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Should our SMSF have kept its Principal Employer?

MissingPiece

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

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

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

To bring in the new, keep the old

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

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

My exposé further explains:

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

Invalid replacement of the power to vary

Say:

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

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

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

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

Marooned without a Principal Employer

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

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

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

Other dated requirements in the power to vary

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

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

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

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

The right “applicable law”?

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

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

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

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

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

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

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

Challenges!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Law on amending lost trust deeds

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

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

is to be considered.

Alteration of a trust by its founders

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

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

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

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

Barrett JA then illustrates the point by this example:

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

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

Alteration of a trust by all beneficiaries of a trust

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

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

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

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

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

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

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

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

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

Update of trust terms by a court

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

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

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

were not correctly decided. Barrett JA said:

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

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

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

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

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

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

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

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

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

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

Significance of the power of amendment as expressed in an OTD

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

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

as considered above.

Amendment practice

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

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

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

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

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

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

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

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

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

Update of the power of amendment?

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

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

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

Later deeds of variation of SMSFs based on a deviation

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

So are replacement SMSF trust deeds a scam?

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

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

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

Other solutions, aside from supreme court applications allowed under:

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

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

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

ACKNOWLEDGEMENTS

The author acknowledges the articles:

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

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

Uneven sharing of the partnership pie – OK for tax?

pie

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

Demonstrating the partnership

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

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

Income tax effective features of a partnerships accepted for tax

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

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

Uneven shares of tax partnership income and losses

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

In order?

State and Territory partnership legislation provides that:

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

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

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

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

accordingly.

Where partners pursuing unequal partnership income/loss entitlements seek:

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

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

Partner salary

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

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

Paragraph 7 of TR 2005/7

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

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

Fights with other partners over entitlements

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

Other problems with partnerships that are not in order for tax

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

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

Conclusions

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

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

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

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

Woes of a beneficiary of a discretionary trust in getting a tax deduction for interest: Chadbourne v. C of T.

CarWoes

In the recent Administrative Appeals Tribunal case Chadbourne and Commissioner of Taxation (Taxation) [2020] 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 [2011] 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 [2010] 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.

Australian non-fixed trust liable for CGT on non-TAP gains given to a foreign resident: Peter Greensill Family Co Pty Ltd

BigBen

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 [2020] 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 [2010] 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.

Changing the trustee of a trust – some elements for success

It is sometimes wrongly assumed that a minute of the current trustee is sufficient to change the trustee of:

  • a family discretionary trust (FDT); or
  • a self 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.

Changing trustee relying on ability to change in the trust deed

It is thus to the trust deed that one needs to look to find:

  1. whether there is a power in the TTOGRs to appoint a new trustee or to otherwise change the trustee; and
  2. if, so, what the procedure or formalities are for doing so.

Changing trustee 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:

  • has died;
  • 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:

  • has died;
  • 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) 1997:

Sub-section 104-10(2) concerning CGT event A1 states:

(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.

Stamp duty

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.

Other requirements

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.

Aggregating for dual $6m MNAV tests following 2018 small business CGT concession integrity changes – with the aid of chess!

ChessPieces

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 AND Object entity must satisfy
MNAV test or SBE test   Modified MNAV test or SBE test and carried on business up to day of sale

When the object entity MNAV test becomes vital

In practice, there is a significant slew of sales of shares or trust interests where the object entity won’t satisfy the SBE test because of:

  • 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 threshold; or
  • 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 following example:

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 the affiliate.

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 entity.

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 company. 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.

Should more than one family share a family discretionary trust?

pointatdeedFrom 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.

Reimbursement agreements

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.

Be wary of constitutional fails by your private company

sqpegroundholeAdministering 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.

Directors meetings

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.

Common seals

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.

Summary

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.

The discretionary capital distribution – it’s a CGT free gift!

giftAnnual 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. [2016] 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.