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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.

How perpetuities law limits can impact trust distributions to other trusts

WaitandSeeVesting of trust property

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.

Example

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 [2005] 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.

Bringing trusts to a timely ending

MovingOnEnding 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.

Tax planning

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.

Conclusion

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.

Minority SMSF investors and related unit trusts

AssociatesA 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 [2017] 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.

Moreover the strict governance which applied to both of the listed companies actually helped the companies to establish that the directors were acting independently and at arms length from the other company even where the directors were directors of the other company too. Short of a sham, or a cipher, as arose in Bywater Investments Ltd v Federal Commissioner of Taxation [2016] HCA 45 (see our blog -Why setting up offshore companies for Australians is a tricky business), the AAT was prepared to rely on the meticulous corporate documents which set out the distinct responsibilities of the directors of the companies they separately served.

Directors in common

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.

SMSFs getting practical to invest in land with others

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.

Practicalities

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.

Preparing to change land ownership from a company to a trust

A company controlled by X owns land. X would prefer it if the land was held by a trust or in an individual name such as X or Y, X’s spouse.

X_diag

Significant capital gains tax (“CGT”) on the transfer of the land is not expected by X and Y. Is a transfer of the land to a trust or to X or Y or both worthwhile? Here are some tax implications X may want to think about:

Capital gains tax

If the land has increased in value X will want to consider CGT more closely:

If the land is not an active asset, or if the small business CGT concessions or the new small business restructure roll-over, can’t apply for some other reason, the value of the land, when disposed of, will be taken into account in determining CGT. i.e. the market value substitution rule will apply in the event of an undervalue transfer of the land.  An undervalue transfer of the land is rarely likely to be effective under tax rules.

The small business CGT concessions and the new small business restructure roll-over don’t apply if the asset is not an active asset. The land won’t be an active asset if it is mainly used by the company, and related parties of the company, to earn rent. As the land is held in a company, the 50% CGT discount is not available to the company on the transfer of the land.

Problems with a gift or an undervalue transfer

If full value is not payable to the company for the land then, without more, a transfer of the land could be treated as a dividend taxable in full to the transferee as a shareholder of the company, as a deemed dividend taxable to the transferee as an associate of the shareholders of the company, or may possibly be taxable to the company as a fringe benefit.  Further if the company has taken the approach of gift there may be difficulties establishing that the company was legally entitled to give the land away to the transferee if that is what is done. Indications of a gift might give a creditor of the company additional rights to pursue the transferee for the value of the land that belonged to the company especially if the stance of the company is that the transfer was not any sort of dividend or remuneration to X or Y.

A sale of the land by the company for full value is more defensible. The sale can be on terms rather than for cash payable on settlement. If the transferee doesn’t follow through, and pay the value in cash or on the agreed terms, then the sale for value can be treated as a sham and the consequences of undervalue transfer can then follow.

So defensible transfers of the land include:

  1. sales at full value on (genuine) terms; and
  2. distribution of the value of the land to the shareholders of the company (not in the form of cash) on the voluntary liquidation of the company.

CGT event A1 – but watch out for CGT event E2 if a transfer to a trust

Usually CGT event A1 is attracted when land is transferred from one beneficial owner to another. CGT event A1 is taken to occur at the time of (in the income year of) the disposal, that is, the time of the transfer unless the transfer is made under a contract. If the transfer occurs under a contract and CGT event A1 applies, CGT event A1 is taken to occur at the time of making of the contract.

This can be significant where a contract and settlement straddle the end of an income year, with the time of the contract bringing forward the capital gain into the earlier income year if CGT event A1 applies. If the transferee is a related trust of the vendor then CGT event E2 can apply rather than CGT event A1.  CGT event E2 though, unlike CGT event A1, does not bring forward the time of the CGT event to the time of the contract so, if CGT event E2 applies, the capital gain will be made in the later income year.

Stamp duty on a transfer

Stamp duty varies from state to state but generally applies to acquisitions of land based on the market value of the land, not the price to the transferee/purchaser. Very generally speaking it is usually charged at around 5% of the land value. The states offer limited stamp duty relief when acquisitions occur without a change in ultimate beneficial or economic ownership of the land. For instance, in New South Wales and Victoria relief exists in the form of corporate reconstruction concessions. These concessions are generally not available where the acquisition is by a trust or an individual. Thus stamp duty would need to be budgeted for by X as a further cost of transferring the land.

Goods and services tax

If the company is registered or ought to be registered for the goods and service tax and the land in used in an enterprise carried on by the company then the company may be obliged to charge 10% GST to the transferee on the transfer (taxable supply) of the land. If the transferee is also registered for GST, and will use the land in the transferee’s enterprise, then the transferee can obtain an input tax credit/refund of the GST charged to the transferee. The company and the transferee, if registered for GST, may also:

  1. be able to claim the GST going concern exemption if they take the necessary steps for the exemption; or
  2. be members of a GST group;

which would relieve the company of the obligation to charge GST to the transferee.

Are there limits to interest deductions in Australia in participative loan arrangements involving entities in the same economic group?

Question on taxlinked.net members forum about Participative Loan Taxation

Since 1st January 2015 in Spain, interests are (interest is) not tax deductible when the participative loan is agreed to between entities of the same economic group. Is there similar treatment in your countries?

Response to post

Generally not in Australia.

In Australia interest is deductible if incurred on debt finance obtained to earn assessable income or to carry on a business even if debt finance arrangements include entities not dealing with each other at arms length.

These deductibility tests are serious purposive tests so non-arms length transactions attract particular scrutiny and, like in most jurisdictions, the burden of making out either purpose is on the taxpayer. As well as the general construct of sham there are a numerous specific instances where the Australian law denies interest deductions including:

  • sometimes where deductions are prepaid;
  • where there is not a sufficient relation between the loan and income received after a “commonsense” or “practical” weighing of the circumstances; and
  • where deductions are artificial or contrived or have those elements– if specific anti-avoidance rules do not apply.

Australia has a longstanding general anti-avoidance provision that can apply even if the interest deduction was otherwise available under the law. In international outbound financing the deduction can be lost because foreign income can be treated as other than assessable income. International debt/hybrid mismatch rules are being developed in Australia following some taxpayer success resisting anti-avoidance rules and the international experience.

Deductions are also lost if a “loan” is technically found to have characteristics of equity in substance.

Australian courts look at the role of associated entities to understand their purpose and look at transactions holistically. In other words they will focus on the economic units, rather than on juristic entities which seems to happening in Spain from what you say. Hence an interest deduction to an entity can be reduced, for instance, if the debt finance is on-lent to a related entity to earn income palpably less than the deduction.

Australia also has thin capitalisation rules which apply to limit otherwise allowable large cross border interest deductions.

Chevron Australia is involved in the first major transfer pricing case under the new BEPS regime where the Commissioner of Taxation is fighting to contend that interest paid and deducted exceeded the arms length amount based on BEPS arms length principles. The Commissioner won the first stage of the case in 2015.