Australia: Tax effective trust deeds - part 1

1. INTRODUCTION

I have been asked to discuss some specific issues which are relevant to modern trust deeds.

There are numerous different categories of trust that are recognised by the law but the most common structure utilised for investment and business purposes in Australia is what is generally described as a 'discretionary trust', although that expression is not defined in legislation or case law.

Private unit trusts are also reasonably common but, for the purpose of this presentation, I will focus mainly on features that should be included in 'smart' discretionary trust deeds.

There are a very large number of trust deed templates that are in wide circulation and it is often difficult for a client or professional adviser to assess whether a particular style of deed is adequate and up to date. The main risk factor in my view is that many trust deeds are based on a precedent that was drafted many years ago and which has not been regularly updated.

In this paper I will consider specific provisions that should be included in trust deeds and then discuss in more detail some particular issues such as income streaming powers and potential problems with deeds that have inadequate amendment powers.

2. PROVISIONS THAT SHOULD BE INCLUDED IN A SMART TRUST DEED

This section of the paper is not intended to be an exhaustive list of key provisions that should appear in trust deeds. Rather I have attempted to identify some specific provisions that my firm has dealt with in our discretionary trust deed to deal with changes in tax and trust law and reflect current practice.

Ensure trustee has discretion to determine how net income is calculated

Following the decision in Commissioner of Taxation v Bamford1 , it is now accepted that a trustee may have the power to determine what amounts will be regarded as being received or paid on revenue or capital account for the purpose of determining the 'distributable income' of the trust.

The basis on which the trustee determines the distributable income does not have to be consistent with tax or accounting principles.

This provides substantial flexibility for clients, which is one of the main advantages of utilising a discretionary trust structure. For example, in Clark v Inglis2 the court considered that the trustee had the power to include unrealised gains on the trust's share portfolio in the distributable income of the trust.

However, the trustee only has discretion if the deed allows it. If the deed does not contain a power to determine what will be income or capital, the distributable income will be determined in accordance with trust law principles. If the deed has a fixed definition of income the trustee has no discretion to adopt a different approach.

In my view the trust deed should:

  • contains a definition of trust income (so that trust law principles do not automatically apply);
  • give the trustee discretion to adopt an alternative concept of income where appropriate; and
  • include a general power allowing the trustee to determine what amounts are received or paid on capital or revenue account each year.

It is also important that income distribution resolutions are drafted in a way that reflects the provisions in the deed. We often see income distribution resolutions that do not reflect the provisions of the trust deed. For example, it is not uncommon to see resolutions where the trustee purports to distribute the accounting income of the trust whereas the trust deed provides that the trust income is equal to 'net income' as defined in section 95 of the Income Tax Assessment Act 1936 (1936 Act), or vice versa.

This can result in significant problems. For example, it may mean that not all trust income is picked up resulting in default assessments to the default beneficiaries or the trustee (under section 99A). In extreme cases the trust resolution may simply not be effective.

The most common approach is for the deed to define the net income of the trust as being equal to 'net income' determined under section 95 of the 1936 Act.

There is merit in this approach (provided the trustee has the discretion to adopt a different concept of income if appropriate) but it is also important to exclude 'notional amounts' from the section 95 concept of net income for this approach to work in practice.

Exclude 'notional amounts' from net income

The danger of having a definition which equates trust income with section 95 'net income' is that the net income determined under section 95 will often include 'notional amounts' that are not actually received by the trustee (e.g. franking credits attached to fully franked dividends and deemed dividends under Division 7A).

For example, if a trust receives a fully franked dividend of $70,000 the section 95 'net income' will be $100,000 (being the dividend ($70,000) plus the franking credit attaching to the dividend of $30,000).

While the taxable income will therefore be $100,000, the only amount available to the trustee for the purpose of making distributions to beneficiaries is $70,000.

The best approach in our view is to provide that the net income of the trust will be equivalent to section 95 net income excluding any notional amounts (while allowing the trustee a discretion to adopt some alternative concept).

The ATO has also made it clear that, in its view, notional amounts such as franking credits cannot be taken into account in calculating the distributable income of the trust.3

Including notional amounts in distributable income may also result in significant non-tax related problems if there are disputes in the future about the effect of previous trust distributions and whether beneficiaries are entitled to call for payment of these notional amounts.

These potential problems are illustrated by the decision in Thomas Nominees Pty Ltd v Thomas4 . In that case the trustee had purported to include franking credits in trust income and to separately distribute those franking credits. The trustee applied to the court for directions as to whether the franking credits were in fact available for distribution. The Queensland Supreme Court initially held that the franking credits could be included in distributable income but this approach was rejected by the Federal Court in Thomas v Commissioner of Taxation5 where Greenwood J said:

The franking credits, however, were not income of the trust. They could not be streamed.6

Allow the trustee to make distributions from gross income to preserve franking credits

A beneficiary is only entitled to claim the benefit of imputation credits attaching to a franked dividend, to the extent the beneficiary is presently entitled to a share of the trust income under section 97.7

The concept of "present entitlement" is not defined in the legislation, but the authorities establish that, in order for a beneficiary to be presently entitled to a share of the income of the trust estate, that beneficiary must have an indefeasible and absolutely vested interest in the income and must be able to demand immediate payment of their share of the income from the trustee. 8

The difficulty where the trust estate has positive "net income" under section 95 only because the net income includes imputation credits, is that, while there may be an amount of 'net income' that is subject to tax, this is a notional amount which cannot be distributed to a beneficiary and therefore they cannot be presently entitled to it.

The view of the ATO is that, if there is no income available for distribution in a year then there is no amount to which a beneficiary can be presently entitled under section 97, even though the trust itself may have a positive "net income" under section 95 because of the requirement to gross up the imputation credit.9

One option that may allow the trustee to pass on imputation credits even where the trust has no distributable net income is to include a provision in the trust deed allowing the trustee to make distributions out of gross income (e.g. by treating some expenses as being on capital account).

Section 97 only requires that the beneficiary is entitled to a share of the "income" and not the net income of the trust estate. This distinction was pointed out by Kitto J in Union Fidelity Trustee Co of Australia Ltd v FCT. 10

Therefore, if the trustee has the power to make distributions out of the gross income (before calculating the distributable net income) it is at least arguable that the beneficiaries are still entitled to a share of the trust "income" under section 97 and would in turn be required to include the same proportion of section 95 "net income" (i.e. the imputation amount) in their assessable income.

It should be noted however that the ATO may take issue with such an approach given the statement in TR 2012/D1 that the 'income of the trust estate' must be 'represented by a net accretion to the trust estate'11

Does the deed have a 'sub-trust' clause?

Most advisers will be aware that the ATO has had a significant focus on Division 7A where trusts have distributed to corporate beneficiaries but have left the distribution amounts as unpaid present entitlements (UPEs).

Originally, the ATO view was that unpaid UPEs owing to a corporate beneficiary did not amount to financial accommodation and therefore would not trigger any deemed loan or unfranked dividend under those provisions.

However, they subsequently revised their position and, as a result, UPEs arising after December 2009 will trigger a deemed dividend under Division 7A unless the UPE is converted to a loan (repayable on terms required by Division 7A) or, alternatively, is placed on a sub-trust with an investment agreement that requires the sub-trust amount to be paid either over a seven or ten year term (depending upon the interest rate applied).

The ATO position on this issue and their requirements for a valid investment agreement are set out in practice statement PS LA 2010/4 which provides that, in order for the trustee to take advantage of the safe harbours provided for in the practice statement, the UPE must be held on a sub-trust for the corporate beneficiary.

The practice statement does indicate that, if the deed does not contain a sub-trust provision, the trustee may still be able to pass a specific resolution placing the unpaid UPE on a sub-trust.12 However, this requires that the advisers are alert to the problem when the resolution is made and a much safer approach is to ensure that there is a sub-trust clause in the trust deed itself.

Ensure trustee can make beneficiary 'specifically entitled' to future capital gains

Since the GCT and dividend 'streaming' provisions were introduced into the Income Tax Assessment Act 1997 (1997 Act), it is clear that trustees can stream capital gains and franked dividends to particular beneficiaries. These measures are considered in more detail later in the paper.

One of the key requirements for a capital gain to be streamed to a particular beneficiary is that the beneficiary must be 'specifically entitled' to the gain by 31 August following the end of the financial year in which the gain arises.13 The practical difficulty is that the actual gain may be deemed to occur in one financial year (because a contract of sale was signed in that year) but the gain itself may not crystallise until much later.

For example, under the earn-out provisions introduced in Tax and Superannuation Laws Amendment (2015 Measures No. 6) Act, if a CGT asset is sold and the consideration is payable over time subject to earn-out conditions, the tax return for the year in which the sale occurred is amended each time an earn out payment is actually received.

This means that, if the parties are intending to stream the capital gain, it will be important that the trustee has power to make a beneficiary specifically entitled to a gain that may not crystallise for some years after the resolution is made. Most trust deeds do not have that specific power although it may be implied in many instances.

Our view is that it is preferable to have a specific provision to eliminate any risk. For example, the deed could include an express power for the trustee to resolve to distribute net income or capital to a beneficiary prior to receipt of the proceeds from the CGT event.

Does the trustee have power to make interim capital distributions from asset revaluation reserve?

It is quite common for trustees of private trusts to seek to revalue assets in order to be able to make interim capital distributions to beneficiaries.

There are a number of circumstances where this can be a useful strategy. For example, if a beneficiary of a discretionary trust wants to exit, the payment of an interim capital distribution to them rather than selling or distributing assets can be very advantageous as it will not attract duty and the beneficiary will also generally not be subject to any capital gains tax on the distribution.14

While this strategy of making interim distributions from a revaluation reserve has been reasonably common, there has been some uncertainty about exactly how effective this was for trust law purposes.

This issue has been considered in the recent High Court decision of Fischer v Nemeske15 where the facts were as follows.

  • The only asset of the Nemes Family Trust consisted of shares in another company.
  • In 1994 the trustee (Nemeske Pty Ltd) revalued those shares (to $3,904,300) and credited that amount to an asset revaluation reserve.
  • Shortly after, the trustee resolved to make a distribution out of the asset revaluation reserve to Mr and Mrs Nemes (two of the Specified Beneficiaries of the trust).
  • No amount was paid to Mr and Mrs Nemies. The amount of $3,904,300 was credited to them in the trust's accounts and the trustee granted a charge over the shares in favour of Mr and Mrs Nemes securing the payment of the distribution amount.
  • Mrs Nemes died in November 2010 and Mr Nemes passed away in September 2011.
  • In Mr Nemes' Will he effectively transferred control of the trust to 'the Fischers' and the residuary estate to other beneficiaries.
  • The Fischers argued that the purported distribution of capital out of the revaluation reserve was ineffective and that the trust had no existing obligation to pay the amount of the purported distribution to the estate (with the consequence that the value of the residue was substantially diminished).

The High Court held (by a majority of three to two) that the resolutions to create a revaluation reserve and then make a distribution from that reserve were effective and that the trustee owed $3,904,300 to Mr Nemes's estate.

However, the majority decision did not establish any general principle that interim distributions of capital from a trust revaluation reserve would always be effective.

Rather the decision makes it clear that the efficacy of the distribution will be dependent on the terms of the trust deed and the resolution purporting to make the distribution. Each of the judges delivered a separate judgement and these provide some guidelines for practitioners who are asked to advise on or implement interim capital distributions.

The first issue is that the trustee must have power to revalue trust assets. The trust acts in the various states allow for this but subject to restrictions. For example, in Queensland, a trustee has a general power to carry out a valuation of trust assets.16 However, where the trustee is not personally qualified to value the property, they must consult a 'duly qualified person'.

In my view it is preferable if there is a specific power in the trust deed that allows the trustee to revalue trust assets at the complete discretion of the trustee.

This power must be wide enough to also allow the trustee to make a distribution from a revaluation reserve and create a binding obligation to pay the beneficiaries notwithstanding that no money or other property is actually distributed or set aside for the benefit of those beneficiaries.

A significant factor in the decisions of some of the majority was that the trust deed gave the trustee a power to 'advance' capital to beneficiaries and we therefore recommend that trust deeds should include a specific power to 'advance' as well as 'distribute' capital.

The judgements also illustrate that it will be critical that any resolution purporting to make a capital distribution from a revaluation reserve is carefully drafted to ensure that the terms of the resolution are consistent with the powers of the trustee under the deed. In her dissenting judgment, Kiefel J appeared to accept that it may have been possible for the trustee to make an effective 'advance' of capital relying on the powers in the trust deed but said that:

Neither the terms of the Resolution nor the entries in the accounts reflect an application under a power of advancement of the property and the Shares representing the capital of the trust.

She also indicated that while it;

...may be accepted ... that an effective exercise of (the power to make an interim distribution) does not depend upon there being cash in the trustee's hands ... . However, for a conclusion that capital was applied there should be a corresponding reduction in the capital of the trust.

'Damage control' provisions where trustee has made family trust election17 (FTE) and then distributes to a beneficiary who is outside the 'family group'

In our practice, we have seen a significant number of cases where trustees who have made FTEs have inadvertently made distributions to beneficiaries that are not members of the relevant family group (tainted distributions).

The consequence of making distributions outside the family group is that the trustee is assessed for 'family trust distribution tax' on the distribution (at the top marginal tax rate). In some cases, this may not be a totally disastrous result because the tainted distribution is then excluded from the assessable income of the beneficiary who received the distribution18.

However, this does not mean that the distribution is invalid. The beneficiary is still entitled to call for payment of the full amount (even though the trustee will be required to pay tax of approximately 50% on the distribution). This means the trustee will effectively have an obligation to pay approximately 150% of the amount distributed (being the tainted distribution plus the family trust distribution tax amount).

The problem is compounded if the original tainted distribution was made to a corporate beneficiary – for several reasons.

  • If the distribution is not paid to the corporate beneficiary, it will still be a UPE which may trigger Division 7A consequences.
  • If the corporate beneficiary pays a dividend to shareholders out of the tainted distribution, the dividend will be unfranked and the shareholders will pay tax on the full dividend at their marginal rate.

The net result in those circumstances (before dealing with the issue of penalties) is that:

  • the trustee and shareholders will (between them) pay approximately $100,000 tax on the distribution of that amount; and
  • the trustee will still owe the $100,000 to the corporate beneficiary.

Therefore, we recommend that trust deeds should include a provision that, if the trustee has made a FTE to anyone outside the 'family group', that distribution is invalid.

In this situation it is likely that the 'default beneficiaries' will be assessed on the amount of the distribution (or the trustee may be assessed under section 99A if there are no default income beneficiaries).

A practical advantage if the tainted distribution is invalid, is that the ATO have a limited time in which to issue an amended assessment to the default beneficiaries (or trustee if there are no default beneficiaries). This will usually be four years from the date of lodgement of their returns.

On the other hand, there is no time limit on when the ATO can issue an assessment for family trust distribution tax.19

Include power to make payments to 'CGT concession stakeholders' if trustee applies small business CGT retirement or 15 year exemptions

Many private trusts are used for carrying on a business or may hold shares in a company that carries on a business. If the business assets or shares are sold, the trust may be eligible to claim all or some of the small business CGT concessions available under Division 152 of the 1997 Act.

In order to claim the '15 year' exemption20 or 'retirement exemption'21, the trustee must make a payment to individuals who qualify as 'CGT concession stakeholders'. These payments are then excluded from the assessable income of the trust and are non-assessable amounts in the hands of the relevant individuals.

However, few trust deeds have any express provision giving the trustee the power to make such a payment. The trustee's distribution powers are generally limited to distributions of trust income or capital and payments made to CGT concession stakeholders may not fit within either category.

This is an important issue for unit trusts because the only power the trustee generally has is to make distributions to unitholders who will generally not be the individuals who qualify as CGT concession stakeholders.

Therefore, our practice is to include a specific power in trust deeds allowing the trustee to make payments to 'CGT concession stakeholders' irrespective of whether they are beneficiaries of the trust.

Do not impose a 30 June deadline on trust distributions

Prior to the Bamford decision, the ATO allowed a period of two months after the end of each financial year for trustees to formally pass resolutions distributing trust income (provided the trust deed did not require resolutions to be made by 30 June).22

However, following the decision in Colonial First State Investment Ltd v Commissioner of Taxation23 the ATO indicated that a beneficiary could not be 'presently entitled' to a share of the distributable income of a trust unless the trust distribution resolution was made by 30 June and the 'old rulings' have been withdrawn.

While the ATO position is that trust distributions must be made by 30 June to be effective for tax purposes, it is not necessary to insert any provision in the deed imposing this 30 June requirement and imposing such a requirement in the deed may lead to unforeseen problems.

For example, if the trust deed requires distributions to be made by 30 June and there is a dispute between beneficiaries and the trustee, the validity of prior year distributions may be challenged if the trustee cannot prove the distribution was in fact made by the due date.

If the trust deed does not stipulate that the discretion to distribute income must be exercised by 30 June then, while the ATO may challenge the tax effectiveness of post 30 June distributions, they should still be effective for trust law purposes provided that the distribution is made within a reasonable time after year end.

This was confirmed in BRK (Bris) Pty Ltd v FCT24 where the court held that the trustee had "a reasonable time within which to decide" how to distribute income where there was no 30 June requirement in the deed.

Should the trustee be an eligible beneficiary?

If clients do want to make distributions to the trustee, it is important to check whether the trustee is actually an eligible beneficiary and, if not, whether they can be added as a beneficiary.

Some trust deeds provide that the trustee is not and cannot be added as a beneficiary. This restriction was commonly inserted in older trust deeds to reduce the imposition of estate and succession duties.

While death duties are no longer an issue, there are some potential duty issues that may arise if the trustee is an eligible beneficiary of the trust.

For example, in New South Wales, a transfer of trust assets pursuant to a change of trustee is exempt from duty only if the trustee cannot become a beneficiary of the trust.25

In Queensland, a transfer of shares in a trustee company could be liable for "landholder duty" if the trustee holds land unless the company is excluded as an eligible beneficiary of the trust.26

Our view is that it is better to exclude the trustee as an eligible beneficiary to avoid these potential duty problems.

Some misconceptions about limiting benefits to the settlor

The practice adopted in most discretionary trust deeds is to have a person who is not related to the client pay a nominal settlement sum to the trustee and sign the trust deed as settlor.

This practice stems from the High Court decision in Truesdale v Federal Commissioner of Taxation,27 where the court held that the trust was created by the settlor who paid the settlement sum and that

... the words, 'created a trust' in s.102 are not, I think, apt to describe the payment of money to a trustee to hold under a trust already constituted. 28

Section 102 of the 1936 Act will apply if;

  • the settlor has power to revoke or alter that trust so as to acquire a beneficial interest in trust income or capital; or
  • trust income is payable or accumulated for the benefit of children of the settlor who are under 18.

If the section applies, the trustee will be liable for tax on all or some portion of the trust income – at the top marginal rate of tax.

Therefore, trust deeds should exclude the settlor or any children of the settlor as beneficiaries. However, most deeds go much further than this and also prohibit distributions to any trusts or companies in which the settlor has an interest.

These more extensive restrictions are not necessary to ensure section 102 does not apply and, in some cases, they may create problems of their own.

For example, discretionary trusts generally include other trusts as eligible beneficiaries if any beneficiary of the first trust is also an actual or contingent beneficiary of the second trust.

If there is any business or family connection between the settlor and the controllers of the trust, it may be that trusts that are intended to be beneficiaries may be excluded because the settlor has some contingent interest.

Link to part 2

Tax effective trust deeds - part 2

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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.

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