Vesting Dates and Trust Distributions: measure twice; cut once – read the deed … and then some

For those that do not otherwise have access to the Weekly Tax Bulletin, a further recent article by View is extracted below.

As previously reported by us in the Weekly Tax Bulletin, there are a range of issues often overlooked in relation to trust distributions (see 2014 WTB 43 [1426]) and extensions to vesting dates (see 2014 WTB 44 [1446]). Rarely, however, do these issues arise together in the same factual scenario.

In the lead up to another 30 June, the decision in Domazet v Jure Investments Pty Limited [2016] ACTSC 33 (7 March 2016) is a timely example of the problems that can arise when a deed is not carefully reviewed before trust distributions are made.

The decision

In summary, a Family Trust was settled in the ACT on 1 April 1980. The Family Trust deed gave the trustee the power to nominate additional beneficiaries, including trusts, so long as the vesting date of the other trust was not longer than that of the Family Trust.

In 2009, a new trust (referred to as the "Finance Trust"), which was part of the same family group was purportedly appointed as a general beneficiary of the Family Trust.

The Family Trust had a cascading optional perpetuity period, which the parties wrongly interpreted as allowing the vesting date to be 80 years from the date of settlement. In fact, the Family Trust vesting date was 21 years after the death of King George VI's living issue as at 1 April 1980.

The Finance Trust, established in 2005, was set to vest either upon the election of the Trustee or a maximum of 80 years from settlement, making it prima facie ineligible. In an attempt to ensure the Finance Trust was an eligible beneficiary of the Family Trust, the vesting date was then amended to be one day before 80 years from 1 April 1980 (ie 31 March 2060).

Practically speaking, this meant that in order for the Finance Trust to be an eligible beneficiary of the Family Trust, it needed to be absolutely certain that at least one of King George VI's living issue in 1980 would still be living on 31 March 2039 (that is, 21 years before 2060), which the Court thought was possible, but not absolutely certain. This meant the appointment of the Finance Trust as a general beneficiary was invalid.

It appears from the decision that a number of capital distributions were purported to be made after the Finance Trust was invalidly appointed as an additional beneficiary. The invalid appointment meant that the distributions made to the Finance Trust would have been done in breach of trust. Furthermore, the invalid distributions would have also caused adverse tax consequences for the parties. This seems to have been a potential issue because the ATO had made submissions as part of the proceedings.

Perpetuity rules

It is critically important to not just read the deed, but also specifically consider which perpetuity rules apply. The difficulties arose in this case because amendments to the rule against perpetuities were progressively rolled out throughout Australia. The advisers which prepared the documents had wrongly assumed the ACT rules, which came into effect on 18 December 1985 (after the Family Trust was settled), were implemented at the same time as the Queensland rules were introduced (1 April 1973).

In this respect, the earliest change to the rule against perpetuities occurred in Victoria in 1968, whereas Tasmania only introduced new rules in 1992. When reviewing trusts which span between these dates, it is therefore critically important to firstly determine the trust's governing jurisdiction, but also consider which perpetuities rules apply.

Some possible workarounds

With the aid of hindsight, there were a number of alternatives that could have avoided the outcome that the parties ultimately faced: a substantive trust to trust distribution being invalid. In summary, the other alternatives that could have been adopted include:

1. The vesting date of the recipient trust could have been amended to provide that - notwithstanding any other provision of either trust instrument, it would automatically vest on or before the date of the distributing trust.
2. The requirement in the distributing trust that the recipient trust needed to vest before it could have simply been deleted. While it still would have been necessary for the recipient trust to have ultimately vested by the date of the distributing trust, it would have been possible to rely on the 'wait and see' rule rather than the distribution being void immediately on the date that it was made.
3. Depending on the factual matrix, the distributing trust could have made a distribution directly to the ultimate intended beneficiaries, even if that may have required a variation to the trust instrument (and thereby avoid the need to distribute to an interposed trust).

In any of the above cases, again with the aid of hindsight, a private ruling could have been sought from the ATO, or indeed a declaration from the Court could have been obtained. While both of these approaches obviously create significant time delays and cost exposure where (as here) there are significant funds at risk, these additional costs can be an appropriate investment.

In regards to the "wait and see" rule, the approach to be taken was summarised in the case of Nemesis Australia Pty Ltd v FCT [2005] FCA 1273 (14 September 2005) (reported at 2005 WTB 40 [1638]). The case confirmed that the "wait and see rule" in each jurisdiction can be relied on in a situation where a trust distributes to another trust with a later perpetuity date.

The "wait and see" rule means the initial distribution will not be void when made, and will not become void until such time as there is a failure to distribute out of the recipient trust before the vesting date of the original distributing trust.

Rectification

The final main alternative to the issues faced in this case, which was the one ultimately adopted, was to seek rectification of the documentation from the Court.

The case provides a very detailed analysis of the way in which the rectification rules work, including heavily quoting Dr Spry, who has been featured prominently in trust related areas, both for his academic writing and his legal challenges in a personal family law dispute (see Kennon v Spry (2008) 238 CLR 366 (reported at 2008 WTB 51 [2303]).

Ultimately, although with some reservation, the Court did rectify the relevant documents to essentially adopt the approach outlined at paragraph (a) above. While it cannot be certain, it is likely that the rectification order settles a number of the potential taxation consequences resulting from what would have otherwise been invalid distributions.

Resolutions v minutes – is there a difference?

Previous posts have looked at a number of the key aspects in relation to trust distributions (for example Trust distributions – 3 reminders for 30 June 2014, and A further reminder – read the deed).

One key issue in relation to effectively distributing from a trust is whether the trustee should prepare a resolution or minute.

The threshold issue under any trust instrument is making sure that the terms of the deed are followed.

This can include, for example:

1. If a decision is initially going to be made orally, confirming that there is the power to do so under the trust instrument. 
2. Methodically following all requirements set out in the trust instrument, including evidencing the decision by the date required under the instrument (regardless of what might otherwise be permitted under the tax laws). 

Assuming the above issues are properly addressed, then generally a trustee can invariably make a distribution either by way of a resolution or a minute.

A minute effectively records the decision made in an earlier meeting. It need not be made contemporaneously with the meeting (in other words, it can be prepared, dated and signed sometime after the meeting).

In contrast, a resolution is effective only from the date of signing. Where a circular resolution is made by a multiple director company or multiple trustees, it is valid on the date that the last director or trustee signs it.

Practically:

1. Sole director companies can only make distributions by way of resolutions. Generally, for trust distributions, this means that a sole director must determine how distributions are to be made and record by way of resolution the decision no later than 30 June in the relevant income year.
2. For individual trustees or trustee companies with more than one director, any decisions can be made up until 30 June and then later documented by way of a minute of meeting.
3. Again, subject to the trust instrument, where a trust has derived a capital gain, it should be possible to delay any decision at all until 31 August immediately following the end of the relevant financial year pursuant to provisions under the tax legislation.

Image courtesy of Shutterstock

Trust distributions – is the recipient a beneficiary?

Numerous previous posts have raised that the trustee of a discretionary trust must ensure that the intended recipient is in fact a potential beneficiary of the trust when making a trust distributive

http://blog.viewlegal.com.au/2014/06/trust-distributions-3-reminders-for-30.html

http://blog.viewlegal.com.au/2013/09/read-deed-another-reminder-re-invalid.html

http://blog.viewlegal.com.au/2013/07/trust-distributions-and-30-june.html

As mentioned in last week’s post, one of the most famous cases in this regard is BRK (Bris) Pty Ltd v FCT [2001] FCA 164 (see - http://blog.viewlegal.com.au/2015/05/trust-distributions-three-reminders.html).

In relation to the aspect of the decision in BRK that concerned the initial failure to make a valid distribution, the circumstances were as follows:

1. The trustee had the power to make distributions amongst potential beneficiaries.
2. The beneficiaries were listed in a schedule to the deed.
3. The trustee believed it had the power to nominate additional beneficiaries, and indeed, prepared resolutions quoting particular clauses in the deed that gave it the requisite power.
4. Unfortunately the trustee must have been referring to some other trust instrument, as the purported power to nominate additional beneficiaries did not in fact exist in the trust deed for the relevant trust.
5. As the trustee did not have the relevant power to make the nomination resolution, the subsequent distribution resolution purporting to pass benefits to the invalidly nominated beneficiaries also failed.

Although it was unnecessary given the above conclusions, the court also noted that even if the trustee had the power that they purported to exercise in nominating the additional beneficiaries, the attempted resolution of income distribution would have failed in any event because:

• one of the beneficiaries nominated did not exist at the date of the distribution;
• the other beneficiary nominated was mis-defined (in particular, a company was noted as a trustee of a particular trust, however that company was not in fact acting as trustee for the trust at the date of nomination).

Image credit: Matthias Ripp cc

Trust distributions – three reminders

Previous posts have focused on the various key aspects in relation to trust distributions (see for example -

http://blog.viewlegal.com.au/2013/10/one-remedy-where-trust-distributions.html

http://blog.viewlegal.com.au/2013/08/a-further-reminder-read-deed.html

http://blog.viewlegal.com.au/2013/07/trust-distributions-and-30-june.html)

As another 30 June looms, it is useful to note that one of the key aspects in this regard relates to the manner in which section 99 of the Tax Act causes the trustee of a discretionary trust to be taxed at the top marginal rate whenever an income year passes where no beneficiary is made presently entitled to the trust income for that year.

In this type of situation, it is critical to consider the way in which the relevant trust deed is crafted, and in particular:

1. understanding if there is a default distribution provision in relation to income;
2. if there is a default provision, ensuring that the potential default beneficiaries reflect the intentions of those ultimately in control of the trust;
3. ensuring that the default provisions do in fact work.

Arguably, the leading case in this area is BRK (Bris) Pty Ltd v FCT [2001] FCA 164.

As usual, a full copy of the case is available at the following link http://www.austlii.edu.au/au/cases/cth/FCA/2001/164.html.

While there was a purported default distribution, it was crafted to only apply if the trustee had not otherwise made a decision 'within a reasonable time after the end of a financial year'.

While the provision was likely valid for trust law purposes, it was ineffective for tax law purposes because section 99 imposes the top marginal tax rate for any undistributed income as at midnight on 30 June each financial year.

Image credit: Ken Teegardin cc

Some ramifications of failed trust distributions

For those that do not otherwise have access to the Weekly Tax Bulletin, the most recent published article by fellow View Legal Director Tara Lucke and I is extracted below.

As regularly addressed in the Weekly Tax Bulletin, a methodical approach is needed when preparing trust distribution resolutions to ensure the intended outcomes are achieved.

As explored at 2014 WTB 27 [942], there are a range of issues often overlooked in relation to distribution resolutions.

Where a purported trust distribution is subsequently found to be invalid, several potential ramifications arise, including:

• The "knowing recipient" principle.
• Disallowed deductions.
• Disclaimers.
• Equity and rectification.
• Impact of any default provisions.

Further comments on each of these issues are set out in turn below.

"Knowing recipient" principle

"Knowing recipient" is a principle that evolved out of situations where a trustee (who holds property on trust on behalf of the beneficiaries of a trust) appropriates trust funds for the benefit of a third party who has knowledge of the trust relationship. 

The concept gives the "wronged" beneficiaries the right to make a personal claim against the third party on the basis that the third party received the trust property, whilst having knowledge of the relationship between the property in question, the trustee and the beneficiaries. 

Impact of disallowed deductions

The treatment of disallowed deductions turns largely on the way in which the relevant distribution resolution is crafted. 

Broadly, there are 3 possible outcomes, namely:

• the amounts representing the disallowed deductions will be validly distributed to a particular beneficiary via the provisions of a distribution resolution;
• the default provisions under the trust deed will regulate the distribution (further comments in this regard are set out below); or
• the amount will be treated as an accumulation to the trust and the trustee will be taxed at the highest marginal tax rate is applied.

Disclaimers

In FCT v Ramsden [2005] FCAFC 39, the court held that the purported disclaimers by particular beneficiaries were ineffective.  However, it was confirmed that any interest acquired in the net income of a trust under the default provisions of a deed could be disclaimed by a beneficiary separately from any other entitlements which might accrue to that beneficiary under other provisions of the deed.

It was also confirmed that a disclaimer can be made retrospectively, provided it is made within a reasonable period of time from the beneficiary first becoming aware of the relevant interest that they wish to disclaim.

Equity and rectification

A court may use the equitable remedy of rectification where there is an error in a trust document which does not reflect the intentions of the parties and in turn, results in an invalid distribution. 

In order for rectification to be granted, the party applying for the court to exercise its discretion must establish 3 elements:

• the intention that the parties had in relation to the document up until the time the distribution resolution was executed
• a mistake was made in the document that does not reflect the parties' true intentions; an
• if the rectification order was granted, it would correct the mistake and match the parties' intentions.

Importantly, rectification will not be granted where there is simply an inadvertent financial result that occurred due to a misunderstanding of the consequences of a deliberate act.

Default provisions

From a trust law perspective, default capital provisions, and in some cases, default income provisions, under discretionary trusts are generally seen as important to ensure that the trust is valid at law.

From a tax perspective, the main objective of a default distribution clause, particularly for income, is to ensure that the default beneficiaries are assessed on the failed distribution, rather than the trustee being assessed at the top marginal rate.

The case of BRK (BRIS) PTY LTD v FCT (2001) 46 ATR 347 is arguably the leading example in this regard.  In this case, the default distribution clause of the relevant trust required, where there was a failure to distribute, that the trustee "divide the Fund equally among the beneficiaries named in the Schedule hereto". 

However, the clause was crafted such that the distribution did not take place until a date after the end of a tax year. 

Based on the drafting of the relevant clause, the court confirmed that while the provisions were valid from a trust law perspective, the trustee was unable to make the required distribution to the default beneficiaries until after the end of each tax year.  This, in turn meant that all undistributed income was in fact effectively accumulated for tax purposes each tax year. Therefore, all undistributed income was taxed to the trustee at the top marginal rate.

Conclusion – start by reading the deed

Given the range of significantly adverse consequences that can result where a purported trust distribution is subsequently found to be invalid, advisers should proactively invest in processes and systems to minimise the risk of such an outcome.

Invariably, best practice dictates that in every situation before preparing a resolution there should be:

1. a comprehensive review of the relevant trust deed including an analysis of every variation or resolution of a trustee or other person (such as a principal, appointor or guardian) that may impact on the interpretation of the trust document;


2.  specific review of the relevant tax legislation applicable to the amounts to be addressed by the resolution; and


3. thought applied to the exact factual scenario that the trustee is addressing, in the context of the trust deed and tax laws.

Until next week.

Scope of the Richstar decision

As set out in earlier posts, and with thanks to the Television Education Network, today’s post addresses the issue of ‘Scope of the Richstar decision’ at the following link -  http://youtu.be/N2VpKrws93c

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

It’s fair to say Richstar is seen as probably the high watermark in relation to how the assets of a trust may be exposed in the context of some sort of bankruptcy litigation. Interestingly, it has remained almost as an outlier decision.

There really haven't been any decisions that have supported the landing the court reached in relation to Richstar. On top of that, the cases like Smith which have come down since Richstar, effectively completely ignore Richstar and go to the extent of saying it doesn't actually represent good law.

Ultimately, pragmatically and practically what the position seems to be is as long as a trust is structured appropriately it will provide a very good level of asset protection from creditors and should be seen as probably the choice structure in an estate planning exercise under a will - in other words, the use of a testamentary discretionary trust - in order to provide an adequate level of protection.

Until next week.

Importance of minimising loan accounts to at risk beneficiaries

As set out in earlier posts, and with thanks to the Television Education Network, today’s post addresses the issue of ‘Importance of minimising loan accounts to at risk beneficiaries’.  If you would like a copy of the video link please email me.

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

The reality in relation to beneficiary loan accounts is that sometimes they're unavoidable.

If distributions are being made by the trustee down to an at risk beneficiary and those amounts aren't physically paid, then they’ll sit on the balance sheet either as a credit loan or an unpaid present entitlement.

In either scenario, that’s clearly an asset of the at risk beneficiary. So it’s really important that on a regular basis those potential assets are reviewed and steps are taken to ideally quarantine them away into a protected environment.

The simplest approach, assuming that you can't avoid the distributions coming down to that person, will be to forgive that debt, or as an alternative, making sure that the outstanding amount is gifted across to a protected environment whether that be a spouse, some other family member or perhaps some other related structure.

The critical thing in all of that, quite aside from the pure bankruptcy issues is however that there must be a particular effort applied to the related issues. That is, things like the commercial debt forgiveness rules, wider tax planning issues and the stamp duty rules, that are unfortunately different in every jurisdiction around the country, are all potentially relevant before any step can be taken to quarantine the loan account wealth. 

Until next week.

Trust distributions – 3 reminders for 30 June 2014

Getting ready for 30 June.

For the fourth time in recent weeks we have been fortunate to have an article featured in the Weekly Tax Bulletin. This time it is by fellow View Legal Director Patrick Ellwood and I and is extracted below for those who do not otherwise have easy access.

As regularly addressed in the Weekly Tax Bulletin, a methodical approach is needed when preparing trust distribution resolutions to ensure the intended outcomes are achieved.

With another 30 June fast approaching, it is timely to consider 3 key issues often overlooked, namely:

1. ensuring that the intended recipient of a distribution is in fact a valid beneficiary of the trust;
2. avoiding distributions to beneficiaries who appear to be validly appointed under a trust deed, however are in a practical sense excluded; and
3. complying with any timing requirements under a trust deed, regardless of what the position at law may otherwise be.

Further comments on each of these issues are set out in turn below.

Is the intended recipient a beneficiary?

A beneficiary is a person or entity who has an equitable interest in the trust fund. A beneficiary has enforceable rights against a trustee who fails to comply with their duties, regardless of whether they have ever received distributions of income or capital from the trust. 

The range of eligible beneficiaries will generally be defined in the trust deed and the first step in any proposed distribution should be to ensure that the intended recipient falls within that defined range.

Once the range of eligible beneficiaries has been determined, the next step is to identify classes of specifically excluded beneficiaries.

These exclusions will usually override the provisions in a trust deed which create the class of potential beneficiaries and some common examples include:

• persons who have either renounced their beneficial interest or have been removed as a beneficiary of the trust fund;
• the settlor and other members of the settlor's family;
• any "notional settler"; and
• the trustee.

A comprehensive review of a trust deed must include an analysis of every variation or resolution of a trustee or other person (such as an appointor) that may impact on the interpretation of the document.

The range of documents that could impact on the potential beneficiaries of a trust at any particular point in time is almost limitless. Some examples include:

• resolutions of the trustee to add or remove beneficiaries pursuant to a power in the trust deed;
• nominations or decisions of persons nominated in roles such as a principal, appointor or nominator; and
• consequential changes triggered by the way in which the trust deed is drafted (eg beneficiaries who are only potential beneficiaries while other named persons are living).

Does the intended recipient appear to be a beneficiary, yet practically is excluded?

It is important to remember that the unilateral actions of a potential beneficiary may impact on whether they can validly receive a distribution. For example, a named beneficiary may disclaim their entitlement to a distribution in any particular year, or may in fact renounce all interests under the trust.

There are also a number of potential issues that can arise in relation to beneficiaries that appear to have been nominated as beneficiaries, as to whether the nomination is effective. These issues can include:

• whether the appointment needs to be made in writing;
• whether the appointor has been validly appointed to their role;
• at what point the nomination needs to take place in the context of the timeframe within which a distribution must be made; and
• are there any consequential ramifications of the nomination, eg stamp duty, resettlement for tax purposes or asset protection.

Family trust election

In addition to the traditional trust law related restrictions on the potential beneficiaries of a trust, it is important to keep in mind the consequences of a trustee making a family trust election or interposed entity election.

Where such an election has been made, despite what might otherwise be provided for in the trust instrument, the election will effectively limit the range of potential beneficiaries who can receive a distribution without triggering a penal tax consequence (being the family trust distribution tax).

A family trust election will generally be made by a trustee for one or more of the following reasons:

• access to franking credits;
• ability to utilise prior year losses and bad debt deductions;
• simplifying the continuity of ownership test; and
• eliminating the need to comply with the trustee beneficiary reporting rules.

While a full analysis of the impact of family trust elections and interposed entity elections is outside the scope of this article, it is critical to consider the potential implications of any such election on what might otherwise appear to be a permissible distribution in accordance with the trust deed.

Complying with any timing requirements under the trust deed

Historically, the Commissioner permitted resolutions to be made after 30 June each year via longstanding ITs 328 and 329, however as practitioners will recall, these were withdrawn in 2011.

The current law does allow resolutions in relation to capital gains to be made no later than 2 months after the end of the relevant income year. Any other distributions, including in particular franked distributions, must be made by 30 June in the relevant income year.

Notwithstanding the general position above, the ATO has regularly confirmed its view that regardless of any timing concessions available under the tax legislation or ATO practice, these concessions are subject always to the provisions of the relevant trust instrument.

In recent times, we have reviewed a number of trust deeds by different providers that require all resolutions to be made by a date earlier than 30 June, eg no later than 12pm on 28 June in the relevant financial year. Unfortunately, in every situation we have seen, all distributions for previous income years were dated 30 June, meaning each resolution was in fact invalid under the deed, regardless of the fact that the resolution otherwise complied with the law.

In these situations, arguably the only practical solution is to proceed with lodgment of amended returns, relying on the default provisions under the trust deed – assuming there are adequate default provisions.

Until next week.

Image credit: Steve Corey cc via Flickr

Taxation consequences of testamentary trust distributions - Part II

Again for those that do not otherwise have easy access to the Weekly Tax Bulletin, Part II of the article by fellow View Legal Director Patrick Ellwood and I is extracted below.

Part I of this article (at 2014 WTB 19 [658]) considered a number of specific aspects of the transfer of assets under a deceased estate testamentary trust. Part II of the article now considers:

• distributions from testamentary trusts to beneficiaries;
• the proposed changes to CGT event K3; and
• the proposed changes where an intended beneficiary dies.

Distributions from testamentary trusts

In 2003, the ATO released PS LA 2003/12, which states that its purpose is to inform ATO staff that the Commissioner will not depart from the long-standing administrative practice of treating the trustee of a testamentary trust in the same way as a legal personal representative (LPR) is treated for the purposes of Div 128 of the ITAA 1997.

In the 2011-12 and 2012-13 Federal Budgets, it was proposed that the current ATO practice set out in PS LA 2003/12 of allowing a testamentary trust to distribute an asset of a deceased person without a capital gains tax (CGT) taxing point occurring would be codified.

While draft legislation to effect the change was prepared, the Federal Government announced that it was reviewing the progress of a large number of unenacted legislative announcements and ultimately confirmed on 14 December 2013 that the amendments would not be implemented - see 2013 WTB 53 [2270] and also 2014 WTB 12 [399].

As set out at 2014 WTB 16 [561], the ATO recently republished PS LA 2003/12 confirming that it intends to continue to consider itself bound by it. Despite the ATO apparently acknowledging that the Government will not proceed with any legislative changes, some amount of confusion has been caused by the ATO stating in updates on its website that it will "accept tax returns as lodged during the period up until the proposed law change is passed by Parliament". Those comments are contained in the ATO update entitled "Refinements to the income tax law in relation to deceased estates" (dated 22 April 2014). It is assumed these comments are simply an oversight by the ATO and that PS LA 2003/12 (as amended) will continue to be applied indefinitely into the future.

The position therefore appears to remain that there is exemption roll-over from CGT covering the "transfer" of assets from the LPR to the trustee of the testamentary trust in the first instance and the subsequent transfer by the trustee to an eventual beneficiary of the testamentary trust. The subsequent transfer may either involve a capital distribution being made by the trustee of the trust to a beneficiary during the lifetime of the trust, or a payment of capital upon vesting of the trust.

The result of PS LA 2003/12 is that, on the subsequent disposal of a CGT asset from a testamentary trust trustee to a beneficiary of the testamentary trust:

• any capital gain or loss that the testamentary trust trustee makes is disregarded under s 128-15(3); and
• the beneficiary will be taken to have acquired the CGT assets of the deceased at the date of the deceased's death (rather than on the date they were distributed by the LPR) and the first element of the cost base and reduced cost base for the beneficiary will be:
• for pre-CGT assets in the hands of the deceased - the market value of the asset on the day the deceased died; and
• for post-CGT assets in the hands of the deceased - the deceased's cost base (or reduced cost base) at the date of their death.

Ultimately under PS LA 2003/12, Div 128 (in particular ss 128(2), (3) and (4)) effectively applies twice:

• initially, when the LPR is the "LPR" for the purposes of Div 128 and the testamentary trust trustee is the "beneficiary"; and
• subsequently, when the testamentary trust trustee is treated as an "LPR" for the purposes of Div 128 and the beneficiaries of the testamentary trust are treated as the "beneficiaries".

CGT event K3

The ATO has indicated that the position in PS LA 2003/12 is subject to CGT event K3, which covers assets passing to tax-advantaged entities.

CGT event K3 operates to ensure that, where assets pass to concessionally taxed entities from a deceased estate, a capital gain or loss is recognised in the deceased's final tax return. This prevents assets with embedded capital gains from avoiding capital gains when they are later disposed of by the concessionally taxed entity. CGT event K3 has, in the past, been avoided by ensuring an asset does not pass to a concessionally taxed entity until after the deceased's standard amendment period (generally 4 years after the assessment) has expired.

As part of the 2011-12 Budget measures, it was announced that amendments would be made to ensure that where CGT event K3 happened outside of the deceased's standard amendment period, a CGT liability still arose in the deceased's tax return. It was proposed this could be achieved by excluding CGT event K3 from the standard amendment period.

In particular, the CGT event would have been deemed to happen to the relevant entity that passed the asset to the concessionally taxed entity (rather than with the beneficiary), avoiding the need to amend the deceased's tax return. This change would have allowed the entity to which CGT event K3 applied to be able to utilise its realised capital losses against CGT event K3, instead of the deceased utilising their capital losses against their capital gain from CGT event K3.

The change would have been consistent with how Div 128 operates under PS LA 2003/12 where an LPR or testamentary trust trustee sells an asset to a third party, rather than passing the asset to the intended beneficiary of the estate.

However, as with other proposed changes mentioned below, the announced changes to CGT event K3 were abandoned in late 2013.

Where an intended beneficiary dies before administration is completed

The Federal Government released a proposal paper "Minor amendments to the capital gains tax law" in June 2012 which specifically addressed the circumstance where an intended beneficiary dies before administration of an estate is completed. Generally, in that situation, s 128-15 provides a CGT roll-over provided that the asset passes from the first deceased's LPR to the beneficiary's LPR.

However, no CGT roll-over exists where the asset passes (ultimately) from the first deceased's LPR via the second deceased's LPR to the trustee of a testamentary trust or a beneficiary of the intended beneficiary's (ie the second deceased) estate because the asset was not one which the intended beneficiary owned when they died.

The former Labor Federal Government proposed to introduce measures to allow the intended beneficiary's LPR to access the roll-over where the intended beneficiary died before an asset that the first deceased owned passed to them, regardless of whether it passed first to a testamentary trust trustee. Again, however, the Coalition Government confirmed the amendments would not be implemented.

Arguably, PS LA 2003/12 can be relied on to provide relief in this type of situation.

Image credit: Alan Cleaver cc

Taxation consequences of testamentary trust distributions - Part I

There has been a refocus on what is likely to be the approach of the ATO in this area.

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

In December 2013, the Federal Government announced its decision to abandon a number of proposed legislative changes in relation to various aspects of the taxation of testamentary trusts - see 2013 WTB 53 [2270] and also 2014 WTB 12 [399]. As a result, there has been a refocus on what is likely to be the approach of the ATO in this area.

Part I of this 2-part article considers the taxation aspects of:

• the transfer of assets under a deceased estate;
• distributions from a will maker to a legal personal representative (LPR);
• distributions from a LPR to a testamentary trust.

Part II of this article will focus on distributions from testamentary trusts to beneficiaries and the abandonment of the previously announced legislative changes.

Transfer of assets

On the death of a will maker, each asset of the estate will potentially be transferred 3 times:

• from the will maker to the LPR;
• from the LPR to the beneficiary of the estate, which may be the trustee of a testamentary trust; and
• where the recipient was the trustee of a testamentary trust, from that trustee to a beneficiary either as a capital distribution during the lifetime of the trust or as a distribution of corpus upon vesting.

The CGT consequences of each of the abovementioned transfers must be separately considered.

Distributions from will maker to LPR

The first roll-over to examine is the initial transfer of a deceased's assets from the deceased person to their LPR for distribution under the terms of the deceased's will.

As a starting point, the general position is that, when a taxpayer dies, any capital gain or loss from any event relating to a CGT asset owned by the deceased is disregarded under s 128-10 of the ITAA 1997. This means that the distribution from the deceased to their LPR does not result in a CGT liability for the deceased.

As to the consequences for the LPR, the CGT assets are taken, under s 128-15 to have been acquired by the LPR on the date the deceased died. The cost base of each CGT asset (other than for a property which was a main residence for the deceased immediately before they died) for the LPR is modified under s 128-15(4) so that:

• for pre-CGT assets in the hands of the deceased - the first element of the LPR's cost base (and reduced cost base) is the market value of the asset on the day the deceased died (meaning that pre-CGT assets in the hands of the deceased become post-CGT assets in the hands of the LPR); and
• for post-CGT assets in the hands of the deceased - the first element of the LPR's cost base (and reduced cost base) is the deceased's cost base (or reduced cost base) at the date of their death (i.e. the deceased effectively passes their cost base and reduced cost base to the LPR).

Distributions from LPR to testamentary trust

From a CGT perspective, a testamentary trust is treated much the same as other trusts. However, it should be noted that CGT event E1 does not apply to the creation of a testamentary trust since that event only applies to the creation of a trust "by declaration or settlement".

In the testamentary trust scenario, there is no such declaration of trust and there is no initial settlement sum.

The CGT rules which apply to the distribution from the deceased to the LPR apply in the same manner to subsequent distributions from the LPR to a "beneficiary" of the estate.

It would appear that "beneficiary" for the purposes of the ITAA 1997 includes the trustee of a testamentary trust (however, as will be explained in Part II of this article, for the purpose of Div 128, the trustee of a testamentary trust is also treated the same as an LPR by the ATO), meaning that distributions from an LPR to the trustee of a testamentary trust are treated in the same manner as distributions from an LPR to an individual beneficiary.

A CGT asset is taken to have passed to a beneficiary of a deceased's estate if the beneficiary (or in this case, the trustee of the testamentary trust) becomes the owner of the asset whether under the terms of:

• the deceased's will;
• under the intestacy laws; or
• under a deed of arrangement.

Section 128-15(3) provides that on a subsequent distribution from the LPR to a beneficiary (including the trustee of a testamentary trust), any capital gain or loss that the LPR makes is disregarded.

Again, the trustee of the testamentary trust is taken to have acquired the CGT assets of the deceased at the date of the deceased's death (rather than on the date they were distributed by the LPR) and the first element of the cost base (and reduced cost base) for the testamentary trust trustee will be:

• for pre-CGT assets in the hands of the deceased - the market value of the asset on the day the deceased died; and
• for post-CGT assets in the hands of the deceased - the deceased's costs base (or reduced cost base) at the date of their death.

The testamentary trust trustee is also able include in its cost base any expenditure the LPR has incurred, up to the time of the disposal by the LPR, that the LPR would have been entitled to include in its cost base had it retained the asset.

Until next week.

Image credit: Barbara Agnew cc

One remedy where trust distributions prove problematic

For those that do not otherwise have access to the Weekly Tax Bulletin, the article from last week is extracted below.

A recent article in this Bulletin focused on the critical need to "read the deed" whenever making trust distributions (see 2013 WTB 38 [1642]).

Even where distributions are made validly to a potential beneficiary, they can prove extremely problematic from an asset protection perspective.

One scenario that seems to arise regularly in this regard is the distribution by a trust to a corporate beneficiary, the shares in which are owned personally by an at-risk individual.

Often, the difficulties with this ownership structure are not identified until after many years of distributions have been made to the bucket company, and anecdotally, the issue is often first identified at a point which is too late, for example, just before litigation proceedings are to commence against the relevant shareholder.

Where this ownership structure is identified and assessed to be inappropriate, the first critical step is to ensure that any future distributions to a corporate beneficiary are directed to a newly established company, the shares in which are owned by a non-risk entity (e.g. a passive family trust).

However, resolving the historical distributions is generally not as simple.

Depending on the circumstances, some form of dividend access share or discretionary dividend share may provide a pathway to remedy the historic distributions, although it will be important to consider the ATO's recent guidance in Draft Taxation Determination TD 2013/D5 (see 2013 WTB 24 [1092]) and Taxpayer Alert TA 2012/4 (see 2012 WTB 30 [1194]) which warned taxpayers of arrangements where accumulated profits of a private company are distributed substantially tax-free to an entity associated with the ordinary shareholders of the private company.

Similarly, since the introduction of the Personal Property Securities Act 2009 (PPSA), steps can often be taken to grant a security interest over the at-risk shares to a low risk related entity.

Broadly, this solution can be achieved by a "gift and loan back" style arrangement, whereby:

1. the at-risk individual gifts a cash amount equal to the gross value of the shares to a protected environment (e.g. a passive family trust);
2. the family trust subsequently lends the gifted amount back to the at-risk individual; and
3. the family trust simultaneously registers a security interest over the shares on the PPS register to secure repayment of the loan. Subject to certain conditions (such as the family trust establishing "control" over the shares) the family trust's interest in the shares should be protected under the PPSA.

The advantages of utilising a gift and loan back, compared to a straight transfer of the shares in the corporate beneficiary can include:

1. the arrangement achieves broadly equivalent protection for the asset compared with a straight transfer; and
2. as there is no change in the legal ownership of the shares, transfer duty (where applicable) and capital gains tax will generally not apply. The only transaction cost should be the PPSR registration fee.

The disadvantages of utilising a gift and loan back approach, compared to a straight transfer of the shares can include:

1. the arrangement is more complex than a simple transfer, and involves the preparation of additional documentation (including a deed of gift, loan agreement and security documentation);
2. it only protects the amount of net equity in the asset at the time of the gifting, however as mentioned above, there should not be any further distributions made to the inappropriately structured corporate beneficiary; and
3. the arrangement is subject to the bankruptcy clawback rules and specialist advice should be obtained in relation to the operation of these provisions.

Until next week.

Read the deed - another reminder re invalid distributions

A structure diagram of the trust in Harris v Harris [2011] FamCAFC 245 

For those that do not otherwise have access to the Weekly Tax Bulletin, the article from last week extracted below.

Practitioners will be aware, from many previous articles in this Bulletin (and elsewhere), of the critical importance that trust deeds should be read before making any distribution of income or capital. While the "read the deed" mantra should be indelibly etched in practitioners' minds, regular reminders of the dangers of not doing this are not out of place.

One example of a family law case of Harris v Harris [2011] FamCAFC 245 where the range of potential beneficiaries was critical was profiled in our article at 2012 WTB 39 [1586].

In that case, the trial judge in a family court matter noted that the recipient of trust distributions (being a company), who was being challenged, was not in fact an eligible beneficiary of the relevant trust. If the company had been simply nominated as a potential beneficiary, then the distributions would have most likely been valid.

A more common example of where difficulties with invalid distributions arise, however, relates to where particular potential beneficiaries are in fact expressly excluded by the trust deed. The most common example in this regard is the exclusion of the trustee, be that the current, former or even a future trustee, from being a beneficiary of a trust.

These types of clauses are often found in deeds prepared by New South Wales advisers. This is primarily because s 54(3) of the Duties Act 1997 (NSW) limits the nominal duty exemption for a change of trustee to trust deeds that contain provisions ensuring that:

1. none of the continuing trustees remaining after the appointment of a new trustee are or can become a beneficiary under the trust; 
2. none of the trustees of the trust after the appointment of a new trustee are or can become a beneficiary under the trust; and 
3. the transfer is not part of a scheme for conferring an interest, in relation to the trust property, on a new trustee or any other person, whether as a beneficiary or otherwise, to the detriment of the beneficial interest or potential beneficial interest of any person. 

An example of a clause adopting an approach that ensures access to the stamp duty relief is as follows:

"The Trustee for the time being of the Trust can not be a beneficiary of the Trust. None of the continuing Trustees remaining after the retirement of a Trustee is or can become a beneficiary under the Trust, and none of the Trustees of the Trust after the appointment of a new Trustee is or can become a beneficiary under the Trust."

New South Wales is the only Australian jurisdiction that has this type of restriction on accessing the duty concessions for a change of trustee and, understandably, clauses drafted in this manner are extremely prevalent with deed providers or lawyers based in New South Wales.

In many instances, however, there may in fact be no other connection with New South Wales for anyone associated with the trust.

The risks created by this drafting approach will, therefore, often be less than obvious. Anecdotally, there would seem to be an increasing number of situations where invalid distributions are being discovered that stretch back over many years and involve significant levels of invalid distributions.The exact ramifications of this type of situation will depend on a range of issues, including how any default provision under the relevant trust deed is crafted. This said, an embracing by all advisers involved with the administration of the trust of the mantra "read the deed" would avoid the issue ever arising in the first place.

Until next week.

A further reminder – read the deed

As regular readers are aware, there have been numerous posts highlighting the importance of reading trust deeds and recently we had (yet another) reminder.

Many advisers would be aware that, particularly for deeds established in New South Wales (due to the stamp duty rules there), there is often a prohibition on any trustee, and in some instances any former trustee, being a beneficiary of a trust.

The example that came up again recently (it seems to be one that comes up every few weeks) involved an individual trustee of a standard family discretionary trust. That individual trustee was also the sole primary beneficiary and sole appointor.

While there were potential issues from an asset protection perspective that we were reviewing, the more fundamental concern was that under the trust deed the trustee was specifically prohibited from ever receiving any income or capital distributions. A brief review of the balance sheet of the trust showed that substantial distributions had in fact been made to the trustee as primary beneficiary over a number of years.

There are now a myriad of issues that the trustee and his adviser are needing to work through, not least of which being how to address the enquiries of the lawyers for the trustee’s former spouse who are alleging a breach of trust and what steps will need to be taken from a tax perspective in relation to the various years in which invalid distributions have taken place.

Until next week.

Trust distributions and 30 June

 

In the wash up of the passing of the financial year, an adviser contacted us last week with yet another reminder about the importance of reading trust deeds. 

In this particular instance, the adviser had taken over a client from another firm. One of the key items on the trust checklist completed for every client of this adviser's firm is confirming what date the trust deed requires income distributions to have been made by. 

The Tax Office has a long stated view that regardless of whatever concessions may be available under the tax legislation in terms of the due date for resolutions, these concessions are subject always to the trust instrument. 

The terms of the trust deed here required all resolutions to be made by no later than 12pm on 29 June in the relevant financial year. Unfortunately, the distributions for each of the previous years had all been dated 30 June, which meant they were invalid under the deed. 

The adviser was, therefore, required to begin the process for lodgement of amended returns, relying on the default provisions under the trust deed and sought our guidance on how to best address this. 

Needless to say that the income determination for the current financial year was made and passed by resolution dated 28 June, so as to at least comply with the deed this year. 

Until next week.

Buy sell deeds, family trusts and the deemed market value substitution rule

Click here for an overview of buy-sell arrangements

With thanks to co View Legal director Tara Lucke, today’s post considers an issue that has been raised with us by an adviser recently.

It is generally accepted that where a business succession plan is structured with self owned insurance policies and a buy sell deed using put and call options, the deemed market value substitution rules apply for taxation purposes.  This outcome occurs notwithstanding that the transfer has been funded (either wholly or partly) by insurance.

Given the recent changes to the rules relating to the taxation of trusts, some uncertainty has arisen in relation to the ability to effectively manage the taxation consequences of a deemed capital gain arising from a transfer under a buy sell deed.

Under the ‘interim’ taxation rules relating to trusts, there can be particular problems relating to distributions of capital gains arising under the deemed market value substitution rule.  In particular, it is generally not possible to create specific entitlement to a deemed capital gain, notwithstanding that there may be a streaming power in the trust deed. 

However, where $1 of consideration has been received (which is how we generally recommend buy sell deeds be crafted), provided a beneficiary is made specifically entitled to the $1 of consideration, the deemed gain should be distributed to that same trust beneficiary.

It will therefore be important in each case to consider the specific terms of the trust deed and the other income of the trust, and to craft the distribution minute correctly to ensure the gain can ultimately be distributed to individuals who can access the general 50% capital gains tax discount. 

Until next week.

Prohibitions on trust deed variations

As mentioned last week, we often find trust deeds have prohibitions on a trustee’s ability to vary the document.

Some of the issues to be aware of in this regard include:

1    Often variations can only be made with the consent of someone other than the trustee, for example an appointor, guardian or even the settlor.

2    In some cases, variations can only be made to the core (or trust) provisions of the deed, as opposed to the more general powers, which will usually limit the ability to vary the income provisions.

3    Alternatively, while powers can be added to a trust, a deed will sometimes provide that any existing powers cannot be varied – this can be particularly problematic where there is a desire to update the income distribution provisions.

4    There are countless other examples of restrictions on variations and indeed, we have come across deeds where there is a blanket prohibition on making variations to the deed, or at least on variations to particular clauses in the deed.

While there are often workarounds no matter what restriction is imposed, the fundamental rule to remember is that each and every deed must be read before embarking on a variation.

Until next week.