Tag Archives: trust deeds

Controlling who gets death benefits from a SMSF

A widower nominated his son and daughter to take equal shares of his superannuation benefits on his death on a basis not binding on the trustee. The daughter, who was the surviving trustee of her father’s self managed superannuation fund (SMSF) after his death, appointed her husband as the new co-trustee and excluded the son from control of the SMSF. The daughter refused to pay the son the equal share of death benefits based on the father’s non-binding death benefit nomination (DBN). The son unsuccessfully challenged the daughter’s conduct in the NSW Supreme Court: Katz v. Grossman [2005] NSWSC 934.

Dilemma – the SMSF trustee’s control over where death benefits go

Katz v. Grossman reveals a dilemma with SMSFs: whoever survives a member as trustee of a SMSF generally has significant autonomy as to whom death benefits of a deceased member will be paid to by default unless the member:

  • has taken effective steps to ensure the DBN is a valid binding DBN (BDBN) to bind the trustee to pay his or her benefits to:
    • dependant/s nominated by the member; or
    • the member’s estate by nominating the member’s legal personal representative (LPR); or
  • the member has made his or her pension reversionary to their chosen dependant: although a reversionary pensioner generally cannot be an adult child as only death benefits dependants contemplated by section 302-195 of the Income Tax Assessment Act 1997 can receive pension, including reversionary pension, death benefits.

(Exceptions)

The challenge of directing death benefits to dependants

Member control of superannuation is all well and good but selection of dependants to receive death benefits, either by member’s DBN or by the trustee of the fund, is fraught and is just as prone to dispute between disgruntled family beneficiaries as disputes over wills (Wills) and deceased estates are.

With superannuation funds generally, and especially SMSFs, it is a challenge for a member to:

  • maintain an up to date expression of where he or she wants his or her benefits to go on his or her death; and
  • to effect those wishes by way of a DBN.

In many cases this will be inconsequential such as where a surviving spouse of a deceased member is the surviving trustee, or controls the trustee, and is the obvious dependant of the member to take death benefits. But where dependants are next generation, or where a member has a blended family, surviving trustee decisions to pay death benefits of the deceased may not align with the deceased member’s wishes or their DBN especially where trusteeship of the SMSF passes into unexpected and unprofessional trustee hands on their demise.

Section 17A of the Superannuation Industry (Supervision) Act 1993 (the SIS Act) limits who can be or control a trustee of a SMSF to:

  • the members of the SMSF; or
  • their enduring attorneys;

unless the fund is a single member fund and, in any case, trustees of a SMSF must be unremunerated in their role as trustee: paragraph 17A(2)(c) of the SIS Act. Member controlled superannuation by a SMSF can be a control vacuum isolated from professional trustee expertise following the death of a SMSF member unless a professional is involved in the limited ways possible under sections 17A and 17B.

Does a SMSF member need to control where their death benefits go?

Is it desirable that the member controls where he or she wants his or her benefits to go in any case? Superannuation is explicitly to provide for a member’s dependants when the member dies. The SIS Act defines a dependant:

“dependant”, in relation to a person, includes the spouse of the person, any child of the person and any person with whom the person has an interdependency relationship.

Section 10 of the SIS Act

A deceased member may nominate a dependant by a DBN that is not the dependant of the member most truly dependent or most in need of the member’s death benefits. That is why it is doubly desirable to have a competent and trustworthy person succeed the member as trustee who will genuinely assess these needs. It is on the assumption that such a trustee will survive the member as SMSF trustee that superannuation fund governing rules (SFGRs) generally give the surviving trustee an open discretion to select the dependant of the deceased member to take the member’s benefits unless one of the Exceptions applies.

So even with the guidance of a non-binding DBN (NDBN), which expresses a deceased’s wishes as to whom his or her benefits are to be paid, SFGRs, the SIS Act and trust law typically give a superannuation trustee a power to pay benefits to dependants the trustee chooses in the trustee’s discretion contrary to and despite a NDBN as occurred in Katz v. Grossman.

The binding death benefit nomination

To immunise a DBN from a wrong choice of trustee, who may select a dependant in their discretion at odds with the member’s wishes, a member can use a BDBN. A widow or widower in circumstances similar to Katz v. Grossman can prevent override of their wishes as to who is to be their superannuation dependant to take their death benefits by force of a BDBN to bind the trustee to pay to that dependant.

The BDBN obstacle course

A SMSF member seeking to impose a BDBN to control his or her superannuation needs to be sure it will take effect. There are numerous contingencies. Consider these:

  • is the capability in SFGRs allowing BDBNs effective and does it have integrity? Does the member appreciate that BDBN forms and arrangements differ from trust deed to trust deed? Not all BDBN arrangements in trust deeds are rigorous;
  • will the BDBN be validly completed? (Wareham v. Marsella discussed below is an instance of invalid completion of a BDBN);
  • if the BDBN is stated to be non-lapsing will it take effect as non-lapsing? That is: will the BDBN continue to bind the trustee more than three years after it is made? In the recent case Re SB; Ex parte AC [2020] QSC 139 a non-lapsing BDBN was accepted by the Supreme Court of Queensland. Non-lapsing BDBNs are understood to be feasible for SMSFs following:
    • Donovan v. Donovan [2009] QSC 26; and
    • Self Managed Superannuation Funds Determination SMSFD 2008/3 Self Managed Superannuation Funds: is there any restriction in the Superannuation Industry (Supervision) legislation on a self managed superannuation fund trustee accepting from a member a binding nomination of the recipients of any benefits payable in the event of the member’s death?
  • what if the member marries, divorces or commences a reversionary pension after making a BDBN?
  • will the BDBN have a fraud risk? Who needs to witness completion of a BDBN form by a member under the SFGRs? Depending on arrangements and the regime in the SFGRs for safe custody and verification of a BDBN, is there a risk that a BDBN may be altered by a dishonest successor trustee or a trustee in a conflict of interest with other dependants or “lost” so the BDBN won’t take effect as intended by the member? and
  • what if the SFGRs are subsequently amended so that a BDBN made under former SFGRs of a SMSF no longer comply with the later SFGRs?

So a member looking to rely on a BDBN to direct who will take their superannuation faces a veritable obstacle course turning on:

  • the SFGRs in the trust deed of the fund;
  • the member’s domestic circumstances; and
  • the security integrity of the BDBN arrangements;

in his or her quest to have a BDBN complied with by the trustee of the SMSF when the member is no longer around.

Better for a BDBN to be in a member’s Will?

Although a payment of death benefits is not a testamentary disposition:  McFadden v Public Trustee for Victoria [1981] 1 NSWLR 15, it is desirable that a BDBN should be set out in, or, in the least, kept with, the Will of a SMSF member to avoid some of the above contingencies.

Generally speaking Wills are:

  • subject to strict witnessing and other evidentiary requirements under state laws which reduce the prospect of fraud. By inclusion of a BDBN in a Will the BDBN can attract the same protections; and
  • revoked on marriage and, depending on state laws, altered by divorce. A dependant nominated in a BDBN may pre-decease the member. On any of these events BDBNs are ideally revisited and, in that context, a non-lapsing BDBN is especially fraught after a situation where a long-dated BDBN should have been updated to reflect changes in a member’s domestic situation. If a BDBN is in a Will there is a greater likelihood that desirable update of a BDBN will not be overlooked.

There is also the advantage of consolidated consideration and expression of the member’s wishes for his or her property and financial resources substantially in a single document. Superannuation death benefits of deceased superannuation members now frequently exceed deceased estate property governed by their Wills in value.

To include a BDBN in a Will there needs to be a basis or regime for making a BDBN in a member’s Will in the SFGRs (in the trust deed) of a SMSF. Ordinarily SFGRs/SMSF trust deeds do not provide for BDBNs to be set out in a Will and instead require the BDBN to be in a discrete BDBN form.

When there is no BDBN

When:

  1. a BDBN fails;
  2. there is a NDBN but no BDBN; or
  3. no DBN at all;

what assurance does a member have that a trustee will act in the interests of and fairly to the prospective dependants of the member?

There is initially the issue with the first and third cases that there is no satisfactory expression of what the member wishes. This situation arose in the recent Victorian Supreme Court Appeal decision in Wareham v. Marsella [2020] VSCA 92.

Wareham v. Marsella

In Wareham v. Marsella the dependants of the deceased member of a SMSF included:

  1. the deceased’s daughter from her earlier marriage, Mrs. Wareham; and
  2. her husband of 32 years up to her death, Mr Marsella.

The deceased had made a BDBN in favour of her grandchildren at the inception of the SMSF but her grandchildren were not her superannuation dependants (see the definition in section 10 of the SIS Act above) so the BDBN was invalid.

Mrs. Wareham was the deceased member’s surviving trustee. Relations between her and the husband, Mr. Marsella, were strained. Mrs. Wareham appointed her husband Mr. Wareham as co-trustee. The trustees paid all of the deceased’s SMSF death benefits to Mrs. Wareham wholly excluding Mr. Marsella.

At first instance McMillan J. held that Mr and Mrs Wareham had exercised their discretion as trustees without giving real and genuine consideration to the interests of the dependants of the SMSF and:

  • set aside the exercise of their trustees’ discretion to favour themselves; and
  • removed Mr and Mrs Wareham as trustees of the SMSF.

This result was upheld on appeal to the Court of Appeal.

The court confirmed the wide autonomy the trustees of the SMSF had to select a dependant to take death benefits:

Apart from cases where trustees disclose their reasons, the exercise of an absolute and unfettered discretion is examinable only as to good faith, real and genuine consideration and absence of ulterior purpose, and not as to the method and manner of its exercise.

from Karger v Paul [1984] VicRP 13

Mr and Mrs Wareham did not give reasons for their decision to distribute all of the death benefits to Mrs. Wareham which meant that Mr. Marsella needed to establish:

  • bad faith;
  • lack of real and genuine consideration by; and/or
  • an ulterior purpose of

the trustees in making the decision (the Challengeable Grounds).  These are all matters that are challenging to prove before a court particularly where there are no expressed reasons of the trustees for making the decision. However in this exceptional case the Supreme Court could focus on:

  • the erroneous response by the trustees’ lawyers in correspondence with Mr. Marsella over his claim to participate as a dependant. From that it could be shown that the trustees misconceived their obligation to give Mr. Marsella’s claim a real and genuine consideration. For instance, the trustees’ lawyers had asserted in the correspondence that “Mr. Marsella was not a beneficiary or dependant and had no interest in the fund”; and
  • the bad faith of the trustees. The court observed that “the decision to pay no part of the death benefit to the deceased’s husband of more than 30 years was, at least, remarkable” and the “grotesquely unreasonable” nature of the decision to exclude him was enough to establish bad faith. As there was actual conflict between Mrs. Wareham, a trustee, and Mr. Marsella the court observed that it may remove a trustee in its discretion.

Balanced against that was:

  • the trustees’ resolution to pay Mrs. Wareham which did not reveal errors that establish any of Challengeable Grounds;
  • the power of the trustees to pay death benefits to a dependant who is a trustee despite the conflict of interest; and
  • the trustees did not give evidence and so where not examined about their consideration of Mr. Marsella’s claims as a dependant;

An exceptional case

So even though Mr. Marsella was successful the case was appealed and hard fought. The trustees’ lawyer’s unlikely lapses in the correspondence and the extreme outcome and treatment of a husband of more than 30 years were vital to the result especially where SFGRs expressly permit a trustee to favour themselves in death benefits discretionary decisions despite their conflict of interest with other potential dependants that could receive those death benefits.

Where a trustee is more cautious and opaque in the course of:

  • their decision to pay death benefits to their own benefit, despite their conflict of interest; and
  • in related correspondence;

the trustee will reveal little which will give a disgruntled dependant Challengeable Grounds to challenge the trustee’s exercise of discretion.

In that respect Katz v. Grossman more likely reflects the reality facing most disgruntled family members who miss out on death benefits, especially those who are not a spouse or in an interdependency relationship. In Katz v. Grossman Mr. Katz may not have been in a position to establish the Challengeable Grounds even though:

  • his father had nominated him on a non-binding basis to take an equal share of his death benefits; and
  • his sister and her husband as trustees of the SMSF instead distributed all of the death benefits of the father to his sister.

Conclusion

It follows that the authority of Wareham v. Marsella may only assist a spouse or interdependency dependant highly deserving of death benefits as dependants in compelling cases where:

  • a SMSF’s trustee makes identifiable error in the process of discretionary decision-making to pay death benefits to himself or herself despite their conflict of interest with the deceased’s spouse or interdependency dependant; and
  • where that spouse or interdependency dependant can endure legal action to challenge the decision based on the Challengeable Grounds.

Otherwise SMSF members need to ensure the right person or people are their successor trustee of their SMSF if a Katz v. Grossman or other situation where a dependant favoured by the member misses out on death benefits is to be avoided. A valid or current expression of wishes either in a NDBN or better:

  • in a BDBN, rigorously backed by SFGRs, included in or with the Will of the member to ensure its integrity, reducing the likelihood that a payment of death benefits will be made to the exclusion of a desired or deserving family member especially where, due to the confines of the SIS Act, the member can’t be confident that their successor SMSF trustee won’t use the opportunity to favour their own benefit; or
  • where a member foresees that their dependants will be in potential conflict, in next generation or blended family circumstances, by taking steps in accordance with the SFGRs to remove trustee autonomy to make the death benefits payment decision and to instead mandate that death benefits are to be paid to the LPR of the member in compliance with core purposes of superannuation which allow payment of death benefits to the LPR under section 62 of the SIS Act. In that case the member can set out how death benefits are to be left in his or her Will.

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.

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.

Full Federal Court pinpoints year end trust resolutions that fail

failContractual principles apply to construe trust resolutions

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

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

Trust resolutions to confer a present entitlement to discretionary trust income

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

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

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

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

Ownership and present right to demand payment

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

After Bamford

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

Construing the Lewski trust resolutions

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

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

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

which the Commissioner disputed.

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

Ms. Lewski wins

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

Resolutions under scrutiny

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

2006 year:

100% to Ms. Lewski

2007 year:

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

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

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

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

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

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

Construing income equalisation clauses

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

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

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

“Trust income” needs to be closed at year end

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