When will an inheritance be at risk?

As set out in earlier posts, and with thanks to the Television Education Network, today’s post addresses the issue of ‘When will an inheritance be at risk?’ at the following link - https://youtu.be/Ks2GvSVp07U

As usual, a transcript of the presentation for those that cannot (or choose not) to view the presentation is below –

There is a true continuum in terms of the approach that the court is going to take, where at one end, assets of a trust will be completely exposed and will be considered property of the relationship. At the other end, you've got a situation where the assets will be completely ignored and they won't even be considered a financial resource. 

Inheritance is a classic example, because in order for the court to make a decision that they're not taken into account, it really does come back, and this will often be used by the lawyers, to the two word answer - 'it depends', because it really does depend on the underlying factual matrix.

 

If people are particularly concerned about trying to exclude inheritances, the types of things that the courts will normally gravitate towards are things like ensuring that the assets pass as late as possible in terms of when the relationship has broken down, and ideally to the extent this can ever be achieved, that the assets don't pass until after the relationship has ended. 

The other things that are relevant include whether the former spouse has in any way contributed to the growth of the assets that are coming via the inheritance. Obviously, and most relevantly in the context of trust planning, whether the people that are handing the assets on have done so directly in the name of the spouse, or preferably have they used some sort of trust structure - for example, a testamentary discretionary trust.

Until next week.

Division 6AA and child maintenance trusts: there are advantages, but pitfalls too

For those that do not otherwise have access to the Weekly Tax Bulletin, the article from earlier this month by fellow View Legal Director Patrick Ellwood and me is extracted below.

In the context of deceased estates (and specifically with the use of testamentary trusts), the excepted trust income rules under Div 6AA of the ITAA 1936 are well known.

In particular, the rules allow income derived by infant children via distributions from a testamentary trust to be assessed at the normal, individual adult rates.  As a result, each infant beneficiary can receive over $20,000  of income tax-free and the balance is taxed at the adult marginal rates.  For most families, this can mean significant tax planning opportunities.

In the vast majority of cases, access to the excepted trust income concessions is only available following someone's death.  One key structure that falls outside this general position however is a "child maintenance trust" (CMT).

A CMT is another form of trust contemplated by Div 6AA that should be at least considered whenever there is a personal relationship (referred to as a "family") breakdown and either party is responsible for making child support payments.  This is because a validly established CMT can also create access to the excepted trust income provisions and the resulting tax concessions.

Given the significant percentage of personal relationships that breakdown irretrievably, many of which then result in child maintenance obligations being imposed, it is important that practitioners are aware of the planning opportunities afforded by CMTs.

What is a "family breakdown"?

Section 102AGA of the ITAA 1936 defines a transfer of property as a result of a "family breakdown" to include legal obligations arising from a range of situations such as:

• The breakdown of a formal marriage.
• The breakdown of a de facto relationship.
• Where a child has been born outside a "traditional" relationship arrangement (for example, a "one night stand").

CMTs are potentially available in relation to children who are:

• born of the union of the relationship that has broken down;
• adopted children; and
• step-children.

ITAA 1936 and excepted trust income

CMTs are specifically provided for in s 102AG of the ITAA 1936.  As noted above, the main advantage of a CMT from a tax perspective is the ability for income of the trust to be treated as excepted trust income. 

A CMT, like most trusts, must be established by deed but, in contrast to many of the other types of trusts contemplated by the excepted trust income rules, cannot be created by a will. 

There are also other requirements that must be met before the income of the trust is treated as excepted trust income, including:

1. the children named as the "primary beneficiaries" of the trust must be younger than 18 at the time the trust is established;
2. income must be derived by the investment of property transferred to the trustee of the trust for the benefit of the primary beneficiary/beneficiaries, as a result of a "family breakdown", as set out above;
3. there is no set time frame in which a CMT must be established following the family breakdown, although they should ideally be set up at the time of the property settlement; and
4. the children for whose benefit the trust is established must ultimately receive all of the capital from the trust in equal shares.

Both in relation to tax planning and asset control, it is important to note that potential income beneficiaries of a CMT may include persons other than children of the relationship subject to the family breakdown, without jeopardising access to the excepted trust income concessions.

Non-arm's length arrangements

The income of a CMT can be generated from non-arm's length arrangements.  However, any income which results from non-arm's length transactions must be of equal value to that which would have been derived on an arm's length basis in order to be considered excepted trust income.

The arm's length requirement is set out in detail in s 102AG(3).  In particular, this section provides that if any 2 or more parties to:

• the derivation of excepted trust income; or
• any act or transaction directly or indirectly connected with the derivation of that excepted trust income,

were not dealing with each other at arm's length, then the excepted trust income (if any) is only so much of that income as would have been derived if they had been dealing with each other at arm's length.

Due to the strict requirements for a valid CMT, particularly on the ultimate vesting of the assets in the children of the relationship that had a family breakdown, one approach often used is to contribute depreciating assets such as plant, equipment and motor vehicles to the trust. These assets can be leased, either to a related individual or business entity for value.

Provided the lease repayments are on an arm's length basis, then the income will be able to be distributed to infant children as excepted trust income.

Other issues to consider  

While there can be tax planning advantages to utilising a CMT, there are also a number of potential pitfalls (in addition to the matters set out above).Some of the things to specifically consider before establishing a CMT include:

1. Taxation Ruling TR 98/4 which sets out in detail the Commissioner's position in relation to CMTs and should be studied carefully before implementing the structure.
2. The CGT relief afforded by Div 126-A of the ITAA 1997 due to a marriage breakdown does not extend to assets transferred to a CMT.
3. Similarly, in relation to non-capital assets (eg depreciating assets), there will generally be no roll-over relief available for asset transfers to the CMT.
4. Generally there will also be no stamp duty relief available for dutiable assets transferred to a CMT, although anecdotally it appears some State Revenue Offices do allow an exemption.
5. It is often extremely difficult to establish a CMT unless both parents work collaboratively, which obviously may not be the case where the personal relationship has otherwise broken down.

Until next week.

Image credit: Steve Corey cc

Trust-owned business succession insurance arrangements: Some clarity at long last

For those that do not otherwise have access to the Weekly Tax Bulletin, the article from earlier this month by fellow View Legal Director Patrick Ellwood and me is extracted below.

Largely due to the level of intergenerational wealth transfer, there has in recent years been an increasing emphasis on all forms of succession planning and, in particular, business succession planning.

In broad terms, a buy-sell agreement is a contractual arrangement between the ultimate owners (or ‘principals’) of a business. The agreement is structured so that if certain events occur, such as the death or incapacity of a principal, the continuing principals are given the option to purchase the interest of the departing principal.

Most commonly, insurance is obtained to help fund buy-sell arrangements.

Since the withdrawal of the ATO's draft Buy Sell Discussion Paper in 2010 there has been some uncertainty about many aspects of insurance funded buy-sell arrangements, particularly those that utilise insurance trusts.

Recent changes introduced as part of the Tax and Superannuation Laws Amendment (2014 Measures No 7) Bill 2014 (now awaiting Royal Assent after having been passed by Parliament without amendment) appear to have clarified the position (the 2015 Changes).

Trust ownership

The trust ownership approach generally involves the establishment of a special purpose entity, often with an independent trustee appointed, to acquire the insurance policies and then distribute proceeds, on the exit of a principal, in accordance with the terms of the trust instrument.

If the trading entity is itself a trust or owned via a trust (for example, a discretionary trust owning shares in a trading company), then it may not be necessary to establish a separate structure.

The core benefit of an insurance trust is its ability to centralise the ownership of all insurance policies and facilitate the efficient transition of an ownership interest following a triggering event.

Historically, from a tax perspective, the level of uncertainty regarding the tax treatment of the insurance proceeds (compared with that of other ownership models such as self-owned insurance) often undermined the commercial attractiveness of the trust ownership approach.

Certainly an insurance policy taken out by a trustee (who was also the beneficiary of the policy) over one or more principals, was likely to see the proceeds paid directly to the trustee and be exempt from CGT pursuant to s 118-300 of the ITAA 1997.

However, due to a lack of guidance from the ATO, many advisers believed there was a risk CGT was triggered where a new principal joined the business and there was any change to the trustee or insurance policy or on the subsequent distribution of the insurance proceeds to the beneficiary. 

The concerns were largely driven by the ongoing uncertainty around the concept of ’absolute entitlement’, discussed later in this article.

2010 ATO ruling

The ATO released Product Ruling PR 2010/18 in relation to the CGT consequences for the beneficiary of what is generally seen as a ’standard’ insurance trust deed.

In many respects, the ruling reflects what most specialists in this area have advised for many years, namely, that a properly crafted insurance trust deed should provide appropriate protection for the principals of a business without any significant tax detriment, notwithstanding there might be other commercial issues to consider regarding the structure.

Unfortunately, the positive aspects of the ruling were largely undermined by the fact that the outcomes are based on the stated assumption that the insurance trust deed will in fact create ’absolute entitlement’ for each beneficiary in the relevant insurance policy.

As has been widely documented, the expressed views of the ATO concerning absolute entitlement are somewhat contentious and the ATO continues to refer to a draft ruling that has never been finalised – despite being issued in 2004 (ie Draft TR 2004/D25).

In this regard, a significant concern was that the Product Ruling confirmed that, in order to ensure absolute entitlement, the relevant beneficiary must be able to call for the asset at any time.  This largely undermined one of the main commercial reasons why advisers historically recommended insurance trusts, being that the trustee will be able to control the payment of any insurance proceeds received.

A further practical issue, given the way in which many providers traditionally structured trust arrangements, was that the Product Ruling only related to insurance trust deeds where the company acting as trustee was an entity owned and controlled by the principals involved in the business entity and the relevant insurer was not a party to the arrangements.

ATO minutes

Minutes released from a National Tax Liaison Group meeting in December 2010 (item 9) provided further insight into the apparent ATO views in relation to insurance trust deeds.

In summary the minutes stated:

• the status of the taxation ruling on absolute entitlement (Draft TR 2004/D25) is unclear;


• the ATO considers the finalisation of Draft TR 2004/D25 as intricately linked to how it will deal with bare trusts, which again remains an unresolved issue;


• the ATO believes that the Product Ruling released in relation to one provider's insurance trust arrangement is based entirely on the assumption that absolute entitlement was created.  This assumption might be an unwise one to make, given the ATO's apparent attitude in this area; and


• while the ATO flags that it will further consider providing appropriate guidance, it specifically confirmed that the ATO Buy Sell Discussion Paper is not current.

Ultimately, given the complexities in this area and the uncertainty created by the ATO Buy Sell Discussion Paper, Draft TR 2004/D25, the Product Ruling and the above minutes, many advisers defaulted to recommending the obtaining of a private ruling on any proposed trust arrangement documenting an insurance funded buy-sell agreement from the ATO before implementing the approach. 

Needing to seek a private ruling on what was otherwise a relatively benign arrangement was for many business owners sufficient reason to either use a different ownership approach or, more commonly, simply decide against implementing a business succession plan.

The 2015 changes

Amongst other amendments, the 2015 changes have adjusted the way insurance payments are taxed in certain circumstances.

In particular, the 2015 changes amend the ITAA 1997 to:

1.  remove the requirement that, in order to access the exemption under s 118-300, the insurance proceeds are received by the original ’beneficial’ owner of the life insurance policy.  The amendment removes the reference to ’beneficial’ to clarify that a trustee is eligible for the exemption, where they hold the beneficial interest in the policy for a beneficiary;


2. extend the exemption for compensation for injury/illness (ie total and permanent disablement and trauma insurance proceeds) in s 118-37 to apply where the proceeds are received by the trustee of a trust or superannuation fund (subject to certain policy ownership prohibitions for superannuation funds), if the injured/ill person is a beneficiary of the trust; and


3. insert a CGT exemption where a trustee makes a payment to a beneficiary (or their legal personal representative) in respect of life, TPD or trauma insurance proceeds.  This change also ensures that where the relevant trust is a unit trust, CGT event E4 does not apply.

The 2015 changes make it likely that trust and superannuation fund ownership of life, total and permanent disablement or trauma insurance policies will be more attractive, given the new clarity regarding the tax treatment of the insurance proceeds.

Importantly, the changes also operate to reflect the intended administrative position of the ATO in this area, and therefore apply from 1 July 2005 and taxpayers adversely impacted who would otherwise be out of time are granted an extension to amend their returns.

Until next week.


Image credit: GotCredit cc

Beyond death do us part – pre-nups and challenges against estates

Following the posts over recent weeks relating to challenges against deceased estates, this week’s post, with thanks to team member Hayden Dunnett, considers another relevant decision, namely Hills v Chalk & Ors (as executors of the estate of Chalk (deceased)) [2008] QCA 159. The case is important because it starkly highlights the potential significance of a Binding Financial Agreement (BFA) even where the BFA does not comply with the Family Law Act. 

As usual, a full copy of the decision is available via the following link http://www.austlii.edu.au/au/cases/qld/QCA/2008/159.html. 

Mr Hills and Mrs Chalk entered into a ‘pre-nuptial’ agreement in 1994, which was before the ability to make an enforceable BFA.  The terms of the pre-nuptial agreement were essentially contractually based and provided that in the event of their separation, they were each to retain their own assets and make no claim for property settlement, or maintenance from the other.  The agreement also recorded a joint intention to preserve their assets for their respective families.  Importantly, they acknowledged that each party should not seek to defeat the intention of the other.

Mrs Chalk died in February 2003, and probate was granted in April 2003 to the children of Mrs Chalk.  In September 2007, some 4 years after her death, Mr Hills made an application for further provision from the deceased estate.  In her will, Mrs Chalk had given Mr Hills a right to reside in her house, and a legacy of $20,000 in recognition of him caring for her during illness.  The balance of her estate was left to her children.

The court refused Mr Hills’ application stating it was ‘distinctly improbable’ that  Mrs Chalk had failed to make adequate provision for Mr Hills.

In particular, it was held that the ‘pre-nuptial’ agreement made by the parties, although not of itself directly decisive against Mr Hills' claim, was of significance to the assessment to be made by the court of Mr Hills' application for further provision.

Following the decision in this case it is generally accepted that a BFA, perhaps even if not binding for Family Law purposes, will be taken into account in any claim for further provision from an estate.

Until next week.

Image credit: Leo Grübler cc

How to avoid a $25 million challenge against your estate

Last week’s post looked at the way in which the notional estate rules work in New South Wales.  Some comments were also made about the fact that no other Australian estate has adopted, to this point, similar provisions.

During the week, the Wright estate case has received a significant amount of media attention.  The decision itself is Mead v Lemon [2015] WASC 71, and as usual, a link to the decision is as follows -  http://decisions.justice.wa.gov.au/supreme/supdcsn.nsf/PDFJudgments-WebVw/2015WASC0071/%24FILE/2015WASC0071.pdf

Much of the decision has focused on the fact that the claimant, in receiving an award of $25 million has, by some $22 million, exceeded the previous largest successful application under the family provision rules in Australia.

In the context of the notional estate provisions, perhaps one of the most interesting aspects of the judgment however relates to the comments about the fact that the duty imposed under the law to properly provide for certain people is (in all states other than New South Wales) able to be avoided.

In particular, the court held –

1. The deceased must have been aware of that duty - he was well advised by a competent solicitor. But it is a duty he could have avoided.


2. The deceased was aware some six months before his death he was afflicted by terminal cancer. At that stage he was free to distribute his estate in any way he wished.


3. That would have meant on his death neither the plaintiff nor anyone else could have maintained a claim - there would have been nothing to claim against.


4. But of course if the deceased had taken that course he would have been liable for millions of dollars in, effectively, gift duty.


5. The price the deceased paid for passing his assets tax free to his nominated beneficiaries was acceptance of the statutory duty arising to the plaintiff.

The bluntness of the above comments are a common theme throughout the judgment, and one of the quotes that has been circulated to me from multiple sources in this regard is as follows –

‘The plaintiff did say she had a boyfriend whom she hoped to marry within the next two years. She anticipated having four children. Of course it is possible after one child she might reconsider; most sensible people do.’

Until next week.


Image credit: thinkpanama cc