Tag Archives: Capital gains tax

Bringing trusts to a timely ending

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

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

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

Ending is all in the timing

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

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

Bringing forward the ending of a trust

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

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

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

Ending by depletion and merger

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

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

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

Merger and SMSFs with individual trustees

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

Some starting points

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

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

Tax planning

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

Errors frustrate the ending

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

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

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

Conclusion

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

Can I have the real estate in my SMSF?

Real estate can be provided in kind to a member as a superannuation benefit. Prohibitions can apply to acquisitions of real estate from members but this prohibition does not apply going the other way. That is: from a fund to a member on a payment out of the fund as a superannuation benefit.

Still a condition of release needs to be met before a superannuation benefit is provided by a SMSF. Let us say that the fund is in pension mode and the member is over the age of sixty-five so a condition of release is met for a benefit to come from the member’s superannuation balance in the fund to the member.

Difficulties providing a real estate benefit from a SMSF in an income stream

A SMSF in pension mode must face these difficulties before releasing a benefit in the form of real estate:

  • the Australian Taxation Office (ATO), if not the superannuation laws unequivocally, require that a pension (a superannuation income stream) benefit must be paid in money and not in kind;
  • the benefit can take the SMSF out of pension mode, where the income of the SMSF is tax exempt on its earnings; and in to accumulation mode, where the fund is taxable at 15% on its earnings; depending on how the commutation of pension is done. This could inadvertently cause the capital gain, the SMSF makes on the disposal of the real estate as a benefit, to be taxable to the SMSF; and
  • the SMSF may not have paid a minimum annual pension payment for the year as required by the superannuation income stream regulations.

Partial commutation solution

A partial commutation of a pension is a work around for these difficulties. A partial commutation of a pension is a commutation of less than the member’s pension balance in the fund as a lump sum. That is the member needs to have remaining member pension balance after the commutation. The ATO has indicated that a partial commutation:

Doing it

There are a number of traps to implementing this solution:

  • The governing rules of the SMSF must allow for partial commutations of pensions, the trustee must have a power under the governing rules to pay benefits in kind and the pension arrangements or agreement with the member must reflect this.
  • The member needs to trigger the partial commutation and the benefit in kind in accordance with the pension arrangements or agreement.
  • The trustee of the SMSF must value the real estate to ascertain the amount of the lump sum benefit being paid to debit to the member’s account.
  • The member getting the real estate benefit must have a sufficient member account balance remaining after the debit to treat the satisfaction of the benefit in kind as a partial commutation of the pension.
  • The fund and conveyancing documentation needs to be prepared on an arms length basis as required under superannuation law.

Although there is no capital gains tax if the fund remains exempt from tax in pension mode, other taxes and duties on a transfer of real estate can still apply.

For instance:

  • GST can apply to the transfer of commercial premises or new residential premises from a SMSF where the fund is registered or is required to be registered for GST.
  • Stamp duty liabilities vary significantly from state to state. Victoria has concessions on the transfer of dutiable property to a beneficiary of a trust. In New South Wales there is generally no relief from full ad valorem duty. A concession which applies in New South Wales on the transfer of dutiable property to a superannuation fund as a contribution does not apply to a transfer out the other way as a benefit.

Thus, to recap our disclaimer, partial commutation of a pension to provide real estate from a SMSF should be considered case by case and specific advice should be taken in relation to the above general comments.

Preparing to change land ownership from a company to a trust

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

X_diag

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

Capital gains tax

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

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

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

Problems with a gift or an undervalue transfer

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

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

So defensible transfers of the land include:

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

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

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

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

Stamp duty on a transfer

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

Goods and services tax

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

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

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

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.

NCGTWHT

Are electronic records OK for tax?

They’re OK.

 

electronic paper-shredder

It’s clear on the ATO website that electronic storage of paper records is acceptable:

This article from Addisons explains the big picture:

  1. including in the context of record keeping obligations of companies under the Corporations Act 2001; and
  2. refers to the general requirement that taxpayers keep their (Commonwealth) tax related documents for five years.

ATO record keeping requirements in detail are in Practice Statement Law Administration PS LA 2005/2. PS LA 2005/2 shows that the period for keeping records referred to in the article can be longer than five years in certain cases. Records of documents going back to when an asset was acquired, even if prior to the introduction of capital gains tax in 1985, need to be kept for five years after the CGT asset is disposed of. It is also apparent under PS LA 2005/2 that the ATO can impose a range of penalties for failure to keep records including referring cases for criminal prosecution to the DPP where they perceive deliberate falsifications of records.

The article shows how ATO record keeping requirements reflect the Electronic Transactions Act (C’th) 1999. In essence, section 12 states that electronic records of paper documents required to be kept under Commonwealth law are OK if the electronic system is capable of conveniently and adequately reproducing the paper record. That section is referred to and is in line with Taxation Ruling TR 2005/9 Income tax: record keeping – electronic records.

Implementing electronic tax records

A taxpayer fails these requirements, and risks penalty, if electronic records are lost. Using a backup system is critical whatever electronic system is being used. Moreover electronic records have ease of duplication and filing advantages that make electronic records preferable to paper records.

There are other risks of loss of electronic records that should be borne in mind. Export to other formats from legacy or crippleware systems is an imperative when the records can no longer be retrieved from computer software say because the software becomes, over time, no longer licensed, no longer runs in the taxpayer’s operating system environment or the software itself has inherent restraints on its archiving capability. Many modern bookkeeping systems have easy to use export features which can be worthwhile using as a failsafe to ensure compliance with record keeping obligations.

Is a tax invoice that is only electronic OK?

The position with tax invoices is clear. In para 12 of Goods and Services Tax Ruling 2013/1 the ATO states:

Tax invoices in electronic form
  1. A document in electronic form that meets the requirements of subsection 29-70(1) (and if applicable, subsections 48-57(1) and 54-50(1)), will be in the approved form for a tax invoice. [Footnote 9 – This record must be in English or readily accessible and easily convertible to English as required by subsection 382-5(8) of Schedule 1 to the TAA 1953.]

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.