On 29 July 2010 the Australian Financial Review1 reported that the ATO was using its new data-matching technology to "cast... a closer eye over trust deeds to ensure the right parties are paying tax on distributions". If a trust distribution is made to an entity that is not a beneficiary, that distribution can be taxed in the hands of the trustee at the top marginal tax rate.
As the ATO can now easily identify disparities between the identity of a trust's beneficiaries and to whom distributions have actually been made, this may result in significant tax liability for those involved in unpermitted trust distributions. Distributions not permitted by the trust instrument are more common than might be expected – whether caused by drafting errors or misunderstood (or even a lack of) instructions.
The Western Australian Supreme Court case of Kirkham as trustee of the Kirkham Family Trust (Unreported, Supreme Court of Western Australia, Martin CJ, 19 May 2010) demonstrates a possible solution to the adverse taxation ramifications of unpermitted trust distributions through the doctrine of rectification. Where a Court rectifies an instrument, that rectification has retrospective effect to the date on which the error was made. The rectified instrument is regarded as having always existed in its rectified form. Rectifying a trust instrument to include the non-beneficiaries to whom distributions have wrongly been made corrects those errors and avoids the negative taxation consequences referred to above.
In Kirkham, distributions had been made from the Kirkham Family Trust (Trust) to recipients who, on a close examination of the trust deed, were not, in fact, beneficiaries. Upon realisation of this, Kirkham applied to the Court for rectification of the trust deed, so that they would be regarded as beneficiaries from the date the trust was established.
A successful claim for rectification requires the party seeking rectification to show "clear and convincing proof" that there is a disconformity between the intention which was to be given effect by the instrument to be rectified and the actual effect of the instrument in question. Whilst a court can order the rectification of a mistake as to the legal effect of the words used, it will not rectify a mistake of law. "Effect" here means the legal and factual operation of the instrument according to its true construction, but does not extend to the legal or factual consequences of the operation of the instrument of a more remote, or collateral kind (for example, an instrument's liability to stamp duty).
Kirkham's claim for rectification was successful by virtue of the following:
Kirkham was able to rely upon affidavits from himself, the solicitors that drafted the will, and his accountant in support of the application.
Consent by the beneficiaries
The Court noted that all likely beneficiaries agreed with the proposed amendments and that none of them wished to be heard in relation to the relief sought.
Subsequent actions of the trustee
Kirkham's intention at the time of drafting the instrument was to include himself as a beneficiary and this was consistent with his subsequent actions as trustee. Kirkham also made distributions to companies in which he had an interest on the assumption that he was a member of the class of general beneficiaries.
Identification of a drafting error
The Court looked behind the terms of the instrument and was satisfied that there had been an erroneous preparation of the trust instrument. It was hypothesised that this was a result of Kirkham being specified personally as the trustee rather than a proprietary limited company (as was the usual practice). This resulted in the standard trust instrument used by the firm being inconsistent with what was intended as Kirkham fell within the definition of 'excluded class' and therefore outside of the class of 'general beneficiaries' (unless expressly made an additional member of that class). The Court was satisfied that this was the result of an oversight.
Logic, plausibility and consistency
Kirkham's actual intention corresponded with the rectification sought. It was supported by logic, plausibility and consistency. As Kirkham was a 'specified beneficiary' it would have been inconsistent and illogical for him to be, at the same time, omitted from the class of general beneficiaries. Further, Kirkham as a beneficiary was also logical, plausible and consistent with the original reasons for the creation of the trust.
In summary, it pays to check to see if persons to whom trust distributions are to be made are, in fact, the beneficiaries of the trust. You should never just assume this to be the case. Serious adverse tax consequences may arise if you get this wrong. If distributions have been made to non-beneficiaries as a result of an instrument that does not reflect the intention of the person creating the trust at the time of execution, Kirkham shows that the rectification remedy may be a perfect solution. With the ATO's recent focus upon trust payments to non-beneficiaries, Kirkham may become an increasingly important superior court precedent for an upsurge of trust-related rectification suits.
1 Michaela Whitbourn, 'ATO's data matching homes in on trusts', Australian Financial Review (29 July 2010, page 4).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.