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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.

Only a loan? Impugnable loans, proving them for tax and shams

Is a loan just a sum advanced to be repaid by a borrower to a lender? Accountants understand that a loan can be a nimble device to explain and show why money and value is elsewhere even when the relationship between the borrower and the lender is not arms length or clear.

Necessary elements of a loan

So a loan is recognised. It is clearly recorded in the books of account and appears as a liability in the financial statements of the “borrower”, the “lender” or frequently both. The individual, who is the controlling mind of the borrower, says yes, it is a loan, and the apparent lender, who has an established relationship with that individual, doesn’t say it is not. Will that apparent loan be accepted as a loan by all persons interested?

A number of recent tax cases in the aggressive tax planning space show that, in those kinds of cases, the Commissioner of Taxation is prepared to commit significant resource and effort into:

disabusing courts that arrangements with the appearance of loans are loans in fact; and
pursuing high profile tax scheme promoters and their clients using arrangements based on inpugnable loans.

A wide but demarcated construct

There is no doubt that a loan is a wide concept. In Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements, the Commissioner took a wide view of what amounts to a loan, or to what amounts to at least one or more of:

(a) an advance of money; and
(b) a provision of credit or any other form of financial accommodation; and(d) a transaction (whatever its terms or form) which in substance effects a loan of money.
(c) a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; and
(d) a transaction (whatever its terms or form) which in substance effects a loan of money.
included as a loan under sub-section 109D(3) of the Income Tax Assessment Act (“ITAA”) 1936

which triggers a deemed dividend to a shareholder or an associate under Division 7A of the ITAA 1936. The “loan” regime in Division 7A is an exception though. Generally, if a taxpayer can establish that a sum received is received as an advance of a loan, that receipt can explain why that money or value is not in the nature of income that may be assessable to the taxpayer. That is a vital capability when the schema of Australian income tax recovery is “asset betterment” allowing the Commissioner to assert that money or value received is income unless the taxpayer can prove that it is otherwise.

Hart v Commissioner of Taxation (No 4)

So it was in Hart v Commissioner of Taxation (No 4) [2017] FCA 572, a decision of Bromwich J. of the Federal Court, concerning the personal tax affairs of the senior tax partner of Brisbane-based law firm and tax planning and tax scheme services provider Cleary Hoare. Mr Hart asserted that the amount in dispute in that case was a loan to him by an associated trust clearly recorded as a credit loan in the books of the trust.

The firm of Cleary Hoare was operated by a practice trust (“the Practice Trust”) in which discretionary trusts of the partners owned units in the Practice Trust which, it transpired, was not structured in accord with Queensland legal professional practice rules. The discretionary trust of Mr Hart owning units in the Practice Trust was referred to in the decision as the Outlook Trust.

Loan or benefit or both to the taxpayer (“borrower”)?

During the 1997 income year, the Outlook Trust included $220,398 in its assessable income as a distribution to it as a unitholder in the Practice Trust under section 97 of the ITAA 1936. The distribution was routed by a series of on-distributions through a network of interposed trust entities associated with Cleary Hoare, or its associates, to a company carrying significant tax losses, Retail Technology Pty. Ltd. and by the making of gifts by way of promissory notes to and through entities that were associated with Cleary Hoare or its associates, including Mr Hart. The Commissioner took issue with the last flow of the money through the arrangement back to Mr Hart. The Commissioner viewed that last flow as a distribution to Mr Hart for the benefit of Mr Hart. For his part, Mr Hart contended that the payment was a loan to him from the Outlook Trust, or alternatively from the Practice Trust, and that the payment was so recorded in the books of account of the Outlook Trust.

The Commissioner also pressed a number of alternative cases including a case that, even if the payments were not trust distributions, the application of general anti-avoidance provision in Part IVA of the ITAA 1936 meant that, in the absence of the scheme, the money would still have been paid to Mr Hart and instead been taxable, to which Mr Hart, for his part, contended that such payments would not have taken place in the absence of the scheme.

Present entitlement by benefiting trust beneficiaries

One of the alternative cases run by the Commissioner was that payments benefiting Mr Hart of at least $84,615.52 of the $220,398 were assessable directly to Mr Hart who was also a special unitholder, as trust distributions to him by the Practice Trust. In the absence of a sustainable case that the $220,398 or any part of it was a loan, the court could find that sections 95A and 101 of the ITAA 1936, which have the effect of deeming payments to or for the benefit of a beneficiary to be payments to which the beneficiary is presently entitled, applied to bring the $84,615.52 into the special unitholder’s assessable income for the 1997 income year.

Although this finding did not directly inform the character of the remaining $135,782, this application of sections 97, 95A and 101 of the ITAA 1936 to at least $84,615.52 of the amount in dispute, which the court accepted, did not assist Mr Hart to prove that the assessment of the greater $220,398 was excessive.

How Mr Hart’s loan contention failed

The court deduced from the submissions of the parties that whether the 1997 assessments of Mr. Hart were excessive or not turned on whether Mr Hart received the $220,398 as a loan. Mr Hart’s counsel contended that the evidence of Mr Hart, including the accounts of the Outlook Trust which showed the borrowing to Mr Hart, was sufficient to show that the funds had been loaned to Mr Hart. However other evidence caused this contention to unravel, viz.:

there was nothing in writing to record or otherwise evidence a loan;
there was no interest paid or payable under the purported loan;
there were no repayments required or made under the purported loan, despite more than 19 years having elapsed since the advance of money under the purported loan (and the “creditor” trust had not traded for 15 years); and
there were records of contemporaneous bank statements showing “pay” or “sol[icitor] pay” which were made on a fortnightly basis to a bank account of Mr and Mrs Hart between at least 5 July 1996 and 23 April 1997.

In addition to this evidence, which the court found, of itself, compelling, was the coup de grâce of a credit approval request by Mr. Hart to Suncorp Bank for two loans in 1999 in which Mr Hart, as an applicant providing personal details, appeared to state he had income of precisely $220,398 in 1997. The court observed that stating this, if it was nothing more than antecedent indebtedness, was hardly going to assist in securing a further loan, so it didn’t make sense as a loan.

Was the loan a sham?

Mr Hart’s counsel asserted that, as the Commissioner had not demonstrated that the purported loan was a sham, the court was obliged to accept the evidence lead by Mr Hart viz. his testimony and the accounts of the Outlook Trust, that there had been a loan. The court observed that a sham requires there to be a purported transaction which is falsely presented as being genuine. The court agreed with the Commissioner that, in this case, there was thus no sham loan, but that no loan had been proven to exist with the burden of proving that there was a loan on the taxpayer.

Loan terms in writing?

In Hart v Commissioner of Taxation (No 4), the taxpayer relied on an undocumented related party loan recorded only in the accounts of a related trust which gave the Commissioner leeway to run a case based on there being no loan at all. That leeway is reduced, of course, if the loan is reduced to writing in a loan agreement. However if that writing does not present the real arrangement then the loan can still be impugned by the Commissioner and the issue of sham will more likely arise with that false presentation.

Commissioner of Taxation v Normandy Finance and Investments Asia Pty Ltd

The taxpayer in Commissioner of Taxation v Normandy Finance and Investments Asia Pty Ltd [2016] FCAFC 180 faced that predicament.

Mr. Townsing was a client of Vanda Gould, a Sydney accountant and offshore tax scheme promoter. The taxpayer and two other companies were controlled by Mr Townsing. The taxpayer asserted that these companies were borrowers under loans from three companies controlled by Mr Gould recorded in written loan arrangements with those companies.

The Townsing controlled companies received substantial advances from the Gould controlled companies. The Commissioner asserted that payments to the Townsing controlled companies were sham borrowings used by Mr Townsing to bring assets held for his benefit into Australia and that they were thus assessable income of the companies.

The judges in this case noted the excessive length of the submissions of more than 1000 pages of submission material, ostensibly in support of oral argument at trial, to the primary judge by the taxpayer and the Commissioner.

Edmonds J. of the Federal Court, (Normandy Finance Pty Ltd v FCT [2015] FCA 1420) found for the taxpayer at first instance but did so on what was to prove a precarious basis. Edmonds J. found that the loans were not shams, even though the loan documents revealed disguises and pretences directed to demonstrating that the loans were at arms length, when the evidence was that the advances under the purported loans happened differently, and not at arm’s length. Still Edmonds J. found that, despite these irregularities, elements of the loans, including commitments to repay the loans, could be indentified in the evidence and so the loans were allowed to stand.

Appeals

The Commissioner appealed to the Full Federal Court. All three judges of the Full Federal Court closely considered the evidence that was before Edmonds J., and the majority, Jagot and Davies JJ., found that the basis on which Edmonds J. had recognised the loan arrangements as loans, distinct from the impugned purported written loan agreements, was expressly negated by the evidence of Mr Townsing under cross-examination by senior counsel for the Commissioner. The majority concluded that, in his evidence, Mr Townsing had rebuffed the facts upon which Edmonds J. had relied to find that there were loans not shams. Logan J., in the minority, disagreed with the majority and agreed with the trial judge’s approach to the evidence.

The taxpayer sought special leave to appeal from the Full Federal Court to the High Court but leave was refused by the High Court on the basis that the taxpayer did not have sufficient prospects of success of reversing the Full Federal Court majority’s findings.

Take-outs

Documenting a loan in writing reduces the scope of the Commissioner to assert there is no loan leaving the taxpayer, carrying the burden of the onus of proof, to prove the loan.

However documenting the loan may be a two-edged sword in contentious situations. Forcing the Commissioner to assert a sham will not necessarily give a taxpayer, who must disprove a sham in Part IVC of the Taxation Administration Act 1953 tax appeal proceedings, an advantage. Costs in litigation with the Commissioner to redress the consequences of a loan inadequately documented, can be significant. Poor documenting may have the adverse effect of revealing aspects of the arrangement that are not real or genuine. In other words, the pretences in the document and later compromising admissions by a taxpayer asserting the loan may irretrievably taint the believable in an asserted loan document and cause a loan to fail as a construct for a payment.

Loans not at arms length are the most likely to be challenged by the Commissioner. Trust beneficiary loan accounts may be held up to particular scrutiny. If a purported trust beneficiary loan is impugned sections 95A and 101 can trigger present entitlement to payments/advances to the beneficiary under the “loan” as assessable income.

These cases and the earlier Full Federal Court case of Millar v FCT [2016] FCAFC 94:

which again involved an impugned loan devised by the Sydney accountant Vanda Gould for other clients; and
where the taxpayers opted not to admit evidence from Mr Gould but relied on evidence of the relevant loan only from the lay taxpayer parties to the purported loan;

show that the Federal Court will not readily allow an appeal based on such restricted evidence as sufficient to prove the existence of a loan or to disprove a sham in the process of determining whether an assessment is excessive and that the High Court is reluctant to allow appeals to disturb these Federal Court decisions.

SMSFs getting practical to invest in land with others

The force of the superannuation law is that investment in land by a SMSF needs to be prudent. An investment needs to be considered in a business-like way.

Limited recourse borrowing is one way to fund investment in real estate. SMSF principals may prefer to arrange equity investment from private connections outside of the SMSF.

Investment as a tenant-in-common?

I am frequently asked about SMSFs participating in land investments as a tenant-in-common with related and unrelated entities of the principals of the SMSF. It is apparent from the NTLG Superannuation sub-committee technical minutes of June 2011, released by the Australian Taxation Office, that tenants in common arrangements for SMSFs are not going to be prudent for the SMSF without careful and restrictive implementation. Wherever other tenants in common could borrow, or use or risk their interest as security, the SMSF tenant-in-common is exposed to uncontrolled risks which would bring into question, for instance, whether the SMSF:

1. has acted prudently pursuing the investment for members for whom it is bound to provide;

2. has breached regulations which prevent charges, or the potential for them, being taken over SMSF property; or

3. has satisfied the sole purpose test.

Investment through a trust?

The tenant-in-common option is frequently turned to because of the restrictive regime that has applied in relation to the investment by SMSFs in related trusts since 1999. Shortly stated, a post 1999 investment by a SMSF in a trust, which is related to the principals of the SMSF, a “related trust”, is treated as an “in-house asset” and more than 5% of the assets of a SMSF in in-house assets can leave the SMSF non-complying.

Non-geared unit trust – expressly relieved from being a related trust

The SIS Regulations provide an express exception. A superannuation fund can invest in a non-geared unit trust (NGUT) to which Regulation 13.22C applies without the NGUT being taken to be a “related trust” and thus the investment isn’t taken to be an investment in an “in-house asset”.

This express exception is especially limited and, aside from relief from “related trust” treatment causing in-house asset difficulty, offers no expansion in the kind of investment that can be pursued with superannuation money. In other words, the investment still needs to address 1 to 3 above, for instance.

The Regulation 13.22C and 13.22D requirements and restrictions on NGUTs essentially mirror the restrictions on regulated superannuation funds. NGUTs cannot borrow and they can only “lend” to operate a bank account. They cannot secure or charge their assets. (A non-SMSF unit holder in a NGUT could give a security over his, her or its units but security could not be given over the assets of the NGUT.) A NGUT cannot run a business – unlike with superannuation funds, this is a direct requirement. Loss of NGUT status, so that the NGUT becomes a related trust triggering in-house asset difficulties follows the merest breach under Regulation 13.22D which can put complying status of a SMSF investor at the mercy of the ATO.

Practicalities

1. Nevertheless a carefully implemented NGUT can be the most practical way to pursue unitised investment in land by related parties and unrelated parties of a SMSF with the SMSF.

2. Compliance with the regulations needs to be closely monitored as stated. Any debtor or creditor, aside from a bank for the (credit only) trust bank account, potentially causes loss of protection from related trust status. Funding of, and money flow to and from, the NGUT without breaching the rules is thus practically challenging. The trustee needs to raise equity (unit) funding whenever any extra funding is required. From a practical and paperwork burden perspective, using partly-paid units is a strategy that might be considered wherever the trust needs a flexible equity facility.

3. The activity of the NGUT that invests in land also needs to be monitored and carefully planned and structured. It is possible for real estate activity by trustees to be considered the carrying on of a business under tax rules. As stated a NGUT cannot carry on a business under the NGUT regulations nor, if it has a trust deed to suit, under its trust deed.

4. Under the special trust rules in NSW, a special trust pays land tax at the highest land tax rate without a threshold. A SMSF can attract a better land tax rate. A NGUT will not automatically qualify for the rate for a SMSF to the extent a SMSF invests in it. However if the NGUT is a “fixed trust” under the land tax rules then a better rate than the special trust rate can be achieved. Hence there can be advantage to structuring a NGUT with a trust deed so that the NGUT can be treated as a fixed trust under the land tax rules.

5. A carefully crafted trust deed can be very useful to assist the trustees of a SMSF and a NGUT to keep within the express requirements and restrictions on NGUTs.

Australia is now tracking & surcharging foreign buyers of land

Turning missing demographics into tax revenue

Hats off to Australian governments who have turned an imperative into a revenue opportunity. The Australian federal government regulator, the Foreign Investment Review Board (the FIRB), has not been well placed to track foreign purchases of real estate to date. The FIRB has been reliant on disclosure, and if prospective foreign buyers didn’t voluntarily disclose their planned land acquisitions, the FIRB has been none the wiser. There has been no register of (foreign) beneficial ownership of buyer entities which the FIRB can go and check even in the case of foreign real estate acquisitions completely prohibited under the foreign acquisitions law: the Foreign Acquisitions and Takeovers Act (C’th) 1975.

That has all changed. Buyers now need to demonstrate that they are not foreign to avoid hiked stamp duty in New South Wales, Victoria and Queensland. Foreigners who buy and sell Australian real estate are now under great scrutiny at both the buyer and seller ends of the land sale especially if the sale is for more than $750,000.

Big city real estate markets are buoyant, prices are high and foreign buyers are not exactly welcome by those looking to buy the same city real estate. The community has been surprised to learn that foreign purchases of Australian land have not been closely monitored. So, politically, it has been an opportune time to introduce these changes. Time will tell if they will be successful. They may well be. They will be a boon to the FIRB, but Australian buyers too will get caught up in the ramp up of imposts on foreign buyers. Why?

Buyers of Australian land

This is the bit for the FIRB. The New South Wales, Victorian and Queensland governments have just introduced hefty stamp duty and land tax surcharges on foreigners. From 21 June, 2016 a sworn Purchaser Declaration (“PD”) is now required from buyers, whether foreign or not, buying real estate in New South Wales. The PD is required along with stamp duty at the band the PD establishes that the buyer should pay to complete the conveyancing of a land sale. If the buyer of land in New South Wales is a foreign person (entity):

a 8% SURCHARGE (for the 2018 tax year, it was 4% for the 2017 tax year) on the stamp duty (i.e. extra) applies (it’s a 7% surcharge in Victoria);
the buyer is not entitled to the 12 month deferral for the payment of stamp duty for off-the-plan purchases of residential property; and
the buyer faces 2% SURCHARGE (for the 2018 tax year, it was 0.75% for the 2017 tax year) on land tax (i.e. extra).

It’s plain on the PD that the information is going to the ATO – it asks for the FIRB application number for the purchase. This will let the Australian Taxation Office (“ATO”) and the FIRB gather comprehensive data on foreign land acquisitions. Coupled with significantly increased penalties for breach of the foreign acquisitions rules, the availability of this information to the ATO and to the FIRB will give the federal government real capability to penalise unlawful real property acquisitions by foreigners.

Where an Australian buyer will be caught out too – example of a buyer that is an Australian-based family discretionary trust

It is notable that the PD doesn’t seek the confidential tax file number (understandable as the ATO can’t get the States to collect those) or the Australian Business Number (if any) of a buyer trust. It relies on the name of the buyer trust and a copy of the trust deed of the buyer trust with all amendments must be included with the PD.

If a foreign individual, company or trust is a potential beneficiary of the usual style of Australian family discretionary trust that is a New South Wales land buyer then, usually, the trustee can distribute 20% or more (Victoria – more than 50%) of the income and capital to that foreign person. That gives the foreign person a “significant interest” in the trust enough to cause the trust to be a foreign trust under these rules to whom the foreign stamp duty and land tax surcharges apply.

So if the copy trust deed supplied with the PD indicates that a remoter family member, who is not an Australian citizen or an Australian permanent resident, but is a foreigner who is a potential beneficiary of an (otherwise) Australian family discretionary trust ABLE to receive 20% of income or capital (more than 50% in Victoria), even if that remoter family member/foreigner may not have:

any current or past entitlement to income or capital of the trust; nor
any strong likelihood of participating in income or capital of the trust;

his or her eligibility under the trust deed exposes the trust to foreign trust/person status and liability for the stamp duty and land tax surcharges under these rules accordingly.

Sellers of Australian land

The ATO has had a problem collecting capital gains tax from sellers who are offshore after the sale of Australian land. Under tax treaties worldwide rights to tax interests in land are almost universally reserved to the governments where the land is. As other forms of assets and activity are moveable and relocatable taxation based on place is not so reserved because it is less effective than taxation based on residence and/or makes less sense.

So, frequently, when a non-resident sells land and makes a capital gain taxable in Australia, the ATO has no interaction with the non-resident, aside from due to their Australian landholding. This has often left the ATO with little leverage to assist them to collect tax debts arising from CGT on disposals of Australian land by non-residents ceasing investment in land in Australia.

The solution is the tried and trusted withholding tax model. From 1 July, 2016, the non-resident capital gains tax withholding tax (“NCGTWHT”) is an obligation on the buyer (statistically likely to be a resident) to pay a non-final withholding tax to cover capital gains tax (likely to be) owing by the non-resident seller.

The NCGTWHT broadly applies as a non-final tax on sales of land worth more than $750,000 (from 1 July 2017, was $2m from 1 July 2016 to 30 June 2017). If the buyer does not receive an ATO clearance certificate from the seller then the buyer must withhold 12.5% (from 1 July 2017, was 10% from 1 July 2016 to 30 June 2017) of the value of the property (so 12.5% of the price for the land if it is an arms length sale, 12.5% of the “first element of the cost base” of the land to the acquirer if a CGT market value substitution rule applies in a non-arms length transaction).

Where an Australian seller will be caught out too – a non-final 12.5% tax

It is of no consequence that the seller is, or might be, an Australian resident/tax resident and the buyer is assured of this. There is no “reason to believe the seller is an Australian resident” exception for sales of freehold interests in land. Even the seller could be wrong – tax residence can a vexed question which is frequently litigated in tax cases.

The liability to the ATO is on the buyer unless the seller can obtain and provide a clearance certificate from the ATO to the buyer no later than settlement of the land sale so, if the seller does not return and pay the CGT on the seller for the sale, the NCGTWHT paid by the buyer on the seller’s behalf won’t be refunded.

Template contracts for the sale of land across Australia have been hastily adjusted to include conditions confirming that, where the land is worth more than $750,000:

the buyer can contractually withhold the NCGTWHT from the price if the clearance certificate is not provided; and
the seller can be assured that the NCGTWHT will be paid immediately by the buyer to the ATO to the credit of the seller.

Is a family trust a good way for setting up a new franchisor business?

A family discretionary trust structure is a slightly more complicated and costly structure but it has more flexibility than a holding company structure for distributing income tax effectively while also being capable of having limited liability protection for the franchisor along with potential access to the company tax rate through a beneficiary company.

But is one trust enough?

For asset protection and management reasons it may be multiple structures are desirable into the future to separately hold IP and property interests (including lease interests to be sub-let).

Trust a conduit to beneficiaries

A family trust can distribute business profits as trust distributions as a conduit of taxable income to adult resident beneficiaries.

Division 7A would not usually apply

A significant advantage with a family trust structure is that Division 7A does not apply to loans from the trust to associated parties (where companies are not involved) to treat them as taxable/unfrankable deemed dividends.

Capital gains tax advantages

The adult resident beneficiaries of a family trust can also use the CGT discount if the trust makes a capital gain. Sometimes a trust is a more difficult structure than a company if a new franchise venture makes losses (say due to difficulties finding and keeping franchisees on good terms).

Bringing in new equity

A family trust isn’t as good as a unit trust or a company for bringing in new equity participants however it appears that, with the new small business restructure CGT rollover relief, a later conversion to a unit trust structure can be done for a low cost.

CGT discount and small business CGT concessions

Capital gains made by a family trust structure could attract the CGT discount and the small business concessions (a company can only get the latter), such as the 50% active assets reduction. A family trust structure has the tax advantage over a company structure if CGT assets of the business, including goodwill, are at some stage sold for a capital gain by the trust.