Individual trustees of a SMSF – useful or a hindrance to SMSF decision making?

In 2008 I wrote an article published in SMSF magazine SeparatedDot

Having individuals as trustees of SMSFs – companies versus individuals as trustees of SMSFs

which mainly looked at when having individuals as trustees of a SMSF can prove a false economy.

A recent Full Federal Court case authoratively sets out reality checks for SMSFs with individual trustees: Frigger v Trenfield (No 3) [2023] FCAFC 49 concerned an accountant, Mrs. Frigger and her husband, Mr. Frigger, who had been made bankrupt.

The bankrupts took action against their official receiver to require the official receiver to treat assets, which had been sequestrated by the official receiver, as the property of their superannuation fund, the Frigger Superannuation Fund (FSF). The aim of the bankrupts was to bring these assets within sub-paragraph 116(2)(d)(iii)(A) of the Bankruptcy Act (C’th) 1966 as assets not divisible amongst the creditors of undischarged bankrupts.

SMSF assets need to be owned by the trustees

Regulation 4.09A(2) of the Superannuation Industry (Supervision) [“SIS”] Regulations contains the following prescribed standard:

A trustee of a regulated superannuation fund that is a self managed superannuation fund must keep the money and other assets of the fund separate from any money and assets, respectively:
(a) that are held by the trustee personally; or
(b) that are money or assets, as the case may be, of a standard employer-sponsor, or an associated of a standard employer-sponsor, of the fund

Despite the above Regulation 4.09A(2), the comparable covenant in paragraph 52(2)(g) of the SIS Act 1993 and trust law principles that forbid trustees from mixing their own property with property held on trust, the bankrupts ran bank accounts and held assets, including rental earning real estate, in their own names which the bankrupts claimed were assets of the FSF in Frigger v Trenfield (No 3). These assets had not been put into the names of all trustees being Mr and Mrs Frigger, their children Mr Michael Frigger and Ms Jessica Frigger jointly either expeditiously or at all.

In my article I looked at the work needed and likely cost to keep assets in the name of the trustees on changes of trustee of a SMSF. The FSF, where there were numerous changes of trustee and numerous assets including real estate, was a chronic case of the imperative to keep fund assets in the name of the trustees and the significant effort and costs required my article considered. The bankrupts and the other trustees of the FSF didn’t act on the imperative made plain below in this post.

Further accounts, tax and SMSF returns and other records relied on by the bankrupts to show that the assets were owned by the FSF, and so attracted sub-paragraph 116(2)(d)(iii)(A) protection from sequestration, were found by the Full Federal Court to be deficient and insufficient to convince the Full Federal Court that the assets were assets of the FSF.

How trust property must be held. protected and made good by individual trustees of a SMSF

In the course of the lengthy joint judgement in Frigger v Trenfield (No 3) the Full Federal Court (Allsop CJ, Anderson And Feutrill JJ) elaborated on how individuals, who are co-trustees of a trust such as a SMSF must reach decisions and hold, protect and, if need be, make good the property of the trust. This elaboration is an aide-memoir for individual trustees of a SMSF:

Decisions of co-trustees must be unanimous: Luke v South Kensington Hotel Co (1879) LR 11 Ch D 121 at 125. In the case of In the Estate of William Just (deceased) (No 1) (1973) 7 SASR 508 (Estate of Just), where money had been paid into a bank account held in the name of one of two co-trustees, Jacobs J said (at 513–514):

… In the case of co-trustees of a private trust, the office is a joint one. Where the administration of the trust is vested in co-trustees, they all form, as it were, but one collective trustee and therefore must execute the duties of the office in their joint capacity. Sometimes, one of several trustees is spoken of as the active trustee, but the court knows of no such distinction: all who accept the office are in the eyes of the law active trustees. If anyone refuses or is incapable to join, it is not competent for the other to proceed without him, and if for any reason they are unable to appoint a new trustee in his place, the administration of the trust must devolve upon the court. Though a trustee joining in a receipt may be safe in permitting his co-trustee to receive in the first instance, yet he will not be justified in allowing the money to remain in his hands longer than reasonably necessary. The proper course is to pay trust money into a joint bank account in the names of both or all the trustees. …

In general, a trustee must discharge the duties and exercise the powers of trustee personally. Where there are co-trustees, in the absence of unanimous agreement, actions taken independently of the other co-trustees lack authority and do not bind all trustees: see, e.g., Lee v Sankey (1872) LR 15 Eq 204 at 211; Astbury v Astbury [1898] 2 Ch 111 at 115–116; Pelham v Pelham & Braybrook [1955] SASR 53 at 57. A co-trustee is not and cannot be bound by a decision of the majority and each co-trustee must turn his or her mind to the exercise of the applicable power and decide on the action to be taken: see, e.g., Cock v Smith (1909) 9 CLR 773 at 800; Re Billington [1949] St R 102 at 111, 115.
As the authors of Ford and Lee: The Law of Trusts (looseleaf at 13 February 2020, Thomson Reuters) (Ford and Lee) observe (at [9.11090]): “A consequence of the unanimity rule is that trust business cannot be transacted except at a meeting at which all the trustees, or their delegates, are present; and that where the trustees cannot agree about a course of action the status quo prevails.” In the case of a regulated superannuation fund, if the superannuation entity has a group of individual trustees, the trustees must keep, and retain for at least 10 years, minutes of all meetings of the trustees at which matters affecting the entity were considered: s 103(1) SIS Act.
It may also be possible for co-trustees to ratify an action taken by another trustee without prior agreement: Meeseena v Carr (1870) LR 9 Eq 260 at 262–263; Hansard v Hansard [2015] 2 NZLR 158 (Hansard v Hansard) at [47] citing Thomas Lewin and others, Lewin on Trusts (18^th Ed, Sweet & Maxwell 2018) at [29-209]. However, for ratification to be effective, the ratifying co-trustee(s) must know of the essential detail of the act or decision in question. It must be more than passive acquiescence to a decision made by another trustee. The act of ratification must show that the co-trustee(s) considered the exercise of power as trustee and consented to the action taken. Thus, “[s]ubsequent approval of financial statements [by all trustees] may therefore not be sufficient to amount to ratification of actions taken without the unanimous approval of trustees”: Hansard v Hansard at [51]. Something more than mere approval of financial statements would be necessary to demonstrate the required ‘act of ratification’.
Property of the trust must be held jointly and it is a breach of the trustees’ duties not to ‘get in’ the trust property and hold the legal (or where applicable equitable) title to that property jointly or otherwise hold the property under joint control: Lewis v Nobbs (1878) 8 Ch D 591 (Lewis v Nobbs) at 594; Guazzi v Pateson (1918) 18 SR (NSW) 275 at 282. As Hall VC explained in Lewis v Nobbs, the rationale for the duty is to ensure that trust property is not dealt with improperly by one of the co-trustees or without the agreement of all co-trustees.
Clause 140 of the FSF Trust Deed required the trustees of the FSF to ensure that money received by the fund was, amongst other things, deposited to the credit of the fund in an account kept with a bank chosen by the trustees. That is, chosen by the co-trustees by unanimous agreement.
While there may be circumstances in which property is conveyed to, or acquired, by one of a number of co-trustees as trust property with the consent of the other trustees, it remains the duty of all trustees to ensure that title to the property is ultimately convey (sic.) to and held by all co-trustees jointly within a reasonable time thereafter: Estate of Just at 513–514. Any inconvenience that might result from the changing composition of the co-trustees from time to time does not absolve the trustees of that duty: see, e.g., Trustees of the Kean Memorial Trust Fund v Attorney-General (SA) [2003] SASC 227; 86 SASR 449 at [94].
Further, in the absence of an express provision permitting mixing, it is also a duty of a trustee to keep personal and trust property separated: Associated Alloys at 605 [34]. A trustee has a positive duty “to distinguish the piece of property he … acquires from other similar things which he may obtain for himself or in which he may be interested”: Van Rassel v Kroon (1953) 87 CLR 298 at 302–303 (Dixon CJ); Heydon and Leeming, Jacob’s Law of Trusts in Australia (8^th ed, LexisNexis, 2016) at [17-02]. It is also trite that a trustee cannot unilaterally repudiate the trust and appropriate the trust property: Ford and Lee (looseleaf as at 14 May 2021) at [17.4530].
A co-trustee is obliged, as part of the duty to get in trust property, to bring proprietary claims against another trustee who, in breach of trust, has misappropriated or mixed trust property with his or her own property. Likewise, a trustee who has participated in such a breach of trust has an obligation, notwithstanding his or her own wrongdoing, to make good the trust property and, if necessary, to institute proceedings against other trustees who participated in the wrongdoing to make good the loss: Young v Murphy [1996] 1 VR 279 at 282–284, (per Brooking J), 300 (per Phillips J), 319 (per Batt J).
The above principles have significance in this appeal because the evidence before the primary judge was to the effect that Mrs Frigger alone held the legal title to the funds in the BW1 and BOQ2 accounts, Mr Frigger alone held the legal title to the funds in the BOQ1 account and Mr and Mrs Frigger jointly held the legal title to the securities in the Main Portfolio. Also, Mrs Frigger held the legal title to the Como and Bayswater properties. Therefore, the legal title to the disputed assets was not held by the co-trustees of the FSF jointly immediately before the sequestration orders were made or by the sole trustee of the FSF (H & A Frigger) immediately after the sequestration orders were made. There was no evidence before the primary judge that any of the individual co-trustees had taken any steps at any time to ‘get in’ the trust property and have funds held in a bank account in the joint names of the four individual trustees (or HAF), to transfer the securities in the Main Account into a CHESS holding account held in the joint names of the four individual trustees (or HAF), or to transfer the Como and Bayswater properties into the joint names of the four individual trustees (or HAF).

So the bankrupts fell short of the exacting requirements on individual trustees.

Majority individual trustee decisions and the unanimity rule?

The above passage from Frigger v Trenfield (No 3) does not countenance a SMSF trust deed that allows individual trustees to reach decisions by a majority of the individual trustees.

It is questionable whether a SMSF trust deed allowing for majority trustee decisions, not in conformity with the unanimity rule, satisfies paragraph 17A(1)(b) of the SIS Act. There is the prospect that a superannuation fund governed by such an (attempted) SMSF trust deed may not be (qualify as) a SMSF. That may be so unless a deeming clause in the trust deed overrides the decisions by majority clauses in the trust deed in which case individual trustees are obliged to comply with the unanimity rule nonetheless so that the superannuation fund can be regulated as a SMSF.

No scope for equivocal individual ownership of SMSF assets

Clearly there can be no presumption that the Australian Taxation Office, a tribunal or a court will accept that an asset not in the name of a SMSF is an asset of the SMSF. The bankrupts may have hoped that, by having individual trustees, the FSF was usefully positioned to assert ownership by the SMSF of multiple properties in the names of one or more trustees but not all of them. But the above principles set out in Frigger v Trenfield (No 3) mean that individual trustees of a SMSF, in particular, need to produce valid minutes of meetings of trustees and documents that establish and explain why an asset, and particularly an asset not in the name of all of the trustees, is an asset of a SMSF before an asset will be inferred to be an asset of a SMSF with individual trustees.

Advantages of a corporate trustee

A corporate trustee, especially a corporate trustee that acts in no other capacity, is better placed to assert ownership of any asset in the name of the corporate trustee and won’t be at the same risk of mixing trust property as a practical matter. Although corporate trustees need to keep records of their decisions, corporate trustee can have streamlined decision making procedures which need not require meetings of directors and their minuting where individual trustees can’t streamline their decision making.

Lessons

Frigger v Trenfield (No 3) is a stark reminder that ownership of assets of a superannuation fund by the trustees needs to be unequivocal should a member of the fund go bankrupt. There are numerous breaches of standards beyond Regulation 4.09A(2) and bankruptcy troubles that can arise where assets of a SMSF are not kept separate from assets that are not successfully.

Correcting a mistake in a prior year return – income tax and GST dovetail

Request an amendment or object?

As we have noted on this blog including in our post:

Is an objection needed to amend a tax assessment? https://wp.me/p6T4vg-k

it will often be better for a taxpayer to object against an assessment of income tax (AOIT) the taxpayer doesn’t accept rather than request an amendment of the AOIT by the Commissioner of Taxation. That can be for a number of reasons for that including:

where the taxpayer seeks to be or needs to be assertive that the AOIT needs to be fixed; or
where time for amendment of the AOIT may be running against the taxpayer.

Dealing with simple mistakes

However were the taxpayer has simply made a mistake on an income tax return (ITR) where:

an objection isn’t worth the trouble; and
the mistake doesn’t present a real risk of overpaid tax to the taxpayer;

then requesting an amendment of an AOIT based on the ITR will be a simple solution and, in the case of a GST where a BAS or BASs have returned the error, won’t even be necessary.

Example – fees overstated in a prior year

Let us say a company registered for GST earned fees from an activity in the 2020 income year, and as a result of a dispute with the payer, the company had to refund those fees back to payer in the 2022 income year.

Income tax

The fees were returned as assessable income in the 2020 income tax return of the company.

The company can either:

request an amendment of the 2020 assessment of income tax (AOIT) (see Request an amendment to a business or super tax return | Australian Taxation Office https://is.gd/lMX69M ) including through the ATO’s online services for tax agents; or
lodge an objection against the 2020 AOIT assessment of income tax. For more on how an objection should be done, see our blog post How is a tax objection form done? https://wp.me/p6T4vg-z.

If the company is a small business entity the company should act promptly to ensure it is within the two year period of review (time limit allowed) for amendments of AOITs.

Goods and services tax

For GST it’s different.

The fees were returned as taxable supplies in BASs of the company in 2020.

The company can correct taxable supplies overstated, on an earlier BAS or BASs, on its upcoming BAS as a credit error so long as the upcoming BAS is within the four period of review of the BAS with the overstated taxable supplies: GSTE 2013/1 Goods and Services Tax: Correcting GST Errors Determination 2013

To be eligible to correct credit errors in this way, rather than by having the prior period BAS amended:

• the error must be within the four year BAS period of review, as stated;

• the error has not been corrected in another BAS; and

• the tax period in which the error was made is not subject to ATO compliance activity.

Part IVA – is a discretionary trust owned bucket company a sitting duck?

The Full Federal Court in Commissioner of Taxation v Guardian AIT Pty Ltd ATF Australian Investment Trust [2023] FCAFC 3 has dismissed the Commissioner’s appeal against decisions at [2021] FCA 1619 of the primary judge, Logan. J, not to impose the reimbursement agreement assessments on the trustee of the AIT under section 100A of the Income Tax Assessment Act (ITAA) 1936.

But the Full Federal Court has unanimously taken a radically different construction of the facts in the case to Logan J. to find that Part IVA of the ITAA 1936 was correctly applied to the Guardian AIT facts to support the Commissioner’s Part IVA determination, run as an alternative to section 100A, made in respect of the 2013 income year.

Reimbursement agreements – a blunt tool?

On this blog we have queried whether the section 100A reimbursement agreement regime is a tool useful to the Commissioner that gives the Commissioner scope to attack trust distributions that are no part of a trust stripping arrangement involving parties external to the trust: 100A trust reimbursement agreement not the tool to fix the bucket company dividend washing machine https://wp.me/p6T4vg-pM . We have also blogged about bucket companies lately, see: Can a family discretionary trust distribute income to its corporate trustee? https://wp.me/p6T4vg-rH

Without going into the detail in this blog post, the Full Federal Court in Guardian AIT has rather confirmed our thoughts about the utility of section 100A. We don’t see that the decision vindicates or gives legal support or backing to the Commissioner’s products and section 100A-based approaches in Taxation Ruling TR 2022/4 and Practical Compliance Guideline PCG 2022/2. Oddly the Commissioner finalised TR 2022/4 and PCG 2022/2 before Guardian AIT ran its course.

In the meantime there is another section 100A case on foot: BBlood Enterprises Pty Ltd v Commissioner of Taxation [2022] FCA 1112, which is also on appeal to the Full Federal Court and there is also the prospect of appeal in Guardian AIT to the High Court.

Part IVA sharpened up?

But Part IVA is a different matter. The Full Federal Court in Guardian AIT has warned how susceptible certain types of discretionary trust strategies, particularly discretionary trust strategies involving trust distributions to bucket company beneficiaries, may be to Part IVA.

This leads me to the key point of difference on the facts in the case between the Full Federal Court and Logan J. mentioned at the outset. Logan J. accepted Mr Springer’s contention that his company, AIT Corporate Services Pty Ltd (AITCS), was set up to accumulate assets for asset protection. Although the Full Federal Court accepted this as a tenable explanation in the 2012 income year, despite AITCS clearing out its asset, the distribution receipt from the AIT back to the AIT as a dividend; repeating the process to clear out the 2013 trust distribution back to the AIT in the 2013 year demonstrated AITCS wasn’t:

holding or protecting anything for asset protections reasons; or
more particularly planning to hold or protect assets accumulated or to be accumulated in the company.

AITCS was plainly being used as a bucket company to receive a trust distribution in the 2013 income year which allowed AITCS to distribute a franked dividend back to the AIT which could then be distributed tax advantageously by the AIT to Mr Springer, a non-resident.

The apparent counterfactual

The Full Federal Court had no difficulty accepting the Commissioner’s Part IVA counterfactual contended in the appeal. That counterfactual was that the AIT would have distributed 2013 year AIT income to Mr Springer directly which “might reasonably be expected to have been included” in 2013 income taxable to the trustee under Division 6 of Part III of the ITAA 1936. That distribution could have been made to Mr Springer without the circularity of the “washing machine” distribution going to AITCS, then back to the AIT as franked dividend and then, finally, going to Mr Springer as NANE income being a form of income not taxable to the trustee nor to Mr Springer under Division 6.

Circularity and the form of the scheme

The Full Federal Court noted the circularity of the scheme which the Commissioner could and did take into account under paragraph 177D(2)(b) of Part IVA in considering the form of the scheme.

Commercial rationale or explanation of the scheme?

The difficulty under the Full Federal Court Part IVA analysis for the AIT was that the only difference in effect between the scheme and the counterfactual was that, under the scheme, the income distribution to the non-resident beneficiary Mr Springer was tax free NANE income. Under the counterfactual though, tax on the trustee of AIT at the highest marginal rate under Division 6 might reasonably have been expected. The same commercial outcome viz. income in Mr Springer’s hands within eight months of the end of the 2013 year of income confirmed that the only difference in what happened between the scheme, and reasonably expected to happen under the counterfactual, was the tax effect: a tax benefit the Commissioner could posit under Part IVA.

section 177CB – tax gives no explanation

The Full Federal Court noted that, following amendment to Part IVA which introduced section 177CB and sub-section 177CB(4) in particular, the tax impact of the scheme viz. the “operation of the Act”, or, more pointedly, the lower tax cost choice, is now expressly excluded as something that might reasonably be expected viz. the tax impact is now precluded by legislation from being a basis for a Part IVA counterfactual. Shortly stated that means the better tax outcome can no longer be a reasonable justification for choosing to implement a scheme caught under Part IVA.

Observations

Once the façade of an asset protection asset accumulating role for AITCS was identified by the Full Federal Court then AITCS was left exposed as a bucket company with a role in a tax scheme to re-purpose a trust distribution as a franked dividend to the tax advantage of Mr Springer in the 2013 year. In the context of potential Part IVA counterfactuals the Commissioner can raise, the AITCS bucket company can be viewed as unfortunately placed as both:

AITCS was a beneficiary of the AIT viz. the bucket company characteristic; and
shares in AITCS were owned by the AIT which facilitated the payment of trust income distributed to AITCS as dividends back to the trust;

enabling the loop or circularity which allowed the AIT to route income via AITCS as a franked dividend back to itself. But a clear or obvious alternative for the trustee of AIT would have been to distribute trust income to a different prominent beneficiary with a history of receiving distributions from the trust, such as Mr Springer. Distribution to Mr Springer was an even more obvious and irrefutable counterfactual when the distribution reflecting the income ultimately ended up with that beneficiary after going around in the circle.

Part IVA risks beyond non-residents?

Why would Part IVA in these situations be confined to where the ultimate beneficiary is a non-resident even though the AITCS scheme was particularly advantageous to AIT given high rates that apply on Division 6 taxation of non-residents? There can also a tax advantage and potential tax benefit too where a resident beneficiary receives discretionary trust income in the form of a franked dividend instead or as ordinary trust income. There is no reason why Part IVA couldn’t be similarly applied to a comparable circular scheme to use a bucket company loop to transform ordinary trust income into more lightly taxed franked dividend income.

Are bucket companies sitting ducks for Part IVA?

As a matter of policy the Commissioner has not used Part IVA to challenge direct distributions by family discretionary trusts to bucket companies to my knowledge. Guardian AIT shows that Part IVA can give the Commissioner a basis or tool to attack distributions to bucket companies which can be shown to have no purpose or reason, objectively determined, other than to save tax.

Where discretionary trust ownership of shares in the bucket company facilitates opportunity for franking or other tax saving by going around in a circle, the trustee may be a sitting duck for the Commissioner’s Part IVA counterfactual positing what the trustee may have done had the distribution been made to the intended beneficiary to receive trust income the first time around.

Integrity measures covering income tax deductions for payments, including salary, to relatives

Involved “associate” issues come up frequently on this blog. For instance:

In this piece I am looking at some core associate rules concerning income tax deductions: how the Income Tax Assessment Acts (ITAA) can restrict income tax deductions for payments, including salary and wages, where the person in receipt is a relative or associate.

Example – mischief to which s26-35 of the ITAA 1997 is directed

Let us say X owns a business which employs X’s son Y and daughter-in-law Z. The business is profitable and X pays tax on income from the business at a high marginal rate. Y and Z only have assessable income from their salary from working in the business and both pay income tax at a lower rate than X. To give Y and Z a helping hand and so X, Y and Z pay less income tax overall X pays Y and Z overly generous salaries taking into account the age, experience, extent and profitability of the work that Y and Z do in the business.

How s26-35 applies

Section 26-35, which operates together with section 65 of the ITAA 1936, to cover off on payments to individuals including payments routed through partnerships, trusts and companies, reduces the deduction for salary and wages X is allowed to the amount the Commissioner of Taxation (Commissioner) considers reasonable based on the nature of the duties performed by, the hours worked by and the total remuneration of the relative. The excess is not deductible.

The section is not punitive: sub-section 26-35(4) operates to treat the non-deductible part of the payment the relative receives as non-taxable (NANE income) to the relative. So in the example assessments of income of X, Y and Z are all in the frame for adjustment by the Commissioner so the reduction in the tax deduction for salary and wages to X can be effected.

Income tax return requirements

The onerous part of section 26-35 is that X must keep sufficient records to substantiate that the payments to relatives claimed as deductions are reasonable. As usual a taxpayer needs to self assess and the burden of proving a payment, such as of salary, is reasonable is on the taxpayer: see our blog The burden of proof in a tax objection

In support of a claim of a reasonable deduction for a payment paid to relative a taxpayer such as X must also return the total of all payments made to associates in their income tax return. This is a flag to the Commissioner that deductions have been claimed for payments to relatives and, for a safe harbour to support the total associate payments deducted, the Commissioner states that a taxpayer needs to keep:

full name of relative or other related entity
relationship
age, if under 18 years of age
nature of duties performed
hours worked
total remuneration
salaries or wages claimed as deductions
other amounts paid – for example, retiring gratuities, bonuses and commissions.

for the Commissioner’s inspection. In the 2022 income tax return X might complete this item is:

P16 Payments to associated persons

with amounts comprising total associate payments deducted returned at item G item P15, These records need to be kept even if, in the view of the taxpayer and his or her advisers, the payments made by the taxpayer to relatives are reasonable and say even align with award entitlements.

Exclusions

The regime catches payments to partnerships where a partner is a relative however a payment by a partnership to a partner (of the same partnership) who is a relative of another partner (of that partnership) is not caught: proviso in sub-section 26-35(3). Hence the above records are not required in the context of deductible payments made to say a wife partner by a husband and wife partnership. (Not of partnership [agreement] “salary” which is not deductible in any case.)

A payment of a deductible superannuation contribution by X as an employer for Y or Z is also not necessarily caught by this regime where the payment is not to a relative either directly or indirectly via a company, trust or partnership within the section 26-35 of the ITAA 1997 and section 65 of the ITAA 1936 regime. The relative is less likely to become entangled in this regime where the relative is not an individual trustee of the superannuation fund contributed to by X.

CGT small business concessions and exotic share classes

Exotic share classes, such as redeemable preference shares and dividend only (dividend access [DA]), shares are a longstanding concern for a private company seeking to access the small business CGT concessions (the Concessions) in Division 152 of the Income Tax Assessment Act (ITAA) 1997. Exotic share classes can derail qualification as a significant individual and thence as a CGT concession stakeholder for all shareholders of the company. The consequences are that a private company, otherwise eligible for the Concessions:

will not be eligible in some cases; and
in more or all cases, where the company is eligible and can apply the Concessions, shareholders of the Company with an insufficient small business participation percentage (SBPP) won’t be able to individually participate in the Concessions along with the company.

Why does this happen?

It’s due to the structure of section 152-70 of the ITAA 1997 which, in the case of a company, determines SBPP based on the “the smaller or smallest”:

… percentage that the entity has because of holding the legal and equitable interests in shares in the company:
(a) the percentage of the voting power in the company; or
(b) the percentage of any dividend that the company may pay; or
(c) the percentage of any distribution of capital that the company may make;
or, if they are different, the smaller or smallest.

Illustration

So a DA share may entitle a shareholder to dividends but not to voting rights or distributions of capital. Dividends of a company with DA shares can be declared on shares in the DA class only so other shareholders of the company, entitled to:

voting rights and distributions of capital e.g. ordinary shareholders; but
not to dividends as they are diverted to the DA share class;

leaves all shareholders with a zero SBPP. The SBPP is driven by the smallest of (a), (b) and (c) above and, in the case of the example ordinary shareholders, it is (b) that is zero. Zero is less than the 20% SBPP needed for a shareholder to be a significant individual: section 152-55.

What to do with dormant DA shares?

But what if a company on the verge of making a capital gain to which the Concessions can apply:

has a DA shareholder who could receive dividends declared to the DA class; but
desists from paying dividends on the DA class and all dividends are instead payable to ordinary shareholders?

Broadly this was what happened in Commissioner of Taxation v Devuba Pty Ltd [2015] FCAFC 168. I have no first-hand knowledge of the background to the case but I imagine Devuba’s experienced tax lawyer, Gregory Ganz, was aware of and advised on section 152-70 in the years in the lead up to the profitable sale of shares in another company, Primacy Underwriting Agency Pty Ltd, for $4,381,645 by Devuba Pty. Ltd. on 19 May 2010.

The DA share dilemma

I can see he and Devuba faced a dilemma. If, by 19 May 2010:

the DA shareholder still held the DA share then section 152-70 could apply to reduce the ordinary shareholders’ SBPPs to zero because Devuba “may pay” dividends on the DA class, This is the view that the Commissioner of Taxation was to take and contest in the case;
Devuba had redeemed or cancelled the DA share so that dividends would no longer be paid on DA shares there would have been a CGT event, probably CGT event C2, on which the DA shareholder would be taxed with the value of the capital proceeds, based on the market value substitution rule, being attended by valuation uncertainty; or
Devuba altered the rights of the DA shareholder so that dividends would no longer be paid on DA shares then CGT impacts and comparable valuation uncertainty would have arisen under the value shifting rules in Part 3-95 of the ITAA 1997 which had commenced to operate from 2002.

In the event Devuba went to the share sale on 19 May 2010 with the DA shareholder still holding the DA share. However, on 1 September 2008, the directors had passed a resolution in the accordance with Article 83 of the Memorandum and Articles of Association of Devuba that dividends were not to be paid on the DA share class until the directors passed a resolution to do so. Effectively this was a somewhat soft touch moratorium on DA class dividends probably insufficient or thought insufficient to trigger an alteration in rights which would have attracted value shifting CGT consequences.

“May pay”

Devuba figured dividends Devuba “may pay” on the DA class became zero as a matter of fact and likelihood because of this resolution. On the other hand the Commissioner took the view that Devuba could nonetheless legally pay dividends to the DA shareholder and so the ordinary shareholders had a SBPP of zero due to (b).

The Federal Court and the Full Federal Court agreed with Devuba. It was found that Devuba was unable to pay dividends immediately before 19 May 2010 to the DA shareholder with the moratorium in place. The courts found that the moratorium was valid and effective under the Memorandum and Articles of Association such that dividends that Devuba “may pay” on the DA class were zero. It followed that the percentage of dividends Devuba “may pay” to ordinary shareholders gave the ordinary shareholders sufficient SBPP to meet the relevant SBPP thresholds for the Concessions relevant in the case.

Exotic share class problem with the Concessions persists

This case shows the concern mentioned at the outset persists: Issued DA shares can still drive SBPP to zero and deprive ordinary shareholders of a company of the Concessions even where dividends are not paid to the DA class. Only with nuanced planning, an understanding of the constitution of a company and its interaction with the terms of the relevant exotic share class can help overcome a SBPP problem caused by an exotic share class with SBPP and the Concessions.

Even further income tax trouble

And income tax problems with exotic share classes like DA shares don’t end there. DA shares used for tax minimisation are considered aggressive tax planning and are the subject of the Commissioner’s:

Taxpayer Alert TA 2012/4 Accessing private company profits through a dividend access share arrangement attempting to circumvent taxation laws

which contains a lengthy list of bases on which the Commissioner can and will tax distributions on DA shares including treatment of DA share class distributions as dividend stripping under Part IVA of the ITAA 1936. Exotic share class can also have unexpected consequences under the debt equity rules in Division 974 of the ITAA 1997.

Reflection

Although the outcome in Devuba was technical and based on its particular facts, it marks a divergent, realistic and perhaps reassuring approach to the enquiry into dividends a company may pay. That stands in comparison to the unrealistic and dogmatic approach taken particularly by Revenue NSW and under the Duties Act (NSW) 1997 (DA NSW) to the questions of:

whether a trustee or trustees may become beneficiaries of a trust for the purposes of obtaining concessional duty on a change of trustee of a trust under sub-section 54(3) of the DA NSW; and
whether foreign person or persons may become a beneficiaries of a trust for the purposes of foreign person stamp duty and land tax surcharges under section 104J of the DA NSW;

obliging substantial, sometimes legally unachievable and largely unnecessary trust deed amendments before it can be accepted that such persons will never take a percentage of a trust as a beneficiary of the trust oblivious to perceivable facts, likelihoods and evidence that such a beneficiary would ever take.

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

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

But is it a good idea?

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

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

TCo needs to be a beneficiary of the FDT

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

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

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

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

It can’t be assumed that:

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

without checking the FDT deed.

Consequences of distributing income to a non-beneficiary

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

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

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

Excluded beneficiaries – conflict of interest

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

Excluded beneficiaries – stamp duty

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

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

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

TCo can qualify as a beneficiary – but what then?

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

Managing TCo’s asset mix

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

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

Serious tax risk of losing track of how TCo owns what

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

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

Is distributing to TCo worth it?

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

Image by Freepik

Statutory exemptions for a trust and containment

Duty on transfer to a discretionary testamentary trust beneficiary

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

Concessional duty of $50 applies to:

(a) a transfer of dutiable property by the legal personal representative of a deceased person to a beneficiary, being–
(i) a transfer made under and in conformity with the trusts contained in the will of the deceased person or arising on an intestacy, or …
under sub-paragraph 63(1)(a)(i) of the Duties Act (NSW) 1007

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

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

Testamentary trusts
30. Often a will may establish a trust with a named trustee and beneficiaries, with a gift to the trustee of that trust. A transfer from the legal personal representative to a beneficiary of the testamentary trust will not obtain the benefit of the section 63 concession, however, a transfer to the trustee of the testamentary trust will be liable to duty of $50 under sub-paragraph 63(1)(a)(i).
Revenue Ruling DUT 46 – Deceased Estates, Revenue NSW states at paragraph 30

Denial of concession explained?

There is no explanation in DUT 46 as to:

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

Scope of statutory exemptions (concessions)

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

find an exemption and get within it

could be trite.

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

Figuring out what Revenue NSW mean

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

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

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

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

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

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

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

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

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

Testamentary trust planning

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

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

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

Containment

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

Perpetuities

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

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

All jurisdictions except South Australia have retained the Perpetuities Rule.

Uneasiness

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

Policy to prevent remoteness of vesting

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

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

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

Significance of a trust discretion

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

Disparity of approach to statutory exemptions

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

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

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

Resistance

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

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

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

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

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

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

Preference

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

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

19. However, the literal rule of construction, whatever the qualifications with which it is expressed, must give way to a statutory injunction to prefer a construction which would promote the purpose of an Act to one which would not, especially where that purpose is set out in the Act. Section 35 of the Interpretation of Legislation Act must, I think, mean that the purposes stated in Pt 5 of the Road Safety Act are to be taken into account in construing the provisions of that Part, not only where those provisions on their face offer more than one construction, but also in determining whether more than one construction is open. The requirement that a court look to the purpose or object of the Act is thus more than an instruction to adopt the traditional mischief or purpose rule in preference to the literal rule of construction. The mischief or purpose rule required an ambiguity or inconsistency before a court could have regard to purpose: Miller v. The Commonwealth (1904) 1 CLR 668 at p 674; Wacal Developments Pty. Ltd. v. Realty Developments Pty. Ltd. (1978) 140 CLR 503 at p 513. The approach required by s.35 needs no ambiguity or inconsistency; it allows a court to consider the purposes of an Act in determining whether there is more than one possible construction. Reference to the purposes may reveal that the draftsman has inadvertently overlooked something which he would have dealt with had his attention been drawn to it and if it is possible as a matter of construction to repair the defect, then this must be done. However, if the literal meaning of a provision is to be modified by reference to the purposes of the Act, the modification must be precisely identifiable as that which is necessary to effectuate those purposes and it must be consistent with the wording otherwise adopted by the draftsman. Section 35 requires a court to construe an Act, not to rewrite it, in the light of its purposes.
Dawson J. in Mills v. Meeking (1990) HCA 6 at para. 19

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

Conclusion

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

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

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

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

CGT beginnings

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

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

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

The uncontained housing tax exemption

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

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

The CGT MR exemption has these characteristics:

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

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

Sources of unaffordable housing

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

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

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

The wrong culprit

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

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

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

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

Tax relief saving for a home?

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

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

A cap on the CGT main residence exemption?

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

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

A home turnover limitation?

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

Challenge

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

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

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

Non-lapsing SMSF BDBNs confirmed

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

External discretions and directions

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

Implications for death benefits directions

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

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

Too much latitude to a SMSF then?

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

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

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

The CGT discount

Obtaining the Discount principally requires:

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

How taxation of foreign income works

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

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

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

Double tax and double tax treaties

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

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

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

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

Burton v Commissioner of Taxation

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

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

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

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

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

84. Read in context, the text of s 770-10 is, in my view, fatal to the success of the alternative foundation of Mr Burton’s appeal, grounds 1 to 4 of which challenge the correctness of the conclusion adverse to him reached by the learned primary judge in relation to the allowance of foreign tax offsets under s 770-10 of the 1997 Act. An amount of foreign tax paid only counts towards a tax offset if it was paid “in respect of an amount that is all or part of an amount included in your assessable income for the year”.
….
86. Section 770-10 looks to “an amount that is all or part of an amount included in your assessable income for the year”. The term “assessable income” is defined in s 995-1 of the 1997 Act, which is not the same as “income” as understood for the purposes of the Convention. As defined in the 1997 Act, assessable income includes “ordinary income” (s 6-5) and, materially, what is termed “statutory income” (s 6-10). One form of statutory income included in assessable income is a net capital gain included pursuant to s 102-5(1) of the 1997 Act. As a matter of ordinary language flowing from the text of s 770-10 and, in turn, s 102-5(1), it is only the net capital gain which is, in each instance, included in Mr Burton’s assessable income. Regard to ss 6-5, 6-10 and 102-5 highlights that the phraseology “included in your assessable income” is pervasive in the 1997 Act. There is no contextual warrant for construing “included in” as extending to an amount which is used for computation of an amount that is included in assessable income. The learned primary judge (at [113] – [114]) reached just such a conclusion. That conclusion was correct, for the reasons given by his Honour.
Burton v Commissioner of Taxation [2019] FCAFC 141 at paras. 84 and 86

Repercussions

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

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

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