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

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:

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

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.

Declarations of trust and stamp duty on disguised conveyances

Each of the state and territory duty jurisdictions include declarations of trust over dutiable property (typically real estate) as dutiable transactions in one form or another. Without a declaration of trust head of duty, or an apt anti-avoidance provision, conveyancing duties that would by paid on a transfer of the dutiable property to B can be avoided by A declaring that property is held on trust for B though still held legally (on title) by A. Duty on a declaration of trust generally applies at full rates chargeable against the value of the dutiable property and differs from the head of duty which applies to declarations of trust which are not made over dutiable property to which a concessional duty or, in some states and territories, no duty will apply.

Duty eagerly assessed on the mention of a trust

So the Commissioners of State Revenues Australia wide are eager to assess any document to duty which purports to contain a declaration of trust over dutiable property which could be viewed as either:

a transfer of beneficial interest in the property in substance; or
a disguised transfer.

Integrity of the state revenues

That zeal can be understood in the context of the integrity of state revenues. In New South Wales, where a “declaration of trust” is a dutiable transaction under section 8 of the Duties Act 1997, Revenue NSW will treat documents which foreshadow or even just mention a trust over dutiable property as dutiable. Hence those who have an eye to the duty implications of deeds and documents that impact dutiable property are justifiably cautious about using the expression “on trust” in a deed or document where dutiable conveyance of the beneficial ownership of dutiable property by that document is not intended.

Ambit declaration duty rejected in W.A.

A recent case in Western Australia shows that duty on documents that state that dutiable property is held on trust can be too readily assessed as a declaration of trust by state revenue. The W.A. Court of Appeal in In Rojoda Pty Ltd v. Commissioner of State Revenue (WA) [2018] WASCA 224 decided against the Commissioner where two deeds of dissolution of partnership in that case explicitly stated that a partner, the surviving registered owner of land, held dutiable property on trust for other surviving partners of the partnerships. The Court of Appeal found that the dissolution of two partnerships involving family members, whose business included property ownership and investment, were not declarations of trust and were not dutiable as declarations of trust over dutiable property.

It was determinative in Rojoda that the trusts recited in the deeds were confirmatory of trusts that already existed. It was significant that the Court of Appeal, in overturning a decision by the State Administrative Tribunal, was prepared to examine the equitable implications and the relevant legal and beneficial interests of the partners just before and on the execution of the deeds of dissolution of the partnerships. The Court of Appeal found that the legal and beneficial interests of the partners, just before the deeds were executed, were sufficiently comparable to the interests set out to be on trust in the deeds and thus held the deeds established no new trusts and thus did not declarations of trust in the context of the W.A. head of duty.

Identifiable new trust needed for a dutiable declaration of trust

The land had been used as partnership property of the partnerships. The Court of Appeal found that the wife, who was the surviving registered proprietor of the land, already held the land for the partners, which included the children of the wife and the husband, or their representatives. They thus had specific and fixed beneficial or equitable interests in the partnership properties before the deeds prepared for the dissolution of the partnerships were executed. These interests, reflecting their respective proportionate share of partnership property, were comparable interests to those said to be held on trust in the deeds. Thus the Court of Appeal found the trusts set out in the deeds were not new trusts declared over property dutiable in W.A.

The High Court has granted the Commissioner of State Revenue special leave to appeal in Rojoda. This case will likely inform what amounts to a declaration of trust dutiable in state and territory stamp jury jurisdictions.

Should more than one family share a family discretionary trust?

From time to time a family discretionary trust is set up for the benefit of two or more families who may be pursuing a business or a venture in common.

Risk of unequal returns from the discretionary trust!

A double (or more) -throated family discretionary trust is unwise on a number of levels and often reflects misunderstanding of the tax and civil dispute realities that can apply to trusts.

If there is a dispute between the business/venture principals then backing out of this kind of structure it can lead to complications where there are assets in the discretionary trust still to be divided and distributed to beneficiaries. One of the principals controlling the trustee may die or become incapacitated and the other principal may take the opportunity to distribute the assets of the trust solely to his or family! The other family may claim, say, that they should get 50% of the assets of the trust, or the value of the work contributed by them to the trust, but the trust document, being based solely on discretion, will disavow that any family has a 50% or other set interest in the trust.

A family discretionary trust is often funded by gift from the beneficiary family or by the unrewarded work of a member of the beneficiary family. That may be but there is no obligation on the trustee to return the capital or the income of the discretionary trust in proportion to those contributions to that family. The families are highly reliant on the arrangements for control of the trustee, who holds the discretion to distribute the income and capital of the trust, to ensure members of each family will participate in the income and capital of the trust on any equal basis.

A hybrid trust is an alternative to a multi family family discretionary trust which addresses such problems but hybrid trusts have their own separate set of commercial and tax difficulties.

Reimbursement agreements

Multi-family family discretionary trusts can be at high risk of audit under the “reimbursement agreement” provisions in s100A of the Income Tax Assessment Act 1936. Income distributions by the trust could be used to shift value between the families tax effectively however, if section 100A is applied, the distributions are void for tax purposes. The principals and their families, as beneficiaries, can’t resist a section 100A assessment with the usual defence based on the definition of “agreement’ in sub-section 100A(13) viz. that the distribution reflects an ordinary dealing within the family, because it does not. They are dealing between families.

Sometimes these structures are used to save establishment costs notably stamp duty which in NSW is as much as $500 to establish a trust where the trust holds no dutiable property. Such savings may prove inadvisable due to later considerable cost.

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

Annual income distributions by family discretionary trusts (FDTs) are routine for trustees for apparent Australian income tax reasons but trustees of FDTs can be reluctant to distribute trust capital. What would be the reason for that reluctance? Why don’t trustees of FDTs make capital distributions more often?

The trust deed

The regime in a FDT deed typically centres on distribution of capital on the vesting of the FDT. However even older and archaic FDT deeds usually expressly allow for interim distribution of capital, that is, distribution of trust capital before the FDT vests and winds up. Interim distribution of capital to beneficiaries, rather than holding it for them until the vesting day, is often conditional on the distribution being for the “maintenance education advancement in life or benefit” either for infant beneficiaries or for beneficiaries generally – see Fischer v Nemeske Pty. Ltd. [2016] HCA 11: a condition which, in ordinary family dealings, can readily be met.

Purpose of a FDT

A FDT is, in its essence, an arrangement to benefit family members. A FDT can be seen as a pool set aside to gift to family members. But is a distribution to a family beneficiary from a FDT treated the same for tax as a family gift to a family member?

It is useful to think about differences between a FDT and other types of entities before answering that:

Difference to a proprietary company

A proprietary company has the legal status of a separate person and the release of company capital to a shareholder of a company is subject to a number of corporations law and tax technicalities. A company can have wide objects but giving its value away to other persons would not usually be one of them. Under tax rules the enrichment of a shareholder’s family member from a company’s capital is likely dividend income assessable to income tax either directly or as a “payment” under section 109C of the Income Tax Assessment Act 1936.

Difference to a unit trust

A trustee of a genuine unit trust would generally be required to make capital distributions in equal proportions based on the unit holdings of unit holders. If capital distributions from a unit trust are feasible the capital gains tax (CGT) rules can discourage the trustee from making these distributions before vesting. CGT event E4 applies to distributions of capital of a unit trust which are not in connection with the disposal of the units to reduce the cost base of the unit holder by the amount of the distribution and, to the extent the cost base doesn’t cover the amount of the distribution, the excess is a capital gain assessable to unit holders.

How CGT applies to distributions of capital by FDTs

CGT event E4 does not apply to non-assessable capital distributions from a FDT. In Taxation Determination TD 2003/28 Income tax: capital gains: does CGT event E4 in section 104-70 of the Income Tax Assessment Act 1997 happen if the trustee of a discretionary trust makes a non-assessable payment to: (a) a mere object; or (b) a default beneficiary? the Commissioner of Taxation confirms his longstanding view and practice, since the introduction of CGT in 1986, that CGT event E4 does not happen if a trustee of a discretionary trust makes a non-assessable payment to a mere object. That is, a mere discretionary beneficiary where the entitlement to the payment arose because the trustee exercised its discretion in the beneficiary’s favour and the interest was not acquired by the beneficiary for consideration or by way of assignment.

The CGT similarity of FDT cash distributions and cash gifts

The enrichment of a family beneficiary of a FDT by an interim distribution of the capital of a FDT is not, of itself, subject to CGT based on TD 2003/28 i.e. there is no CGT on a distribution of cash to a beneficiary from the capital of a FDT. If there is a distribution of a CGT asset from the capital of a FDT to a beneficiary that is a different story. CGT events E5 and E7 can apply to subject the realisation of the CGT asset by the FDT to a family beneficiary to CGT (see sub-sections 104-75(3) and 104-85(3) respectively of the Income Tax Assessment Act 1997 which visits the CGT event on the the trustee of the trust – sub-sections 104-75(6) and 104-85(6) generally enable the beneficiary of a FDT to disregard a capital gain or capital loss under either of these CGT events where the beneficiary acquired the asset within the trust without incurring expenditure viz. on a capital distribution by the trustee the beneficiary is treated only as the acquirer of the asset for CGT purposes).

But there is no fundamental difference between a distribution of a CGT asset from the capital of a FDT, and the CGT events that apply to it, and how a family gift of a CGT asset by an individual is treated for CGT. That is, a gift of cash is CGT free and a gift in the form of property that is a CGT asset is subjected to CGT: not because of the gift but because a CGT asset is being realised and the CGT regime brings gains in value on a CGT asset to tax on a change of ownership.

So cash distributions of capital by a FDT, where permissible under a trust deed of a FDT, can generally occur, either with income year end income distributions or at other times during the currency of a FDT, without income tax consequences.

However there is a problematic exception:

Small business CGT concessions participation percentage

Under item 2 in the table in section 152-70 of the Income Tax Assessment Act 1997 the “small business participation percentage” of a beneficiary of a FDT is the smaller of the percentages of the beneficiary’s entitlement to income and the beneficiary’s entitlement to capital in an income year if both income distributions and capital distributions are made in that year. Generally beneficiaries are better off qualifying for a sufficient small business participation percentage to qualify for the concessions if no distribution of capital, or no divergent distribution of capital (bearing in mind that a capital gain on an active asset distributed by a FDT is likely to have a capital component), has been made in the income year the relevant capital gain has been made in to some other beneficiary.

So if a capital gain arises to a FDT in an income year which can attract the small business CGT concessions in Division 152 of that Act, then a distribution of the income in that income year substantially to family member A, including entitlement to a capital gain, may not count or count sufficiently in the measurement of small business participation percentage where a cash distribution of capital has been made to family member B and not family member A who is left with a “smaller” participation percentage. It could be that family member A may thus not qualify as a significant individual or as a CGT concession stakeholder without the sufficient interest in capital distributions of the FDT in the relevant income year in which the capital gain was made.

So a trustee of FDT needs to be wary of cash distributions of capital from a FDT and, indeed, the streaming of capital gains where there has been a capital gain that can attract the small business CGT concessions to ensure that the desired beneficiaries have sufficient entitlements to capital that can attract the concessions. If the small business CGT concessions participation percentage is not in issue a cash distribution from from the capital of a FDT to a beneficiary can be a tax benign.

How perpetuities law limits can impact trust distributions to other trusts

Vesting of trust property

Perpetuities laws apply in Australian states to limit the period by the end of which interests in property of a trust must vest in a beneficiary. As I mentioned in my March 2018 post on bringing trusts to a timely end, “vest” broadly means to imbue with ownership of property. So, when property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.

Discretionary trusts are subject to an eighty year maximum perpetuity period

The maximum perpetuity period (MaxPP) under each perpetuity law is the maximum period by the end of which property held on trust must vest. As I observe in my March 2018 post, property of a trust can already be vested in beneficiaries but, in the case of property of an ongoing discretionary trust, where there is a discretion to distribute income or capital to discretionary beneficiaries; the property held on the trust has not vested.

The MaxPP is consistently eighty years from when the trust commences under state perpetuities laws excepting South Australia where the perpetuity law has been repealed.

Where a disposition of property held by a discretionary trust does not vest within the MaxPP then the disposition of property to the trust is void under the perpetuities laws. That is the trust fails over that disposition and the property that was supposedly to be held on the trust is vested in and held for return to the settlor and the others who have given it to the supposed trustee.

“Wait and see” rule

The states that have a perpetuity law also adopt a “wait and see” rule to soften the harsh outcome of causing a trust over property, which might fail to vest the property within the MaxPP, to be void. Under the “wait and see” rule persons interested can wait until the expiry of the perpetuity period to see whether a disposition of property on trust has vested. If the property has not vested in a beneficiary by then, then the affected disposition of property to the trust is void.

The perpetuities complication of trusts as discretionary beneficiaries of a trust

Many family discretionary trust arrangements allow distribution of income or capital of the trust to other trusts.

Example

Let us say Trust A and Trust B:

are family discretionary trusts that commenced in 2010 and 2015 respectively;
to which the law of Queensland applies;
with each specifying a perpetuity period for the vesting of their property of eighty years from their commencement.

Trust B is a beneficiary of Trust A and in 2018, the trustee of Trust A exercises its discretion and distributes some of the 2018 income of Trust A to Trust B.

Under the perpetuities law the MaxPP is eighty years. The income of Trust A, which was the property of Trust A, must vest in accordance with that law and under its perpetuity period term by 2090. But, following the distribution to Trust B the prospects are that the trustee of Trust B:

may not vest the income received from Trust A by 2090 even though 2090 is the expiry of the MaxPP applicable to property (that wasn’t vested in a beneficiary) that was held in Trust A; and
is not obliged to vest the property of Trust B under the perpetuity period applicable to Trust B before 2095.

If the trustee of Trust B hasn’t vested the income received from Trust A by 2090, the disposition of that income from Trust A to Trust B is void as the property of Trust A hasn’t vested by the expiry of the MaxPP for Trust A when the “wait and see” rule no longer has effect. But does that prospect invalidate that disposition at an earlier point in time because Trust B, which has received the property which must vest by 2090, is not slated to definitely vest until 2095?

Nemesis Australia Pty Ltd

This situation was considered by the Federal Court in Nemesis Australia Pty Ltd v Commissioner of Taxation [2005] FCA 1273. In that case the Commissioner asserted that distributions by the Steve Hart Family Trust to other trusts that were discretionary beneficiaries of the Steve Hart Family Trust, each of which had perpetuity periods which extended beyond the MaxPP applicable to the Steve Hart Family Trust, were too remote i.e. violated the perpetuities law and were thus void.

The Commissioner contended that the “wait and see” rule should not save the distributions where the source Steve Hart Family Trust and the relevant receiving beneficiary trust, looked at together, prescribed a period longer than the allowable eighty years applicable to the disposition in the deed of the Steve Hart Family Trust.

Tamberlin J. rejected the Commissioners contention and found that the “wait and see” rule applied to prevent the perpetuities law from invalidating the dispositions even though the receiving trusts might not vest the property they had received from the Steve Hart Family Trust before the expiry of the eighty year MaxPP applicable to property held in the Steve Hart Family Trust. The “wait and see” rule could apply because the trustees of the receiving trusts could act to advance their vesting dates so as to bring them within that MaxPP applicable to property they received from the Steve Hart Family Trust.

Inferences from Nemesis Australia

It follows from Nemesis Australia that the distribution in my example from Trust A to Trust B won’t be void under the perpetuities law as “wait and see” applies even though the income Trust B has from Trust A might not vest until 2095.

Should the trust deed of Trust A constrain distributions to trusts that may vest outside of the eighty year MaxPP applicable to property in Trust A?

Where Trust A distributes income of Trust A to Trust B and a beneficiary B1 of Trust B is presently entitled to that income of Trust B, which originated in Trust A, then B1 has an interest which has vested thus there is no need to “wait and see” any longer to see if the interest has vested: that disposition does not offend the perpetuity law. Where, however, Trust A distributes income or capital of Trust A to Trust B which does not vest in individual or corporate beneficiaries before the MaxPP applicable to Trust A expires then that income or capital will inadvertantly revert to the settlor or to other persons who have funded Trust A.

So the inclusion of a mechanism in discretionary trust deeds which synchronises vesting dates applicable to particular interests in income or capital that are distributed to other trusts with a later vesting day may avoid inadvertant ownership outcomes and liabilities when source discretionary trusts reach the end of their MaxPP. Following Nemesis Australia more radical restriction and control of discretionary trust distributions to other trusts as discretionary beneficiaries does not appear necessary.

Bringing trusts to a timely ending

Ending a trust is straight forward, isn’t it? Vest all interests in the trust in beneficiaries and make the right accounting entries and the trust is terminated? Not quite.

That word “vest”. What does it mean? Vest is a technical legal term. Broadly it means to imbue with ownership of property. So, when a trust ends and the property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.

But not all trusts end that way. For instance a unit trust or an unpaid present entitlement may already be vested in a beneficiary or beneficiaries. Clearly something other than vesting is needed to bring trusts of that type to an end. In those cases property that has already vested in beneficiaries may need to be paid to or put in the possession of the beneficiaries too for the trust to end.

Ending is all in the timing

In most states and territories of Australia trusts must vest within a statutory perpetuity period, typically 80 years. From this point this post relates to jurisdictions where a statutory perpetuity period applies.

Trusts that are fully vested, such as bare trusts, fixed trusts, some sorts of unit trusts and “indefinitely continuing” superannuation funds may continue for longer than the perpetuity period. A discretionary trust must vest no later than the perpetuity period, that is, discretions to distribute all income and capital of the trust must be taken and sunset once the time for vesting has been reached otherwise it will be too late and the formula for distribution for “takers-in-default” set out in the trust deed will apply to the property then left in the trust. The divesting of those interests, which are then held by the trustee outright for those beneficiaries, by payment over to, or at the direction of, the beneficiaries, can happen later after the expiry of the perpetuity period.

Bringing forward the ending of a trust

The trust deed should also set out how the time for vesting can be brought forward from the expiry of the perpetuity period. That time of expiry will usually be the “default” time for vesting, or a time just before it, (the last vesting time) in a well-crafted discretionary trust deed.

An objective of winding up a trust is to satisfy all parties with interests, in the wider sense, in the trust, including creditors, trustees, beneficiaries and the Commissioner of Taxation.

Failure to address these interests of the parties interested, or the trust deed requirements and formalities for the bring forward of the time of vesting, can mean that the trust, or its aftermath, will remain a matter in contention or dispute which is diametrically not what a trustee will want to occur following their effort to bring the trust to an end. A trustee can face difficulty in the converse case too where a trust is inadvertently brought to an end prematurely. In other words trustees can face problems where a trust has a mistimed ending either way. A trust may go on longer than planned or it may be inadvertently brought to an end before the trust should end. An example of the latter is to be found in trust deeds which set an inexplicably early time for vesting many years prior to the expiry of the perpetuity period.

Ending by depletion and merger

Depletion and merger are two other ways a trust may be brought to an end even where the intent of the trustee and beneficiaries is, and the trust deed may suggest that, the trust is to go on for longer.

Depletion is where the trustee no longer holds property on trust. If trust property is depleted and the trustee acquires more property on trust, the arrangement is treated as a new and separate trust. A “resettlement” occurs as well as likely confusion about which trust is which. Hence the device of a “settled sum” for a discretionary trust, which remains as trust property, to ensure continuity of the (original) trust even where the trust is in deficiency and has no other identifiable property.

Merger also brings a trust to an end in an untimely and premature way. Merger occurs where the trustee and the beneficiary are or become the same person. In the case of a merger the trust obligation of the trustee under the terms of the trust is no longer owed to the beneficiary so the trust does not continue.

Merger and SMSFs with individual trustees

Merger can be an interesting issue in the case of a self managed superannuation fund with individual trustees. There is no merger while the fund has two trustees: Trustee A has trust obligations to member B and trustee B has trust obligations to member A. However if a trustee/member dies and the surviving sole trustee is also the sole member of the fund with a fully vested beneficiary account of the entirety of the fund, the fund likely merges. It follows that the fund is no longer a trust. The Commissioner of Taxation has not addressed how the doctrine of merger may apply in these cases, and, as I understand it, the Commissioner treats a fund in this situation as continuing on as a matter of administrative convenience. If the Commissioner’s approach, which may be tantamount to a recognition of a self managed superannuation fund that is not a trust, came before the courts, it is unclear how it might be explained or permitted.

Some starting points

Trusts that require winding up usually commence by and are governed by a trust deed. I am not writing here of testamentary trusts. A trust deed will usually state the requirements to wind up the trust including how the time of vesting must be brought forward. A trust deed may also provide for other things which complicate vesting or winding up, or both. The trust deed may require that a party’s consent is required before either can happen. There may be other forerunner steps which haven’t been taken which must be taken before the trust can vest under the deed. A grasp of the design or method of the trust provisions in the trust deed will build confidence that all requirements for a winding up raised in a trust deed have been identified and addressed.

If the accounts of the trust have been correctly prepared then the current balance sheet, in particular, gives a list of activity to be addressed before the trust can be wound up. For a company liquidation, liabilities need to be satisfied with the balance of assets (property) distributed to owners. Trusts are no different. The more assets have been converted to cash and liabilities have been met the simpler the contemporary balance sheet and the winding up will be.

Tax planning

The conversion of assets to cash can give rise to taxable capital gains and assessable balancing charges but the alternative, their distribution to beneficiaries on a winding up inevitably does so too. It is generally simpler or more tax effective, or both, if these CGT events are contemporaneous with the trust coming to an end. In the cases of a fixed trust or a unit trust CGT event E4 can occur where a non-assessable part of a capital gain is distributed to a beneficiary when the interest of the beneficiary in the capital of the trust persists.

Errors frustrate the ending

Correct accounting in the trust will follow correct treatment of interests, assets or liabilities in the trust by the trustee. But correct treatment of interests, assets or liabilities doesn’t always happen. Notable examples where correct treatment doesn’t happen include:

the elimination of entitlements of family beneficiaries in the course of a winding up. Trustees of discretionary trusts distribute trust income to family members on lower tax rates (A) which remains unpaid and which is treated in the accounts of the trust as an unpaid present entitlement under terms in the trust deed. On winding up the distribution may revert to or may be paid to the principals of the family (B) instead without explanation. That suggests that the present entitlement of beneficiaries to former income of the trust was a sham or misunderstood with potential tax liability for the trustee;
distribution in the course of a winding up to individuals where the trust holds money or property sourced from a private company to which Division 7A of the Income Tax Assessment Act 1936 applies. This may be inconsistent with repayment of the money or property to the relevant company and could trigger a “deemed dividend” tax liability; and
backdating and forgiveness of loans – it can be tempting for a trustee to purge debts to related parties in the accounts of a trust but the purge is unlikely to be legally effective. A more nuanced treatment, which actually addresses the nature of the original transaction, is more likely to be accepted.

The Commissioner of Taxation investigates, audits and challenges trusts and the parties involved in these kinds of errors including after a winding up.

Conclusion

The affairs of trusts vary greatly and some have deeply intransigent issues. Getting a trust ready to wind up, and executing that wind up at a custom desired point in time may pose a number of challenges which should be considered and addressed in the process. The legal, accounting, business and practical attributes of the trust and possible errors should be considered through the due diligence process so that a non-contentious consignment of the trust to history can be effectively documented.

Minority SMSF investors and related unit trusts

A popular pro-active SMSF strategy is to skirt the boundaries of the associate rules in Part 8 of the Superannuation Industry (Supervision) Act 1993 (SISA) with minority SMSF investors taking units in a unit trust with no apparent majority controller with other unrelated SMSF or non-SMSF investors. The object of the minority strategy is that the minority SMSF investor and associates have a less than 50% entitlement to income and capital of the unit trust and so the unit trust will not be a related trust of the SMSF automatically. This is an alternative strategy to investing in a non-geared unit trust which complies with Regulation 13.22C of the Superannuation Industry (Supervision) Regulations.

If the minority strategy doesn’t work

If the unit trust is, or becomes, a related trust of the SMSF the consequences can be severe. The investment in the related trust by the SMSF is taken to be an in-house asset. A SMSF that fails to remedy an investment of more than 5% of its assets in in-house assets faces loss of complying status potentially causing:

tax at 47% on its current income; and
loss of almost half of the assets of the SMSF in a one-off additional tax bill in the year in which the SMSF becomes non-complying; or
prosecution for civil or criminal breach of a civil penalty provision under the SISA.

An investment in a non-geared unit trust which complies with Regulation 13.22C is specifically excluded from being an in-house asset. The minority strategy does not give the same assurance to a SMSF investor in units in a unit trust which is not Regulation 13.22C compliant.

Control of a trust

The more than 50% entitlement to income and capital test is one of the tests of control of a trust in sub-section 70E(2) of the SISA which determine whether or not a trust is controlled and is thus an associate and, by that, a related trust. An alternate test in paragraph 70E(2)(b), sometimes overlooked by users of the minority strategy, is the directions, instructions or wishes test which is an alternative test of control of a trust. Its formulation:

an entity controls a trust if:

… (b) the trustee of the trust, or a majority of the trustees of the trust, is accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of a group in relation to the entity (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed companies, partnerships or trusts);

is based on a similar formulation in sub-section 318(6) of the Income Tax Assessment Act 1936 which deals with associates under the income tax controlled foreign corporations (CFC) rules.

MWYS v. Commissioner of Taxation

The directions, instructions or wishes test in paragraph 318(6)(b) in the CFC rules was recently considered by the Administrative Appeals Tribunal in MWYS v. Commissioner of Taxation [2017] AATA 3037 (22 December 2017) and the companies in dispute with the Commissioner in that case were found not to be associated even though the companies concerned had the same directors.

Deputy President Logan found that, despite the unanimity of the directors of the companies involved, the companies were not associates as it could not be concluded, on the evidence, that the directors of one company, acting in that capacity, would influence themselves acting in their capacity as directors of the other company. Deputy President Logan observed that the arrangements between the companies involved: an Australian listed company and a UK publicly listed company which enabled them to dual list on the ASX and the London Stock Exchange, were for the purpose of compliance with dual listing requirements but, within that framework, the companies were structured with similarity to unrelated joint venturers. No inference could be drawn about one company acting on the directions of the other.

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

Directors in common

It is certainly clear from MWYS that commonality of directors of a company, or in the case of paragraph 70E(2)(b) of the SISA, commonality of directors of a corporate trustee is not enough, in itself, to amount to a reasonable expectation that one company will act in accordance with the directions, instructions or wishes of the other company or of a group including it.

Is MWYS good news for SMSFs using the minority strategy?

Is the decision in MWYS a relief to minority SMSF investors in unit trusts concerned about paragraph 70E(2)(b) of the SISA? Maybe not. Documents of SMSF trustees and of unit trusts, in which they invest, are far less likely to be as meticulous at keeping the affairs of entities being examined for control apart. A unit trust deed is more likely than, say, a joint venture arrangement to show that the trustee of a unit trust might act in accordance with the directions, instructions or wishes of a unitholder, albeit a minority unitholder.

Frequently, under unit trust deeds, minority unitholders have the right to vote on resolutions which bind the trustee of the unit trust to act. A minority unitholder may not have the votes, alone, to so bind the trustee; but the question posed by the test is whether the trustee is accustomed to act, or whether there is a reasonable expectation that the trustee of the unit trust will act, in accordance with the directions, instructions or wishes of a minority unitholder. The answer in fact is equivocal – yes, if the minority unitholder votes are in the majority and no, if not. So yes, a part of the time or on some occasions. So the minority SMSF investor and the trustee of the unit trust are associated?

What will facts show under scrutiny?

The concern for SMSF users of the minority strategy is: will their position, that the unit trust they invest in is not a related trust, become less defensible under scrutiny from the Commissioner? From the activities of the SMSF investor, its associates and the trustee of the unit trust the Commissioner can gauge how the trustee of the unit trust has reached decisions, which may not have been in accord with documents, whether sound or not, and form a view as to how likely the trustee of the unit trust is likely to have acted on directions, instructions or wishes of the SMSF investor and its associates.

Until the circumstances of a SMSF using a minority strategy, including the relevant documents, are considered it can be uncertain whether a SMSF minority unitholder may “control” a unit trust and cause it to be a related trust.

Aussiegolfa SMSF hits sole purpose flag

The sole purpose test in section 62 of the Superannuation Industry (Supervision) Act 1993 (the SIS Act), which requires that superannuation funds be conducted solely for core and ancillary purposes (superannuation purposes) with core purposes including:

funding for retirement from gainful employment of a member;
a member reaching a prescribed age; or
the death of a member,

is fundamental to the integrity of Australia’s tax-privileged and compulsory superannuation system.

The sole in sole purpose

In practice section 62 is a difficult provision to apply at the margin because of the ostensible purity of purpose of conduct of a superannuation fund to meet the sole purpose standard, or more precisely, a collection of allowed purposes.

Between commencement of the SIS Act in 1993 and December 2017 the meaning and scope of “sole” in the sole purpose test was not specifically considered in reported court cases.

The opening round

In Case 43/95, 1995 ATC 374 (the Swiss Chalet Case) the Administrative Appeals Tribunal considered whether a superannuation fund had met the sole purpose test where the fund had invested in:

shares which enabled access to a golf club for; and
a Swiss chalet which earned income for the family trust of:

the managing director of the employer-sponsor of the fund. The AAT found that the fund had been conducted for purposes other than superannuation purposes and thus the fund failed the sole purpose test.

The latest play

The Federal Court has now considered “sole” in the sole purpose test and referred, with approval, to the reasoning in the Swiss Chalet Case in Aussiegolfa Pty Ltd (Trustee) v Commissioner of Taxation [2017] FCA 1525. Given the significance of the golf club access of the managing director in the Swiss Chalet Case and the allusion to golf in the name of the trustee of the superannuation fund, one might think that the trustee was looking for the attention and the view of the Commissioner of Taxation, as the regulator of self managed superannuation funds, on the purposes of Aussiegolfa Pty Ltd.

A provisional ball?

Indeed, the facts in Aussiegolfa indicate the trustee sought to test whether residential properties held by self-managed superannuation funds could be used by related parties under the SIS Act.

Facts in Aussiegolfa

In Aussiegolfa the trustee was the trustee of the personal SMSF of the Victorian State Manager of DomaCom Australia Ltd., a managed investment scheme regulated by the Australian Securities and Investments Commission. The trustee of the SMSF and the family of the member of the SMSF invested in units in DomaCom which were directed to and funded investment by DomaCom in a student residential accommodation to be leased to the daughter of the member of the SMSF who was a university student. DomaCom was hopeful that they had initiated an effective and attractive SMSF investment strategy.

Investment in an in-house asset?

The first SIS Act hurdle for the SMSF trustee to overcome in Aussiegolfa was whether there was an investment in a related trust causing the investment to be an in-house asset to which section 82 of the SIS Act would apply (with or without a determination by the Commissioner that the investment was an in-house asset under sub-section 71(4) of the SIS Act).

The investment by the SMSF trustee was in units in DomaCom, a managed investment trust. The Federal Court worked its way through the terms of the constitution of DomaCom, and amendments of it, and a series of product disclosure statements to determine the basis on which the SMSF trustee had invested in DomaCom at the time of its investment. Pagone J. found that the trustee had invested in a sub-trust which was a discrete trust and so a related trust of the SMSF for SIS Act purposes.

Not out of bounds

That finding was despite equivocal provisions in the applicable terms of the constitution of DomaCom which sought to reinforce, unsuccessfully to Pagone J., that the units in DomaCom did not give a unit holder, whose investment had been directed to certain assets and whose income and entitlements were ring-fenced to those assets, an interest in those particular assets and that DomaCom was one indivisible trust of many assets.

It followed from this framing of what was the trust by the Federal Court that the SMSF trustee could not rely on the widely held unit trust exclusion in paragraph 71(1)(h) of the SIS Act from being a related trust and an in-house asset.

… and hitting the sole purpose red flag

Turning to the sole purpose issue, Pagone J. accepted the reasoning in the Swiss Chalet Case and applied authority which explains how a “sole” purpose requirement is to be interpreted and applied. Broadly, Pagone J. concluded that:

the inquiry into sole purpose is a question of fact;
the inquiry is not an inquiry into motive but into the “end sought to be accomplished”;
the sole purpose requirement precludes there being any other purpose , however minor; and
there may be facts which could suggest pursuit of other purposes, if those facts were considered separately, but these do not necessarily connote other purposes if they show pursuit for the required sole purpose.

In Aussiegolfa Pagone J. held that providing housing to the daughter of the member of the SMSF was not within and inconsistent with superannuation purposes and so the SMSF failed the sole purpose test.

A two shot penalty

The trustee of the SMSF in Aussiegolfa had hoped that its investment in units in DomaCom would not jeopardise its status as a complying superannuation fund. But due to the decision of the Federal Court:

the units are an in-house asset comprising more than 5% of the assets of the SMSF so section 82 can be applied to deprive the SMSF of complying superannuation fund status if the level of the in-house assets of the SMSF is not brought to 5% or under before the end of the income year following the income year of acquisition of the in-house asset; and
the SMSF can be made non-complying because it has failed the sole purpose test in section 62;

and various other civil and criminal penalties can potentially be applied for both of the SMSF’s breaches of the SIS Act by the Commissioner of Taxation.

An uncertain lie in the rough?

Pagone J. observed in Aussiegolfa that there may be circumstances where a lease to a related party would not breach the sole purpose test but, in Aussiegolfa, he observed that the evidence was that the purpose of the investment through DomaCom was, in part, for another purpose of providing housing to the daughter of the member of the SMSF. This is not a complete reassurance to other SMSFs that invest in business real property to lease to a related party. That investment can be excluded from being an in house asset under paragraph 71(1)(g) of the SIS Act but does it follow that the investment is in the circumstances which would not breach the sole purpose test Pagone J. describes? Can we safely infer that an investment that attracts a statutory exclusion from being an in-house asset should be excluded from failing the sole purpose test too?

Checking my card

I have paraphrased particularly in describing how Pagone J. applied the sole purpose test. I also take responsibility for the golfing headings through this post which I appreciate will be vague and wearisome to those lucky enough to be non-golfers.

Full Federal Court pinpoints year end trust resolutions that fail

Contractual principles apply to construe trust resolutions

The Full Court of the Federal Court in Lewski v. Commissioner of Taxation [2017] FCAFC 145 has given us a roadmap to construing trust resolutions in line with principles for the construction of contracts, from Byrnes v Kendle [2011] HCA 26, and has applied two of those principles of contractual construction to pinpoint invalid trust resolutions as follows:

an invalid trust resolution can be severed from another valid resolution or resolutions so that those resolutions can stand, but only if those resolutions are not interdependent with the invalid resolution and it is not artificial for them to stand severed from the invalid resolution; and
if there are two open constructions of a trust resolution, one of which results in validity and one of which results in invalidity, the construction that preserves validity is to be preferred.

Trust resolutions to confer a present entitlement to discretionary trust income

An Australian tax resident beneficiary must be presently entitled to the income of a discretionary trust in the income year in which income has earned by the trust before the relevant share of that income can be included in the assessable income of the beneficiary: sub-section 97(1) of the Income Tax Assessment Act (ITAA) 1936. If it cannot be shown that:

"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."  

High Court in Harmer v. Commissioner of Taxation (1991) 173 CLR 264 at p. 271

then the beneficiary is not presently entitled to the relevant share of income with section 99A of the ITAA 1936 applying to tax the trustee on the income to which no beneficiary is presently entitled at the highest individual marginal income tax rate.

Ownership and present right to demand payment

“Vested in interest” and “vested in possession” are technical concepts which broadly equate to ownership, and the extent of ownership required for present entitlement is ownership of the share of income sufficient to bestow a present legal right to demand payment of the income. The legal right to demand and receive payment of an ascertainable entitlement to a share of income must be present and fully defined in the income year even if the entitlement cannot be numerically ascertained due to accounts not having been taken by the end of the relevant income year. In a discretionary trust the trustee is generally reliant on a valid year end trust resolution to distribute income of the trust to confer a sufficient present entitlement to the income of a discretionary trust on a beneficiary so that section 99A will not be attracted.

After Bamford

We have known, especially since 2011, when the Commissioner of Taxation came to take a harder and more sophisticated line on year end trust resolutions following the High Court decision in Commissioner of Taxation v Bamford [2010] HCA 10 and the Tax Laws Amendment (2011 Measures No. 5) Act 2011 introduced in response to the Bamford decision; that the form of the year end trust income distribution resolution is vital to the taxation of discretionary distributions to beneficiaries.

Construing the Lewski trust resolutions

In Lewski discretionary trust resolutions to distribute income were stress tested for present entitlement, meaning and validity to determine where liabilities to tax lay.

The Commissioner, in amended assessments issued to Ms. Lewski, and the Administrative Appeals Tribunal (“AAT”) at first instance, disallowed carry forward tax losses to discretionary trusts and assessed trust income of $10,108,621 and $3,143,199 to Ms. Lewski as a presently entitled beneficiary of each trust under sub-section 97(1). Ms. Lewski sought to reduce or deflect the tax liability on this income by claiming that, alternatively:

the carry forward trust losses should have been allowed as deductible to the trusts;
her entitlements to the income of the trusts had been disclaimed;
the trust distributions were ineffective as they were made in a manner beyond the power of the trustees; and
Ms. Lewski was not presently entitled to the trust distributions;

which the Commissioner disputed.

The strategy of Ms. Lewski was to reduce the liability to tax or to deflect liability to tax under the amended assessments elsewhere, whether to the trustees of the trusts on income to which no beneficiary was presently entitled under section 99A or to default beneficiaries of the trusts, companies ACUPL and AISPL respectively (abbreviated), claimed to be entitled to the adjusted income of the trusts under the amended assessments instead of Ms. Lewski. It is supposed that, in both income years, less tax was recoverable by the Commissioner in those cases than if Ms. Lewski was presently entitled as a beneficiary of the trusts to the adjusted income.

Ms. Lewski wins

Before the Full Court of the Federal Court Ms. Lewski successfully challenged the disallowance of the tax losses and thus won her appeal against the imposition of the tax liabilities.

Resolutions under scrutiny

The applicable year end trust resolution documents distributed the income of the trusts:

2006 year:

100% to Ms. Lewski

2007 year:

the first $3.5 million to AISPL and the balance to Ms. Lewski.

In each resolution document, there was also a ‘variation of income’ resolution to the effect that, should the Commissioner disallow any amount claimed as a deduction or include any amount of the deduction in the assessable income of the trust, there would be a “deemed” distribution to the default beneficiaries (in the 2006 year, 100% to ACUPL; in the 2007 year, 100% to AISPL).

The “variation of income” resolutions made the 2006 year and 2007 year distributions contingent on events that could occur after the end of those years of income respectively. The Commissioner contended that the variation of income resolutions, which were of doubtful validity, could be severed from the valid resolutions in the resolution documents distributing the income of the trusts. Applying the principles and authorities relating to the severance of provisions in contracts the court did not accept this approach. The distribution resolutions and the variation of income resolutions where found to be interdependent and so the variation of income resolutions could not be “severed” from the distribution resolutions with the effect that either:

each purported income distribution was subject to a live contingency in the variation of income resolutions after the end of the applicable income year – the court’s preferred view; or
the distributions failed as the interdependent variation of income resolution was invalid in each case – the court’s alternative view;

defeating the present entitlement of Ms. Lewski to the income of the trusts at the end of the year of income of each trust in either case.

The trust deeds of each of the trusts contained notably complicated clauses for the ascertainment and distribution of the income of the trusts. Ms. Lewski contended that the distribution of “income” in the trust resolutions, rather than “net income”, was beyond the power of the trustees and so failed as resolutions beyond the power of the trustees given in the trust deeds. The court rejected this contention after applying the contractual principle that where there are two open constructions of a provision, the construction of the provision that preserves validity is to be preferred. From that perspective “income” in the trust resolutions could be treated as meaning “net income”.

Construing income equalisation clauses

Two aspects of the Full Federal Court decision in Lewski are useful in construing income equalisation clauses in discretionary trust deeds.

Generally an income equalisation clause sets the net income of the trust to which sub-section 97(1) applies, being “trust income” or “distributable income” identified in Bamford, equal to the net income of the trust under section 95 of the ITAA 1936. Understanding that the Commissioner can amend the net income of the trust under section 95 by an amended assessment well after the end of the income year, can this contingency affect the “trust income” or “distributable income” by which the shares and proportions of income distributed to beneficiaries are ascertained?

The preferred construction, if available, of an income equalisation clause is that “trust income” is set to the net income of the trust under section 95 of the ITAA 1936 based on understandings that are ascertainable at the end of the year of income when the income distribution is made. In other words the taxable income of the trust that is ascertainable. That follows from Lewski where the court found, in the context of distributions asserted by Ms. Lewski to be beyond the power of the trustees, that where there are two open constructions of a trust distribution resolution, the construction which results in validity is to be preferred to the construction which results in invalidity.

“Trust income” needs to be closed at year end

To sustain a valid construction an income equalisation, effectuated by an income equalisation clause in a discretionary trust deed, needs to be a closed parameter at the end of a year of income. If the parameter is open, that is, if “trust income” or “distributable income” identified in Bamford is not fully ascertainable by the end of the applicable income year using the income equalisation mechanism in a trust deed, then a distribution based on trust income reliant on that mechanism will not confer a present entitlement and section 99A can apply to the income purportedly distributed as income to which no beneficiary is presently entitled.