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Some warning about discretionary distribution of trust income to a deceased estate

The principal and controller of a family discretionary trust (FDT) may have died. The trustee of the FDT (Trustee) may be inclined to distribute income of the trust at financial year end (ITFYE) to his or her deceased estate (DE) for two apparent reasons nevertheless:

the Trustee may seek to broadly maintain, at least in transition, the same pattern of distribution of ITFYE to family beneficiaries where the deceased had been a major discretionary beneficiary of the FDT prior to his or her death; and
the Trustee may believe that the DE, as an Australian tax resident DE, has or is expected to have the tax advantage of income tax at rates equivalent to an adult resident individual including the tax free threshold available for three years following death in Schedule 10 of the Income Tax Rates Act (C’th) (ITRA) 1986 (Schedule 10).

But will this distribution of ITFYE to the DE be effective?

A distribution of income of the FDT made both before death and, where permitted by the trust deed of the FDT, the end of the financial year say to a terminally ill beneficiary:

does not give rise the difficulties considered in this blog post; and
can be income of the DE under sub-section 101A(1) of the Income Tax Assessment Act (ITAA) 1936 where the entitlement to ITFYE arose before death (with evidence of a resolution to distribute then) where the beneficiary dies later before the end of the financial year.

However a trustee of FDT may not follow, may not utilise or have the opportunity afforded by a trust deed to distribute current year income of the FDT on a timely basis before the beneficiary dies.

The beneficiary after death?

After the death of a deceased beneficiary:

the deceased is no longer a person, both physically and legally;
the DE arises as a separate entity, including, for income tax purposes: as a trust: paragraph 960-100(1)(f) of the ITAA 1997 and by the inclusion of executors and administrators (of DEs – in the view of the Commissioner of Taxation – ;see below) in the definition of trustee in sub-section 6(1) of the ITAA 1936;
property belonging to the deceased, including any property that would have been due to them after the date of death had he or she survived, constitutes property of the DE; and
that separate entity, the DE, is not ordinarily a beneficiary of the FDT.

The implications of these parameters, and their interplay with the income tax rules relating to distributions of ITFYE of FDTs in particular, need to be examined to better understand whether or not a distribution of ITFYE can be made to a DE.

1. BENEFICIARY NO LONGER LEGALLY A PERSON

In essence a discretionary distribution from a FDT is a gift by the trustee in exercise of a discretion to appoint income or capital of the FDT to a discretionary beneficiary of the FDT. It is fundamental that a deceased person cannot receive a gift. Lord Parker formulated when a gift can be valid this way:

I think, well to bear in mind certain general and perhaps somewhat elementary principles. At common law the conditions essential to the validity of a gift are reasonably clear. The subject-matter must be certain; the donor must have the necessary disposing power over, and must employ the means recognized by common law as sufficient for the transfer of, the subject-matter; and, finally, the donee must be capable of acquiring the subject-matter. If these conditions be fulfilled, the property in the subject-matter of the gift passes to the donee, and he becomes the absolute owner thereof and can deal with the same as he thinks fit. The common law takes no notice whatever of the donor’s motive in making the gift or of the purposes for which he intends the property to be applied by the donee, or of any condition or direction purporting to affect its free disposition in the hands of the donee. It is immaterial that the gift is intended to be applied for a purpose actually illegal – as, for example, in trade with the King’s enemies – or in a manner contrary to the policy of the law – as, for example, in paying the fines of persons convicted of poaching. In either case, the essential conditions being fulfilled, the gift is complete, the property has passed, and there is an end of the matter. A gift at common law is never executory in the sense that it requires the intervention of the Courts to enforce it.

With regard to the conditions essential to the validity of a gift, equity follows the common law. On the one hand, if the subject-matter be property transferable at common law, equity will not as a rule aid a gift which does not fulfil the essential conditions. On the other hand, when the property is transferable in equity only, equity also requires that the subject-matter must be certain, that the donor must have the necessary disposing power, and must employ the means which equity recognizes as sufficient for a of the subject-matter, and that the donee must be capable of acquiring the subject-matter.
Bowman v Secular Society [1917] A.C. 406

A deceased person is not a donee capable of acquiring the subject-matter of a gift in these terms.

This passage remains authoritative and was referred to more recently in Australia in Grain Technology Australia Ltd v Rosewood Research Pty Ltd (No 3) [2023] NSWSC 238.

The beneficiary principle

Any trust, including a FDT, must meet the beneficiary principle:

For there to be a valid trust there must be beneficiary (corporate or human) in whose favour performance of the trust may be decreed unless the trust falls within a group of exceptional anomalous cases when it is valid but unenforceable so that the trustee may perform it if they wish.

which was formulated as far back as Morice v. Bishop of Durham (1804) 9 Ves 399, 405 in these terms:

every other [than charitable] trust must have a definite object

(An object in this context is a cestui que trust viz. a beneficiary.)

Few kinds of trusts can escape the beneficiary principle and must have beneficiaries which are persons. The exceptions include charitable trusts and some other types of trusts for purposes rather than persons. A deceased person is neither.

To emphasize the point let us say a A gives B property on trust to hold for either C, A’s son or D, a blow-up inflatable woman as B shall select in B’s discretion. The prospect that D could potentially take all of the property of the trust can cause the trust to be invalid as it fails the beneficiary principle. If D is, instead, a deceased person then I see the position as indistinguishable.

Doctrine of lapse

The courts apply a doctrine of lapse to a testamentary gift to a person who does not survive the will-maker. Lapsed testamentary gifts to a deceased beneficiary with descendants who survive the deceased beneficiary are saved by “anti-lapse” statute so don’t fail due to lapse. e.g. in NSW, section 41 of the Succession Act 2006.

The doctrine of lapse and anti-lapse statute do not apply to non-will (inter vivos) trusts but the doctrine illustrates how a gift or distribution to a deceased person will fail.

2. THE DECEASED ESTATE ARISES AS A SEPARATE ENTITY TO THE DECEASED

Notionally, at least, a DE can be a trust with a trustee and so could receive a distribution of property from a separate trust such as a FDT.

But, shortly after the death of a deceased, a DE is in its early stages of administration and, until probate is granted viz. the Will of the deceased is “proven”, the DE has no executor and trustee: Income Tax Ruling IT 2622 – Income Tax : Present entitlement during the stages of administration of deceased estates and F.C. of T. v Whiting [1943] 68 CLR 199.

The Commissioner of Taxation states in IT 2622:

5. Even where a will does not envisage the creation of a testamentary trust, the executor must assume a trustee’s fiduciary capacity for some period after death. The responsibilities of the executor are similar to, though legally separate and distinct from, those of a testamentary trustee. The estate represents a legal entity or relationship quite separate from the testamentary trust. In practice it is only in rare cases that two different persons assume the roles of executor and testamentary trustee and, for income tax purposes, the estate and the testamentary trust are treated as one and the same. In fact, the term “trustee” is defined in subsection 6(1) of the Income Tax Assessment Act 1936 (“the Act”) to include persons acting as executors or administrators.
Paragraph 5 of IT 2622

Until a DE has reached the stage of a testamentary trust under the will of the deceased, or until the DE has a trustee once the executor and trustee under the will of the deceased has been granted probate, the DE has no apparent legal standing or business in receiving a distribution from a FDT whatever its entity status for income tax may be.

Let us say this problem of the personality of the DE is overcome and an executor and trustee of the DE can putatively receive a distribution from a trust. Then on what basis can the distribution be made by the FDT to a DE?

3. A DECEASED ESTATE IS NOT ORDINARILY A BENEFICIARY OF ANOTHER TRUST

Usually or frequently a trust deed of a FDT will not name or specify a DE as a beneficiary of the FDT. The trust deed of the FDT could be amended on a timely basis to include a sufficiently administered DE as a beneficiary before a distribution to the DE is attempted.

Alternatively the FDT trust deed may allow for something like a related trusts class of beneficiaries which specifies that trusts, in which named FDT beneficiaries have an interest, are also to be beneficiaries of the FDT. However I understand that a related trusts clause like this will generally be insufficient, by itself, to include a DE of a deceased beneficiary as a beneficiary of the FDT even where, as is likely, the DE will have beneficiaries in common with the FDT. I understand that will be so unless the DE is specifically contemplated in the related trust formulation to be adopted in the FDT The relation that adds beneficiaries of a trust in a related trust beneficiary clause to is given a strict or narrow interpretation by virtue of Attorney-General (NSW) v Perpetual Trustee Co (Ltd) [1940] HCA 12; 63 CLR 209 Dixon & Evatt JJ. stated:

Estates and interests are limited with a view of creating precise and definite proprietary rights, to the intent that property shall devolve according to the form of the gift and not otherwise.
at CLR p. 233

But so naming or explicitly clarifying that a DE as a beneficiary of the FDT has ramifications including ramifications for income tax – I will refer to these ramifications below as the First Ramifications.

Can or should a DE receive the gift or distribution from a FDT?

At the early stage of DE administration an executor seeks probate and then has duties to get the property of the deceased in to his or name and to hold only that property in the DE.

Those duties don’t include getting in property which is not property of, or accruing to the deceased after death because of rights and entitlement of, or connection to the lifetime of, the deceased (Deceased Property).

Once probate of the Will is obtained it is then proper for the Executor to consult the Will which may contain a direction allowing the executor and trustee to receive property other than Deceased Property, including distributions from other trusts, in to the DE. However this has further ramifications including for the same income tax reasons which I will call the Second Ramifications.

In addition to the income tax ramifications I note that the Second Ramifications include:

an executor and trustee of a DE may be unwilling to take on responsibility for property in the DE beyond and extraneous to Deceased Property;
a beneficiary of the DE may not want property other than Deceased Property to be included in the DE; and
the DE may become tainted as it does may not come to wholly hold Deceased Property and so various privileges, concessions and exemptions available to ordinary DEs, including in relation to stamp duty, social security or under foreign tax and investment rules may be lost.

INCOME TAX RAMIFICATIONS

The income tax rates equivalent to adult resident individual rates, including the tax free threshold available for three years following death, in Schedule 10 available to a tax resident DE where the DE is taxed under section 99 of the ITAA 1936 are not available to an executor and trustee of a DE by way of right. Section 99 only applies where the DE negotiates a gateway for section 99 to apply in section 99A.

Generally, in cases where no beneficiary is presently entitled to the income of a trust for an income year, section 99A applies to tax the trustee of the trust at the highest marginal rate of income tax: sub-section 12(9) of the ITRA 1986.

Commissioner’s discretion

The Commissioner of Taxation can determine, in his discretion, that paragraph 99A(2)(a) of the ITAA 1936 is not to apply to a DE when taxing a DE as a trust. Ordinarily, for most DEs, the Commissioner will have no reason to deny section 99/Schedule 10 rates to the executor and trustee. However where the First Ramifications or the Second Ramifications, or both, are applicable to DE then the Commissioner is given reason to deny the concessional section 99/Schedule 10 rates in his consideration of the factors in sub-section 99A(3). Those factors focus on transfers of property between the DE and other trusts explicitly and whether special rights or privileges have been conferred in relation to property in other trusts.

In other words where the Commissioner can form a view that the DE is not wholly comprised of Deceased Property, but includes property transferred in to the DE from other trusts, and that there were clear plans afoot so that could occur, the DE will be treated as a regular trust and not a DE and the ordinary section 99A highest marginal income tax rate will apply to the income of the tainted DE.

Risk to a deceased estate of higher income tax rate

The upshot of a refusal by the Commissioner to exercise the discretion in paragraph 99A(2)(a) would be that the resident trustee of the DE, as a resident taxpayer, would lose entitlement to adult resident income tax rates and would be taxed at the highest marginal rate on income to which no beneficiary is presently entitled.

Shortly stated it would mean that a resident DE that receives a transfer of property from another trust, such as a FDT, risks losing DE status for tax because the property held in the DE does not wholly comprise Deceased Property.

Can or should a discretionary trust distribute to someone who has died?

Gift icons created by Freepik – Flaticon

These days trust deeds (Deeds) of family discretionary trusts (FDTs) frequently allow a trustee of a FDT to distribute to a trust as a beneficiary (TAAB) where the TAAB has a beneficiary or beneficiaries in common with the FDT. So could it be that, once a named beneficiary of the FDT has died, their deceased estate qualifies under a TAAB formulation in the Deed without need for alteration of the Deed.

Or a trustee of a FDT may just decide to distribute to a beneficiary who has died.

Valid gifts

Pursuing these aims may overlook an important principle. Beneficiaries of non-purpose trusts must be persons who are human (alive) or other legal persons e.g. companies. A clear expression of when a gift is valid is in Bowman v, Secular Society:

I think, well to bear in mind certain general and perhaps somewhat elementary principles. At common law the conditions essential to the validity of a gift are reasonably clear. The subject-matter must be certain; the donor must have the necessary disposing power over, and must employ the means recognized by common law as sufficient for the transfer of, the subject-matter; and, finally, the donee must be capable of acquiring the subject-matter. If these conditions be fulfilled, the property in the subject-matter of the gift passes to the donee, and he becomes the absolute owner thereof and can deal with the same as he thinks fit. The common law takes no notice whatever of the donor’s motive in making the gift or of the purposes for which he intends the property to be applied by the donee, or of any condition or direction purporting to affect its free disposition in the hands of the donee. It is immaterial that the gift is intended to be applied for a purpose actually illegal – as, for example, in trade with the King’s enemies – or in a manner contrary to the policy of the law – as, for example, in paying the fines of persons convicted of poaching. In either case, the essential conditions being fulfilled, the gift is complete, the property has passed, and there is an end of the matter. A gift at common law is never executory in the sense that it requires the intervention of the Courts to enforce it.

With regard to the conditions essential to the validity of a gift, equity follows the common law. On the one hand, if the subject-matter be property transferable at common law, equity will not as a rule aid a gift which does not fulfil the essential conditions. On the other hand, when the property is transferable in equity only, equity also requires that the subject-matter must be certain, that the donor must have the necessary disposing power, and must employ the means which equity recognizes as sufficient for a of the subject-matter, and that the donee must be capable of acquiring the subject-matter.
[1917] A.C. 406 per Lord Parker

This passage remains authoritative and was recently referred to in Grain Technology Australia Ltd v Rosewood Research Pty Ltd (No 3) [2023] NSWSC 238

Doctrine of lapse

This is comparable to and consistent with the doctrine of lapse which applies to testamentary gifts in Wills to persons who do not survive a testator by thirty days. Lapsed testamentary gifts under a Will to a legatee who is a child of the deceased who have children themselves are saved by statute and pass to his or her descendants so the gift won’t fail due to lapse: in NSW, section 41 of the Succession Act 2006.

So a gift to someone who has died generally fails.

Gifts to deceased estates

A gift to a deceased estate does not fail or necessarily fail where the deceased estate is a trust with a trustee. But before a will of a deceased person is proven and admitted to probate there is no trust.

These may be matters of consequence where the gift is litigated or in the event of a dispute with the Commissioner of Taxation. However specific tax rules can make the question of whether or not a gift fails inconsequential as the income tax legislation applies similarly where an Australian resident FDT attempts to distribute income to a resident deceased estate.

Income tax problems with distributions of trust income to deceased estates

An executor/trustee of an estate of a deceased person admitted to probate may or may not accept a distribution from a FDT. If the executor/trustee of the deceased estate (ETODE) accepts the distribution as a gift from the FDT, the trustee of the FDT and the ETODE face these income tax disadvantages:

until there is a valid gift to a TAAB that exists no beneficiary of the deceased estate is presently entitled to a distribution of income from the FDT. So, even though a distribution of income by a FDT is made to immediately benefit deceased estate beneficiaries, sub-section 99A(4A) of the Income Tax Assessment Act (ITAA) 1936 applies to tax the trustee of the FDT on income of the FDT to which no beneficiary is then presently entitled at the highest personal rate of income tax where the deceased estate is not a trust by the end of the income year in which the distribution is made;
in any case section 101A of the ITAA 1936 operates to ensure that income received by the trustee of a deceased estate, that would have been income of the deceased had it been received during the lifetime of the deceased, is treated as income of the FDT to which no beneficiary is presently entitled such that the income is taxed to the trustee of the FDT at the highest personal rate of tax under sub-section 99A(4A) – the same result; and
on accepting the distribution the ETODE runs a risk that the Commissioner of Taxation will not exercise the discretion in section 99A(2) to apply the lower rates of income tax applicable under section 99 such that the highest personal rate of income tax can apply to income of the deceased estate to which no estate beneficiary is presently entitled in periods before the deceased estate is fully administered. This risk of denial of lower section 99 rates to a deceased estate arises in cases where an ETODE mixes property which the deceased held or was entitled to on their death with property that is not.

So an income distribution by a FDT to a deceased estate can not only attract the highest personal rate on the income to the trustee of the FDT. The integrity of the deceased estate and income tax on other income of the ETODE unrelated to the distribution can be impacted too.

Conclusion

Reasons why a someone would want to make a gift to a deceased person after they have died or why a trustee of a FDT would want to make a distribution to a deceased estate TAAB are not obvious. Whatever they are they are unlikely to be tax effective.

When can a trustee favour itself as a beneficiary of a family discretionary trust?

Usually but the answer is nuanced. It is often claimed that a trustee exercising a discretion [Discretion] to favour himself/herself/themselves/itself (HHTI) as a beneficiary of a family discretionary trust (FDT) is acceptable but legal authority for the claim isn’t given. Even the Australian Taxation Office distills the proposition to a sentence. They say:

The trustee may also be a beneficiary, but not the sole beneficiary unless there is more than one trustee.
Trusts, trustees and beneficiaries | Australian Taxation Office

To be fair this comment by the ATO mainly concerns the merger of trusts (considered in our blog post at Bringing trusts to a timely ending ) so maybe full accuracy shouldn’t be expected on the subsidiary point they raise about whether a trustee of a trust may be a beneficiary of the trust.

Conflict of interest

Is not the trustee exercising a Discretion to favour HHTI in a position of conflict of interest? Shouldn’t there be control over a trustee of a trust limiting when the trustee of a trust can exercise the Discretion to favour the trustee?

A primary concern for a trustee who exercises the Discretion is successful suit by a disgruntled beneficiary (DB) where the trustee distributes income or capital of the trust to HHTI instead of to the DB. Another concern is whether the trust is real or a sham: a trustee taking property held on trust for HHI is inconsistent with holding the property on trust.

Fiduciaries

Has a trustee who has done this breached a fiduciary duty?

A trustee is a fiduciary. The law imposes strict standards on a fiduciary:

It is an inflexible rule of the court of equity that a person in a fiduciary position, such as the plaintiff’s, is not, unless otherwise expressly provided, entitled to make a profit; he is not allowed to put himself in a position where his interest and duty conflict. It does not appear to me that this rule is, as has been said, founded upon principles of morality. I regard it rather as based on the consideration that, human nature being what it is, there is danger, in such circumstances, of the person holding a fiduciary position being swayed by interest rather than by duty, and thus prejudicing those whom he was bound to protect. It has, therefore, been deemed expedient to lay down this positive rule.
Lord Herschell in Bray v. Ford [1894] AC 44

and

It is perhaps stated most highly against trustee or director in the celebrated speech of Lord Cranworth L.C. in Aberdeen Railway v. Blaikie, where he said: “[a]nd it is a rule of universal application, that no one, having such duties to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting, or which possibly may conflict, with the interests of those whom he is bound to protect.
Lord Upjohn in Boardman & Anor v. Phipps [1966] UKHL 2; [1967] 2 AC 46 at page 124

A trustee who exercises the Discretion to favour HHTI can be exposed to suit for breach of fiduciary duty under this line of legal authority.

Impartiality

Another duty of a trustee of a trust is to act impartially between beneficiaries. This duty was described in Cowan v. Scargill:

The starting point is the duty of trustees to exercise their powers in the best interests of the present and future beneficiaries of the trust, holding the scales impartially between different classes of beneficiaries. This duty of the trustees towards their beneficiaries is paramount.
Cowan v. Scargill [1985] Ch 270 at 290-292 (Megarry VC)

Context of trustee power

One may infer from the nineteenth century case authorities cited, in particular, that these duties apply universally to all trustees. The inference is incorrect. In Bray v. Ford the exception ”unless otherwise expressly provided” is significant. Inquiry is needed into the the power given to the trustee to understand whether the rule said to be “inflexible” applies. That is, the extents of the trustee duties of fiduciaries and of impartiality to beneficiaries are at least flexibly ascertained in the context of the power given to the trustee.

In the case of a Discretion in a FDT the trustee will ordinarily be given an explicit power and duty to choose between beneficiaries. In the context of the exercise of a discretionary power in relation to a discretionary trust, there will then be no duty on the trustee to ensure impartiality; that is equal treatment of each beneficiary: Edge v. Pensions Ombudsman [1998] Ch 512, Elovalis V. Elovalis [2008] WASCA 141. In Edge v. Pensions Ombudsman, Scott V-C stated of the rule in Cowan v. Scargill:

Sir Robert Megarry was dealing with an issue regarding the exercise by pension fund trustees of an investment power. He was not dealing with the exercise of a discretionary power to choose which beneficiaries, or which classes of beneficiaries, should be the recipients of trust benefits. In relation to a discretionary power of that character it is, in my opinion, meaningless to speak of a duty on the trustees to act impartially. Trustees, when exercising a discretionary power to choose, must of course not take into account irrelevant, irrational or improper factors. But, provided they avoid doing so, they are entitled to choose and to prefer some beneficiaries over others.
Edge v. Pensions Ombudsman [1998] Ch 512 at p. 533

The limits of FDT trustee power

Adequately cast discretionary powers of a trustee such as given to the trustee of a FDT are thus unlikely to transgress fiduciary and impartiality duties contextually inapplicable to these powers. What checks on the exercise of a Discretion remain? These are explained in Karger v. Paul [1984] VR 161 where it was found that a trustee with an absolute and unfettered discretion must nevertheless exercise the discretion:

in good faith;
upon a real and genuine consideration of the interests of the beneficiaries; and
in accordance with the purpose for which the discretion was conferred.

In this way the obligation on the trustee not to take irrelevant, irrational or improper factors referred to in Edge v. Pensions Ombudsman is put in more positive terms in Australian courts. These benchmarks from Karger v. Paul were applied, and trustees fell short, in Owies v. JJE Nominees Pty Ltd [2022] VSCA 142 and in Wareham v. Marsella [2020] VSCA 92 (which is also considered in this blog at:

Controlling who gets death benefits from a SMSF )

Real and genuine consideration

The real and genuine consideration of the interests of the beneficiaries’ obligation of the trustee on exercising a Discretion will depend on the kind of trust, the interest of the beneficiary in the trust and the standards to be imposed on the type of trustee. For instance in Finch v. Telstra Super Pty. Ltd. [2010] HCA 36, a professional trustee of a large superannuation fund was found to have an amplified real and genuine consideration obligation extending to giving reasons in writing for the exercise or non-exercise of the discretion to pay total and permanent invalidity benefit benefits to a member of the fund.

In contrast an unpaid trustee, such as a family trustee of a FDT, is ordinarily under no obligation to provide the DB with written reasons for a decision to exercise or not exercise a Discretion. Without written reasons the DB can be left with scant evidence to challenge a trustee who instead favours another beneficiary, beneficiaries or HHTI by an exercise of a Discretion under Karger v. Paul benchmarks.

Freedom of a trustee of a FDT to favour beneficiaries including HHTI over others

Within the context and confines of those parameters a trustee of a FDT can favour one beneficiary over another. It follows that a trustee of a FDT can usually exercise a Discretion to favour HHTI to the complete exclusion of the DB so long as the Karger v. Paul parameters are observed.

But power to favour beneficiaries is exceptional

Whether or not there is an exceptional Discretion turns on the purpose for which the Discretion was conferred evident in the terms of the Discretion which is in the trust deed of the trust. An adequate expression of the Discretion in the trust deed of a FDT is expected and needed so its purpose, as an absolute and unfettered discretion to choose between beneficiaries and as to amount distributed to them, is clear.

Certainty of beneficiaries

Who the discretionary beneficiaries of a FDT also must be clear. Frequently a trust deed of a FDT will prescribe persons who are excluded from being a beneficiary of the FDT and occasionally the trustee can be so excluded because of the perceived conflict of interest or, in New South Wales, for a stamp duty reason.

A FDT for a family which includes trustee or trustees included as discretionary beneficiaries is likely to be accepted as genuine:

where the trustee is a merely a discretionary beneficiary among a widely cast class of family beneficiaries; and
and is understandable where family members of the family sought to benefit under trust terms are or could be trustees.

So a trust deed of a FDT should be checked to confirm that the trustee is a beneficiary of the trust before the trustee of a FDT exercises a Discretion to distribute to itself. It is only where the trustee qualifies as a discretionary beneficiary under the terms of the trust instrument that a distribution can be safely made to the trustee/beneficiary where the trustee is satisfied that the distribution complies with the Karger v. Paul parameters.

The drafting of the FDT deed

Ideally the trust instrument will expressly confirm that the trustee of the FDT is a beneficiary. It can be the case that the trustee is a member of a class which is included as beneficiaries under the trust instrument but the trust deed might not expressly say that a trustee can be a beneficiary. An exercise of the Discretion in the favour of the trustee is likely OK then too but the trustee runs a risk and could possibly face action asserting the trust instrument ought to be construed on a basis that the trustee is unacceptable as a beneficiary.

The useful family trust election and income “injection”

In 1998 the trust tax loss measures in Schedule 2F of the Income Tax Assessment Act (ITAA) 1936 (Schedule 2F) were finally enacted to curb the unscrupulous trade in trust tax losses.

Income injection test

An essential and not so well understood retardant of the trade in these measures is the income injection test (IIT). Neither the term income injection nor the words inject or injection are in Schedule 2F. Nevertheless the test is there in Division 270 of Schedule 2F under the heading Schemes to take advantage of deductions.

The ITAAs and Schedule 2F, in particular, have much jargon which is in italics in this post.

Unlike some other tests in Schedule 2F, such as the stake test and the control test, which are both applicable to non-fixed trusts, transgression of the IIT doesn’t disqualify a trust from using all of its tax losses including carry forward prior year tax losses. A trust that fails the IIT is precluded from offsetting otherwise tax deductible tax losses against (taxable) assessable income (only) to the extent of scheme assessable income.

Scheme assessable income is what is “injected”.

How the IIT works

As an anti-avoidance provision designed for wide reach, the IIT in Division 270 of Schedule 2F is so expressed. Scheme, as is usual in anti-avoidance laws in the ITAAs, is widely defined and an outsider or outsider to the trust, is pervasive under the IIT. In the case of a trust that isn’t a Schedule 2F family trust (a 2FFT) an outsider to the trust is a (any) person other than the trustee of the trust or a person with a fixed entitlement to income or capital of the trust: see section 270-25(2) of Schedule 2F.

Scheme assessable income arises where (in any order):

the trust earns assessable income;
an outsider to the trust directly or indirectly provides a benefit (also widely cast – can be money, property or anything else of benefit set out in section 270-20 – which may be but need not be the scheme assessable income) to the trustee of the trust, a beneficiary of the trust or an associate of either of them; and
the trustee of the trust, a beneficiary of the trust or either of them provides a benefit to the outsider to the trust or an associate wholly or partly, but not incidentally, because the deduction is allowable to the trust.

Context of the IIT

With this broad formula the IIT in the tax trust loss measures of Schedule 2F can be contrasted to the business continuity test that applies to company tax losses under Division 165 of the ITAA 1997. An injection by, viz. a benefit from, an outsider to the trust or an associate that can produce income in the trust, against which unrelated tax losses might otherwise have been deducted, gives rise to scheme assessable income against which tax losses cannot be deducted.

When the IIT applies – outsiders

So let us say:

a private company with profits and a family discretionary trust (FDT) with tax losses but no current income producing activity of its own are controlled by a family;
the FDT owns shares in the company; and
the company pays dividends to the FDT.

A clear distinction between a FDT and a 2FFT needs to be understood. Schedule 2F refers to a “family trust”, i.e. a 2FFT, as a trust that has made a family trust election (FTE). A 2FFT in comparison can be a FDT, a fixed trust or a unit trust that has lodged a FTE which is in force. A FDT can be called a family trust in common parlance but a FDT will be a non-fixed trust under Schedule 2F; that is, not a Schedule 2F “family trust” until it lodges a FTE to become a 2FFT.

At least initially (see below), the company in my example is an outsider to the trust. There the benefit to the trust of the dividends is the scheme assessable income. The benefit to the company and its associates viz. the family, is that income tax isn’t payable on the dividends to the extent tax losses of the trust can be deducted against assessable income of the trust and the parties can’t disprove that this tax advantage of declaring dividends to the FDT shareholder was more than incidental.

How a family trust election can modify how the income injection test is applied

To avoid losses to the extent of so imputed scheme assessable income being denied to the trust under the IIT:

the trustee of the trust can make a FTE and become a 2FFT, and;
the company can make an interposed entity election (IEE).

The FTE would need to cover the period, in the case of carry forward tax losses of the trust, from when the losses were incurred by the FDT/2FFT to when they are sought to be deducted against assessable income (for tax) by the FDT/2FFT.

Companies and trusts that have a FTE or an IEE in place are excluded from being outsiders to the trust. The IIT is then an IIT of modified operation which can still be failed but the IIT will now only fail where benefits flow from and to a now reduced, less pervasive, range of outsiders to the trust. but is not failed when the flow is between 2FFTs. interposed entities and individual family members that are taken to be a part of the family group under Schedule 2F: see sub-section 270-25(1) of Schedule 2F.

Downside of a family trust election

Where a company, trust of partnership (Entity) meets the family control test viz. the Entity is controlled by the family group viz. a family, and is so eligible to become a part of a family group by way of a FTE or an IEE then the prospect of family trust distributions tax (FTDT), which is distinct from trust income tax and only applies to 2FFTs, needs to be considered.

Once an Entity lodges a FTE or an IEE then distributions by the Entity outside of the family group of the individual specified in the FTE or IEE, as the case may be, are caught by FTDT at the highest marginal income tax rate.

A FTE or an IEE is a de facto limitation by way of tax penalty on beneficiaries to whom income and capital of a 2FFT can be distributed.

Upside of a family trust election

A FTE can be lodged by a trust with commencement from when or before its prior year trust losses were incurred so the modified IIT can apply from that time to prevent scheme assessable income arising. That is so, so long as the commencement date of the trust as a 2FFT is no earlier than 1 July 2004. This is sometimes known or understood as “backdating” but that, like the use of the term “family trust” itself in Schedule 2F, is a misnomer and selecting a past commencement date for a 2FFT is lawful and allowed under Schedule 2F.

So long as a 2FFT can keep its distributions within the family group and so avoid FTDT, lodging a FTE or an IEE will be dually beneficial to the parties and the beneficiaries of the 2FFT to whom the franked dividends are on-distributed in my example once tax losses of the 2FFT are exhausted and the 2FFT has (positive) trust income as:

current and prior year losses can be offset by the trustee of the 2FFT against the dividends which are assessable income when received by the 2FFT where a FTE is in effect over the required periods and an IEE is in effect for the company so the company is within the family group; and
the 2FFT can meet the holding period rule and beneficiaries of the 2FFT to whom the franked dividends received by the 2FFT are distributed, after losses have been so offset, can then use franking credits on the dividends: see section 207-145(1)(a) of the ITAA 1997 and under the heading THE HOLDING PERIOD RULES REGULATING ACCESS TO FRANKING CREDITS at Family trusts – concessions | Australian Taxation Office https://is.gd/Nck0zS.

Reasons to be a 2FFT

The Australian Taxation Office at Family trusts – concessions https://is.gd/Nck0zS: lists five main “reasons” (actually imperatives for accessing tax concessions) why a trustee of a trust may want to make a FTE and become a 2FFT:

accessing trust tax losses to deduct them against trust assessable income;
to trace eligibility for company losses through a trust;
access of beneficiaries of a trust to franking credits under the holding period rules;
relief from the trustee beneficiary reporting rules; and
access to the small business restructure rollover in Sub-division 328-G of the ITAA 1997.

Schedule 2F doesn’t apply to deny capital losses that can be offset against capital gains under section 102-5 of the ITAA 1997.

Part IVA – is a discretionary trust owned bucket company a sitting duck?

The Full Federal Court in Commissioner of Taxation v Guardian AIT Pty Ltd ATF Australian Investment Trust [2023] FCAFC 3 has dismissed the Commissioner’s appeal against decisions at [2021] FCA 1619 of the primary judge, Logan. J, not to impose the reimbursement agreement assessments on the trustee of the AIT under section 100A of the Income Tax Assessment Act (ITAA) 1936.

But the Full Federal Court has unanimously taken a radically different construction of the facts in the case to Logan J. to find that Part IVA of the ITAA 1936 was correctly applied to the Guardian AIT facts to support the Commissioner’s Part IVA determination, run as an alternative to section 100A, made in respect of the 2013 income year.

Reimbursement agreements – a blunt tool?

On this blog we have queried whether the section 100A reimbursement agreement regime is a tool useful to the Commissioner that gives the Commissioner scope to attack trust distributions that are no part of a trust stripping arrangement involving parties external to the trust: 100A trust reimbursement agreement not the tool to fix the bucket company dividend washing machine https://wp.me/p6T4vg-pM . We have also blogged about bucket companies lately, see: Can a family discretionary trust distribute income to its corporate trustee? https://wp.me/p6T4vg-rH

Without going into the detail in this blog post, the Full Federal Court in Guardian AIT has rather confirmed our thoughts about the utility of section 100A. We don’t see that the decision vindicates or gives legal support or backing to the Commissioner’s products and section 100A-based approaches in Taxation Ruling TR 2022/4 and Practical Compliance Guideline PCG 2022/2. Oddly the Commissioner finalised TR 2022/4 and PCG 2022/2 before Guardian AIT ran its course.

In the meantime there is another section 100A case on foot: BBlood Enterprises Pty Ltd v Commissioner of Taxation [2022] FCA 1112, which is also on appeal to the Full Federal Court and there is also the prospect of appeal in Guardian AIT to the High Court.

Part IVA sharpened up?

But Part IVA is a different matter. The Full Federal Court in Guardian AIT has warned how susceptible certain types of discretionary trust strategies, particularly discretionary trust strategies involving trust distributions to bucket company beneficiaries, may be to Part IVA.

This leads me to the key point of difference on the facts in the case between the Full Federal Court and Logan J. mentioned at the outset. Logan J. accepted Mr Springer’s contention that his company, AIT Corporate Services Pty Ltd (AITCS), was set up to accumulate assets for asset protection. Although the Full Federal Court accepted this as a tenable explanation in the 2012 income year, despite AITCS clearing out its asset, the distribution receipt from the AIT back to the AIT as a dividend; repeating the process to clear out the 2013 trust distribution back to the AIT in the 2013 year demonstrated AITCS wasn’t:

holding or protecting anything for asset protections reasons; or
more particularly planning to hold or protect assets accumulated or to be accumulated in the company.

AITCS was plainly being used as a bucket company to receive a trust distribution in the 2013 income year which allowed AITCS to distribute a franked dividend back to the AIT which could then be distributed tax advantageously by the AIT to Mr Springer, a non-resident.

The apparent counterfactual

The Full Federal Court had no difficulty accepting the Commissioner’s Part IVA counterfactual contended in the appeal. That counterfactual was that the AIT would have distributed 2013 year AIT income to Mr Springer directly which “might reasonably be expected to have been included” in 2013 income taxable to the trustee under Division 6 of Part III of the ITAA 1936. That distribution could have been made to Mr Springer without the circularity of the “washing machine” distribution going to AITCS, then back to the AIT as franked dividend and then, finally, going to Mr Springer as NANE income being a form of income not taxable to the trustee nor to Mr Springer under Division 6.

Circularity and the form of the scheme

The Full Federal Court noted the circularity of the scheme which the Commissioner could and did take into account under paragraph 177D(2)(b) of Part IVA in considering the form of the scheme.

Commercial rationale or explanation of the scheme?

The difficulty under the Full Federal Court Part IVA analysis for the AIT was that the only difference in effect between the scheme and the counterfactual was that, under the scheme, the income distribution to the non-resident beneficiary Mr Springer was tax free NANE income. Under the counterfactual though, tax on the trustee of AIT at the highest marginal rate under Division 6 might reasonably have been expected. The same commercial outcome viz. income in Mr Springer’s hands within eight months of the end of the 2013 year of income confirmed that the only difference in what happened between the scheme, and reasonably expected to happen under the counterfactual, was the tax effect: a tax benefit the Commissioner could posit under Part IVA.

section 177CB – tax gives no explanation

The Full Federal Court noted that, following amendment to Part IVA which introduced section 177CB and sub-section 177CB(4) in particular, the tax impact of the scheme viz. the “operation of the Act”, or, more pointedly, the lower tax cost choice, is now expressly excluded as something that might reasonably be expected viz. the tax impact is now precluded by legislation from being a basis for a Part IVA counterfactual. Shortly stated that means the better tax outcome can no longer be a reasonable justification for choosing to implement a scheme caught under Part IVA.

Observations

Once the façade of an asset protection asset accumulating role for AITCS was identified by the Full Federal Court then AITCS was left exposed as a bucket company with a role in a tax scheme to re-purpose a trust distribution as a franked dividend to the tax advantage of Mr Springer in the 2013 year. In the context of potential Part IVA counterfactuals the Commissioner can raise, the AITCS bucket company can be viewed as unfortunately placed as both:

AITCS was a beneficiary of the AIT viz. the bucket company characteristic; and
shares in AITCS were owned by the AIT which facilitated the payment of trust income distributed to AITCS as dividends back to the trust;

enabling the loop or circularity which allowed the AIT to route income via AITCS as a franked dividend back to itself. But a clear or obvious alternative for the trustee of AIT would have been to distribute trust income to a different prominent beneficiary with a history of receiving distributions from the trust, such as Mr Springer. Distribution to Mr Springer was an even more obvious and irrefutable counterfactual when the distribution reflecting the income ultimately ended up with that beneficiary after going around in the circle.

Part IVA risks beyond non-residents?

Why would Part IVA in these situations be confined to where the ultimate beneficiary is a non-resident even though the AITCS scheme was particularly advantageous to AIT given high rates that apply on Division 6 taxation of non-residents? There can also a tax advantage and potential tax benefit too where a resident beneficiary receives discretionary trust income in the form of a franked dividend instead or as ordinary trust income. There is no reason why Part IVA couldn’t be similarly applied to a comparable circular scheme to use a bucket company loop to transform ordinary trust income into more lightly taxed franked dividend income.

Are bucket companies sitting ducks for Part IVA?

As a matter of policy the Commissioner has not used Part IVA to challenge direct distributions by family discretionary trusts to bucket companies to my knowledge. Guardian AIT shows that Part IVA can give the Commissioner a basis or tool to attack distributions to bucket companies which can be shown to have no purpose or reason, objectively determined, other than to save tax.

Where discretionary trust ownership of shares in the bucket company facilitates opportunity for franking or other tax saving by going around in a circle, the trustee may be a sitting duck for the Commissioner’s Part IVA counterfactual positing what the trustee may have done had the distribution been made to the intended beneficiary to receive trust income the first time around.

Can a family discretionary trust distribute income to its corporate trustee?

A family discretionary trust (FDT) often has a corporate trustee (TCo) for limited liability and other reasons. With a private company able to access a 30% or lower tax rate on an income distribution received from a FDT, distribution to a private company such as TCo can be a way to access a lower company income rate for a family that does not own or control a private company aside from TCo out of thrift.

But is it a good idea?

Distribution by a FDT to its corporate trustee, TCo, as a “bucket company”, is not necessarily allowable or advisable.

It needs to be understood that FDT deed terms, quality of the FDT deed and FDT set up, including attention to who is a beneficiary of the FDT, vary widely across Australia.

TCo needs to be a beneficiary of the FDT

FDT distributions can only be made to beneficiaries of the FDT. It follows that TCo would need to be entitled in its own right as a beneficiary to a distribution under the terms of the FDT deed. TCo may or may not be a named discretionary beneficiary under the FDT deed.

Many FDT deeds provide for a class of discretionary beneficiary which includes companies owned or controlled by a (some other) beneficiary of the FDT. Sometimes this class is referred to as “eligible corporations” which the FDT deed terms state become beneficiaries of the FDT. These provisions in FDT deeds, if they exist, vary too. Sometimes qualification within a corporate class of discretionary beneficiary turns on someone who qualifies as a beneficiary in the deed:

owning shares in the company; or
being a director of the company;

and it can be just one or the other and not necessarily both.

It can’t be assumed that:

beneficiary qualification in these ways is possible; or
that TCo meets these beneficiary qualifications;

without checking the FDT deed.

Consequences of distributing income to a non-beneficiary

Consequences of a FDT distributing trust income to a person or company who is not a beneficiary under the deed of a FDT can be:

failure of the distribution for legal and tax purposes so that the trustee of the FDT is assessed under section 99A of the Income Tax Assessment Act (ITAA) 1936 with income tax at the highest marginal rate; and/or
treatment of the FDT and distributions from the FDT as a sham by the Australian Taxation Office, other government departments, creditors or others.

Even where TCo may appear to qualify as a beneficiary due to the above, many FDT deeds have overriding exclusionary provisions which exclude persons and companies otherwise specified as beneficiaries from being beneficiaries for various reasons:

Excluded beneficiaries – conflict of interest

Frequently a trustee of a FDT is excluded from being a beneficiary because the trustee, which can exercise the discretion to select discretionary beneficiaries, is in a position of conflict of interest and so TCo, despite qualification as a beneficiary otherwise, is ultimately excluded from being a beneficiary of the FDT. More commonly FDT deeds contain other means which allow a family to control who becomes and acts as a trustee which displaces or should displace inapt conflict of interest considerations as a control redundancy within the deed.

Excluded beneficiaries – stamp duty

But even then a trustee, such as TCo, that may otherwise have qualified as a beneficiary, may still be excluded as a beneficiary by the FDT deed for stamp duty reasons. In New South Wales, in particular, an entitlement to concessional duty under sub-section 54(3) of the Duties Act (NSW) 1997 on a change of trustee of a trust that owns dutiable property can be lost where the a trustee can participate as a beneficiary of the trust.

The consequence of that is a change of trustee of a FDT, say by deed, is treated as a fully ad valorem dutiable transfer of all of the NSW dutiable property of the FDT to the new trustee/s.

Although this limitation of a duty concession varies from other exemptions and concessions applicable to changes of trustee of trusts in states and territories other than NSW, FDT deeds frequently exclude trustees from being beneficiaries out of an abundance of caution that this or a similar stamp duty concession may be lost where the trustee of the FDT is not excluded.

TCo can qualify as a beneficiary – but what then?

If it can be confirmed that TCo does qualify as a beneficiary and is not ultimately excluded as a beneficiary under the trust deed of a FDT, distribution to TCo, rather than another discrete company is still not necessarily a good idea.

Managing TCo’s asset mix

Should TCo receive income from a FDT, and so come to have assets in its own right, TCo will need to manage its assets to ensure that property it holds in its own right and property TCo holds for the FDT are not mixed. A trustee of a trust has a fiduciary duty not to mix trust property with property held not on that trust. This trustee duty is often explicitly set out in FDT deeds.

In terms of title, property distributed to TCo in its own right will be indistinguishable so, without careful accounting and administration of TCo’s activities to ensure trust property isn’t mixed with non-trust property, there is the prospect that a family in control of a FDT may lose track of in which capacity the TCo is owning property and doing things. It will often fall to the accountant of the FDT to sort this out unless the FDT has a very capable and aware functionary administering the FDT for the trustee.

Serious tax risk of losing track of how TCo owns what

Tax risks of unpaid present entitlements (UPE) of TCo in its own right are also high following the recent Draft Taxation Determination TD 2022/D1 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of ‘financial accommodation’? – see our blog post – Draft ATO reimbursement agreement suite out in the wake of Guardian AIT https://wp.me/p6T4vg-q6. Under that draft determination a UPE of a FDT to a private company not detected and promptly repaid (has TCo repaid TCo?) or dealt with under a section 109N of the ITAA 1936 loan agreement, by the time the tax return of the company beneficiary for the income year in which the UPE arises is due, will likely precipitate a deemed and unfrankable dividend to the FDT.

Understanding a company can’t enter into a legally enforceable agreement with itself how could TCo even comply with section 109N as a way to avoid a deemed dividend?

Is distributing to TCo worth it?

Despite the above distribution by FDTs to their corporate trustee as a bucket company is commonplace but done without a keen appreciation of the risks of doing so. I don’t encourage FDTs to distribute to their own trustee even when I am familiar with the trust deed of the FDT. I appreciate there is a cost saving but the costs of running a separate “bucket company”, including the setup and annual ASIC fees and accounting costs, are or should be relatively low so be wary that multi-purposing of TCo can be a false economy for many families with FDTs when the above is taken into account.

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Statutory exemptions for a trust and containment

Duty on transfer to a discretionary testamentary trust beneficiary

According to Revenue NSW section 63 of the Duties Act (NSW) 1997 does not extend concessional relief to the transfer of dutiable property by a testamentary trust (TT) trustee to a beneficiary.

Concessional duty of $50 applies to:

(a) a transfer of dutiable property by the legal personal representative of a deceased person to a beneficiary, being–
(i) a transfer made under and in conformity with the trusts contained in the will of the deceased person or arising on an intestacy, or …
under sub-paragraph 63(1)(a)(i) of the Duties Act (NSW) 1007

Accepting that a TT trustee is a LPR of a deceased person, or at least disregarding cases where it is not the case, a transfer of NSW real estate by a TT trustee to a TT beneficiary named in the will of the deceased person (Will) in conformity with a TT in the Will appears to make out the requirement of the concession. But Revenue NSW differs.

In Revenue Ruling DUT 46 – Deceased Estates, Revenue NSW states at paragraph 30:

Testamentary trusts
30. Often a will may establish a trust with a named trustee and beneficiaries, with a gift to the trustee of that trust. A transfer from the legal personal representative to a beneficiary of the testamentary trust will not obtain the benefit of the section 63 concession, however, a transfer to the trustee of the testamentary trust will be liable to duty of $50 under sub-paragraph 63(1)(a)(i).
Revenue Ruling DUT 46 – Deceased Estates, Revenue NSW states at paragraph 30

Denial of concession explained?

There is no explanation in DUT 46 as to:

why a transfer to a beneficiary seemingly in conformity with the section 63 concession doesn’t attract the concession; or
how sub-paragraph 63(1)(a)(i) may apply where a beneficiary of a TT has an absolute or indefeasible interest in dutiable property under the TT in the Will.

Scope of statutory exemptions (concessions)

An adage and exhortation about stamp duty, statutory exemptions to duty and those who seek to rely on an exemption is:

find an exemption and get within it

could be trite.

A corollary of no lesser importance is that where a situation doesn’t meet all requirements of an exemption there will be no exemption.

Figuring out what Revenue NSW mean

I understand Revenue NSW to be saying that not all requirements of the formulation:

in conformity with the trusts contained in the will of the deceased person

are met in the case of transfer of dutiable property by a LPR to a TT beneficiary.

Some indication of what Revenue NSW means is at paragraph 7 of DUT 046 which states:

7. The transfer must be made both under and in conformity with the trusts of the will or arising on intestacy. It is not sufficient that the transfer not be inconsistent with those trusts.

with Sanders v Chief Commissioner of State Revenue [2003] NSWADTAP 22 cited in support.

Paragraph 7 hints at the problem an LPR or a TT trustee of a discretionary TT in a Will may have with the section 63 concession. A transfer to a specific discretionary beneficiary in a class of beneficiaries under a discretionary TT is not a stipulation of the testator contained in the Will. The transfer occurs instead because someone other than the testator has been given a power beyond the Will to decide who among the class of TT beneficiaries is to receive the dutiable property.

That exercise of discretion by a living person is extraneous to the Will but is authorised by the Will. Yet, because a discretionary TT beneficiary doesn’t take the dutiable property by direction of the testator and the Will, Revenue NSW seem to say that the transfer is not in conformity with the trusts contained in the Will. That is an undeniably strict interpretation of section 63 bearing in mind that a transfer to an identifiable discretionary beneficiary of a TT to give effect to a valid gift to the beneficiary in the Will is entirely within, anticipated by and “in conformity with” the wishes of a testator expressed in his or her Will.

To describe a transfer made in pursuance of a Will-reposed discretion to gift property among a class of named discretionary beneficiaries as a mere consistency with the Will is somehow inadequate.

Testamentary trust planning

An ongoing discretionary TT included in a Will by a testator may not necessarily be of use to or in the interests of TT beneficiaries who are to take the testator’s property. So a collapsible TT can be desirable and useful to a testator’s survivors instead. Broadly a collapsible TT is where a LPR, TT trustee or appointor is given ability under a Will to collapse a discretionary TT and take the TT property as if the Will had made a gift of the property bypassing holding the property on the TT.

Based on the above such a gift on collapse of a discretionary TT to a named beneficiary is or should be wholly in conformity with a stated gift in the Will and so should attract concessional duty under sub-paragraph 63(1)(a)(i). It follows that a collapsible TT can lead to a duty saving where:

the TT is over property including dutiable property;
the TT is collapsed, bypassed and doesn’t take effect as a TT; and
the dutiable property that was to be held on the TT is instead transferred to the named beneficiary expressly under the terms of the Will and the sub-paragraph 63(1)(a)(i) exemption can thus be made out.

Containment

So to achieve a stamp duty exemption in conformity with the trusts contained in the Will under the Revenue NSW regime no actions extraneous to the Will, such as the exercise of a Will-based discretion to distribute dutiable property to a TT beneficiary, are “within” the concession. That is: the gift pathway of the dutiable property from testator to beneficiary needs to be wholly contained in the Will.

Perpetuities

There is a curious comparison between the approach of Revenue NSW to duty on transfer by a LPR to a discretionary TT beneficiary and the approach of the Federal Court to the rule against perpetuities.

In an earlier blog How perpetuities law limits can impact trust distributions to other trusts I considered the “wait and see” rule as it applies to the perpetuities following the Federal Court decision in Federal Court in Nemesis Australia Pty Ltd v Commissioner of Taxation [2005] FCA 1273. What would the outcome in that case have been if such a narrow or strict approach to the “wait and see” rule, which is effectively an exemption from the common law rule against perpetuities now codified by statute in most states (the Perpetuities Rule), been taken?

All jurisdictions except South Australia have retained the Perpetuities Rule.

Uneasiness

I am uneasy about the Nemesis Australia decision as the last words in my blog suggest. If Nemesis Australia is later found by a court to be incorrectly decided then the consequences will be severe for trusts impacted: where the Perpetuities Rule applies to a trust, the trust is void and treated as if it was never valid. This harshness was the reason for the introduction of “wait and see” rule, under which dispositions of property under a trust, that would otherwise be void under the Perpetuities Rule, are not void from the outset and the parties can “wait and see” whether the disposition of property under the trust will vest within the applicable perpetuity period. Only where the property does not so vest is the trust then invalidated by the Perpetuities Rule.

Policy to prevent remoteness of vesting

The policy of the Perpetuities Rule (the Policy) is:

to prohibit lengthy remoteness of vesting of property interests in private hands and indestructible private trusts;
to limit property owners’ capacity to restrict free alienation of property ; and
to limit the control of property by trust founders or testators to a reasonable period.

The Perpetuities Rule applies to private trusts aside from charitable trusts and superannuation funds to achieve this Policy.

Significance of a trust discretion

The Nemesis Australia decision turned on the significance of an exercise of a discretion: it was found that the “wait and see” rule could be applied because the trustee of Trust B had a discretion to bring forward the vesting day and the parties could then “wait and see” whether the vesting day of Trust B will be brought forward by exercise of discretion to the earlier vesting date of Trust A. Should that happen property from Trust A, received into Trust B as a distribution from Trust A, would not vest outside of the Perpetuities Rule perpetuity period for property vested in Trust A. (See my blog How perpetuities law limits can impact trust distributions to other trusts )

Disparity of approach to statutory exemptions

There is a disparity between how the “wait and see” rule was interpreted in Nemesis Australia where a discretion, whose exercise is not dictated by the terms of a trust, was acceptable to invoke the “wait and see” rule and Revenue NSW’s rejection of exercise of a Will-based discretion not dictated by a Will as not being in conformity with the trusts in a Will for section 63 of the Duties Act 1997 purposes.

There are a number of principles of statutory interpretation that can be applied to exemptions which were not considered in Nemesis Australia. These principles do not support a construction of the “wait and see” rule that saves a trust from being void under the Perpetuities Rule where the parties wait to see if a trust terms-based discretion will be exercised to bring forward the vesting date of the trust:

an interpretation of a statute which will permit a person to take advantage of his or her own wrong is to be resisted (Resistance); and
an interpretation of a statute that promotes the purpose of a statute is to be preferred to a literal construction (Preference).

Resistance

An instance of a Resistance given in Pearce & Geddes “Statutory Interpretation” 7^th ed. is in Holden v. Nuttall (1945) VLR 171 where, on an application for possession of leased premises, a court was required by statute to take into account whether an order for possession would cause the lessee “hardship”. Evidence showed that the lessee had acted in a manner contrived by the lessee to enable him to take the benefit of the hardship exception. Herring CJ found that the meaning of “hardship” should be limited so that no injustice would be brought about by allowing a person to benefit from his or her own wrong.

This is comparable to where a trust is established with say a last vesting date of 160 years which is well beyond perpetuity periods allowed under Perpetuity Rules. (See also the similar hypothetical raised by the Respondent referred to in paragraph 43 in the judgement in Nemesis Australia.) This differs much from a case of say, a trust where when property may vest turns on a genuine and unplanned contingency or contingencies that may or may not occur within the perpetuity period, such as how long a beneficiary of a trust may live for, which is the type of contingency the “wait and see” rule ordinarily contemplates.

Still trust terms may allow a trustee, or some other person; a discretion to bring forward the vesting day as in Nemesis Australia, or even in the absence of a term allowing the bring forward of the vesting date of the trust, state law may allow a trustee to apply to a state court for a vesting order prior to expiry of the applicable perpetuity period. If Nemesis Australia is correctly decided the parties to the trust may then “wait and see” whether a vesting order is applied for and vesting happens within the perpetuity period of a trust flagrantly in breach of the Perpetuity Rule and the Purpose and, in the meantime, the trust would be valid.

But a 160 year last vesting date for a trust may be a wrong, such as considered in Holden v. Nuttall, by the founder of a trust. That is a wrong that is contrary to the Policy when considered in the context of the Policy. Shouldn’t a trust established on the premise of that wrong, if it is a wrong, be considered:

contrived to take advantage of the “wait and see” rule?; and
beyond what is meant as a “wait and see” under the “wait and see” rule?;

and denied “wait and see” exemption from the Perpetuities Rule?

Preference

The construction of the “wait and see” rule in Nemesis Australia is literal. The Preference, as Pearce & Geddes explain, is that an interpretation of a statutory provision under section 15AA of the Acts Interpretation Act (C’th) 1901 and comparable state and territory legislation should promote a construction of a statute based on the purpose of a statute as preferable to a literal construction.

Pearce & Geddes also refer to the explanation of Dawson J. in Mills v. Meeking (1990) HCA 6 at para. 19 as follows:

19. However, the literal rule of construction, whatever the qualifications with which it is expressed, must give way to a statutory injunction to prefer a construction which would promote the purpose of an Act to one which would not, especially where that purpose is set out in the Act. Section 35 of the Interpretation of Legislation Act must, I think, mean that the purposes stated in Pt 5 of the Road Safety Act are to be taken into account in construing the provisions of that Part, not only where those provisions on their face offer more than one construction, but also in determining whether more than one construction is open. The requirement that a court look to the purpose or object of the Act is thus more than an instruction to adopt the traditional mischief or purpose rule in preference to the literal rule of construction. The mischief or purpose rule required an ambiguity or inconsistency before a court could have regard to purpose: Miller v. The Commonwealth (1904) 1 CLR 668 at p 674; Wacal Developments Pty. Ltd. v. Realty Developments Pty. Ltd. (1978) 140 CLR 503 at p 513. The approach required by s.35 needs no ambiguity or inconsistency; it allows a court to consider the purposes of an Act in determining whether there is more than one possible construction. Reference to the purposes may reveal that the draftsman has inadvertently overlooked something which he would have dealt with had his attention been drawn to it and if it is possible as a matter of construction to repair the defect, then this must be done. However, if the literal meaning of a provision is to be modified by reference to the purposes of the Act, the modification must be precisely identifiable as that which is necessary to effectuate those purposes and it must be consistent with the wording otherwise adopted by the draftsman. Section 35 requires a court to construe an Act, not to rewrite it, in the light of its purposes.
Dawson J. in Mills v. Meeking (1990) HCA 6 at para. 19

The purpose of the Perpetuities Rule is the Policy. The Policy is defeated where a contingency that a trustee could apply for a vesting order prior to the expiry of the perpetuity period applicable to the trust prevents the Perpetuities Rule from taking effect in an abundance of cases. The Respondent’s submission referred to in paragraph 43 in the Nemesis Australia judgement cogently establishes why the Policy fails where the “wait and see” rule is applied literally but the Federal Court in the Nemesis Australia seemed to gives minimal credence or importance to the Policy as the legislative intent of the Perpetuities Rule.

Conclusion

All requirements to make use of a statutory exemption from a law need to be met. Occasionally exemptions, including exemptions which are not clearly expressed, will be construed strictly perhaps to unanticipated standards. Equivocally drafted statutory exemptions can lead to unexpected outcomes so, where much turns on whether or not an exemption is available, caution should be exercised and a conservative approach taken.

Hopefully Revenue NSW’s view in paragraph 30 of Revenue Ruling DUT 46 on duty on transfers of dutiable property to a beneficiary of a testamentary trust will eventually be tested and explained in a reported court decision.

With regard to perpetuities, the Perpetuities Rule and the “wait and see” rule I suggest that appropriate fail safes should be included in discretionary trust deeds so that the Perpetuities Rule can be complied with and the trust will remain valid, just in case Nemesis Australia doesn’t persist as the accepted Australian understanding of how the “wait and see” rule applies on some basis I have or haven’t anticipated.

Used the wrong/ trustee’s ABN for a new trust? How to fix …

A common mistake, misstep or omission on setting up a family discretionary trust (FDT) or other kinds of trusts is to use the Australian Business Number (ABN) of the trustee of the trust, typically a proprietary company, rather than to obtain and use a separate ABN after the trust has been established to run a business or enterprise.

Situations where this can happen include:

an ABN application form is completed incorrectly for the company without correctly identifying the FDT as the entity to which the application applies;
early application for the ABN is made by the company for an ABN, say so the company can say, open a bank account before the trust formation; or
the company is already doing other things and has an ABN already.

In each of these situations a client of an accountant can be tempted to use the ABN already to hand for the FDT. A client so tempted may well think – my accountant can sort this out later!

ABN for the wrong entity

It’s a clear mistake as a trust is clearly a separate entity to the company. An entity that can obtain an ABN under the A New Tax System (Australian Business Number) Act 1999 is equivalent to an entity as defined under the companion GST legislation which is:

(1) Entity means any of the following:
(a) an individual;
(b) a body corporate;
(c) a corporation sole;
(d) a body politic;
(e) a partnership;
(f) any other unincorporated association or body of persons;
(g) a trust;
(h) a superannuation fund.
Note: The term entity is used in a number of different but related senses. It covers all kinds of legal persons. It also covers groups of legal persons, and other things, that in practice are treated as having a separate identity in the same way as a legal person does.
sub-section 184-1(1) of the A New Tax System (Goods And Services Tax) Act 1999

which also conforms with other definitions of entity in the Income Tax Assessment Acts (ITAAs). Its clear that a company can have an ABN and a trust with a company as its trustee can and should separately obtain another ABN where the trust is to carry on an enterprise requiring an ABN.

The usual trust implementation

The usual implementation of an asset protected FDT is to set up the FDT with a corporate trustee with limited liability where the company is to be a dormant company. That is the company will have modest nominal share capital so it can register as a proprietary company with the Australian Securities and Investments Commission (ASIC) but the company will not have business or other substantive assets or liabilities on its own behalf as all intended activity of the FDT will be as the trustee of the FDT.

The company must have a right to be indemnified out of the property of the FDT so that the directors will not be personally liable for the debts of the trust under section 197 of the Corporations Act 2001 but, in terms of the balance sheet of the corporate trustee of a FDT, that right and the share capital are about the only few assets the company needs in the role of trustee of a FDT.

Impact of the wrong ABN

But if an ABN for the company is quoted on bank accounts and on invoices then the Australian Taxation Office (ATO) and all others concerned with the business are informed that transactions thought to be made by the FDT for its business are made by the company in its own right. The accountant for the FDT will have little choice but to record the transactions as transactions of the company in its own right and prepare the accounts of the company accordingly. Significant penalties can apply if the company persists with a position that it was quoting the ABN of the company for activity of an entity without an ABN rather than for activity in its own right.

So instead of the accounts of the company being dormant and those of the FDT being active, the business transactions will go to the accounts of the company and nothing will happen on FDT accounts and the implementation of the trust to operate the business will misfire.

If the business is being run under a business name, where the ABN of the company was used to apply for and obtain the business name, then the ATO and all others concerned with the business will view and treat the business name as a business name of the company and not the FDT.

Fixing the problem – reverting to the trust structure

This is one of those problems that can’t be fixed retrospectively without penalty trouble – the ABN has been quoted and relied on, but the problem can be fixed going forward.

Get the right ABN

The FDT can belatedly apply for an ABN. It is possible for an ABN to have retrospective application viz. the ABN can take effect from a date nominated by the applicant some time prior to the time of the application. But the ABN taking earlier effect won’t cure the problem of where the wrong ABN has been quoted since then.

Restore the company balance sheet

The company shouldn’t need to be voluntarily liquidated but a comparable internal process can be done to transfer the assets and liabilities in the accounts of the company to the FDT and to restore the balance sheet of the company to the modest assets described under The usual trust implementation above from a set fix or changeover date. If the problem is picked up early enough – it should be! –significant income tax profit and capital gains tax exposures of transferring assets to the FDT that may require remedy such as the small business restructure rollover in Division 328-G of the ITAA 1997 may not necessarily be needed to reset the company balance sheet.

Coping with the administrative consequences of changeover

If a client of an accountant has put itself into this sort of tangle it is likely that the client will struggle with this remedial action too which presents some administrative challenges as the client is now dealing with, effectively, two discrete businesses before and after the changeover day: The business initially carried on by the company with its ABN and then the business carried on by the FDT with its ABN from the changeover day.

It is important that the accounting and administrative team of the client (the Team) can pinpoint company period transactions before the changeover date and FDT period transactions that happen after the changeover day.

So a further element of the fix proposed here is to change the name of the company and for the Team to be meticulous about changing processes and stationery etc. to the new company name once the changeover day happens and the FDT period is underway.

There is an ASIC cost to change the name of the company and stationery etc., and time of the Team to manage all of this, but that cost should be considered in the context of alternatives that are costlier such as to voluntarily liquidate the company, to start afresh with an entirely new business structure to get the ABN process right or to abandon plans to use the FDT structure altogether.

A common technique for a name change for a company running a business, when a name change isn’t really wanted for public facing reasons; is to change NameOfCompany Pty. Ltd. to say NameOfCompany (Aust.) Pty. Ltd. This can help the Team and its customers to apply the right ABN and to get the accounting right (e.g. sales put through the right books of the two distinct entities NameOfCompany Pty. Ltd. to NameOfCompany (Aust.) Pty. Ltd (as trustee for the FDT) in this example for before and after changeover day transactions.

Unless something like this is done the Team and customers of the business might get very confused and might not manage the transition to the FDT as sought all along.

Impact of name change on the appointed FDT trustee

Unlike a liquidation of the company, after which a new trustee of the trust would need to be set up and appointed, a name change won’t affect the position of the company as the trustee of the trust.

Draft ATO reimbursement agreement suite out in the wake of Guardian AIT

In my blog post 100A trust reimbursement agreement not the tool to fix the bucket company dividend washing machine last month I looked at reimbursement agreements following Guardian AIT Pty Ltd ATF Australian Investment Trust v. Commissioner of Taxation [2021] FCA 1619 (Guardian AIT).

The Commissioner acts

In the meantime the Commissioner has appealed Logan J.’s decision in Guardian AIT to the Full Federal Court. The Commissioner has also released a suite of “draft products” which set out the compliance approach of the Commissioner relating to reimbursement agreements under section 100A of the Income Tax Assessment Act (ITAA) 1936:

Draft Taxation Ruling TR 2022/D1 Income tax: section 100A reimbursement agreements
Draft Practical Compliance Guideline PCG 2022/D1 Section 100A reimbursement agreements – ATO compliance approach
Draft Taxation Determination TD 2022/D1 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of ‘financial accommodation’?
Taxpayer Alert TA 2022/1 Trusts: parents benefitting from the trust entitlements of their children over 18 years of age

Evolution of the draft products

The suite clearly evolves from a similar suite finalised nearly twelve years ago which included Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements and Practice Statement Law Administration PS LA 2010/4 Division 7A: trust entitlements which focused on unpaid present entitlements of private companies, deemed loans and sub trusts. The Commissioner now takes a tougher line, prospectively, on what is a financial accommodation and thus a deemed loan for the purposes of Division 7A of the ITAA 1936 in TD 2022/D1. A company will need to demand immediate payment when it becomes aware of and has an unpaid present entitlement (UPE) to income of a trust. There will still be a financial accommodation, despite arrangement to pay a commercial rate of interest, which will be enough to be deemed loan and potentially a deemed dividend. Section 109N of the ITAA 1936 complying loan terms are needed so that UPE will not trigger a deemed dividend under section 109D.

This does not appear to be a relevant matter in Full Federal Court appeal in Guardian AIT in relation to the the bucket company dividend washing machine (BCDWS) arrangement used in that case. Under that BCDWS a dividend was declared by the bucket company back to the Australian Investment Trust (AIT) in the window allowed for a private company debit loan before the income tax return for the bucket company was due. That declaration is a prompt if not immediate action to extinguish any financial accommodation by the bucket company to the AIT.

Staying red?

The dividend washing machine arrangement comes up as Red zone scenario 2 in paragraphs 33 to 36 of PCG 2022/D1 where red zone activity in PCG 2022/D1 is activity at high risk for ATO action with compliance resources. It is not expected that, even if the Commissioner is unsuccessful in the Full Federal Court case in Guardian AIT, the BCDWS will be reclassified out of the red zone and will become an acceptable tax practice.

Repercussions of Guardian AIT?

It remains to be seen whether section 100A risks addressed in the draft products will align with Guardian AIT following the Commissioner’s appeal. Will higher courts adopt Logan J.’s understanding of the facts which accepted the BCDWS as an ordinary family or commercial dealing?

Perhaps more problematic for the Commissioner will be to convince a higher court that there was a reimbursement agreement at all in Guardian AIT. Logan J.’s findings that there was no timely reimbursement agreement for the bucket company to pay dividends to the Australian Investment Trust, and no plausible counterfactual as to whom otherwise the trustee of the Australian Investment Trust would have distributed income of that trust had it not been distributed to the Australian Investment Trust, meant the Commissioner could not make out a reimbursement agreement to which section 100A could apply.

In running the appeal the Commissioner may run the risk that the Full Federal Court will establish authority that section 100A cannot readily apply where the impugned distributions to which the Commissioner seeks to apply section 100A is made to immediate family members such as Simon and Sam in Example 7 in paragraphs 85 to 92 of PCG 2022/D1.

Example 7 – amounts provided to the parent in respect of expenses incurred before the beneficiary turns 18 years of age
85. Brown Trust’s beneficiaries include the members of the Brown Family. Brown Co is the trustee of Brown Trust, and Bronwyn Brown is the sole shareholder and director of the trustee.
86. Bronwyn is the parent of three adult children; Sandra (aged 26), Simon (aged 21) and Sam (aged 19).
87. During the 2022-23 income year, Sandra is self-employed and has a taxable income of $90,000. Simon and Sam study full-time and derive no income during the income year. Bronwyn’s children live at home with her at all times throughout the income year.
88. During the 2022-23 income year, Brown Trust derives $240,000 in income (the trust’s net income is also $240,000). Throughout that year, Brown Co makes regular payments totalling $240,000 into Bronwyn’s bank account. Those payments are recorded as a ‘beneficiary loan’ in the accounts of Brown Trust. Bronwyn uses these amounts throughout the year to meet her personal living expenses and those of the household.
89. On 30 June 2023, Brown Co resolves to make Simon and Sam each presently entitled to $120,000 of the Brown Trust income.
90. Brown Co applies their entitlements against the beneficiary loan owed by Bronwyn. The entitlements of Simon and Sam are each recorded as having been fully paid in the accounts of Brown Trust. Bronwyn assists in the preparation of Simon and Sam’s tax returns and pays the tax liability arising in relation to their entitlements from her personal funds.
91. The entitlements of Simon and Sam are applied in this manner because they each purportedly have an outstanding debt owed to Bronwyn in respect of education expenses and their share of the Brown household expenses that Bronwyn paid before they each turned 18.
92. Diagram 10 of this Guideline illustrates the circumstances in this example.
Example 7 in PCG 2022/D1

Under sub-section 100(8) an agreement is carved out from being a reimbursement agreement unless there is what the Commissioner refers to as the tax reduction purpose.

Even though a distribution in that Example 7 to Bronwyn was a “lawful possibility” why “would have” distributions made to Simon and Sam (assuming the distributions were real and genuine) who are equally family beneficiaries with Bronwyn have been made to Bronwyn? Isn’t the true issue that the trust distributions to Simon and Sam are a sham and that Simon and Sam did not have a real entitlement and so are not presently entitled to the distributions in the first place?

The Commissioner appears to be reliant on the Full Federal Court agreeing with the construction of sub-section 100A(8) expressed in paragraphs 156 to 158 of Draft Taxation Ruling TR 2022/D1 Income tax: section 100A reimbursement agreements rather than the construction of that sub-section preferred by Logan J.

100A trust reimbursement agreement not the tool to fix the bucket company dividend washing machine

This blog post is about tax avoidance. That is not apparent from the odd title of this blog which I should explain:

Bucket companies

A bucket company is a private company included as a beneficiary of a trust and is used to receive income of a trust. It is a popular discretionary trust strategy for a trust to distribute trust income to a bucket company as a beneficiary of the trust when, as at present, company income tax rates are lower than income tax rates:

for beneficiaries who are individuals typically on significant incomes (individual beneficiaries); and
the (can be even higher – highest marginal) rate generally paid when no beneficiary receives (technically: is distributed or becomes presently entitled to) the income of the trust;

(the Higher Rates).

Thus the “bucket” takes the overflow of trust income which the trustee or trust doesn’t wish:

to flow to high income individual beneficiaries; and
to be taxed at their higher rates.

Not considered tax avoidance

The Commissioner of Taxation (Commissioner) doesn’t view the simple use of a bucket company as a beneficiary of a trust as tax avoidance. That is the case even though less tax will be collected from a trust’s trustee and beneficiaries when the Higher Rates won’t be paid by the trustee and the beneficiaries of the trust when a BC beneficiary is used. There are measures in place: notably the deemed dividend anti-avoidance rules in Division 7A of Part III of the Income Tax Assessment Act (ITAA) 1936 (Div 7A), which generally give the Commissioner assurance that:

a private company is a no mere lowly taxed conduit or way for high income individual individuals to receive trust income; and so
value either within and distributed to a private company stay within the company or are otherwise treated as non-frankable shareholder/associate dividends they are deemed to receive and to be taxable on.

The washing machine

The bucket company dividend washing machine (BCDWS) though pushes the Commissioner’s tolerance for the bucket company tax strategy.

The BCDWS is like this:

A family discretionary trust (FDT) makes a substantial distribution of trust income (Distribution 1) to a bucket company (BC) in Year 1.
Distribution 1 is not paid and thus becomes an unpaid present entitlement owed to BC by FDT to be paid later.
BC is taxable on Distribution 1 in Year 1 at the company rate which is lower than the Higher Rates.
In Year 2, but in the window before the income tax return for BC is due, and thus before Div 7A treats Distribution 1 to BC to be a deemed dividend based on the analysis of when unpaid present entitlements, including unpaid present entitlements of companies in trust income, can be loans and deemed dividends in Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements; the bucket company declares and pays a dividend to cover Distribution 1.
BC has franking credits to frank the dividend from the payment of tax as a beneficiary on Distribution 1.
The sole shareholder of BC entitled to the dividends is the (trustee of) FDT which has been set up as the owner of the shares in BC that can participate in these dividends.
No actual payment is required as Distribution 1 has gone around the washing machine and has come back to FDT in Year 2 as dividends fully franked by BC.
So in Year 2 the trustee of FDT distributes Distribution 2 of the same amount as Distribution 1 to BC again. It is again unpaid until early in Year 3. The distribution is fully franked which is how the dividends were received from BC so there is no further tax for BC to pay.
The arrangement can be repeated on and on.

By using a concession in Div 7A, the BCDWS in effect enables BC to access a lower company income tax rate for an amount which is not actually paid over or intended to be paid over to a beneficiary but circulates back to the trustee.

Income tax rate integrity problem

So it’s like the trustee is accumulating the income and never having to pay it to a beneficiary but paying less tax as if the income had been paid to a company.

Understandably the Commissioner is concerned with the integrity of income tax rates, and the particularly the integrity of the Higher Rates including the highest marginal rate applicable where no beneficiary is presently entitled to income under section 99A of the ITAA 1936. The Commissioner would like to see that the BCDWS will have the same rate outcome. It does if a BCDWS is a trust reimbursement agreement: a share of trust income arising from a section 100A reimbursement agreement is deemed to be income to which no beneficiary is presently entitled: sub-section 100A(1).

So it is that, at the ATO website, https://www.ato.gov.au/General/Trusts/In-detail/Distributions/Trust-taxation—reimbursement-agreement/ where, at example 5, the Commissioner observes that the trust reimbursement agreement provisions in section 100A of the ITAA 1936 apply to a BCDWS arrangement.

Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation

The Commissioner’s observation in example 5 is put into doubt by the December 2021 Federal Court case Guardian AIT Pty Ltd ATF Australian Investment Trust v. Commissioner of Taxation [2021] FCA 1619. In that case the Commissioner was unsuccessful assessing a BCDWS using anti-avoidance tax laws including section 100A. The taxpayer’s appeal to the Federal Court concerned the Commissioner’s assessments applying the anti-avoidance provisions in section 100A and, alternatively, based on the general anti-avoidance provisions in Part IVA of the ITAA 1936.

Logan J. found that there was no reimbursement agreement and that Part IVA didn’t apply.

The Commissioner had at least these significant difficulties in making out that the BCDWS in the case was a reimbursement agreement:

firstly, that there was any agreement to which sub-section 100A(7) and (8) could apply, and particularly establishing a counterfactual as to whether Mr. Springer, who controlled Guardian AIT Pty Ltd, would have been liable to pay income tax had the “agreement” not been implemented;
secondly, that there was provision of “payment of money or the transfer of property to, or the provision of services or other benefits for, a person or persons other than the beneficiary …” under that agreement: sub-section 100A(7); and
thirdly, that the agreement was not an ordinary family or commercial dealing: sub-section 100A(13).

· agreement

Mr. Springer was wealthy and conducted a well prepared case before the Federal Court in which the taxpayer was able to establish that the BC, Guardian AIT Pty Ltd, had not been set up with the intent, understanding or expectation that the BC would pay dividends back to the Australian Investment Trust (the FDT). That is what eventually transpired though, and a BCDWS, largely as described above and in the Commissioner’s example 5 happened.

There must be an agreement first

Logan J. accepted that even though it was legally possible for the BC to pay the dividends to the FDT there was no evidence of any timely agreement or plan (my words) to do so. To make out a section 100A reimbursement agreement the Commissioner had to make out that there was “agreement” (though widely defined) between the FDT and its beneficiary/ies before BC started paying dividends to the FDT to make the income tax saving.

Counterfactual not accepted

Logan J. found the Commissioner’s counterfactual under the section 100A(8) “would have been” hypothetical: that Mr. Springer personally would have been liable to pay income tax, that is Mr. Springer would presumably have to have been the beneficiary presently entitled to the income distributed to the BC rather than the BC, had it not been for the reimbursement agreement, could not be reconciled with the evidence in the case.

· payment, transfer etc.

Logan J. did not accept that there has provision for a payment , transfer etc. to another beneficiary…. The BC was a related entity of Mr. Springer that was a beneficiary of the FDT and a part of the family structure in its own right (that incidentally happened to be on a lower tax rate as an income beneficiary).

Unlike with a unrelated entity that takes, say, a payment to be made a beneficiary of trust income in a trust stripping, which is the use of trusts abuse to which section 100A is directed; the BC in this case can be seen as a beneficiary related to and having no reason for such arm’s length like dealing with Mr. Springer or other members of his family.

· ordinary family or commercial dealing

Section 100A was introduced to combat trust stripping typically involving unrelated parties (see Federal Commissioner of Taxation v Prestige Motors Pty Ltd (1998) 82 FCR 195) and “specially introduced beneficiaries having a fiscally advantageous status” particularly. Logan J. did not accept that this characterisation applied to the BC, Guardian AIT Pty Ltd. From the evidence Logan J. found that the implementation and use of Guardian AIT Pty Ltd as a “clean” (for instance, no carry forward losses or other utilisable positive tax attributes) company beneficiary of the FDT, Australian Investment Trust, was an ordinary family dealing.

Observations

Guardian AIT confirms that a reimbursement agreement contains a number of technical elements that the Commissioner can be hard pressed to establish where a taxpayer produces facts contrary to the Commissioner’s position on them. These elements can make section 100A, as a tool in the anti-tax avoidance armoury of the Commissioner, ill-suited to enforce the integrity of the Higher Rates applicable to trust income and the rate applicable under section 99A of the ITAA 1936 where there is no beneficiary presently entitled to income in particular. That is not to say that the Commissioner should not endeavour to enforce that integrity.

Based on authority referred to in Guardian AIT Logan J. was unwilling to accept that the reimbursement agreement rules in section 100A, directed as they are to the contrived introduction of specially introduced beneficiaries with a fiscally advantageous status, had application to a clean company introduced within Mr. Springer’s family structure despite the overtly unplanned tax arbitrage Mr. Springer could achieve due to the lower company income tax rate.

There is the prospect that the Commissioner will appeal to the Full Federal Court. The government could better protect the integrity of the trust tax rates with specific amendment so that circulating BCDWS distributions, which do or must have some aspect of artificiality or contrivance by virtue or their circularity or non-distribution, attracted the highest marginal rate of tax without the Commissioner having to contest assessments based on section 100A and Part IVA attack or sham characterisation which are more costly, fraught and complicated for the Commissioner to prosecute.