Game over for trust splitting? The ATO embraces Revisionist History

 

The ATO has released its views on trust splitting in Draft Taxation Determination (TD 2018/D3).

 

There are a range of concerns with TD 2018/D3 for all trust advisers.  

 

A summary of the key issues is set out below. 

 

Examples

The factual matrix provided in TD 2018/D3 is very specific and lists a number of line items that may, or may not, be a part of a trust splitting arrangement. Many of the arrangements we have seen historically have involved a change of trustee in relation to specific assets and few or none of the other features listed in the draft ruling (for instance, no changes to the appointors, right of indemnity or range of beneficiaries).

 

For TD 2018/D3 to be credible, it will be imperative that more examples are included highlighting the range of potential trust splits, and in turn, highlighting the types of trust splitting arrangements that will not give rise to any CGT consequences.

 

For example, the ATO appears to place significant weight on issues such as varying the trustee’s right of indemnity and adjusting the range of potential beneficiaries together with a decision to change appointorship.

 

It is well settled law (and the ATO has long accepted - for instance, in the withdrawn Statement of Principles on Trust Resettlements and subsequently in TD 2012/21) that each of these changes in isolation do not cause any CGT event to arise. It is therefore critical to highlight what combination of changes, in the ATO’s view, amount to a resettlement.

 

Flawed assumptions

Unfortunately, in concluding that trust splitting will cause CGT event E1, it appears the ATO has ignored most case law and legislation in the area, and indeed its most recent private ruling and earlier private rulings.

 

Arguably, TD 2018/D3 turns entirely on an assumption that, without any analysis, concludes how a court may respond to the application of an aggrieved beneficiary of a discretionary trust the subject of a trust splitting arrangement.

 

The assumption is unfortunately fundamentally flawed in at least 3 areas: 

• Despite a virtually identical factual scenario, TD 2018/D3 assumes that in 1 instance, the court will be resistant to an application, and yet in another instance, will support an application. There is no authority provided for either conclusion.
• More fundamentally, the paragraphs are based on a significant misunderstanding of the law in this area. There is substantive and longstanding case law confirming that the beneficiary of a discretionary trust does not have a proprietary interest in the trust assets and their rights against the trustee are limited. In particular, while a beneficiary has a right to proper administration and a right to be considered in relation to distributions of income or capital, a discretionary beneficiary does not have any legal or equitable right to distributions. TD 2018/D3 completely ignores this position.
• Finally, TD 2018/D3 fails to acknowledge that the mere amendment of a range of potential beneficiaries is highly unlikely to of itself cause a resettlement (as acknowledged by the ATO in TD 2012/21). Therefore, if a trust splitting arrangement takes place, and as part of the arrangement, the range of beneficiaries of the split trust is narrowed, then the conclusions in the abovementioned paragraphs are irrelevant. 

 

Furthermore, the conclusions in TD 2018/D3 are such that it would mean every single change of trustee or even a change of appointor (or principal) of a family trust would be liable to trigger (if the ATO felt the arrangement was not usual) CGT event E1 – a clearly unsustainable position. In particular, the logic of the ATO would imply that at any time the trustee of a trust is changed, it automatically means that the new trustee (and their family) would benefit from the trust to the exclusion of the old trustee (and their family) and that a court would with certainty intervene if ever requested by a disgruntled beneficiary.

 

Frustratingly TD 2018/D3 also contains long winded paragraphs, unsupported with any authority. Some of these statements are indeed arguably irrelevant to the subject matter. See for example the entire section under the heading ‘Settlement of assets on terms of a different trust’ – and in particular the sweeping generalisations at paragraph 28 about ‘practical problems’ with trust splits. At what point did ‘practical problems’ become a key factor in triggering CGT events? 

 

Resettlement?

Similarly, the ATO essentially ignores both High Court and Full Federal Court authority in decisions such as FCT v Commercial Nominees of Australia Ltd (2001) 47 ATR 220 (Commercial Nominees) and FCT v Clark (2011) 190 FCR 206 (Clark) when making conclusions in TD 2018/D3 about resettlement.

 

In particular, both Commercial Nominees and Clark acknowledged that it is completely expected that over the life of an 80-year discretionary trust, there will be changes, at times significant changes, in relation to the conduct of the trust. This is reflective of a continuing trust. 

 

Indeed, given current life expectancies of humans, it would be impossible not to have fundamental changes to the make-up of a trust over an 80-year period.

 

It appears that TD 2018/D3 is implicitly predicated on a belief that, despite superior court authority, a separate set of rules apply to discretionary trusts as compared to unit trusts and superannuation funds.

 

Such a belief is unsustainable in the context of both High Court and Full Federal Court authority and in the context of the ATO’s own publications. It is similarly unsustainable that steps as simple as changing an appointor, trustee and the potential range of beneficiaries could be said to amount to a resettlement.

 

This conclusion is further reinforced by a failure in TD 2018/D3 to coherently address why the specific tax exemption available for discretionary trusts on a change of trusteeship, that being the rollover relief available under s 104-10 of the ITAA 1997, can be ignored.

 

Nor is the requirement under s 102-25 of the ITAA 1997 mentioned – that is, that if there are multiple potential tax events, the most specific must apply.

 

Aside from the specific exemption for changes of trustee, applying the principles from Commercial Nominees, Clark and TD 2012/21, it is clear that at law that a change in the terms of any trust (ie including a discretionary trust) pursuant to the exercise of an existing power will not result in the termination or establishment of a new trust.

 

Therefore, the example provided in TD 2018/D3 that the proposed amendment to appoint separate appointors and trustees of the sub-trust, pursuant to an express power under the trust deed allowing the appointments to be made, is incorrect.

  

In a sentence, none of the changes in the example in TD 2018/D3 give rise to a separate charter of rights and obligations so substantive that could give rise to the conclusion that assets have been settled on terms of a different trust.

 

Case law

In some instances, TD 2018/D3 refers to the decision in Commissioner of State Revenue v Lam and Kym Pty Ltd [2004] VSCA 204 (Lam & Kym), however reference to this decision is not helpful to the ATO’s arguments.

 

In particular:

• Lam & Kym involved an express declaration of trust over specific assets, which does not appear to be the case in the factual scenario considered in TD 2018/D3;
• In any event, Lam & Kym was a Victorian Supreme Court case which has been largely superseded by the High Court in Clark; and
• Clark confirmed, as acknowledged by the ATO in TD 2012/21, that a variation of a trust by the trustee in accordance with an express power in the trust instrument can generally not result in the establishment of a new trust. 

Furthermore, while the case of Oswal v FCT [2013] FCA 745 (Oswal) is referenced, it again is not helpful to the position that the ATO is trying to sustain as Oswal specifically related to assets being held for the benefit of 1 beneficiary of a trust – in our experience, it is never the case that a trust split occurs in the manner that is analogous to the Oswal decision.

 

The ATO reaches the quite extraordinary conclusions without any supporting argument in relation to the case law or legislation in this area that despite an identical trust instrument applying, there are somehow circumstances that lead to the conclusion that the trust powers of the split trust are suddenly distinct. 

 

Even relying on the well-known legal principle from the 1997 film ‘The Castle’ (‘it’s the vibe’) would fail to support such a conclusion. Indeed, there would appear to be no legislation or case law which would support the conclusion reached.

 

The ATO also concludes that trust splitting occurs by declaration of trust, without any attempt to justify its conclusion. This is another concerning assumption given that in our experience, we are unaware of any trust splitting that takes place in a manner other than by way of a change of trusteeship.

 

To argue that a change of trusteeship amounts to a declaration of trust over assets is nonsensical – the whole commercial framework of the change of trusteeship is that the existing trust remains in place and there is simply a change in the legal owner of the trust assets, with that trustee however being completely bound by the terms of the original trust instrument.

 

Furthermore, to reach these conclusions, again without any reference to the legislative position outlined above and the specific CGT exemption available for changes of trusteeship, is inappropriate.

 

Retrospective

The ATO states that the ruling is to apply on both a retrospective and prospective basis. 

 

To issue a ruling with retrospective effect when there have been positive rulings issued by the ATO over an extended period is arguably irresponsible and will likely cause unnecessary and significant taxpayer and industry backlash.

 

Conclusion

As noted above, there are private rulings previously published by the ATO (as recently as 2016) confirming that trust splitting arrangements on similar terms did not constitute an E1 event.

 

It is extremely concerning that the ATO is purporting to now retrospectively change its approach to a longstanding, and tax benign, arrangement.

 

At a minimum, there should be an explanation as to why the position adopted by the ATO historically has been abandoned and not considered relevant.

 

TD 2018/D3 also fails to explain why the change in approach by the ATO was not implemented when the trust cloning exemption was abolished for discretionary trusts by the Government without warning on 31 October 2008.

 

Trust splitting was extremely prevalent at the time of the removal of the trust cloning rollover relief.

 

Indeed, a cursory level of research would have demonstrated that leading tax specialists recommended trust splitting as the preferred approach to trust cloning for years before and after 2008 due to its effectiveness from a stamp duty perspective in some States.

 

Ultimately, there is a material risk that TD 2018/D3 will cause significant damage to the reputation of the ATO for failing to address these issues 10 years ago, if it truly felt an argument that trust cloning and trust splitting was essentially the same was sustainable. As Malcolm Gladwell might ask, is TD 2018/D3 another example of the ATO unilaterally embracing its own version of Revisionist History?

 

The above post is based on an article originally published in the Weekly Tax Bulletin.

 

Trust Splitting and Kennon v Spry

Earlier posts have looked at various aspects of the leading family law and trust case of Kennon v Spry – see -

Impact of the Spry decision on trusts

Spry - one year on

As set out in earlier posts, and with thanks to the Television Education Network, today’s post considers some related practical issues in relation to this case in a ‘vidcast’ at the following link - https://vimeo.com/148843224

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

The trust split that took place in Kennon v Spry was probably the fundamental thing that meant the whole structure and intended strategy fell over.

After the separation with his wife, Dr Spry took steps to split the trust or segregate the assets of what was in the initial family trust and create four separate sub-trusts for each of the four daughters of the relationship.

Dr Spry did that effectively, in the court’s view, as a way to mean that not only did he not have the assets, so that he could be subject to giving them up to his wife, it also meant that his wife didn’t have them either.

Essentially it was his way of saying to the family court ‘catch me if you can’.

Where the court landed was that they effectively ignored the attempted trust split.

While it might have been effective for tax purposes, while it might have been effective for stamp duty purposes, while it may have even been effective from an estate planning perspective, it was done after the relationship had broken down.

Although there were a myriad of other factual issues that called into question the way Dr Spry conducted himself, the court effectively simply ignored the trust split.

What that meant in a practical sense was that all of the assets that had otherwise been given to the control and benefit of the four daughters of the relationship were returned back into the head trust and the control of that trust was deemed to be solely with Dr Spry.

Once the court had gone through the unwinding of the estate planning exercise, or what was argued to be an estate planning exercise, once all that was unwound and all the assets were back up under the main trust, it was then quite easy for the court to say that trust was under the sole direction and coercion of Dr Spry. Therefore, those assets could then be administered under the terms of the family court order and pass entirely to the benefit of the wife.

Trust Splitting – some clarity at last

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

The recent Tax Office Private Binding Ruling Authorisation number 1012921290075 (Ruling), considers a number of key issues relating to the concept of trust splitting.

While trust cloning is generally seen as preferable to trust splitting, there are a range of reasons cloning may be commercially inappropriate including –

• an inability to access any of the small business CGT rollovers;
• assets that do not lend themselves to complete separation;
• no stamp duty relief (which is the case in most Australian states).

The Ruling is a timely reminder of the need to ensure care is taken with any intended rearrangement of an existing trust.

Overview of questions answered

The Ruling confirms the following key conclusions -

• the insertion of powers into a trust instrument to provide a trustee the ability to create a split trust will not be a resettlement if the power of variation is sufficiently wide;
• a change of trusteeship in relation to certain trust assets will not cause any tax consequences, again subject to the trust deed providing the requisite powers;
• a change to the person nominated as principal or appointor of a split trust will not cause any tax consequences, again subject to the trust deed providing the requisite powers; 
• varying a trust deed to limit each trustee’s right of indemnity such that each trustee is only permitted to be identified from the assets of the split trust they act as trustee for will not cause a resettlement; 
• narrowing by deed amendment the class of beneficiaries of each split trust to focus around the family unit intended to control that trust will cause a resettlement. 

Arguably, since the decision in FCT v Clark [2011] FCAFC 5 (Clark) and the ATO’s response in Tax Determination 2012/21, none of the above conclusions are controversial, other than in relation to the narrowing of beneficiaries causing a resettlement. It is important to note however that the ability to limit the right of indemnity does change the previously adopted ATO position.

It might be recalled that in Clark, a majority of the Full Federal Court held that changes to a trust (primarily a change in the ownership of units of beneficial entitlement to the trust property and changes to the trust property itself) did not result in a break in continuity of the trust. As a result, capital losses incurred by the trustee before those changes occurred could be offset in calculating net capital gains arising after the changes occurred.

Each of these issues are explored in more detail below.

Narrowing of right of indemnity

One of the fundamental concerns with trust splitting, as compared with trust cloning, was the asset protection issues with trust splitting, if the trustee of each split trust remained able to be indemnified from assets held by other trustees of assets in a different split trust.

Prior to this Ruling, ATO guidance has historically indicated that limiting a trustee’s right of indemnity as part of a trust splitting arrangement could cause CGT event E1 to happen.

In particular, in ATO Interpretative Decision 2009/86, it was decided that a trust split did trigger CGT event E1 on the basis that there was a 'fundamental change to the rights and obligations attaching to the trust assets’. A key aspect raised by the ATO was that the trustee's rights of the ‘original’ trust had been altered by excluding the transferred assets from its right of indemnity.

In the Ruling, a desire to limit the right of indemnity was based on achieving the asset protection objectives and to align with the estate plans of the shareholders and directors of the trustee of the orignal trust.

However the ATO confirms in the Ruling that, following Clark, this type of change does not result in the trust estate as originally constituted coming to an end.

Furthermore the altering of the indemnity does not cause any of the assets of a trust to be subject to a new charter of rights or obligations separate to those on which the property was originally settled.

Rather, the restriction of the respective trustee’s rights to be indemnified is in fact consistent with the appointment of separate trustees over different assets of a trust. Ultimately then the changes, without more, did not alter the rights of the beneficiaries to be able to benefit from all of the assets of the trust.

Narrowing the class of beneficiaries

Again due to the objectives under the estate plans of the shareholders and directors of the trustee of the orignal trust, there was a desire to narrow the class of potential beneficiaries.

In the Ruling the ATO states that any such change will amount to a situation where assets are commenced to be held on trusts different to the original trust. In other words, that CGT event E1 would happen by reason of the changes.

In reaching this conclusion the ATO relies heavily on the decision in Commissioner of State Revenue v. Lam & Kym Pty Ltd (2004) 58 ATR 60 (Lam & Kym).

Whether the position adopted by the ATO on this point is correct would need to be considered in light of the following –

• Lam & Kym involved an express declaration of trust over specific assets, which does not appear to be the case in the factual scenario considered in the Ruling.
• In any event, Lam & Kym was a Victorian Supreme Court case which has been largely superseded by the High Court in Clark.
• Clark confirmed, as acknowledged in TD 2012/21, that a variation of a trust by the trustee in accordance with an express power in the trust instrument will generally not result in the establishment of a new trust. 
• The narrowing of a beneficiary class is analogous to Clark and TD 2012/21, which confirm that no resettlement arises from a variation of beneficiaries where the variation is permitted by the trust deed and there is continuity of the trust estate. 

Conclusion

The Ruling provides useful clarity around the scope of changes that can be implemented as part of a trust splitting arrangement. While the ATO’s position in relation to narrowing beneficiary classes is disappointing, there remains significant scope for helping trustees achieve succession planning objectives via trust splitting.

Image credit: OuadiO cc

Clark v Inglis and Trust Splitting

As set out in earlier posts, and with thanks to the Television Education Network, today’s post addresses some of the key issues from the Clark v Inglis decision (please email me if you would like a copy of the case) and trust splitting in a ‘vidcast’ at the following link - https://vimeo.com/143343257.

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

Clark v Inglis was focused on an estate planning exercise.

As part of that estate planning exercise, there was a standard family trust under which the main asset was listed shares sitting inside the trust that overtime had grown significantly in value.

As part of that estate planning exercise, there was an asset revaluation reserve undertaken by the trustee of the trust.

As part of that asset revaluation reserve, and as part of the overall estate planning exercise, there was a distribution on paper effectively of that increase in value of the shares to the person who was actually making their will.

Glossing over some of the facts and the key issue as it relates to trust splitting, what happened under the estate planning exercise was that firstly, the trustee company, and therefore the control of the trust went to the kids of the willmaker from his first marriage (i.e. marriage No.1.).

However the big debt that was outstanding between the trust and the deceased person went to wife No.2.

The core issue was - was it a valid exercise of trustee’s discretion to revalue those assets and then notionally distribute them out?

If that was valid, what was the terms of the loan whereby the willmaker effectively was lending that money back into the trust and was that loan repayable by the trustee company into the estate and therefore passing to the second wife? Obviously, there was quite a lot of tension between wife No.2 and kids from the first relationship. The key take outs in the context of the trust splitting exercise were that yes, the arrangement was entirely valid; yes, the loan was outstanding and formed an asset in the estate; and yes, it was repayable on demand to the second wife.