Why the weird donation trust beneficiary qualification?

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

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

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

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

Certainty of objects necessary for validity of a trust

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

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

beneficiaries; or
charitable purposes;

must be certain in a valid trust.

It is clear law that a trust (other than a charitable trust) must be for ascertainable beneficiaries.
Re Vandervell’s Trusts (No 2) [1974] Ch 239 at 319 per Lord Denning

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

Donations

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

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

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

There are limits to this though.

Or just a gift?

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

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

Family trust?

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

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

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

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

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

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

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

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

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

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

Reimbursement agreements

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

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

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

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

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

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

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The tax burden of handing over business assets to trust beneficiaries

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

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

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

Trading stock taken out of a business for private use

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

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

Handing over depreciable equipment

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

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

Taxable GST supply without consideration

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

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

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

Not worth the tax and accounting trouble

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

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

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

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

Uneven sharing of the partnership pie – OK for tax?

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

Demonstrating the partnership

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

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

Income tax effective features of a partnerships accepted for tax

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

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

Uneven shares of tax partnership income and losses

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

In order?

State and Territory partnership legislation provides that:

all partners share equally in the capital and profits of the business, and must contribute equally towards the losses, whether of capital or otherwise, sustained by the partnership
from paragraph 24 of Taxation Ruling TR 2005/7 [footnoting Section 24(I) of the Partnership Act 1892 (NSW); section 28(1) of the Partnership Act 1958 (Vic); section 27(1) of the Partnership Act 1891 (Qld); section 24(I) of the Partnership Act 1891 (SA); section 34(1) of the Partnership Act 1895 (WA); section 29(a) of the Partnership Act 1891 (Tas); section 29(1) of the Partnership Act 1963 (ACT) ]

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

partnership income and losses; and
returns of partnership capital;

accordingly.

Where partners pursuing unequal partnership income/loss entitlements seek:

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

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

Partner salary

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

A ‘partnership salary’ is not truly a salary, nor is it an expense of the partnership, but instead is a distribution of partnership profits to the recipient partner. Thus, the payment of a ‘partnership salary’ to a partner, whether or not for personal services provided by the partner, is not taken into account as an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997…
Paragraph 7 of TR 2005/7

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

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

Fights with other partners over entitlements

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

Conclusions

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

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

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

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

Tax risks of low or zero interest loans to private companies

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

Total Holdings

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

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

No Division 7A deemed dividend

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

a shareholder of the lender; or
associated with a shareholder of the lender;

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

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

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

A private company is not taken under section 109C or 109D to pay a dividend because of a payment or loan the private company makes to another company.
Note: This does not apply to a payment or loan to a company in its capacity as trustee. (See section 109ZE.)
Section 109K of the ITAA 1936

The protrusive LOZIL

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

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

by the Commissioner of Taxation.

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

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

LOZILs as de facto shareholder capital funding

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

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

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

Loans at will

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

When might a LOZIL be a tax problem?

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

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

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

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

… must be one of Wilde’s …

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

A good deed for an old friend going through a divorce

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

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

2016 sale of the home for a profit

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

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

Mr. Green not taxed on his windfall?

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

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

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

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

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

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

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

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

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

The hard road

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

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

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

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

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

The arm’s length obstacle

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

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

Symmetry prevails

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

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

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

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

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

Determining the AAT fee on a tax appeal to the AAT

The applicable fees to appeal

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

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

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

Who can appeal to the SBDT?

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

Multiple decisions – single fee on an applicant

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

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

Partnership CGT SBDT appeal

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

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

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

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

Should a single fee have applied to the partnership?

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

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

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

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

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

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

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

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

Vodafone

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

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

Cairn

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

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

Source taxation

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

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

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

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

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

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

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

4. Gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State.
Article 13(4) of the OECD model convention

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

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

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

Comparison with taxes on business profits under OECD-like treaties

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

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

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

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

are subject to Australian CGT.

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

Australian opportunities for non-residents and tax havens

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

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

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

Desirable destinations for foreign investment

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

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

The retrospectivity stumbling block

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

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

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

Treaty arbitration

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

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

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

Conclusion

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

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

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

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

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

AvoidIgloo

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

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

When to look out for GST on land sales

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

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

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

Unanticipated GST and reducing GST with the margin scheme

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

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

the vendor who receives a higher nett price.

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

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

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

The general conditions in the NSW Contract state that:

Normally, if a party must pay the price or any other amount to the other party under this contract, GST is not to be added to the price or amount. (Emphasis added)
General condition 13.2

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

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

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

Contract could not be rectified

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

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

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

The price includes GST of: $ _________

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

The margin scheme and the price

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

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

The GST residential withholding amount when the margin scheme applies

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

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

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

Etmekdjian – the disqualified are out of the SMSF system

In an Administrative Appeals Tribunal decision this month in Etmekdjian v. Commissioner of Taxation [2020] AATA 3821 (1 October 2020), the AAT refused to extend a waiver of disqualification to the applicant so the applicant could manage his own self managed superannuation fund (SMSF). The applicant had been disqualified under Part 15 of the Superannuation Industry (Supervision) Act 1993 (SIS Act).

Automatic disqualification and its waiver

There are a thin 14 days following disqualification to apply for a waiver of the disqualification once a person is disqualified: section 126B. In this case the applicant had been disqualified automatically under sub-section 120(3) of the SIS Act on conviction, by a NSW Local Court, for Commonwealth Criminal Code offences. The offences were for dishonestly backdating employee share scheme elections under former section 139E of the Income Tax Assessment Act 1936.

The applicant was outside of the 14 days allowed to seek the waiver so the applicant sought an extension of time to do so from the AAT.

AAT decision

The AAT refused:

to accept that the applicant’s unsuccessful appeal to the District Court against the conviction stayed the conviction by the Local Court and thus the date of automatic disqualification for section 120 purposes; and
to allow the extension of time as there was an absence of exceptional circumstances explaining the failure to lodge the application for waiver against disqualification within 14 days.

Context of the AAT decision and Part 15 disqualifications

Deputy President Bernard McCabe observed at the outset in paragraph 1 of the AAT decision:

Managing a superannuation fund – even a small, self-managed fund – is a big responsibility. There is a public interest in managing these funds properly given the tax advantages they enjoy. To that end, the Superannuation Industry (Supervision) Act 1993 (Cth) (SISA) establishes rules designed to ensure prudent management. Part 15 of SISA includes rules regarding disqualified persons. A disqualified person may not be a trustee, investment manager or custodian of a superannuation entity, or be a responsible officer (such as a director) of a corporation that performs those roles: s 126K. A person can be disqualified by the Commissioner of Taxation (where the Commissioner is the regulator) or the Federal Court (where the Australian Prudential Regulatory Authority is the regulator) on a variety of grounds, but a person will be automatically disqualified in circumstances set out in s 120. .…
[2020] AATA 3821 at paragraph 1

The AAT found that it only had power to extend the 14 day period strictly when exceptional circumstances warranted that extension. Deputy President McCabe concluded:

….The law requires that I identify exceptional circumstances that prevented the applicant from complying with the 14 day time limit. It is not enough to establish the applicant had a good excuse, or that non-compliance does not result in any harm, or that the applicant has a good case in relation to the substantive issue. This is not a standard ‘extension of time’ case.
21. The applicant has failed to identify any ‘exceptional circumstances’ that prevented him from making the application within the time frame contemplated in s 126B(3). In those circumstances, the decision under review must be affirmed.
[2020] AATA 3821 at paragraphs 20 and 21

The AAT’s strict approach is no surprise when it comes to the disqualification rules in Part 15. Part 15 reflects a low tolerance approach in the SIS Act to persons designated unfit to manage a superannuation fund.

Difficulties – SMSFs with a disqualified trustee/director/member

The author has seen Part 15 disqualifications happen on bankruptcy by operation of sub-section 120(1) of the SIS Act.

A person disqualified on bankruptcy, or any other disqualified person such as Mr. Etmekdjian, can’t be a trustee, a director of the trustee or a member of a SMSF. A fund with a disqualified participant falls off the register of superannuation funds as a SMSF regulated by the Commissioner of Taxation. The fund becomes (at least notionally) regulated by the Australian Prudential Regulatory Authority (APRA) instead.

So the Australian Taxation Office won’t and can’t assist once the fund is no longer a SMSF.

Unless a deactivated SMSF, on a participant becoming Part 15 disqualified, can nimbly:

convert to an APRA regulated fund; and
appoint an approved trustee;

based on a power in the trust deed of the fund to do so, or disqualified persons promptly vacate the fund to prevent deactivation, the fund reverts to an administrative no man’s land. Even arranging a roll out of benefits to another fund is fraught following deactivation. The fund won’t be practically manageable or administrable.

Time for a SMSF deed upgrade?

Lack of capability in a SMSF trust deed to convert a SMSF to an APRA fund is one of a number of indicators that SMSF trust deed may need of an upgrade to comply with today’s SIS Act requirements.

Foreign purchaser stamp duty and land tax surcharges – design faults & unit trusts

Advent of the state foreign person property surcharges

Foreign person surcharges have applied on New South Wales, Victoria, Queensland, Tasmania, Western Australia and Australian Capital Territory property taxes following Commonwealth action to have the Foreign Investment Review Board more closely monitor the acquisition and holding of Australian real estate by foreign interests: see our July 2016 blog post:

Australia is now tracking & surcharging foreign buyers of land

https://wp.me/p6T4vg-56

NSW surcharges and current rates

In NSW, surcharges imposed since 2016 are:

(a) a surcharge purchaser duty (currently 8% of the market value of the property) on the acquisition of residential property in NSW (Chapter 2A of the Duties Act (NSW) 1997 [DA]); and

(b) a surcharge land tax (currently 2% of the unimproved value of the land) for residential property in NSW owned as at 31 December each year (section 5A of the Land Tax Act (NSW) 1956).

(Surcharges)

The foreign trusts that aren’t foreign problem

Discretionary trusts with all or predominantly Australian participants and entitled beneficiaries can nevertheless be caught as foreign trusts that must pay the Surcharges. Liability for the Surcharges is based or grounded on sub-section 18(3) of the Foreign Acquisitions and Takeovers Act (C’th) 1975 (FATA): Sub-section 18(3) provides:

For the purposes of this Act, if, under the terms of a trust, a trustee has a power or discretion to distribute the income or property of the trust to one or more beneficiaries, each beneficiary is taken to hold a beneficial interest in the maximum percentage of income or property of the trust that the trustee may distribute to that beneficiary.
sub-section 18(3) of the Foreign Acquisitions and Takeovers Act (C’th) 1975

If the income or property (capital) that could be distributed to a foreign beneficiary of a trust is 20% or more of income in a year or property of the trust, the trust is foreign for FATA and Surcharge purposes. An ameliorating aspect of the Surcharges legislation is that:

Australian citizens who are non-residents of Australia; and
some New Zealand citizens with certain Australian visas;

who are foreign persons under the wide sweep of sub-section 18(3) of the FATA are excluded from being foreign persons for NSW Surcharges purposes: see sub-section 104J(2) of the DA.

The lengthy transition

Even for those not averse to the idea that foreign individual and foreign trust investors should pay higher property dues the implementation of the Surcharges in NSW has been agonising. Even now, in 2020, four years after liabilities for Surcharges were first imposed under the DA and the LTA the State Revenue Legislation Further Amendment Act (NSW) 2020 (“SRLFAA”) is still needed to phase in the Surcharges, and transitional relief from them, as they apply to trusts.

As well as imposing the wide sweep of what the FATA treats as foreign, the SRLFAA:

imposes impugnable trust deed requirements on discretionary trusts (see below); and
extends transitional arrangements that were set to end on earlier dates in versions of Revenue Ruling G010 from Revenue NSW and the State Revenue Legislation Further Amendment Bill (NSW) 2019.

Trust deed requirements on discretionary trusts

Where a trust is a discretionary trust for Surcharge purposes then the SRLFAA requires that the terms of the trust must be amended by 31 December 2020 so:

(a) no potential beneficiary of the trust is or can be a foreign person [the no foreign beneficiary requirement]; and
(b) the terms of the trust cannot be amended in a manner so a foreign person could become a beneficiary [the no amendment requirement];

and then only does the discretionary trust, even a discretionary trust that:

has no foreign participants or beneficiaries; and
thus is not foreign after the FATA wide sweep and sub-section 104J(2) of the DA are considered;

(a Local DT) escape treatment as a foreign trust for Surcharge purposes.

Why the no amendment requirement?

The object of the no amendment requirement is to impose the Surcharges based on the contingency or possibility only that a Local DT may come to have a foreign beneficiary in the future. The position of Revenue NSW is understood to be that Revenue NSW does not have the compliance resources to monitor Local DTs for foreign beneficiaries into the future on an ongoing basis.

Although nearly all discretionary trust deeds contain some kind of variation power, a design fault of such resource-saving requirements viz.:

the “irrevocable” requirement of Revenue NSW in paragraph 6 of Revenue Ruling DUT 037 concerning sub-section 54(3) of the DA concerning concessional duty on changes of trustee; and
the no amendment requirement now in the SRLFAA;

is that the variation power in many or most trust deeds of trusts in NSW may not permit modification of the variation power to satisfy either of these requirements.

Changing the scope or amending the terms of a trust amendment power

In Jenkins v. Ellett, Douglas J. of the Queensland Supreme Court stated the relevant law and learning about changing the variation power in a trust deed:

[15] The scope of powers of amendment of a trust deed is discussed in an illuminating fashion in Thomas on Powers (1st ed., 1998) at pp. 585-586, paras 14-31 to 14-32 in these terms:
“In all cases, the scope of the relevant power is determined by the construction of the words in which it is couched, in accordance with the surrounding context and also of such extrinsic evidence (if any) as may be properly admissible. A power of amendment or variation in a trust instrument ought not to be construed in a narrow or unreal way. It will have been created in order to provide flexibility, whether in relation to specific matters or more generally. Such a power ought, therefore, to be construed liberally so as to permit any amendment which is not prohibited by an express direction to the contrary or by some necessary implication, provided always that any such amendment does not derogate from the fundamental purposes for which the power was created ….It does not follow, of course, that the power of amendment itself can be amended in this way. Indeed, it is probably the case that there is an implied (albeit rebuttable) presumption, in the absence of an express direction to that effect, that a power of amendment (like any other kind of power) cannot be used to extend its own scope or amend its own terms. Moreover, a power of amendment is not likely to be held to extend to varying the trust in a way which would destroy its ‘substratum’. The underlying purpose for the furtherance of which the power was initially created or conferred will obviously be paramount.”
Jenkins v. Ellett [2007] QSC 154

In our experience a small minority of trusts in NSW have a variation power which expressly permits extension of its own scope or amendment of its own terms. That kind of extended power can raise its own set of difficulties which explains why these extended variation powers are not especially popular. It follows, as stated, that a substantial number of variations of the terms of discretionary trust deeds which the no amendment requirement imposes are prone, or likely, to be beyond the power conferred by the variation power of the trust and thus ineffective on a trust by trust reckoning.

discretionary trust for Surcharges purposes

In section 1 in the dictionary of the DA a discretionary trust is defined for DA and Surcharges purposes:

“discretionary trust” means a trust under which the vesting of the whole or any part of the capital of the trust estate, or the whole or any part of the income from that capital, or both–
(a) is required to be determined by a person either in respect of the identity of the beneficiaries, or the quantum of interest to be taken, or both, or
(b) will occur if a discretion conferred under the trust is not exercised, or
(c) has occurred but under which the whole or any part of that capital or the whole or any part of that income, or both, will be divested from the person or persons in whom it is vested if a discretion conferred under the trust is exercised.
section 1 of the dictionary of the Duties Act (NSW) 1997

More time to check for unexpected foreign trust treatment

With time extended to 31 December 2020 by the SRLFAA to amend trust deeds so a discretionary trust won’t be treated as a foreign person it is timely during the remainder of 2020 to also check the terms of residential land holding trusts that may not ordinarily be thought of as a discretionary trust.

A trust, including a unit trust, that contains powers in its terms which:

allow for a beneficiary to be selected by someone to take income or capital;
allow for the amount of income or capital a beneficiary is to take to be set by someone;
which can change the income or capital a beneficiary will take if the discretion is not exercised; or
which can divest a beneficiary of an interest in income or capital which they otherwise would take;

that brings the trust within a discretionary trust in section 1 of the dictionary of the DA needs to meet the no foreign beneficiary requirement and the no amendment requirement in the SRLFAA.

Hybrid trusts and other unit trusts

This definition brings in trusts known as hybrid trusts within this construct of discretionary trust. Shortly stated a hybrid trust is a tax aggressive structure where unit or interest holders have standing vested interests in income or capital of the trust but where, usually, the trustee has a supervening power or powers to divest those interests in income, capital or both in favour of other beneficiaries such as family or related companies or trusts controlled by the unit or interest holder with the standing interest.

Other unit trust arrangements can be treated as a DA discretionary trust even where the discretion is historical, redundant and income tax benign. For instance an older style standard unit trust may be set up by way of initial units and the trustee may be given a discretion in the trust deed not to distribute income or capital to initial unitholders once ordinary units in the trust are issued.

This discretion in the terms of a trust is enough for the unit trust to be treated as a discretionary trust so it would be prudent for the terms of the unit trust to be amended to remove the discretion if that can be done:

without resettling the trust; and
less onerously than amending the trust deed to comply with the no foreign beneficiary requirement and the no amendment requirement.