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.
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;
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.
Taxation Ruling TR 2005/7 concerns the taxation implications of ‘partnership salary’. The ruling explains:
A ‘partnership salary’ is not truly a salary, nor is it an expense of the partnership, but instead is a distribution of partnership profits to the recipient partner. Thus, the payment of a ‘partnership salary’ to a partner, whether or not for personal services provided by the partner, is not taken into account as an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997…
Paragraph 7 of TR 2005/7
At paragraph 10 of TR 2005/7 the Commissioner further states that, to be effective for tax purposes, an agreement to pay a partnership salary must be entered into before the end of the income year in which a claimed partnership salary is drawn.
TR 2005/7 has a number of useful examples of how accounting for a partnership salary can be done in a way that will be acceptable for tax by the Commissioner.
Fights with other partners over entitlements
A partner in receipt of a partnership salary for personal services should thus be mindful that a partnership deed may or will be vital to showing he or she received a partnership salary, as agreed, for those services in fact and that amounts received by the partners were additional, as salary, to and not an advance or drawings of the partner’s statutory equal share of income.
Other problems with partnerships that are not in order for tax
Not partnership salary issues and so not addressed in TR 2005/7 are:
where the Commissioner may adjust partnership income of a partner where a partner does not have real or effective control of or of disposal of partnership income using the uncontrolled partnership income provision in section 94 of the ITAA 1936; and
where the Commissioner asserts a partnership is a sham: that is, the partnership is without legal effect despite documentation, such as an purported agreement, of it.
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.
In the recent Administrative Appeals Tribunal case Chadbourne and Commissioner of Taxation (Taxation)  AATA 2441 (10 July 2020) the AAT confirmed the disallowance of tax deductions to Mr. D. Chadbourne (the Applicant).
The Applicant was a beneficiary of the D & M Chadbourne Family Trust (DMCFT) and the Applicant was denied deductions for:
interest on money borrowed by the Applicant to fund the acquisition of real estate and shares by the DMCFT; and
other expenses incurred by the Applicant expended;
so the DMCFT could earn income.
The discretionary trust
The DMCFT was a discretionary trust. In Chadbourne Deputy President Britten-Jones usefully described a discretionary trust:
I note that the meaning of the term ‘discretionary trust’ is disclosed by a consideration of usage rather than doctrine, and the usage is descriptive rather than normative. It is used to identify a species of express trust, one where the entitlement of beneficiaries to income, or to corpus, or both, is not immediately ascertainable; rather, the beneficiaries are selected from a nominated class by the trustee or some other person and this power (which may be a special or hybrid power) may be exercisable once or from time to time.
Chadbourne at paragraph 8
The mere expectancy of a beneficiary of a discretionary trust
Because the beneficiaries of a discretionary trust are not immediately ascertainable and are to be selected, a prospective beneficiary only has an expectancy of earning trust income unless and until the beneficiary is so selected by the trustee to take income:
Unless and until the Trustee of the discretionary trust exercises the discretion to distribute a share of the income of the trust estate to the applicant, the applicant’s interest in the income of the discretionary trust is a mere expectancy. It is neither vested in interest nor vested in possession, and the applicant has no right to demand and receive payment of it.
Chadbourne at paragraph 57
or in the case of a beneficiary who takes in default of exercise of discretion they have no more than a similar expectancy.
The Applicant was a beneficiary of the DMCFT with an expectancy interest.
The available tax deduction
The Applicant could not satisfy the first limb of the general deduction provision, now in the Income Tax Assessment Act (ITAA) 1997, which allows an income tax deduction for a loss or outgoing to the extent:
it is incurred in gaining or producing your assessable income
paragraph 8-1(1)(a) of the ITAA 1997 (emphasis added)
In Chadbourne the Applicant’s expenditure was incurred to gain or produce income for the trustee of the DMCFT, a separate legal entity. Applying authority including Federal Commissioner of Taxation v Munro (1926) 38 CLR 153, Antonopoulos and FCT  AATA 431; 84 ATR 311, Case M36 (1980) 80 ATC 280, Commissioner of Taxation v Roberts and Smith (1992) 37 FCR 246, where Hill J. referred to Ure v Federal Commissioner of Taxation (1981) 50 FLR 219, Fletcher v Commissioner of Taxation (1991) 173 CLR 1 and other cases, the AAT required a nexus between loss or outgoings of the Applicant and the assessable income of the Applicant; not the DMCFT. Although the Applicant stood to earn income indirectly as the likely beneficiary of the DMCFT the AAT found:
The Trust is a discretionary trust the terms of which require the Trustee to exercise a discretion as to whom a distribution of net income is to be made. It is an inherent requirement of the exercise of that discretion that it be given real and genuine consideration. There must be ‘the exercise of an active discretion’. There were numerous beneficiaries in the Trust. There was no certainty provided by the terms of the Trust that the Trustee would exercise its discretionary power of appointment in favour of the applicant.
Chadbourne at paragraph 53
and the Applicant thus had not incurred the expenditure in gaining or producing the assessable income of the Applicant.
Why did the Applicant run the AAT appeal?
The Applicant in Chadbourne was self-represented. With the benefit of professional advice or assistance the Applicant may have:
more readily foreseen the outcome of his appeal to the AAT which, in the light of the authority applied by Deputy President Britten-Jones, could be seen as inevitable; or
moreover, arranged the loan to achieve the required section 8-1 nexus between the outgoings and the assessable income of a taxpayer.
Safer alternative 1 – trustee loan
The most obvious alternative would have been for the trustee of the trust to have been the borrower and to have directly incurred the relevant expenses though those actions would have been different commercial arrangements to those that were done.
These actions may have been more complicated and expensive to arrange: not the least because the financier may have required the Applicant to personally guarantee repayment of the loan by the trustee of the trust which was a corporate trustee with limited liability. Nonetheless these precautions would have ensured section 8-1 deductions were available to the trustee of the trust.
(Somewhat) safer alternative 2 – on-loan to the trustee
The other and perhaps commercially easier alternative would have been an on-loan of the borrowed funds by the Applicant to the trust.
The Applicant in Chadbourne may have belatedly considered an on-loan solution. At paragraph 11 of the AAT decision it was observed that the Applicant had abandoned a contention that there was a “written funding agreement” between the Applicant and the trustee of the DMCFT which the Commissioner had suggested was an invention to assist the Applicant in the appeal.
In the event of a genuine on-loan the trustee of the trust would hold the borrowed funds as loan funds with a clarity as to whom interest and principal is to be repaid rather than as a capital contribution or gift to the trust without that clarity.
On-loan – interest free
Clearly the on-loan by the Applicant to the trustee of the trust should not be interest free as the Applicant then faces the Chadbourne problem of having no assessable income with which to justify a section 8-1 deduction. In the words of Taxation Determination TD 2018/9 Income tax: deductibility of interest expenses incurred by a beneficiary of a discretionary trust on borrowings on-lent interest-free to the trustee:
A beneficiary of a discretionary trust who borrows money, and on-lends all or part of that money to the trustee of the discretionary trust interest-free, is usually not entitled to a deduction for any interest expenditure incurred by the beneficiary in relation to the borrowed money on-lent to the trustee under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)…
TD 2018/9 – paragraph 1
On-loan – at low interest
An on-loan at low interest was arranged in Ure v. Federal Commissioner of Taxation (1981) 11 ATR 484. In Ure the borrower borrowed funds at up to 12.5% p.a. interest and on-lent the funds to his wife and his discretionary trust at 1% p.a. The Full Federal Court found that the deduction Mr. Ure could claim under the first limb of the general deduction provision, sub-section 51(1) of the ITAA 1936, was limited to the 1% p.a. by which the interest income earned by Mr. Ure from his on-loan was confined.
On loan – at equivalent interest
It thus follows from TD 2018/9, Ure and Chadbourne that, to achieve deductibility in full for interest on funds borrowed and on-lent to a related discretionary trust, the interest earned by the beneficiary/on-lender on the on-loan should be the interest payable by the on-lender on the loan from the financier. This should leave the beneficiary/borrower in a tax neutral position on his or her loan on-loaned with assessable interest earned under the on-loan equalling deductible interest paid on the loan.
Related loan issues
As the on-loan is a related loan there are further considerations which will attract the scrutiny of the Commissioner:
A related on-loan should ideally be carefully documented and it should be clarified that the beneficiary/on-lender has an indefeasible right to the interest even though the on-lender is a related party of the borrower. It is also important that commitments in the on-loan agreement are met and generally interest due to the beneficiary/on-lender shouldn’t be capitalised and, especially, shouldn’t be aggregated with unpaid present entitlements due to the beneficiary.
The Commissioner could take these positions:
that the on-loan with interest is inadequately documented and can’t be proved so accounting entries capitalising interest shouldn’t be considered conclusive; or
the on-loan may be documented but it is a sham and the failure of the trust to pay interest when due shows this.
See my blog post at this site “Only a loan? Impugnable loans, proving them for tax and shams” https://wp.me/p6T4vg-8a which shows the fallibility of related party loans when these questions are contested with the Commissioner.
Woes with hybrid trusts
A hybrid trust, also a descriptive rather than a normative structure, can also fit the Deputy President Britten-Jones formulation of a discretionary trust where the entitlement of beneficiaries of the hybrid trust to income is not immediately ascertainable and is subject to the exercise of a discretion. It has been recognised, including in the Commissioner’s Taxpayer Alert TA 2008/3 Uncommercial use of certain trusts that the considerations of the AAT in Chadbourne can similarly apply to deny a section 8-1 deduction to the holder of an interest in a hybrid trust who incurs expenditure to earn income through a hybrid trust structure.
In passing I note my wariness of hybrid trusts which are typically aggressive and sometimes tax abusive arrangements. The Commissioner’s Tax Alerts are particularly directed against tax aggressive activity.
That said, the trust in the case of Forrest v Commissioner of Taxation  FCAFC 6, which was referred to in a citation (sic.) in Chadbourne, appears to have been an instance of a hybrid trust where entitlement of unit holders to ordinary income was ascertainable and not subject to a discretion. On appeal to the Full Federal Court, the unit holders in Forrest could establish a nexus between borrowing expenditure incurred and assessable income.
A mirror of the general principle of source and residence taxation broadly setting the parameters of international taxation, and reflected in Australia’s income tax law, is that income of a foreign resident not from sources in the state is not taxable in the state (in this post called the Mirror Principle). In Australia:
interests in real property in Australia and related interests; and
interests in assets used in business in permanent establishments in Australia:
are designated “Taxable Australian Property” (TAP) (see Division 855 of the Income Tax Assessment Act (ITAA) 1997). TAP is used in Australian income tax law to apply the Mirror Principle.
Foreign resident capital gains from non-TAP disregarded
Property which is not TAP, that is, property not taken to be connected to Australia for income tax purposes in the hands of foreign residents includes shares and securities as opposed to property interests in or related to Australian land or of permanent establishments carrying on enterprises in Australia which are TAP.
Capital gains made by foreign residents from non-TAP assets are disregarded for tax purposes: section 855-10.
Trouble pinpointing trusts as foreign or not
Trusts are elusive and create enormous difficulties in the international tax system see Trusts – Weapons of Mass Injustice. Trusts can detach beneficiaries who benefit from property who may be in one state from:
the trustee of the trust, in whose name the property is held, who may be in another state; and
the activities of trust which may be in yet another state.
Apt taxation of those activities in line with Mirror Principle thus poses a significant challenge to governments. States are justified imposing laws to counter offshoring with trusts to ensure the integrity of their tax systems.
Some states don’t recognise trusts.
In Australia trusts are mainstream. Some types of trusts are considered tax benign and conducive to legitimate business, investment and prudential activity. Fixed trusts are often treated transparently for Australian income tax purposes so that a fixed trust interest holder is:
taxed similarly to a regular taxpayer or investor; and
no worse off, tax wise, than a taxpayer or investor who owns the property outright rather than by way of a trust beneficial interest.
So, consistent with the Mirror Principle that a foreign resident owner of non-TAP who makes a gain on the non-TAP shouldn’t be taxable on the gain, a foreign resident beneficiary (FRB) of a fixed trust can disregard a capital gain made in relation to their interest in a fixed trust: section 855-40.
Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation
In the Federal Court case Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation  FCA 559 this week the issue arose whether an Australian resident family discretionary trust – a non-fixed trust, was entitled to rely on section 855-10 and the Mirror Principle to disregard capital gains distributed to a FRB, a beneficiary based in London, of the trust from realisation by the trust of shares in a private company, GCPL, which were non-TAP of the trust.
Detachment of capital gains from the workings of trust CGT tax rules
The capital gains of a trustee are distant from the capital gains of a beneficiary under the ITAA 1936 and the ITAA 1997. Transparent treatment or look through to the capital gains of the trustee as capital gains of the beneficiary/ies became even more remote following changes to Sub-division 115-C of the ITAA 1997 including the introduction of Division 6E of Part III of the ITAA 1936.
These changes brought in distinct treatment of capital gains and franked distributions of a trust from other trust income following the High Court decision in Commissioner of Taxation v Bamford  HCA 10 and the clarification of taxation of trust income in that case.
Legislation unsupportive of transparent treatment
In Greensill Thawley J. analysed the provisions in Sub-division 115-C and Division 6E to deconstruct the applicant’s case to disregard capital gains using Division 855.
Section 855-40 specifically allows a FRB of a fixed trust to disregard non-TAP capital gains. The absence of an equivalent exemption for FRBs of non-fixed trusts is telling unless section 855-40 is otiose or represents an abundance of caution. Thawley J. did not follow that line. As the applicant in Greensill could not disregard the capital gains using section 855-40 in the case of non-fixed trust, or section 855-10, the capital gains were taxable in Australia.
Unless there is an appeal to the Full Federal Court the Commissioner can finalise his draft taxation determination TD 2019/D6 Income tax: does Subdivision 855-A (or subsection 768-915(1)) of the Income Tax Assessment Act 1997 disregard a capital gain that a foreign resident (or temporary resident) beneficiary of a resident non-fixed trust makes because of subsection 115-215(3)? as the Federal Court has accepted the view in it.
It is sometimes
wrongly assumed that a minute of the current trustee is sufficient to change
the trustee of:
discretionary trust (FDT); or
managed superannuation fund (SMSF) (which must be a trust with a trustee too –
see sub-section 19(2) of the Superannuation
Industry (Superannuation) Act (C’th) 1993 (SIS Act));
and that a change of
trustee will have no serious tax consequences. The second proposition is more
likely to be true, but not always.
FDTs and SMSFs
invariably commence with a deed which contains the terms (the trust terms or
governing rules – TTOGRs) on which the trust commences. That, in itself, is a
reason why I contended in 2009 in Redoing the deed
that an instrument or resolution less than a deed to change the trustee is
prone to be ineffective even where change by less than or other than a deed is
stated to be permitted by the TTOGRs in the trust deed.
relying on ability to change in the trust deed
It is thus to the
trust deed that one needs to look to find:
whether there is a power in the TTOGRs to appoint a new trustee or to otherwise change the trustee; and
if, so, what the procedure or formalities are for doing so.
relying on the Trustee Acts
If ability to change
trustee is not present, or is derelict, in the TTOGRs then the Trustee Acts in
states (and territories) provide options for appointing a new or additional
trustee which vary state to state.
Trustee Act – New South Wales
In New South Wales: section
6 of the Trustee Act (NSW) 1925
allows a person nominated for the purpose of appointing trustees in the TTOGRs,
a surviving trustee or a continuing trustee to appoint a new trustee in certain
specified situations such as where a trustee:
is incapable of acting as trustee; or
is absent for a specified period out of the state.
However an appointment of a new trustee in these situations must be effected by registered deed: sub-section 6(1) That is the deed of appointment must be registered with the general registry kept by the NSW Registrar-General, which is publicly searchable, and the applicable fee to so register the deed must be paid to NSW Land Registry Services for the appointment to take effect.
It is apparent from sub-section 6(13) that registration of a deed of appointment is not required where ability to appoint a new trustee is in the TTOGRs where the TTOGRs express a contrary intention; that is: where the TTOGRs expressly and effectively allow an appointment to be effected without a registered deed.
Trustee Act – Victoria
In Victoria there is a comparable capability for a person nominated for the purpose of appointing trustees in the TTOGRs, a surviving trustee or a continuing trustee to appoint a new trustee in writing in certain specified situations such as where a trustee:
is incapable of acting as trustee; or
is absent for a specified period out of the state;
under section 41 of the Trustee Act (Vic.) 1958. However this Victorian law does not impose any requirement that the required instrument of appointment in writing must be registered.
Changing trustee by obtaining a court order
The supreme courts of the states and territories are also given a residual statutory capability to appoint trustees under the respective Trustee Acts. However applying to a supreme court for an order to change a trustee of a FDT or a SMSF with sufficient supporting grounds is an option of last resort given likely significant costs and uncertainties of obtaining the order.
Changing trustee by deed
The TTOGRs in a trust deed of a FDT or a SMSF will frequently require that an appointment of a new trustee may or must be effected by a deed. It is desirable that it should do so to ensure the appointment of a new trustee does not become of a matter of uncertainty and difficulty for the reasons I have described in Redoing the deed.
Tax consequences of a change of trustee
As a change of trustee without more generally does not change beneficial
entitlements under a trust, the tax consequences are usually benign:
For capital gains tax (CGT), assurance that changing trustee does not give
rise to a CGT event for all of the CGT assets held in a trust is diffuse under
the Income Tax Assessment Act (C’th) (ITAA)
(2) You dispose of a * CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner.
Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event A1 will not happen merely because of a change in the trustee.
Sub-section 960-100(2) with the Notes below it in fact say:
(2) The trustee of a trust, of a superannuation fund or of an approved deposit fund is taken to be an entity consisting of the person who is the trustee, or the persons who are the trustees, at any given time.
Note 1: This is because a right or obligation cannot be conferred or imposed on an entity that is not a legal person.
Note 2: The entity that is the trustee of a trust or fund does not change merely because of a change in the person who is the trustee of the trust or fund, or persons who are the trustees of the trust or fund.
Similarly sections 104-55 and 104-60 of the ITAA 1997 which concern:
• Creating a trust over a CGT asset: CGT event E1
• Transferring a CGT asset to a trust: CGT event E2
each restate the above Note: viz.
Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event E… will not happen merely because of a change in the trustee.
A change of trustee can have stamp duty consequences where the trust holds
dutiable property such as real estate.
Duty – NSW
Concessional stamp duty on the transfer of the dutiable property of the trust to the new trustee can be denied in NSW to a FDT unless the trust deed of the trust limits who can be a beneficiary, for anti-avoidance reasons: see sub-section 54(3) of the Duties Act (NSW) 1997.
Indeed Revenue NSW withholds the requisite satisfaction in sub-section 54(3) unless the TTOGRs provide or have been varied in such a way so that an appointed new trustee or a continuing trustee irrevocably cannot participate as a beneficiary of the trust. Contentiously satisfaction is withheld by Revenue NSW unless a variation to a FDT to so limit the beneficiaries is “irrevocable“ : see paragraph 6 of Revenue Ruling DUT 037, even though that variation may not be plausible or permissible under the TTOGRs of the FDT.
This hard line is taken by Revenue NSW to defeat schemes where someone, who might otherwise be a purchaser of dutiable property who would pay full duty on purchase of the property from the trust, becomes both a trustee and beneficiary able to control and beneficially own the property who is thus able to contrive liability only for concessional duty and avoid full duty,
Duty – Victoria
Although the Duties Act (Vic.) 2000 contains anti-avoidance provisions addressed at this kind of anti-avoidance arrangement, there is no comparable hard line to that in NSW in sub-section 33(3) of the Duties Act (Vic.) 2000 so that the transfer of dutiable property, including real estate, on changing trustee is more readily exempt from stamp duty.
A prominent requirement on changing trustee of a SMSF is notification to the Australian Taxation Office, as the regulator of SMSFs, within twenty-eight days of the change: see Changes to your SMSF at the ATO website.
Where changing trustee involves a corporate trustee then there may also be an obligation to inform the Australian Securities and Investments Commission of changes to details of directors of the corporate trustee, if any. There may be further matters to be addressed if any new or continuing directors are or will become non-residents of Australia and, with SMSFs, the general requirement in section 17A of the SIS Act that the parity between members of the fund on the one hand and trustees, or directors of the corporate trustee on the other, needs to borne in mind and, if need be, addressed.
Those seeking the small business capital gains tax (CGT)
concessions in the 2018 and later income years need to be wary of modified
small business CGT concession integrity rules which apply from 8 February 2018
by virtue of Schedule 2 of the Treasury
Laws Amendment (Tax Integrity and Other Measures) Act 2018 (TIOMA).
The small business CGT concessions in Division 152 of the Income Tax Assessment Act (ITAA) 1997 may look straight forward but there are subtle complications within the misnamed “basic” conditions for the relief which can be matrixlike. The small business CGT concessions are generous so perhaps it is right that rules to protect their integrity, as ramped up by the TIOMA, are more complicated than the rules that ordinarily impose a CGT liability on sales of small business related CGT assets.
Share or interest sales need to meet additional basic conditions
For CGT events involving sales of shares in companies or interests in trusts “additional” basic conditions have commenced with the TIOMA. The additional basic conditions go further than what I describe here. In this post I wish to focus on the significance of the dual $6m maximum net asset value tests that the TIOMA initiates. So in the below considerations I am going to assume that the other basic conditions for the small business CGT concessions, including the additional basic conditions, such as the dual active asset test, which also needs to be considered following the introduction of the TIOMA, will be met.
The dual MNAV and SBE tests
The dual $6m maximum net asset value (MNAV) tests are alternative tests with the similarly dual small business entity ($2m aggregated turnover) (SBE) tests which apply where the small business CGT relief is sought on a sale of shares in a company or an interest in a trust. The dual MNAV tests and SBE tests separately test both the taxpayer (“you”) and the object entity which is the relevant company or trust in which the shares are or interest is held by the taxpayer as the case may be. To obtain relief under the basic conditions, and under the additional basic conditions set out in sub-section 152-10 as revised by the TIOMA, the dual tests must be separately satisfied to obtain any small business CGT concession relief:
Taxpayer must satisfy
Object entity must satisfy
MNAV testorSBE test
Modified MNAV testorSBE test and carried on
business up to day of sale
When the object entity MNAV test
In practice, there is a significant slew of sales of shares
or trust interests where the object
entity won’t satisfy the SBE test
an aggregated annual turnover of the object entity of more than $2 million; or
alternatively, the object entity may satisfy that SBE test but paragraph 152-10(2)(a) may apply because the object entity ceased to carry on its business some time before the sale.
In those cases the object entity also needs to satisfy the MNAV test even where the taxpayer has separately satisfied either of the MNAV test or the SBE test or both.
Satisfaction of the MNAV
test by the object entity may
thus be vital to the availability of the small
business CGT concessions to a taxpayer selling shares or a trust interest.
Where the object entity, let us say a
private company with multiple owners, is worth more than $6m overall, this may
well be a problem for minority owners who otherwise are:
on or over the 20% significant individual/CGT stakeholder
with net asset value (NAV) under $6m who sell
their shares looking for the small
business CGT concessions.
The Explanatory Memorandum with the TIOMA gives the
Example 2.4: Investment in large business
Karen carries on a small
consulting business as a sole trader. She is a CGT small business entity
(according to the general rules) for the 2019-20 income year. Karen also owns
30 per cent of the shares in Big Pty Ltd, a large private company with annual
turnover in excess of $20 million in both the 2018-19 and 2019 CGT assets
exceeds $100 million throughout this period. On 1 October 2019, Karen sells her
shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT
concessions for any resulting capital gain. Even if Karen satisfies the other
basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd
is not a CGT small business entity in the 2019-20 income year. It also does not
satisfy the maximum net asset value test in relation to the capital gain, as
its net assets exceed $6 million immediately prior to the CGT event happening
(being in excess of $100 million for the entire income year).
MNAV test complexities
Like the SBE test
with aggregated turnover of the taxpayer, affiliates and their connected
entities, compliance with the MNAV test
relies on, or more specifically NAV (net
asset value) must stay under the
relevant $6m limit after, aggregation.
Before aggregation is considered there is a flip side: the
exclusions from the MNAV test: The
substantial exclusions are confined to individual taxpayers viz. interests in
an individual’s main residence, personal use assets, superannuation and
insurance: section 152-20 of the ITAA 1997. The other exclusions in this
section are largely to prevent accounting anomalies with:
accounting provisions; and
the double counting of the value of an asset indirectly held in an entity and the value of the stake in the entity including the asset, representing the same value, in NAV.
Liabilities are also excluded from NAV where they relate to
assets so the MNAV test can be a maximum net
asset value test.
The value of assets that are not excluded are tallied in NAV
when applying the MNAV test. Then
aggregation must be done. Just like with the complexity of small business CGT concessions integrity more generally, MNAV tests and sometimes qualification
for the concessions, involve a hierarchy of constructs which, for the purposes
of illustration, can be loosely compared to the pieces on a chessboard one’s
opponent in chess may hold:
Chess piece: King
Div 152 construct: The taxpayer
Comment: If the King falls,
it’s game over. If either NAV of the taxpayer or (modified) NAV of the object entity exceeds $6m in each
required MNAV test the basic
condition is failed unless there is a pathway to compliance through the SBE test as described above.
Chess piece: Queen
Div 152 construct: An affiliate
Comment: Although an
affiliate is not the taxpayer (or object
entity), the NAV of the affiliate also counts/aggregates to the taxpayer
(or object entity) when applying the MNAV test to the taxpayer (or object entity), in all directions
including NAV aggregated from connected (and Oconnected in the case of an object entity – see below) entities of
Chess piece: Bishop
Div 152 construct: Connected entities
Comment: The whole of the
NAV of the connected entity (excluding the exclusions described above) counts
in the MNAV test. So if a taxpayer,
or an affiliate, has a stake of 50% in a connected entity X, all (100%) of X’s
net value is aggregated to the taxpayer’s NAV (including NAV relating to the
stake in X of minority stakeholders unrelated to the taxpayer or affiliate). If
Y is a connected entity of X then aggregate all (100%) of Y’s net value to the
taxpayer’s NAV too.
Chess piece: Knight
Div 152 construct: Oconnected entities
Comment: The Oconnected entity (my terminology – I thought
of using “controlled entity” which is in contrast to a connected entity which
can either control or be controlled by the other entity it is connected to. But
controlled entity is misleading for, as we shall see, only a 20% stake, hardly
control in any sense, is needed to trigger this link) is a new construct
introduced with the additional basic conditions in the TIOMA relating to the object entity.
The NAV of a Oconnected entity is aggregated to the NAV of
the object entity but it is look through forward to aggregate and
not look through back too (unlike
“controlled by the other entity” which can connect too to a connected entity).
An example is needed to explain constructs here: So if O, an object entity controls Q an Oconnected
entity, due to a 20% or greater stake in Q, and P is another unrelated
stakeholder in Q; the value of Q owned by P is included in the NAV of Q aggregated
to O (see the outcome of that in the below Example 2.5 drawn from the
Explanatory Memorandum) but the NAV of P and its connected entities is excluded
from the NAV of O (if they are not separately affiliated/connected to O).
In chess the Knight moves
in a weird way so the Knight is the allegory chosen here!
Chess piece: Pawn
Div 152 construct: Asset or investment of the above
Comment: A pawn generally
moves one space in chess. $1 in value of an asset or investment owned by a
taxpayer or object entity, which is
not excluded, counts $1 to the NAV of the taxpayer or an object entity. $1 in value
of an asset or investment owned by affiliates, connected entities and Oconnected
entities, which are not excluded, count $1 to the affiliate, connected entity
and Oconnected entity, as the case may be, but if that NAV is in an affiliate,
a connected entity or a Oconnected entity of the taxpayer or object entity in applying the dual
tests, the whole NAV of the relevant
entity is aggregated to the taxpayer/object
entity, not its proportionate NAV
based on percentage stake. i.e. A percentage stake is only used for an interest
in an entity where the entity the interest is held in is not an affiliate,
connected entity or, in the case of the object
entity MNAV test, an Oconnected entity.
I don’t play chess and I accept my chess analogy with the
workings of the MNAV tests is far
from perfect. My endeavour is to make this consideration of the hierarchical
workings of the MNAV tests a little
more comprehendible and so, perhaps, if you are still reading by this point I
have succeeded? If the comparison with chess conveys:
that counts of over $6m by either of the taxpayer NAV or the object entity NAV will generally mean failure of a basic condition for the Division 152 CGT relief so can lead to loss of the game; and
that high value pieces accelerate aggregation of NAV to the $6m limit. That is they can move more than one space: every $1 of a stake a taxpayer (or object entity) in a connected entity (or Oconnected entity), and affiliates and their connected entities without needing any stake in the affiliate of the taxpayer (or object entity) will generally aggregate more than $1 to NAV as the value of others’ stakes in these entities will count to the NAV attributed to the taxpayer (or object entity) too.
The modified MNAV test of the object entity & the modified Oconnected entity
The NAV for controlled entities of an object entity is different due to sub-paras 152-10(2)(c)(iii), (iv)
& (v) in the TIOMA:
The threshold between unrelated entity, counted simply as an asset or investment (pawn) to NAV and connected entity (bishop) consistent with other tests of control in the ITAA 1936 and the ITAA 1997 is 40% with a discretion given to the Commissioner where:
there is 40% or over and under a 50% stake; and
it can be established to the Commissioner that
some other entity controls the entity that would otherwise be the connected
In practice this means expect the Commissioner to de-connect A from connection with X if A owned 48% of X and B (unconnected to A) owned 52% of X.
When applying the object
entity MNAV test, sub-paras 152-10(2)(c)(iii), (iv) & (v) have
operation so that the threshold is lowered to a 20% stake in the other entity.
That is enough “control” to make the other entity, otherwise an asset or
investment, an Oconnected entity (knight). This is apparent from another
example in the Explanatory Memorandum with the TIOMA:
Example 2.5: Indirect investment in large business
Tien owns 20 per cent of the
shares in Investment Co, a company that carries on an investment business.
Investment Co is a CGT small business entity (according to the general rules)
for the 2020-21 income year. Investment Co holds 20 per cent of Van Co, a transport
Van’s assets mean that it is not a CGT small business entity in the 2020-21 income year and does not satisfy the maximum net asset value test at any point during the income year.
On 15 May 2021, Tien sells his shares in Investment Co. He is not eligible to access the Division 152 CGT concessions for any resulting capital gain. Even if Tien satisfies the other conditions, he cannot satisfy the new condition requiring the object entity be a CGT small business entity or satisfy the maximum net asset value test due to the modifications that apply when determining this matter for the purposes of this condition. For the purposes of this condition, Investment Co is considered to be connected with Van Co, as Investment Co holds 20 per cent of Van.
As stated in the table above there is no look through back so in a case where an object entity has a stake of 21% of X,
the NAV in entities connected to X by virtue of the remaining 79% stakes in X
are excluded from the object entity
NAV although the NAV of the assets of X,
including that relating to the other stakeholders, counts to the object entity NAV.
From time to time a family discretionary trust is set up for the benefit of two or more families who may be pursuing a business or a venture in common.
Risk of unequal returns from the discretionary trust!
A double (or more) -throated family discretionary trust is unwise on a number of levels and often reflects misunderstanding of the tax and civil dispute realities that can apply to trusts.
If there is a dispute between the business/venture principals then backing out of this kind of structure it can lead to complications where there are assets in the discretionary trust still to be divided and distributed to beneficiaries. One of the principals controlling the trustee may die or become incapacitated and the other principal may take the opportunity to distribute the assets of the trust solely to his or family! The other family may claim, say, that they should get 50% of the assets of the trust, or the value of the work contributed by them to the trust, but the trust document, being based solely on discretion, will disavow that any family has a 50% or other set interest in the trust.
A family discretionary trust is often funded by gift from the beneficiary family or by the unrewarded work of a member of the beneficiary family. That may be but there is no obligation on the trustee to return the capital or the income of the discretionary trust in proportion to those contributions to that family. The families are highly reliant on the arrangements for control of the trustee, who holds the discretion to distribute the income and capital of the trust, to ensure members of each family will participate in the income and capital of the trust on any equal basis.
A hybrid trust is an alternative to a multi family family discretionary trust which addresses such problems but hybrid trusts have their own separate set of commercial and tax difficulties.
Multi-family family discretionary trusts can be at high risk of audit under the “reimbursement agreement” provisions in s100A of the Income Tax Assessment Act 1936. Income distributions by the trust could be used to shift value between the families tax effectively however, if section 100A is applied, the distributions are void for tax purposes. The principals and their families, as beneficiaries, can’t resist a section 100A assessment with the usual defence based on the definition of “agreement’ in sub-section 100A(13) viz. that the distribution reflects an ordinary dealing within the family, because it does not. They are dealing between families.
Sometimes these structures are used to save establishment costs notably stamp duty which in NSW is as much as $500 to establish a trust where the trust holds no dutiable property. Such savings may prove inadvisable due to later considerable cost.
Administering a private company requires sound business skill and judgment. Since the Commonwealth has substantially taken legislative responsibility for companies and securities from the states, regulatory reform has been introduced so that numerous compliance obligations have been streamlined in a practical way.
It is not always understood that the reforms were only to the regulatory framework of companies. They do not necessarily extend to the differing regimes in place for each company. Conduct of a private company still very much remains the responsibility of the directors of the company who are required to observe the constitution of the company (COTC). A number of the regulatory reforms have no affect on the regime that applies to a company unless the company takes the necessary action to enliven them.
From 1998 – the “replaceable rules”
Reform to the framework in the Company Law Review Act 1998 (CLRA 1998) introduced “replaceable rules” that apply to a proprietary (private) company other than a company with a sole director/shareholder. Unlike “Table A” in the former states’ Companies Acts, which could be adopted as articles of association optionally by a private company, the “replaceable rules” take effect by default. In other words a company, which does not adopt a custom divergent COTC, is taken to adopt and can rely on the “replaceable rules” in the Corporations Act 2001. Nevertheless a majority of private companies, including companies established prior to 1998, have adopted a COTC which overrides the replaceable rules and their impact. So the reforms reflected in the “replaceable rules” don’t apply to those companies.
This post highlights some of the difficulties this causes to private companies that we notice in practice.
When private companies take significant actions resolutions need to be passed by the directors. As a standard, resolutions of directors need to be passed or agreed to at a directors meeting. It is a common alternative practice for directors of a company to complete a “circulated” resolution of directors signed by all directors of the company without formally holding a directors meeting. For most private companies that is fine as their COTC permits this procedure as an alternative to the company holding a directors meeting. The alternative procedure is authorised both in:
model “Table A” type COTCs which pre-date the reforms; and
section 248A of the Corporations Act 2001 where section 248A applies to the company as a replaceable rule.
However there is a minority of companies with old or inadequately drafted COTCs where the “circulated” resolution of directors capability is not available to the company either under the COTC, or under the replaceable rule in section 248A where the provisions in the COTC replace the replaceable rules including section 248A.
Invalid directors’ resolutions
Thus directors of private companies may be completing “circulated” directors’ resolutions on the mistaken assumption that their COTC, or the replaceable rule in section 248A, authorises the resolution without the holding of a directors meeting. The impugning of all of the resolutions of the directors of a company done in this way could have far reaching consequences for the company particularly if the activity of the company comes under the close scrutiny of government or lawyers. For instance, say a company in this predicament is a trustee of family discretionary trust: It is open for the Commissioner of Taxation to treat a resolution to distribute income to beneficiaries done in a way unauthorised by the COTC as invalid and not made in time to prevent the income being assessed for income tax to the trustee of the trust at the highest marginal rate under s99A of the Income Tax Assessment Act 1936.
If a COTC displaces the replaceable rules it is prudent to identify the capability in the COTC that permits the directors to use a circulated resolution instead of holding a directors meeting and to cite the reference to the capability in the circulated resolution. Look for wording in your COTC similar to section 248A. It is often the last article under the DIRECTORS PROCEEDINGS part of a COTC.
A COTC without the circulated resolution capability frequently has other shortcomings such as no capability for a director to attend a directors’ meeting by telephone or online over the internet. This is another case where inadequacy of the COTC can lead to invalidity of attempted directors resolutions done with this capability assumed by the directors.
Directors resolutions can also fail due to other procedural misunderstandings such as:
failure to give notice of a directors’ meeting to all directors;
a meeting may have a quorum requirement under a COTC which is not met; and
a proceeding by a single director is not a meeting.
Single director companies
The CLRA 1998 also changed the regulatory framework to allow for single director companies. Prior to the CLRA 1998 the minimum number of individual shareholders of a private company was two and so many memorandums and articles of association of private companies then in place, which became their COTCs from 1998, entrenched the two individual director minimum to comply with the pre-CLRA 1998 law. These COTCs required alteration to remove the minimum of two individual director stipulations and to allow the company to have a single director. This is a more obvious case of where a pre-CLRA 1998 COTC, in particular, needs alteration should the private company seek to have only one director.
The obligation of a company to use a common seal to execute documents was also removed from the regulatory framework by the CLRA 1998. Still a private company which was established before 1998, or any private company that has otherwise adopted a common seal, may need to act to dispense with its obligation to use the common seal.
Ordinarily this action would be:
The COTC is altered to:
provide that the company need not have a common seal; and
support the execution of documents by the company without a common seal.
The directors resolve to dispense with the common seal.
Execution of deeds and other documents, including, for example, an election by a company as trustee to become a regulated superannuation fund, can be invalidated if the private company must use a common seal that remains adopted by the company but executes the deed or documents without that common seal.
Special purpose superannuation companies – reduced ASIC annual fee
The reforms allowed for a company that has been set up to act solely as the trustee of a regulated superannuation fund, or for other designated special purposes, to apply a substantially reduced ASIC annual fee of $40 rather than $226.50. Entitlement to the reduced fee for a company that has been set up to act solely as the trustee of a regulated superannuation fund turns on the limit on the purposes for which the company can act being effectively included in the COTC.
It’s a fail for the directors to complete the declaration to claim the reduced fee without understanding whether the provisions of the COTC support the entitlement to a reduced fee.
Directors of a private company are expected to understand and to take responsibility for what is in the COTC.
Although the company regulatory framework has been reformed:
to more readily allow circulated directors’ resolutions as an alternative to holding directors’ meetings;
to allow private companies to have a single director;
to make common seals optional; and
to extend a reduced ASIC annual fee to dedicated superannuation trustee companies;
among other reforms, the COTC of the company and the standing resolutions of the directors are a regime which constrains how the reforms may apply to a private company. Directors of companies should check COTCs and their records to ensure that they support the company using capabilities supported by the reforms.
Annual income distributions by family discretionary trusts (FDTs) are routine for trustees for apparent Australian income tax reasons but trustees of FDTs can be reluctant to distribute trust capital. What would be the reason for that reluctance? Why don’t trustees of FDTs make capital distributions more often?
The trust deed
The regime in a FDT deed typically centres on distribution of capital on the vesting of the FDT. However even older and archaic FDT deeds usually expressly allow for interim distribution of capital, that is, distribution of trust capital before the FDT vests and winds up. Interim distribution of capital to beneficiaries, rather than holding it for them until the vesting day, is often conditional on the distribution being for the “maintenance education advancement in life or benefit” either for infant beneficiaries or for beneficiaries generally – see Fischer v Nemeske Pty. Ltd.  HCA 11: a condition which, in ordinary family dealings, can readily be met.
Purpose of a FDT
A FDT is, in its essence, an arrangement to benefit family members. A FDT can be seen as a pool set aside to gift to family members. But is a distribution to a family beneficiary from a FDT treated the same for tax as a family gift to a family member?
It is useful to think about differences between a FDT and other types of entities before answering that:
Difference to a proprietary company
A proprietary company has the legal status of a separate person and the release of company capital to a shareholder of a company is subject to a number of corporations law and tax technicalities. A company can have wide objects but giving its value away to other persons would not usually be one of them. Under tax rules the enrichment of a shareholder’s family member from a company’s capital is likely dividend income assessable to income tax either directly or as a “payment” under section 109C of the Income Tax Assessment Act 1936.
Difference to a unit trust
A trustee of a genuine unit trust would generally be required to make capital distributions in equal proportions based on the unit holdings of unit holders. If capital distributions from a unit trust are feasible the capital gains tax (CGT) rules can discourage the trustee from making these distributions before vesting. CGT event E4 applies to distributions of capital of a unit trust which are not in connection with the disposal of the units to reduce the cost base of the unit holder by the amount of the distribution and, to the extent the cost base doesn’t cover the amount of the distribution, the excess is a capital gain assessable to unit holders.
How CGT applies to distributions of capital by FDTs
CGT event E4 does not apply to non-assessable capital distributions from a FDT. In Taxation Determination TD 2003/28 Income tax: capital gains: does CGT event E4 in section 104-70 of the Income Tax Assessment Act 1997 happen if the trustee of a discretionary trust makes a non-assessable payment to: (a) a mere object; or (b) a default beneficiary? the Commissioner of Taxation confirms his longstanding view and practice, since the introduction of CGT in 1986, that CGT event E4 does not happen if a trustee of a discretionary trust makes a non-assessable payment to a mere object. That is, a mere discretionary beneficiary where the entitlement to the payment arose because the trustee exercised its discretion in the beneficiary’s favour and the interest was not acquired by the beneficiary for consideration or by way of assignment.
The CGT similarity of FDT cash distributions and cash gifts
The enrichment of a family beneficiary of a FDT by an interim distribution of the capital of a FDT is not, of itself, subject to CGT based on TD 2003/28 i.e. there is no CGT on a distribution of cash to a beneficiary from the capital of a FDT. If there is a distribution of a CGT asset from the capital of a FDT to a beneficiary that is a different story. CGT events E5 and E7 can apply to subject the realisation of the CGT asset by the FDT to a family beneficiary to CGT (see sub-sections 104-75(3) and 104-85(3) respectively of the Income Tax Assessment Act 1997 which visits the CGT event on the the trustee of the trust – sub-sections 104-75(6) and 104-85(6) generally enable the beneficiary of a FDT to disregard a capital gain or capital loss under either of these CGT events where the beneficiary acquired the asset within the trust without incurring expenditure viz. on a capital distribution by the trustee the beneficiary is treated only as the acquirer of the asset for CGT purposes).
But there is no fundamental difference between a distribution of a CGT asset from the capital of a FDT, and the CGT events that apply to it, and how a family gift of a CGT asset by an individual is treated for CGT. That is, a gift of cash is CGT free and a gift in the form of property that is a CGT asset is subjected to CGT: not because of the gift but because a CGT asset is being realised and the CGT regime brings gains in value on a CGT asset to tax on a change of ownership.
So cash distributions of capital by a FDT, where permissible under a trust deed of a FDT, can generally occur, either with income year end income distributions or at other times during the currency of a FDT, without income tax consequences.
However there is a problematic exception:
Small business CGT concessions participation percentage
Under item 2 in the table in section 152-70 of the Income Tax Assessment Act 1997 the “small business participation percentage” of a beneficiary of a FDT is the smaller of the percentages of the beneficiary’s entitlement to income and the beneficiary’s entitlement to capital in an income year if both income distributions and capital distributions are made in that year. Generally beneficiaries are better off qualifying for a sufficient small business participation percentage to qualify for the concessions if no distribution of capital, or no divergent distribution of capital (bearing in mind that a capital gain on an active asset distributed by a FDT is likely to have a capital component), has been made in the income year the relevant capital gain has been made in to some other beneficiary.
So if a capital gain arises to a FDT in an income year which can attract the small business CGT concessions in Division 152 of that Act, then a distribution of the income in that income year substantially to family member A, including entitlement to a capital gain, may not count or count sufficiently in the measurement of small business participation percentage where a cash distribution of capital has been made to family member B and not family member A who is left with a “smaller” participation percentage. It could be that family member A may thus not qualify as a significant individual or as a CGT concession stakeholder without the sufficient interest in capital distributions of the FDT in the relevant income year in which the capital gain was made.
So a trustee of FDT needs to be wary of cash distributions of capital from a FDT and, indeed, the streaming of capital gains where there has been a capital gain that can attract the small business CGT concessions to ensure that the desired beneficiaries have sufficient entitlements to capital that can attract the concessions. If the small business CGT concessions participation percentage is not in issue a cash distribution from from the capital of a FDT to a beneficiary can be a tax benign.
Perpetuities laws apply in Australian states to limit the period by the end of which interests in property of a trust must vest in a beneficiary. As I mentioned in my March 2018 post on bringing trusts to a timely end, “vest” broadly means to imbue with ownership of property. So, when property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.
Discretionary trusts are subject to an eighty year maximum perpetuity period
The maximum perpetuity period (MaxPP) under each perpetuity law is the maximum period by the end of which property held on trust must vest. As I observe in my March 2018 post, property of a trust can already be vested in beneficiaries but, in the case of property of an ongoing discretionary trust, where there is a discretion to distribute income or capital to discretionary beneficiaries; the property held on the trust has not vested.
The MaxPP is consistently eighty years from when the trust commences under state perpetuities laws excepting South Australia where the perpetuity law has been repealed.
Where a disposition of property held by a discretionary trust does not vest within the MaxPP then the disposition of property to the trust is void under the perpetuities laws. That is the trust fails over that disposition and the property that was supposedly to be held on the trust is vested in and held for return to the settlor and the others who have given it to the supposed trustee.
“Wait and see” rule
The states that have a perpetuity law also adopt a “wait and see” rule to soften the harsh outcome of causing a trust over property, which might fail to vest the property within the MaxPP, to be void. Under the “wait and see” rule persons interested can wait until the expiry of the perpetuity period to see whether a disposition of property on trust has vested. If the property has not vested in a beneficiary by then, then the affected disposition of property to the trust is void.
The perpetuities complication of trusts as discretionary beneficiaries of a trust
Many family discretionary trust arrangements allow distribution of income or capital of the trust to other trusts.
Let us say Trust A and Trust B:
are family discretionary trusts that commenced in 2010 and 2015 respectively;
to which the law of Queensland applies;
with each specifying a perpetuity period for the vesting of their property of eighty years from their commencement.
Trust B is a beneficiary of Trust A and in 2018, the trustee of Trust A exercises its discretion and distributes some of the 2018 income of Trust A to Trust B.
Under the perpetuities law the MaxPP is eighty years. The income of Trust A, which was the property of Trust A, must vest in accordance with that law and under its perpetuity period term by 2090. But, following the distribution to Trust B the prospects are that the trustee of Trust B:
may not vest the income received from Trust A by 2090 even though 2090 is the expiry of the MaxPP applicable to property (that wasn’t vested in a beneficiary) that was held in Trust A; and
is not obliged to vest the property of Trust B under the perpetuity period applicable to Trust B before 2095.
If the trustee of Trust B hasn’t vested the income received from Trust A by 2090, the disposition of that income from Trust A to Trust B is void as the property of Trust A hasn’t vested by the expiry of the MaxPP for Trust A when the “wait and see” rule no longer has effect. But does that prospect invalidate that disposition at an earlier point in time because Trust B, which has received the property which must vest by 2090, is not slated to definitely vest until 2095?
Nemesis Australia Pty Ltd
This situation was considered by the Federal Court in Nemesis Australia Pty Ltd v Commissioner of Taxation  FCA 1273. In that case the Commissioner asserted that distributions by the Steve Hart Family Trust to other trusts that were discretionary beneficiaries of the Steve Hart Family Trust, each of which had perpetuity periods which extended beyond the MaxPP applicable to the Steve Hart Family Trust, were too remote i.e. violated the perpetuities law and were thus void.
The Commissioner contended that the “wait and see” rule should not save the distributions where the source Steve Hart Family Trust and the relevant receiving beneficiary trust, looked at together, prescribed a period longer than the allowable eighty years applicable to the disposition in the deed of the Steve Hart Family Trust.
Tamberlin J. rejected the Commissioners contention and found that the “wait and see” rule applied to prevent the perpetuities law from invalidating the dispositions even though the receiving trusts might not vest the property they had received from the Steve Hart Family Trust before the expiry of the eighty year MaxPP applicable to property held in the Steve Hart Family Trust. The “wait and see” rule could apply because the trustees of the receiving trusts could act to advance their vesting dates so as to bring them within that MaxPP applicable to property they received from the Steve Hart Family Trust.
Inferences from Nemesis Australia
It follows from Nemesis Australia that the distribution in my example from Trust A to Trust B won’t be void under the perpetuities law as “wait and see” applies even though the income Trust B has from Trust A might not vest until 2095.
Should the trust deed of Trust A constrain distributions to trusts that may vest outside of the eighty year MaxPP applicable to property in Trust A?
Where Trust A distributes income of Trust A to Trust B and a beneficiary B1 of Trust B is presently entitled to that income of Trust B, which originated in Trust A, then B1 has an interest which has vested thus there is no need to “wait and see” any longer to see if the interest has vested: that disposition does not offend the perpetuity law. Where, however, Trust A distributes income or capital of Trust A to Trust B which does not vest in individual or corporate beneficiaries before the MaxPP applicable to Trust A expires then that income or capital will inadvertantly revert to the settlor or to other persons who have funded Trust A.
So the inclusion of a mechanism in discretionary trust deeds which synchronises vesting dates applicable to particular interests in income or capital that are distributed to other trusts with a later vesting day may avoid inadvertant ownership outcomes and liabilities when source discretionary trusts reach the end of their MaxPP. Following Nemesis Australia more radical restriction and control of discretionary trust distributions to other trusts as discretionary beneficiaries does not appear necessary.
Ending a trust is straight forward, isn’t it? Vest all interests in the trust in beneficiaries and make the right accounting entries and the trust is terminated? Not quite.
That word “vest”. What does it mean? Vest is a technical legal term. Broadly it means to imbue with ownership of property. So, when a trust ends and the property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.
But not all trusts end that way. For instance a unit trust or an unpaid present entitlement may already be vested in a beneficiary or beneficiaries. Clearly something other than vesting is needed to bring trusts of that type to an end. In those cases property that has already vested in beneficiaries may need to be paid to or put in the possession of the beneficiaries too for the trust to end.
Ending is all in the timing
In most states and territories of Australia trusts must vest within a statutory perpetuity period, typically 80 years. From this point this post relates to jurisdictions where a statutory perpetuity period applies.
Trusts that are fully vested, such as bare trusts, fixed trusts, some sorts of unit trusts and “indefinitely continuing” superannuation funds may continue for longer than the perpetuity period. A discretionary trust must vest no later than the perpetuity period, that is, discretions to distribute all income and capital of the trust must be taken and sunset once the time for vesting has been reached otherwise it will be too late and the formula for distribution for “takers-in-default” set out in the trust deed will apply to the property then left in the trust. The divesting of those interests, which are then held by the trustee outright for those beneficiaries, by payment over to, or at the direction of, the beneficiaries, can happen later after the expiry of the perpetuity period.
Bringing forward the ending of a trust
The trust deed should also set out how the time for vesting can be brought forward from the expiry of the perpetuity period. That time of expiry will usually be the “default” time for vesting, or a time just before it, (the last vesting time) in a well-crafted discretionary trust deed.
An objective of winding up a trust is to satisfy all parties with interests, in the wider sense, in the trust, including creditors, trustees, beneficiaries and the Commissioner of Taxation.
Failure to address these interests of the parties interested, or the trust deed requirements and formalities for the bring forward of the time of vesting, can mean that the trust, or its aftermath, will remain a matter in contention or dispute which is diametrically not what a trustee will want to occur following their effort to bring the trust to an end. A trustee can face difficulty in the converse case too where a trust is inadvertently brought to an end prematurely. In other words trustees can face problems where a trust has a mistimed ending either way. A trust may go on longer than planned or it may be inadvertently brought to an end before the trust should end. An example of the latter is to be found in trust deeds which set an inexplicably early time for vesting many years prior to the expiry of the perpetuity period.
Ending by depletion and merger
Depletion and merger are two other ways a trust may be brought to an end even where the intent of the trustee and beneficiaries is, and the trust deed may suggest that, the trust is to go on for longer.
Depletion is where the trustee no longer holds property on trust. If trust property is depleted and the trustee acquires more property on trust, the arrangement is treated as a new and separate trust. A “resettlement” occurs as well as likely confusion about which trust is which. Hence the device of a “settled sum” for a discretionary trust, which remains as trust property, to ensure continuity of the (original) trust even where the trust is in deficiency and has no other identifiable property.
Merger also brings a trust to an end in an untimely and premature way. Merger occurs where the trustee and the beneficiary are or become the same person. In the case of a merger the trust obligation of the trustee under the terms of the trust is no longer owed to the beneficiary so the trust does not continue.
Merger and SMSFs with individual trustees
Merger can be an interesting issue in the case of a self managed superannuation fund with individual trustees. There is no merger while the fund has two trustees: Trustee A has trust obligations to member B and trustee B has trust obligations to member A. However if a trustee/member dies and the surviving sole trustee is also the sole member of the fund with a fully vested beneficiary account of the entirety of the fund, the fund likely merges. It follows that the fund is no longer a trust. The Commissioner of Taxation has not addressed how the doctrine of merger may apply in these cases, and, as I understand it, the Commissioner treats a fund in this situation as continuing on as a matter of administrative convenience. If the Commissioner’s approach, which may be tantamount to a recognition of a self managed superannuation fund that is not a trust, came before the courts, it is unclear how it might be explained or permitted.
Some starting points
Trusts that require winding up usually commence by and are governed by a trust deed. I am not writing here of testamentary trusts. A trust deed will usually state the requirements to wind up the trust including how the time of vesting must be brought forward. A trust deed may also provide for other things which complicate vesting or winding up, or both. The trust deed may require that a party’s consent is required before either can happen. There may be other forerunner steps which haven’t been taken which must be taken before the trust can vest under the deed. A grasp of the design or method of the trust provisions in the trust deed will build confidence that all requirements for a winding up raised in a trust deed have been identified and addressed.
If the accounts of the trust have been correctly prepared then the current balance sheet, in particular, gives a list of activity to be addressed before the trust can be wound up. For a company liquidation, liabilities need to be satisfied with the balance of assets (property) distributed to owners. Trusts are no different. The more assets have been converted to cash and liabilities have been met the simpler the contemporary balance sheet and the winding up will be.
The conversion of assets to cash can give rise to taxable capital gains and assessable balancing charges but the alternative, their distribution to beneficiaries on a winding up inevitably does so too. It is generally simpler or more tax effective, or both, if these CGT events are contemporaneous with the trust coming to an end. In the cases of a fixed trust or a unit trust CGT event E4 can occur where a non-assessable part of a capital gain is distributed to a beneficiary when the interest of the beneficiary in the capital of the trust persists.
Errors frustrate the ending
Correct accounting in the trust will follow correct treatment of interests, assets or liabilities in the trust by the trustee. But correct treatment of interests, assets or liabilities doesn’t always happen. Notable examples where correct treatment doesn’t happen include:
the elimination of entitlements of family beneficiaries in the course of a winding up. Trustees of discretionary trusts distribute trust income to family members on lower tax rates (A) which remains unpaid and which is treated in the accounts of the trust as an unpaid present entitlement under terms in the trust deed. On winding up the distribution may revert to or may be paid to the principals of the family (B) instead without explanation. That suggests that the present entitlement of beneficiaries to former income of the trust was a sham or misunderstood with potential tax liability for the trustee;
distribution in the course of a winding up to individuals where the trust holds money or property sourced from a private company to which Division 7A of the Income Tax Assessment Act 1936 applies. This may be inconsistent with repayment of the money or property to the relevant company and could trigger a “deemed dividend” tax liability; and
backdating and forgiveness of loans – it can be tempting for a trustee to purge debts to related parties in the accounts of a trust but the purge is unlikely to be legally effective. A more nuanced treatment, which actually addresses the nature of the original transaction, is more likely to be accepted.
The Commissioner of Taxation investigates, audits and challenges trusts and the parties involved in these kinds of errors including after a winding up.
The affairs of trusts vary greatly and some have deeply intransigent issues. Getting a trust ready to wind up, and executing that wind up at a custom desired point in time may pose a number of challenges which should be considered and addressed in the process. The legal, accounting, business and practical attributes of the trust and possible errors should be considered through the due diligence process so that a non-contentious consignment of the trust to history can be effectively documented.