A mirror of the general principle of source and residence taxation broadly setting the parameters of international taxation, and reflected in Australia’s income tax law, is that income of a foreign resident not from sources in the state is not taxable in the state (in this post called the Mirror Principle). In Australia:
interests in real property in Australia and related interests; and
interests in assets used in business in permanent establishments in Australia:
are designated “Taxable Australian Property” (TAP) (see Division 855 of the Income Tax Assessment Act (ITAA) 1997). TAP is used in Australian income tax law to apply the Mirror Principle.
Foreign resident capital gains from non-TAP disregarded
Property which is not TAP, that is, property not taken to be connected to Australia for income tax purposes in the hands of foreign residents includes shares and securities as opposed to property interests in or related to Australian land or of permanent establishments carrying on enterprises in Australia which are TAP.
Capital gains made by foreign residents from non-TAP assets are disregarded for tax purposes: section 855-10.
Trouble pinpointing trusts as foreign or not
Trusts are elusive and create enormous difficulties in the international tax system see Trusts – Weapons of Mass Injustice. Trusts can detach beneficiaries who benefit from property who may be in one state from:
the trustee of the trust, in whose name the property is held, who may be in another state; and
the activities of trust which may be in yet another state.
Apt taxation of those activities in line with Mirror Principle thus poses a significant challenge to governments. States are justified imposing laws to counter offshoring with trusts to ensure the integrity of their tax systems.
Some states don’t recognise trusts.
In Australia trusts are mainstream. Some types of trusts are considered tax benign and conducive to legitimate business, investment and prudential activity. Fixed trusts are often treated transparently for Australian income tax purposes so that a fixed trust interest holder is:
taxed similarly to a regular taxpayer or investor; and
no worse off, tax wise, than a taxpayer or investor who owns the property outright rather than by way of a trust beneficial interest.
So, consistent with the Mirror Principle that a foreign resident owner of non-TAP who makes a gain on the non-TAP shouldn’t be taxable on the gain, a foreign resident beneficiary (FRB) of a fixed trust can disregard a capital gain made in relation to their interest in a fixed trust: section 855-40.
Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation
In the Federal Court case Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation  FCA 559 this week the issue arose whether an Australian resident family discretionary trust – a non-fixed trust, was entitled to rely on section 855-10 and the Mirror Principle to disregard capital gains distributed to a FRB, a beneficiary based in London, of the trust from realisation by the trust of shares in a private company, GCPL, which were non-TAP of the trust.
Detachment of capital gains from the workings of trust CGT tax rules
The capital gains of a trustee are distant from the capital gains of a beneficiary under the ITAA 1936 and the ITAA 1997. Transparent treatment or look through to the capital gains of the trustee as capital gains of the beneficiary/ies became even more remote following changes to Sub-division 115-C of the ITAA 1997 including the introduction of Division 6E of Part III of the ITAA 1936.
These changes brought in distinct treatment of capital gains and franked distributions of a trust from other trust income following the High Court decision in Commissioner of Taxation v Bamford  HCA 10 and the clarification of taxation of trust income in that case.
Legislation unsupportive of transparent treatment
In Greensill Thawley J. analysed the provisions in Sub-division 115-C and Division 6E to deconstruct the applicant’s case to disregard capital gains using Division 855.
Section 855-40 specifically allows a FRB of a fixed trust to disregard non-TAP capital gains. The absence of an equivalent exemption for FRBs of non-fixed trusts is telling unless section 855-40 is otiose or represents an abundance of caution. Thawley J. did not follow that line. As the applicant in Greensill could not disregard the capital gains using section 855-40 in the case of non-fixed trust, or section 855-10, the capital gains were taxable in Australia.
Unless there is an appeal to the Full Federal Court the Commissioner can finalise his draft taxation determination TD 2019/D6 Income tax: does Subdivision 855-A (or subsection 768-915(1)) of the Income Tax Assessment Act 1997 disregard a capital gain that a foreign resident (or temporary resident) beneficiary of a resident non-fixed trust makes because of subsection 115-215(3)? as the Federal Court has accepted the view in it.
It is sometimes
wrongly assumed that a minute of the current trustee is sufficient to change
the trustee of:
discretionary trust (FDT); or
managed superannuation fund (SMSF) (which must be a trust with a trustee too –
see sub-section 19(2) of the Superannuation
Industry (Superannuation) Act (C’th) 1993 (SIS Act));
and that a change of
trustee will have no serious tax consequences. The second proposition is more
likely to be true, but not always.
FDTs and SMSFs
invariably commence with a deed which contains the terms (the trust terms or
governing rules – TTOGRs) on which the trust commences. That, in itself, is a
reason why I contended in 2009 in Redoing the deed
that an instrument or resolution less than a deed to change the trustee is
prone to be ineffective even where change by less than or other than a deed is
stated to be permitted by the TTOGRs in the trust deed.
relying on ability to change in the trust deed
It is thus to the
trust deed that one needs to look to find:
whether there is a power in the TTOGRs to appoint a new trustee or to otherwise change the trustee; and
if, so, what the procedure or formalities are for doing so.
relying on the Trustee Acts
If ability to change
trustee is not present, or is derelict, in the TTOGRs then the Trustee Acts in
states (and territories) provide options for appointing a new or additional
trustee which vary state to state.
Trustee Act – New South Wales
In New South Wales: section
6 of the Trustee Act (NSW) 1925
allows a person nominated for the purpose of appointing trustees in the TTOGRs,
a surviving trustee or a continuing trustee to appoint a new trustee in certain
specified situations such as where a trustee:
is incapable of acting as trustee; or
is absent for a specified period out of the state.
However an appointment of a new trustee in these situations must be effected by registered deed: sub-section 6(1) That is the deed of appointment must be registered with the general registry kept by the NSW Registrar-General, which is publicly searchable, and the applicable fee to so register the deed must be paid to NSW Land Registry Services for the appointment to take effect.
It is apparent from sub-section 6(13) that registration of a deed of appointment is not required where ability to appoint a new trustee is in the TTOGRs where the TTOGRs express a contrary intention; that is: where the TTOGRs expressly and effectively allow an appointment to be effected without a registered deed.
Trustee Act – Victoria
In Victoria there is a comparable capability for a person nominated for the purpose of appointing trustees in the TTOGRs, a surviving trustee or a continuing trustee to appoint a new trustee in writing in certain specified situations such as where a trustee:
is incapable of acting as trustee; or
is absent for a specified period out of the state;
under section 41 of the Trustee Act (Vic.) 1958. However this Victorian law does not impose any requirement that the required instrument of appointment in writing must be registered.
Changing trustee by obtaining a court order
The supreme courts of the states and territories are also given a residual statutory capability to appoint trustees under the respective Trustee Acts. However applying to a supreme court for an order to change a trustee of a FDT or a SMSF with sufficient supporting grounds is an option of last resort given likely significant costs and uncertainties of obtaining the order.
Changing trustee by deed
The TTOGRs in a trust deed of a FDT or a SMSF will frequently require that an appointment of a new trustee may or must be effected by a deed. It is desirable that it should do so to ensure the appointment of a new trustee does not become of a matter of uncertainty and difficulty for the reasons I have described in Redoing the deed.
Tax consequences of a change of trustee
As a change of trustee without more generally does not change beneficial
entitlements under a trust, the tax consequences are usually benign:
For capital gains tax (CGT), assurance that changing trustee does not give
rise to a CGT event for all of the CGT assets held in a trust is diffuse under
the Income Tax Assessment Act (C’th) (ITAA)
(2) You dispose of a * CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner.
Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event A1 will not happen merely because of a change in the trustee.
Sub-section 960-100(2) with the Notes below it in fact say:
(2) The trustee of a trust, of a superannuation fund or of an approved deposit fund is taken to be an entity consisting of the person who is the trustee, or the persons who are the trustees, at any given time.
Note 1: This is because a right or obligation cannot be conferred or imposed on an entity that is not a legal person.
Note 2: The entity that is the trustee of a trust or fund does not change merely because of a change in the person who is the trustee of the trust or fund, or persons who are the trustees of the trust or fund.
Similarly sections 104-55 and 104-60 of the ITAA 1997 which concern:
• Creating a trust over a CGT asset: CGT event E1
• Transferring a CGT asset to a trust: CGT event E2
each restate the above Note: viz.
Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event E… will not happen merely because of a change in the trustee.
A change of trustee can have stamp duty consequences where the trust holds
dutiable property such as real estate.
Duty – NSW
Concessional stamp duty on the transfer of the dutiable property of the trust to the new trustee can be denied in NSW to a FDT unless the trust deed of the trust limits who can be a beneficiary, for anti-avoidance reasons: see sub-section 54(3) of the Duties Act (NSW) 1997.
Indeed Revenue NSW withholds the requisite satisfaction in sub-section 54(3) unless the TTOGRs provide or have been varied in such a way so that an appointed new trustee or a continuing trustee irrevocably cannot participate as a beneficiary of the trust. Contentiously satisfaction is withheld by Revenue NSW unless a variation to a FDT to so limit the beneficiaries is “irrevocable“ : see paragraph 6 of Revenue Ruling DUT 037, even though that variation may not be plausible or permissible under the TTOGRs of the FDT.
This hard line is taken by Revenue NSW to defeat schemes where someone, who might otherwise be a purchaser of dutiable property who would pay full duty on purchase of the property from the trust, becomes both a trustee and beneficiary able to control and beneficially own the property who is thus able to contrive liability only for concessional duty and avoid full duty,
Duty – Victoria
Although the Duties Act (Vic.) 2000 contains anti-avoidance provisions addressed at this kind of anti-avoidance arrangement, there is no comparable hard line to that in NSW in sub-section 33(3) of the Duties Act (Vic.) 2000 so that the transfer of dutiable property, including real estate, on changing trustee is more readily exempt from stamp duty.
A prominent requirement on changing trustee of a SMSF is notification to the Australian Taxation Office, as the regulator of SMSFs, within twenty-eight days of the change: see Changes to your SMSF at the ATO website.
Where changing trustee involves a corporate trustee then there may also be an obligation to inform the Australian Securities and Investments Commission of changes to details of directors of the corporate trustee, if any. There may be further matters to be addressed if any new or continuing directors are or will become non-residents of Australia and, with SMSFs, the general requirement in section 17A of the SIS Act that the parity between members of the fund on the one hand and trustees, or directors of the corporate trustee on the other, needs to borne in mind and, if need be, addressed.
Those seeking the small business capital gains tax (CGT)
concessions in the 2018 and later income years need to be wary of modified
small business CGT concession integrity rules which apply from 8 February 2018
by virtue of Schedule 2 of the Treasury
Laws Amendment (Tax Integrity and Other Measures) Act 2018 (TIOMA).
The small business CGT concessions in Division 152 of the Income Tax Assessment Act (ITAA) 1997 may look straight forward but there are subtle complications within the misnamed “basic” conditions for the relief which can be matrixlike. The small business CGT concessions are generous so perhaps it is right that rules to protect their integrity, as ramped up by the TIOMA, are more complicated than the rules that ordinarily impose a CGT liability on sales of small business related CGT assets.
Share or interest sales need to meet additional basic conditions
For CGT events involving sales of shares in companies or interests in trusts “additional” basic conditions have commenced with the TIOMA. The additional basic conditions go further than what I describe here. In this post I wish to focus on the significance of the dual $6m maximum net asset value tests that the TIOMA initiates. So in the below considerations I am going to assume that the other basic conditions for the small business CGT concessions, including the additional basic conditions, such as the dual active asset test, which also needs to be considered following the introduction of the TIOMA, will be met.
The dual MNAV and SBE tests
The dual $6m maximum net asset value (MNAV) tests are alternative tests with the similarly dual small business entity ($2m aggregated turnover) (SBE) tests which apply where the small business CGT relief is sought on a sale of shares in a company or an interest in a trust. The dual MNAV tests and SBE tests separately test both the taxpayer (“you”) and the object entity which is the relevant company or trust in which the shares are or interest is held by the taxpayer as the case may be. To obtain relief under the basic conditions, and under the additional basic conditions set out in sub-section 152-10 as revised by the TIOMA, the dual tests must be separately satisfied to obtain any small business CGT concession relief:
Taxpayer must satisfy
Object entity must satisfy
MNAV testorSBE test
Modified MNAV testorSBE test and carried on
business up to day of sale
When the object entity MNAV test
In practice, there is a significant slew of sales of shares
or trust interests where the object
entity won’t satisfy the SBE test
an aggregated annual turnover of the object entity of more than $2 million; or
alternatively, the object entity may satisfy that SBE test but paragraph 152-10(2)(a) may apply because the object entity ceased to carry on its business some time before the sale.
In those cases the object entity also needs to satisfy the MNAV test even where the taxpayer has separately satisfied either of the MNAV test or the SBE test or both.
Satisfaction of the MNAV
test by the object entity may
thus be vital to the availability of the small
business CGT concessions to a taxpayer selling shares or a trust interest.
Where the object entity, let us say a
private company with multiple owners, is worth more than $6m overall, this may
well be a problem for minority owners who otherwise are:
on or over the 20% significant individual/CGT stakeholder
with net asset value (NAV) under $6m who sell
their shares looking for the small
business CGT concessions.
The Explanatory Memorandum with the TIOMA gives the
Example 2.4: Investment in large business
Karen carries on a small
consulting business as a sole trader. She is a CGT small business entity
(according to the general rules) for the 2019-20 income year. Karen also owns
30 per cent of the shares in Big Pty Ltd, a large private company with annual
turnover in excess of $20 million in both the 2018-19 and 2019 CGT assets
exceeds $100 million throughout this period. On 1 October 2019, Karen sells her
shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT
concessions for any resulting capital gain. Even if Karen satisfies the other
basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd
is not a CGT small business entity in the 2019-20 income year. It also does not
satisfy the maximum net asset value test in relation to the capital gain, as
its net assets exceed $6 million immediately prior to the CGT event happening
(being in excess of $100 million for the entire income year).
MNAV test complexities
Like the SBE test
with aggregated turnover of the taxpayer, affiliates and their connected
entities, compliance with the MNAV test
relies on, or more specifically NAV (net
asset value) must stay under the
relevant $6m limit after, aggregation.
Before aggregation is considered there is a flip side: the
exclusions from the MNAV test: The
substantial exclusions are confined to individual taxpayers viz. interests in
an individual’s main residence, personal use assets, superannuation and
insurance: section 152-20 of the ITAA 1997. The other exclusions in this
section are largely to prevent accounting anomalies with:
accounting provisions; and
the double counting of the value of an asset indirectly held in an entity and the value of the stake in the entity including the asset, representing the same value, in NAV.
Liabilities are also excluded from NAV where they relate to
assets so the MNAV test can be a maximum net
asset value test.
The value of assets that are not excluded are tallied in NAV
when applying the MNAV test. Then
aggregation must be done. Just like with the complexity of small business CGT concessions integrity more generally, MNAV tests and sometimes qualification
for the concessions, involve a hierarchy of constructs which, for the purposes
of illustration, can be loosely compared to the pieces on a chessboard one’s
opponent in chess may hold:
Chess piece: King
Div 152 construct: The taxpayer
Comment: If the King falls,
it’s game over. If either NAV of the taxpayer or (modified) NAV of the object entity exceeds $6m in each
required MNAV test the basic
condition is failed unless there is a pathway to compliance through the SBE test as described above.
Chess piece: Queen
Div 152 construct: An affiliate
Comment: Although an
affiliate is not the taxpayer (or object
entity), the NAV of the affiliate also counts/aggregates to the taxpayer
(or object entity) when applying the MNAV test to the taxpayer (or object entity), in all directions
including NAV aggregated from connected (and Oconnected in the case of an object entity – see below) entities of
Chess piece: Bishop
Div 152 construct: Connected entities
Comment: The whole of the
NAV of the connected entity (excluding the exclusions described above) counts
in the MNAV test. So if a taxpayer,
or an affiliate, has a stake of 50% in a connected entity X, all (100%) of X’s
net value is aggregated to the taxpayer’s NAV (including NAV relating to the
stake in X of minority stakeholders unrelated to the taxpayer or affiliate). If
Y is a connected entity of X then aggregate all (100%) of Y’s net value to the
taxpayer’s NAV too.
Chess piece: Knight
Div 152 construct: Oconnected entities
Comment: The Oconnected entity (my terminology – I thought
of using “controlled entity” which is in contrast to a connected entity which
can either control or be controlled by the other entity it is connected to. But
controlled entity is misleading for, as we shall see, only a 20% stake, hardly
control in any sense, is needed to trigger this link) is a new construct
introduced with the additional basic conditions in the TIOMA relating to the object entity.
The NAV of a Oconnected entity is aggregated to the NAV of
the object entity but it is look through forward to aggregate and
not look through back too (unlike
“controlled by the other entity” which can connect too to a connected entity).
An example is needed to explain constructs here: So if O, an object entity controls Q an Oconnected
entity, due to a 20% or greater stake in Q, and P is another unrelated
stakeholder in Q; the value of Q owned by P is included in the NAV of Q aggregated
to O (see the outcome of that in the below Example 2.5 drawn from the
Explanatory Memorandum) but the NAV of P and its connected entities is excluded
from the NAV of O (if they are not separately affiliated/connected to O).
In chess the Knight moves
in a weird way so the Knight is the allegory chosen here!
Chess piece: Pawn
Div 152 construct: Asset or investment of the above
Comment: A pawn generally
moves one space in chess. $1 in value of an asset or investment owned by a
taxpayer or object entity, which is
not excluded, counts $1 to the NAV of the taxpayer or an object entity. $1 in value
of an asset or investment owned by affiliates, connected entities and Oconnected
entities, which are not excluded, count $1 to the affiliate, connected entity
and Oconnected entity, as the case may be, but if that NAV is in an affiliate,
a connected entity or a Oconnected entity of the taxpayer or object entity in applying the dual
tests, the whole NAV of the relevant
entity is aggregated to the taxpayer/object
entity, not its proportionate NAV
based on percentage stake. i.e. A percentage stake is only used for an interest
in an entity where the entity the interest is held in is not an affiliate,
connected entity or, in the case of the object
entity MNAV test, an Oconnected entity.
I don’t play chess and I accept my chess analogy with the
workings of the MNAV tests is far
from perfect. My endeavour is to make this consideration of the hierarchical
workings of the MNAV tests a little
more comprehendible and so, perhaps, if you are still reading by this point I
have succeeded? If the comparison with chess conveys:
that counts of over $6m by either of the taxpayer NAV or the object entity NAV will generally mean failure of a basic condition for the Division 152 CGT relief so can lead to loss of the game; and
that high value pieces accelerate aggregation of NAV to the $6m limit. That is they can move more than one space: every $1 of a stake a taxpayer (or object entity) in a connected entity (or Oconnected entity), and affiliates and their connected entities without needing any stake in the affiliate of the taxpayer (or object entity) will generally aggregate more than $1 to NAV as the value of others’ stakes in these entities will count to the NAV attributed to the taxpayer (or object entity) too.
The modified MNAV test of the object entity & the modified Oconnected entity
The NAV for controlled entities of an object entity is different due to sub-paras 152-10(2)(c)(iii), (iv)
& (v) in the TIOMA:
The threshold between unrelated entity, counted simply as an asset or investment (pawn) to NAV and connected entity (bishop) consistent with other tests of control in the ITAA 1936 and the ITAA 1997 is 40% with a discretion given to the Commissioner where:
there is 40% or over and under a 50% stake; and
it can be established to the Commissioner that
some other entity controls the entity that would otherwise be the connected
In practice this means expect the Commissioner to de-connect A from connection with X if A owned 48% of X and B (unconnected to A) owned 52% of X.
When applying the object
entity MNAV test, sub-paras 152-10(2)(c)(iii), (iv) & (v) have
operation so that the threshold is lowered to a 20% stake in the other entity.
That is enough “control” to make the other entity, otherwise an asset or
investment, an Oconnected entity (knight). This is apparent from another
example in the Explanatory Memorandum with the TIOMA:
Example 2.5: Indirect investment in large business
Tien owns 20 per cent of the
shares in Investment Co, a company that carries on an investment business.
Investment Co is a CGT small business entity (according to the general rules)
for the 2020-21 income year. Investment Co holds 20 per cent of Van Co, a transport
Van’s assets mean that it is not a CGT small business entity in the 2020-21 income year and does not satisfy the maximum net asset value test at any point during the income year.
On 15 May 2021, Tien sells his shares in Investment Co. He is not eligible to access the Division 152 CGT concessions for any resulting capital gain. Even if Tien satisfies the other conditions, he cannot satisfy the new condition requiring the object entity be a CGT small business entity or satisfy the maximum net asset value test due to the modifications that apply when determining this matter for the purposes of this condition. For the purposes of this condition, Investment Co is considered to be connected with Van Co, as Investment Co holds 20 per cent of Van.
As stated in the table above there is no look through back so in a case where an object entity has a stake of 21% of X,
the NAV in entities connected to X by virtue of the remaining 79% stakes in X
are excluded from the object entity
NAV although the NAV of the assets of X,
including that relating to the other stakeholders, counts to the object entity NAV.
From time to time a family discretionary trust is set up for the benefit of two or more families who may be pursuing a business or a venture in common.
Risk of unequal returns from the discretionary trust!
A double (or more) -throated family discretionary trust is unwise on a number of levels and often reflects misunderstanding of the tax and civil dispute realities that can apply to trusts.
If there is a dispute between the business/venture principals then backing out of this kind of structure it can lead to complications where there are assets in the discretionary trust still to be divided and distributed to beneficiaries. One of the principals controlling the trustee may die or become incapacitated and the other principal may take the opportunity to distribute the assets of the trust solely to his or family! The other family may claim, say, that they should get 50% of the assets of the trust, or the value of the work contributed by them to the trust, but the trust document, being based solely on discretion, will disavow that any family has a 50% or other set interest in the trust.
A family discretionary trust is often funded by gift from the beneficiary family or by the unrewarded work of a member of the beneficiary family. That may be but there is no obligation on the trustee to return the capital or the income of the discretionary trust in proportion to those contributions to that family. The families are highly reliant on the arrangements for control of the trustee, who holds the discretion to distribute the income and capital of the trust, to ensure members of each family will participate in the income and capital of the trust on any equal basis.
A hybrid trust is an alternative to a multi family family discretionary trust which addresses such problems but hybrid trusts have their own separate set of commercial and tax difficulties.
Multi-family family discretionary trusts can be at high risk of audit under the “reimbursement agreement” provisions in s100A of the Income Tax Assessment Act 1936. Income distributions by the trust could be used to shift value between the families tax effectively however, if section 100A is applied, the distributions are void for tax purposes. The principals and their families, as beneficiaries, can’t resist a section 100A assessment with the usual defence based on the definition of “agreement’ in sub-section 100A(13) viz. that the distribution reflects an ordinary dealing within the family, because it does not. They are dealing between families.
Sometimes these structures are used to save establishment costs notably stamp duty which in NSW is as much as $500 to establish a trust where the trust holds no dutiable property. Such savings may prove inadvisable due to later considerable cost.
Administering a private company requires sound business skill and judgment. Since the Commonwealth has substantially taken legislative responsibility for companies and securities from the states, regulatory reform has been introduced so that numerous compliance obligations have been streamlined in a practical way.
It is not always understood that the reforms were only to the regulatory framework of companies. They do not necessarily extend to the differing regimes in place for each company. Conduct of a private company still very much remains the responsibility of the directors of the company who are required to observe the constitution of the company (COTC). A number of the regulatory reforms have no affect on the regime that applies to a company unless the company takes the necessary action to enliven them.
From 1998 – the “replaceable rules”
Reform to the framework in the Company Law Review Act 1998 (CLRA 1998) introduced “replaceable rules” that apply to a proprietary (private) company other than a company with a sole director/shareholder. Unlike “Table A” in the former states’ Companies Acts, which could be adopted as articles of association optionally by a private company, the “replaceable rules” take effect by default. In other words a company, which does not adopt a custom divergent COTC, is taken to adopt and can rely on the “replaceable rules” in the Corporations Act 2001. Nevertheless a majority of private companies, including companies established prior to 1998, have adopted a COTC which overrides the replaceable rules and their impact. So the reforms reflected in the “replaceable rules” don’t apply to those companies.
This post highlights some of the difficulties this causes to private companies that we notice in practice.
When private companies take significant actions resolutions need to be passed by the directors. As a standard, resolutions of directors need to be passed or agreed to at a directors meeting. It is a common alternative practice for directors of a company to complete a “circulated” resolution of directors signed by all directors of the company without formally holding a directors meeting. For most private companies that is fine as their COTC permits this procedure as an alternative to the company holding a directors meeting. The alternative procedure is authorised both in:
model “Table A” type COTCs which pre-date the reforms; and
section 248A of the Corporations Act 2001 where section 248A applies to the company as a replaceable rule.
However there is a minority of companies with old or inadequately drafted COTCs where the “circulated” resolution of directors capability is not available to the company either under the COTC, or under the replaceable rule in section 248A where the provisions in the COTC replace the replaceable rules including section 248A.
Invalid directors’ resolutions
Thus directors of private companies may be completing “circulated” directors’ resolutions on the mistaken assumption that their COTC, or the replaceable rule in section 248A, authorises the resolution without the holding of a directors meeting. The impugning of all of the resolutions of the directors of a company done in this way could have far reaching consequences for the company particularly if the activity of the company comes under the close scrutiny of government or lawyers. For instance, say a company in this predicament is a trustee of family discretionary trust: It is open for the Commissioner of Taxation to treat a resolution to distribute income to beneficiaries done in a way unauthorised by the COTC as invalid and not made in time to prevent the income being assessed for income tax to the trustee of the trust at the highest marginal rate under s99A of the Income Tax Assessment Act 1936.
If a COTC displaces the replaceable rules it is prudent to identify the capability in the COTC that permits the directors to use a circulated resolution instead of holding a directors meeting and to cite the reference to the capability in the circulated resolution. Look for wording in your COTC similar to section 248A. It is often the last article under the DIRECTORS PROCEEDINGS part of a COTC.
A COTC without the circulated resolution capability frequently has other shortcomings such as no capability for a director to attend a directors’ meeting by telephone or online over the internet. This is another case where inadequacy of the COTC can lead to invalidity of attempted directors resolutions done with this capability assumed by the directors.
Directors resolutions can also fail due to other procedural misunderstandings such as:
failure to give notice of a directors’ meeting to all directors;
a meeting may have a quorum requirement under a COTC which is not met; and
a proceeding by a single director is not a meeting.
Single director companies
The CLRA 1998 also changed the regulatory framework to allow for single director companies. Prior to the CLRA 1998 the minimum number of individual shareholders of a private company was two and so many memorandums and articles of association of private companies then in place, which became their COTCs from 1998, entrenched the two individual director minimum to comply with the pre-CLRA 1998 law. These COTCs required alteration to remove the minimum of two individual director stipulations and to allow the company to have a single director. This is a more obvious case of where a pre-CLRA 1998 COTC, in particular, needs alteration should the private company seek to have only one director.
The obligation of a company to use a common seal to execute documents was also removed from the regulatory framework by the CLRA 1998. Still a private company which was established before 1998, or any private company that has otherwise adopted a common seal, may need to act to dispense with its obligation to use the common seal.
Ordinarily this action would be:
The COTC is altered to:
provide that the company need not have a common seal; and
support the execution of documents by the company without a common seal.
The directors resolve to dispense with the common seal.
Execution of deeds and other documents, including, for example, an election by a company as trustee to become a regulated superannuation fund, can be invalidated if the private company must use a common seal that remains adopted by the company but executes the deed or documents without that common seal.
Special purpose superannuation companies – reduced ASIC annual fee
The reforms allowed for a company that has been set up to act solely as the trustee of a regulated superannuation fund, or for other designated special purposes, to apply a substantially reduced ASIC annual fee of $40 rather than $226.50. Entitlement to the reduced fee for a company that has been set up to act solely as the trustee of a regulated superannuation fund turns on the limit on the purposes for which the company can act being effectively included in the COTC.
It’s a fail for the directors to complete the declaration to claim the reduced fee without understanding whether the provisions of the COTC support the entitlement to a reduced fee.
Directors of a private company are expected to understand and to take responsibility for what is in the COTC.
Although the company regulatory framework has been reformed:
to more readily allow circulated directors’ resolutions as an alternative to holding directors’ meetings;
to allow private companies to have a single director;
to make common seals optional; and
to extend a reduced ASIC annual fee to dedicated superannuation trustee companies;
among other reforms, the COTC of the company and the standing resolutions of the directors are a regime which constrains how the reforms may apply to a private company. Directors of companies should check COTCs and their records to ensure that they support the company using capabilities supported by the reforms.
Annual income distributions by family discretionary trusts (FDTs) are routine for trustees for apparent Australian income tax reasons but trustees of FDTs can be reluctant to distribute trust capital. What would be the reason for that reluctance? Why don’t trustees of FDTs make capital distributions more often?
The trust deed
The regime in a FDT deed typically centres on distribution of capital on the vesting of the FDT. However even older and archaic FDT deeds usually expressly allow for interim distribution of capital, that is, distribution of trust capital before the FDT vests and winds up. Interim distribution of capital to beneficiaries, rather than holding it for them until the vesting day, is often conditional on the distribution being for the “maintenance education advancement in life or benefit” either for infant beneficiaries or for beneficiaries generally – see Fischer v Nemeske Pty. Ltd.  HCA 11: a condition which, in ordinary family dealings, can readily be met.
Purpose of a FDT
A FDT is, in its essence, an arrangement to benefit family members. A FDT can be seen as a pool set aside to gift to family members. But is a distribution to a family beneficiary from a FDT treated the same for tax as a family gift to a family member?
It is useful to think about differences between a FDT and other types of entities before answering that:
Difference to a proprietary company
A proprietary company has the legal status of a separate person and the release of company capital to a shareholder of a company is subject to a number of corporations law and tax technicalities. A company can have wide objects but giving its value away to other persons would not usually be one of them. Under tax rules the enrichment of a shareholder’s family member from a company’s capital is likely dividend income assessable to income tax either directly or as a “payment” under section 109C of the Income Tax Assessment Act 1936.
Difference to a unit trust
A trustee of a genuine unit trust would generally be required to make capital distributions in equal proportions based on the unit holdings of unit holders. If capital distributions from a unit trust are feasible the capital gains tax (CGT) rules can discourage the trustee from making these distributions before vesting. CGT event E4 applies to distributions of capital of a unit trust which are not in connection with the disposal of the units to reduce the cost base of the unit holder by the amount of the distribution and, to the extent the cost base doesn’t cover the amount of the distribution, the excess is a capital gain assessable to unit holders.
How CGT applies to distributions of capital by FDTs
CGT event E4 does not apply to non-assessable capital distributions from a FDT. In Taxation Determination TD 2003/28 Income tax: capital gains: does CGT event E4 in section 104-70 of the Income Tax Assessment Act 1997 happen if the trustee of a discretionary trust makes a non-assessable payment to: (a) a mere object; or (b) a default beneficiary? the Commissioner of Taxation confirms his longstanding view and practice, since the introduction of CGT in 1986, that CGT event E4 does not happen if a trustee of a discretionary trust makes a non-assessable payment to a mere object. That is, a mere discretionary beneficiary where the entitlement to the payment arose because the trustee exercised its discretion in the beneficiary’s favour and the interest was not acquired by the beneficiary for consideration or by way of assignment.
The CGT similarity of FDT cash distributions and cash gifts
The enrichment of a family beneficiary of a FDT by an interim distribution of the capital of a FDT is not, of itself, subject to CGT based on TD 2003/28 i.e. there is no CGT on a distribution of cash to a beneficiary from the capital of a FDT. If there is a distribution of a CGT asset from the capital of a FDT to a beneficiary that is a different story. CGT events E5 and E7 can apply to subject the realisation of the CGT asset by the FDT to a family beneficiary to CGT. But there is no fundamental difference between a distribution of a CGT asset from the capital of a FDT, and the CGT events that apply to it, and how a family gift of a CGT asset by an individual is treated for CGT. That is, a gift of cash is CGT free and a gift in the form of property that is a CGT asset is subjected to CGT: not because of the gift but because a CGT asset is being realised and the CGT regime brings gains in value on a CGT asset to tax on a change of ownership.
So cash distributions of capital by a FDT, where permissible under a trust deed of a FDT, can generally occur, either with income year end income distributions or at other times during the currency of a FDT, without income tax consequences.
However there is a problematic exception:
Small business CGT concessions participation percentage
Under item 2 in the table in section 152-70 of the Income Tax Assessment Act 1997 the “small business participation percentage” of a beneficiary of a FDT is the smaller of the percentages of the beneficiary’s entitlement to income and the beneficiary’s entitlement to capital in an income year if both income distributions and capital distributions are made in that year. Generally beneficiaries are better off qualifying for a sufficient small business participation percentage to qualify for the concessions if no distribution of capital, or no divergent distribution of capital (bearing in mind that a capital gain on an active asset distributed by a FDT is likely to have a capital component), has been made in the income year the relevant capital gain has been made in to some other beneficiary.
So if a capital gain arises to a FDT in an income year which can attract the small business CGT concessions in Division 152 of that Act, then a distribution of the income in that income year substantially to family member A, including entitlement to a capital gain, may not count or count sufficiently in the measurement of small business participation percentage where a cash distribution of capital has been made to family member B and not family member A who is left with a “smaller” participation percentage. It could be that family member A may thus not qualify as a significant individual or as a CGT concession stakeholder without the sufficient interest in capital distributions of the FDT in the relevant income year in which the capital gain was made.
So a trustee of FDT needs to be wary of cash distributions of capital from a FDT and, indeed, the streaming of capital gains where there has been a capital gain that can attract the small business CGT concessions to ensure that the desired beneficiaries have sufficient entitlements to capital that can attract the concessions. If the small business CGT concessions participation percentage is not in issue a cash distribution from from the capital of a FDT to a beneficiary can be a tax benign.
Perpetuities laws apply in Australian states to limit the period by the end of which interests in property of a trust must vest in a beneficiary. As I mentioned in my March 2018 post on bringing trusts to a timely end, “vest” broadly means to imbue with ownership of property. So, when property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.
Discretionary trusts are subject to an eighty year maximum perpetuity period
The maximum perpetuity period (MaxPP) under each perpetuity law is the maximum period by the end of which property held on trust must vest. As I observe in my March 2018 post, property of a trust can already be vested in beneficiaries but, in the case of property of an ongoing discretionary trust, where there is a discretion to distribute income or capital to discretionary beneficiaries; the property held on the trust has not vested.
The MaxPP is consistently eighty years from when the trust commences under state perpetuities laws excepting South Australia where the perpetuity law has been repealed.
Where a disposition of property held by a discretionary trust does not vest within the MaxPP then the disposition of property to the trust is void under the perpetuities laws. That is the trust fails over that disposition and the property that was supposedly to be held on the trust is vested in and held for return to the settlor and the others who have given it to the supposed trustee.
“Wait and see” rule
The states that have a perpetuity law also adopt a “wait and see” rule to soften the harsh outcome of causing a trust over property, which might fail to vest the property within the MaxPP, to be void. Under the “wait and see” rule persons interested can wait until the expiry of the perpetuity period to see whether a disposition of property on trust has vested. If the property has not vested in a beneficiary by then, then the affected disposition of property to the trust is void.
The perpetuities complication of trusts as discretionary beneficiaries of a trust
Many family discretionary trust arrangements allow distribution of income or capital of the trust to other trusts.
Let us say Trust A and Trust B:
are family discretionary trusts that commenced in 2010 and 2015 respectively;
to which the law of Queensland applies;
with each specifying a perpetuity period for the vesting of their property of eighty years from their commencement.
Trust B is a beneficiary of Trust A and in 2018, the trustee of Trust A exercises its discretion and distributes some of the 2018 income of Trust A to Trust B.
Under the perpetuities law the MaxPP is eighty years. The income of Trust A, which was the property of Trust A, must vest in accordance with that law and under its perpetuity period term by 2090. But, following the distribution to Trust B the prospects are that the trustee of Trust B:
may not vest the income received from Trust A by 2090 even though 2090 is the expiry of the MaxPP applicable to property (that wasn’t vested in a beneficiary) that was held in Trust A; and
is not obliged to vest the property of Trust B under the perpetuity period applicable to Trust B before 2095.
If the trustee of Trust B hasn’t vested the income received from Trust A by 2090, the disposition of that income from Trust A to Trust B is void as the property of Trust A hasn’t vested by the expiry of the MaxPP for Trust A when the “wait and see” rule no longer has effect. But does that prospect invalidate that disposition at an earlier point in time because Trust B, which has received the property which must vest by 2090, is not slated to definitely vest until 2095?
Nemesis Australia Pty Ltd
This situation was considered by the Federal Court in Nemesis Australia Pty Ltd v Commissioner of Taxation  FCA 1273. In that case the Commissioner asserted that distributions by the Steve Hart Family Trust to other trusts that were discretionary beneficiaries of the Steve Hart Family Trust, each of which had perpetuity periods which extended beyond the MaxPP applicable to the Steve Hart Family Trust, were too remote i.e. violated the perpetuities law and were thus void.
The Commissioner contended that the “wait and see” rule should not save the distributions where the source Steve Hart Family Trust and the relevant receiving beneficiary trust, looked at together, prescribed a period longer than the allowable eighty years applicable to the disposition in the deed of the Steve Hart Family Trust.
Tamberlin J. rejected the Commissioners contention and found that the “wait and see” rule applied to prevent the perpetuities law from invalidating the dispositions even though the receiving trusts might not vest the property they had received from the Steve Hart Family Trust before the expiry of the eighty year MaxPP applicable to property held in the Steve Hart Family Trust. The “wait and see” rule could apply because the trustees of the receiving trusts could act to advance their vesting dates so as to bring them within that MaxPP applicable to property they received from the Steve Hart Family Trust.
Inferences from Nemesis Australia
It follows from Nemesis Australia that the distribution in my example from Trust A to Trust B won’t be void under the perpetuities law as “wait and see” applies even though the income Trust B has from Trust A might not vest until 2095.
Should the trust deed of Trust A constrain distributions to trusts that may vest outside of the eighty year MaxPP applicable to property in Trust A?
Where Trust A distributes income of Trust A to Trust B and a beneficiary B1 of Trust B is presently entitled to that income of Trust B, which originated in Trust A, then B1 has an interest which has vested thus there is no need to “wait and see” any longer to see if the interest has vested: that disposition does not offend the perpetuity law. Where, however, Trust A distributes income or capital of Trust A to Trust B which does not vest in individual or corporate beneficiaries before the MaxPP applicable to Trust A expires then that income or capital will inadvertantly revert to the settlor or to other persons who have funded Trust A.
So the inclusion of a mechanism in discretionary trust deeds which synchronises vesting dates applicable to particular interests in income or capital that are distributed to other trusts with a later vesting day may avoid inadvertant ownership outcomes and liabilities when source discretionary trusts reach the end of their MaxPP. Following Nemesis Australia more radical restriction and control of discretionary trust distributions to other trusts as discretionary beneficiaries does not appear necessary.
Ending a trust is straight forward, isn’t it? Vest all interests in the trust in beneficiaries and make the right accounting entries and the trust is terminated? Not quite.
That word “vest”. What does it mean? Vest is a technical legal term. Broadly it means to imbue with ownership of property. So, when a trust ends and the property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.
But not all trusts end that way. For instance a unit trust or an unpaid present entitlement may already be vested in a beneficiary or beneficiaries. Clearly something other than vesting is needed to bring trusts of that type to an end. In those cases property that has already vested in beneficiaries may need to be paid to or put in the possession of the beneficiaries too for the trust to end.
Ending is all in the timing
In most states and territories of Australia trusts must vest within a statutory perpetuity period, typically 80 years. From this point this post relates to jurisdictions where a statutory perpetuity period applies.
Trusts that are fully vested, such as bare trusts, fixed trusts, some sorts of unit trusts and “indefinitely continuing” superannuation funds may continue for longer than the perpetuity period. A discretionary trust must vest no later than the perpetuity period, that is, discretions to distribute all income and capital of the trust must be taken and sunset once the time for vesting has been reached otherwise it will be too late and the formula for distribution for “takers-in-default” set out in the trust deed will apply to the property then left in the trust. The divesting of those interests, which are then held by the trustee outright for those beneficiaries, by payment over to, or at the direction of, the beneficiaries, can happen later after the expiry of the perpetuity period.
Bringing forward the ending of a trust
The trust deed should also set out how the time for vesting can be brought forward from the expiry of the perpetuity period. That time of expiry will usually be the “default” time for vesting, or a time just before it, (the last vesting time) in a well-crafted discretionary trust deed.
An objective of winding up a trust is to satisfy all parties with interests, in the wider sense, in the trust, including creditors, trustees, beneficiaries and the Commissioner of Taxation.
Failure to address these interests of the parties interested, or the trust deed requirements and formalities for the bring forward of the time of vesting, can mean that the trust, or its aftermath, will remain a matter in contention or dispute which is diametrically not what a trustee will want to occur following their effort to bring the trust to an end. A trustee can face difficulty in the converse case too where a trust is inadvertently brought to an end prematurely. In other words trustees can face problems where a trust has a mistimed ending either way. A trust may go on longer than planned or it may be inadvertently brought to an end before the trust should end. An example of the latter is to be found in trust deeds which set an inexplicably early time for vesting many years prior to the expiry of the perpetuity period.
Ending by depletion and merger
Depletion and merger are two other ways a trust may be brought to an end even where the intent of the trustee and beneficiaries is, and the trust deed may suggest that, the trust is to go on for longer.
Depletion is where the trustee no longer holds property on trust. If trust property is depleted and the trustee acquires more property on trust, the arrangement is treated as a new and separate trust. A “resettlement” occurs as well as likely confusion about which trust is which. Hence the device of a “settled sum” for a discretionary trust, which remains as trust property, to ensure continuity of the (original) trust even where the trust is in deficiency and has no other identifiable property.
Merger also brings a trust to an end in an untimely and premature way. Merger occurs where the trustee and the beneficiary are or become the same person. In the case of a merger the trust obligation of the trustee under the terms of the trust is no longer owed to the beneficiary so the trust does not continue.
Merger and SMSFs with individual trustees
Merger can be an interesting issue in the case of a self managed superannuation fund with individual trustees. There is no merger while the fund has two trustees: Trustee A has trust obligations to member B and trustee B has trust obligations to member A. However if a trustee/member dies and the surviving sole trustee is also the sole member of the fund with a fully vested beneficiary account of the entirety of the fund, the fund likely merges. It follows that the fund is no longer a trust. The Commissioner of Taxation has not addressed how the doctrine of merger may apply in these cases, and, as I understand it, the Commissioner treats a fund in this situation as continuing on as a matter of administrative convenience. If the Commissioner’s approach, which may be tantamount to a recognition of a self managed superannuation fund that is not a trust, came before the courts, it is unclear how it might be explained or permitted.
Some starting points
Trusts that require winding up usually commence by and are governed by a trust deed. I am not writing here of testamentary trusts. A trust deed will usually state the requirements to wind up the trust including how the time of vesting must be brought forward. A trust deed may also provide for other things which complicate vesting or winding up, or both. The trust deed may require that a party’s consent is required before either can happen. There may be other forerunner steps which haven’t been taken which must be taken before the trust can vest under the deed. A grasp of the design or method of the trust provisions in the trust deed will build confidence that all requirements for a winding up raised in a trust deed have been identified and addressed.
If the accounts of the trust have been correctly prepared then the current balance sheet, in particular, gives a list of activity to be addressed before the trust can be wound up. For a company liquidation, liabilities need to be satisfied with the balance of assets (property) distributed to owners. Trusts are no different. The more assets have been converted to cash and liabilities have been met the simpler the contemporary balance sheet and the winding up will be.
The conversion of assets to cash can give rise to taxable capital gains and assessable balancing charges but the alternative, their distribution to beneficiaries on a winding up inevitably does so too. It is generally simpler or more tax effective, or both, if these CGT events are contemporaneous with the trust coming to an end. In the cases of a fixed trust or a unit trust CGT event E4 can occur where a non-assessable part of a capital gain is distributed to a beneficiary when the interest of the beneficiary in the capital of the trust persists.
Errors frustrate the ending
Correct accounting in the trust will follow correct treatment of interests, assets or liabilities in the trust by the trustee. But correct treatment of interests, assets or liabilities doesn’t always happen. Notable examples where correct treatment doesn’t happen include:
the elimination of entitlements of family beneficiaries in the course of a winding up. Trustees of discretionary trusts distribute trust income to family members on lower tax rates (A) which remains unpaid and which is treated in the accounts of the trust as an unpaid present entitlement under terms in the trust deed. On winding up the distribution may revert to or may be paid to the principals of the family (B) instead without explanation. That suggests that the present entitlement of beneficiaries to former income of the trust was a sham or misunderstood with potential tax liability for the trustee;
distribution in the course of a winding up to individuals where the trust holds money or property sourced from a private company to which Division 7A of the Income Tax Assessment Act 1936 applies. This may be inconsistent with repayment of the money or property to the relevant company and could trigger a “deemed dividend” tax liability; and
backdating and forgiveness of loans – it can be tempting for a trustee to purge debts to related parties in the accounts of a trust but the purge is unlikely to be legally effective. A more nuanced treatment, which actually addresses the nature of the original transaction, is more likely to be accepted.
The Commissioner of Taxation investigates, audits and challenges trusts and the parties involved in these kinds of errors including after a winding up.
The affairs of trusts vary greatly and some have deeply intransigent issues. Getting a trust ready to wind up, and executing that wind up at a custom desired point in time may pose a number of challenges which should be considered and addressed in the process. The legal, accounting, business and practical attributes of the trust and possible errors should be considered through the due diligence process so that a non-contentious consignment of the trust to history can be effectively documented.
A popular pro-active SMSF strategy is to skirt the boundaries of the associate rules in Part 8 of the Superannuation Industry (Supervision) Act 1993 (SISA) with minority SMSF investors taking units in a unit trust with no apparent majority controller with other unrelated SMSF or non-SMSF investors. The object of the minority strategy is that the minority SMSF investor and associates have a less than 50% entitlement to income and capital of the unit trust and so the unit trust will not be a related trust of the SMSF automatically. This is an alternative strategy to investing in a non-geared unit trust which complies with Regulation 13.22C of the Superannuation Industry (Supervision) Regulations.
If the minority strategy doesn’t work
If the unit trust is, or becomes, a related trust of the SMSF the consequences can be severe. The investment in the related trust by the SMSF is taken to be an in-house asset. A SMSF that fails to remedy an investment of more than 5% of its assets in in-house assets faces loss of complying status potentially causing:
tax at 47% on its current income; and
loss of almost half of the assets of the SMSF in a one-off additional tax bill in the year in which the SMSF becomes non-complying; or
prosecution for civil or criminal breach of a civil penalty provision under the SISA.
An investment in a non-geared unit trust which complies with Regulation 13.22C is specifically excluded from being an in-house asset. The minority strategy does not give the same assurance to a SMSF investor in units in a unit trust which is not Regulation 13.22C compliant.
Control of a trust
The more than 50% entitlement to income and capital test is one of the tests of control of a trust in sub-section 70E(2) of the SISA which determine whether or not a trust is controlled and is thus an associate and, by that, a related trust. An alternate test in paragraph 70E(2)(b), sometimes overlooked by users of the minority strategy, is the directions, instructions or wishes test which is an alternative test of control of a trust. Its formulation:
an entity controls a trust if:
… (b) the trustee of the trust, or a majority of the trustees of the trust, is accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of a group in relation to the entity (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed companies, partnerships or trusts);
is based on a similar formulation in sub-section 318(6) of the Income Tax Assessment Act 1936 which deals with associates under the income tax controlled foreign corporations (CFC) rules.
MWYS v. Commissioner of Taxation
The directions, instructions or wishes test in paragraph 318(6)(b) in the CFC rules was recently considered by the Administrative Appeals Tribunal in MWYS v. Commissioner of Taxation  AATA 3037 (22 December 2017) and the companies in dispute with the Commissioner in that case were found not to be associated even though the companies concerned had the same directors.
Deputy President Logan found that, despite the unanimity of the directors of the companies involved, the companies were not associates as it could not be concluded, on the evidence, that the directors of one company, acting in that capacity, would influence themselves acting in their capacity as directors of the other company. Deputy President Logan observed that the arrangements between the companies involved: an Australian listed company and a UK publicly listed company which enabled them to dual list on the ASX and the London Stock Exchange, were for the purpose of compliance with dual listing requirements but, within that framework, the companies were structured with similarity to unrelated joint venturers. No inference could be drawn about one company acting on the directions of the other.
It is certainly clear from MWYS that commonality of directors of a company, or in the case of paragraph 70E(2)(b) of the SISA, commonality of directors of a corporate trustee is not enough, in itself, to amount to a reasonable expectation that one company will act in accordance with the directions, instructions or wishes of the other company or of a group including it.
Is MWYS good news for SMSFs using the minority strategy?
Is the decision in MWYS a relief to minority SMSF investors in unit trusts concerned about paragraph 70E(2)(b) of the SISA? Maybe not. Documents of SMSF trustees and of unit trusts, in which they invest, are far less likely to be as meticulous at keeping the affairs of entities being examined for control apart. A unit trust deed is more likely than, say, a joint venture arrangement to show that the trustee of a unit trust might act in accordance with the directions, instructions or wishes of a unitholder, albeit a minority unitholder.
Frequently, under unit trust deeds, minority unitholders have the right to vote on resolutions which bind the trustee of the unit trust to act. A minority unitholder may not have the votes, alone, to so bind the trustee; but the question posed by the test is whether the trustee is accustomed to act, or whether there is a reasonable expectation that the trustee of the unit trust will act, in accordance with the directions, instructions or wishes of a minority unitholder. The answer in fact is equivocal – yes, if the minority unitholder votes are in the majority and no, if not. So yes, a part of the time or on some occasions. So the minority SMSF investor and the trustee of the unit trust are associated?
What will facts show under scrutiny?
The concern for SMSF users of the minority strategy is: will their position, that the unit trust they invest in is not a related trust, become less defensible under scrutiny from the Commissioner? From the activities of the SMSF investor, its associates and the trustee of the unit trust the Commissioner can gauge how the trustee of the unit trust has reached decisions, which may not have been in accord with documents, whether sound or not, and form a view as to how likely the trustee of the unit trust is likely to have acted on directions, instructions or wishes of the SMSF investor and its associates.
Until the circumstances of a SMSF using a minority strategy, including the relevant documents, are considered it can be uncertain whether a SMSF minority unitholder may “control” a unit trust and cause it to be a related trust.
The force of the superannuation law is that investment in land by a SMSF needs to be prudent. An investment needs to be considered in a business-like way.
Limited recourse borrowing is one way to fund investment in real estate. SMSF principals may prefer to arrange equity investment from private connections outside of the SMSF.
Investment as a tenant-in-common?
I am frequently asked about SMSFs participating in land investments as a tenant-in-common with related and unrelated entities of the principals of the SMSF. It is apparent from the NTLG Superannuation sub-committee technical minutes of June 2011, released by the Australian Taxation Office, that tenants in common arrangements for SMSFs are not going to be prudent for the SMSF without careful and restrictive implementation. Wherever other tenants in common could borrow, or use or risk their interest as security, the SMSF tenant-in-common is exposed to uncontrolled risks which would bring into question, for instance, whether the SMSF:
1. has acted prudently pursuing the investment for members for whom it is bound to provide;
2. has breached regulations which prevent charges, or the potential for them, being taken over SMSF property; or
3. has satisfied the sole purpose test.
Investment through a trust?
The tenant-in-common option is frequently turned to because of the restrictive regime that has applied in relation to the investment by SMSFs in related trusts since 1999. Shortly stated, a post 1999 investment by a SMSF in a trust, which is related to the principals of the SMSF, a “related trust”, is treated as an “in-house asset” and more than 5% of the assets of a SMSF in in-house assets can leave the SMSF non-complying.
Non-geared unit trust – expressly relieved from being a related trust
The SIS Regulations provide an express exception. A superannuation fund can invest in a non-geared unit trust (NGUT) to which Regulation 13.22C applies without the NGUT being taken to be a “related trust” and thus the investment isn’t taken to be an investment in an “in-house asset”.
This express exception is especially limited and, aside from relief from “related trust” treatment causing in-house asset difficulty, offers no expansion in the kind of investment that can be pursued with superannuation money. In other words, the investment still needs to address 1 to 3 above, for instance.
The Regulation 13.22C and 13.22D requirements and restrictions on NGUTs essentially mirror the restrictions on regulated superannuation funds. NGUTs cannot borrow and they can only “lend” to operate a bank account. They cannot secure or charge their assets. (A non-SMSF unit holder in a NGUT could give a security over his, her or its units but security could not be given over the assets of the NGUT.) A NGUT cannot run a business – unlike with superannuation funds, this is a direct requirement. Loss of NGUT status, so that the NGUT becomes a related trust triggering in-house asset difficulties follows the merest breach under Regulation 13.22D which can put complying status of a SMSF investor at the mercy of the ATO.
1. Nevertheless a carefully implemented NGUT can be the most practical way to pursue unitised investment in land by related parties and unrelated parties of a SMSF with the SMSF.
2. Compliance with the regulations needs to be closely monitored as stated. Any debtor or creditor, aside from a bank for the (credit only) trust bank account, potentially causes loss of protection from related trust status. Funding of, and money flow to and from, the NGUT without breaching the rules is thus practically challenging. The trustee needs to raise equity (unit) funding whenever any extra funding is required. From a practical and paperwork burden perspective, using partly-paid units is a strategy that might be considered wherever the trust needs a flexible equity facility.
3. The activity of the NGUT that invests in land also needs to be monitored and carefully planned and structured. It is possible for real estate activity by trustees to be considered the carrying on of a business under tax rules. As stated a NGUT cannot carry on a business under the NGUT regulations nor, if it has a trust deed to suit, under its trust deed.
4. Under the special trust rules in NSW, a special trust pays land tax at the highest land tax rate without a threshold. A SMSF can attract a better land tax rate. A NGUT will not automatically qualify for the rate for a SMSF to the extent a SMSF invests in it. However if the NGUT is a “fixed trust” under the land tax rules then a better rate than the special trust rate can be achieved. Hence there can be advantage to structuring a NGUT with a trust deed so that the NGUT can be treated as a fixed trust under the land tax rules.
5. A carefully crafted trust deed can be very useful to assist the trustees of a SMSF and a NGUT to keep within the express requirements and restrictions on NGUTs.