courts to enforce it.

With regard to the conditions essential to the validity of a gift, equity follows the common law. On the one hand, if the subject-matter be property transferable at common law, equity will not as a rule aid a gift which does not fulfil the essential conditions. On the other hand, when the property is transferable in equity only, equity also requires that the subject-matter must be certain, that the donor must have the necessary disposing power, and must employ the means which equity recognizes as sufficient for a of the subject-matter, and that the donee must be capable of acquiring the subject-matter.
Bowman v Secular Society [1917] A.C. 406

A deceased person is not a donee capable of acquiring the subject-matter of a gift in these terms.

This passage remains authoritative and was referred to more recently in Australia in Grain Technology Australia Ltd v Rosewood Research Pty Ltd (No 3) [2023] NSWSC 238.

The beneficiary principle

Any trust, including a FDT, must meet the beneficiary principle:

For there to be a valid trust there must be beneficiary (corporate or human) in whose favour performance of the trust may be decreed unless the trust falls within a group of exceptional anomalous cases when it is valid but unenforceable so that the trustee may perform it if they wish.

which was formulated as far back as Morice v. Bishop of Durham (1804) 9 Ves 399, 405 in these terms:

every other [than charitable] trust must have a definite object

(An object in this context is a cestui que trust viz. a beneficiary.)

Few kinds of trusts can escape the beneficiary principle and must have beneficiaries which are persons. The exceptions include charitable trusts and some other types of trusts for purposes rather than persons. A deceased person is neither.

To emphasize the point let us say a A gives B property on trust to hold for either C, A’s son or D, a blow-up inflatable woman as B shall select in B’s discretion. The prospect that D could potentially take all of the property of the trust can cause the trust to be invalid as it fails the beneficiary principle. If D is, instead, a deceased person then I see the position as indistinguishable.

Doctrine of lapse

The courts apply a doctrine of lapse to a testamentary gift to a person who does not survive the will-maker. Lapsed testamentary gifts to a deceased beneficiary with descendants who survive the deceased beneficiary are saved by “anti-lapse” statute so don’t fail due to lapse. e.g. in NSW, section 41 of the Succession Act 2006.

The doctrine of lapse and anti-lapse statute do not apply to non-will (inter vivos) trusts but the doctrine illustrates how a gift or distribution to a deceased person will fail.

2. THE DECEASED ESTATE ARISES AS A SEPARATE ENTITY TO THE DECEASED

Notionally, at least, a DE can be a trust with a trustee and so could receive a distribution of property from a separate trust such as a FDT.

But, shortly after the death of a deceased, a DE is in its early stages of administration and, until probate is granted viz. the Will of the deceased is “proven”, the DE has no executor and trustee: Income Tax Ruling IT 2622 – Income Tax : Present entitlement during the stages of administration of deceased estates and F.C. of T. v Whiting [1943] 68 CLR 199.

The Commissioner of Taxation states in IT 2622:

5. Even where a will does not envisage the creation of a testamentary trust, the executor must assume a trustee’s fiduciary capacity for some period after death. The responsibilities of the executor are similar to, though legally separate and distinct from, those of a testamentary trustee. The estate represents a legal entity or relationship quite separate from the testamentary trust. In practice it is only in rare cases that two different persons assume the roles of executor and testamentary trustee and, for income tax purposes, the estate and the testamentary trust are treated as one and the same. In fact, the term “trustee” is defined in subsection 6(1) of the Income Tax Assessment Act 1936 (“the Act”) to include persons acting as executors or administrators.
Paragraph 5 of IT 2622

Until a DE has reached the stage of a testamentary trust under the will of the deceased, or until the DE has a trustee once the executor and trustee under the will of the deceased has been granted probate, the DE has no apparent legal standing or business in receiving a distribution from a FDT whatever its entity status for income tax may be.

Let us say this problem of the personality of the DE is overcome and an executor and trustee of the DE can putatively receive a distribution from a trust. Then on what basis can the distribution be made by the FDT to a DE?

3. A DECEASED ESTATE IS NOT ORDINARILY A BENEFICIARY OF ANOTHER TRUST

Usually or frequently a trust deed of a FDT will not name or specify a DE as a beneficiary of the FDT. The trust deed of the FDT could be amended on a timely basis to include a sufficiently administered DE as a beneficiary before a distribution to the DE is attempted.

Alternatively the FDT trust deed may allow for something like a related trusts class of beneficiaries which specifies that trusts, in which named FDT beneficiaries have an interest, are also to be beneficiaries of the FDT. However I understand that a related trusts clause like this will generally be insufficient, by itself, to include a DE of a deceased beneficiary as a beneficiary of the FDT even where, as is likely, the DE will have beneficiaries in common with the FDT. I understand that will be so unless the DE is specifically contemplated in the related trust formulation to be adopted in the FDT The relation that adds beneficiaries of a trust in a related trust beneficiary clause to is given a strict or narrow interpretation by virtue of Attorney-General (NSW) v Perpetual Trustee Co (Ltd) [1940] HCA 12; 63 CLR 209 Dixon & Evatt JJ. stated:

Estates and interests are limited with a view of creating precise and definite proprietary rights, to the intent that property shall devolve according to the form of the gift and not otherwise.
at CLR p. 233

But so naming or explicitly clarifying that a DE as a beneficiary of the FDT has ramifications including ramifications for income tax – I will refer to these ramifications below as the First Ramifications.

Can or should a DE receive the gift or distribution from a FDT?

At the early stage of DE administration an executor seeks probate and then has duties to get the property of the deceased in to his or name and to hold only that property in the DE.

Those duties don’t include getting in property which is not property of, or accruing to the deceased after death because of rights and entitlement of, or connection to the lifetime of, the deceased (Deceased Property).

Once probate of the Will is obtained it is then proper for the Executor to consult the Will which may contain a direction allowing the executor and trustee to receive property other than Deceased Property, including distributions from other trusts, in to the DE. However this has further ramifications including for the same income tax reasons which I will call the Second Ramifications.

In addition to the income tax ramifications I note that the Second Ramifications include:

an executor and trustee of a DE may be unwilling to take on responsibility for property in the DE beyond and extraneous to Deceased Property;
a beneficiary of the DE may not want property other than Deceased Property to be included in the DE; and
the DE may become tainted as it does may not come to wholly hold Deceased Property and so various privileges, concessions and exemptions available to ordinary DEs, including in relation to stamp duty, social security or under foreign tax and investment rules may be lost.

INCOME TAX RAMIFICATIONS

The income tax rates equivalent to adult resident individual rates, including the tax free threshold available for three years following death, in Schedule 10 available to a tax resident DE where the DE is taxed under section 99 of the ITAA 1936 are not available to an executor and trustee of a DE by way of right. Section 99 only applies where the DE negotiates a gateway for section 99 to apply in section 99A.

Generally, in cases where no beneficiary is presently entitled to the income of a trust for an income year, section 99A applies to tax the trustee of the trust at the highest marginal rate of income tax: sub-section 12(9) of the ITRA 1986.

Commissioner’s discretion

The Commissioner of Taxation can determine, in his discretion, that paragraph 99A(2)(a) of the ITAA 1936 is not to apply to a DE when taxing a DE as a trust. Ordinarily, for most DEs, the Commissioner will have no reason to deny section 99/Schedule 10 rates to the executor and trustee. However where the First Ramifications or the Second Ramifications, or both, are applicable to DE then the Commissioner is given reason to deny the concessional section 99/Schedule 10 rates in his consideration of the factors in sub-section 99A(3). Those factors focus on transfers of property between the DE and other trusts explicitly and whether special rights or privileges have been conferred in relation to property in other trusts.

In other words where the Commissioner can form a view that the DE is not wholly comprised of Deceased Property, but includes property transferred in to the DE from other trusts, and that there were clear plans afoot so that could occur, the DE will be treated as a regular trust and not a DE and the ordinary section 99A highest marginal income tax rate will apply to the income of the tainted DE.

Risk to a deceased estate of higher income tax rate

The upshot of a refusal by the Commissioner to exercise the discretion in paragraph 99A(2)(a) would be that the resident trustee of the DE, as a resident taxpayer, would lose entitlement to adult resident income tax rates and would be taxed at the highest marginal rate on income to which no beneficiary is presently entitled.

Shortly stated it would mean that a resident DE that receives a transfer of property from another trust, such as a FDT, risks losing DE status for tax because the property held in the DE does not wholly comprise Deceased Property.

Can or should a discretionary trust distribute to someone who has died?

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These days trust deeds (Deeds) of family discretionary trusts (FDTs) frequently allow a trustee of a FDT to distribute to a trust as a beneficiary (TAAB) where the TAAB has a beneficiary or beneficiaries in common with the FDT. So could it be that, once a named beneficiary of the FDT has died, their deceased estate qualifies under a TAAB formulation in the Deed without need for alteration of the Deed.

Or a trustee of a FDT may just decide to distribute to a beneficiary who has died.

Valid gifts

Pursuing these aims may overlook an important principle. Beneficiaries of non-purpose trusts must be persons who are human (alive) or other legal persons e.g. companies. A clear expression of when a gift is valid is in Bowman v, Secular Society:

I think, well to bear in mind certain general and perhaps somewhat elementary principles. At common law the conditions essential to the validity of a gift are reasonably clear. The subject-matter must be certain; the donor must have the necessary disposing power over, and must employ the means recognized by common law as sufficient for the transfer of, the subject-matter; and, finally, the donee must be capable of acquiring the subject-matter. If these conditions be fulfilled, the property in the subject-matter of the gift passes to the donee, and he becomes the absolute owner thereof and can deal with the same as he thinks fit. The common law takes no notice whatever of the donor’s motive in making the gift or of the purposes for which he intends the property to be applied by the donee, or of any condition or direction purporting to affect its free disposition in the hands of the donee. It is immaterial that the gift is intended to be applied for a purpose actually illegal – as, for example, in trade with the King’s enemies – or in a manner contrary to the policy of the law – as, for example, in paying the fines of persons convicted of poaching. In either case, the essential conditions being fulfilled, the gift is complete, the property has passed, and there is an end of the matter. A gift at common law is never executory in the sense that it requires the intervention of the Courts to enforce it.

With regard to the conditions essential to the validity of a gift, equity follows the common law. On the one hand, if the subject-matter be property transferable at common law, equity will not as a rule aid a gift which does not fulfil the essential conditions. On the other hand, when the property is transferable in equity only, equity also requires that the subject-matter must be certain, that the donor must have the necessary disposing power, and must employ the means which equity recognizes as sufficient for a of the subject-matter, and that the donee must be capable of acquiring the subject-matter.
[1917] A.C. 406 per Lord Parker

This passage remains authoritative and was recently referred to in Grain Technology Australia Ltd v Rosewood Research Pty Ltd (No 3) [2023] NSWSC 238

Doctrine of lapse

This is comparable to and consistent with the doctrine of lapse which applies to testamentary gifts in Wills to persons who do not survive a testator by thirty days. Lapsed testamentary gifts under a Will to a legatee who is a child of the deceased who have children themselves are saved by statute and pass to his or her descendants so the gift won’t fail due to lapse: in NSW, section 41 of the Succession Act 2006.

So a gift to someone who has died generally fails.

Gifts to deceased estates

A gift to a deceased estate does not fail or necessarily fail where the deceased estate is a trust with a trustee. But before a will of a deceased person is proven and admitted to probate there is no trust.

These may be matters of consequence where the gift is litigated or in the event of a dispute with the Commissioner of Taxation. However specific tax rules can make the question of whether or not a gift fails inconsequential as the income tax legislation applies similarly where an Australian resident FDT attempts to distribute income to a resident deceased estate.

Income tax problems with distributions of trust income to deceased estates

An executor/trustee of an estate of a deceased person admitted to probate may or may not accept a distribution from a FDT. If the executor/trustee of the deceased estate (ETODE) accepts the distribution as a gift from the FDT, the trustee of the FDT and the ETODE face these income tax disadvantages:

until there is a valid gift to a TAAB that exists no beneficiary of the deceased estate is presently entitled to a distribution of income from the FDT. So, even though a distribution of income by a FDT is made to immediately benefit deceased estate beneficiaries, sub-section 99A(4A) of the Income Tax Assessment Act (ITAA) 1936 applies to tax the trustee of the FDT on income of the FDT to which no beneficiary is then presently entitled at the highest personal rate of income tax where the deceased estate is not a trust by the end of the income year in which the distribution is made;
in any case section 101A of the ITAA 1936 operates to ensure that income received by the trustee of a deceased estate, that would have been income of the deceased had it been received during the lifetime of the deceased, is treated as income of the FDT to which no beneficiary is presently entitled such that the income is taxed to the trustee of the FDT at the highest personal rate of tax under sub-section 99A(4A) – the same result; and
on accepting the distribution the ETODE runs a risk that the Commissioner of Taxation will not exercise the discretion in section 99A(2) to apply the lower rates of income tax applicable under section 99 such that the highest personal rate of income tax can apply to income of the deceased estate to which no estate beneficiary is presently entitled in periods before the deceased estate is fully administered. This risk of denial of lower section 99 rates to a deceased estate arises in cases where an ETODE mixes property which the deceased held or was entitled to on their death with property that is not.

So an income distribution by a FDT to a deceased estate can not only attract the highest personal rate on the income to the trustee of the FDT. The integrity of the deceased estate and income tax on other income of the ETODE unrelated to the distribution can be impacted too.

Conclusion

Reasons why a someone would want to make a gift to a deceased person after they have died or why a trustee of a FDT would want to make a distribution to a deceased estate TAAB are not obvious. Whatever they are they are unlikely to be tax effective.

Perils travelling to your SMSF’s overseas residential property investment

across the border - icon created by Three musketeers - Flaticon

Will a self managed superannuation fund (SMSF) investment in an overseas apartment or investment property open up assisted overseas travel opportunities for the members of the SMSF? Can or should the SMSF reimburse the members who travel to an overseas residential property (ORP) to improve, maintain or to get the ORP ready for letting, for their travel costs? Are the travel expenses deductible to the SMSF or to SMSF members who incur them?

Deductions

These expenses are not deductible to a SMSF member as they are not incurred in earning assessable income of a SMSF member. Rental income earned by a SMSF is not income of a SMSF member. It follows only the SMSF earning the rental income is placed to deduct its expenditure on earning its assessable income under section 8-1 of the Income Tax Assessment Act (ITAA) 1997 (see the Kei example given by the Australian Taxation Office (ATO) at Rental properties and travel expenses | Australian Taxation Office https://is.gd/mucEvN ) while the SMSF is in accumulation phase.

Limits on travel expenses to income earning residential properties

Since 2017 travel expense deductions, that might have been deductible under section 8-1 before then, have been restricted by section 26-31 of the ITAA 1997 which provides:

Travel related to use of residential premises as residential accommodation
(1) You cannot deduct under this Act a loss or outgoing you incur, insofar as it is related to travel, if:
(a) it is incurred in gaining or producing your assessable income from the use of residential premises as residential accommodation; and
(b) it is not necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.
Exception–kind of entity
(2) Subsection (1) does not stop you deducting a loss or outgoing if, at any time during the income year in which the loss or outgoing is incurred, you are:
(a) a corporate tax entity; or
(b) a superannuation plan that is not a self managed superannuation fund; or
(c) a managed investment trust; or
(d) a public unit trust (within the meaning of section 102P of the ITAA 1936); or
(e) a unit trust or partnership, if each member of the trust or partnership is covered by a paragraph of this subsection at that time during the income year.
section 26-31 of the ITAA 1997

SMSFs earning residential rents are more likely to be, and be treated as, investors and not business operators and in those cases the SMSF won’t carry on a business that satisfies the negative limb of paragraph 26-31(1)(b) meaning travel expense deductions will indeed be constrained by section 26-31.

and see:
Rental properties and travel expenses | Australian Taxation Office https://is.gd/mucEvN

How about the SMSF earning residential rental income through a business?

Generally SMSFs are poorly placed to carry on a business of earning rents from its residential properties:

for regulatory reasons: see: Carrying on a business in an SMSF | Australian Taxation Office https://is.gd/ildkCR; and
for structural reasons including scale and other reasons considered in:
1. Taxation Determination TD 2011/21 Income tax: does it follow merely from the fact that an investment has been made by a trustee that any gain or loss from the investment will be on capital account for tax purposes?;
2. Commissioner of Taxation v. Radnor [1991] FCA 499; and
3. section 295-85 of the ITAA 1997 under which capital gains tax, as it applies to investors, is specified as the primary income tax code applicable to complying superannuation funds (CSFs).

How about the SMSF earning income from use of the ORP as an airbnb or similar?

Under the goods and services tax rules residential premises, rents from which are input taxed, are distinguished from commercial residential premises such as motels and the like where tariffs are for taxable supplies of accommodation. But even if the ORP of a SMSF is commercial residential premises for GST purposes this does not mean they are not residential premises for the purposes of section 26-31.

The A New Tax System (Goods And Services Tax) Act 1999 provides:

Residential rent

(1) A supply of premises that is by way of lease, hire or licence (including a renewal or extension of a lease, hire or licence) is input taxed if:

(a) the supply is of residential premises (other than a supply of commercial residential premises or a supply of accommodation in commercial residential premises provided to an individual by the entity that owns or controls the commercial residential premises ); or

(b) the supply is of commercial accommodation and Division 87 (which is about long-term accommodation in commercial premises) would apply to the supply but …
sub-section 40-35(1) of the A New Tax System (Goods And Services Tax) Act 1999

which shows that, even for GST purposes, commercial residential premises is not a carve out from residential premises as such but the GST legislation differentiates only for specific purposes, viz. those in section 40-35, where supplies of residential premises that are not commercial residential premises are input taxed.

So an ORP used as an airbnb or similar can still be residential premises for the purposes of paragraph 26-31(1)(b) even though they may be commercial residential premises to which paragraph 40-35(1)(a) of the A New Tax System (Goods And Services Tax) Act 1999 may apply.

Can the SMSF meet the travel expenses in any case even when they are non-deductible for income tax?

A trustee of a SMSF may consider:

paying the cost of the flight directly; or
reimbursing the director/s but on a non-deductible basis.

But these concerns with the SMSF meeting the travel costs also need to be considered:

the expense may not be incurred on an arm’s length basis as required under section 109 of the Superannuation Industry (Supervision) [SIS] Act 1993;
the expense and other circumstances of the investment in ORP may indicate that the investment in ORP is not being maintained for the purposes listed under section 62 of the SIS Act; or
the expense may be a non arm’s length expense (NALE) viz. a loss, outgoing or expenditure caught by the non arm’s length income (NALI) rules in section 295-550 of the ITAA 1997 applicable to complying superannuation entities including SMSFs either in accumulation phase or pension phase.

Following the Treasury Laws Amendment (Support for Small Business and Charities and Other Measures) Act 2024 a NALE is taxed to the SMSF at the highest marginal rate based on twice the difference between the NALE incurred and what would have been incurred had the SMSF met the NALE on an arm’s length rate: see new sub-section 295-550(8) of the SIS Act. The first two infractions viz. the arm’s length requirement in section 109 and the sole purpose test in section 62, have potentially wider and more serious ramifications.

Actions the ATO can take against trustees of SMSFs

Section 62 should only apply where a SMSF acquires and holds ORP seemingly as a lifestyle choice, that is for the use or enjoyment of members rather than to provide for the retirement, permanent incapacity or for dependents on death of members being the sole purposes for which regulated superannuation funds can invest.

SMSF funded travel expenses so a member, family and friends can travel to an ORP to stay can stand out to the ATO as the use of the ORP as lifestyle asset diverging from permissible purposes.

As the regulator of SMSFs, the ATO can:

apply to an Australian superior court to impose civil penalties on the trustee/s or its director/s of the SMSF (SMSFTsDs): section 197 of the SIS Act 1993 for breach of a civil penalty provision: section 193, further bearing in mind that an Australian superior court can impose criminal sanctions on SMSFTsDs where the court finds a breach of a civil penalty provision involve dishonesty for financial gain, deception or fraud: section 202 of the SIS Act 1993; and/or
determine that a SMSF is a non-complying fund due to contravention of a civil penalty provision: paragraph 39(1)(b) and section 42 of the SIS Act 1993.

Should the ATO go to court then fines for breach of a civil penalty provision can easily be around $20,000 per breach and other orders, such as education orders, can be made, and the trustees/ directors can be disqualified from acting as SMSFTsDs.

Meeting travel expense in a SMSF – rethink

So, given all this can occur, hard questions should be asked before a SMSF meets travel costs of member or related party of a SMSF to visit an ORP.

Could the visit to the ORP for inspection, maintenance or investment evaluation have been done by a locally based professional or tradesperson at arm’s length from the SMSF where no or negligible local travel costs would have been incurred?
What did the member do other than these activities on the overseas journey to the ORP?
What tariff did the member pay where the member or their related parties where accommodated at the ORP?
Why was an ORP, which is more challenging to inspect and maintain from a distance, chosen as a preferred investment in line with the investment strategy of the SMSF?

Non-compliance – loss of nearly half a SMSF’s assets in income tax

Where a SMSF is made non-complying by the ATO then item 2 of table in section 295-320 of the ITAA 1997 applies which broadly brings the assets in the SMSF as a non-CSF that was previously a CSF to income tax at, presently, a 45% rate. From then on, while the SMSF remains a non-CSF, that rate applies to income of the SMSF.

The range of outcomes that can happen where SMSFTsDs breach the SIS Act 1993, including the 45% tax on all assets, is considered in this video from the ATO: SMSF – What happens if your fund breaches the law? – ATOtv https://is.gd/YQSRJE .

Disproportionate consequences

So there is risk of significant and disproportionate consequences where travel costs are subject to ATO review or audit. It is up to the trustee of the SMSF as to how this risk is best dealt with.

It follows that if there is payment for or reimbursement to the directors it should be scrupulous – backed by strong reason as to the imperative for a member to attend an ORP in person with costs carefully apportioned where there is any private component with no tax deduction claimable by the SMSF unless section 26-31 of the ITAA 1997 can somehow be addressed.

Icon created by Three musketeers – Flaticon

Investing in real estate with a SMSF – traps & entanglement

There is more to investing in real estate together with a self managed superannuation fund (SMSF) than meets the eye. It can be fraught and illegal under SMSF rules. This blog looks at why.

Joint tenancy ownership compared to ownership by tenants-in-common

The title of this blog piece does not refer to investing jointly with a SMSF and this is deliberate. Co-ownership of land can be joint: viz. as joint tenants, where a surviving joint owner or owners take the interest of a joint owner who dies, or can be as tenant/s-in-common (TsIC) where each co-owner owns a discrete co-ownership interest in a fixed proportion of the whole outright ownership interest in the land which, in the case of an individual on his or her demise, will form a part of his or her estate just as an interest in land owned by a sole individual owner would.

Which type of ownership works where a (trustee of a) SMSF is a co-owner?

Joint tenancy is usually only appropriate for life partners. Investing in a joint tenancy can also work for joint trustees of a trust where, on the death of a trustee, it is appropriate that the property be legally owned by surviving trustee/s.

The point here is joint tenancy is inapt and inappropriate investing between a member of a SMSF and the SMSF obliged to deal on arm’s length basis under section 109 of the Superannuation Industry (Supervision) Act (C’th) 1993 (SIS Act) with all parties including the member when co-ownership of an asset is under contemplation. A SMSF needs to acquire assets at arm’s length and assets acquired need to have a discrete integrity which joint tenancy ownership doesn’t give.

So, if there is to be co-ownership between members or related parties and a SMSF investing in land, it needs to be as TsIC.

Related parties of a SMSF include:

relatives of the Members (spouse, children, siblings, etc.);
the (business) partners (Partners) of the Members;
the spouse and children of the Partners;
companies (Companies) controlled by the Members or any of the above (Associates);
the members of the SMSF (Members) themselves; or
trusts controlled by the Members, Associates and Companies.

(See Part 8 associates in Sub-division B of Part 8 of the SIS Act.)

Co-ownership of land between SMSF members and the SMSF as tenants-in-common

There is a further trap where SMSF members or other related parties and a SMSF contemplate co-ownership of land as TsIC where the land is residential property (RP):

Prohibition on acquisition of assets from superannuation fund members and related parties

With very limited exceptions, real estate with a residence cannot be business real property (BRP): see Self Managed Superannuation Funds Ruling SMSFR 2009/1 Self Managed Superannuation Funds: business real property for the purposes of the Superannuation Industry (Supervision) Act 1993. A SMSF cannot acquire an asset from a related party of the SMSF (section 66(1) of the SIS Act) unless an exception applies such as the exception for BRP (permitted under para 66(2)(b) of the SIS Act).

A breach by a trustee of a SMSF of section 66 can result in criminal prosecution and imprisonment of the individual trustee/s or director/s of the trustee (TEsDRs), as the case may be, for up to one year (sub-section 66(4) of the SIS Act).

It follows that the trustee of a SMSF cannot, or likely cannot, lawfully acquire RP already owned by a member/related party of the SMSF unless the RP is BRP. This prohibition works in substance as schemes that have the result that RP of a member/related party of a SMSF is acquired by a SMSF, say indirectly via sale to the SMSF and then purchase back by the SMSF from an intermediary unrelated to the SMSF, are also caught by section 66 and are similarly prohibited: sub-section 66(3).

Implications for related co-owners who own RP as tenants-in-common with a SMSF

This has further implication when RP is acquired and co-owned where a SMSF is an established co-owner: let us say where the RP is purchased in an arm’s length sale on the open market.

The SMSF owns a part of the RP as a TsIC but section 66 prohibits the SMSF from buying more of the RP from the related TsIC who is now a co-owner too. That further purchase would be acquisition of an asset from a member/related party. The same anti-scheme rule in sub-section 66(3) again applies to prevent the SMSF acquiring a further interest owned by a related party as a TsIC indirectly through a scheme.

An unsatisfactory entanglement

So the entanglement of a related party in the ownership of RP effectively prevents the SMSF from ever owning the whole of a RP it invests in as TsIC with a related party. This bears on, or should have borne on, the investment decision of the SMSF trustee to invest in the RP in the first place.

Entanglement gets worse when a SMSF has individual trustees and these individual trustees are members of the SMSF with whom the SMSF co-invests in RP. Under land law in most Australian states and territories only these individuals appear on title as registered owners of the RP. Without further steps, such as registering a caveat, the trustees of the SMSF, obliged to act at arm’s length from themselves, are poorly placed to assert co-ownership of the RP by the SMSF and to comply with mandatory covenants applicable to a SMSF including:

(b)   to exercise, in relation to all matters affecting the fund, the same degree of care, skill and diligence as an ordinary prudent person would exercise in dealing with property of another for whom the person felt morally bound to provide;

…

(d)   to keep the money and other assets of the fund separate from any money and assets, respectively:

(i)   that are held by the trustee personally; or

(ii)   that are money or assets, as the case may be, of a standard employer – sponsor, or an associate of a standard employer – sponsor, of the fund;

(e)   not to enter into any contract, or do anything else, that would prevent the trustee from, or hinder the trustee in, properly performing or exercising the trustee’s functions and powers;
from sub-section 52B(2) of the SIS Act

Entanglement disrupting sale of the TsIC interest by a SMSF

An investment in an asset which is not discretely saleable raises further section 52B covenant difficulty. The section 52B covenants continue:

(f)   to formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the fund including, but not limited to, the following:

(i)   the risk involved in making, holding and realising, and the likely return from, the fund’s investments, having regard to its objectives and its expected cash flow requirements;

(ii)   the composition of the fund’s investments as a whole including the extent to which the investments are diverse or involve the fund in being exposed to risks from inadequate diversification;

(iii)   the liquidity of the fund’s investments, having regard to its expected cash flow requirements;

(iv)   the ability of the fund to discharge its existing and prospective liabilities;
paragraph 52B(2)(f) of the SIS Act

Investing in a marooned asset

So does a trustee of a SMSF who invests in a asset that is marooned, because it can’t be readily sold without the co-operation of a co-owner or co-owners also selling, adequately deal with the risks referred to in paragraph 52B(2)(f)? Assumption that a related party TsIC will always co-operate with a co-owner trustee of a SMSF TsIC is incompatible with the section 109 of the SIS Act obligation of the trustee to act an arm’s length basis in its dealings including dealings with related parties.

Based on the section 52B covenants and section 109 the trustee/s of a SMSF should establish proper motive for making an investment as a co-owner in RP. To do that there likely needs to be either an exchange of:

tag along drag along rights; or
rights to require other TsICs to buy each other out of their interests;

so the SMSF can realise its investment in a TsIC investment interest in RP when it needs to meet its s52B(2)(f) covenants without being marooned in the investment.

The mandatory covenants in section 52B on trustees of SMSFs are between the trustee/s of the SMSF and the members of the SMSF. When they are the same people there are only occasional cases where a member would sue trustees for breach. The covenants are not civil penalty provisions.

Civil penalty provisions

In the SIS Act civil penalty provisions have these potential consequences for SMSFs:

breach can lead to the Australian Taxation Office as SMSF regulator (ATO as R) issuing a notice of non-compliance (NONC) to a SMSF so it is no longer a complying superannuation fund where:
1. non-complying superannuation funds pay 45% income tax on their assessable income; and
2. the assessable income of a fund that becomes a non-complying superannuation fund under a NONC must include the value of the assets of the fund, less undeducted contributions, at the beginning of the income year when the fund becomes non-complying. This is a significant penalty as it effectively taxes the fund’s accumulated assets at the 45% rate: see Subdivision 295-E of the Income Tax Assessment Act 1997.
intentional breach can result in criminal prosecution of TEsDRs: section 202 of the SIS Act;
administrative penalties on TEsDRs (in less serious cases taken not to warrant the above): s166 of the SIS Act; and
the ATO as R can give the TEsDRs directions to rectify (section 159 of the SIS Act) the breach or educational directions (section 160 of the SIS Act).
Consequences 1 to 3 don’t apply to a breach that is solely or simply a breach of the section 52B mandatory covenants. Consequences 4 can happen though: the ATO as R can give TEsDRs a direction to rectify requiring sale of a marooned TsIC interest acquired in RP in breach of the covenants in paragraph 52B(2)(f).

Sole purpose fails

Even where the RP is let out under a lease entirely at arm’s length to an arm’s length tenant there could still be a sole purpose civil penalty provision problem under section 62 of the SIS Act where the purpose of an investment by the SMSF in RP was not so much to generate returns to the SMSF, or to assist a SMSF to fund the payment of SMSF benefits to members, but rather to finance SMSF member acquisition of an investment property. Not bothering to arrange the above rights for the SMSF amplifies the prospect that a SMSF auditor or the ATO as R will reach that conclusion about the illicit purpose of the trustee/s of the SMSF.

Where the RP is acquired for a member or related party of the SMSF to live in then breach of the section 62 civil penalty provision will be yet more serious and clear cut.

Entanglement of financing

The need for a SMSF member and SMSF co-investors in RP as TsIC to co-operate extends further. The SMSF member borrowing with recourse or security over the property can amount to a charge over the property breaching SIS Regulations 13.14 and 13.15 and, where the recourse or security is called in, the SMSF might find itself co-investing with a financier eager to sell up the RP. In June 2011 the Commissioner and tax professionals considered these issues which were reported in National Tax Liason Group technical minutes. These can be difficult to locate on the somewhat dynamic Australian Taxation Office website so we have uploaded a copy here

It follows that a mortgage can’t be given to the financier of the co-owning member/s of the SMSF over the RP co-owned by the SMSF. Giving security over the TsIC interest only of the member/s of the SMSF who borrow only may be possible but that security needs to be carefully target only the borrower’s TsIC interest so that it has no reach to impact or to give any recourse against the TsIC interest of the SMSF in the RP.

Unit trust alternative?

Investment of more than 5% of a superannuation fund in in-house assets under Part 8 of the SIS Act can give rise to breach of a civil penalty provision with the potential Consequences 1-4 described above: section 84 of the SIS Act.

In 1999 the meaning of in house asset was widened to curtail significant investment by SMSFs in particular in related unit trusts. A popular strategy, to establish a unit trust to hold RP in which SMSFs and their related parties could hold units, could no longer be used without running into an in house asset problem. A carve-out to in house asset treatment was extended in Division 13.3A–In-house assets of superannuation funds of the SIS Regulations for companies and unit trusts that:
- are continuously non-geared, that is never have liabilities;
- have assets that are not investments in other entities;
- do not conduct a business; and
- neither lend nor borrow
so that SMSFs could invest in shares or units in them without these being in house assets.

An exception in sub-paragraph 66(2A)(a)(iv) of the SIS Act means that investment in say a SIS Regulation 13.22C non-geared unit trust to hold RP is not only excluded from being an in-house asset under paragraph 71(1)(j), but its acquisition from a related party is not prohibited under sub-section 66(1).

Non-geared unit trust compared to co-investing in residential property as tenants-in-common

This is a significant advantage over investing in an interest as a TsIC in RP. So a SIS Regulation 13.22C non-geared vehicle should be seriously considered as an alternative to investing with a related party in RP as a TsIC. Still a SIS Regulation 13.22C non-geared unit trust is nevertheless a challenging structure for indirect SMSF investing in RP as:
1. the compliance requirements, especially those that cause abrupt loss of the in house asset exclusion in SIS Regulation 13.22D are daunting (albeit the problems with investing as a TsIC in RP are covertly so and are all across the SIS Act , as this post illustrates); and
2. units in a non-geared unit trust that don’t amount to all of the units in the trust still have the same propensity to be marooned assets of the SMSF unless the investing SMSF can compel all other unit holders to buy or drag along when the SMSF needs to realise its investment.

When can a trustee favour itself as a beneficiary of a family discretionary trust?

Usually but the answer is nuanced. It is often claimed that a trustee exercising a discretion [Discretion] to favour himself/herself/themselves/itself (HHTI) as a beneficiary of a family discretionary trust (FDT) is acceptable but legal authority for the claim isn’t given. Even the Australian Taxation Office distills the proposition to a sentence. They say:

The trustee may also be a beneficiary, but not the sole beneficiary unless there is more than one trustee.
Trusts, trustees and beneficiaries | Australian Taxation Office

To be fair this comment by the ATO mainly concerns the merger of trusts (considered in our blog post at Bringing trusts to a timely ending ) so maybe full accuracy shouldn’t be expected on the subsidiary point they raise about whether a trustee of a trust may be a beneficiary of the trust.

Conflict of interest

Is not the trustee exercising a Discretion to favour HHTI in a position of conflict of interest? Shouldn’t there be control over a trustee of a trust limiting when the trustee of a trust can exercise the Discretion to favour the trustee?

A primary concern for a trustee who exercises the Discretion is successful suit by a disgruntled beneficiary (DB) where the trustee distributes income or capital of the trust to HHTI instead of to the DB. Another concern is whether the trust is real or a sham: a trustee taking property held on trust for HHI is inconsistent with holding the property on trust.

Fiduciaries

Has a trustee who has done this breached a fiduciary duty?

A trustee is a fiduciary. The law imposes strict standards on a fiduciary:

It is an inflexible rule of the court of equity that a person in a fiduciary position, such as the plaintiff’s, is not, unless otherwise expressly provided, entitled to make a profit; he is not allowed to put himself in a position where his interest and duty conflict. It does not appear to me that this rule is, as has been said, founded upon principles of morality. I regard it rather as based on the consideration that, human nature being what it is, there is danger, in such circumstances, of the person holding a fiduciary position being swayed by interest rather than by duty, and thus prejudicing those whom he was bound to protect. It has, therefore, been deemed expedient to lay down this positive rule.
Lord Herschell in Bray v. Ford [1894] AC 44

and

It is perhaps stated most highly against trustee or director in the celebrated speech of Lord Cranworth L.C. in Aberdeen Railway v. Blaikie, where he said: “[a]nd it is a rule of universal application, that no one, having such duties to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting, or which possibly may conflict, with the interests of those whom he is bound to protect.
Lord Upjohn in Boardman & Anor v. Phipps [1966] UKHL 2; [1967] 2 AC 46 at page 124

A trustee who exercises the Discretion to favour HHTI can be exposed to suit for breach of fiduciary duty under this line of legal authority.

Impartiality

Another duty of a trustee of a trust is to act impartially between beneficiaries. This duty was described in Cowan v. Scargill:

The starting point is the duty of trustees to exercise their powers in the best interests of the present and future beneficiaries of the trust, holding the scales impartially between different classes of beneficiaries. This duty of the trustees towards their beneficiaries is paramount.
Cowan v. Scargill [1985] Ch 270 at 290-292 (Megarry VC)

Context of trustee power

One may infer from the nineteenth century case authorities cited, in particular, that these duties apply universally to all trustees. The inference is incorrect. In Bray v. Ford the exception ”unless otherwise expressly provided” is significant. Inquiry is needed into the the power given to the trustee to understand whether the rule said to be “inflexible” applies. That is, the extents of the trustee duties of fiduciaries and of impartiality to beneficiaries are at least flexibly ascertained in the context of the power given to the trustee.

In the case of a Discretion in a FDT the trustee will ordinarily be given an explicit power and duty to choose between beneficiaries. In the context of the exercise of a discretionary power in relation to a discretionary trust, there will then be no duty on the trustee to ensure impartiality; that is equal treatment of each beneficiary: Edge v. Pensions Ombudsman [1998] Ch 512, Elovalis V. Elovalis [2008] WASCA 141. In Edge v. Pensions Ombudsman, Scott V-C stated of the rule in Cowan v. Scargill:

Sir Robert Megarry was dealing with an issue regarding the exercise by pension fund trustees of an investment power. He was not dealing with the exercise of a discretionary power to choose which beneficiaries, or which classes of beneficiaries, should be the recipients of trust benefits. In relation to a discretionary power of that character it is, in my opinion, meaningless to speak of a duty on the trustees to act impartially. Trustees, when exercising a discretionary power to choose, must of course not take into account irrelevant, irrational or improper factors. But, provided they avoid doing so, they are entitled to choose and to prefer some beneficiaries over others.
Edge v. Pensions Ombudsman [1998] Ch 512 at p. 533

The limits of FDT trustee power

Adequately cast discretionary powers of a trustee such as given to the trustee of a FDT are thus unlikely to transgress fiduciary and impartiality duties contextually inapplicable to these powers. What checks on the exercise of a Discretion remain? These are explained in Karger v. Paul [1984] VR 161 where it was found that a trustee with an absolute and unfettered discretion must nevertheless exercise the discretion:

in good faith;
upon a real and genuine consideration of the interests of the beneficiaries; and
in accordance with the purpose for which the discretion was conferred.

In this way the obligation on the trustee not to take irrelevant, irrational or improper factors referred to in Edge v. Pensions Ombudsman is put in more positive terms in Australian courts. These benchmarks from Karger v. Paul were applied, and trustees fell short, in Owies v. JJE Nominees Pty Ltd [2022] VSCA 142 and in Wareham v. Marsella [2020] VSCA 92 (which is also considered in this blog at:

Controlling who gets death benefits from a SMSF )

Real and genuine consideration

The real and genuine consideration of the interests of the beneficiaries’ obligation of the trustee on exercising a Discretion will depend on the kind of trust, the interest of the beneficiary in the trust and the standards to be imposed on the type of trustee. For instance in Finch v. Telstra Super Pty. Ltd. [2010] HCA 36, a professional trustee of a large superannuation fund was found to have an amplified real and genuine consideration obligation extending to giving reasons in writing for the exercise or non-exercise of the discretion to pay total and permanent invalidity benefit benefits to a member of the fund.

In contrast an unpaid trustee, such as a family trustee of a FDT, is ordinarily under no obligation to provide the DB with written reasons for a decision to exercise or not exercise a Discretion. Without written reasons the DB can be left with scant evidence to challenge a trustee who instead favours another beneficiary, beneficiaries or HHTI by an exercise of a Discretion under Karger v. Paul benchmarks.

Freedom of a trustee of a FDT to favour beneficiaries including HHTI over others

Within the context and confines of those parameters a trustee of a FDT can favour one beneficiary over another. It follows that a trustee of a FDT can usually exercise a Discretion to favour HHTI to the complete exclusion of the DB so long as the Karger v. Paul parameters are observed.

But power to favour beneficiaries is exceptional

Whether or not there is an exceptional Discretion turns on the purpose for which the Discretion was conferred evident in the terms of the Discretion which is in the trust deed of the trust. An adequate expression of the Discretion in the trust deed of a FDT is expected and needed so its purpose, as an absolute and unfettered discretion to choose between beneficiaries and as to amount distributed to them, is clear.

Certainty of beneficiaries

Who the discretionary beneficiaries of a FDT also must be clear. Frequently a trust deed of a FDT will prescribe persons who are excluded from being a beneficiary of the FDT and occasionally the trustee can be so excluded because of the perceived conflict of interest or, in New South Wales, for a stamp duty reason.

A FDT for a family which includes trustee or trustees included as discretionary beneficiaries is likely to be accepted as genuine:

where the trustee is a merely a discretionary beneficiary among a widely cast class of family beneficiaries; and
and is understandable where family members of the family sought to benefit under trust terms are or could be trustees.

So a trust deed of a FDT should be checked to confirm that the trustee is a beneficiary of the trust before the trustee of a FDT exercises a Discretion to distribute to itself. It is only where the trustee qualifies as a discretionary beneficiary under the terms of the trust instrument that a distribution can be safely made to the trustee/beneficiary where the trustee is satisfied that the distribution complies with the Karger v. Paul parameters.

The drafting of the FDT deed

Ideally the trust instrument will expressly confirm that the trustee of the FDT is a beneficiary. It can be the case that the trustee is a member of a class which is included as beneficiaries under the trust instrument but the trust deed might not expressly say that a trustee can be a beneficiary. An exercise of the Discretion in the favour of the trustee is likely OK then too but the trustee runs a risk and could possibly face action asserting the trust instrument ought to be construed on a basis that the trustee is unacceptable as a beneficiary.

Fixed trust present entitlement – a land tax trap?

Trusts and land tax in NSW

To protect the integrity of land tax:

so no advantage is given to trust owned land that can’t be treated as owned by a taxable person viz. an individual or a company; and
by means now also similarly adopted in other jurisdictions, notably Victoria (trust surcharge rate applicable mainly to land acquired by a trust after 31 December 2005 Land tax and trusts | State Revenue Office Victoria https://t.ly/ex6Jw );

New South Wales taxes a trust that owns NSW land not entitled to concessional tax treatment at an ample land tax rate as a special trust without threshold allowed to an outright individual or a company owner of land viz. not subject to a trust: see section 25A of the Land Tax Management Act (NSW) 1956 (LTMA).

Photo by Jon Tyson on Unsplash

Fixed trusts

A key concession where the special trust rate will not apply is where a trust is a fixed trust:

the equitable estate in all of the land that is the subject of the trust is owned by a person or persons who are owners of the land for land tax purposes …

and the trust won’t then be a special trust: sub-sections 3A(1) and 3A(2) of the LTMA.

Where a trust is a fixed trust the trustee is not separately taxed for persons, who are owners of the equitable estate in the land:

are taken to be owners for land tax purposes;
are liable for land tax as if they were the legal owners of the land: section 25 of the LTMA; and
unlike the trustee of a special trust who can’t apply threshold, these land tax owners can apply their remaining threshold and thereby access or potentially access a lower land tax rate.

Usually, as this term of art is understood in trust law, a fixed trust will be a fixed trust under section 3A of the LTMA. It doesn’t follow that a unit trust will usually be a fixed trust.

When can a unit trust be a fixed trust?

Whether or not a unit trust is a (section 3A) fixed trust will vary case by case as some unit trusts meet the above formulation of a fixed trust in sub-section 3A(2) and some, likely most, do not.

The demarcation was authoritatively considered by the High Court in CPT Custodian Pty Ltd v Commissioner of State Revenue; Commissioner of State Revenue v Karingal 2 Holdings Pty Ltd [2005] HCA 53. CPT Custodian Pty Ltd was a Victorian land tax case where unit holders of a unit trust where found not to have an equitable estate in the property of the trust. It followed that the unit holders could not be treated as having a fixed interest in the property of the trust and so they could not be treated as owners of the land of the trust for Victorian land tax purposes.

CPT Custodian Pty Ltd distinguished the earlier decision of the High Court in Charles v. Federal Commissioner of Taxation (1954) HCA 16 where, unlike in CPT Custodian, unit holders were conferred equitable proprietary interests in the property of the unit trust in the proportions in which they held units under the terms of the trust deed of the relevant trust in Charles, the Second Provident Unit Trust.

The LTMA approach

If what is a fixed trust under the LTMA ended with the sub-section 3A(2) formulation as enunciated in CPT Custodian Pty Ltd then a fixed trust under the LTMA would be conceptually clear and land tax integrity aims would be achieved. But sub-section 3A(2) and CPT Custodian Pty Ltd are either:

somehow not enough assurance of the integrity of the distinction to the legislator; or
unintelligible to or incapable of ready application by Revenue NSW officers;

and so the LTMA proffers additional relevant criteria viz. guidelines for what is a fixed trust viz. when the “relevant” criteria are met, a trust will be taken to be a fixed trust with owners taken to have the required equitable estate in the land of the trust: section 3A(3A) of the LTMA.

Safe harbour?

In other words the relevant criteria are a safe harbour viz. where the relevant criteria are satisfied by a trust then it will be notionally unnecessary to separately apply the principles enunciated in CPT Custodian to ascertain whether the equitable estate in the subject land under the trust is wholly owned by a person or persons who are owners of the land for land tax purposes.

The relevant criteria are:

(a) the trust deed specifically provides that the beneficiaries of the trust–

        (i) are presently entitled to the income of the trust, subject only to payment of proper expenses by and of the trustee relating to the administration of the trust, and

        (ii) are presently entitled to the capital of the trust, and may require the trustee to wind up the trust and distribute the trust property or the net proceeds of the trust property,

    (b) the entitlements referred to in paragraph (a) cannot be removed, restricted or otherwise affected by the exercise of any discretion, or by a failure to exercise any discretion, conferred on a person by the trust deed,

    (c) if the trust is a unit trust–

        (i) there must be only one class of units issued, and

        (ii) the proportion of trust capital to which a unit holder is entitled on a winding up or surrender of units must be fixed and must be the same as the proportion of income of the trust to which the unit holder is entitled.
section 3A(3B) of the LTMA (emphasis added)

But what safety is there in the safe harbour?

So if you are establishing a unit trust to hold NSW land that is to be treated as a fixed trust, or you are the lawyer acting for prospective NSW land owners setting up a unit trust what do you do? Should you simply include the relevant criteria so a Revenue NSW officer can give the trust a sign off on the safe harbour for a fixed trust under section 3A(3A) so the trustee won’t be taxed on the land on a special trust basis?

Discretions and classes of units

Section 3A(3A)’s relevant criteria concerning discretions shouldn’t present a difficulty. A unit trust that meets the principles in CPT Custodian and is comparable to the Second Provident Unit Trust in Charles doesn’t give discretions to any person to distribute, redirect or accumulate income or to distribute or redirect capital to beneficiaries other to the unit holder who holds the so fixed proportion of the equitable estate of the trust. Similarly there would be no point to more than one class of units, as prescribed by the relevant criteria, when designing a trust with fixed proportions of the equitable estate in property of the trust referable to each unit as in Charles.

However present entitlements proposed by Section 3A(3A)’s relevant criteria for a fixed trust are a different matter:

Present entitlements are inapt

Present entitlement as a measure in the relevant criteria is drawn from sub-section 97(1) of the Income Tax Assessment Act (C’th) 1936 (C’th ITAA 36) which speaks of “a beneficiary of a trust estate” who is “presently entitled to a share of the income of the trust estate” and is understood to have a corresponding meaning in the relevant criteria.

Under Division 6 of Part III of the C’th ITAA 36 (Division 6) a beneficiary is presently entitled if, and only if:

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

[Federal Commissioner of Taxation v. Whiting (1943) 68 CLR 199, at pp 215-216, 219-220; Taylor v. Federal Commissioner of Taxation (1970) 119 CLR 444, at pp 450-452; Harmer v. Federal Commissioner of Taxation [1991] HCA 51 at para. 8 and Commissioner of Taxation v. Bamford & Ors, Bamford & Ors v. Commissioner of Taxation [2010] HCA 10 at para. 37.]

Present entitlement is an evaluative state at a particular point of time which is applied under Division 6 to retrospectively determine income tax liability at the end of either an income year or some other period of a trust in practice. In that context present entitlement is not used as a means to define estates or interests in trusts in succession prospectively by a preparer of a trust deed. It is instead used as a determinant of tax liability turning on whether a person is presently entitled to income of a trust. Despite that the relevant criteria in sub-section 3A(3B) agitate specific trust deed provisions that beneficiaries of a trust “are presently entitled” to income and capital of a fixed trust to attract the safe harbour.

Temporal fail

This doesn’t work as even a fixed trust with fixed correlation between the income and capital of the unit holders as holders of the equitable estate in the property of the trust can’t always achieve present entitlement in a time continuum, and certainly not at the outset of the trust when a trust deed of a trust may likely be drafted to potentially include the relevant criteria and executed, and the trust is yet to acquire property to which the beneficiaries may become presently entitled to income and capital but not “are” yet.

The relevant criteria oblige that beneficiaries are presently entitled seemingly to all income and capital of the trust through its existence. Beneficiaries can’t be presently entitled to income and capital in property of a trust that the trust is yet to acquire or to income of future periods or to capital on dates in the future of the trust. Beneficiaries are not presently entitled to income and capital from property that is yet to be property of the trust and a provision to the contrary in a trust deed to the effect that they are makes no sense.

Senseless provisions in a trust deeds unhinge the effectiveness of their other provisions and the trust itself.

Present entitlement when a unit holder dies?

Further Division 6 contains failsafes that apply where no beneficiary is presently entitled viz. sections 99 and 99A. Section 99 dealing with deceased estate cases is of particular significance as it could be that a unit holder in a unit trust with provisions in its trust deed to comply with the relevant criteria and to gain the safe harbour dies. From the moments after death until full administration of the deceased estate of the deceased unit holder, if that occurs, there is no owner of an equitable estate in the property of the trust reflecting the interest of the deceased who is presently entitled to the income of the property such as the fixed trust interest in the deceased estate: see Taxation Ruling IT 2622 Income tax: present entitlement during the stages of administration of deceased estates.

Until a legal personal representative obtains probate or letters of administration no equitable owner has standing to require the trustee of the fixed trust to require the trustee to transfer the property reflecting the interest of the deceased over to them.

But that is contrary to and in breach of a trust deed that obliges continual present entitlement, viz. that beneficiaries remain “are” presently entitled to the income and capital in land in succession.

Present entitlement when a unit holder is an infant or lacks legal capacity?

It could be that units in a unitised fixed trust that has adopted the relevant criteria come be to owned by an infant or a beneficiary subject to a disability who cannot be presently entitled to income or capital of the trust. In Taylor v. Federal Commissioner of Taxation (1970) 119 CLR 444, at pp 450-452 Kitto. J was able to deal with how section 98 can apply to these beneficiaries at para. 11 as follows:

Notwithstanding a passage in the joint judgment of Latham C.J. and Williams J. (Federal Commissioner of Taxation v. Whiting (1943) 68 CLR, at pp 214-215 ) which I must own I do not altogether understand in view of the recognition by s. 98 that a beneficiary may be “presently entitled” to income notwithstanding that by reason of a legal disability he has no right to obtain immediate payment, the tenor of the judgments is, I think, that “presently entitled” refers to an interest in possession in an amount of income that is legally ready for distribution so that the beneficiary would have a right to obtain payment of it if he were not under a disability.
(at p452)

but sub-section 3A(3B)(a) of the LTMA, unlike section 98 in Division 6, is neither qualified nor focused on application to a beneficiary under a legal disability who has no right to immediate payment of the amount such that the beneficiary can be considered presently entitled to income and capital of the trust so there is no reason why present entitlement of an infant unit holder, who can’t demand payment of trust income to him or her, for instance, should be inferred under sub-section 3A(3B)(a) of the LTMA based on Taylor.

Companies that “are” presently entitled – more likely to work

Unlike individuals, companies have perpetual succession and so, when they are beneficiaries of a fixed trust they can likely sustain continual present entitlement to the income and capital of a trust.

Is the inference thus to be drawn that a trust deed of a trust that includes the “are” presently entitled conditions to meet the relevant criteria and attract the safe harbour precludes individuals from becoming beneficiaries because an individual cannot necessarily sustain continual present entitlement such that they always are presently entitled because they may die, lose or never have legal capacity?

Lawyer’s quandary

How is a drafter of a deed for a fixed trust to deal with sub-section 3A(3A)’s relevant criteria in sub-section 3A(3B) then? I can’t follow what legitimate concern it is of the NSW legislature in a taxation statute or Revenue NSW to dictate trust terms to lawyers tasked with defining fixed interests in estates in succession but clearly blind adoption of the relevant criteria gives a tempting assurance to a drafter of a trust deed that a trust will be a fixed trust not land taxed as a special trust.

But inclusion of the relevant criteria which shouldn’t be strictly necessary has unintended consequences. A lawyer drafting a trust deed for a client is obliged to ensure that the drafting of a trust:

does not have adverse implications for the client such as precluding individuals who can be taxable owners for land tax from being unit holders; and
needs be wary of including trust deed terms that make no sense for which the lawyer, and not the legislator, is professionally responsible to the client.

Of further concern is that, despite the primary notion of the definition of fixed trust in section 3A(2), my recent experience is that Revenue NSW is obliging trustees to meet section 3A(3A)’s relevant criteria as if it is on those criteria, rather than the actual definition of fixed trust in section 3A(2), on which a fixed trust characterisation under the LTMA will turn. Without express inclusion of the are presently entitled stipulations of beneficiary interests in the trust deed of the trust Revenue NSW is treating a fixed trust that meets the CPT Custodian principles and so makes out as a fixed trust under section 3A(2) as a special trust. Officers at Revenue NSW don’t appear to follow or recognise that sub-sections 3A(3A) and (3B) are a safe harbor for the fixed trust notion specifically defined in sub-section 3A(2) of the LTMA.

Land tax assessments arising due to this approach by Revenue NSW should be challenged and disputed.

Has the AAT in Bendel reset the treatment of UPEs from trusts as Division 7A deemed dividends?

The Commissioner of Taxation’s longstanding practice as to when an unpaid present entitlement (UPE) of a private company beneficiary of a trust will give rise to a deemed dividend under Division 7A of the Income Tax Assessment Act 1936 has been dismantled by the Administrative Appeals Tribunal (AAT) in Bendel v. Commissioner of Taxation [2023] AATA 3074.

The Commissioner’s practice

That practice was set out by the Commissioner in Taxation Ruling TR 2010/3 and Practice Statement Law Administration PS LA 2010/4 and is now adjusted by Taxation Determination TD 2022/11 (the Practice).

Unfortunately the AAT decision in Bendel doesn’t directly deal with or critique the Practice, which has been foundational to the administration of Division 7A and trusts, and has dealt with the prospect of a trust UPE loophole in Division 7A, since 2010. It is clear that the AAT has diverged from the Practice by its approach to the Division 7A provisions in Bendel.

Sub-trusts?

The AAT in Bendel found that, despite the Commissioner’s position in the Practice and as a party in Bendel that a sub-trust arises where a trustee holds a UPE to income for a beneficiary of a family discretionary trust (FDT), no new or separate trust arises as a matter of law: On the authority of the High Court in Fischer v. Nemeske Pty. Ltd. [2016] HCA 11 which the AAT found “more to the point”, the AAT observed:

it is difficult to see any reason in principle why such an unconditional and irrevocable allocation of trust property must take the form of an alteration of the beneficial ownership of one or more specific trust assets;
there was no suggestion that the trustee’s exercise of the power to apply trust property involved a resettlement of trust property so as to result in the creation of a new trust;
further, the exercise of that power effected an alteration of beneficial entitlements in property which the trustee continued to hold on trust under the terms of the existing settlement was orthodox as a matter of principle. It was also unremarkable as a matter of practice…; and
An absolute beneficial entitlement to some part of a fund of property that is held on trust need not be reflected in an absolute beneficial entitlement to the whole or some part of any specific asset within that fund. That must be so whether the absolute beneficial entitlement to some part of a fund of property that is held on trust is defined by the terms of the trust settlement itself, or whether such absolute beneficial entitlement to some part of a fund of property that is held on trust is defined by an exercise of a power conferred on a trustee under the terms of a trust settlement.

[Italicised are extracts from the judgment of Gagelar J. of the High Court in Fischer v. Nemeske Pty. Ltd. [2016] HCA 11 at paras 95 to 99 included in the AAT decision.]

It follows that a UPE remains an entitlement of the beneficiary under the terms of the head or main trust.

But what of explicitly declared sub-trusts in the trust deed?

The AAT in Bendel did not consider the impact of the terms of the trust deed of the FDT on that reasoning. The deed explicitly sought to establish sub-trusts for UPEs arising under the FDT which counters the AAT finding, on the authority of Fischer v. Nemeske Pty. Ltd., that the UPE remains an entitlement under the main FDT. In my estimation these terms “settling” a UPE sub-trust could have been ineffectual in any case due to them having been:

internally inconsistent: on the one hand a sub-trust was stated to be held for a beneficiary “absolutely” but on the other the trustee was given wide discretion to resort to and deal with the assets of the sub-trust and, in practice and in the accounts, the property of UPE sub-trusts, if they existed, was intermingled with the property of the main trust and so separate sub-trusts were thus perhaps a sham or without legal effect? and
insufficiently clear to establish or “re-settle” sub-trusts or to alter beneficial interests as explained in Fischer v. Nemeske Pty. Ltd.: the sub-trust provisions of the deed had “no work to do” just like the Second Declaration of Trust in Benidorm Pty Ltd v. Chief Commissioner of State Revenue [2020] NSWSC 471.

Is a UPE an extended loan?

A UPE under a trust is not and is divergent from a loan in the ordinary sense. That is not disputed. Unfortunately, surprisingly and more controversially the AAT does not appear to directly deal with the question of whether a UPE from a trust is what was referred to in TR 2010/3 as a “section three loan” or a loan within the extended meaning of loan under sub-section 109D(3) of the ITAA 1936 (extended loan) although submissions of the parties on the questions of whether or not a UPE is either:

a financial accommodation; or
an in substance loan;

were received and outlined in the Bendel decision but received scant consideration in the decision.

It isn’t apparent that the AAT accepted the taxpayer’s contentions to the effect that a financial accommodation and an in substance loan are a subset of director/creditor type or loan-like relationships and are inapplicable to a trust entitlement and so concurred that a passive UPE owed to a beneficiary cannot be either a financial accommodation or an in substance loan that triggers an extended loan as considered by the Commissioner in paragraphs 19 to 26 of TR 2010/3. Rather the AAT gave a matrix in paragraph 101 of the decision (see below) to seemingly justify not giving a concluded view on these contentions.

Dictionary definitions and restrictive views

Maybe the AAT had financial accommodation front of mind when the taxpayer’s counsel referred to dictionary definitions being considered out of statutory context and legislative history as: a foundation for error where the outcome is contrary to statutory context and legislative history (SCLH)?

I am not so sure the SCLH, when considered in the context of twelve or more years of the Practice where the Commissioner has clearly relied on his wide view of financial accommodation in sub-section 109D(3) such that it can encompass an omission to pay out a UPE within the standard time frame allowed under paragraph 109D(1)(b), demands the restrictive view of when a UPE can be an extended loan the AAT has apparently taken in Bendel.

What should follow from legislative flaws in Division 7A concerning UPEs perceived by the AAT?

If I understand the AAT decision in Bendel correctly, the AAT have inferred from the SCLH, of which the AAT is critical, that the parliamentary intent on introducing section 109UB and, later, its replacement Subdivision EA, or that the effect of those provisions by dent of design fault, was that they are to apply to UPEs from trusts to the exclusion of the core provision governing what is a loan in section 109D.

If section 109UB, section 109XA et al. in the SCLH are so deficient, why would the AAT give them paramountcy over the core provisions which the Commissioner has been able to satisfactorily administer with the Practice over a long period? Couldn’t the AAT have inferred that the legislature, and the Commissioner prior to his adoption of the Practice, had acted on an unnecessary and untested assumption that a UPE from a trust could not be or would not be an extended loan under sub-section 109D(3)?

Does the Practice really tax two people over the one UPE?

A further departure of the decision of the AAT from the Practice is that applying section 109D:

raises the spectre of taxing two people in respect of precisely the same underlying circumstance, namely the same UPE
see paragraph 98 of the AAT decision in Bendel

In my view it is open to the Commissioner and reasonable, given the legislative policy of Division 7A, to treat the distribution from the FDT to a corporate beneficiary and the UPE arising in favour of the beneficiary as a distinct and earlier in time transaction from the failure to satisfy the UPE by payment within the standard time frame allowed under paragraph 109D(1)(b).

This is just as much taxing two people in respect of the same income as a private company earning income subject to company tax and a shareholder of the company thereupon receiving that already company taxed income as an unfranked dividend which is thereupon taxable to the shareholder. It is to this outcome that Division 7A, as an anti-avoidance regime underpinning the integrity of the company tax system, seems rightly directed.

Interpretation approaches to the provisions

It occurs to me that, that being so:

the shortcomings of the Division 7A legislation insofar as it addressed UPEs from trusts set out in the decision;
the restrictive reading of it by the AAT in the context of the SCLH;
an interpretation based on generalia specialibus non derogant so that section 109UB and Subdivision EA, despite what the AAT says was its flawed passage into law, overrides the general provision: section 109D; and
a possible further contention by the taxpayer that a financial accommodation, an in substance loan or both are part of a ejusdem generis list that should be confined to financial accommodations or in substance loans within or comparable to advances of money, provisions of credit and the like viz. strictly debtor creditor financial activity;

are approaches and considerations likely to be or should be subordinated to the need to “ascertain the legislative intention from the terms of the instrument viewed as a whole”: Cooper Brookes (Wollongong) Pty Ltd v. Federal Commissioner of Taxation [1981] HCA 26 understanding that the Acts Interpretation Act (C’th) 1901 provides:

In the interpretation of a provision of an Act a construction that would promote the purpose or object underlying the Act (whether that purpose or object is expressly stated in the Act or not) shall be preferred to a construction that would not promote that purpose or object.
section 15AA of the Acts Interpretation Act (C’th) 1901

and applies to taxing Acts as well as other Acts and that the purpose of Division 7A is directed to maintaining the integrity of the Australian system of taxation of private companies.

I think it unlikely that a court would be confused by or would miss the purpose of the provisions due to the AAT’s questionable matrix set out as follows:

Having regard to:

    (a)          the policy of Division 7A to tax those who in substance enjoy the benefit of corporate profits without bearing taxation that would arise had the company paid dividends in the usual way;

    (b)          statutory construction principles that call for

        (i)          regard to statutory context and legislative history; and

        (ii)         potentially competing provisions to be construed in a manner which ‘gives effect to harmonious goals’;

    (c)          there being no tiebreaker provision which mandates which of two competing assessing provisions would apply if an unpaid present entitlement constituted a loan within the meaning of s 109D(3);

    (d)          the s 109RB discretion not being designed to allow relieving discretions to be exercise outside the s 109RD(1)(b) gateways of honest mistakes and inadvertent omissions and thus not a discretion that would relieve inappropriate double taxing;

    (e)          Subdivision EA being a specific, and therefore lead, provision containing an express set of rules that can be regarded as a particular path has been chosen to deal with the taxation effect of unpaid present entitlements in favour of corporate beneficiaries in prescribed circumstances;

    (f)          the lack of clarity as to the nature of an unpaid present entitlement and the separate trust concept often broached in conjunction with the unpaid present entitlement topic;

    (g)          the expressed explanation accompanying s 109UB, the predecessor of Subdivision EA, to the effect:

        (iii)        that an unpaid present entitlement in favour of a corporate beneficiary and a contemporaneous loan by the trustee to a shareholder in the corporate beneficiary (or associate) is in substance a loan by the company to the shareholder; and

        (iv)         that an amount to which a company is entitled ‘held on a secondary trust for the benefit of the company’ is regarded as unpaid and within the ambit of s 109UB;

    (h)          the operation of Subdivision EA which taxes the shareholder in the foregoing circumstances as if the company had lent money directly to that shareholder which falls squarely within the Division 7A policy framework;

    (i)          there being no provision in either of the Assessment Acts that anyone points to that expressly allows assessment of two people arising out of the same circumstance with one of those people potentially not enjoying any benefit of the corporate profits that are the underlying cause of the assessment,

the necessary conclusion is that a loan within the meaning of s 109D(3) does not reach so far as to embrace the rights in equity created when entitlements to trust income (or capital) are created but not satisfied and remain unpaid. The balance of an outstanding or unpaid entitlement of a corporate beneficiary of a trust, whether held on a separate trust or otherwise, is not a loan to the trustee of that trust.
para 101 of the AAT decision in Bendel

Towards a purposive construction of the provisions

In adopting a purposive construction of these provisions of Division 7A I would be surprised if a court would replicate the AAT’s disdain for parliament’s efforts to plug the UPE loophole with section 109UB and, later, its replacement Subdivision EA. If I read the AAT decision correctly, these provisions and the manner of their introduction prejudice the Commissioner and the Revenue such that the language of sub-section 109D(3), as a generality, can no longer be applied to UPEs from trusts.

Ironically if the AAT decision is correct, and what is an extended loan is constrained by it, then the legislative clarity from the government the AAT appears to urge and seek in Bendel can no longer be achieved by the repeal of Subdivision EA.

In any case one can expect the government to amend the UPE rules in Division 7A to reverse Bendel should the Bendel decision originated by the AAT persist as authority.

It is clear from Fischer v. Nemeske Pty. Ltd. that a UPE from a trust is different to a loan but the differences between a trust and a loan conflate in that case too. Gagelar J. states:

In challenging the Court of Appeal’s holding concerning the effect in law of the Trustee going on to record a liability to Mr and Mrs Nemes in the sum of $3,904,300 in the Trust’s balance sheet, the appellants do not dispute that a trustee who admits to having an unconditional obligation to pay a specified amount of money to a beneficiary can thereby become liable to an action at law for the recovery of that amount as money had and received to the benefit of the beneficiary, so as to overlay the equitable relationship of trustee and beneficiary with the legal relationship of debtor and creditor. That has been settled since at least the middle of the nineteenth century[107].
at para 105 of Fischer v. Nemeske Pty. Ltd.

It can be inferred that a trustee of a FDT given an unconditional obligation to pay money to a beneficiary under a UPE has been given a financial accommodation, an in substance loan or both under sub-section 109D(3). A loan and a UPE give rise to clearly comparable liabilities which is precisely the mischief to which section 109D is directed.

Further, an in substance loan is a particularly apt characterisation of the UPE in Bendel where the taxpayer, the FDT and the company beneficiary are related parties as they will be in most of these cases. Where they are related it is clearly commercially open to the trustee of the FDT and related parties to achieve the same liability as understood from para 105 of Fischer v. Nemeske Pty. Ltd. and the same financial goal by either a loan or by a UPE which, in substance, offers the related parties the same thing.

Can the CGT main residence exemption be used to save tax on a profitable property development?

In my August 2022 blog:

The capital gains tax main residence exemption, affordable housing and caps – The capital gains tax main residence exemption, affordable housing and caps https://wp.me/p6T4vg-rg

I considered the generous, unlimited and regressive CGT main residence (MR) exemption under Australian income tax and pondered the extent to which the CGT MR exemption has contributed to housing unaffordability. As I said in that post, for those who occupy and turnover homes they own in Australia, the CGT MR exemption delivers uncapped tax free uplifts in wealth as prices rise.

But the line can be overstepped.

A’s residential building project

Let us take A who has significantly benefitted from tax free CGT uplifts on previous sales of A’s former homes:

A acquires real estate which can be subdivided and on which two homes can be built.
A’s idea with this acquisition is to move in to one of the homes (Lot 1) once it is built and occupiable.
But A doesn’t plan to live in Lot 1 long term. A’s plans are to sell Lot 1 and Lot 2 with completed dwellings for a hoped for profit.
Will the CGT MR exemption enable A to enjoy profits from the project tax free?

The Commissioner of Taxation can treat the above development for sale as an adventure in the nature of trade to sell the land and buildings for profit. The occupation by A of Lot 1 as A’s home is incidental to the project. This differs from another case where, say, B uses real estate, on which B’s existing home is located, for a development where B subdivides, builds and sells where there was clearly an initial time pre-project where the real estate was only used by B as B’s home.

Proceeds or profits from sales and ordinary income

Where a project is a development for sale at a profit, such as in A’s case for the whole time and, in B’s case, for the phase of development to sale, the proceeds or profits can be treated as ordinary income by the Commissioner based on cases and tax principles referred to in:

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income

in which profits or gains in the ordinary course of business and from profit-making undertakings or schemes are considered.

Where proceeds or profits from sales are ordinary income arising either in the ordinary course of business or in a profit-making venture and also produce (otherwise taxable) capital gains then, due to section 118-20 of the Income Tax Assessment Act 1997, the proceeds or profits are treated as ordinary income and capital gains are not taxed. That is CGT does not apply and CGT principles, concessions and exemptions don’t apply to gains or losses made on income account.

So in A’s case, where the proceeds or profits from the sales of Units 1 and 2 are ordinary income:

no CGT MR exemption can be applied to reduce tax on Unit 1 as there is no taxable capital gain; and
further, no 50% CGT discount can be applied to reduce the extent to which proceeds or profits on sales are included in A’s assessable income as ordinary income

even though A is a resident individual generally entitled to such capital gain concessions.

Commissioner on the lookout

A’s plans to sell are not necessarily:

going to be obvious to; or
reported to;

the Commissioner particularly in the early stages of the A’s project. However that should change once Lot 1 and Lot 2 do sell. That is because:

the Commissioner is on the lookout for residential real estate developments that are an adventure in the nature of trade and are an enterprise under goods and services tax (GST) rules:

Miscellaneous Taxation Ruling MT 2006/1 The New Tax System: the meaning of entity carrying on an enterprise for the purposes of entitlement to an Australian Business Number

and it is Australian Business Number and GST information gathering by the Commissioner that may well reveal that A’s project is to develop and sell. The project can then be a review or audit target where proceeds and profits have not been returned by A as ordinary income.

New residential premises and GST taxable supplies

The sales of Units 1 and 2 are taxable supplies of new residential premises for GST where the sales happen within five years of when Units 1 and 2 are built and occupied as residences.

Generally the sale of a someone’s home is not treated as a taxable supply however that reassurance, considered at paragraph 11 of:

Goods and Services Tax Ruling GSTR 2003/3 Goods and services tax: when is a sale of real property a sale of new residential premises?

does not apply if the sale occurs as part of a profit making undertaking of scheme viz. where the supply is in the course of an enterprise and is not a mere realisation of the owner’s home: see paragraph 263 of MT 2006/1 et al.

Project trading stock or taxation of project profit?

What of B? How would B be taxed on income account when B’s earlier use of real estate was exclusively as B’s private home? When B sells B will be dealing with two events treated like sales for tax over an earlier and a later period. CGT and the CGT MR exemption can apply up to when B’s property is put to B’s development for sale project. But at that point B can be taken to have put the property to use as trading stock and section 70-30 of the ITAA 1997 applies to treat B as having sold the property and as having re-acquired the property as trading stock even though B continues to own the property [possibilitity 1].

In:

Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as ‘trading stock’?

the Commissioner states:

Land is treated as trading stock for income tax purposes if:

• it is held for the purpose of resale; and

• a business activity which involves dealing in land has commenced.

Even where the development for sale is not considered to be a “business activity”, but is nonetheless an isolated transaction within the ambit of TR 92/3; B’s profits, not B’s sale proceeds, can comprise the assessable income of B from the the development [possibility 2]. Those profits are based on the value of the property as a cost at the time the property is ventured to the development based on the High Court decision in F.C. of T. v. Whitfords Beach Pty. Ltd. (1982) HCA 8; 150 CLR 355.

The use as a home phase and the project development to sale phase are treated separately for tax either with possibility 1 and possibility 2.

GST, enterprise and creditable acquisitions

As A’s (or B’s) project leads to taxable supplies of new residential premises it will follow that A’s project is an enterprise requiring A to be registered for GST: see MT 2006/1. When that is understood by A, A may then register for the GST on a timely basis positioning A to more easily claim project expenses as creditable acquisitions and obtain GST credit or refunds.

That opportunity gets complicated where the new dwellings on Lots 1 and 2 may come to be used by A once built – say privately as A’s main residence, or say where held and used to earn rent, rather than sold, in which cases creditable acquisition claims on activity statements may need to be adjusted under GST rules due to A’s change in creditable purpose.

C the builder

Let us now consider C who, like A, has significantly benefitted from tax free uplifts, questionably, on previous sales of C’s former homes using the CGT MR exemption. But C is or has become a professional builder and C’s buy, build/renovate and sell for a profit can be understood and characterised as C’s business activity/profit making venturing after C’s real estate owning history is fully understood. The frequency and amount of those previous tax free uplifts taken with claims of the CGT MR exemption is a part of that history.

The cases and tax principles referred to TR 92/3 mean that C can still be taxed on income account, and cannot access the CGT MR exemption on this next project, even where C uses a dwelling built/renovated by C as C’s home during times when the dwellings C builds or renovates become occupiable.

Cases raising the income/capital dichotomy and these complications do not necessarily have the same tax outcomes and will turn on their own whole factual story.

The useful family trust election and income “injection”

In 1998 the trust tax loss measures in Schedule 2F of the Income Tax Assessment Act (ITAA) 1936 (Schedule 2F) were finally enacted to curb the unscrupulous trade in trust tax losses.

Income injection test

An essential and not so well understood retardant of the trade in these measures is the income injection test (IIT). Neither the term income injection nor the words inject or injection are in Schedule 2F. Nevertheless the test is there in Division 270 of Schedule 2F under the heading Schemes to take advantage of deductions.

The ITAAs and Schedule 2F, in particular, have much jargon which is in italics in this post.

Unlike some other tests in Schedule 2F, such as the stake test and the control test, which are both applicable to non-fixed trusts, transgression of the IIT doesn’t disqualify a trust from using all of its tax losses including carry forward prior year tax losses. A trust that fails the IIT is precluded from offsetting otherwise tax deductible tax losses against (taxable) assessable income (only) to the extent of scheme assessable income.

Scheme assessable income is what is “injected”.

How the IIT works

As an anti-avoidance provision designed for wide reach, the IIT in Division 270 of Schedule 2F is so expressed. Scheme, as is usual in anti-avoidance laws in the ITAAs, is widely defined and an outsider or outsider to the trust, is pervasive under the IIT. In the case of a trust that isn’t a Schedule 2F family trust (a 2FFT) an outsider to the trust is a (any) person other than the trustee of the trust or a person with a fixed entitlement to income or capital of the trust: see section 270-25(2) of Schedule 2F.

Scheme assessable income arises where (in any order):

the trust earns assessable income;
an outsider to the trust directly or indirectly provides a benefit (also widely cast – can be money, property or anything else of benefit set out in section 270-20 – which may be but need not be the scheme assessable income) to the trustee of the trust, a beneficiary of the trust or an associate of either of them; and
the trustee of the trust, a beneficiary of the trust or either of them provides a benefit to the outsider to the trust or an associate wholly or partly, but not incidentally, because the deduction is allowable to the trust.

Context of the IIT

With this broad formula the IIT in the tax trust loss measures of Schedule 2F can be contrasted to the business continuity test that applies to company tax losses under Division 165 of the ITAA 1997. An injection by, viz. a benefit from, an outsider to the trust or an associate that can produce income in the trust, against which unrelated tax losses might otherwise have been deducted, gives rise to scheme assessable income against which tax losses cannot be deducted.

When the IIT applies – outsiders

So let us say:

a private company with profits and a family discretionary trust (FDT) with tax losses but no current income producing activity of its own are controlled by a family;
the FDT owns shares in the company; and
the company pays dividends to the FDT.

A clear distinction between a FDT and a 2FFT needs to be understood. Schedule 2F refers to a “family trust”, i.e. a 2FFT, as a trust that has made a family trust election (FTE). A 2FFT in comparison can be a FDT, a fixed trust or a unit trust that has lodged a FTE which is in force. A FDT can be called a family trust in common parlance but a FDT will be a non-fixed trust under Schedule 2F; that is, not a Schedule 2F “family trust” until it lodges a FTE to become a 2FFT.

At least initially (see below), the company in my example is an outsider to the trust. There the benefit to the trust of the dividends is the scheme assessable income. The benefit to the company and its associates viz. the family, is that income tax isn’t payable on the dividends to the extent tax losses of the trust can be deducted against assessable income of the trust and the parties can’t disprove that this tax advantage of declaring dividends to the FDT shareholder was more than incidental.

How a family trust election can modify how the income injection test is applied

To avoid losses to the extent of so imputed scheme assessable income being denied to the trust under the IIT:

the trustee of the trust can make a FTE and become a 2FFT, and;
the company can make an interposed entity election (IEE).

The FTE would need to cover the period, in the case of carry forward tax losses of the trust, from when the losses were incurred by the FDT/2FFT to when they are sought to be deducted against assessable income (for tax) by the FDT/2FFT.

Companies and trusts that have a FTE or an IEE in place are excluded from being outsiders to the trust. The IIT is then an IIT of modified operation which can still be failed but the IIT will now only fail where benefits flow from and to a now reduced, less pervasive, range of outsiders to the trust. but is not failed when the flow is between 2FFTs. interposed entities and individual family members that are taken to be a part of the family group under Schedule 2F: see sub-section 270-25(1) of Schedule 2F.

Downside of a family trust election

Where a company, trust of partnership (Entity) meets the family control test viz. the Entity is controlled by the family group viz. a family, and is so eligible to become a part of a family group by way of a FTE or an IEE then the prospect of family trust distributions tax (FTDT), which is distinct from trust income tax and only applies to 2FFTs, needs to be considered.

Once an Entity lodges a FTE or an IEE then distributions by the Entity outside of the family group of the individual specified in the FTE or IEE, as the case may be, are caught by FTDT at the highest marginal income tax rate.

A FTE or an IEE is a de facto limitation by way of tax penalty on beneficiaries to whom income and capital of a 2FFT can be distributed.

Upside of a family trust election

A FTE can be lodged by a trust with commencement from when or before its prior year trust losses were incurred so the modified IIT can apply from that time to prevent scheme assessable income arising. That is so, so long as the commencement date of the trust as a 2FFT is no earlier than 1 July 2004. This is sometimes known or understood as “backdating” but that, like the use of the term “family trust” itself in Schedule 2F, is a misnomer and selecting a past commencement date for a 2FFT is lawful and allowed under Schedule 2F.

So long as a 2FFT can keep its distributions within the family group and so avoid FTDT, lodging a FTE or an IEE will be dually beneficial to the parties and the beneficiaries of the 2FFT to whom the franked dividends are on-distributed in my example once tax losses of the 2FFT are exhausted and the 2FFT has (positive) trust income as:

current and prior year losses can be offset by the trustee of the 2FFT against the dividends which are assessable income when received by the 2FFT where a FTE is in effect over the required periods and an IEE is in effect for the company so the company is within the family group; and
the 2FFT can meet the holding period rule and beneficiaries of the 2FFT to whom the franked dividends received by the 2FFT are distributed, after losses have been so offset, can then use franking credits on the dividends: see section 207-145(1)(a) of the ITAA 1997 and under the heading THE HOLDING PERIOD RULES REGULATING ACCESS TO FRANKING CREDITS at Family trusts – concessions | Australian Taxation Office https://is.gd/Nck0zS.

Reasons to be a 2FFT

The Australian Taxation Office at Family trusts – concessions https://is.gd/Nck0zS: lists five main “reasons” (actually imperatives for accessing tax concessions) why a trustee of a trust may want to make a FTE and become a 2FFT:

accessing trust tax losses to deduct them against trust assessable income;
to trace eligibility for company losses through a trust;
access of beneficiaries of a trust to franking credits under the holding period rules;
relief from the trustee beneficiary reporting rules; and
access to the small business restructure rollover in Sub-division 328-G of the ITAA 1997.

Schedule 2F doesn’t apply to deny capital losses that can be offset against capital gains under section 102-5 of the ITAA 1997.

The three certainties

When a trust has certainty of objects

A dovetail

McPhail v. Doulton – the is or is not test adopted in England

Applying the is or is not test to an AAOP in a FDT

Extent of invalidation

Can a trustee of a FDT rely on Evans v. Commissioner of Taxation?

Impact of takers-in-default of appointment on a trust power to appoint

Conclusion

The beneficiary after death?

1. BENEFICIARY NO LONGER LEGALLY A PERSON

The beneficiary principle

Doctrine of lapse

2. THE DECEASED ESTATE ARISES AS A SEPARATE ENTITY TO THE DECEASED

3. A DECEASED ESTATE IS NOT ORDINARILY A BENEFICIARY OF ANOTHER TRUST

Can or should a DE receive the gift or distribution from a FDT?

INCOME TAX RAMIFICATIONS

Commissioner’s discretion

Risk to a deceased estate of higher income tax rate

Valid gifts

Doctrine of lapse

Gifts to deceased estates

Income tax problems with distributions of trust income to deceased estates

Conclusion

Deductions

Limits on travel expenses to income earning residential properties

How about the SMSF earning residential rental income through a business?

How about the SMSF earning income from use of the ORP as an airbnb or similar?

Can the SMSF meet the travel expenses in any case even when they are non-deductible for income tax?

Actions the ATO can take against trustees of SMSFs

Meeting travel expense in a SMSF – rethink

Non-compliance – loss of nearly half a SMSF’s assets in income tax

Disproportionate consequences

Joint tenancy ownership compared to ownership by tenants-in-common

Which type of ownership works where a (trustee of a) SMSF is a co-owner?

Co-ownership of land between SMSF members and the SMSF as tenants-in-common

Prohibition on acquisition of assets from superannuation fund members and related parties

Implications for related co-owners who own RP as tenants-in-common with a SMSF

An unsatisfactory entanglement

Entanglement disrupting sale of the TsIC interest by a SMSF

Investing in a marooned asset

Civil penalty provisions

Sole purpose fails

Entanglement of financing

Unit trust alternative?

Non-geared unit trust compared to co-investing in residential property as tenants-in-common

Conflict of interest

Fiduciaries

Impartiality

Context of trustee power

The limits of FDT trustee power

Real and genuine consideration

Freedom of a trustee of a FDT to favour beneficiaries including HHTI over others

But power to favour beneficiaries is exceptional

Certainty of beneficiaries

The drafting of the FDT deed

Trusts and land tax in NSW

Fixed trusts

When can a unit trust be a fixed trust?

The LTMA approach

Safe harbour?

But what safety is there in the safe harbour?

Discretions and classes of units

Present entitlements are inapt

Temporal fail

Present entitlement when a unit holder dies?

Present entitlement when a unit holder is an infant or lacks legal capacity?

Companies that “are” presently entitled – more likely to work

Lawyer’s quandary

The Commissioner’s practice

Sub-trusts?

But what of explicitly declared sub-trusts in the trust deed?

Is a UPE an extended loan?

Dictionary definitions and restrictive views

What should follow from legislative flaws in Division 7A concerning UPEs perceived by the AAT?

Does the Practice really tax two people over the one UPE?

Interpretation approaches to the provisions

Towards a purposive construction of the provisions

A’s residential building project

Proceeds or profits from sales and ordinary income