King of the mountain** - Principal's or Appointor’s appointing themselves as trustees

The position according to case law is that the powers of a principal or appointor style role of a trust are fiduciary powers that must be exercised for the benefit of the beneficiaries.

Arguably the leading case in relation to the general prohibition is In re Skeats' Settlement (1889) 42 Ch D 552.

In this case it was relevantly held that:

1. the ordinary power of appointing new trustees imposes upon the person who has the power of appointment the duty of selecting honest and good persons who can be trusted with the very difficult, onerous, and often delicate duties which trustees have to perform;
2. there is a duty to select to the best of the appointor's ability the best people;
3. there is a universal rule that a person should not be a judge in their own case; in other words a person should not decide that they are the best possible person, and say that they ought to be the trustee.

Subject therefore to the trust deed of a trust, a principal or appointor cannot use their powers to appoint themselves as trustee.

As set out in previous posts many modern trust deeds contain an exception to this rule.

The general prohibition is also removed by legislation in some states.

As usual, please make contact if you would like access to any of the content mentioned in this post.

** For the trainspotters, the title of today's post is riffed from the Kate Bush song ‘King of the mountain’.

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Sole trustees of a partnership of trusts: No Surprises**

Posts over recent weeks have considered the issues surrounding whether a partnership exists where two or more trusts have the same corporate trustee.

As mentioned last week, while the so called 'self-dealing rule' can potentially invalidate a structure of a single trustee of multiple trusts, that rule can be ignored where this is addressed in the relevant trust instruments.

Subject to this requirement, it appears that at least some professional bodies and third parties (for example the Law Society and Stamps Office) interpret the relevant legislation as allowing a sole corporate trustee of multiple trusts in partnership.

Two commercial examples in this regard would include trust cloning and trust splitting, both of which are founded on the basis that it is possible for the same trustee to contract with itself in relation to multiple trusts.

There does however need to be provisions along the lines set out in the trust deed for each partner.

++++++++++

Example trust deed clauses

Conflicts of interest

1.1 The Trustee may:

1. contract with, or sell or grant options to buy any part of the Trust Fund to;
2. purchase Property from;
3. borrow money from; or
4. enter into any share farming or agistment agreement, lease, tenancy or partnership with, the Trustee in its own or any other capacity, either alone or in conjunction with any other persons or:
5. any company or partnership, even if the Trustee, or any shareholder or director of the Trustee, is a shareholder, director, member or partner of that company or partnership; or
6. a Child of the Trustee.

1.2 The Trustee may exercise (or concur in exercising) all of the powers and discretions contained in this document or otherwise conferred by law, even if:

1. the Trustee, or any director or shareholder of a Trustee that is a company:
1. has or may have any direct or personal interest in the mode or result of exercising that power or discretion; or
2. may benefit either directly or indirectly as a result of the exercise of that power or discretion;
3. is a party in its personal capacity to the transaction being contemplated; or
2. the Trustee is the sole trustee.

1.3 The Trustee may sell, transfer, dispose, divide in specie, hire or lease any part of the Trust Fund to carry on or carry out any profit making undertaking or scheme in partnership with:

1. the Trustee in any capacity (including its personal capacity, or in its capacity as trustee of another trust fund);
2. any company or partnership, even if the Trustee, or any shareholder or director of the Trustee, is a shareholder, director, member or partner of that company or partnership; or
3. a Child of the Trustee.

As usual, please make contact if you would like access to any of the content mentioned in this post.

** For the trainspotters, the title of today's post is riffed from the Radiohead song ‘No surprises’.

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Sole trustees of a partnership of trusts: not so hard to explain**

Posts over recent weeks have considered the issues surrounding whether a partnership exists where two or more trusts have the same corporate trustee.

A related issue in this regard relates to whether a company as trustee of two different trusts can contract with itself.

Generally there are potentially prohibitions against this style of structure under the various state based Property Law Acts. These prohibitions are analogous to the common law ‘self-dealing’ rule, which prevent a trustee conveying or selling property to itself because it places the trustee’s personal interest in conflict with the duty to the beneficiaries.

That is, at common law, there must be at least two parties to a contract. Therefore it is the case that a party cannot contract with a nominee for itself or with its own agent, if that agent is contracting with its principal in that capacity - and two agents of the same principal cannot contract with each other, see Infigo II v Linmas Holdings [2023] NSWSC 75. This case also succinctly confirms that:

1. A trustee, in its personal capacity and in its capacity as a trustee, remains the same legal person.
2. Except as permitted by statute, whilst a trustee can contract in two different capacities, it cannot contract with itself.
3. The assumption that a trustee in its personal capacity and in its trustee capacity are different persons is false (see MacarthurCook Fund Management Ltd v Zhaofeng Funds Ltd [2012] NSWSC 911).
4. A legal person cannot act as agent for itself (see McCausland v Surfing Hardware International Holdings Pty Ltd [2013] NSWSC 902).

Having said the above, the common law rule is largely removed by the Property Law Acts. Under these Acts, a distinction is made between a person conveying land to itself (void) and a person conveying land to itself in another capacity (voidable), that is, as a trustee. In the latter case, a single corporate trustee of a partnership is generally valid, although could in theory be unwound if (say) a beneficiary of one of the partner trusts seeks to object to the arrangement. Any risk is therefore a commercial rather than a legal one.

The decision in Leximed Pty Ltd v Morgan [2016] 2 Qd R 442 provides some context in this regard. This case involved a partnership agreement between 2 trusts with the same trustee. The court confirmed that the partnership agreement was likely to be unenforceable at common law on the basis that the partnership was a nullity under the ‘self dealing’ rule, although a concluded position was not reached on the issue. Part of the reason the issue of invalidity due to self dealing was not determined was because the relevant Property Law Act overruled the common law position and therefore would have created the requisite ability to enforce the arrangements.

Similar to the Property Law Acts, under the Tax Act, section 960-100(3) confirms 'A legal person can have a number of different capacities in which the person does things. In each of those capacities, the person is taken to be a different entity' (see Re David Christie as trustee for The Moreton Bay Trading Company [2004] AATA 1396).

In this regard, there are two exceptions to the self-dealing rule as it relates to the trustee of a trust:

1. it is authorised or contemplated by the trust instrument; or
2. it is authorised by each of the beneficiaries (who are of legal age) and the transaction occurs at arm’s length terms.

While the law is not settled on this point, assuming the documentation is drafted in a way to ensure the intention was clear that the trusts would be forming a partnership with one corporate trustee, and the practical arrangements reflected this intention, such a structure is at most voidable if a successful application is made by (say) one of the beneficiaries.

Practically, there is often also utility in having an appointor or principal power in each trust deed, to facilitate a change of trustee if required of any partner, without terminating the partnership.

As usual, please make contact if you would like access to any of the content mentioned in this post.

** For the trainspotters, the title of today's post is riffed from the Strokes song ‘Hard to explain'.

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Can trusts last forever now? **

Following on from recent posts it is useful to understand that the majority of Australian jurisdictions decided that a life in being plus 21 years was too complicated. Instead, the rule was replaced with a statutory provision which allows up to 80 years as the maximum length of trust in Australia.

As mentioned last week, there are exceptions to this rule. In relation to discretionary trusts, the highest profile exception is in South Australia where the rule has effectively been abolished.

Another exception is in relation to superannuation funds.

Superannuation funds are simply a form of trust instrument, although a highly regulated form of trust due to the Superannuation Industry Supervision Act which imposes a whole range of specific rules.

In relation to the core of the underlying structure of a superannuation fund however, it is simply a trust structure. Importantly however there is no concept of an ending period. In other words, in theory superannuation funds can last forever.

There are obviously tax issues for self-managed superannuation funds meaning maintaining the structure indefinitely may not be a particularly smart idea. However in the context of trust vesting, superannuation funds are a clear and obvious exception to the vesting rules.

As usual, please make contact if you would like access to any of the content mentioned in this post.

** For trainspotters, ‘Forever now’ is song by legendary Australian band Cold Chisel from 1982.

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When one is no more fun – another tip on changing trustees **

As highlighted in previous posts, there are a myriad of issues that should be taken into account in relation to any decision to change the trustee of a trust (see for example our post on 7 February 2017).

One critical issue under the Trusts Acts in most states is the rule that where there are two or more individual trustees appointed initially of a trust, the retiring trustees will continue to be liable unless replaced by:

1. at least two individual trustees; or
2. a ‘trustee corporation’.

For the purposes of these rules the ‘trustee corporation’ must be a formal trustee company, as opposed to a private propriety company.

Importantly, the trust instrument may override these rules and allow trustees to be discharged, even when replaced by a single trustee.

Often however trustees will be changed without the required permission in the trust instrument, completely ignorant of the Trust Acts rules, meaning the retiring trustees unknowingly continue to be liable.

For obvious reasons we therefore generally recommend an amendment to any trust deed that does not expressly override the Trusts Acts requirement, however this is approach is also subject to the standard mantra ‘read the deed’ as often deeds will not in fact permit this type of variation.

In situations where a variation is not permitted, one work around that helps in some (but unfortunately not all) states is to appoint (say) one individual trustee and a propriety company of which the individual trustee is the sole shareholder and director.

As usual, please make contact if you would like access to any of the content mentioned in this post.

** For trainspotters, ‘More Fun’ is song by legendary Australian band Radio Birdman.

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I fought the law … **

As set out in last week's post, this week's post considers some possible solutions to the issues that arose in the Domazet decision.

The first work around is probably the easiest and the best one in some respects. Simply, the No.2 trust could have included a clause that said, “Our trust automatically ends the day before the No.1 trust.” This one sentence would have arguably avoided the issue.

The second idea would have been to amend the trust deed for No.1 trust and remove the prohibition. In other words, amending the terms of the No. 1 trust instrument so that it required any other recipient trust end before the No.1 trust.

This idea, would have essentially relied on the wait and see rule which has been explored in previous posts.

The third idea is that the No.1 trust could have skipped distributing to No.2 and simply distributed directly to the relevant beneficiary. Many might however say, “Well Matthew, that sounds nice, but I suspect there would have been a lot of wider tax planning strategies that were being utilised by the No.2 trust.” Thus, there should be an asterisk next to this idea because in many instances this style of approach may not have actually worked.

The fourth idea is in fact what they actually did in the Domazet case, which is they applied to the court for rectification.

The rectification adopted the first approach outlined above (that is the variation to amend the vesting date of the No. 2 trust).

Thus, while the taxpayer 'won', they had all the issues that go with a rectification. They had pain, they had suffering, they had delays, they had vastly increased costs, and they had significantly more attention.

As usual, please make contact if you would like access to any of the content mentioned in this post.

** For the trainspotters, see early punk outfit The Clash perform the Sonny Curtis (of 'The Crickets' fame) song 'I fought the law and the law won'.

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Trust distributions and the Domazet decision – it’s a miracle !**

Domazet is arguably, one of the highest high profile trust vesting-related cases. As usual, if you would like a copy of the decision please contact me.

The factual matrix in board terms was as follows.

The original trust was set up in the 1970s, named here as the No. 1 trust.

Many years later there is a desire to distribute to another trust (named here as the No.2 trust). The No.1 trust was set up in the 1970’s. The No.2 trust set up in the 2010s - in other words, many years later.

The provisions in the trust deed for the No.1 trust provided that distributions to another trust as beneficiary were possible, as long as the receiving trust ended before the vesting date of the No.1 trust.

Here, No.1 trust, or the trustee and its advisers assumed that the vesting date of the No.2 trust would be 80 years.

The reason they assumed that is because the Australian Capital Territory (ACT) had at one point introduced the statutory 80-year perpetuity period and the No. 1 trust was established in the ACT.

It was therefore assumed that the legislation applied. The problem was that they had misunderstood the way the statutory limit had been implemented.

In particular, each Australian jurisdiction implemented the 80 years statutory limit at different points in time. The adviser for the No.1 trust was Queensland-based.

The Queensland legislation had come in before the No.1 trust was set up. So, they just assumed that would be the case in the ACT. In fact, the ACT legislation came in after the No.1 trust was set up.

They then amended the No. 2 trust to ensure it ended with 80 years of the No. 1 trust being set up.

What this meant in the practical sense was that when the distributions took place, the No.2 trust in fact had a vesting date after the No.1 trust because the No. 1 trust did not with certainty have an 80 year life.

This was a big problem because it meant that distribution was void according to the terms of the No. 1 trust.

What that meant was that the No.1 trust would be assessed, as if there was no trust distribution at all, which triggers a flat rate of tax of 48.5 cents. To the extent there were any capital gains, the 50% general discount would also be completely ignored.

Next week's post with consider some possible solutions given the factual matrix here.

As usual, please make contact if you would like access to any of the content mentioned in this post.

** For the trainspotters, the title of today's post is riffed from the Culture Club song 'It's a Miracle’.

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Changing an appointor - just like (starting over**) - or changing a trustee; simple! (in theory ...)

A previous post explored the key revenue issues in relation to changing the trustee of a discretionary trust.

An equally important and related issue concerns a decision to change the principal or appointor role of a family trust. That is, the person, people, or company having the unilateral right to remove and appoint a trustee.

As regular readers of this blog will know, there does not necessarily need to be an appointor or principal provision under a trust deed. However, where there is one, a trust deed itself will normally set out in some detail the way in which the role of appointor is dealt with on the death or incapacity of the person (or people) originally appointed.

Where there are no provisions in relation to the succession of the appointor role, it is often necessary to try and rely on any power of variation under the deed to achieve an equivalent outcome.

Generally, from a trust law perspective, it is possible for the appointor provisions to be amended. However, any intended change must be permitted by the trust instrument, meaning the starting point must always be to 'read the deed' – a mantra regularly profiled in this blog. The decision in Mercanti v Mercanti [2016] WASCA 206 (this Court of Appeal judgment stands following the High Court's refusal to reject an appeal) being a leading example of the principle in the context of purported changes to appointorship.

The tax and stamp duty consequences of changing an appointor can be similarly complex.

Stamp duty costs on changing an appointor

In broad terms, the stamp duty consequences of changing an appointor provision can normally be managed in most Australian states.

This said, care always needs to be taken, particularly where the trust deed simply defines the appointor by reference to some other named beneficiary in the trust.

For example, it can often be the case that the appointor is defined as being the primary beneficiary of the trust and that primary beneficiary may also be a default beneficiary.

In these circumstances, depending on how the deed is crafted, there may be stamp duty consequences of implementing any change.

Tax Office views on changing an appointor

In relation to the tax consequences of changing an appointor, there are a number of private rulings published by the Tax Office which support the ability to change an appointor role, particularly if it is part of a standard family succession plan.

Arguably the 2 leading private rulings concerning the tax consequences of changing an appointor are Authorisation numbers 1011616699832 and 1011623239706. Broadly, these each confirm that there should be no tax resettlement on the change of an appointor where –

• The relevant trust deed provides the appointor with the power to nominate new appointors and also allows for the resignation of an appointor;
• The intended change complies with the trust deed (the "read the deed" mantra again highlighted);
• The proposed amendment is otherwise analogous with the changing of a trustee and is thus essentially procedural in nature; and
• The original intention of the settlor is not changed such that there will not be any change to the beneficiaries, the obligations of the trustee or the terms or nature of the trust.

Clark case

The conclusion that there should be no adverse tax consequences on changing an appointor is also supported by the decision in FCT v Clark [2011] FCAFC 5 ("Clark") and which has been profiled previously in this blog.

In particular, the Full Federal Court in Clark held that significant changes to a trust instrument would not of themselves cause a resettlement of the trust for tax purposes, so long as there is a continuum of property and membership, that can be identified at any time, even if different from time to time. That meant that, in Clark, although there had been a change of trustee, a change of control of the trust, a change in the trust assets and a change in the unitholders of the trust between 2 income years, this did not trigger a resettlement for tax purposes.

Rather, it is only where a trust has been effectively deprived of all assets and then 're-endowed', that a resettlement will occur.

While the Tax Office released a Taxation Determination (namely TD 2012/21) following Clark, it unfortunately does not provide any specific commentary around when the Tax Office will deem changes to an appointor or principal of a trust to amount to a capital gains tax event under CGT events E1 and E2 (ie a resettlement).

Rather, in broad terms, the Tax Office simply states that unless variations cause a trust to terminate, then there will be no resettlement for tax purposes.

While a number of examples are provided, which give some guidance around issues such as changes of beneficiaries and updates to address distribution of trust income, the examples ignore issues such as changing appointors and multiple changes (for example, changing beneficiaries, the trustee and the appointor as part of an estate planning exercise).

As usual, please make contact if you would like access to any of the content mentioned in this post.

The above post is based on an article that we originally contributed to the Weekly Tax Bulletin

** For the trainspotters, the title of today's post is riffed from the John Lennon song ‘Just like starting over’.

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Tax law v Property law – as stark as the difference between Wit and Chu**

Many previous View posts can be filed under the heading ‘trust horror stories’ – and indeed every year we run seminars solely on this topic (with entirely new content each year).

Recently we were reminded of a Tax Office private ruling (being Authorisation Number 1012450031835) that was a horror story, at least with reference to the interplay between the property law regime and tax law.

Briefly the factual matrix was as follows:

1. A firm (presumably a law firm) prepared and supplied four copies of the trust deed to the settlor of the trust.
2. The settlor paid the settlement sum to the trustee and it was banked in the trust bank account.
3. The accountant involved provided the four unsigned copies of the trust deed to the trustee for signing.
4. The trustee executed all four copies of the deed and returned them to the settlor for signing.
5. The accountant held the trust deeds in safe keeping for a few years and then returned three copies of the trust deed to the trustee. On receipt, the trustee discovered that the settlor had not signed any of these three copies of the trust deed.
6. The sole signed copy was retained by the accountant and not returned to the trustee. However on that document, the settlor had signed in the witness space, and the signature was not witnessed.
7. A Deed of Confirmation was drafted to show that a trust was created and the parties intended to create the trust, however while the trustee and beneficiaries were willing to sign this document, the settlor refused.

The Tax Office confirmed:

1. The trust deed was invalid under the Property Law Act 1974 (Qld) due to the failure of the settlor to validly sign the document.
2. This said, the 4 key elements of a trust (being a trustee, trust property, beneficiaries and obligations on the trustee) were all present.
3. That is, as explained in Harmer v FCT (1989) 20 ATR 1461, a trust is the relationship which arises wherever a person called the trustee is compelled in equity to hold property, whether real or personal, and whether by legal or equitable title, for the benefit of some persons or for some object permitted by law, in such a way that the real benefit of the property accrues, not to the trustee, but to the beneficiary or other object of the trust.
4. Unlike under the Property Law Act which requires trusts in relation to real property to be documented in writing, a formal trust deed is not a specific requirement under tax legislation, so long as there is a clear intention - which there was here.

As usual, please contact me if you would like access to any of the content mentioned in this post.

** for the trainspotters, the title today is riffed from the song by Queens of the Stone Age and ‘Make it Wit Chu’.

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At last some clarity with the streaming of franking credits? But trust law re-write still urgently needed

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

For ease of reference, an earlier post addressing a previous decision in this matter is at the following link - http://blog.viewlegal.com.au/2010/11/streaming-decision-released.html

The recent case of Thomas v FCT [2015] FCA 968, reported in this Bulletin, considers a number of key issues relating to the distribution of franking credits by the trustee of a discretionary trust, including the ability to stream franking credits as a separate class of income.

It follows the well-publicised decision of the Queensland Supreme Court in Thomas Nominees Pty Ltd ACN 010 049 788 v Thomas & Anor [2010] QSC 417 (reported at 2010 WTB 49 [1884]), which relevantly held that franking credits could form part of the income of a trust estate for trust law purposes and be streamed to particular beneficiaries.  The Commissioner was not a party to that earlier decision.

The Thomas case explores the interaction between s 95 and s 97 of the ITAA 1936 dealing with trust income and Div 207 of the ITAA 1997 dealing with the imputation system.

The decision is a timely reminder of the need to ensure that trust distributions are made in compliance with the trust deed, the ITAA 1936 and the ITAA 1997, and of the complexities that can arise when streaming different classes of income.

Facts

A more detailed summary of the facts of the case are set out separately in this Bulletin, however in brief, the trustee of Thomas Investment Trust purported to distribute the trust's income in several consecutive financial years as follows:

• Around 90% of the franking credits and foreign income and 1% of the remaining net income to an individual beneficiary.
• The balance of the net income to a corporate beneficiary.

The Commissioner challenged the effect of the distributions and in essence, argued that the franking credits could not be distributed to a beneficiary independently of the franked dividend to which those franking credits related.

The taxpayer contended that the franking credits were in fact a class of income capable of being streamed to particular beneficiaries in accordance with the trust instrument.

A number of other matters relating to the trust instrument and distribution resolutions were considered by the Court, which are beyond the scope of this article.

Outcome

The judgment, which the Commissioner at least is likely to believe is a thorough and well-crafted decision, rejects the earlier conclusion in Thomas Nominees Pty Ltd ACN 010 049 788 v Thomas & Anor [2010] QSC 417 and provides significant guidance in relation to the streaming of franked dividends and franking credits.

It is widely understood that Div 207-55(3) of the ITAA 1997 provides that a beneficiary's share of a franked distribution is equal to the amount included when determining the beneficiary's share of the trust's income under s 95 of the ITAA 1936.

Div 207 also recognises and permits a trustee to stream some or all of a franked dividend to one or more beneficiaries to the exclusion of others, subject to the requisite powers under the trust deed.

Provided the relevant trust instrument expressly permits streaming of franked dividends as a separate class of income, a trustee can choose to make one or more beneficiaries specifically entitled to franked dividends, while distributing other classes of income to different beneficiaries.

Any beneficiary who is made specifically entitled to franked dividends is then entitled to the benefit of the franking credits attaching to those dividends.

In Thomas, the trustee purported to stream franking credits as a separate class of income from the dividends themselves.  This approach, permitted under the trust deed, saw one beneficiary receive the benefit of the tax offset under the imputation system at their marginal tax rate, while another beneficiary paid income tax on the dividend at the corporate tax rate.

The Court held that, although franking credits will generally have a clear commercial value to a beneficiary (as a result of the beneficiary's ability to claim a tax offset from the credit), a franking credit is not "income" for trust law purposes.

Specifically, although franking credits constitute statutory income for the purposes of the gross-up provisions, they are a notional, statutory creation in this regard and do not constitute "ordinary income" under trust law principles.

As a result, the operation of Div 207 makes it clear that franking credits can only "attach" to the franked dividend and cannot be streamed as a separate class of income, notwithstanding any other provision that may indicate to the contrary within the trust instrument.

The outcome of the case can perhaps be best summarised by the following quote from the judgment:

"What cannot occur if the tax offset is to be preserved…is an allocation of the s 95 net income amongst beneficiaries on a particular basis and a distribution of the franking credits otherwise attached or stapled to the franked dividends on an entirely unrelated basis, amongst the same beneficiaries." [Court's emphasis]

Lessons

A number of lessons can be taken from the case, including:

• As regularly highlighted in this Bulletin, it is critical to "read the deed" before purporting to exercise trust powers, particularly in relation to trust distributions.

• While reading the trust deed (including all valid variations) is necessary, it will not be sufficient by itself.  There are a myriad of related issues that need to be considered that may impact on the intended distribution, aside from whatever powers are set out in the trust instrument.  Examples include renunciations and disclaimers by beneficiaries, purported changes that are not permitted under the relevant trust instrument (see for example the article at 2015 WTB 37 [1373] in relation to amending trust deeds) and the effective narrowing (for tax purposes) of permissible beneficiaries due to the impact of family trust and interposed entity elections.

• The wording of the distribution minute or resolution will be critical for determining the consequences of the distribution.  Terms like "income" and "net income" will be defined differently depending on the trust instrument (even deeds that have been sourced from the same provider) and failing to understand those distinctions can result in inadvertent adverse outcomes for the trustee and beneficiaries.

• Distribution resolutions must also be crafted with reference to the trust instrument, trust law principles, the ITAA 1936 and the ITAA 1997.  For example, with increasing regularity, we are seeing trust deeds that require distributions take place before they are otherwise needed under the ITAA.

• Trustees should act with significant care when dealing with "notional" amounts such as franking credits, to ensure the intended tax and commercial objectives are achieved.

• Trustees have a duty to ensure they are aware of their rights and responsibilities under the trust deed and the limitations under the ITAA 1936 and the ITAA 1997.  A failure to discharge this duty can mean a trustee is personally liable.

Ultimately however the latest installment in this series of cases (so far) also highlights the need for the Government to prioritise the long awaited re-write of the legislation governing the taxation of trusts in order to simplify what continues to be an unnecessarily complex area of the taxation law.

Image credit: Dwayne Bent 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.