Dynamics of Trust Laws

                                                                                                                                               Author: S. Perkovic

Asset Protection Eroded  

Court Decisions

Clients should take care as their assets may not be protected by their existing trust structures, although they believe they are. The future of trusts is becoming increasingly unclear:

     - ASIC v Carey (No. 6) [2006] 3745 FCA 814

     -  Kennon v Spry (2008) 238 CLR 366.

Compare with

      - Farr v Hardy [2008] NSWSC 996

ASIC v Carey (No. 6) [2006] 3745 FCA 814 is a case which arose out of the litigation over the collapse of the Westpoint group.

French J. (as His Honor then was) in ASIC v Carey (No. 6) [2006]

374 5 FCA 814 made a decision to appoint receivers to property held by

a third party as trustee for a trust in which the individual was a

beneficiary.

He stated that when the beneficiary effectively controls the trustee's power to make distributions, then the beneficiary has something approaching a proprietary interest in the trust property for the purposes of the Corporations Act 2001 (Cth). A proprietary interest may exists if the trustees of the discretionary trusts were 'alter egos' of their beneficiaries (subject to their effective control), then the beneficiaries would have an interest for the purposes of the section 9 def

His Honor concluded that: -

(a) a beneficiary who effectively controls the trustee of a discretionary trust may have what approaches a general power and thus have a proprietary interest in the income and corpus of the trust (at [19].

(b) a beneficiary will effectively control the trustee if he or she is the trustee or one of them or if he or she controls the corporate trustee and /or if he or she has the power to appoint a new trustee (at [37}.

 By way of example, the judge stated that in the case, he was willing to consider an application to extend the receiver orders to cover "expectancies" in the following circumstances:

A family trust with: a defendant as a beneficiary, and a director and a secretary of the trustee company (along with his wife), and a trust deed that conferred wide discretion to distribute to one beneficiary to the exclusion of others. In these situations the defendant had effective ownership of the trust property for the purposes of the Act.

A trust with a defendant as current trustee and a member of an open class of beneficiaries (with other family members

and a range of charities); and in which the defendant had a discretion to distribute 39% of the income or capital to any

 beneficiary as the defendant had effective ownership of at least 39% of the trust property for the purposes of the Act.

A trust with a defendant as one of an open class of beneficiaries with the defendant having the power to remove and appoint new trustees as the defendant     has at least a contingent interest in the property of the trust, if not a general power of selection that approached ownership of trust property for the purposes of the Act. 

Significance

It was a decision of a single judge of the Federal Court which was interlocutory in nature and substantive orders affecting the property of the parties have not yet been made and it may arguably be limited in application to interpreting section 9 of the Corporations Act 2001 (Cth) reasoning could be applied in other circumstances.

However, bearing in mind His Honors current position[1] and changing society’s attitude towards trusts, the above may be an influential decision.

The decision has, however, received little enthusiasm in NSW. For example, see Farr v Hardy [2008] NSWSC 996; but the landscape must be carefully considered in the light of His Honor’s present position and decisions with similarity such as Kennon v Spry (2008) 238 CLR 366.

CONTROLLED ENTITIES PART 6, DIV 4A BANKRUPTCY ACT

1966 (Cth)

Importantly, the definition of a proprietary interest in s. 9 of the Corporations Act 2001 (Cth)  is comparable to the definition in s.5 of the Bankruptcy Act 1966 (Cth).

Therefore, if the Courts accept the above interpretation that will affect the interpretation of legislation.  

The only published decisions about the above sections are Birdseye v Sheahan (2002) 196 ALR 598 and Horne v Concord Australia Pty Limited [1997] FCA 503 which pre-date the most recent amendments.

The Division 4A under our consideration was inserted in 1987. It has been amended twice since, in 1990 and in 2006.

Sections 5B, 5C, 5D, and 5E provide lengthy definitions of associated entities including companies, natural persons, partnerships, and trusts.

The scheme of this Part 6 of which the above Division is a part came about as a consequence of high earning professional operating their businesses through related entities such as a family or trading trusts. Whilst the insertion of Division 4B altered significantly the ability of a trustee to secure contributions from a high income bankrupt, the ability to prove “control” of an entity by a bankrupt proved extraordinarily difficult. In the case of a properly constituted trust, the task of obtaining a vesting order was regarded as an impossible task.

The most recent amendments were inserted to cover a situation in which a non-bankrupt spouse acquired an interest in property as a result of financial contributions by the bankrupt and the bankrupt uses or derives a benefit from that property.

However, if the principles from the Carey decision are extended, there will be very little work to be done by Part 6 of Division 4A.

CONCLUSION

Drafting consequences: attention must be drawn that a beneficiary is not deemed to effectively control the trustee (control the trustee, is trustee, or has the power to appoint a new trustee)

Trust deeds should be reviewed. 

Changes in Taxation of Trusts:

          - court decisions;

          - statutory changes and tax determinations.

Court Decisions

Bramford Case

ANZ Case

Bramford Case

Bramford Case Details

The facts

P & D Bamford Enterprises Pty Ltd was the trustee of a discretionary trust.

In the 2000 income year, the trustee resolved to distributed any income to the following eligible beneficiaries:

- $643 each of the two children of Mr and Mrs Bamford

- The next $12,500 to Narconon Anzo Inc

- The next $106,000 to the Church of Scientology

- The next $68,000 to Mr and Mrs Bamford in equal shares

- The balance to the Church of Scientology.

Based on the 2000 tax return as lodged, there was only $187,530 net income to distribute to beneficiaries.

The Commissioner subsequently reassessed the 2000 tax return of the trust to disallow a deductions totalling $191,701. The net income of the trust, as a result of the reassessment, became $379,231.

Further, in the 2002 income year, the only income of the trust was a net capital gain of $29,227.

The trustee distributed the capital gain equally to Mr and Mrs Bamford

The issues

1. How should the additional income of the trust (resulting from the 2000 reassessment) be distributed?

The taxpayer argued that the net income of the trust should be distributed in accordance with the Trust Resolution (as outlined above).

The ATO argued that the additional net income of the trust should be distributed to the beneficiaries in accordance with the proportion of the income that they received from the original tax return.

2. Whether the capital gain derived in the 2002 year was part of the income of the trust and could be distributed (and taxed) to the relevant beneficiaries.

The taxpayer argued that the capital gain formed part of the income of the trust estate in the 2002 year and, therefore, could be distributed to the relevant beneficiaries.

The ATO argued that the capital gain was not part of the income of the trust estate for income tax purposes. Consequently, the ATO argued that there was no income to distribute to beneficiaries and the trustee would therefore be assessed on the gain.

The decision

Issue 1 – Distribution of trust income

The High Court held that the amount on which a beneficiary is taxed is to be based on their proportionate share of the income of the trust (this was the ATO’s argument as outlined in the table above). For example, if the trust declaration is that the beneficiary receives 30% of the income of the trust estate, than this percentage of the income of the trust is taxable in the hands of the beneficiary, regardless of what the tax returns reveals. 

Issue 2 – Definition of “income”

With regards to the definition of income, the High Court held that the trust deed can determine the net income of the trust for income tax purposes and that this definition may include net capital gains.

Two major IMPLICATIONS:

a) The term “income of a trust” is to be interpreted in accordance with trust law concepts and not tax law concepts. Therefore, the income of a trust deed( is what the trust deed says it is. In this case a capital profit made by the trust was “income of the trust estate” for the purposes of the Income Tax Assessment Act 1936 (“ITAA” )for that tax year, because the trust deed gave the trustee the power to treat capital profit as income (Bramford wins this argument against ATO). .

TAX IMPLICATIONS: Because of this interpretation, taxable income of a trust estate does not necessarily equal the income of the trust estate and whether it does, or not, depends on the relevant clauses in the deed. Therefore, the distribution statement in a trust’s tax return is not the sole basis for a tax assessment.

Some DRAFTING implications: ideally, a trustee should have power to characterize receipts, otherwise a trust deed would specify when a receipt is income or, if not, then a term “income of the trust estate” is determined in accordance with trust law principles.

b) Further, the court upheld ATO’s claim that if a beneficiary is entitled to a percentage of a trust estate, then their percentage must include the percentage of the trust’s taxable income regardless of the beneficiary’s individual income tax return. A beneficiary’s share of income means their proportionate entitlement of the trust estate (not a fixed dollar amount to which they are entitled).

TAX IMPLICATIONS: This may affect the application of the proportionate approach to taxing beneficiaries under s 97 ITAA on their share of the “income of the trust estate”. It is important to decide who- the trustee or the beneficiaries- are liable to pay tax on the taxable income of a trust estate D6 PII ITAA36. If a beneficiary of a trust who is not under a legal disability is presently entitled to a share of income of the trust estate, then he or she is required to pay income tax on the taxable income of the trust estate. If no beneficiary is presently entitled to the income of the trust estate, then the trustee will be liable to pay income tax on the taxable income of the trust estate. In particular, the consequences may be negative for beneficiaries if trust pays income on capital gains and on franked dividends as discounts and benefits provided to individuals are lost in that case.

ANZ Case

The Bramford case upholds that trustee can treat capital as income in a case where capital gain is involved. However, the ANZ case, did not upheld that the reverse is possible and Court did not upheld a situation where income was treated as capital gain, using reasoning that the words of the trust could not alter the character of the moneys in the hands of the trustees.

ATO does not feel free to consider that the ANZ was wrongly decided.  

Taxation Rulings  TR2012/S1 and TR2012/D1 by ATO

ATO’s View of Bramford and ANZ Cases  

ATO made it clear that they will proceed on the basis of two cases (the ANZ – trustee is not allowed to treat income as capital, and the Bramford, case, a trustee is allowed to treat capital as income.

It issued Taxation Rulings TR2012/S1 and TR2012/D1.

It should be noted that importance of ruling is limited as ATO views sometimes change.

In ’the above ATO ruling (TR2012/S1) Income Tax: meaning of income of the trust estate in Division 6 of Part III of the ITAA 1936 and related provisions (28 March 2011)ATO had to agree with the Bramford case that the meaning of the expression “income of the trust estate) used in Division 6 will depend principally on the terms of that trust and the general law of trusts.

TH2012/D1

“Notional Income”

In Ruling TR2012/D1 ATO has introduced a new concept of “notional income” to the taxation of trusts.

The difference with the position before this ruling that the capital gain (for example) before this ruling would be assessed in the hands of beneficiaries – and after this ruling, the deemed capital gain will, in some cases as e.g. capital gain which can not be distributed , be classified as notional income and taxed in the trustee’s hands under s99A of ITAA. Section 115-222 of ITAA 1997 denies either the general CGT discount or the active asset discount under Division 152 so there are no CGT concessions available.

IMPLICATION

When these views are put into practice it will have a significant negative impact on business succession when business assets are owned by a trust, 

as they apply effectively requiring the amount of the net income of a trust estate to be recalculated by excluding:

-         its capital gains;

-          franked dividends; and

-          franking credits

      - franking credit amounts included under s 207-35(1) of the ITAA97;

      - net capital gain as a result of the market value substitution rule in         

         s112-20 (cost base) s116-30 (capital proceeds) of the ITAA97;

        - deemed dividend amounts under subs109D(1) of the ITAA36;

        - amount of attributable income under accruals regime such as Part           

         X (foreign companies) or 6AAA (ITA36 – non resident trusts); and

        - amount included in the income of the trust under s 97(1) ITAA 36

          that represent a share of the net income of another trust, but does

          not represent a distribution of income of that other trust).

when working out the amount to be in the assessable incomes of the beneficiaries and trustee of trust estate (Section 102UW of ITAA 36).

These amounts may be streamed to beneficiaries.

Other examples of notional income are amounts such as undistributed entitlements to the net income of another trust, or amounts of attributed income under an attribution/accruals regime such as the controlled foreign companies’ rules.

DRAFTING IMPLICATIONS:

Trust Deed must adequately allow that income to be distributed to the intended beneficiaries (proposed changes to existing Trust Deeds).

In drafting Trust deeds there are two current approaches: a) an income equalization clause which is an attempt to equate the trust’s distributable income with its taxable income or b) a re-classification clause which allows the trustee to re-classify distributable amounts as either income or capital so that distributable income will be more closely aligned with taxable income.

Problem with a former, for example is, uncertainty with e.g. franking credits which are not strictly income; and with a latter as ATO sees it as a possibility to manipulate tax liabilities.

An Amount that Formed  a Part of a Trust Estate at the Start of the Year  (Discussion About this ATO Phrase)

Although ATO agrees with the Bramford case, it states that even if the trust deed provides trustee with an absolute discretion to determine what income is, an amount that formed a part of a trust estate at the start of a particular income year cannot be income of the trust estate for the purposes of section 97(1) of ITAA. Given the context of Division 6, the ATO considers that for an amount to constitute “income of a trust estate” it must be:

-         measured in respect of distinct years of income;

-          be product of the trust estate; and

-         be an amount to which a beneficiary is, or can be made, presently entitled.

In addition, income of the trust estate for s97 (1) of ITAA is not the gross income of the trust estate, but the distributable income of the trust estate available for distribution to beneficiaries or accumulation by the trustee.

This may have significant consequences on the taxation of undistributed income.

Moreover, income of the trust estate for a year cannot be more than the aggregate accretions to the trust estate for that income year, less any outgoings or expenditure which is referable against income under general trust law and any amounts derived by the trust estate which do not constitute income 

Steps which Need to be Taken Because of TR 2012 /D1:

As mentioned above, substantial changes will be required to most trust deeds.   They are meant to better align the key concepts “income of the trust estate – by trust law interpreted to mean distributable income, with a tax law concept of net income of the trust estate (taxable income); and to ensure that capital gains and franked distributions can be streamed to particular beneficiaries

 Most trustees of family and other fully discretionary trusts such as beneficiary controlled testamentary trusts will need to take steps to ensure that they are best placed to deal with the new world for trusts and deceased estates:

Firstly, it needs to be identified whether trust or deceased estate can operate as a standard trust or needs to be treated as a non standard trust by accountants, because of its particular limitation.  – For example,  older trusts (70s and 80s) usually lack the power to distribute capital prior to winding up the trust or lack the usual expected beneficiaries. Unfortunately, if we amend their trust deeds now it may trigger a CGT event.

These trusts must be treated as non-standard trusts that need to be administered with regard to their limitation.

With standard trusts, if there are changes need to be made to the terms of trust to bring trust up to date with current requirements to that the trust can be administered in the same cost effective way as other standard trust, than there is need to draft deeds of amendment.

In particular, the tasks are to ensure that a trustee:

- has a power to stream income, capital and expenses and thus to create specific entitlements – amendment must not re-settle the trust;

- has a power to re-characterize an asset or receipt as income or capital, e.g. an asset that is to be the subject of distribution – if the income and capital beneficiaries are identical, this should be able to be added by amendment without resettling the trust.

- able to hold associations of income on sub trust and avoid the operation of the deemed dividend rules (no resettling)

- able to choose the definition of trust income for a particular financial year, so that the trust of deceased estate (e.g.) have the same definition of income as a related trust or the same definition of income as other standard trust with a common accountant.

The most desirable is one power for all of the above.

Every year, components of trust distributions are likely to include:

-a nomination of the income definition for the year although many accountants will seek to use a common definition across all their standard family trusts)

- creation of specific entitlements in respect of capital gains and of franked dividends;

- finally, making a choice between percentage benefits and specified amount benefits.

Importantly, it would be the most desirable solution to,  in addition, for new trusts draft a trust deed or for existing trusts

amend a trust (if already not included and if permitted) by agreement between beneficiaries (if capacity present) of by a Court order, that the executor or trustee have power to reimburse whatever beneficiaries will have to bear the tax liability for the net capital gain. 

There are categories where changes impact differently

- not impacted by the changes of TR2012/D1 e.g. single beneficiary receives both the trust income and capital, e.g. the lifetime principal beneficiary of a special disability trust;

  impacted by the specific entitlement rules and TR but amending their terms is not desirable (unit trusts however, definition of trust income for it may influence the choice of definition for any unit-holding family trust); 

For Capital Preserved Trusts

Life interests and other do not have a wide choice in how they deal particularly with capital gains. It may not be possible to create a specific entitlements and a proportional approach should be considered (instead of accumulating the gain and losing the 50% CGT discount).

Miscellaneous

          - 

             Tax Law Amendment (2007 Measures No 4) Act 2007 (Cth) (TLA 

             2007) and Tax Laws Amendment (2008 Measures No. 3) Bill 2008

             (Cth) (TLB 2008)

            Tax Laws Amendment (2011 Measures No.5) Bill 2011

            Discussions about Possible Legislative Changes

             Capital Gains

Tax Law Amendment (2007 Measures No 4) Act 2007 (Cth) (TLA 2007)

Tax Laws Amendment (2008 Measures No. 3) Bill 2008 (Cth) (TLB 2008)

Introduction

In 2007 there were a number of amendments made to the family trust

regime in Schedule 2F of the Income Tax Assessment Act 1936 until September 2008 as a result of the proposal of the new Rudd Labour

Government to reverse the amendments made to Schedule 2F of ITAA36 with retrospective application effective from 1 July 2008.

General Regime (regardless of this Act)

Generally to claim the benefit of franking credits attached to a dividend, a shareholder must be a qualified person (i.e. they must satisfy a 45 day holding rule) – Subsection 207-145(1)(a) of the ITA97 (does not apply to shares owned prior to the commencement of the Act).

Discretionary trusts can not satisfy this rule because their beneficiaries do not have a fixed interest in trust.

To circumvent this requirement, most family trust make a family trust election and then only a trustee has to comply with the requirement of a 45 day holding rule. To do this, a trust must satisfy a family control test.  

Distributions outside the family group are subject to the highest family trust distribution tax.

The other main reason for a family trust election is to enable access to trust losses That is because the trust loss provisions of S2F of ITAA36 family trusts are “excepted trusts” which are not required to satisfy a number of the threshold tests of that section in order to claim tax losses and certain debt deduction.

Changes by TLA 2007

Procedural mechanism of making a FTE changed by s 272-90(3A) which provides that each trust which has made a FTE nominating the same test individual will automatically fall within the same family group without the need for potentially making multiple IEE’s (Interposed entity election) – entities which can elect to be included with the family group. There is also a limited right of revocation of a FTE, to vary test individual, and the definitions of family and family group where amended (widen, former spouses, stepchildren, etc).

TLAMB2008 did not revoke the above amendments of TLAMA2007 so they are current law. 

More about the changes in the Appendix 1.

A digression:

 regarding a matter that many accountants query: S109C of the ITAA 1936 a transfer of property by a company to a shareholder, or an associate of a shareholder, is taken to be an assessable and un-frankable dividend equal to the difference between market value and the amount of consideration provided.

However, this can be avoided if, before the day the company tax return is due, the potential dividend is converted into a loan, which the legislation anticipates in s109D(4A). The loan, created by an agreement that complies with s109 , can be for 25 years if secured by a mortgage of real property with a value of at least 110 per cent of the loan, or for 7 years if unsecured, (interest must be paid, current 7,8%)

Tax Laws Amendment (2011 Measures No.5) Bill 2011

This law was brought in response to the Bamford's case to clarify uncertainty on streaming of capital gains and franked distribution (including any attached franking credits); and to introduce an anti-avoidance measure for distributions to exempt entities.

The amendments in the Bill are interim measures which deal with the  'proportionate approach' highlighted in the Bamford's case.

The power to stream remains in the trust deed, not in law.

As mentioned on the page 20 the trust deeds should be amended to allow for certain powers of trustees in streaming.

We discuss the concepts in details in the Appendix 2 and give highlights below:

a)  Beneficiary specifically entitled including the formula calculating specific entitlement;  The elements of the formula are

a1 Capital Gain/Franked Distribution

a2 Net Financial Benefit (economic value)

a3 Share of Net Financial Benefit.

b) Distributing remaining income: the remaining income of the trust is assessable to beneficiaries on a proportionate basis, based on their present entitlement to income of the trust estate (excluding capital gains and franked distributions to which any entity is specifically entitled).

c) If there is some of this income to which no beneficiary is entitled (apart from capital gains and franked distributions to which any entity is specifically entitled), the trustee may be assessed for tax on that income under section 99 or 99A of the ITAA 1936.

Anti-avoidance rules

The Act introduces two specific anti-avoidance rules to address the inappropriate use of exempt entities to 'shelter' the taxable income of a trust.

The first rule (the pay or notify rule) is contained in new section 100AA of the ITAA 1936. It generally applies where an exempt beneficiary has not been notified of or paid their present entitlement to income of the trust estate within two months of the end of the income year. In this circumstance, they are treated as not being - and never having been - presently entitled to that income.

The second rule (the benchmark percentage rule), is contained in new section 100AB of the ITAA 1936. It generally applies where an exempt entity's entitlement to the income of the trust estate (ignoring any franked distributions and capital gains to which any entity is specifically entitled), expressed as a percentage, exceeds a benchmark percentage.

The benchmark percentage is, broadly, the exempt entity's entitlement to any amount forming part of the trust's taxable income expressed as a percentage.

Capital Gains Tax (Slide Twenty Four

Disregarding capital gain or loss on death

There is a general rule that CGT applies to any change of ownership of a CGT asset, unless the asset was acquired before 20 September 1985 (pre-CGT).

There is a special rule that allows any capital gain or capital loss made on a post-CGT asset to be disregarded if, when a person dies, an asset they owned passes: