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Should our SMSF have kept its Principal Employer?

MissingPiece

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

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

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

To bring in the new, keep the old

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

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

My exposé further explains:

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

Invalid replacement of the power to vary

Say:

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

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

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

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

Marooned without a Principal Employer

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

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

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

Other dated requirements in the power to vary

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

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

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

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

The right “applicable law”?

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

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

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

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

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

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

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

Challenges!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Law on amending lost trust deeds

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

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

is to be considered.

Alteration of a trust by its founders

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

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

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

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

Barrett JA then illustrates the point by this example:

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

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

Alteration of a trust by all beneficiaries of a trust

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

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

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

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

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

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

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

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

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

Update of trust terms by a court

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

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

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

were not correctly decided. Barrett JA said:

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

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

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

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

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

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

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

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

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

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

Significance of the power of amendment as expressed in an OTD

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

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

as considered above.

Amendment practice

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

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

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

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

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

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

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

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

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

Update of the power of amendment?

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

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

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

Later deeds of variation of SMSFs based on a deviation

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

So are replacement SMSF trust deeds a scam?

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

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

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

Other solutions, aside from supreme court applications allowed under:

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

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

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

ACKNOWLEDGEMENTS

The author acknowledges the articles:

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

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

Why the weird donation trust beneficiary qualification?

Donation

I was recently asked why a trust deed for a family discretionary trust (FDT) contained this somewhat unusual means of qualifying as a discretionary beneficiary (DB) of the FDT:

any person who makes a donation of (some minimum amount) to …

As the questioner rightly observed, this mechanism readily allows someone outside of a family specified as the DBs, in the main, of a FDT to become a DB. Wouldn’t that mean that a FDT with this mechanism is not or can’t be a family trust?

The answer to this depends on what is meant by family trust.

Certainty of objects necessary for validity of a trust

The thinking behind this kind of provision is that a trust deploying a beneficiary by donation mechanism such as above in its trust deed will be valid.

Certainty of objects is essential for validity of a trust in Australia: Kinsela v. Caldwell (1975) HCA 10. Objects, that is who are or what are to benefit from the trust, being:

  • beneficiaries; or
  • charitable purposes;

must be certain in a valid trust.

It is clear law that a trust (other than a charitable trust) must be for ascertainable beneficiaries.

Re Vandervell’s Trusts (No 2) [1974] Ch 239 at 319 per Lord Denning

When DBs are specifically named or family members qualify by virtue of specified family relationships in a trust deed of a FDT, who qualifies as a beneficiary under the FDT generally presents no uncertainty. It is where classes of beneficiaries are wider and looser that problems of certainty arise and can cause a trust to fail for invalidity. For instance, in R. v District Auditor exparte West Yorkshire Metropolitan County Council (1986) 1 RVR 24, an English Court found a trust, where the class of beneficiaries was expressed as 2½ million inhabitants of West Yorkshire, was invalid as the class was too large and was thus uncertain.

Donations

It follows that a beneficiary by donation mechanism for DBs in a trust deed of a FDT can readily meet the certainty of objects requirement. A person either has or has not made the requisite donation and so the trustee can perfunctorily ascertain that the person is a DB under the mechanism once the person has made the specified donation. Similarly every person who:

  1. has not made the specified donation;
  2. is not named as a DB; or
  3. is not in any other class of DB;

under the trust deed can be categorised not as a DB of the FDT with certainty.

There are limits to this though.

Or just a gift?

Where the beneficiary by donation mechanism in the trust deed is to a charity then the trustee can observe a donation by the prospective beneficiary. Sometimes I have seen trust deeds where the beneficiary by donation mechanism is a minimum donation not to a charity but to a beneficiary of the trust! A question arises here whether a payment of the minimum amount to qualify as a beneficiary under the mechanism is a donation, or is simply a gift (or perhaps a reimbursement agreement! see below), because the recipient beneficiary is not in need. A donation may need to be both a gift and a gift made to a recipient understood by the donor to be in need based on what a donation is commonly understood to be. Beneficiaries of private trusts in Australia are often well-heeled and are clearly not in need.

It may then follow that the donor does not qualify as a beneficiary of the trust because the donor has not made a donation.

Family trust?

Understanding then that an appropriately constructed beneficiary by donation mechanism for DBs in a FDT, which DBs are not necessarily members of the specified DB family in the trust deed, will not compromise the validity of the FDT as a trust, is it still fair to say that a FDT with this mechanism is still a family trust, that is a trust for a family, in substance?

FDTs as matter of course include charities as objects either so:

  • the trustee with discretion to choose who takes trust property can favour a charity as well as or instead of named beneficiaries and their family members; or
  • FDT income or capital does not become bona vacantia. That is before trust property reverts to the state as ownerless when the trustee doesn’t, can’t or doesn’t wish to exercise its discretion to distribute the property to a DB of the FDT, a charity or often a wide range of charities are able to take trust property under the trust deed of a FDT either by exercise of the trustee’s discretion or on default of that exercise without offending the certainty of objects requirement.

So clearly a FDT can still be a “family trust” in substance even though charities beyond the family can also benefit from the largesse of an FDT.

From that perspective it can be seen that a beneficiary by donation mechanism in the trust deed of a FDT, particularly if it is sparingly used by a trustee of a FDT to benefit non-family beneficiaries, is unlikely to make a FDT any less a family trust.

The point of a donation qualification mechanism in a FDT is to ensure the trust is/remains valid even if a person becomes a beneficiary of the trust using the mechanism who is not within the family or other class of who is a beneficiary in the trust deed. Whether a trust is a family trust or not is not pertinent to that.

Schedule 2F (trust tax losses etc.) family trusts

A “family trust” (2FFT) for the purposes of the (trust loss measures in) Schedule 2F of the Income Tax Assessment Act 1936 is a different matter. Sections 272-90 and 272-95 of Schedule 2F include certain specified relations of a test individual as members of a family group. Although distributions to individuals outside of the family group are liable to family trust distributions tax (FTDT) under Division 271 of Schedule 2F at the highest marginal income tax rate imposed on the trustee, trust distributions by a 2FFT to those individuals are not precluded by Schedule 2F either by law or in practice.

It can be seen that, unlike with state stamp duty and land tax surcharge measures which impacted who can be a DB of a FDT, the family trust and FTDT regimes in Schedule 2F do not impact on who can be a beneficiary of a FDT. Where a FDT elects to become a 2FFT, no FTDT arises until the 2FFT makes a distribution to an outsider outside of the family group. It matters not under Schedule 2F who qualifies as a DB of a 2FFT but does not receive a distribution.

If Schedule 2F had instead tax penalised 2FFTs with DBs outside of the family group whether or not distributions were made to them we would have seen the range of beneficiaries of FDTs reduce back to family groups and beneficiary by donation mechanisms superseded.

Reimbursement agreements

Another serious fetter on a trustee of a FDT exercising their discretion to distribute trust income to a DB who qualifies as a DB by using a beneficiary by donation mechanism is the high risk and potential that the Commissioner of Taxation may impose section 100A of the ITAA 1936 to tax the distribution on the trustee also at the highest marginal income tax rate.

A discretionary distribution by a trustee of a FDT to a person who is not a member of the family designated for benefit under the FDT begs the question why the distribution is being made outside of the family to this person. It is unusual that a trustee of FDT would seek to benefit someone outside of that family without the family receiving a quid pro quo in some form.

A quid pro quo grounds a reimbursement agreement which triggers section 100A.

A true gift to the non-family DB and the absence of a quid pro quo are facts the trustee and the family would need to prove, to resist a section 100A reimbursement agreement assessment on the trustee of the FDT. Situations where distributions to DBs who are not members of the family are more likely to be accepted by the Commissioner as not involving a reimbursement agreement include where:

  • the DB is a relation of a family member who is narrowly outside the class of family included as beneficiaries under the FDT;
  • the designated family may have few if any surviving family members; or
  • the DB is a person in need;

or a mix of those circumstances and then a beneficiary by donation mechanism in a trust deed of a FDT that is not a 2FFT may be usable without draconian tax consequences.

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The tax burden of handing over business assets to trust beneficiaries

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Business assets of GST registered entities, including business assets of a business carried on in a trust, attract significant tax concessions and advantages including:

  • income tax deductibility – generally either in the income year when they cost money: notably on purchase, or across their effective life in the case of depreciation; and
  • goods and services tax (GST) credits on GST creditable acquisitions.

It is to be expected that there are clawbacks under the taxation law when a business asset, that has attracted concessions and advantages under the taxation system in anticipation of its productive business use, is transferred to a beneficiary of a business trust that owns the asset for the beneficiary’s private use.

Trading stock taken out of a business for private use

It can be seen with business trading stock, for example, that a strictly market value disposition is taken to occur for income tax purposes when trading stock is taken for private use without regard to the money that may have changed hands. This treatment contrasts with the more flexible choice of actual cost, replacement cost and market selling value that is allowed to a business in determining trading stock on hand: section 70-45 of the Income Tax Assessment Act (ITAA) 1997.

Section 70-90 of the ITAA 1997 includes the market value of trading stock in income assessable to income tax when it is disposed of outside of the ordinary course of business. Section 70-100 can also include the market value of trading stock in the same income where the item, though not disposed of, has ceased to be trading stock.

Handing over depreciable equipment

The balancing charge or adjustment which is assessable to income tax on the disposal of an item of depreciable plant and equipment, such as a car used in the business of a trust, is determined based on its termination value. Where a business (taxpayer) stops holding the item under a non-arm’s length dealing for less than market value, then the item’s termination value is taken to be the market value of the item just before that dealing under item 6 in the table in section 40-300 of the ITAA 1997.

Where business equipment being depreciated by a trust is used privately by a beneficiary of the trust without being disposed of to the beneficiary the item will precipitate a non-deductible private use proportion of use of the equipment. When the item is eventually sold or otherwise disposed of for more than its cost, a capital gain under CGT event K7 attributable to the private use component can arise to the trustee of the trust.

Taxable GST supply without consideration

Generally a supply of property, goods or services by a business that is registered or required to be registered for GST for consideration is a taxable supply. Under section 72-5 of the A New Tax System (Goods And Services Tax) Act 1999 a supply to an associate:

  • not registered or required to be registered for GST; or
  • where the associate acquires the thing supplied otherwise than for a solely creditable purpose;

is treated as taxable supply even when there is no consideration for the supply. The value of a section 72-5 taxable supply without consideration (a price) is the GST exclusive market value of the supply: section 72-10.

Not worth the tax and accounting trouble

It can be seen from the above that taxation consistently based on market value substitution applies to non-arm’s length provision of business assets to beneficiaries of business trusts for the beneficiary’s private use.

The in specie distribution of a business asset of a GST registered trust to a trust beneficiary for no consideration, or an inadequate consideration, (price) is thus discouraged by the clawbacks. There is no apparent tax advantage to a trust in giving an asset to a beneficiary of the trust when the gift is compared to a sale of the asset. A sale raises far fewer tax compliance challenges!

How getting the business asset to the beneficiary might be done?

A less problematic way to achieve the same thing would be for the trustee to simply sell the business asset in the ordinary course of its business to the beneficiary for its market value (plus GST in the case of a sale by a GST registered business trust) and, concurrently make a capital distribution to the beneficiary to cover the price. Then the clawbacks would not need to be endured.

Foreign purchaser stamp duty and land tax surcharges – design faults & unit trusts

DesignFault

Advent of the state foreign person property surcharges

Foreign person surcharges have applied on New South Wales, Victoria, Queensland, Tasmania, Western Australia and Australian Capital Territory property taxes following Commonwealth action to have the Foreign Investment Review Board more closely monitor the acquisition and holding of Australian real estate by foreign interests: see our July 2016 blog post:

Australia is now tracking & surcharging foreign buyers of land

https://wp.me/p6T4vg-56

NSW surcharges and current rates

In NSW, surcharges imposed since 2016 are:

(a)          a surcharge purchaser duty (currently 8% of the market value of the property) on the acquisition of residential property in NSW (Chapter 2A of the Duties Act (NSW) 1997 [DA]); and

(b)          a surcharge land tax (currently 2% of the unimproved value of the land) for  residential property in NSW owned as at 31 December each year (section 5A of the Land Tax Act (NSW) 1956).

(Surcharges)

The foreign trusts that aren’t foreign problem

Discretionary trusts with all or predominantly Australian participants and entitled beneficiaries can nevertheless be caught as foreign trusts that must pay the Surcharges. Liability for the Surcharges is based or grounded on sub-section 18(3) of the Foreign Acquisitions and Takeovers Act (C’th) 1975 (FATA): Sub-section 18(3) provides:

For the purposes of this Act, if, under the terms of a trust, a trustee has a power or discretion to distribute the income or property of the trust to one or more beneficiaries, each beneficiary is taken to hold a beneficial interest in the maximum percentage of income or property of the trust that the trustee may distribute to that beneficiary.

sub-section 18(3) of the Foreign Acquisitions and Takeovers Act (C’th) 1975

If the income or property (capital) that could be distributed to a foreign beneficiary of a trust is 20% or more of income in a year or property of the trust, the trust is foreign for FATA and Surcharge purposes. An ameliorating aspect of the Surcharges legislation is that:

  • Australian citizens who are non-residents of Australia; and
  • some New Zealand citizens with certain Australian visas;

who are foreign persons under the wide sweep of sub-section 18(3) of the FATA are excluded from being foreign persons for NSW Surcharges purposes: see sub-section 104J(2) of the DA.

The lengthy transition

Even for those not averse to the idea that foreign individual and foreign trust investors should pay higher property dues the implementation of the Surcharges in NSW has been agonising. Even now, in 2020, four years after liabilities for Surcharges were first imposed under the DA and the LTA the State Revenue Legislation Further Amendment Act (NSW) 2020 (“SRLFAA”) is still needed to phase in the Surcharges, and transitional relief from them, as they apply to trusts.

As well as imposing the wide sweep of what the FATA treats as foreign, the SRLFAA:

  • imposes impugnable trust deed requirements on discretionary trusts (see below); and
  • extends transitional arrangements that were set to end on earlier dates in versions of Revenue Ruling G010 from Revenue NSW and the State Revenue Legislation Further Amendment Bill (NSW) 2019.

Trust deed requirements on discretionary trusts

Where a trust is a discretionary trust for Surcharge purposes then the SRLFAA requires that the terms of the trust must be amended by 31 December 2020 so:

(a) no potential beneficiary of the trust is or can be a foreign person [the no foreign beneficiary requirement]; and
(b) the terms of the trust cannot be amended in a manner so a foreign person could become a beneficiary [the no amendment requirement];

and then only does the discretionary trust, even a discretionary trust that:

  • has no foreign participants or beneficiaries; and
  • thus is not foreign after the FATA wide sweep and sub-section 104J(2) of the DA are considered;

(a Local DT) escape treatment as a foreign trust for Surcharge purposes.

Why the no amendment requirement?

The object of the no amendment requirement is to impose the Surcharges based on the contingency or possibility only that a Local DT may come to have a foreign beneficiary in the future. The position of Revenue NSW is understood to be that Revenue NSW does not have the compliance resources to monitor Local DTs for foreign beneficiaries into the future on an ongoing basis.

Although nearly all discretionary trust deeds contain some kind of variation power, a design fault of such resource-saving requirements viz.:

  • the “irrevocable” requirement of Revenue NSW in paragraph 6 of Revenue Ruling DUT 037 concerning sub-section 54(3) of the DA concerning concessional duty on changes of trustee; and
  • the no amendment requirement now in the SRLFAA;

is that the variation power in many or most trust deeds of trusts in NSW may not permit modification of the variation power to satisfy either of these requirements.

Changing the scope or amending the terms of a trust amendment power

In Jenkins v. Ellett, Douglas J. of the Queensland Supreme Court stated the relevant law and learning about changing the variation power in a trust deed:

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

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

Jenkins v. Ellett [2007] QSC 154

In our experience a small minority of trusts in NSW have a variation power which expressly permits extension of its own scope or amendment of its own terms. That kind of extended power can raise its own set of difficulties which explains why these extended variation powers are not especially popular. It follows, as stated, that a substantial number of variations of the terms of discretionary trust deeds which the no amendment requirement imposes are prone, or likely, to be beyond the power conferred by the variation power of the trust and thus ineffective on a trust by trust reckoning.

discretionary trust for Surcharges purposes

In section 1 in the dictionary of the DA a discretionary trust is defined for DA and Surcharges purposes:

“discretionary trust” means a trust under which the vesting of the whole or any part of the capital of the trust estate, or the whole or any part of the income from that capital, or both–
(a) is required to be determined by a person either in respect of the identity of the beneficiaries, or the quantum of interest to be taken, or both, or
(b) will occur if a discretion conferred under the trust is not exercised, or
(c) has occurred but under which the whole or any part of that capital or the whole or any part of that income, or both, will be divested from the person or persons in whom it is vested if a discretion conferred under the trust is exercised.

section 1 of the dictionary of the Duties Act (NSW) 1997

More time to check for unexpected foreign trust treatment

With time extended to 31 December 2020 by the SRLFAA to amend trust deeds so a discretionary trust won’t be treated as a foreign person it is timely during the remainder of 2020 to also check the terms of residential land holding trusts that may not ordinarily be thought of as a discretionary trust.

A trust, including a unit trust, that contains powers in its terms which:

  • allow for a beneficiary to be selected by someone to take income or capital;
  • allow for the amount of income or capital a beneficiary is to take to be set by someone;
  • which can change the income or capital a beneficiary will take if the discretion is not exercised; or
  • which can divest a beneficiary of an interest in income or capital which they otherwise would take;

that brings the trust within a discretionary trust in section 1 of the dictionary of the DA needs to meet the no foreign beneficiary requirement and the no amendment requirement in the SRLFAA.

Hybrid trusts and other unit trusts

This definition brings in trusts known as hybrid trusts within this construct of discretionary trust. Shortly stated a hybrid trust is a tax aggressive structure where unit or interest holders have standing vested interests in income or capital of the trust but where, usually, the trustee has a supervening power or powers to divest those interests in income, capital or both in favour of other beneficiaries such as family or related companies or trusts controlled by the unit or interest holder with the standing interest.

Other unit trust arrangements can be treated as a DA discretionary trust even where the discretion is historical, redundant and income tax benign. For instance an older style standard unit trust may be set up by way of initial units and the trustee may be given a discretion in the trust deed not to distribute income or capital to initial unitholders once ordinary units in the trust are issued.

This discretion in the terms of a trust is enough for the unit trust to be treated as a discretionary trust so it would be prudent for the terms of the unit trust to be amended to remove the discretion if that can be done:

  • without resettling the trust; and
  • less onerously than amending the trust deed to comply with the no foreign beneficiary requirement and the no amendment requirement.

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

CarWoes

In the recent Administrative Appeals Tribunal case Chadbourne and Commissioner of Taxation (Taxation) [2020] AATA 2441 (10 July 2020) the AAT confirmed the disallowance of tax deductions to Mr. D. Chadbourne (the Applicant).

The Applicant was a beneficiary of the D & M Chadbourne Family Trust (DMCFT) and the Applicant was denied deductions for:

  • interest on money borrowed by the Applicant to fund the acquisition of real estate and shares by the DMCFT; and
  • other expenses incurred by the Applicant expended;

so the DMCFT could earn income.

The discretionary trust

The DMCFT was a discretionary trust. In Chadbourne Deputy President Britten-Jones usefully described a discretionary trust:

I note that the meaning of the term ‘discretionary trust’ is disclosed by a consideration of usage rather than doctrine, and the usage is descriptive rather than normative. It is used to identify a species of express trust, one where the entitlement of beneficiaries to income, or to corpus, or both, is not immediately ascertainable; rather, the beneficiaries are selected from a nominated class by the trustee or some other person and this power (which may be a special or hybrid power) may be exercisable once or from time to time.

Chadbourne at paragraph 8

The mere expectancy of a beneficiary of a discretionary trust

Because the beneficiaries of a discretionary trust are not immediately ascertainable and are to be selected, a prospective beneficiary only has an expectancy of earning trust income unless and until the beneficiary is so selected by the trustee to take income:

Unless and until the Trustee of the discretionary trust exercises the discretion to distribute a share of the income of the trust estate to the applicant, the applicant’s interest in the income of the discretionary trust is a mere expectancy. It is neither vested in interest nor vested in possession, and the applicant has no right to demand and receive payment of it.

Chadbourne at paragraph 57

or in the case of a beneficiary who takes in default of exercise of discretion they have no more than a similar expectancy.

The Applicant was a beneficiary of the DMCFT with an expectancy interest.

The available tax deduction

The Applicant could not satisfy the first limb of the general deduction provision, now in the Income Tax Assessment Act (ITAA) 1997, which allows an income tax deduction for a loss or outgoing to the extent:

it is incurred in gaining or producing your assessable income 

paragraph 8-1(1)(a) of the ITAA 1997 (emphasis added)

In Chadbourne the Applicant’s expenditure was incurred to gain or produce income for the trustee of the DMCFT, a separate legal entity. Applying authority including Federal Commissioner of Taxation v Munro (1926) 38 CLR 153, Antonopoulos and FCT [2011] AATA 431; 84 ATR 311, Case M36 (1980) 80 ATC 280,  Commissioner of Taxation v Roberts and Smith (1992) 37 FCR 246, where Hill J. referred to Ure v Federal Commissioner of Taxation (1981) 50 FLR 219, Fletcher v Commissioner of Taxation (1991) 173 CLR 1 and other cases, the AAT required a nexus between loss or outgoings of the Applicant and the assessable income of the Applicant; not the DMCFT. Although the Applicant stood to earn income indirectly as the likely beneficiary of the DMCFT the AAT found:

The Trust is a discretionary trust the terms of which require the Trustee to exercise a discretion as to whom a distribution of net income is to be made.  It is an inherent requirement of the exercise of that discretion that it be given real and genuine consideration. There must be ‘the exercise of an active discretion’. There were numerous beneficiaries in the Trust.  There was no certainty provided by the terms of the Trust that the Trustee would exercise its discretionary power of appointment in favour of the applicant.

Chadbourne at paragraph 53

and the Applicant thus had not incurred the expenditure in gaining or producing the assessable income of the Applicant.

Why did the Applicant run the AAT appeal?

The Applicant in Chadbourne was self-represented. With the benefit of professional advice or assistance the Applicant may have:

  • more readily foreseen the outcome of his appeal to the AAT which, in the light of the authority applied by Deputy President Britten-Jones, could be seen as inevitable; or
  • moreover, arranged the loan to achieve the required section 8-1 nexus between the outgoings and the assessable income of a taxpayer.

Safer alternative 1 – trustee loan

The most obvious alternative would have been for the trustee of the trust to have been the borrower and to have directly incurred the relevant expenses though those actions would have been different commercial arrangements to those that were done.

These actions may have been more complicated and expensive to arrange: not the least because the financier may have required the Applicant to personally guarantee repayment of the loan by the trustee of the trust which was a corporate trustee with limited liability. Nonetheless these precautions would have ensured section 8-1 deductions were available to the trustee of the trust.

(Somewhat) safer alternative 2 – on-loan to the trustee

The other and perhaps commercially easier alternative would have been an on-loan of the borrowed funds by the Applicant to the trust.

The Applicant in Chadbourne may have belatedly considered an on-loan solution. At paragraph 11 of the AAT decision it was observed that the Applicant had abandoned a contention that there was a “written funding agreement” between the Applicant and the trustee of the DMCFT which the Commissioner had suggested was an invention to assist the Applicant in the appeal.

In the event of a genuine on-loan the trustee of the trust would hold the borrowed funds as loan funds with a clarity as to whom interest and principal is to be repaid rather than as a capital contribution or gift to the trust without that clarity.

On-loan – interest free

Clearly the on-loan by the Applicant to the trustee of the trust should not be interest free as the Applicant then faces the Chadbourne problem of having no assessable income with which to justify a section 8-1 deduction. In the words of Taxation Determination TD 2018/9 Income tax: deductibility of interest expenses incurred by a beneficiary of a discretionary trust on borrowings on-lent interest-free to the trustee:

A beneficiary of a discretionary trust who borrows money, and on-lends all or part of that money to the trustee of the discretionary trust interest-free, is usually not entitled to a deduction for any interest expenditure incurred by the beneficiary in relation to the borrowed money on-lent to the trustee under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)…  

TD 2018/9 – paragraph 1

On-loan – at low interest

An on-loan at low interest was arranged in Ure v. Federal Commissioner of Taxation (1981) 11 ATR 484. In Ure the borrower borrowed funds at up to 12.5% p.a. interest and on-lent the funds to his wife and his discretionary trust at 1% p.a. The Full Federal Court found that the deduction Mr. Ure could claim under the first limb of the general deduction provision, sub-section 51(1) of the ITAA 1936, was limited to the 1% p.a. by which the interest income earned by Mr. Ure from his on-loan was confined.

On loan – at equivalent interest

It thus follows from TD 2018/9, Ure and Chadbourne that, to achieve deductibility in full for interest on funds borrowed and on-lent to a related discretionary trust, the interest earned by the beneficiary/on-lender on the on-loan should be the interest payable by the on-lender on the loan from the financier. This should leave the beneficiary/borrower in a tax neutral position on his or her loan on-loaned with assessable interest earned under the on-loan equalling deductible interest paid on the loan.

Related loan issues

As the on-loan is a related loan there are further considerations which will attract the scrutiny of the Commissioner:

A related on-loan should ideally be carefully documented and it should be clarified that the beneficiary/on-lender has an indefeasible right to the interest even though the on-lender is a related party of the borrower. It is also important that commitments in the on-loan agreement are met and generally interest due to the beneficiary/on-lender shouldn’t be capitalised and, especially, shouldn’t be aggregated with unpaid present entitlements due to the beneficiary.

The Commissioner could take these positions:

  • that the on-loan with interest is inadequately documented and can’t be proved so accounting entries capitalising interest shouldn’t be considered conclusive; or
  • the on-loan may be documented but it is a sham and the failure of the trust to pay interest when due shows this.

See my blog post at this site “Only a loan? Impugnable loans, proving them for tax and shams” https://wp.me/p6T4vg-8a which shows the fallibility of related party loans when these questions are contested with the Commissioner.

Woes with hybrid trusts

A hybrid trust, also a descriptive rather than a normative structure, can also fit the Deputy President Britten-Jones formulation of a discretionary trust where the entitlement of beneficiaries of the hybrid trust to income is not immediately ascertainable and is subject to the exercise of a discretion. It has been recognised,  including in the Commissioner’s Taxpayer Alert TA 2008/3 Uncommercial use of certain trusts that the considerations of the AAT in Chadbourne can similarly apply to deny a section 8-1 deduction to the holder of an interest in a hybrid trust who incurs expenditure to earn income through a hybrid trust structure.

In passing I note my wariness of hybrid trusts which are typically aggressive and sometimes tax abusive arrangements. The Commissioner’s Tax Alerts are particularly directed against tax aggressive activity.

That said, the trust in the case of Forrest v Commissioner of Taxation [2010] FCAFC 6, which was referred to in a citation (sic.) in Chadbourne, appears to have been an instance of a hybrid trust where entitlement of unit holders to ordinary income was ascertainable and not subject to a discretion. On appeal to the Full Federal Court, the unit holders in Forrest could establish a nexus between borrowing expenditure incurred and assessable income.

The AAT applies Bamford to rubbery number trust income distributions in Donkin – or does it?

RubberyNumbers

In Donkin & Others v. Federal Commissioner of Taxation [2019] AATA 6746, a recently published decision of the Administrative Appeals Tribunal (AAT), the AAT considered how section 97 of the Income Tax Assessment Act (ITAA) 1936 applied to distributions by the trustee of a family discretionary trust (FDT).

Distributions of income were made to up to five beneficiaries (the Participating Beneficiaries) by resolution of the trustee of the Joshline Family Trust (the JFT), a FDT, for the 2010 to 2013 income years (the Years).

Tax audit – taxable income of the JFT increased

Following an audit of the first Participating Beneficiary, Mr Donkin, and his associated entities the Commissioner of Taxation (Commissioner):

  • disallowed deductions to the JFT increasing the taxable income of the JFT for the Years; and so
  • increased the taxable income of the JFT.

Before the AAT the Participating Beneficiaries contended that:

  • on the increase in the taxable income of the JFT the respective shares of taxable income of the Participating Beneficiaries should remain constant (unaltered); with
  • the increase in JFT taxable income taxable to (another) residuary beneficiary Joshline (understood to be a company taxable at no more than 30%).

The Commissioner contended that, based on the High Court authority in Commissioner of Taxation v. Bamford [2010] HCA 10 (Bamford), the proportionate approach should be applied to proportionately increase the taxable income of the Participating Beneficiaries under section 97 from their shares of taxable income on which they were originally assessed.

AAT decides – aligns with Commissioner

The AAT accepted the Commissioner’s contentions and increased the taxable income of:

  • the Participating Beneficiaries where section 97 applied; and
  • the trustee in respect of Participating Beneficiaries where section 98 applied.

The residuary beneficiary Joshline was not assessed to any of the increase.

Opaque expression of distributable income

The resolutions of the JFT during the Years were odd in that they expressed or specified distributions as amounts of assessable income to which (“trust law”) income (unspecified) was to equate to. The trust deed of the JFT supported this novel approach which was directed to tax planning and, in particular, to certainty of assessable income that each Participating Beneficiary would receive.

These resolutions did not specify distributable income and so obliged a backwards calculation from shares of “assessable income” of the JFT to ascertain the distributable income and the share of it each Participating Beneficiary was entitled to.

How distributable income can be distributed

“Trust law” income, referred to in the legislation as “a share of the income of the trust estate”, considered by the High Court in Bamford to be “distributable income” is, and was described in Bamford as:

income ascertained by the trustee according to appropriate accounting principles and the trust instrument

Bamford at paragraph 45

which can be distributed and which the trustee distributes to beneficiaries and by which the respective shares of assessable income of beneficiaries, and trustees on behalf of other beneficiaries of a trust, is determined under sections 97 and 98 respectively.

If, on a 30 June at the end of an income year (30 June), the trustee has a specified a prescription for the distribution of income of a FDT whether it be:

  • an amount (from);
  • a set proportion, say expressed in percentage terms; or
  • a residue or remaining amount;

of distributable income then that can be accepted understanding that, almost universally, the trustee will not have had the opportunity, by 30 June, to ascertain the distributable income of the FDT to a final figure or amount.

Timing of present entitlement to distributable income

Nevertheless:

  • distributions are FDT trustee decisions that need to be made by 30 June if the distributions are to confer present entitlement on beneficiaries in the year of income; and
  • beneficiaries must be presently entitled to a share of the distributable income for either of section 97 or section 98 to apply.

Section 99A will apply to a FDT to tax the income to which no beneficiary is presently entitled by 30 June to the trustee at the highest marginal income tax rate. See my post (My Lewski Post) about Lewski v. Commissioner of Taxation [2017] FCAFC 145 where that happened. Lewski was referred to by the AAT in Donkin: Full Federal Court pinpoints year end trust resolutions that fail https://wp.me/p6T4vg-8s

Setting distributable income by 30 June

It follows that to effectively confer present entitlement a trustee decision to distribute trust income under a discretion needs to determine the share of distributable income of each beneficiary by 30 June. That determination of the trustee is confirmed and applied when the trustee prepares accounts for trust purposes in accordance with the terms of the trust deed and, if beneficiaries are entitled to a proportion or a residue of distributable income rather than a fixed amount of distributable income, those entitlements can then be ascertained from distributable income or the remaining distributable income numerically.

Distributable income not set in Donkin

However, in Donkin, the Participating Beneficiaries had entitlements to a proportion of “assessable income” (viz. taxable income or “net income” for the purposes of sub-section 95(1) of the ITAA 1936) (Taxable Income).  For instance, under the resolutions Mr. Donkin was entitled to 70.11% of the Taxable Income, not distributable income, of the JFT for the 2013 income year. So in the Commissioner’s contention, as accepted by the AAT, Mr. Donkin was taxable under section 97 on:

  • $262,659 being 70.11% of the Taxable Income of the JFT for the 2013 year when an original assessment was raised on Mr. Donkin’s share of trust Taxable Income returned by the trustee of the trust; and then
  • $304,137 being 70.11% of the Taxable Income of the JFT for the 2013 year following the amendment of the assessments following the audit.

It can be inferred from and is consistent with the Commissioner’s contention that, on the amendment of Mr Donkin’s 2013 assessment in or around 2015, the distributable income of Mr. Donkin was increased at that later time – the proportion of Taxable Income, 70.11%, did not change.

But how can distributable income of a trust increase after 30 June income year end?

Understanding that the trustee of the JFT determined the distributable income of the JFT and Mr. Donkin’s share of it by 30 June 2013 by mechanisms in the trust deed fixing and thus making Mr. Donkin presently entitled to a share of income confirmable and confirmed when 2013 accounts of the JFT were taken, how can a 2015 amendment to Taxable Income of the JFT alter the 2013 distributable income of the JFT and the present entitlement of Mr. Donkin to it at 30 June 2013?

It seems to me that the AAT has set out good reasons why the Commissioner’s contentions to:

  • alter distributable income; and
  • increase the present entitlement of each Participating Beneficiary supposedly by the end of the relevant June 30;

should not have been accepted and there should have been no change in distributable income of the Participating Beneficiaries in the Years. In paragraphs 42 and 43 of the AAT’s decision, in a response to different propositions put by the Applicants, the AAT stated:

42. It seems to us that on the Applicants’ construction of the resolutions their alternative submission would be correct. That is to say, the resolutions would be ineffective to confer a present entitlement on the individual beneficiaries because they involved a contingency.

43. They would depend on the occurrence of an event which may or may not happen, in particular, the Respondent disallowing a deduction and including an additional amount in assessable income. It follows that the individual beneficiaries would not be “presently entitled” under ss 97 or 98 of the ITAA36 to a share of the income of the JFT.

Donkin & Others v. Federal Commissioner of Taxation [2019] AATA 6746 paragraphs 42-43

These findings do resonate against the Commissioner’s and the AAT’s construction of the resolutions and the trust deed too.

Construing trust income resolutions applying Bamford

The High Court in Bamford stated:

The opening words of s 97(1) speak of “a beneficiary of a trust estate” who is “presently entitled to a share of the income of the trust estate”. The language of present entitlement is that of the general law of trusts, but adapted to the operation of the 1936 Act upon distinct years of income. The effect of the authorities dealing with the phrase “presently entitled” was considered in Harmer v Federal Commissioner of Taxation where it was accepted that a beneficiary would be so entitled if, and only if,

“(a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and (b) the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment.”

Bamford at paragraph 37

So in whatever way the trust deed of the trust allows the trustee to ascertain distributable income, the trustee must identify distributable income, or use a method which enables identification of distributable income not subject to contingency, by 30 June to confer present entitlement by 30 June. Without that a beneficiary has no present legal right to demand and receive payment of their share of income by 30 June.

It is that identification of distributable income referred to in Zeta Force Pty Ltd v Commissioner of Taxation  (1998) 84 FCR 70 at 74‑75 to which the High Court in Bamford refers where the High Court cites Sundberg J. with approval:

The words ‘income of the trust estate’ in the opening part of s 97(1) refer to distributable income, that is to say income ascertained by the trustee according to appropriate accounting principles and the trust instrument. That the words have this meaning is confirmed by the use elsewhere in Div 6 of the contrasting expression ‘net income of the trust estate’. The beneficiary’s ‘share’ is his share of the distributable income.”

….

“Having identified the share of the distributable income to which the beneficiary is presently entitled, s 97(1) requires one to ascertain ‘that share of the net income of the trust estate’. That share is included in the beneficiary’s assessable income.”

….

from Bamford at paragraph 45

It is respectfully suggested that the later part of Sundberg J.’s findings cited by the High Court:

Once the share of the distributable income to which the beneficiary is presently entitled is worked out, the notion of present entitlement has served its purpose, and the beneficiary is to be taxed on that share (or proportion) of the taxable ncome of the trust estate.

from Bamford at paragraph 45

does not mean that the distributable income of a FDT is to be or can be derived from Taxable Income of the FDT unless that proportion must be quantified or quantifiable, maybe by backwards calculation, by 30 June. For instance, the trustee’s own estimate of Taxable Income on or before 30 June, which could be supported by evidence after the fact, could be a parameter of distributable income which must be fixed if not ascertained by 30 June to achieve present entitlement.

Distributable income at 30 June is then routinely reflected in the accounts of a FDT at 30 June and other evidence which later demonstates what the trustee fixed as distributable income at 30 June.

Why was there no distributable income calculation for each 30 June in Donkin?

The Commissioner too could have worked out the amount of, or the figure for, distributable income of the JFT consistent with resolutions and accounts for the Years and other evidence. including trust tax returns, prepared and lodged later. It is implausible that the trustee of the JFT took into account the 2015 inclusions in Taxable Income in its 2010 to 2013 decisions which the AAT correctly observed was a contingency at the each of the 30 Junes through the Years.

Section 99A should have applied

In my understanding:

  • the Participating Beneficiaries in Donkin were not presently entitled in the Years to a proportion of amounts first included in Taxable Income in around 2015 following the Commissioner’s audit and amendment of assessments: and
  • section 99A should thus have been applied to these proportions when they became Taxable Income in 2015.

Distributable income – no place for a variable parameter

The AAT appears to have accepted that distributable income can be a variable parameter which can fluctuate after 30 June; the Commissioner and the AAT accepted a distribution method in Donkin based on a set proportion of Taxable Income, a variable parameter, which, in their view, caused distributable income to vary after 30 June when assessments were varied following audit. This sanctioned the use of rubbery numbers for ascertaining shares of distributable income, which the trust deed of the JFT contemplated for opaque tax reasons, without applying section 99A which, in my understanding and based on this analysis, should have applied.

That is disappointing, especially on the urging of the Commissioner, as the AAT decisions may influence future practice and encourage rubbery distributions of distributable income and the use of contorted trust deed provisions that facilitate them.

Income equalisation clauses

Family discretionary trust deeds I have prepared for over thirty years, and deeds drawn by many other preparers, have long based distributions of distributable income on an income equalisation clause. I suggest that an income equalisation clause is, and has always been, a more conventional mechanism for practically dealing with the divergence between distributable income and Taxable Income in section 97 of the ITAA 1936 than the mechanisms contained in the trust deed of the JFT.

An income equalisation clause is a provision in a FDT trust deed which allows the trustee to align the distributable income of a FDT to Taxable Income.

The above analysis is also relevant to how an income equalisation clause using Taxable Income, a parameter that can change after a 30 June year end, should be construed. I addressed this question in My Lewski Post. There I concluded, based on the Full Federal Court’s views of how trust deeds and resolutions are to be construed, that Taxable Income in an income equalisation clause should be construed as Taxable Income based on knowledge of the trustee, informing the trustee’s decision at the time of the distribution, which is confirmed when accounts of the FDT for the relevant income year are taken and the mechanisms from the trust deed for determining distributable income are applied. On that construction Taxable Income is or should be fixed and present entitlement of beneficiaries to shares of distributable income of a FDT at 30 June can thus be attained.

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

BigBen

A mirror of the general principle of source and residence taxation broadly setting the parameters of international taxation, and reflected in Australia’s income tax law, is that income of a foreign resident not from sources in the state is not taxable in the state (in this post called the Mirror Principle). In Australia:

  • interests in real property in Australia and related interests; and
  • interests in assets used in business in permanent establishments in Australia:

are designated “Taxable Australian Property” (TAP) (see Division 855 of the Income Tax Assessment Act (ITAA) 1997). TAP is used in Australian income tax law to apply the Mirror Principle.

Foreign resident capital gains from non-TAP disregarded

Property which is not TAP, that is, property not taken to be connected to Australia for income tax purposes in the hands of foreign residents includes shares and securities as opposed to property interests in or related to Australian land or of permanent establishments carrying on enterprises in Australia which are TAP.

Capital gains made by foreign residents from non-TAP assets are disregarded for tax purposes: section 855-10.

Trouble pinpointing trusts as foreign or not

Trusts are elusive and create enormous difficulties in the international tax system see Trusts – Weapons of Mass Injustice. Trusts can detach beneficiaries who benefit from property who may be in one state from:

  • the trustee of the trust, in whose name the property is held, who may be in another state; and
  • the activities of trust which may be in yet another state.

Apt taxation of those activities in line with Mirror Principle thus poses a significant challenge to governments. States are justified imposing laws to counter offshoring with trusts to ensure the integrity of their tax systems.

Some states don’t recognise trusts.

In Australia trusts are mainstream. Some types of trusts are considered tax benign and conducive to legitimate business, investment and prudential activity. Fixed trusts are often treated transparently for Australian income tax purposes so that a fixed trust interest holder is:

  • taxed similarly to a regular taxpayer or investor; and
  • no worse off, tax wise, than a taxpayer or investor who owns the property outright rather than by way of a trust beneficial interest.

So, consistent with the Mirror Principle that a foreign resident owner of non-TAP who makes a gain on the non-TAP shouldn’t be taxable on the gain, a foreign resident beneficiary (FRB) of a fixed trust can disregard a capital gain made in relation to their interest in a fixed trust: section 855-40.

Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation

In the Federal Court case Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation [2020] FCA 559 this week the issue arose whether an Australian resident family discretionary trust – a non-fixed trust, was entitled to rely on section 855-10 and the Mirror Principle to disregard capital gains distributed to a FRB, a beneficiary based in London, of the trust from realisation by the trust of shares in a private company, GCPL, which were non-TAP of the trust.

Detachment of capital gains from the workings of trust CGT tax rules

The capital gains of a trustee are distant from the capital gains of a beneficiary under the ITAA 1936 and the ITAA 1997. Transparent treatment or look through to the capital gains of the trustee as capital gains of the beneficiary/ies became even more remote following changes to Sub-division 115-C of the ITAA 1997 including the introduction of Division 6E of Part III of the ITAA 1936.

These changes brought in distinct treatment of capital gains and franked distributions of a trust from other trust income following the High Court decision in Commissioner of Taxation v Bamford [2010] HCA 10 and the clarification of taxation of trust income in that case.

Legislation unsupportive of transparent treatment

In Greensill Thawley J. analysed the provisions in Sub-division 115-C and Division 6E to deconstruct the applicant’s case to disregard capital gains using Division 855. 

Section 855-40 specifically allows a FRB of a fixed trust to disregard non-TAP capital gains. The absence of an equivalent exemption for FRBs of non-fixed trusts is telling unless section 855-40 is otiose or represents an abundance of caution. Thawley J. did not follow that line. As the applicant in Greensill could not disregard the capital gains using section 855-40 in the case of non-fixed trust, or section 855-10, the capital gains were taxable in Australia.

Unless there is an appeal to the Full Federal Court the Commissioner can finalise his draft taxation determination TD 2019/D6 Income tax: does Subdivision 855-A (or subsection 768-915(1)) of the Income Tax Assessment Act 1997 disregard a capital gain that a foreign resident (or temporary resident) beneficiary of a resident non-fixed trust makes because of subsection 115-215(3)? as the Federal Court has accepted the view in it.

Closely held trusts, “family trusts” and circular trust distributions – a tax net nuanced again for the compliance burden

trusts guardrail

In Australia the income taxation of trusts is based on the trust being a conduit with look-through to beneficiaries of the trust who are presently entitled to the income of the trust. In the standard case of an adult resident beneficiary of a trust, the beneficiary is taxed on trust income and the trust is broadly treated as a transparent entity and isn’t taxed.

Even where a beneficiary is:

  • not an adult; or
  • not a tax resident;

the trustee of the trust pays tax though ostensibly on behalf of the beneficiary entitled to trust income at the rate applicable to the beneficiary and the beneficiary is entitled to a credit for tax paid on that income should the beneficiary file his, her or its own tax return.

Tax capture when no beneficiary entitled to the income

Look-through taxation of income doesn’t work when there is no beneficiary presently entitled to income of the trust to look through to. Under the Australian system, in these cases, the trustee of a trust pays tax at the highest marginal rate on income plus applicable levies including medicare levy. That is where no beneficiary is presently entitled to the income of a trust under section 99A of the Income Tax Assessment Act 1936.

The trustee beneficiary complication

Trusts can be beneficiaries of other trusts. These beneficiaries are “trustee beneficiaries” of a trust.

Example

  • The trustee of trust B is a beneficiary and so is a trustee beneficiary of trust A.
  • C, a beneficiary of trust B, takes (is presently entitled to) a share of the income of trust A.
  • C may be an individual or a company, viz. an ultimate beneficiary, or may be a further trust – a further trustee beneficiary.

It is then necessary to trace trust income of trust A through trustee beneficiaries to find if there is an ultimate individual or company beneficiary entitled to that income. There may be no ultimate beneficiary entitled to income and the case of a “circular” trust distribution is a case in point.

The circular trust distribution by trusts

A definitive example of a circular trust distribution of income is where:

  • trust X distributes income of trust X to trust Y; and
  • trust Y distributes its income (back) to trust X.

There is thus no ultimate individual or company beneficiary. The income is in a state of flux.  Nonetheless it is clear no beneficiary is presently entitled to the income and the highest marginal rate and applicable levies imposed under section 99A should be applicable to a circular trust distribution of income under the regime so far described.

That is a fair point in principle but a circular trust distribution, or any distribution to a trustee beneficiary that isn’t on-distributed to an ultimate beneficiary, is not necessarily readily traceable and identifiable as income to which no beneficiary is entitled. That is especially so where a labyrinthine structure of numerous trusts is used to conceal who is entitled to trust income and that there is no ultimate beneficiary who is not a trustee beneficiary entitled to trust income.

The legislative countermeasures

Countermeasures in the below legislation apply to support the integrity of flow through taxation of trusts. These countermeasures were introduced in Division 6D of Part III of the Income Tax Assessment Act 1936 which has lead to these new taxes:

  • firstly, the ultimate beneficiary non-disclosure tax when introduced with the A New Tax System (Closely Held Trusts) Act 1999 (see below); and
  • currently the trustee beneficiary non-disclosure tax as introduced to reform the ultimate beneficiary non-disclosure tax under the Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No. 1) 2007 and the Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No. 2) 2007.

These taxes were or are in substance proxies for tax on the trustee under section 99A for presumed lack of present entitlement of an ultimate beneficiary to ensure that income of a trust does not escape income tax either:

  • for want of an ultimate beneficiary entitled to the income; or
  • because of the opaque lack of an ultimate beneficiary where a trustee beneficiary may seem to be an ultimate beneficiary in the tax return of the trust.

Like the rate that applies under section 99A the rate of trustee beneficiary non-disclosure tax is the highest marginal rate plus applicable levies including the medicare levy.

The countermeasures also include a concept of “trustee” group which expands liability for trustee beneficiary non-disclosure tax to corporate directors of trustees of closely held trusts personally: an impost beyond the section 99A impost for falling under the purview of these anti-avoidance provisions.

A New Tax System (Closely Held Trusts) Act 1999

The first legislation to grapple with the tracing problem was in the A New Tax System (Closely Held Trusts) Act 1999 which introduced a wide and indiscriminate ultimate beneficiary statement reporting obligation on all closely held trusts.

Closely held trusts

A trust is a closely held trust if it:

  • is a discretionary trust, or
  • has up to 20 individuals who, between them, directly or indirectly, and for their own benefit, have fixed entitlements to a 75% or more share of the income or a 75% or more share of the capital of the trust;

where the trust is not an excluded trust. Examples of excluded trusts are complying superannuation funds and, for their first five years, deceased estates.

Reset of the closely held trust compliance burden

In response to sustained complaints from many trustees of trusts which did not distribute to trustee beneficiaries and their advisers, the federal government came to amend the regime in 2007 so that only trustees of closely held trusts which distribute income to:

  • trustee beneficiaries;
  • where the distribution includes an “untaxed part”;

have reporting obligations to file a trustee beneficiary (TB) statement. TB statements need to be filed with a tax return and, in the case of resident trustee beneficiaries, need to disclose the following about the trustee beneficiary:

  • name,
  • tax file number,
  • the untaxed part of their share of trust income; and
  • their share of tax preferred amounts;

and to withhold trustee beneficiary non-disclosure tax and to pay it to the Commissioner of Taxation where the relevant trustee beneficiary fails to provide the information for the TB statement when it is sought by the (distributor) closely held trust.

This more nuanced or targeted solution imposes a less onerous compliance burden on closely held trusts than the 1999 measures did.

Further, in accord with policy to treat “family trusts” viz. trusts that have

  • a valid family trust election; or
  • a valid interposed entity election;

in force or that otherwise forms part of a “family group” less onerously, family trusts were excluded trusts to which the closely held trusts regime did not apply following the 2007 reform.

2018-19 Budget changes to closely held trusts

Following an announcement in the 2018-19 Federal Budget, the closely held trust arrangements have been further tweaked by the Treasury Laws Amendment (2019 Tax Integrity and Other Measures No. 1) Act 2019. Under these changes it is still the case that family trusts still do not have to comply with the TB statement reporting requirements however family trusts are no longer excluded trusts.

That means that a family trust that is a closely held trust (which will often be the case) must now comply with the closely held trust obligations but a family trust remains relieved from the obligation to file TB statements and pay trustee beneficiary non-disclosure tax on omission to file a TB statement. Despite that a family trust is now liable for trustee beneficiary non-disclosure tax on circular trust distributions under section 102UM of the Income Tax Assessment Act 1936 but not on distributions received from other trusts (which are not circular and to which section 102UM does not apply).

How will compliance with the changes work?

It is perhaps unusual that the changed closely held trusts regime relieves a family trust, no longer an excluded trust and that distributes income to a trustee beneficiary, from filing a TB statement. The Commissioner of Taxation will have no TB statement to aid detection of a taxable circular distribution back to the family trust. Further, in the case of family trusts, the Commissioner won’t obtain TB statement level information about distributions by family trusts to trustee beneficiaries that are not circular or the opportunity to impose the trustee beneficiary non-disclosure tax on those distributions as a matter of course on the omission to file a TB statement.

Nevertheless the Commissioner of Taxation will have trustee beneficiary contact details and perhaps a tax file number, or will be alerted by the absence of a tax file number; from the tax return of a closely held trust family trust. The Commissioner can trace a distribution and ascertain when a circular trust distribution by a family trust occurs by investigative activity. Further, risk of family trust distributions tax liability under Schedule 2F of the Income Tax Assessment Act 1936 makes it less likely that a family trust will make a distribution liable to that tax, particularly a distribution of a tax preferred amount, to a trustee beneficiary that is:

  • outside of the family group; and
  • where that trustee beneficiary’s tax file number is not known by the trustee of the trust and reported in the trust tax return.

Changing the trustee of a trust – some elements for success

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

  • a family discretionary trust (FDT); or
  • a self managed superannuation fund (SMSF) (which must be a trust with a trustee too – see sub-section 19(2) of the Superannuation Industry (Superannuation) Act (C’th) 1993 (SIS Act));

and that a change of trustee will have no serious tax consequences. The second proposition is more likely to be true, but not always.

FDTs and SMSFs invariably commence with a deed which contains the terms (the trust terms or governing rules – TTOGRs) on which the trust commences. That, in itself, is a reason why I contended in 2009 in Redoing the deed that an instrument or resolution less than a deed to change the trustee is prone to be ineffective even where change by less than or other than a deed is stated to be permitted by the TTOGRs in the trust deed.

Changing trustee relying on ability to change in the trust deed

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

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

Changing trustee relying on the Trustee Acts

If ability to change trustee is not present, or is derelict, in the TTOGRs then the Trustee Acts in states (and territories) provide options for appointing a new or additional trustee which vary state to state.

Trustee Act – New South Wales

In New South Wales: section 6 of the Trustee Act (NSW) 1925 allows a person nominated for the purpose of appointing trustees in the TTOGRs, a surviving trustee or a continuing trustee to appoint a new trustee in certain specified situations such as where a trustee:

  • has died;
  • is incapable of acting as trustee; or
  • is absent for a specified period out of the state.

However an appointment of a new trustee in these situations must be effected by registered deed: sub-section 6(1) That is the deed of appointment must be registered with the general registry kept by the NSW Registrar-General, which is publicly searchable, and the applicable fee to so register the deed must be paid to NSW Land Registry Services for the appointment to take effect.

It is apparent from sub-section 6(13) that registration of a deed of appointment is not required where ability to appoint a new trustee is in the TTOGRs where the TTOGRs express a contrary intention; that is: where the TTOGRs expressly and effectively allow an appointment to be effected without a registered deed.

Trustee Act – Victoria

In Victoria there is a comparable capability for a person nominated for the purpose of appointing trustees in the TTOGRs, a surviving trustee or a continuing trustee to appoint a new trustee in writing in certain specified situations such as where a trustee:

  • has died;
  • is incapable of acting as trustee; or
  • is absent for a specified period out of the state;

under section 41 of the Trustee Act (Vic.) 1958. However this Victorian law does not impose any requirement that the required instrument of appointment in writing must be registered.

Changing trustee by obtaining a court order

The supreme courts of the states and territories are also given a residual statutory capability to appoint trustees under the respective Trustee Acts. However applying to a supreme court for an order to change a trustee of a FDT or a SMSF with sufficient supporting grounds is an option of last resort given likely significant costs and uncertainties of obtaining the order.

Changing trustee by deed

The TTOGRs in a trust deed of a FDT or a SMSF will frequently require that an appointment of a new trustee may or must be effected by a deed. It is desirable that it should do so to ensure the appointment of a new trustee does not become of a matter of uncertainty and difficulty for the reasons I have described in Redoing the deed.

Tax consequences of a change of trustee

As a change of trustee without more generally does not change beneficial entitlements under a trust, the tax consequences are usually benign:

For capital gains tax (CGT), assurance that changing trustee does not give rise to a CGT event for all of the CGT assets held in a trust is diffuse under the Income Tax Assessment Act (C’th) (ITAA) 1997:

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

(2) You dispose of a * CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner.

Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event A1 will not happen merely because of a change in the trustee.

Sub-section 960-100(2) with the Notes below it in fact say:

(2) The trustee of a trust, of a superannuation fund or of an approved deposit fund is taken to be an entity consisting of the person who is the trustee, or the persons who are the trustees, at any given time.

Note 1: This is because a right or obligation cannot be conferred or imposed on an entity that is not a legal person.

Note 2: The entity that is the trustee of a trust or fund does not change merely because of a change in the person who is the trustee of the trust or fund, or persons who are the trustees of the trust or fund.

Similarly sections 104-55 and 104-60 of the ITAA 1997 which concern:

• Creating a trust over a CGT asset: CGT event E1

• Transferring a CGT asset to a trust: CGT event E2

each restate the above Note: viz.

Note: A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2)). This means that CGT event E… will not happen merely because of a change in the trustee.

Stamp duty

A change of trustee can have stamp duty consequences where the trust holds dutiable property such as real estate.

Duty – NSW

Concessional stamp duty on the transfer of the dutiable property of the trust to the new trustee can be denied in NSW to a FDT unless the trust deed of the trust limits who can be a beneficiary, for anti-avoidance reasons: see sub-section 54(3) of the Duties Act (NSW) 1997.

Indeed Revenue NSW withholds the requisite satisfaction in sub-section 54(3) unless the TTOGRs provide or have been varied in such a way so that an appointed new trustee or a continuing trustee irrevocably cannot participate as a beneficiary of the trust. Contentiously satisfaction is withheld by Revenue NSW unless a variation to a FDT to so limit the beneficiaries is “irrevocable“ : see paragraph 6 of Revenue Ruling DUT 037, even though that variation may not be plausible or permissible under the TTOGRs of the FDT.

This hard line is taken by Revenue NSW to defeat schemes where someone, who might otherwise be a purchaser of dutiable property who would pay full duty on purchase of the property from the trust, becomes both a trustee and beneficiary able to control and beneficially own the property who is thus able to contrive liability only for concessional duty and avoid full duty,

Duty – Victoria

Although the Duties Act (Vic.) 2000 contains anti-avoidance provisions addressed at this kind of anti-avoidance arrangement, there is no comparable hard line to that in NSW in sub-section 33(3) of the Duties Act (Vic.) 2000 so that the transfer of dutiable property, including real estate, on changing trustee is more readily exempt from stamp duty.

Other requirements

A prominent requirement on changing trustee of a SMSF is notification to the Australian Taxation Office, as the regulator of SMSFs, within twenty-eight days of the change: see Changes to your SMSF at the ATO website.

Where changing trustee involves a corporate trustee then there may also be an obligation to inform the Australian Securities and Investments Commission of changes to details of directors of the corporate trustee, if any. There may be further matters to be addressed if any new or continuing directors are or will become non-residents of Australia and, with SMSFs, the general requirement in section 17A of the SIS Act that the parity between members of the fund on the one hand and trustees, or directors of the corporate trustee on the other, needs to borne in mind and, if need be, addressed.