Tag Archives: Family trusts

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.

Image by Freepik

Used the wrong/ trustee’s ABN for a new trust? How to fix …

WrongBox

A common mistake, misstep or omission on setting up a family discretionary trust (FDT) or other kinds of trusts is to use the Australian Business Number (ABN) of the trustee of the trust, typically a proprietary company, rather than to obtain and use a separate ABN after the trust has been established to run a business or enterprise.

Situations where this can happen include:

  • an ABN application form is completed incorrectly for the company without correctly identifying the FDT as the entity to which the application applies;
  • early application for the ABN is made by the company for an ABN, say so the company can say, open a bank account before the trust formation; or
  • the company is already doing other things and has an ABN already.

In each of these situations a client of an accountant can be tempted to use the ABN already to hand for the FDT. A client so tempted may well think – my accountant can sort this out later!

ABN for the wrong entity

It’s a clear mistake as a trust is clearly a separate entity to the company. An entity that can obtain an ABN under the A New Tax System (Australian Business Number) Act 1999 is equivalent to an entity as defined under the companion GST legislation which is:

(1)  Entity means any of the following:

(a) an individual;

(b) a body corporate;

(c) a corporation sole;

(d) a body politic;

(e) a partnership;

(f) any other unincorporated association or body of persons;

(g) a trust;

(h) a superannuation fund.

Note: The term entity is used in a number of different but related senses. It covers all kinds of legal persons. It also covers groups of legal persons, and other things, that in practice are treated as having a separate identity in the same way as a legal person does.

sub-section 184-1(1) of the A New Tax System (Goods And Services Tax) Act 1999

which also conforms with other definitions of entity in the Income Tax Assessment Acts (ITAAs). Its clear that a company can have an ABN and a trust with a company as its trustee can and should separately obtain another ABN where the trust is to carry on an enterprise requiring an ABN.

The usual trust implementation

The usual implementation of an asset protected FDT is to set up the FDT with a corporate trustee with limited liability where the company is to be a dormant company. That is the company will have modest nominal share capital so it can register as a proprietary company with the Australian Securities and Investments Commission (ASIC) but the company will not have business or other substantive assets or liabilities on its own behalf as all intended activity of the FDT will be as the trustee of the FDT.

The company must have a right to be indemnified out of the property of the FDT so that the directors will not be personally liable for the debts of the trust under section 197 of the Corporations Act 2001 but, in terms of the balance sheet of the corporate trustee of a FDT, that right and the share capital are about the only few assets the company needs in the role of trustee of a FDT.

Impact of the wrong ABN

But if an ABN for the company is quoted on bank accounts and on invoices then the Australian Taxation Office (ATO) and all others concerned with the business are informed that transactions thought to be made by the FDT for its business are made by the company in its own right. The accountant for the FDT will have little choice but to record the transactions as transactions of the company in its own right and prepare the accounts of the company accordingly. Significant penalties can apply if the company persists with a position that it was quoting the ABN of the company for activity of an entity without an ABN rather than for activity in its own right.

So instead of the accounts of the company being dormant and those of the FDT being active, the business transactions will go to the accounts of the company and nothing will happen on FDT accounts and the implementation of the trust to operate the business will misfire.

If the business is being run under a business name, where the ABN of the company was used to apply for and obtain the business name, then the ATO and all others concerned with the business will view and treat the business name as a business name of the company and not the FDT.

Fixing the problem – reverting to the trust structure

This is one of those problems that can’t be fixed retrospectively without penalty trouble – the ABN has been quoted and relied on, but the problem can be fixed going forward.

Get the right ABN

The FDT can belatedly apply for an ABN. It is possible for an ABN to have retrospective application viz. the ABN can take effect from a date nominated by the applicant some time prior to the time of the application. But the ABN taking earlier effect won’t cure the problem of where the wrong ABN has been quoted since then.

Restore the company balance sheet

The company shouldn’t need to be voluntarily liquidated but a comparable internal process can be done to transfer the assets and liabilities in the accounts of the company to the FDT and to restore the balance sheet of the company to the modest assets described under The usual trust implementation above from a set fix or changeover date. If the problem is picked up early enough – it should be! –significant income tax profit and capital gains tax exposures of transferring assets to the FDT that may require remedy such as the small business restructure rollover in Division 328-G of the ITAA 1997 may not necessarily be needed to reset the company balance sheet.

Coping with the administrative consequences of changeover

If a client of an accountant has put itself into this sort of tangle it is likely that the client will struggle with this remedial action too which presents some administrative challenges as the client is now dealing with, effectively, two discrete businesses before and after the changeover day: The business initially carried on by the company with its ABN and then the business carried on by the FDT with its ABN from the changeover day.

It is important that the accounting and administrative team of the client (the Team) can pinpoint company period transactions before the changeover date and FDT period transactions that happen after the changeover day.

So a further element of the fix proposed here is to change the name of the company and for the Team to be meticulous about changing processes and stationery etc. to the new company name once the changeover day happens and the FDT period is underway.

There is an ASIC cost to change the name of the company and stationery etc., and time of the Team to manage all of this, but that cost should be considered in the context of alternatives that are costlier such as to voluntarily liquidate the company, to start afresh with an entirely new business structure to get the ABN process right or to abandon plans to use the FDT structure altogether.

A common technique for a name change for a company running a business, when a name change isn’t really wanted for public facing reasons; is to change NameOfCompany Pty. Ltd. to say NameOfCompany (Aust.) Pty. Ltd. This can help the Team and its customers to apply the right ABN and to get the accounting right (e.g. sales put through the right books of the two distinct entities NameOfCompany Pty. Ltd. to NameOfCompany (Aust.) Pty. Ltd (as trustee for the FDT) in this example for before and after changeover day transactions.

Unless something like this is done the Team and customers of the business might get very confused and might not manage the transition to the FDT as sought all along.

Impact of name change on the appointed FDT trustee

Unlike a liquidation of the company, after which a new trustee of the trust would need to be set up and appointed, a name change won’t affect the position of the company as the trustee of the trust.

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.

Graphic designed by Freepik

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

RubberyNumbers

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

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

Tax audit – taxable income of the JFT increased

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

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

Before the AAT the Participating Beneficiaries contended that:

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

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

AAT decides – aligns with Commissioner

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

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

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

Opaque expression of distributable income

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

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

How distributable income can be distributed

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

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

Bamford at paragraph 45

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

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

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

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

Timing of present entitlement to distributable income

Nevertheless:

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

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

Setting distributable income by 30 June

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

Distributable income not set in Donkin

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

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

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

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

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

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

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

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

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

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

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

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

Construing trust income resolutions applying Bamford

The High Court in Bamford stated:

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

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

Bamford at paragraph 37

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

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

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

….

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

….

from Bamford at paragraph 45

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

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

from Bamford at paragraph 45

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

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

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

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

Section 99A should have applied

In my understanding:

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

Distributable income – no place for a variable parameter

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

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

Income equalisation clauses

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

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

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

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

trusts guardrail

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

Even where a beneficiary is:

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

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

Tax capture when no beneficiary entitled to the income

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

The trustee beneficiary complication

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

Example

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

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

The circular trust distribution by trusts

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

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

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

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

The legislative countermeasures

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

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

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

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

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

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

A New Tax System (Closely Held Trusts) Act 1999

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

Closely held trusts

A trust is a closely held trust if it:

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

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

Reset of the closely held trust compliance burden

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

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

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

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

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

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

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

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

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

2018-19 Budget changes to closely held trusts

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

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

How will compliance with the changes work?

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

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

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

Changing the trustee of a trust – some elements for success

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

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

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

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

Changing trustee relying on ability to change in the trust deed

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

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

Changing trustee relying on the Trustee Acts

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

Trustee Act – New South Wales

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

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

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

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

Trustee Act – Victoria

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

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

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

Changing trustee by obtaining a court order

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

Changing trustee by deed

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

Tax consequences of a change of trustee

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

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

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

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

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

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

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

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

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

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

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

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

each restate the above Note: viz.

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

Stamp duty

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

Duty – NSW

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

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

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

Duty – Victoria

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

Other requirements

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

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

Should more than one family share a family discretionary trust?

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

Risk of unequal returns from the discretionary trust!

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

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

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

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

Reimbursement agreements

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

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

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

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

The trust deed

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

Purpose of a FDT

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

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

Difference to a proprietary company

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

Difference to a unit trust

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

How CGT applies to distributions of capital by FDTs

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

The CGT similarity of FDT cash distributions and cash gifts

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

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

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

However there is a problematic exception:

Small business CGT concessions participation percentage

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

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

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