Tag Archives: discretionary trusts

Problems vaguely adding beneficiaries to a trust

I admit to trepidation when I find a trust deed for a family discretionary trust (FDT) has a power allowing the trustee to add anyone as beneficiary of the trust – an add anyone power (AAOP). Why should this be of concern?

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The three certainties

The essentials of a valid trust are certainty of:

1.              intention to create the trust;

2.              subject matter (trust property); and

3.              objects.

Certainty of objects means certainty of beneficiaries of the trust. Potentially a power like an AAOP is not only invalid itself but can invalidate the whole trust causing the trust to fail. In the case of a FDT that means the property is not held for beneficiaries as set out in the deed but is instead returned, or held for return, to whoever gave property on trust to, or settled trust property on, the trustee.

The risk that trust terms of a FDT meant to delineate its beneficiaries may themselves fail can be opaque.

When a trust has certainty of objects

Traditionally, to comply with the certainty of objects essential for a trust, a trustee of supposed trust needed to satisfy the complete list test. That is, for a trust to be valid , the trustee, or a court, had to be able to compile a complete and exhaustive list of all beneficiaries of the trust.

Under the complete list test, a trustee or court needs to able to:

  • identify all beneficiaries within each class of beneficiary with certainty; and
  • ensure that no potential beneficiary was omitted or left indeterminate.

A trust with an AAOP clearly fails the complete list test.

The complete list test generally remains critical to trusts including fixed trusts in determining whether a trust has certainty of objects needed for a valid trust.

A dovetail

However, in the latter half of the last century, English courts were confronted with trust terms for discretionary trusts with large or diffuse classes of beneficiaries. These beneficiaries were only to participate in the property of the trust on the exercise of a discretion in their favour. These were not FDTs but discretionary trusts with a wider range of potential beneficiaries whom the founder sought to benefit selectively.

In these cases it was realised that complete list certainty worked well for fixed trusts but worked less well as a way to scope who may be benefit under these kinds of discretionary trusts. There was a tension between the complete list test, and giving wide flexibility in the selection of beneficiaries to take, where a precision more appropriate to fixed trusts was required.

McPhail v. Doulton – the is or is not test adopted in England

So in McPhail v. Doulton [1970] UKHL 1, the House of Lords relaxed the complete list requirement for certainty of objects of a discretionary trust and found that beneficiaries of the trust were sufficiently certain where an is or is not test could be satisfied. That is, a discretionary trust can be valid where it is possible for the trustee of a court to determine if any given person is or is not a beneficiary within the trust terms. This wasn’t an original formulation but drew on the same test applicable to the validity of trust powers which by then had been expressed in Re Gulbenkian’s Settlement Trusts (No 1) | [1968] UKHL 5.

Thus the court in McPhail v. Doulton recognised that a discretionary trust should not simply be treated as a trust but as an exceptional mix of a trust and power/s with the is or is not test relevant to ascertain whether powers granted in trust terms meet certainty of objects standards.

The is or is not test itself needed further elaboration in McPhail v. Doulton. On the remand of the case, in Re Baden’s Deed Trusts (No 2) [1972] EWCA Civ 10, the UK Court of Appeal demarcated  between conceptual uncertainty, where it is uncertain a person is a beneficiary under terms, and evidential uncertainty where it is uncertain that a person is beneficiary because it cannot be proven that he, she or it is a member of a conceptually sound class of beneficiaries. It was found that a discretionary trust will fail under the is or is not test in the case of conceptual uncertainty but will not fail in the case of evidential uncertainty unless that uncertainty makes administration of the discretionary trust impracticable.

Applying the is or is not test to an AAOP in a FDT

Where someone can only be a discretionary beneficiary of a FDT on the later exercise of a AAOP by a trustee of a FDT it is impossible to tell, just from the FDT terms, whether or not the person is or is not a beneficiary. It follows that a FDT with these terms fails the is or is not test.

But since McPhail v. Doulton courts have taken a piecemeal approach to the is or is not test focusing on the kind of power the donee of the power can exercise within the framework of the discretionary trust. The focus is then on whether a power or powers within trust terms have sufficient certainty of objects with the level of certainty required depending on the kind of power concerned.

The certainty of objects for different kinds of powers to appoint i.e. give or benefit beneficiaries with trust capital or trust income within a discretionary trust is now generally understood to be:

Power Type Definition Key Features
Special Power A power to appoint property to a defined and limited group of beneficiaries.
  • Restricted to specific individuals or groups (e.g., “my children”).
  • Requires certainty of class members viz. strict conceptual certainty.
Intermediate (Hybrid) Power A power to appoint property to a broad class of beneficiaries, subject to exclusions.
  • Broad, but excludes certain groups (e.g., “anyone except family members”).
  • Requires broad rather than strict conceptual certainty which is enough to establish that a beneficiary is outside of the exclusions.
  • Upheld unless administratively unworkable or legally problematic.
General Power A power to appoint property to anyone, including the donee of the power.
  • Unrestricted in scope, effectively ownership rights.
  • No specific exclusions or limitations.

From this table it is evident that where a purely general power of the trustee or other donee can be isolated certainty of objects requirements are even more relaxed to no requirement at all viz. no requirement even to apply the is or is not test which is akin to the unlimited rights an absolute owner of property enjoys.

Extent of invalidation

Does it follow that, in the case of a FDT with an AAOP, the AAOP is a power that can be isolated and considered separately from other powers of the trustee under a FDT?  Other powers usually found in a FDT where the is or is not test does apply include the power to appoint income at the end of an income year and the power to appoint capital on the vesting of the FDT to a particular discretionary beneficiary. Further, in the case of an uncertain power, it could be that only the supposed power itself, and not all trust terms, that will be invalid and won’t be exercisable where only the power is uncertain. That is the approach that appears to have been taken in Evans v. Commissioner of Taxation (1988) 19 ATR 1784, (1988) 88 ATC 4771.

In Evans v. Commissioner of Taxation a deed of a FDT gave the trustee a power to add beneficiaries of the FDT in clause 10 of the trust deed in these terms:

At any time prior to the vesting date, the Trustee may, …, by deed … vary any of the trusts, powers, discretion, or duties herein set forth in any manner whatsoever, including … enlarging any category of eligible beneficiaries and adding a further class of eligible beneficiaries, PROVIDED HOWEVER that no exercise of this power of variation shall be capable of conferring any interest in the trust fund upon the Settlor, and any alteration which would otherwise do so shall, to that extent, be ineffective.

Fisher J. of the Federal Court identified the power to add beneficiaries as a hybrid or intermediate power which, without the exclusion of the settlor of the FDT, only slightly differing from a general power which was found not be invalid for these reasons:

On the assumption that the purported addition of Orebody Investments as an eligible beneficiary was prima facie an effective exercise of power under clause 10, counsel contended that the clause was void for uncertainty. He described the clause as conferring a power which was a “hybrid or intermediate power” and was administratively unworkable. He cited McPhail v Doulton [1971] AC 424, especially at 457, and Re Hay’s Settlement Trusts [1982] 1 WLR 202 at 213 as authority for this proposition.

A contrary authority is Re Manisty’s Settlement [1974] Ch 17, a decision of Templeman J (as he then was), which counsel for the Commissioner contended was either distinguishable or ought not to be followed in Australia. In that matter, his Lordship had to consider a power to add to the class of beneficiaries which was said to be an intermediate power and wider than any special power as it was practically unlimited. Thus, it was contended that the power was too wide, uncertain, and invalid. However, he declined to apply the requirement of class certainty to mere powers as opposed to trust powers.

This case and its reasoning have been approved in Australia by the authors of Jacobs’ Law of Trusts in Australia (5th ed, p 345, para 258), and by Professor R. P. Austin in an article entitled “A Survey of Recent Cases in the Law of Trusts.” Likewise, Megarry VC applied Re Manisty’s Settlement in Re Hay’s Settlement Trusts, where at 212 the Vice-Chancellor said:

    Nor do I see how the power in the present case could be invalidated as being too vague, a possible ground of invalidity considered in Re Manisty’s Settlement, at 24. Of course, if there is some real vice in a power, and there are real problems of administration or execution, the court may have to hold the power invalid: but I think that the court should be slow to do this. Dispositions ought, if possible, to be upheld, and the court ought not to be astute to find grounds upon which a power can be invalidated. Naturally, if it is shown that a power offends against some rule of law or equity, then it will be held to be void: but a power should not be held void upon a peradventure. In my judgment, the power conferred by clause 4 of the settlement is valid.

It is my opinion that I should refrain from declaring clause 10 void for uncertainty in these proceedings, as sought by the Commissioner, not only because I find in his favour on this aspect of the appeals on another ground but also because the matter was not argued in depth. Furthermore, any such finding could have an impact upon persons not before the court, even though they would not be bound by the finding. I am not considering the matter as a court of construction and hearing all parties interested in various possible interpretations.

Can a trustee of a FDT rely on Evans v. Commissioner of Taxation?

So Evans v. Commissioner of Taxation, a decision of a single judge of the Federal Court, does not purport to be immutable authority on the issue of uncertainty of a wide intermediate or hybrid power was not isolated from the or a general power, such as an AAOP, in a FDT. Further, the correctness of the decision is open to doubt as the intermediate or hybrid power of the trustee: the appoint anyone other than the settlor power in clause 10 of the trust deed, was not isolated from other trust powers/duties of the trustee to which the is or is not test does apply. That is the appoint anyone other than the settlor power in clause 10 cannot be decoupled from the other trust terms which uncertain alteration of who can be a beneficiary impacts including in Evans v. Commissioner of Taxation:

  • the power to appoint income at the end of an income year: sub-clause 3(a); and
  • the power to appoint capital on the vesting of the FDT: clause 4;

which were trust duties of the trustee to perform under the deed which each need to comply with the is or is not test and, further, core trust duties on which the validity of the whole trust stands.

Impact of takers-in-default of appointment on a trust power to appoint

My questioning of the decision in Evans v. Commissioner of Taxation relies on an understanding that the power to appoint income at the end of an income year and the power to appoint capital on the vesting of the FDT are trust powers/duties that significantly differ from a general power or a wide intermediate or hybrid power. In an Australian FDT this distinction can be fine because powers to appoint income or capital on vesting in a FDT will generally specify takers-in-default of appointment. However, generally in a FDT, as in McPhail v. Doulton, the presence of gifts over in default of appointment does not eliminate the duty or obligation on the trustee to perform its obligation: that is, to exercise its discretion and select beneficiaries to take. A gift over in default of appointment acts no more than as a failsafe in the event that the trustee fails to exercise its discretion, say in breach of trust. That is a gift over in default gives no liberty to the trustee of a FDT not to exercise their discretion like an absolute owner of property has.

If I am correct and an AAOP with uncertain objects cannot be isolated from obligatory trust powers to appoint income at the end of an income year and the power to appoint capital then it may be possible to manage the certainty of objects by having the trustee (donee) leaving an impugned AAOP dormant. By desisting to use the AAOP the trustee can ensure that beneficiaries selected under the appointment powers continue to meet the is or is not test despite the presence of the AAOP in the trust terms. Perhaps a additional beneficiary or beneficiaries could be added to the FDT is some other way? With the aid of the principle on which Evans v. Commissioner of Taxation, ultimately relies viz.

Dispositions ought, if possible, to be upheld, and the court ought not to be astute to find grounds upon which a power can be invalidated.

supra.

desisiting from exercising the impugned AAOP to add a person as a beneficiary and appointing income or capital to that person may save a trust from invalidity.

Conclusion

It follows that, despite Evans v. Commissioner of Taxation, an AAOP in the trust terms of a FDT may run risk of being invalid with chaotic outcomes where the trust that so fails was thought to hold significant property. Thank kind of clause appears reckless and unnecessary when parameter or parameters of a trust class can be readily designed so that beneficiaries can be added to a trust within the wide certainty that the is or is not test allows.

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

HazardWarning

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

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

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

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

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

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

The beneficiary after death?

After the death of a deceased beneficiary:

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

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

1.       BENEFICIARY NO LONGER LEGALLY A PERSON

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

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

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

Bowman v Secular Society [1917] A.C. 406

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

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

The beneficiary principle

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

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

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

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

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

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

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

Doctrine of lapse

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

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

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

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

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

The Commissioner of Taxation states in IT 2622:

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

Paragraph 5 of IT 2622

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

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

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

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

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

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

at CLR p. 233

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

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

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

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

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

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

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

INCOME TAX RAMIFICATIONS

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

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

Commissioner’s discretion

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

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

Risk to a deceased estate of higher income tax rate

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

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

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

Gift icons created by Freepik – Flaticon

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

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

Valid gifts

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

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

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

[1917] A.C. 406 per Lord Parker

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

Doctrine of lapse

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

So a gift to someone who has died generally fails.

Gifts to deceased estates

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

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

Income tax problems with distributions of trust income to deceased estates

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

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

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

Conclusion

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

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

Give it back!

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

The trustee may also be a beneficiary, but not the sole beneficiary unless there is more than one trustee.

Trusts, trustees and beneficiaries | Australian Taxation Office

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

Conflict of interest

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

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

Fiduciaries

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

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

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

Lord Herschell in Bray v. Ford [1894] AC 44

and

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

Lord Upjohn in Boardman & Anor v. Phipps [1966] UKHL 2; [1967] 2 AC 46 at page 124

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

Impartiality

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

The starting point is the duty of trustees to exercise their powers in the best interests of the present and future beneficiaries of the trust, holding the scales impartially between different classes of beneficiaries. This duty of the trustees towards their beneficiaries is paramount.

Cowan v. Scargill [1985] Ch 270 at 290-292 (Megarry VC)

Context of trustee power

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

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

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

Edge v. Pensions Ombudsman [1998] Ch 512 at p. 533

The limits of FDT trustee power

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

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

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

Controlling who gets death benefits from a SMSF )

Real and genuine consideration

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

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

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

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

But power to favour beneficiaries is exceptional

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

Certainty of beneficiaries

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

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

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

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

The drafting of the FDT deed

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

Has the AAT in Bendel reset the treatment of UPEs from trusts as Division 7A deemed dividends?

dismantle

The Commissioner of Taxation’s longstanding practice as to when an unpaid present entitlement (UPE) of a private company beneficiary of a trust will give rise to a deemed dividend under Division 7A of the Income Tax Assessment  Act 1936 has been dismantled by the Administrative Appeals Tribunal (AAT) in Bendel v. Commissioner of Taxation [2023] AATA 3074.

The Commissioner’s practice

That practice was set out by the Commissioner in Taxation Ruling TR 2010/3 and Practice Statement Law Administration PS LA 2010/4 and is now adjusted by Taxation Determination TD 2022/11 (the Practice).

Unfortunately the AAT decision in Bendel doesn’t directly deal with or critique the Practice, which has been foundational to the administration of Division 7A and trusts, and has dealt with the prospect of a trust UPE loophole in Division 7A, since 2010. It is clear that the AAT has diverged from the Practice by its approach to the Division 7A provisions in Bendel.

Sub-trusts?

The AAT in Bendel found that, despite the Commissioner’s position in the Practice and as a party in Bendel that a sub-trust arises where a trustee holds a UPE to income for a beneficiary of a family discretionary trust (FDT), no new or separate trust arises as a matter of law: On the authority of the High Court in Fischer v. Nemeske Pty. Ltd. [2016] HCA 11 which the AAT found “more to the point”, the AAT observed:

  • it is difficult to see any reason in principle why such an unconditional and irrevocable allocation of trust property must take the form of an alteration of the beneficial ownership of one or more specific trust assets;
  • there was no suggestion that the trustee’s exercise of the power to apply trust property involved a resettlement of trust property so as to result in the creation of a new trust;
  • further, the exercise of that power effected an alteration of beneficial entitlements in property which the trustee continued to hold on trust under the terms of the existing settlement was orthodox as a matter of principle. It was also unremarkable as a matter of practice…; and
  • An absolute beneficial entitlement to some part of a fund of property that is held on trust need not be reflected in an absolute beneficial entitlement to the whole or some part of any specific asset within that fund. That must be so whether the absolute beneficial entitlement to some part of a fund of property that is held on trust is defined by the terms of the trust settlement itself, or whether such absolute beneficial entitlement to some part of a fund of property that is held on trust is defined by an exercise of a power conferred on a trustee under the terms of a trust settlement.

[Italicised are extracts from the judgment of Gagelar J. of the High Court in Fischer v. Nemeske Pty. Ltd. [2016] HCA 11  at paras 95 to 99 included in the AAT decision.]

It follows that a UPE remains an entitlement of the beneficiary under the terms of the head or main trust.

But what of explicitly declared sub-trusts in the trust deed?

The AAT in Bendel did not consider the impact of the terms of the trust deed of the FDT on that reasoning. The deed explicitly sought to establish sub-trusts for UPEs arising under the FDT which counters the AAT finding, on the authority of Fischer v. Nemeske Pty. Ltd., that the UPE remains an entitlement under the main FDT. In my estimation these terms “settling” a UPE sub-trust could have been ineffectual in any case due to them having been:

  • internally inconsistent: on the one hand a sub-trust was stated to be held for a beneficiary “absolutely” but on the other the trustee was given wide discretion to resort to and deal with the assets of the sub-trust and, in practice and in the accounts, the property of UPE sub-trusts, if they existed, was intermingled with the property of the main trust and so separate sub-trusts were thus perhaps a sham or without legal effect? and
  • insufficiently clear to establish or “re-settle” sub-trusts or to alter beneficial interests as explained in Fischer v. Nemeske Pty. Ltd.: the sub-trust provisions of the deed had “no work to do” just like the Second Declaration of Trust in Benidorm Pty Ltd v. Chief Commissioner of State Revenue [2020] NSWSC 471.

Is a UPE an extended loan?

A UPE under a trust is not and is divergent from a loan in the ordinary sense. That is not disputed. Unfortunately, surprisingly and more controversially the AAT does not appear to directly deal with the question of whether a UPE from a trust is what was referred to in TR 2010/3 as a “section three loan” or a loan within the extended meaning of loan under sub-section 109D(3) of the ITAA 1936 (extended loan) although submissions of the parties on the questions of whether or not a UPE is either:

  • a financial accommodation; or
  • an in substance loan;

were received and outlined in the Bendel decision but received scant consideration in the decision.

It isn’t apparent that the AAT accepted the taxpayer’s contentions to the effect that a financial accommodation and an in substance loan are a subset of director/creditor type or loan-like relationships and are inapplicable to a trust entitlement and so concurred that a passive UPE owed to a beneficiary cannot be either a financial accommodation or an in substance loan that triggers an extended loan as considered by the Commissioner in paragraphs 19 to 26 of TR 2010/3. Rather the AAT gave a matrix in paragraph 101 of the decision (see below) to seemingly justify not giving a concluded view on these contentions.

Dictionary definitions and restrictive views

Maybe the AAT had financial accommodation front of mind when the taxpayer’s counsel referred to dictionary definitions being considered out of statutory context and legislative history as: a foundation for error where the outcome is contrary to statutory context and legislative history (SCLH)?

I am not so sure the SCLH, when considered in the context of twelve or more years of the Practice where the Commissioner has clearly relied on his wide view of financial accommodation in sub-section 109D(3) such that it can encompass an omission to pay out a UPE within the standard time frame allowed under paragraph 109D(1)(b), demands the restrictive view of when a UPE can be an extended loan the AAT has apparently taken in Bendel.

What should follow from legislative flaws in Division 7A concerning UPEs perceived by the AAT?

If I understand the AAT decision in Bendel correctly, the AAT have inferred from the SCLH, of which the AAT is critical, that the parliamentary intent on introducing section 109UB and, later, its replacement Subdivision EA, or that the effect of those provisions by dent of design fault, was that they are to apply to UPEs from trusts to the exclusion of the core provision governing what is a loan in section 109D.

If section 109UB, section 109XA et al. in the SCLH are so deficient, why would the AAT give them paramountcy over the core provisions which the Commissioner has been able to satisfactorily administer with the Practice over a long period? Couldn’t the AAT have inferred that the legislature, and the Commissioner prior to his adoption of the Practice, had acted on an unnecessary and untested assumption that a UPE from a trust could not be or would not be an extended loan under sub-section 109D(3)?

Does the Practice really tax two people over the one UPE?

A further departure of the decision of the AAT from the Practice is that applying section 109D:

raises the spectre of taxing two people in respect of precisely the same underlying circumstance, namely the same UPE

see paragraph 98 of the AAT decision in Bendel

In my view it is open to the Commissioner and reasonable, given the legislative policy of Division 7A, to treat the distribution from the FDT to a corporate beneficiary and the UPE arising in favour of the beneficiary as a distinct and earlier in time transaction from the failure to satisfy the UPE by payment within the standard time frame allowed under paragraph 109D(1)(b).

This is just as much taxing two people in respect of the same income as a private company earning income subject to company tax and a shareholder of the company thereupon receiving that already company taxed income as an unfranked dividend which is thereupon taxable to the shareholder. It is to this outcome that Division 7A, as an anti-avoidance regime underpinning the integrity of the company tax system, seems rightly directed.

Interpretation approaches to the provisions

It occurs to me that, that being so:

  • the shortcomings of the Division 7A legislation insofar as it addressed UPEs from trusts set out in the decision;
  • the restrictive reading of it by the AAT in the context of the SCLH;
  • an interpretation based on generalia specialibus non derogant so that section 109UB and Subdivision EA, despite what the AAT says was its flawed passage into law, overrides the general provision: section 109D; and
  • a possible further contention by the taxpayer that a financial accommodation, an in substance loan or both are part of a ejusdem generis list that should be confined to financial accommodations or in substance loans within or comparable to advances of money, provisions of credit and the like viz. strictly debtor creditor financial activity;

are approaches and considerations likely to be or should be subordinated to the need to “ascertain the legislative intention from the terms of the instrument viewed as a whole”: Cooper Brookes (Wollongong) Pty Ltd v. Federal Commissioner of Taxation [1981] HCA 26 understanding that the Acts Interpretation Act (C’th) 1901 provides:

In the interpretation of a provision of an Act a construction that would promote the purpose or object underlying the Act (whether that purpose or object is expressly stated in the Act or not) shall be preferred to a construction that would not promote that purpose or object.

section 15AA of the Acts Interpretation Act (C’th) 1901

and applies to taxing Acts as well as other Acts and that the purpose of Division 7A is directed to maintaining the integrity of the Australian system of taxation of private companies.

I think it unlikely that a court would be confused by or would miss the purpose of the provisions due to the AAT’s questionable matrix set out as follows:

Having regard to:

    (a)          the policy of Division 7A to tax those who in substance enjoy the benefit of corporate profits without bearing taxation that would arise had the company paid dividends in the usual way;

    (b)          statutory construction principles that call for

        (i)          regard to statutory context and legislative history; and

        (ii)         potentially competing provisions to be construed in a manner which ‘gives effect to harmonious goals’;

    (c)          there being no tiebreaker provision which mandates which of two competing assessing provisions would apply if an unpaid present entitlement constituted a loan within the meaning of s 109D(3);

    (d)          the s 109RB discretion not being designed to allow relieving discretions to be exercise outside the s 109RD(1)(b) gateways of honest mistakes and inadvertent omissions and thus not a discretion that would relieve inappropriate double taxing;

    (e)          Subdivision EA being a specific, and therefore lead, provision containing an express set of rules that can be regarded as a particular path has been chosen to deal with the taxation effect of unpaid present entitlements in favour of corporate beneficiaries in prescribed circumstances;

    (f)          the lack of clarity as to the nature of an unpaid present entitlement and the separate trust concept often broached in conjunction with the unpaid present entitlement topic;

    (g)          the expressed explanation accompanying s 109UB, the predecessor of Subdivision EA, to the effect:

        (iii)        that an unpaid present entitlement in favour of a corporate beneficiary and a contemporaneous loan by the trustee to a shareholder in the corporate beneficiary (or associate) is in substance a loan by the company to the shareholder; and

        (iv)         that an amount to which a company is entitled ‘held on a secondary trust for the benefit of the company’ is regarded as unpaid and within the ambit of s 109UB;

    (h)          the operation of Subdivision EA which taxes the shareholder in the foregoing circumstances as if the company had lent money directly to that shareholder which falls squarely within the Division 7A policy framework;

    (i)          there being no provision in either of the Assessment Acts that anyone points to that expressly allows assessment of two people arising out of the same circumstance with one of those people potentially not enjoying any benefit of the corporate profits that are the underlying cause of the assessment,

the necessary conclusion is that a loan within the meaning of s 109D(3) does not reach so far as to embrace the rights in equity created when entitlements to trust income (or capital) are created but not satisfied and remain unpaid. The balance of an outstanding or unpaid entitlement of a corporate beneficiary of a trust, whether held on a separate trust or otherwise, is not a loan to the trustee of that trust.

para 101 of the AAT decision in Bendel

Towards a purposive construction of the provisions

In adopting a purposive construction of these provisions of Division 7A I would be surprised if a court would replicate the AAT’s disdain for parliament’s efforts to plug the UPE loophole with section 109UB and, later, its replacement Subdivision EA. If I read the AAT decision correctly, these provisions and the manner of their introduction prejudice the Commissioner and the Revenue such that the language of sub-section 109D(3), as a generality, can no longer be applied to UPEs from trusts.

Ironically if the AAT decision is correct, and what is an extended loan is constrained by it, then the legislative clarity from the government the AAT appears to urge and seek in Bendel can no longer be achieved by the repeal of Subdivision EA.

In any case one can expect the government to amend the UPE rules in Division 7A to reverse Bendel should the Bendel decision originated by the AAT persist as authority.

It is clear from Fischer v. Nemeske Pty. Ltd. that a UPE from a trust is different to a loan but the differences between a trust and a loan conflate in that case too. Gagelar J. states:

In challenging the Court of Appeal’s holding concerning the effect in law of the Trustee going on to record a liability to Mr and Mrs Nemes in the sum of $3,904,300 in the Trust’s balance sheet, the appellants do not dispute that a trustee who admits to having an unconditional obligation to pay a specified amount of money to a beneficiary can thereby become liable to an action at law for the recovery of that amount as money had and received to the benefit of the beneficiary, so as to overlay the equitable relationship of trustee and beneficiary with the legal relationship of debtor and creditor.  That has been settled since at least the middle of the nineteenth century[107].

at para 105 of Fischer v. Nemeske Pty. Ltd.

It can be inferred that a trustee of a FDT given an unconditional obligation to pay money to a beneficiary under a UPE has been given a financial accommodation, an in substance loan or both under sub-section 109D(3). A loan and a UPE give rise to clearly comparable liabilities which is precisely the mischief to which section 109D is directed.

Further, an in substance loan is a particularly apt characterisation of the UPE in Bendel where the taxpayer, the FDT and the company beneficiary are related parties as they will be in most of these cases. Where they are related it is clearly commercially open to the trustee of the FDT and related parties to achieve the same liability as understood from para 105 of Fischer v. Nemeske Pty. Ltd. and the same financial goal by either a loan or by a UPE which, in substance, offers the related parties the same thing.

The useful family trust election and income “injection”

injection

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

Income injection test

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

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

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

Scheme assessable income is what is “injected”.

How the IIT works

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

Scheme assessable income arises where (in any order):

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

Context of the IIT

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

When the IIT applies – outsiders

So let us say:

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

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

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

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

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

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

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

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

Downside of a family trust election

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

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

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

Upside of a family trust election

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

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

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

Reasons to be a 2FFT

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

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

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

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

ducks

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

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

Reimbursement agreements – a blunt tool?

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

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

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

Part IVA sharpened up?

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

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

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

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

The apparent counterfactual

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

Circularity and the form of the scheme

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

Commercial rationale or explanation of the scheme?

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

section 177CB – tax gives no explanation

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

Observations

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

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

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

Part IVA risks beyond non-residents?

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

Are bucket companies sitting ducks for Part IVA?

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

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

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

Businesswoman piggybank desk

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

But is it a good idea?

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

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

TCo needs to be a beneficiary of the FDT

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

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

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

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

It can’t be assumed that:

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

without checking the FDT deed.

Consequences of distributing income to a non-beneficiary

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

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

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

Excluded beneficiaries – conflict of interest

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

Excluded beneficiaries – stamp duty

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

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

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

TCo can qualify as a beneficiary  – but what then?

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

Managing TCo’s asset mix

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

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

Serious tax risk of losing track of how TCo owns what

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

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

Is distributing to TCo worth it?

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

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Why the weird donation trust beneficiary qualification?

Donation

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

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

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

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

Certainty of objects necessary for validity of a trust

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

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

  • beneficiaries; or
  • charitable purposes;

must be certain in a valid trust.

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

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

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

Donations

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

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

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

There are limits to this though.

Or just a gift?

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

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

Family trust?

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

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

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

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

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

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

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

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

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

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

Reimbursement agreements

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

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

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

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

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

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

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

CarWoes

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

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

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

so the DMCFT could earn income.

The discretionary trust

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

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

Chadbourne at paragraph 8

The mere expectancy of a beneficiary of a discretionary trust

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

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

Chadbourne at paragraph 57

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

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

The available tax deduction

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

it is incurred in gaining or producing your assessable income 

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

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

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

Chadbourne at paragraph 53

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

Why did the Applicant run the AAT appeal?

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

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

Safer alternative 1 – trustee loan

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

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

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

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

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

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

On-loan – interest free

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

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

TD 2018/9 – paragraph 1

On-loan – at low interest

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

On loan – at equivalent interest

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

Related loan issues

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

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

The Commissioner could take these positions:

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

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

Woes with hybrid trusts

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

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

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