Australian trusts tax handbook 2015-16. [(2016-17 Edition)] 9780864609809, 0864609809

Citation preview

Australian Trusts Tax Handbook 2016-17

Anna Ziaras

Published in Sydney by Thomson Reuters (Professional) Australia Limited ABN 64 058 914 668 19 Harris Street, Pyrmont, NSW A Cataloguing-in-Publication entry for this book is available from the National Library of Australia. ISBN 978 0 864 609809 Material Code: 41970543

© 2016 Thomson Reuters (Professional) Australia Limited This publication is copyright. Other than for the purposes of and subject to the conditions prescribed under the Copyright Act, no part of it may in any form or by any means (electronic, mechanical, microcopying, photocopying, recording or otherwise) be reproduced, stored in a retrieval system or transmitted without prior written permission. Inquiries should be addressed to the publishers. All legislative material herein is reproduced by permission but does not purport to be the official or authorised version. It is subject to Commonwealth of Australia copyright. The Copyright Act 1968 permits certain reproduction and publication of Commonwealth legislation. In particular, s 182A of the Act enables a complete copy to be made by or on behalf of a particular person. For reproduction or publication beyond that permitted by the Act, permission should be sought in writing. Requests should be submitted online at http://www.ag.gov.au/cca, faxed to (02) 6250 5989 or mailed to Commonwealth Copyright Administration, Attorney-General’s Department, Robert Garran Offices, National Circuit, Barton ACT 2600. Product Developer: Pip Hughes Printed by Ligare Pty Ltd, Riverwood, NSW This book has been printed on paper certified by the Programme for the Endorsement of Forest Certification (PEFC). PEFC is committed to sustainable forest management through third party forest certification of responsibly managed forests. For more info: http://www.pefc.org

ABOUT THE AUTHORS Anna Ziaras Anna Ziaras is the author of A-Z of Trusts and writes tax commentary for Thomson Reuters’ income tax and GST services. She was previously a barrister at the Victorian Bar.

PREVIOUS CONTRIBUTING AUTHORS George Kolliou George Kolliou is the Principal of KOLLIOUTAX Pty Ltd – Lawyers and has worked in tax for over 25 years first as an accountant and now as a lawyer. He advises accountants, lawyers, SME clients and family businesses on tax matters with an emphasis on trusts, estate planning, business structuring and tax litigation. George is a Fellow of the Taxation Institute of Australia, the Institute of Public Accountants and a Member of the Law Institute of Victoria. George was also a contributing author to the first edition of the Australian Trusts Tax Handbook. Kirk Wilson Kirk Wilson is a respected author and commentator on all matters involving CGT. A Senior Tax Writer with Thomson Reuters, Kirk writes extensively on CGT for a range of our publications including the Australian Tax Handbook and tax news services, such as the Weekly Tax Bulletin and CGT Bulletin. Pip Hughes Pip Hughes has a deep understanding of the tax laws gained from many years experience in tax publishing, both as a tax writer and in developing a wide range of products for the tax and accounting profession. She has been involved in writing detailed tax commentary for key income tax services as well as concise explanations of the tax law for major annual tax books. David Coombes David Coombes is an accredited tax law specialist and has particular expertise in income tax, CGT, GST, stamp duty and other indirect taxes. Having previously worked at Norton Rose Australia, David’s contribution to the first edition of the Australian Trusts Tax Handbook was written in co-authorship with Senior Associate, Anna Wilson. Robin Pennell Robin Pennell is a chartered accountant and Associate Director in the firm ShineWing Australia (formerly Moore Stephens Melbourne), which has provided cost effective consulting, technology, financial planning, tax and assurance solutions to mid-sized organisations since 1935.

2016 THOMSON REUTERS

iii

AUSTRALIAN TRUSTS TAX HANDBOOK 2016-17

iv

2016 THOMSON REUTERS

PREFACE The Australian Trusts Tax Handbook 2016-17 is a practical guide to the rules relating to the taxation of trusts. It is streamlined to meet the needs of taxpayers, students, practitioners and advisers, and brings together all the key tax provisions and concepts into the one publication, with plain English explanations, definitions, examples, case studies, sample trust deed clauses, tips and alerts. The proposal to rewrite and simplify the trust income tax provisions has stalled, so taxpayers, practitioners and advisers must continue to apply the complex rules in Div 6 of the ITAA 1936 and the streaming provisions of the ITAA 1997. To assist in this task, the Australian Trusts Tax Handbook includes step-by-step guides on: • how to calculate the income and net income of a trust; • how to stream capital gains and franked distributions; • how to make effective trust distributions; and • how to draft the distribution minutes. This edition of the Australian Trusts Tax Handbook has been restructured to include a dedicated chapter on trusts and small business relief (chapter 8), which focuses on the CGT concessions and the new restructure rollover for discretionary trusts and other small business entities. There is also a new chapter on the state and territory taxes affecting trusts (chapter 17). Up to date as at 30 June 2016. Thomson Reuters 30 June 2016

2016 THOMSON REUTERS

v

AUSTRALIAN TRUSTS TAX HANDBOOK 2016-17

vi

2016 THOMSON REUTERS

TABLE OF CONTENTS About the authors ............................................................................................................ iii Preface ................................................................................................................................ v Table of contents .............................................................................................................. vii Table of abbreviations ...................................................................................................... ix

PART 1 – GENERAL PRINCIPLES Ch 1 — Key trust concepts ...................................................................................... 3 Ch 2 — The importance of the trust deed .......................................................... 15

PART 2 – TRUST INCOME Ch 3 — Taxation of trust income – Div 6 ........................................................... 49 Ch 4 — Streaming of trust income ....................................................................... 95 Ch 5 — Trusts and capital gains tax .................................................................. 125 Ch 6 — Trust-related deductions ........................................................................ 163 Ch 7 — Trust losses ............................................................................................... 171

PART 3 – TAX CONCESSIONS Ch 8 — Trusts and small business relief ........................................................... 189 Ch 9 — Primary producer concessions for beneficiaries ................................ 211

PART 4 – INTEGRITY MEASURES Ch 10 — Anti-avoidance rules ............................................................................ 219 Ch 11 — Trusts and deemed dividends – Div 7A ........................................... 229 Ch 12 — Closely held trusts ................................................................................ 275 Ch 13 — Unearned income of children ............................................................. 281

PART 5 – ADMINISTRATION Ch 14 — Administration, tax returns, tax rates ............................................... 291 Ch 15 — Rates of tax ............................................................................................ 301

2016 THOMSON REUTERS

vii

AUSTRALIAN TRUSTS TAX HANDBOOK 2016-17

PART 6 – OTHER ISSUES Ch 16 — Review of trust tax provisions ........................................................... 309 Ch 17 — State and territory taxes ...................................................................... 315 Index ......................................................................................................................... 325

viii

2016 THOMSON REUTERS

ABBREVIATIONS Abbreviations used extensively throughout this publication are listed below. AAT ABN ATO ATO ID ATR CGT FCA FCT FMD GST GST Act IT ITAA 1936 ITAA 1997 LCG LPR MIT MT PAYG PS LA SBPP TAA TB TD TFN TR Tax Office UPE

2016 THOMSON REUTERS

Administrative Appeals Tribunal Australian business number Australian Taxation Office ATO Interpretative Decision Australian Tax Reports capital gains tax Federal Court of Australia Federal Commissioner of Taxation farm management deposit goods and services tax A New Tax System (Goods And Services Tax) Act 1999 Income Tax Ruling (old series) Income Tax Assessment Act 1936 Income Tax Assessment Act 1997 Law Companion Guidelines legal personal representative managed investment trust Miscellaneous Taxation Ruling Pay As You Go Practice Statement Law Administration small business participation percentage Taxation Administration Act 1953 trustee beneficiary Taxation Determination tax file number Taxation Ruling Australian Taxation Office unpaid present entitlement

ix

AUSTRALIAN TRUSTS TAX HANDBOOK 2016-17

x

2016 THOMSON REUTERS

PART 1 GENERAL PRINCIPLES 1 KEY TRUST CONCEPTS 2 THE IMPORTANCE OF THE TRUST DEED

2016 THOMSON REUTERS

1

2

2016 THOMSON REUTERS

KEY TRUST CONCEPTS

1

What is a trust? ........................................................................................... [1 000] How is a trust created? .............................................................................. [1 010] How is a trust taxed? ................................................................................. [1 020]

TYPES OF TRUSTS Common types of trusts and business structures involving trusts .............................................................................................................. [1 100] Discretionary trusts ..................................................................................... [1 110] Fixed trusts ................................................................................................... [1 120] Hybrid trusts ................................................................................................ [1 130] Testamentary trusts ..................................................................................... [1 140] Child maintenance trusts ........................................................................... [1 150] Special disability trusts .............................................................................. [1 160] Charitable trusts .......................................................................................... [1 170] Bare trusts ..................................................................................................... [1 180] Superannuation funds ................................................................................ [1 190] Managed investment trusts ....................................................................... [1 200]

[1 000] What is a trust? A trust is not a separate legal entity. It is a fiduciary relationship between a trustee who is the legal owner of property and one or more beneficiaries for whose benefit the property is held. The distinguishing feature of this relationship is the trustee’s obligation to act honestly and in good faith to serve the interests of the beneficiaries: see [2 440]. A trust may be created by a settlor transferring property to a trustee during the settlor’s lifetime (an inter vivos trust) or by will on the death of the settlor (a testamentary trust): see [1 010]. In a simple settlement of a trust: • a person (the settlor) • transfers property (the trust property) • to a second person (the legal owner or the trustee) • to hold on trust (the personal obligations attached to the trust property) • for a third person (one or more beneficiaries or objects). Trust law draws a fundamental distinction between corpus and income. Where an asset is the subject of a trust (the trust property), the asset itself is corpus. When the asset is put to work and earns money, then the money earned is income. The trust income tax provisions in Div 6 of Pt III of ITAA 1936 use the expression ‘‘trust estate’’ to refer to the property that forms the subject of a trust 2016 THOMSON REUTERS

3

[1 010]

KEY TRUST CONCEPTS

or the source of the income that is subject to a trust: see [3 000]. This means that the “income of the trust estate” is the income that arises from the property (or other source) that is the ‘‘trust estate’’. The form of the trust (see [1 100]) and its constituent documents (see [2 000]) determine the nature of a beneficiary’s interest in the trust property. In many trusts, there might be no specified equitable owner because the trustee has the discretion to allocate income or capital among a number of potential beneficiaries. These may be identified as a class, for example, ‘‘the children of (a named person)’’: see [2 460]. A trust cannot continue indefinitely (unless it is a charitable trust). The rule against perpetuities means that a trust must have a certain life span, and then be wound up, or ‘‘vest’’: see [2 500]. In some situations, changes made to a trust may have the effect of terminating that trust and creating a new one: see [2 520]. The consequences of terminating the trust can include: • the realisation at the trustee level of the trust property and the loss of carried forward tax benefits and disposal by beneficiaries of their interests; • an acquisition of interests in the new trust with associated capital gains tax consequences; and • State duty implications.

[1 010] How is a trust created? A trust usually arises from an express intention to create a trust interest (an express trust). A trust may also be imposed by law in the absence of an express or inferred intention to create a trust interest (a non-express trust). A trust does not require consideration. Therefore, a trust can arise without consideration from the beneficiary (and even without the beneficiary’s knowledge): see JW Broomhead (Vic) Pty Ltd (in liq) v JW Broomhead Pty Ltd [1985] VR 891.

Express trusts An express trust usually arises when a settlor ‘‘settles’’ trust property by transferring the legal ownership of the property to a trustee. Such a trust is called an inter vivos trust because it is created during the settlor’s lifetime. Discretionary trusts and unit trusts are examples of express trusts: see [1 100]. An inter vivos trust is typically created by the settlor making a ‘‘declaration of trust’’ in the form of a trust deed. This declaration of trust usually appoints the trustee and describes the trust property and the beneficiaries. If the trust property includes land, the settlor needs to ensure that everything is done to legally transfer title in the property to the trustee. Where the trustee is granted ownership of a debt, the settlor must transfer the debt in writing and also give the debtor written notice. An express trust requires certainty of intention, certainty of subject matter and certainty of object. In Korda v Australian Executor Trustees (SA) Ltd [2015] HCA 6, the High Court held that the documentation for a timber plantation investment scheme did not support the existence of an express trust in favour of 4

2016 THOMSON REUTERS

KEY TRUST CONCEPTS

[1 020]

the scheme investors. These documents comprised individual covenants between the plantation management company and investors, a trust deed appointing a corporate trustee, and a tripartite agreement between the corporate trustee, the management company and an associated company. The High Court stated that while the documents imposed various obligations on the entities operating the scheme, these documents contained no provision expressly declaring that those entities were acting as trustees for the scheme investors. The High Court also observed that the tax benefits offered under the scheme prospectus tended against an imputation of an intention to create a trust. There is no requirement that a trust must be in writing and an inter vivos trust can also be created by oral declaration. Where an owner of property declares that he or she holds it on trust, the owner is both the settlor and the trustee. An express trust can also arise following the death of a person (the ‘‘testator’’). Such a trust is called a testamentary trust and its terms are contained in the testator’s will: see [1 140]. Where there is no will, the terms of the trust are determined by operation of law.

Non-express trusts Subject to certain statutory restrictions, a trust may arise by implication of law (an implied or resulting trust) or constructively from the circumstances (a constructive trust). A constructive trust may be imposed by law as a remedy to protect a person’s interest in property. In order for a beneficiary to gain the protection of a constructive trust, there must be an unconscionable denial by the legal owner of the equitable interest held by another. There are tax consequences where trusts arise in this way. For example, in Zobory v FCT [1995] FCA 1226; 30 ATR 412, a constructive trust arose when an employee stole $1 million from his employer and deposited the amount in a bank account. As a result, interest earned was not assessable to the thief personally. In Re the Employed Accountant and FCT [2012] AATA 770; 91 ATR 217, the Commissioner became the beneficiary of a constructive trust when an accountant deposited clients’ cheques (drawn in favour of the Tax Office) into his own bank account. In contrast, in Howard v FCT (2014) 92 ATR 38, the High Court held that equitable compensation received by a company director in satisfaction of a judgment was not the subject of a constructive trust in the company’s favour.

[1 020] How is a trust taxed? At law, a trust is not a separate legal entity and the income tax assessing rules (in particular Div 6 of Pt III of ITAA 1936 and the streaming rules in ITAA 1997) generally treat a trust as a flow-through vehicle rather than a taxable entity. However, trusts are included in the definition of “entity” for income tax purposes (s 960-100(1)(f) of ITAA 1997) and some tax provisions, including the GST rules (see [14 040]), operate on the assumption that trusts are legal entities. Under the income tax assessing rules, the trustee is taxed on income accumulated in the trust rather than distributed to beneficiaries and such accumulated income is generally taxed at the highest marginal tax rate. To avoid 2016 THOMSON REUTERS

5

[1 100]

KEY TRUST CONCEPTS

this situation, the trustee must resolve by the end of each relevant income year to distribute the trust income to the beneficiaries so that they are presently entitled to it: see [2 300]. Income to which a beneficiary (not under a legal disability) is presently entitled is aggregated with the beneficiary’s other assessable income and the normal rates of tax applicable to that beneficiary apply. If the beneficiary is a company, the income will be taxed at the corporate rate of tax. Income accumulated in the trust which has been taxed in the hands of the trustee is not generally taxed again when it is distributed to the beneficiaries. Where a trustee is assessed and is a corporate trustee, it is not taxed as a company and does not pay primary company tax on trust income. By way of exception – to prevent the use of trusts to carry on businesses that would ordinarily be carried on by a company – corporate unit trusts and public trading trusts are taxed in the same way as companies. Net capital gains are included in the net income of the trust estate. Special rules take account of the CGT discount and the small business 50% reduction discount. Where the trust makes a net capital loss for the year, the loss is carried forward and taken into account in determining the net capital gain of the trust estate for the following year. See further [5 000] and following. Capital gains and franked distributions can be streamed to specifically entitled beneficiaries: see [4 000]. Division 6 and the streaming rules generally apply to all forms of trust (see [1 100]), although certain trusts (eg attribution managed investment trusts, public trading trusts and superannuation funds) are subject to specific income tax regimes: see [3 010]. The trust income tax provisions draw a distinction between resident trusts and non-residents trusts as different consequences follow: see [3 200]. There are some differences in the treatment of discretionary trusts and units trusts under the CGT rules. In addition, the trust loss recoupment provisions apply differently to ‘‘fixed trusts’’ and ‘‘non-fixed trusts’’: see [7 000] and following. Discretionary trusts and fixed trusts that come within the definition of ‘‘closely held trust’’ are subject to special reporting obligations: see [12 000] and following. The trust income tax provisions (Div 6 of Pt III of ITAA 1936) are discussed at [3 000] and following.

TYPES OF TRUSTS [1 100] Common types of trusts and business structures involving trusts The main types of trusts that accountants and advisers are concerned with are: • discretionary trusts (see [1 110]); • fixed trusts and unit trusts (see [1 120]); and • trusts that combine the features of discretionary trusts and fixed trusts (see [1 130]). 6

2016 THOMSON REUTERS

KEY TRUST CONCEPTS

[1 110]

There are many other forms of trusts, which are discussed at [1 140] and following. Over the past decade, the discretionary trust has become a very popular business and investment structure, as it is a very flexible structure from both a tax and commercial viewpoint. Most of the trusts registered in Australia’s tax system are discretionary trusts, and many are used for active trading purposes (see the report of the Productivity Commission, Business Set-up, Transfer and Closure, released on 7 December 2015). Some closely held businesses use a combination of discretionary trusts and private companies to structure their business, enabling the business owners to get the advantages of a corporate entity (eg limited liability and a lower tax rate) as well as the advantages applying to trusts (eg asset protection, flexibility as to distributions and access to the 50% CGT general discount). A common form of structuring is the ‘‘bucket company’’ arrangement, where a company is a beneficiary of the trust and is assessed on its share of the net income at the corporate tax rate. It is also common for trusts to have a corporate trustee: see [2 420]. The deemed dividend rules (Div 7A of Pt III of ITAA 1936) may need to be considered where the business structure includes a private company: see [11 300]. Another form of structuring is a chain of trusts, where the trustee of one trust (the head trust) is a beneficiary of another trust or trusts (sub-trusts). Income distributed from the head trust to the trustee of a sub-trust (as a beneficiary of the head trust) forms part of the income of the sub-trust, to be distributed according to the trust deed of the sub-trust. In certain circumstances, the income tax assessing rules are varied where a beneficiary holds a beneficial interest in a trust in the capacity of trustee in another trust (ss 95B and 99E of ITAA 1936). Under a partnership of trusts, each partner is also the trustee of a trust, typically a discretionary trust. The Tax Office is examining arrangements where accountants, lawyers or other professionals operate through partnerships of discretionary trusts: see [10 020].

[1 110] Discretionary trusts A discretionary trust is usually established for the members of a particular family and entities associated with that family. Under a discretionary trust, the trustee has the flexibility (or discretion) to distribute income and capital among a range of beneficiaries: see [2 460]. The trustee might also have the power to add or remove beneficiaries. From a commercial perspective, this provides the trustee with the ability to supplement the income of lower earning beneficiaries. Having this flexibility is important as the income of potential beneficiaries can vary significantly from year to year. Subject to income and gains being distributed to beneficiaries, the tax profile within a discretionary trust is very similar to investing in individual names in the following sense: • individual beneficiaries are taxed at their marginal rates; • the 50% CGT discount is available for capital gains within the trust for assets held for more than 12 months (unless the beneficiary is a non-resident individual); and 2016 THOMSON REUTERS

7

[1 120]

KEY TRUST CONCEPTS

• any unused imputation credits are refundable in the individual beneficiary’s hands, subject to meeting certain compliance tests. Where a discretionary trust differs from investing in individual names is that any tax losses are quarantined for offset against future trust income. Losses incurred within a trust structure cannot be offset against the personal income of beneficiaries. However, a trust cannot automatically recoup its carried forward losses – it must first satisfy the trust loss recoupment rules: see [7 000]. While discretionary trusts are commonly known as family trusts, this is now a defined term in the tax legislation which carries with it certain tax consequences, some positive and some negative. On the positive side, a trust that qualifies as a ‘‘family trust’’ can generally recoup past and current year losses and claim debt deductions: see [7 100]. On the other side, the trustee or an interposed entity will be liable for family trust distribution tax if any distributions are made to persons outside the family group: see [7 200].

TIP

For the purposes of the trust loss recoupment provisions, a trust will only be a family trust if it makes a valid family trust election: see [7 110]. Care therefore needs to be taken when describing a discretionary trust as a family trust.

[1 120] Fixed trusts Under a fixed trust, each beneficiary is entitled to a fixed or predetermined share of the income and/or capital of the trust, instead of the distribution being at the discretion of the trustee: see [7 020]. The fixed entitlement may be defined as a set fraction or a set amount of the income and/or capital of the trust, or the balance or part of the balance of income or capital after taking account of the entitlements of other beneficiaries. A fixed trust where up to 20 individuals have between them fixed entitlements to 75% or more of the income or capital of the trust is a closely held trust for tax purposes: see [12 000].

Unit trusts A unit trust is a form of fixed trust under which the entitlements of each beneficiary is determined by the number of units owned by the beneficiary. The trust instrument may allow units to be transferred in the same way as shares in a company. Many investment funds adopt this structure. Two recent cases have considered the meaning of ‘‘unit’’ in the context of whether worker entitlement funds are unit trusts for the purposes of the public trading trust provisions (Div 6C of Pt III of ITAA 1936). ‘‘Unit’’ is defined in s 102M to include ‘‘a beneficial interest, however described, in any of the income or property of the trust estate’’. In FCT v ElecNet (Aust) Pty Ltd (Trustee) [2015] FCAFC 178, an industry severance scheme provided benefits to workers who left or changed their employment. The trust deed gave the trustee the discretion to distribute the income to the workers’ employers rather than to the workers alone. The trustee 8

2016 THOMSON REUTERS

KEY TRUST CONCEPTS

[1 140]

also had discretionary powers in relation to how the capital of the fund would be distributed. The Full Federal Court held that the scheme did not qualify as a unit trust because the trustee’s discretionary powers had the effect that the workers’ interests were not ‘‘unitised’’. This finding overturned the primary judge’s decision in ElecNet (Aust) Pty Ltd (Trustee) v FCT [2015] FCA 456 that each worker had a discrete proprietary interest in the contributions made for the worker into the fund and standing to the worker’s account, and that this proprietary interest was sufficient to give rise to a beneficial interest in any property of the trust estate within the meaning of ‘‘unit’’ in s 102M. In the earlier decision of Re BERT Pty Ltd and FCT [2013] AATA 584; 95 ATR 457, the AAT also found that the members of an approved worker entitlement fund did not have units in the fund because no member had a right to, or an interest in, any money or assets of the fund. At best, the members had a right to the due administration of the trust property in accordance with the trustee’s duties.

[1 130] Hybrid trusts A hybrid trust is a trust that has features of both discretionary trusts and fixed trusts. There is no single way to describe a hybrid trust but the following two examples illustrate some hybrid trusts used in practice. Fixed discretionary trust: This type of trust specifies that a fixed percentage of income and capital must be applied for the benefit of a particular class of beneficiaries, with a separate class benefiting from another percentage and so on. These structures are rarely used outside family groups as the benefits of tax losses and franking credits are usually lost where multiple family groups are involved. Discretionary unit trust: Units are issued to unit holders entitling them to a certain fixed share of income and/or capital of the trust. The balance is distributed to beneficiaries at the discretion of the trustee. This type of structure might be used where one entity or person in a family group has the majority of funds or borrowing power but others are to receive benefit from any surplus returns. In Forrest v FCT [2010] FCAFC 6; 78 ATR 417, the trust had a discretionary component (all income representing capital gains) and a unit component (all income, other than capital gains and the capital of the trust). The Commissioner argued that various terms of the trust deed, in particular a clause empowering the trustee to determine whether amounts received by the trust were income or capital for income tax purposes, resulted in the trust being a discretionary trust. The Full Federal Court disagreed, holding that the trust was a fixed trust of income other than capital gains.

[1 140] Testamentary trusts A testamentary trust is a trust that is established by a will and may be discretionary or fixed. However it is important to understand the distinction between a testamentary trust and a deceased estate. If a deceased person left a valid will, the executor nominated in the will or appointed by the court assumes responsibility for the administration of the deceased’s estate. The executor in effect steps into the shoes of the deceased 2016 THOMSON REUTERS

9

[1 150]

KEY TRUST CONCEPTS

person and winds up his or her affairs, including collecting all the assets, paying all the debts and making specific gifts under the will. After these matters have been resolved, the executor then distributes the property of the deceased to the beneficiaries of the estate or holds it on a testamentary trust if one is established by the will. Where a trust is established by a will, it does not commence until after the executor has finalised the administration of the deceased estate. It is only then that the property to be held in a testamentary trust is no longer part of the estate and the beneficiaries obtain an equitable interest in the property. A testamentary trust is normally structured with two classes of beneficiaries: primary beneficiaries and general or discretionary beneficiaries. Primary beneficiaries are specified by name or their relationship with the testator and have an absolute entitlement to the assets of the trust. General beneficiaries – usually a wide class such as nieces, uncles and cousins – have no entitlement to the capital or income of the trust and only receive distributions at the discretion of the trustee. A testamentary trust can be both a tax effective structure for the beneficiaries and a tool by which testators (ie settlors) can determine how their assets are distributed and managed after their death. Testamentary trusts allow primary beneficiaries to distribute income and assets to general beneficiaries and therefore general beneficiaries who have low marginal rates of tax or capital losses can be utilised for tax minimisation purposes. There are also benefits to children. Normal discretionary trusts that distribute income to minors suffer penalty tax rates after the first $416: see [13 000]. However, testamentary trusts are able to distribute trust income to minors at normal adult rates and each minor child of a primary beneficiary can receive $18,200 of income tax-free (2015-16 figures): see [13 110]. For income tax purposes, the executor under a will, an administrator of an intestate estate and the trustee of a testamentary trust are each considered to be a ‘‘trustee’’ (s 6 of ITAA 1936). The executor of a deceased estate is taxed as a trustee under Div 6 of Pt III even though as a matter of general law the executor is not a trustee.

[1 150] Child maintenance trusts A child maintenance trust is a trust set up to provide support or maintenance for a child where there has been a family breakdown. A child maintenance trust arrangement is more likely to be put in place where the person obliged to provide maintenance payments for the child faces high marginal tax rates on his or her own income or where the maintenance payments are not exempt from tax under s 51-50 of ITAA 1997, for example, because they are not periodic payments. In these situations, there may be considerable tax reductions from the use of the trust. The trust can be used to distribute income to a child under 18 without attracting the penalty tax rates that usually apply to the unearned income of minors (Div 6AA of Pt III of ITAA 1936). Those provisions do not apply to the assessable income of a trust where the amount is derived by the trustee from the investment of property transferred to the trustee as a result of a family 10

2016 THOMSON REUTERS

KEY TRUST CONCEPTS

[1 170]

breakdown: see [13 150]. For the family breakdown exception to apply, the property must vest in the beneficiary when the trust ends (see Taxation Ruling TR 98/4).

[1 160] Special disability trusts A special disability trust is a trust established by parents or other immediate family of a person with a severe disability (the principal beneficiary) for the purpose of making financial provision for the future care and accommodation of the person. All trust income and trust assets up to the value of $636,750 for 2015-16 (indexed each year) will not affect the principal beneficiary’s social security payments or veterans’ entitlements payments. Furthermore, gifts valued at up to $500,000 from parents or immediate family will not affect the donor’s social security or veterans’ entitlements payments. The following tax concessions apply to ensure that tax laws are not a disincentive to establishing a special disability trust: • unexpended income of a special disability trust is taxed at the principal beneficiary’s personal income tax rate, rather than automatically at the top personal tax rate plus Medicare levy (s 95AB of ITAA 1936); • any capital gain or loss from gifting an asset to a special disability trust is disregarded (s 118-85 of ITAA 1997); and • the capital gains tax main residence exemption extends to a residence owned by a special disability trust and used by the principal beneficiary as his or her main residence (s 118-218 of ITAA 1997). To qualify for these concessions, the trust must meet the specific legislative requirements set out in the relevant legislation (Pt 3.18A of the Social Security Act 1991; Div 11B of Pt IIIB of the Veterans’ Entitlements Act 1986). In particular, the trust must be established for the sole purpose of the care and accommodation of the disabled person.

[1 170] Charitable trusts A charitable trust is a not-for-profit entity that is established for charitable purposes. To access various tax concessions, the trust must be: • registered with the Australian Charities and Not-for-Profits Commission as a charity; and • endorsed by the Tax Office as a tax concession charity. The charity tax concessions include an exemption from income tax (Div 50 of ITAA 1997) and a range of GST and fringe benefits tax concessions. The Commissioner can also give a registered charity deductible gift recipient status. A charitable trust is not subject to the rule against perpetuities (see [2 500]), so it can continue indefinitely. Since 1 January 2014, statutory definitions of ‘‘charity’’ and ‘‘charitable purpose’’ have applied to all Commonwealth laws, including tax laws (ss 5 and 12 of Charities Act 2013). 2016 THOMSON REUTERS

11

[1 180]

KEY TRUST CONCEPTS

[1 180] Bare trusts The simplest form of trust is a bare trust. This is a nominee arrangement where one person (often a company) owns an asset but another person enjoys the entire beneficial interest in the asset. A common example is legal ownership of shares by a trustee company, with the shares being beneficially owned by another person. As a matter of practice, the existence of a bare trust is generally ignored for income tax purposes. However, a bare trustee is expected to lodge a trust tax return if the application of the trust tax provisions would result in the trustee being assessed under Div 6 of ITAA 1936 (Practice Statement PS LA 2000/2, as amended on 14 March 2012). One implication of this is that where the trustee has a tax liability, the losses of the bare trust will be trapped. In the context of GST, the Tax Office has ruled that when dealing with real property held by a bare trust, it is the beneficiary who is liable for GST if there is a taxable supply and who is entitled to input tax credits if there is a creditable acquisition (GST Ruling GSTR 2008/3).

[1 190] Superannuation funds Superannuation funds are basically trust funds established to provide benefits to members or their dependants on the sickness, death or retirement of the member. Some government schemes may be funded from consolidated revenue without a separate trust existing. Superannuation funds must meet a range of operating standards to qualify for concessional tax treatment. The Tax Office administers the prudential and operating standards of self-managed funds while the Australian Prudential Regulation Authority regulates other superannuation funds. A complex legislative framework governs the operation of superannuation. The tax treatment and regulation of superannuation funds is outside the scope of this publication. For full commentary in this area, see Thomson Reuters’ Australian Superannuation Handbook.

[1 200] Managed investment trusts Managed investment trusts are subject to special tax rules. A trust will qualify as a managed investment trust (MIT) if: • it is widely held; • it is a managed investment scheme within the meaning of the Corporations Act 2001; • the trustee is an Australian resident or the central management and control of the trust is in Australia; • a substantial portion of the investment management activities of the trust in respect of certain assets of the trust (assets situated in Australia, taxable Australian property and shares or units listed on the Australian stock exchange) is carried on in Australia; and • it is not a trading trust and does not carry on or control a trading business. 12

2016 THOMSON REUTERS

KEY TRUST CONCEPTS

[1 200]

The operation of the income tax law is modified in the following ways for income derived by managed investment trusts: 1. Amounts distributed by MITs to foreign residents are subject to a special withholding tax regime (Subdiv 12-H of Sch 1 to TAA). A final withholding tax rate of 15% applies if the recipient is resident of a country that has an effective exchange of information arrangement with Australia. A concessional rate of 10% applies to MITs that hold newly constructed energy efficient commercial buildings. In all other cases, the withholding tax rate is 30%. 2. MITs can elect to apply the CGT provisions (instead of being assessed on revenue account) on gains and losses made from disposing of certain assets held as passive investments (Div 275 of ITAA 1997). Eligible assets include shares, units in a unit trust, real property and rights or options to acquire or dispose of any of those types of asset (s 275-105 of ITAA 1997). 3. MITs are not subject to the streaming rules unless they choose to apply them (see [4 100]).

Elective regime for managed investment trusts From 1 July 2016, a separate tax regime (in Div 276 of ITAA 1997) is available to eligible MITs that elect to be treated as ‘‘attribution managed investment trusts’’ (AMITs). Where this choice is validly made, the general income tax rules for trusts cease to apply to the AMIT and its members (s 95AAD of ITAA 1936). A trust can choose to be treated as an AMIT if it satisfies the definition of ‘‘managed investment trust’’ (in Subdiv 275-A of ITAA 1997) and its members have clearly defined interests in relation to the income and capital of the trust. Once the choice is made, it cannot be revoked. MITs that do not elect to be AMITs continue to be subject to Div 6 of ITAA 1936, although they can choose not to apply the streaming rules for the 2015-16 and 2016-17 income years. A key feature of the tax regime for AMITs is an attribution method of taxation (instead of the present entitlement system in Div 6 of ITAA 1936), with investors taxed on income allocated to them on a fair and reasonable basis, consistent with their entitlements. If it later turns out that the amounts actually attributed differ from the amounts that should have been attributed, the trustee can reconcile the variance using an ‘‘unders’’ and ‘‘overs’’ system. AMITS are treated as fixed trusts for income tax purposes, including for the purposes of the trust loss rules and the franking provisions.

2016 THOMSON REUTERS

13

14

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

2

THE IMPORTANCE OF THE TRUST DEED Why is the trust deed so important? ....................................................... [2 000]

INCOME AND NET INCOME OF A TRUST ESTATE Differences between ‘‘income’’ and ‘‘net income’’ ................................ [2 100] Characterisation of capital as income and vice versa .......................... [2 110] Streaming and matching of income and capital gains ......................... [2 120] Trust deed inclusions to reflect streaming measures ............................ [2 130]

TRUSTEE DISTRIBUTIONS AND RESOLUTIONS Trustee distributions and resolutions ...................................................... [2 300] Unpaid present entitlements, sub-trusts and Div 7A ........................... [2 320]

ELEMENTS OF A TRUST AND RELEVANCE TO THE TRUST DEED Key elements of a trust .............................................................................. [2 The settlor and the trust property ........................................................... [2 The trustee .................................................................................................... [2 Powers of the trustee .................................................................................. [2 Duties of the trustee ................................................................................... [2 Trustee’s right of indemnity ...................................................................... [2 Beneficiaries .................................................................................................. [2 Appointors .................................................................................................... [2 Guardians ..................................................................................................... [2

400] 410] 420] 430] 440] 450] 460] 470] 480]

LIFE SPAN OF A TRUST Trusts have a certain life span .................................................................. [2 Vesting of the trust ...................................................................................... [2 Power to amend the trust deed ................................................................ [2 Changes to a trust resulting in resettlement .......................................... [2 Applying to a court to vary the trust deed ........................................... [2

2016 THOMSON REUTERS

500] 510] 520] 530] 540]

15

[2 000]

THE IMPORTANCE OF THE TRUST DEED

THE IMPORTANCE OF THE TRUST DEED [2 000] Why is the trust deed so important? The terms of a trust deed have become more significant than ever before as a result of the High Court’s decision in FCT v Bamford [2010] HCA 10; 75 ATR 1, the enactment of specific streaming rules in 2011 (see [4 330]) and attempts to rewrite of the trust income tax provisions (see [16 000]). This requires a focus on several vital issues where the particular wording of the trust deed will assist: (1) the definitions of ‘‘net income’’ and ‘‘income’’; (2) whether particular types of income and capital gains can be streamed through the trust to particular beneficiaries; (3) whether the trustee has the power to re-characterise income as capital and vice versa and the power to apply particular costs and expenses against items of income and capital. Part of the beauty of trusts is that each one is unique, governed by its own trust deed. General rules can be formulated regarding trusts, their advantages and disadvantages, and the applicable taxation treatment, but it is always imperative to closely examine the trust deed. The trust must be administered in accordance with its unique set of rules and the exact wording used in the trust deed may determine the correct taxation treatment of the income of the trust. The drafter of a trust deed for a discretionary trust will seek to achieve: • certainty of meaning; • flexibility to support the exercise of broad discretions in the distribution of income and capital and to anticipate changes in circumstances of the beneficiaries, and in the law; and • appropriate mechanisms for amendments should that prove desirable. The clauses relating to recognition and distribution of income and of capital gains are among the most crucial, difficult to get right and essential to keep right, given that they lie at the heart of the perennial debate among taxation bureaucrats, the judiciary and politicians as to what they may fairly allow. KEY ISSUES TO CONSIDER IN RELATION TO DISCRETIONARY TRUST DEEDS (1) Definitions of ‘‘income of the trust estate’’ and ‘‘net income of the trust estate’’, the implications of the Bamford decision and the Tax Office’s position: see [2 100]; (2) the streaming and matching of income and the specific tax rules allowing the streaming of capital gains and franked distributions: see [2 120]; (3) trustee distributions and the importance of trustee resolutions: see [2 300]; (4) unpaid present entitlements of corporate beneficiaries, sub-trusts and the deemed dividend rules: see [2 320]; (5) the definition of the beneficiaries of the trust and excluded beneficiaries: see [2 460]; (6) selection of the trustee and settlor: see [2 410] and [2 420]; (7) the powers and duties of the trustee: see [2 430] and [2 440]; (8) the trustee’s right of indemnity from the trust fund: see [2 440];

16

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 100]

(9) appointors and guardians, control and succession issues: see [2 460] and [2 470]; (10) the perpetuity period and vesting of the trust: see [2 500] and [2 510]; and (11) the power to amend the trust deed: see [2 520].

INCOME AND NET INCOME OF A TRUST ESTATE [2 100] Differences between ‘‘income’’ and ‘‘net income’’ Many of the uncertainties and complexities regarding the taxation of trusts arise when the ‘‘income of the trust estate’’, calculated in accordance with accounting principles, is not the same as the ‘‘net income of the trust estate’’, calculated in accordance with tax law. The High Court in FCT v Bamford [2010] HCA 10; 75 ATR 1 confirmed that the correct application of the rules in the trust income tax provisions in Div 6 of Part III of ITAA 1936 means that the ‘‘proportionate approach’’ should be used. If a beneficiary is ‘‘presently entitled to a share of the income of the trust estate’’, the beneficiary will be required to include in assessable income that same proportion of the ‘‘net income’’ of the trust estate. Bamford’s case is discussed at [4 310]. Prior to the enactment of the streaming rules in 2011 (Subdivs 115-C and 207-B of ITAA 1997), the proportionate approach could lead to results that were counter-intuitive or that appeared unjust. For example, if a trust had only $1 of ordinary income and a capital gain of $100,000 and the trust deed did not define ‘‘income’’, then the ‘‘income of the trust estate’’ was $1 whereas the ‘‘net income’’ was $100,001. If $1 was distributed to Beneficiary A, then Beneficiary A was presently entitled to 100% of the income of the trust estate. Therefore, applying the proportionate approach, Beneficiary A was liable to tax on 100% of the net income of the trust, or $100,001, even if the capital gain was not distributed to Beneficiary A. The High Court in Bamford’s case also highlighted the importance of the trust deed when determining the ‘‘income of the trust estate’’. If the trust deed states that the ‘‘income of the trust estate’’ is the same as the ‘‘net income’’ calculated under the ITAA 1936 and ITAA 1997, this will ensure that capital gains are included in the income of the trust estate and can be distributed to beneficiaries in the same way as ordinary income. Accordingly, following the Bamford decision, best practice was to ensure that a trust deed contained a definition of ‘‘income of the trust estate’’ that generally included capital gains, but also gave the trustee flexibility to exclude such gains by determination. Although such a strategy may deal effectively with actual capital gains, there remains uncertainty as to whether this deals adequately with amounts that represent notional tax amounts, such as franking credits, amounts included by the operation of the general anti-avoidance provisions and deemed capital gains 2016 THOMSON REUTERS

17

[2 110]

THE IMPORTANCE OF THE TRUST DEED

included by the operation of the market substitution rule: see Colonial First State Investments Ltd v FCT [2011] FCA 16; 81 ATR 772. In Thomas v FCT [2015] FCA 968, which concerned income years before the start of the streaming rules, the Federal Court held that franking credits cannot be streamed independently of the franked distributions to which they are attached: see [2 120]. In Draft Taxation Ruling TR 2012/D1, the Commissioner’s preliminary view is that notional income amounts cannot generally be taken into account in calculating the trust’s income: see [3 340].

WARNING! Label 53A of the 2016 Trust Tax Return requires trustees to record the ‘‘income of the trust estate’’. Trustees are not obliged to follow Draft Taxation Ruling TR 2012/D1 when completing this label. The 2016 Trust Tax Return Instructions advise trustees that if they calculate the trust income in accordance with an income equalisation clause, but the Tax Office subsequently determines that the trust income is a different amount, a trustee will not be treated as having made an error in completing label 53A.

[2 110] Characterisation of capital as income and vice versa A further aspect of the High Court’s decision in FCT v Bamford [2010] HCA 10; 75 ATR 1 is that a provision enabling the trustee to re-characterise a capital receipt as income is valid and effective. For example, if a trust deed contains no specific definition of ‘‘income of the trust estate’’ (so that ordinary trust principles apply and capital gains are not included) but the trust deed allows the trustee to determine that a capital receipt is to be treated as income, then a capital gain made through trust can be declared by the trustee to be income and therefore fall within the ‘‘income of the trust estate’’. However, this principle has some limitations in that a trustee’s power of re-characterisation is not an unconfined discretion. For example, the trustee may not be permitted to re-characterise a receipt that is clearly of a capital nature as income, when that will allow the trustee to benefit one class of beneficiaries at the expense of another class (see Forrest v FCT [2010] FCAFC 6; 78 ATR 417). In its Decision Impact Statement on the Bamford decision, the Tax Office accepted that a trustee may re-characterise a capital receipt as income, but did not accept that the opposite position also holds true (ie provisions allowing the trustee to re-characterise income as capital). In situations where the trust deed differentiates between income beneficiaries and capital beneficiaries, it may be that provisions enabling the trustee to re-characterise capital as income and vice versa must be interpreted cautiously.

[2 120] Streaming and matching of income and capital gains Streaming and matching provisions in a trust deed allow the trustee, for example, to allocate a capital gain to one beneficiary, and dividend income to another, rather than simply allocating a percentage of the income of the trust 18

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 120]

estate to each beneficiary, being a mixture of capital gain and dividend income. Such provisions also enable the trustee to offset expenses of the trust against income of a certain type. While previously there was uncertainty as to whether streaming and matching provisions were effective or not for tax purposes, the streaming rules in Subdivs 115-C and 207-B of ITAA 1997 largely settled the matter as they provide a specific mechanism for the streaming of capital gains and franked dividends. The streaming measures ensure that – where permitted by the trust deed – capital gains and franked distributions can be effectively streamed for tax purposes to beneficiaries by making them ‘‘specifically entitled’’ to those amounts: see [4 000] and following. The measures do not in any way give trustees the power to stream where they do not already have the power under the trust deed to do so.

WARNING! The Tax Office view is that it is not possible to stream anything other than capital gains and franked dividends: see the ATO documents Trustee Resolutions Must be Made no Later than 30 June (May 2013) and Resolutions Checklist (May 2015) and the Decision Impact Statement on FCT v Greenhatch [2012] FCAFC 84; 88 ATR 560 (July 2013). In Thomas v FCT [2015] FCA 968, which concerned income years before the enactment of the streaming measures, the trustee of a discretionary trust sought to distribute $9 million in franking credits to a beneficiary in order to maximise the refundable tax offsets available to him. The Federal Court held that the franking credits could not be dealt with separately from the franked distributions to which they were attached. This was because franking credits are not ordinary income, the trust deed did not treat franking credits as a separate category of income and Div 207 of ITAA 1997 (on the effect of receiving a franked distribution) makes it clear that franking credits can only ‘‘attach’’ to the franked dividend and cannot be streamed as a separate class of income. Under the streaming measures, a beneficiary cannot be made specifically entitled to franking credits: see [4 230]. In its October 2012 policy options paper for rewriting the trust income tax provisions (see [16 020]), the previous Government indicated that any new model for taxing trust income should allow all amounts flowing through a trust to be streamed. The policy options paper provided (at page 10): “All amounts that flow through a trust can be streamed in a tax effective way to particular beneficiaries in accordance with the trust deed (subject to any other rules in the tax laws). This does not mean that there must be a separate and explicit streaming power in the trust deed; just that the trustee must comply with the trust deed and trust law more generally.”

Given the ongoing debate about the streaming and matching of income generally, it is recommended that the streaming and matching clause in a trust deed be amended to extend to all types of income, and not only capital gains and franked distributions. For example, the following clause may be used (with appropriate definitions):

2016 THOMSON REUTERS

19

[2 120]

THE IMPORTANCE OF THE TRUST DEED STREAMING AND MATCHING CLAUSE (1) The Trustee may: (a) identify and segregate income from different sources or of different natures for the purpose of dealing with it separately; and (b) where the income of an Accounting Period is directly or indirectly derived from different sources, in making a Determination to pay, apply or set aside income for a Beneficiary or to accumulate the same, determine from what source that income is derived. (2) The Trustee may make separate Determinations to pay, apply or set aside any income of a particular nature or character or from a particular source in the manner described in clause (1). (3) The Trustee may create a separate account in respect of: (a) any particular type or source of income including but not limited to: (i) income attributable to capital gains included in the assessable income of the Trust Fund for the purposes of ITAA; (ii) income derived from carrying on or being engaged in the business of primary production as defined in ITAA; (iii) income attributable to dividends (whether generally or of a particular corporation or franked or unfranked or otherwise); (iv) income derived from rental of property; (v) interest; (vi) income which is foreign source income for the purposes of ITAA; and (vii) income not falling within any other class; (b) any taxation offsets or credits available to the Trustee under ITAA; and upon receipt of that type or source of income or taxation offset/credit, the Trustee may pay the money into or apply the offset/credit against the appropriate separate account. (4) Any amount paid, applied or set aside to or for a Beneficiary out of such a separate account: (a) retains its character; and (b) is of the same type, nature and substance in the hands of the Beneficiary as it was in the hands of the Trustee.

Definition of specifically entitled ‘‘Specifically entitled’’ is a core concept under the streaming measures. For a beneficiary to be specifically entitled, the beneficiary must receive, or reasonably be expected to receive, an amount equal to the net financial benefit referable to the capital gain or franked distribution: see [4 200]. In addition, the entitlement must be recorded in the accounts or records of the trust in its character as a capital gain or franked distribution: see [4 220].

20

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 120]

WARNING! A resolution to make a beneficiary specifically entitled to a capital gain or franked distribution must be made by 30 June. The entitlement to a capital gain must be recorded by 31 August. For franked distributions, the entitlement must be recorded by 30 June.

A trustee determination is a ‘‘record of the trust’’ and therefore a trustee determination will be sufficient, provided it is properly worded. Examples given in the Explanatory Memorandum to the streaming measures of trust records that would evidence a specific entitlement to a capital gain or franked distribution are shown in the box below. TRUST RECORD OF SPECIFIC ENTITLEMENT • $50 referable to a franked distribution; • half of the ‘‘trust gain’’ realised on the sale of an asset; • the amount of franked distribution remaining after calculating directly relevant expenses and distributing $10 to another beneficiary; • 30% of a ‘‘net dividends account’’ that includes all franked and unfranked distributions, less directly relevant expenses charged against the account (so long as the beneficiary’s specific entitlement to net franked distributions can be determined); and • the amount of (tax) capital gain included in the calculation of the trust’s taxable income remaining after the application of the capital gains tax (CGT) discount. (In such a case, the beneficiary would generally be specifically entitled to only half of the gain, and that entitlement is taken to be made up equally of the taxable and discount parts of the gain.)

It is open to a trustee of a resident trust to elect to bear the tax on a capital gain, rather than having it streamed to beneficiaries in accordance with their share of the income of the trust: see [4 320]. However, this can only be done in respect of the whole of the capital gain, and the trust deed must provide the trustee with the power to do so. Also, for the election to be effective, no amount referable to the gain can be received by a beneficiary during the income year or within two months after the end of the income year. Care must be taken in framing the trustee resolution when there are multiple capital gains and losses. It is possible to choose to offset one capital gain with the capital losses in the trust, and to stream another capital gain to a beneficiary. However, unintended results may occur if the trustee’s determination regarding the distribution of the capital gains and the accounting treatment of the capital gains and losses of the trust do not match. Where there are multiple parcels of shares that give rise to franked distributions, those parcels can be pooled and distributed as one single class of income: see [4 420].

2016 THOMSON REUTERS

21

[2 130]

THE IMPORTANCE OF THE TRUST DEED

However, if the trustee wishes to separately stream franked distributions from one parcel of shares, then pooling will not be possible for the balance of the franked distributions. For further details on the streaming measures see [4 000] and following.

[2 130] Trust deed inclusions to reflect streaming measures In light of the streaming measures, it is necessary to consider what should be included in a trust deed.

Definition of income A definition of ‘‘income of the trust estate’’ remains important, because where no one is specifically entitled to a capital gain or franked distribution, the definition of ‘‘income of the trust estate’’ becomes relevant in calculating the proportion of the capital gain and franked distributions attributed to each beneficiary (and the trustee). The definition of ‘‘income of the trust estate’’ is also important in respect of other types of income where there may be a difference between the income for trust law purposes and the income for tax law purposes. The following definition provides the trustee with the flexibility to use the tax law definition of ‘‘net income’’ (in s 95(1) of ITAA 1936: see [3 200]) to calculate the income of the trust estate, or to determine that another method should be used: INCOME CLAUSE Income means the amount calculated as the net income of the Trust Fund for an Accounting Period in accordance with the ITAA including: (a) the amount calculated as the net capital gain of the Trust Fund for an Accounting Period in accordance with the ITAA, prior to the application of the discount percentage applicable to any discount capital gain under Division 115 and any of the small business concessions in Division 152 of the ITAA; and (b) to the extent allowable, any taxation offsets or credits available to the Trustee under the ITAA including but not limited to: (i) foreign income tax offsets; (ii) PAYG credits; and (iii) franking credits, unless the Trustee determines in respect of any Accounting Period that the Income for that Accounting Period means the income of the Trust Fund calculated in accordance with established accounting principles and trust law.

Power to re-characterise A provision enabling the re-characterisation of capital as income, and vice versa, has less relevance in the light of the streaming measures, although if the trust deed contains no definition of income of the trust estate, such provisions assume importance in calculating the proportion of the capital gain and franked 22

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 130]

distributions attributed to each beneficiary (and the trustee) in a situation where no one is specifically entitled to those amounts of income: see [4 260].

Power to determine expenses The streaming measures dictate that only capital losses can be offset against a capital gain of the trust to determine whether there is a net capital gain remaining that can be streamed. Therefore, provisions enabling the trustee to determine whether expenses of the trust are to be borne by capital or income may appear redundant. However, these can also play a role in determining the ‘‘income of the trust estate’’. In addition, as the rules regarding the taxation of trusts are still to be re-written, such provisions may prove important in the future. Accordingly, an example of a re-characterisation clause that maintains maximum flexibility for the trustee is as follows: RE-CHARACTERISATION CLAUSE The Trustee may in its absolute discretion determine: (1) whether: (a) any property; (b) any increase or decrease in amount, number or value of any property or holdings of property; or (c) any receipt or payment from, for or in connection with any property; is treated as and credited or debited to capital or to income and out of what part of the Trust Fund; and (2) whether any expense or outgoing is borne by capital or income.

Power to stream income, capital gains and franked distributions It is imperative that the trust deed allow streaming of capital gains and franked distributions so that it is possible for a beneficiary to become ‘‘specifically entitled’’ to a capital gain and/or franked distribution. Also, as the debate regarding the streaming of other types of income is not yet over, a streaming clause such as that set out in [2 120] is to be recommended.

Power to advance capital A beneficiary can also become specifically entitled to a capital gain if it is distributed as an advance of capital, and not as a distribution of the income of the trust. This may be a useful device for older trust deeds which do not include capital gains in the definition of ‘‘income of the trust estate’’. A typical clause allowing for the advancement of capital is set out at [2 430]. The streaming measures are complex and must be applied with care. It is doubtful that they achieve the stated goal of simplifying the taxation of trusts and reducing uncertainty. That may have to await the foreshadowed rewrite of Div 6: see [16 000].

2016 THOMSON REUTERS

23

[2 300]

THE IMPORTANCE OF THE TRUST DEED

TRUSTEE DISTRIBUTIONS AND RESOLUTIONS [2 300] Trustee distributions and resolutions The rules in Div 6 of Pt III of ITAA 1936 seek to ensure that, between the trustee and the beneficiaries of a trust, 100% of the assessable income derived through the trust is subject to taxation. Ignoring complications such as beneficiaries changing residency status, or beneficiaries subject to legal disabilities, the rules require the following steps to be taken: • The ‘‘net income’’ of the relevant trust estate must be calculated as if the trustee were an Australian resident taxpayer in respect of that income. The ‘‘net income’’ is the income of the trust estate calculated under the ITAA 1936 and ITAA 1997. It therefore includes any capital gains. • It must be determined if a beneficiary of the trust is ‘‘presently entitled to a share of the income of the trust estate’’. For these purposes, the term ‘‘income of the trust estate’’ is used. This refers to a trust law concept of income which is not necessarily the same as the ‘‘net income’’ under Div 6 of ITAA 1936. Generally it relies on accounting concepts of income and so does not include capital gains, but this can be affected by the provisions of the trust deed. • If a beneficiary is ‘‘presently entitled to a share of the income of the trust estate’’, the beneficiary is required to include in assessable income that same proportion of the ‘‘net income’’ of the trust estate. • Where the net income includes a capital gain or franked distribution, the streaming rules assess any beneficiary who is ‘‘specifically entitled’’ to the capital gain or franked distribution. • The trustee is liable to taxation at the highest rate on any part of the net income of the trust estate that is not included in the assessable income of a beneficiary. The key to ensuring that tax is payable by the beneficiary of the trust, at the appropriate marginal rate, and not by the trustee at the top marginal rate, is that the beneficiary is ‘‘presently entitled’’ to the income of the trust estate. There is a large body of law regarding the meaning of the words ‘‘presently entitled’’. It does not mean that the beneficiary must already have the distribution in his or her hands. However, the beneficiary should be able to call for it: see further [3 100]. For a discretionary trust, it can be necessary for the trustee to make a determination regarding the distribution of the income of the trust estate on or before 30 June of the relevant income year to ensure that a beneficiary or beneficiaries are ‘‘presently entitled’’ to that income.

WARNING! If the trustee resolution is not made by 30 June, and no beneficiary is presently entitled to trust income at that date, the trustee will be assessed on the trust’s taxable income at the highest marginal tax rate plus the Medicare levy.

24

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 300]

It is prudent, but not essential, for the resolution to be recorded in writing by 30 June. The Commissioner accepts that unwritten decisions can create valid entitlements, although a written record may avoid a later dispute. A written record is essential for making a beneficiary specifically entitled to a capital gain or franked distribution. See further the Tax Office document Resolutions Checklist (May 2015), available on the ATO website.

Prior to 1 July 2011, the Tax Office was lenient in not challenging distributions where the determination was made after the end of the income year. In Taxation Rulings IT 328 and IT 329 (withdrawn), the Commissioner recognised that it was often not possible to determine the amount of the net income of the trust estate until after the close of the year of income, and therefore the Tax Office allowed a present entitlement to be created by determination up to two months after the end of the income year. Taxation Rulings IT 328 and IT 329 were withdrawn in September 2011 following the decision in Colonial First State Investments Ltd v FCT [2011] FCA 16; 81 ATR 772 (where the Federal Court held that a present entitlement must arise by 30 June).

TIP

The trust deed must be referred to, to ensure that any time line or requirement under the trust deed to effectively distribute income of the trust is complied with.

Indeed, in a 2001 case BRK (Bris) Pty Ltd v FCT [2001] FCA 164; 46 ATR 347, it was held that the default clause in the trust deed considered in that case would only make the default beneficiaries presently entitled to the income in the following year, so that it remained ‘‘income to which no beneficiary was presently entitled’’ in the year in which it was derived through the trust. To guard against this result, it is possible to include ‘‘default beneficiaries’’ in the trust deed, so that if the trustee fails to make a determination by 30 June, the ‘‘default beneficiaries’’ become automatically entitled to the income. For example, the relevant clause of the trust deed could provide as follows: DEFAULT BENEFICIARIES CLAUSE 1.1 The Trustee has a discretion to make a determination at any time before the end of an Accounting Period, in respect of all or any part of the Net Income for that Accounting Period: (1) to pay, apply or set it aside to or for any one or more of the Beneficiaries to the exclusion of the others and in such manner and in such sums or proportions as the Trustee thinks fit; or (2) to accumulate it. 1.2 If the Trustee does not exercise the discretion contained in clause 1.1 before the end of the Accounting Period (or to the extent to which the Trustee does not exercise or does not effectively exercise that discretion

2016 THOMSON REUTERS

25

[2 320]

THE IMPORTANCE OF THE TRUST DEED before the end of the Accounting Period), the Trustee holds the Net Income for the Accounting Period at the end of that Accounting Period for the Default Beneficiaries living on the last day of the Accounting Period and if more than one in equal shares. 1.3 If any Residuary Beneficiary dies before the last day of the Accounting Period leaving children or remoter issue who survive that date, those issue take in equal shares per stirpes the share which the Default Beneficiary would have taken had he or she survived the last day of the Accounting Period.

If such a clause is to be included, the consequences of the trustee failing to exercise its discretion by 30 June need to be specifically pointed out to the client. It is important to ensure that the default beneficiaries are the people the client would want to be entitled to the income if the trustee fails to make a determination in time.

WARNING! In its October 2012 policy options paper for rewriting the trust income tax rules, the previous Government indicated that under any new model for taxing trust income, the trustee should have until 31 August to determine entitlements (where the trust deed permits): see further [16 020].

[2 320] Unpaid present entitlements, sub-trusts and Div 7A The Commissioner takes the view in Taxation Ruling TR 2010/3 that an unpaid present entitlement (UPE) from a trust to a private company beneficiary may qualify as a loan for the purposes of the deemed dividend rules in Div 7A of ITAA 1936: see [11 300]. In the context of a family group, the Tax Office will treat any UPE that is not ‘‘called for’’ by the corporate beneficiary as a loan unless the UPE is placed in a sub-trust for the beneficiary’s sole benefit. Where it is desired to place UPEs on a sub-trust (see [11 320]), the trust deed should be carefully reviewed to ensure that the trustee has the power to do so. However, the Tax Office will accept that this power exists if the trust deed contains words to the effect that: The Trustee has the power to set aside the income of the trust for the exclusive benefit of one or all of the beneficiaries.

See [11 000] and following for further details as to the application of Div 7A to trusts.

26

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 410]

ELEMENTS OF A TRUST AND RELEVANCE TO THE TRUST DEED [2 400] Key elements of a trust Four elements are required to constitute a valid trust: (1) property of the trust (see [2 410]); (2) a trustee (see [2 420]); (3) one or more beneficiaries of the trust (see [2 460]); and (4) the fiduciary duty owed by the trustee to the beneficiaries (see [2 440]). A settlor may create the trust by providing the initial trust property (see [2 410]). Other relevant entities are appointors (see [2 470]) and guardians (see [2 480]).

[2 410] The settlor and the trust property The settlor is the person who contributes property to the trustee to initially establish the trust. Therefore, the settlor has the important role of contributing one of the four essential elements of the trust, that is, trust property. Trust property can be tangible (eg land or goods) or intangible (eg mining rights, intellectual property or a statutory licence). However, a mere licence to occupy land (such as an annual ticket to a racecourse) is not sufficient property for a trust. An interest in property which cannot be gained until the beneficiary reaches a certain age will be sufficient property for the creation of a trust. Commonly, a cheque for a sum of money (the ‘‘settled sum’’) is provided by the settlor to the trustee, and that cheque should be banked in the bank account which has been created for the trust as evidence of the creation of the trust and the existence of trust property. The settlor has nothing further to do with the trust. A typical introduction to a trust deed will provide: TYPICAL TRUST DEED INTRODUCTION (A) The Settlor wishes to create the Trust to make provision for the Beneficiaries. (B) The Settlor has paid or intends on the execution of this Deed to pay to the Trustee the Settled Sum. (C) The Trustee has consented to become the Trustee of the Trust subject to the provisions of this Deed.

Once the settlor has contributed the trust property and the trust has been established, title to the trust property is divided into two elements – legal title and beneficial (equitable) title. The trustee holds the legal interest and is recognised at law as the owner of the trust property (eg the trustee will be named as the registered owner on any documents dealing with the property). The beneficiaries hold the beneficial interest in the trust property. These two interests combined form the complete ownership of the trust property. 2016 THOMSON REUTERS

27

[2 420]

THE IMPORTANCE OF THE TRUST DEED

A special anti-avoidance provision operates to prevent a settlor manipulating his or her taxable income by creating a trust for the benefit of other persons, but retaining sufficient power to ensure that ultimately the benefit is enjoyed by the settlor personally (s 102 of ITAA 1936): see [10 040]. This provision results in the trustee being assessed on some or all of the income of the trust if the settlor has the power to revoke or alter the trust so as to acquire a beneficial interest in the income of the trust. To ensure that s 102 is not triggered, the safest path is to ensure that the settlor has no power to revoke or alter the trust. For a family discretionary trust, the settlor should not be a person associated with the relevant family. For a unit trust, the settlor should not be a person who may become a unit holder. It is also important that the settlor actually pays the settled sum and is not reimbursed. If it can be shown that the settled sum came, for example, from the family for whose benefit a discretionary trust is established, this may also trigger s 102.

TIP

It is acceptable for an accountant to act as the settlor but the settled sum must not be charged back to the client as a disbursement.

[2 420] The trustee The trustee is the person or entity in whose name all property of the trust is held, subject to the fiduciary responsibilities that the trustee has to administer the trust for the benefit of the beneficiaries. The trustee is therefore sometimes described as the legal owner of the property, while the beneficiaries are the beneficial owners. Having an individual or individuals as trustee(s) can be administratively burdensome because, every time the trustee changes, the property of the trust must be transferred into the name of the new trustee. If the property of the trust is dutiable property, then applications must be made to the relevant State or Territory Revenue Office for an exemption from duty on the transfer. For this reason, a corporate trustee is to be recommended. The use of a corporate trustee should minimise the need for a change in trustee. Instead, if it is necessary for new persons to control the trustee (ie a new generation is to take over administration of the trust), the directors and shareholders of the corporate trustee can be changed. Preferably, the corporate trustee should be a sole purpose company that does nothing other than act as trustee of the relevant trust. This ensures that no conflict of interest arises for the trustee company. It can also avoid the confusion that is possible when a company acts as trustee but also pursues its own business or investment activities. In such circumstances it can become unclear which assets are trust assets and which assets are held by the company in its own right. This problem can easily be compounded as 20, 30, 40 or more years elapse since the establishment of the trust. Note that if there is a change in the individual or company holding the office of trustee, the trustee remains the same entity for income tax purposes: see [14 030]. 28

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 430]

Transfers of property due to change in trustee In New South Wales, for example, the relevant exception for a transfer of dutiable property that arises solely due to a change in trustee is dependent on the NSW Chief Commissioner being satisfied that the new trustee is not, and cannot become, a beneficiary under the trust. To ensure this rule is not breached, trust deeds may provide that any person appointed as trustee is automatically disqualified from being a beneficiary. For a sole purpose company that is incorporated only to act as trustee, this should not pose any problems. However, if the company has other activities, some due diligence may need to be undertaken. The definition of ‘‘beneficiaries’’ in a trust deed often includes a definition of ‘‘Eligible Companies’’ which includes any company in which a beneficiary holds at least one share. If such a company were appointed trustee, and were then disqualified from being a beneficiary, any practice of making distributions to that company would need to cease.

TIP

A sole purpose trustee company is best practice. This avoids any conflicts of interest, and any possible traps for the unwary when administering the trust.

[2 430] Powers of the trustee The trustee holds legal title to trust property which it must administer for the benefit of the beneficiaries. The trust deed must provide the trustee with sufficient power to carry out its duties, whether they are to actively run a business, manage a portfolio of investments or some other activity. The trust deed should carefully set out the trustee’s powers to ensure the trustee does not find itself in a situation where it wishes to borrow money, or provide security, and the bank refuses to deal with the trustee until the trust deed is amended to specifically empower the trustee to do so. A trust deed will typically use the approach in s 124 of the Corporations Act 2001, of granting the trustee all the powers of an individual, but also specifying some particular powers. For example: TRUSTEE’S POWERS General power … (a) The Trustee has all the powers over and in respect of the Trust Fund and the assets of the Trust Fund including carrying on business on behalf of the Trust and using the assets and credit of the Trust and doing anything else on behalf of the Trust which it could exercise and do if it was the absolute and beneficial owner of the Trust Fund and the assets of the Trust Fund.

2016 THOMSON REUTERS

29

[2 430]

THE IMPORTANCE OF THE TRUST DEED

Particular powers … (b) Without limiting the general power contained in clause (a), the Trustee has the particular powers referred to in clause #.

Trustees most commonly discover the inadequacy of their trust deed when they deal with banks, and wish to borrow money, provide security or act as guarantor. The absence of such powers has caused many a trustee grief when the bank has reviewed the trust deed. Therefore, these powers should be specifically set out in the trust deed. Banks also generally insist on the trustee having an indemnity from the trust fund for actions undertaken by the trustee (absent fraud). The bank wants to ensure that, if it is necessary to sue the trustee, the bank will have access to the property of the trust. A further power which should be included is the power to advance capital to a beneficiary against a future share of the trust fund. This can enable provision to be made for a beneficiary facing hard times, or someone wishing to purchase a house, get married or start a family for whom money in the present, rather than in the future, when the trust vests, would be welcome. A typical clause allowing advancements of capital is as follows: CAPITAL ADVANCEMENT CLAUSE (1) The Trustee may as the Trustee thinks fit: (a) determine that any property forming part of the Trust Fund or that any part of the Trust Fund is held for the benefit of a Beneficiary absolutely; (b) transfer the whole or any part of the Trust Fund to any Beneficiary for that Beneficiary’s own use and benefit or apply the same for the benefit of that Beneficiary and, for that purpose, may raise the sum out of the capital of the Trust Fund; (c) lend any sum out of the Trust Fund and any money held in trust under this Deed to any Beneficiary upon terms the Trustee thinks fit; (d) pay or apply to or for any Beneficiary the whole or any part of the capital or income to which that Beneficiary is either absolutely or contingently entitled (even though the Beneficiary’s interest is liable to be defeated or diminished by the exercise of any power of appointment or revocation or by reason of any other matter); (e) where the Trustee is required or in its discretion has decided to pay any money to any Beneficiary who is either under the age of 18 years or under a legal disability, pay that money: (i) to the guardian or other person having the care or custody of the Beneficiary; (ii) to the parent of the Beneficiary whether the parent is the guardian or has the care or custody of the Beneficiary or not; or (iii) direct to the Beneficiary; without the Trustee being bound to see to its application; and (f) allow any Beneficiary to occupy, have custody of or use any property forming part of the Trust Fund, with or without payment of rent or other

30

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 440]

return and on such terms or conditions as to inventories, repair, replacement, insurance, outgoings or otherwise as the Trustee thinks fit. (2) The Trustee may appropriate any part of the Trust Fund or any asset of the Trust Fund in specie in satisfaction of the whole or any part of any sum which the Trustee may determine to pay or apply to or for the benefit of any Beneficiary under clause (1).

[2 440] Duties of the trustee A key element of a trust is the fiduciary relationship between the trustee and each beneficiary. The distinguishing characteristic of this relationship is that the trustee must act honestly and in good faith to serve the interests of the beneficiaries. The trustee is not free to use trust assets to pursue separate interests and cannot favour one beneficiary over another. However, this does not prevent the trustee of a discretionary trust from exercising a discretion in favour of one or more potential beneficiaries, provided the discretion is exercised honestly and in good faith and for the purposes of the trust. As well as the key fiduciary duty owed to the beneficiaries, a range of duties are imposed on the trustee by the trust deed, at general law and in equity, and by statute, under the relevant State or Territory Trustee Act. Specific legislation may impose additional duties on the trustees of certain types of trusts (eg the covenants applying to superannuation fund trustees by virtue of the Superannuation Industry (Supervision) Act 1993). It is therefore imperative that the trustee is fully aware of the terms of the trust deed and any applicable laws. A trustee must act with reasonable care. This means that the trustee’s duties need to be discharged to the standard of what an ordinary, prudent business person would do when managing similar affairs on behalf of another person. The trustee must invest the trust funds and manage the trust assets with prudence and skill, particularly in a commercial trust arrangement. This may mean that the trustee needs to manage an even spread of investments to ensure a continuing return or to invest more funds in capital appreciating assets over a period of time, depending on the objectives of the trust. As part of the duty to preserve property, a trustee might be required to pursue any debts owing to the trust and to properly supervise the conduct of managers. The trustee needs to keep a full and candid record of all transactions and activities of the trusteeship. The records or accounts should show how the trustee deals with trust property and whether those dealings are permitted by the trust deed. Beneficiaries generally have the right to access these trust documents, so the trustee is obliged to provide this information on request (Hancock v Rinehart [2015] NSWSC 646). On retirement, the trustee must deliver the trust documents to the new or continuing trustee. The duties and powers of the trustee cannot generally be delegated, even if an agent or employee is appointed. The trustee must act personally in regard to decisions and is personally accountable for the management of the trust assets. A trustee who commits a breach of trust may, depending on the nature of the breach, be personally liable to the beneficiaries. However, a court may relieve the 2016 THOMSON REUTERS

31

[2 450]

THE IMPORTANCE OF THE TRUST DEED

trustee from personal liability if the trustee has acted honestly and reasonably: eg see s 63(2) of the Trustee Act 1925 (NSW), s 67 of the Trustee Act 1958 (Vic).

[2 450] Trustee’s right of indemnity As a trust is not a legal entity, it is the trustee who is personally liable for debts and liabilities incurred by the trustee in its role as trustee. However, as a matter of general principle the trustee is entitled to be indemnified against the assets of the trust, provided the trustee is not acting fraudulently, or beyond its authorised powers under the trust deed. This general principle is of long standing. The income tax law recognises this right of indemnity by providing that a trustee is authorised (and also required) to retain, from money received in the trustee’s representative capacity, an amount sufficient to pay assessed tax (s 254(1)(d) of ITAA 1936): see [14 030]. For example, where a trustee borrows money for trust purposes, the trustee is personally liable for the debt, but is entitled to be indemnified against the assets of the trust. A distinction is drawn between the circumstance where a trustee discharges a debt from personal property and is then entitled to be reimbursed from the trust fund and the circumstance where the trustee is entitled to apply trust property to discharge the debt. In such a case it is said that the trustee is entitled to ‘‘exoneration’’. In some Australian States and Territories, the trustee’s right to be indemnified from trust property has been codified in legislation. Despite this, banks will generally insist on the trust deed containing an indemnity for the trustee before loaning money to the trustee, or allowing the trustee to act as guarantor. A bank is generally concerned to ensure that, if it must sue the trustee under the loan/guarantee, and the trustee has insufficient assets to cover the liability, the bank will have ultimate recourse to the assets of the trust. A typical indemnity clause is as follows: TRUSTEE INDEMNITY CLAUSE (1) The Trustee is entitled to be indemnified out of the Trust Fund against liabilities incurred by the Trustee by virtue of being the trustee of the Trust. (2) The Trustee is not entitled to be indemnified by the Settlor or by any Beneficiary personally in respect of any liabilities incurred by the Trustee in the administration of the Trust. (3) The Trustee is entitled to be reimbursed from the Trust Fund for all money expended and debts incurred in or about the administration of the Trust. (4) The Trustee may apply the Trust Fund to satisfy the rights of reimbursement or indemnity to which the Trustee is entitled.

In Chief Commissioner of Stamp Duties (NSW) v Buckle [1998] HCA 4; 37 ATR 393, the High Court held that a trustee’s right of indemnity out of trust assets is not an encumbrance on the interests of the beneficiaries (and therefore for State duty purposes does not decrease the value of the trust assets) but that it gives the trustee a beneficial interest in the trust assets. The High Court also held that the right of the trustee to be indemnified takes priority over the right of beneficiaries

32

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 450]

in relation to the assets. Accordingly, until the trustee’s right of reimbursement or exoneration has been satisfied, it is impossible to say what the trust fund is. This means in practice that a trustee cannot be compelled to surrender the trust property to the beneficiaries until the trustee’s right of indemnity has been satisfied. The entitlement of the beneficiaries is confined to so much of those assets as is available after the trustee’s right of indemnity has been satisfied or provision made for it. This aspect of the decision was confirmed by the High Court in the case of CPT Custodian Pty Ltd v Commissioner for State Revenue (Vic) [2005] HCA 53; 60 ATR 371. There are some court decisions to the effect that if there are insufficient trust assets to indemnify the trustee, the right of indemnity can be exercised against the beneficiaries personally (unless prohibited by the trust deed): see Hardoon v Belilios [1901] AC 118, JW Broomhead (Vic) Pty Ltd (in liq) v JW Broomhead [1985] VR 891, Poignand v NZI Securities Australia Ltd (1992) 37 FCR 363, Balkin v Peck (1998) 43 NSWLR 706. However, this would not apply to discretionary trusts. The Full Federal Court in Bruton Holdings Pty Ltd (in liq) v FCT [2011] FCAFC 79; 83 ATR 864 held that a corporate trustee that had been wound up and so was acting as bare trustee in relation to the trust assets nevertheless maintained its right of indemnity out of trust funds for legal fees it had incurred in contesting a garnishee notice served by the Commissioner. The Full Court held that although a bare trustee has a duty to refrain from active management of the trust, it still has an obligation to actively protect and maintain trust property. In the Bruton Holdings case, the bare trustee’s obligation extended to opposing the Commissioner’s claim. Accordingly, the Full Court found that the trustee was entitled to be indemnified out of the trust funds for the costs of its actions. Although these decisions are to be welcomed by trustees and liquidators, the priority given to the trustee’s right of indemnity may have unwanted capital gains tax consequences. Section 106-50 of ITAA 1997 allows the trust to essentially be ‘‘looked-through’’ when determining the CGT consequences of a CGT event where a beneficiary is ‘‘absolutely entitled’’ to a trust asset as against the trustee. In light of the decisions in the Buckle and CPT cases, it is to be queried whether a beneficiary can ever be said to be absolutely entitled to an asset as against the trustee, except in the case of a simple trust with no debts. Note that if the liability of a trustee exceeds the amount of trust assets and the trustee cannot exercise the right of indemnity against the beneficiaries, the trustee may be exposed to unlimited personal liability. For example, in Wooster v Morris [2013] VSC 594, the surviving trustee of a self-managed superannuation fund was personally liable to pay a death benefit to the deceased’s children, as well as statutory interest and the children’s legal costs, after the trustee failed to act impartially in administering the trust and breached her obligations as trustee. The potential personal exposure of trustees is one reason why a company is often used to act as a trustee: see [2 420]. However, the courts have the power to ‘‘pierce the corporate veil’’ to make a shareholder responsible for a company’s actions. This is what occurred in Wooster v Morris, where the surviving trustee was the sole director and shareholder of the company she appointed as co-trustee. 2016 THOMSON REUTERS

33

[2 460]

THE IMPORTANCE OF THE TRUST DEED

[2 460] Beneficiaries Beneficiaries can be individuals (including persons under a legal disability and children who are not yet born), trusts, companies and unincorporated associations. The settlor and the trustee can also be beneficiaries. However, if the trustee becomes the sole beneficiary, the legal and beneficial interests in the trust property will ‘‘merge’’ and the trust will cease to exist. To ensure the validity of the trust, it is necessary that the beneficiaries are sufficiently certain. It is not good enough to describe the beneficiaries as ‘‘all persons seen by Mr Smith in his lifetime’’ as this would not be sufficiently certain. However, to describe the class as ‘‘Mr Smith, his wife, children and grandchildren’’ is sufficiently certain, although this class may grow over time as children and grandchildren are born. Consideration should be given to the particular circumstances of the client and whether, for example, children should include adopted children, and whether, rather than ‘‘wife’’, it is better to use the term ‘‘spouse’’ to cover unmarried couples. It is advisable to allow for a broad range of beneficiaries to give maximum flexibility and cater for changing circumstances over time. A discretionary trust may have 50 beneficiaries but in fact distribute to only three. However, retaining the possibility to distribute to a wider range of beneficiaries is the best use of the trust structure. This must be balanced against the requirement for the class of beneficiaries to be sufficiently certain, so that the trust is not invalidated, and the requirement that there is a genuine intention of the trust existing for the benefit of the beneficiaries as defined, so that the trust is not a sham.

WARNING! A person named as a potential object of a discretionary trust is treated as a beneficiary of the trust for tax purposes, even if the person has not received any distributions from the trust: see Yazbek v FCT [2013] FCA 39; 88 ATR 792.

For discretionary trusts, it is usual to define the beneficiaries by reference to one or more ‘‘Named Beneficiaries’’. For example, a typical definition of beneficiaries reads: BENEFICIARIES DEFINITION CLAUSE (1) Discretionary Beneficiaries means: (a) the Named Discretionary Beneficiaries; (b) the parents of either of the Named Discretionary Beneficiaries; (c) the children and remoter issue of either of the Named Discretionary Beneficiaries; (d) the brothers and sisters of either of the Named Discretionary Beneficiaries, the children and grandchildren of such brothers and sisters and the spouses, widows or widowers of any of those persons; (e) the spouse of either of the Named Discretionary Beneficiaries or of the parents, children or remoter issue of either of the Named Discretionary Beneficiaries; and

34

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 460]

(f) any (i) (ii) (iii)

of the following entities, whether formed in Australia or elsewhere: the trustee, in its capacity as such, of any Eligible Trust; any Eligible Corporation; any other legal entity in which at least one share or other interest is beneficially owned by a Beneficiary including an Eligible Trust and/or an Eligible Corporation; (iv) any religious, charitable or educational institution; and (v) any other person or class of persons which the Trustee may determine; but every member of the Excluded Class is excluded even though such member may otherwise be or be qualified to be included as a Discretionary Beneficiary.

‘‘Eligible Corporation’’ is typically defined in the trust deed as ‘‘any corporation in which at least one share is owned by an Eligible Trust, or the Trust, or beneficially owned by a Beneficiary’’. Such a definition can encompass a wide range of companies. This definition is also likely to include the trustee itself (if it is a company). As it is preferable that the trustee be a sole purpose company (see [2 420]), it can then be specifically excluded from being a beneficiary to ensure that no argument can be run that the trustee has a conflict of interest or that income of the trust estate is essentially income of the trustee. However, if in fact the trustee also acts as trustee of other trusts, or carries out other functions in its own right, the trust deed may need to be carefully worded so that the trustee is not able to benefit from the trust in its capacity as trustee, but can distribute to itself as trustee of another trust, or in its own right. The definition of ‘‘Eligible Trust’’ is typically: ELIGIBLE TRUST CLAUSE Any trust or settlement, including any superannuation fund or approved deposit fund, under which any Beneficiary: (a) is a beneficiary; (b) may benefit as the result of the exercise of any power of appointment; or (c) is the holder of any interest, whether vested, contingent, prospective or expectant, or any interest which is likely to be divested including, without limitation, any expectancy; and which has a vesting date or which vests within the Perpetuity Period.

The definition of Eligible Trust does not have to be restricted to trusts with a vesting date within the perpetuity period. However, if distributions are made from one trust, which must vest by 31 December 2050, to another trust, which does not have to vest until 31 December 2080, the distribution will be valid when made, but will be invalidated on 1 January 2051 if the second trust has not vested by then. This is known as the ‘‘wait and see’’ rule. The ‘‘wait and see rule’’ means that distributions are not automatically invalidated simply because there is a possibility that the distribution will be held in another trust beyond the 2016 THOMSON REUTERS

35

[2 470]

THE IMPORTANCE OF THE TRUST DEED

end of the perpetuity period of the trust making the distribution. It will only be invalidated when in fact the rule against perpetuities is offended. See further Nemesis Australia Pty Ltd v FCT [2005] FCA 1273; 61 ATR 119, which considered Queensland’s ‘‘wait and see’’ rule (in s 210 of the Property Law Act 1974 (Qld)). To avoid the operation of this rule, it is safer to ensure that distributions are only made to trusts with a vesting date no later than that of the trust. A typical definition of ‘‘Excluded Beneficiaries’’ is as follows: EXCLUDED BENEFICIARIES CLAUSE (1) Excluded Class means: (a) the Settlor and any person claiming under or in right of the Settlor; (b) any child of the Settlor who is under the age of 18 years but only for so long as the child continues to be under the age of 18 years; and (c) any person whom the Trustee may determine to exclude from being a Beneficiary even though the person otherwise is or may become a Beneficiary and, as from the date of the Determination, the Beneficiaries are reduced accordingly; the Trustee may make the Determination either revocable or irrevocable, but if this is not stated the Determination is revocable.

Beneficiaries’ rights Beneficiaries have the right to proper administration of the trust: Gartside v IRC [1968] AC 553. They can apply to a court for an order requiring the trustee to act in accordance with the trust deed and can, in some circumstances, ask the court to grant an order requiring the trustee to discharge the trust. If the trustee has breached its obligations by, for example, converting trust assets into personal assets, the beneficiaries can sue for breach of trust. They can trace property improperly disposed of and may be entitled to reclaim the assets either from the trustee or from a third person. Where all the beneficiaries of a trust are of full age and sound mind (‘‘sui juris’’) and have an absolute vested and indefeasible interest in the entire trust property, they can group together and call on the trustee to transfer the property to them or at their direction. This is known as the rule in Saunders v Vautier (1841) 49 ER 282 and will result in the termination of the trust and the beneficiaries becoming the owners of the trust property.

[2 470] Appointors The appointor is someone identified in the trust deed with the power to remove, replace or add to the trustees of the trust. Accordingly, the appointor has ultimate control over the trust. It is not necessary to have an appointor – in the absence of the appointor, normally the trustee would have the right to resign, replace themselves or appoint additional trustees. However, the office of appointor provides a simple and effective method of controlling the trust, and allowing for succession planning. 36

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 470]

For a corporate trustee, control of the trustee will hinge upon the directors and shareholders of the trustee company. This can be complex to administer through the wills and estates of the relevant persons. It is simpler if a trust has an appointor. The trust deed can dictate who is to succeed to the office of appointor, and can also allow the appointor to appoint their own successors, or alter their successors, by execution of a deed. An appointor can be an individual or company, although in practice individuals are more common. In the context of a family discretionary trust, the appointor will commonly be the ‘‘directing mind’’ of the trust, that is, a husband or wife (or both) or another family member (eg see Re Gutteridge and FCT [2013] AATA 947, Mercanti v Mercanti [2015] WASC 297). A typical provision in a trust deed regarding the appointor and successor to the office of appointor will provide as follows: APPOINTOR AND SUCCESSOR CLAUSE (1) The following persons in succession are the Appointor: (a) the person named in Item # of the Schedule as the Appointor; (b) if more than one (unless otherwise stipulated in the Schedule) the persons so described jointly and their survivors (being those who have neither died nor resigned) jointly and the last survivor; and (c) upon the death or resignation of the person so described or the last of the persons so described, such person as the person described or the last of the persons so described may by deed (revocable or irrevocable) or will appoint. (2) A person appointed Appointor under clause (1) or if more than one the last survivor (who has not resigned) has the same right by deed or will of appointing an Appointor as the person who appointed him or her. (3) In default of appointment under the preceding provisions of this clause, the legal personal representative or the liquidator of the last Appointor may exercise the powers conferred by clause (1)(c).

Whether the trustee has the power to remove and replace the appointor depends on the terms of the trust deed. In Mercanti v Mercanti [2015] WASC 297, a family business was conducted via two discretionary trusts. The father was the appointor of both trusts. His youngest son was general manager of the business. Initially, the father and mother were the sole directors of the corporate trustees. Subsequently, the son was added as a director and the trust deeds of both trusts were amended to remove the father as appointor and replace him with the son. Some years later, the relationship between the son and his parents broke down and the father commenced legal proceedings, seeking declarations that he was invalidly removed as appointor of the trusts. While the proceedings were on foot and the son was overseas, the parents staged a ‘‘palace coup’’ by seizing the business premises and removing the son as director of the corporate trustees. The next day the son, in his capacity as appointor, replaced the corporate trustees of each trust with a company controlled by him. The Western Australian Supreme Court held that the father was validly removed as the appointor of one of the trusts because the trust deed allowed the trustee to amend the provisions of the trust deed, including the schedule describing the appointor. However, the 2016 THOMSON REUTERS

37

[2 480]

THE IMPORTANCE OF THE TRUST DEED

Court held that the trustee of the second trust did not have the power to remove the appointor. The relevant clause of the second trust deed allowed the trustee to vary ‘‘the trusts hereinbefore provided’’. In the Court’s view, this power of variation did not extend to varying the terms and conditions of the trust deed dealing with the office of appointor. It followed that the amendment to the second trust deed was invalid and the subsequent replacement of the trustee was not legally effective. The overall result was that son controlled the first trust while his father controlled the second.

[2 480] Guardians A trust does not have to have a guardian. However, a guardian can act as a check and balance to ensure that the trustee administers the trust in accordance with the intentions of the persons who established it. Typically the trust deed will require the consent of the guardian before the trustee may exercise certain powers, such as adding to the class of beneficiaries, determining that a person is excluded from being a beneficiary, amending the trust deed or exercising the discretion as to the manner of distribution of income of the trust. For instance, the trustee may not be able to distribute income and capital to certain beneficiaries without obtaining the guardian’s consent to do so. For the office of guardian to be effective, it needs to be a person or company independent of the trustee and, as in the case of the appointor, successors must be appointed, or able to be appointed.

LIFE SPAN OF A TRUST [2 500] Trusts have a certain life span Trusts, unlike companies, cannot live forever. The rule against perpetuities means that trusts must have a certain life span, and then be wound up, or ‘‘vest’’. The rule against perpetuities is an old common law doctrine. The rule seeks to prevent an unreasonable delay in property passing from one individual to another by tying it up in a trust structure. Originally the rule was that property could not be held in a trust for longer than a period ending 21 years after the death of a person alive when the trust was created. The custom of referring to a royal life as the passing of a member of the royal family is well documented and therefore allows the vesting date of the trust to be easily ascertained. In Australia, each State and Territory except South Australia has a statutory rule against perpetuities. In Victoria, it is possible to choose between a statutory perpetuity period of 80 years from establishment of the trust or the old common law rule. In South Australia, although theoretically trusts can continue forever, s 62 of the Law of Property Act 1936 (SA) allows parties to apply to the Supreme Court to end a trust 80 years after its establishment. To ensure that the rule against perpetuities is not infringed, trust deeds will generally require the trust to vest within the perpetuity period: see [2 510]. 38

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 510]

The rule against perpetuities does not apply to charitable trusts. Therefore charitable trusts can live forever.

[2 510] Vesting of the trust A trust deed will generally specify when the trust must end or ‘‘vest’’ or be ‘‘wound up’’. Except in South Australia, a trust will no longer be valid after the expiry of the perpetuity period: see [2 500]. Accordingly, most trust deeds will specify that the trust must vest on the last day of the perpetuity period but will also grant the trustee the discretion to determine that the trust ends on an earlier date. A spate of ‘‘death duty’’ trusts are now vesting and the vesting date of such trusts is generally dependent on the age of the grandchildren of the ‘‘directing mind’’ of the trust. However, this practice is no longer common. On vesting of the trust, the trustee is obliged to call in and sell all property, discharge all debts and liabilities of the trust and distribute the remaining property to the beneficiaries in accordance with the deed. The trustee will also be required to file a tax return for the trust up to the date of vesting, cancel the tax file number and, if applicable, GST registration and Australian business number. A trust deed should permit the trustee to wind up the trust and distribute the assets of the trust in specie to the beneficiaries rather than being required to sell those assets and distribute the proceeds of sale. The vesting of the trust may give rise to CGT, State duty and GST liabilities. A sale of assets of the trust to third parties will result in CGT event A1 occurring, which may give rise to capital gains or losses at the trust level: see [5 100]. A distribution of assets in specie to beneficiaries will generally result in CGT event E5 occurring as the beneficiaries become ‘‘absolutely entitled’’ to those assets, and this can have CGT consequences for both trustee and beneficiary: see [5 160]. It is therefore wise not to distribute all assets of the trust before the tax liabilities have been calculated and accounted for. A typical clause regarding the vesting date of the trust is as follows: VESTING DATE CLAUSE The Trustee may determine that the Trust terminates on any date, which is before the last day of the Perpetuity Period, as it thinks fit.

A typical clause regarding the trustee’s obligations on vesting of the trust is as follows: TRUSTEE’S OBLIGATIONS ON VESTING CLAUSE (1) As from the Vesting Date, the Trustee must hold the Trust Fund and its income: (a) for any of the Discretionary Beneficiaries to the exclusion of the others and in such proportions as the Trustee determines, which Determination may be either revocable or irrevocable but, if the Determination is revocable, it is revocable only until the end of the day preceding the Vesting Date when it becomes irrevocable; or

2016 THOMSON REUTERS

39

[2 520]

THE IMPORTANCE OF THE TRUST DEED (b) if the Trustee does not exercise the discretion contained in clause (1)(a) (or to the extent to which the Trustee does not exercise or does not effectively exercise that discretion), for the Residuary Beneficiaries living at the Vesting Date and if more than one in equal shares, but if any Residuary Beneficiary dies before the Vesting Date leaving children or remoter issue living at the Vesting Date, those issue take in equal shares per stirpes the share which the Residuary Beneficiary would have taken had he or she survived to the Vesting Date. (2) If any part of the Trust Fund is not effectively or validly disposed by the provisions of clause (1), the Trustee holds that part of the Trust Fund for such charitable objects or purposes as the Trustee determines and, in default of any Determination, as any court having jurisdiction decides, any resulting trust to any member of the Excluded Class being expressly negatived.

[2 520] Power to amend the trust deed Trusts are typically established with an intended life span of up to 80 years. Many of the trusts vesting today may have been established in the 1930’s. The changes in law, particularly taxation laws, culture, business and methods of transacting business, mean that a trust deed is likely to become out of date during its life span. It is therefore important that a trust deed permits the trustee to amend the deed, subject to safeguards. A typical clause is as follows: CLAUSE RELATING TO AMENDMENTS TO TRUST DEED (1) The Trustee may by Determination (revocable or irrevocable) revoke, add to or vary all or any of the trusts, powers, terms and conditions contained in this Deed (or the trusts, powers, terms and conditions contained in any variation, alteration or addition made to this Deed) and may, by the same or any other Determination, declare any new or other trusts, powers, terms and conditions concerning the whole or any part of the Trust Fund. (a) The Determination may state the date from which the various alterations or additions take effect. (b) This date may be earlier or later than the date on which the Determination is made, and the variations, alterations or additions take effect from the date so stated. (c) If no date is stated then the variations, alterations or additions take effect from the date the Determination is made. (2) No revocation, addition or variation may: (a) be in favour of or for the benefit of any member of the Excluded Class; (b) affect the beneficial entitlement to any amount set aside for any Beneficiary prior to the date of the variation, alteration or addition; or (c) have the effect of extending the Vesting Date beyond the Perpetuity Period. (3) Subject to clause (2) any revocation, addition or variation may: (a) vary all or any of the powers or provisions contained in this Deed (or in any variation of this Deed);

40

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 530]

(b) add any persons or class of persons as Beneficiaries; or (c) exclude any persons or class of persons as Beneficiaries.

In Andtrust Pty Ltd v Andreatta [2015] NSWSC 38, the trust deed gave the trustee of a discretionary trust the power to ‘‘vary any of the trusts, powers discretions or duties herein set forth in any manner whatever including but without in any way limiting the generality of the foregoing, enlarging any category of eligible beneficiaries so far as this power shall not infringe the rule against perpetuities’’. The NSW Supreme Court held that this clause empowered the trustee to extend the vesting date of the trust (to the maximum statutory period). Amendments to a trust deed raise the issue of ‘‘resettlement’’ of the trust: see [2 530]. The trustee’s power to amend a trust deed must be exercised bona fide for the benefit of the beneficiaries as a whole and not merely in the interests of one beneficiary or for the trustee personally. In Re Lambert and FCT [2013] AATA 442, the trustee was also one of the beneficiaries of a discretionary trust (together with his spouse and certain charities). He executed a deed of variation, the intended effect of which was to enable him to receive the entire income from the trust fund unless he gave notice to the trustee (himself) that he should not receive all of the income. The trustee then purchased three investment properties. Rental income from these properties was paid into the trustee’s personal bank account. The AAT found that the purported variation to the trust deed was an ineffective exercise of the power to amend the trust deed. This was because it was exercised solely for the trustee’s benefit and without fulfilling the obligation to disclose details of the variation to the other beneficiaries of the trust.

[2 530] Changes to a trust resulting in resettlement The Commissioner’s former view on whether a resettlement arises for income tax purposes was contained in a controversial document, Creation of a New Trust – Statement of Principles (Statement of Principles), issued in 1999 and updated in August 2001. The Statement of Principles provided that a new trust would arise if there was a change in the essential nature and character of the original trust relationship. The Statement of Principles listed the following as some of the changes which raised the question of whether a new trust had been created: (i) Any change in beneficial interests in trust property. (ii) A new class of beneficial interest (whether introduced or altered). The Commissioner considered that changes amounting to a redefinition of the membership class or classes would terminate the original trust, whereas changes in the membership of a continuing class were consistent with a continuing trust. (iii) A possible redefinition of the beneficiary class. (iv) Changes in the terms of the trust or the rights or obligations of the trustee. (v) Changes in the nature or features of trust property. 2016 THOMSON REUTERS

41

[2 530]

THE IMPORTANCE OF THE TRUST DEED

(vi) Additions of property which could amount to a new and separate settlement. (vii) Depletion of the trust property. (viii) A change in the termination date of the trust. (ix) A change to the trust that is not contemplated by the terms of the original trust. (x) A change in the essential nature and purpose of the trust. (xi) A merger of two or more trusts or a splitting of a trust into two or more trusts. In its Decision Impact Statement on FCT v Bamford [2010] HCA 10; 75 ATR 1, the Tax Office said that where a trust deed is amended to insert a definition of income (particularly if a re-characterisation or equalisation clause is inserted), the tax effect of the amendment would need to be determined in accordance with its Statement of Principles. The Tax Office view in the Statement of Principles was demonstrated by two court decisions to be overly conservative. In FCT v Commercial Nominees of Australia Ltd [2001] HCA 33; 47 ATR 220, the issue was whether changes to a superannuation trust deed caused a resettlement of the superannuation trust fund. Even though the changes were significant (the trust changed from a defined benefits fund to an accumulation fund) the High Court held that there was no resettlement. However, the Tax Office confined its view of the case to superannuation funds only, and considered that its Statement of Principles was still a correct statement of the law with respect to all other types of trusts. In a subsequent case, FCT v Clark [2011] FCAFC 5; 79 ATR 550, the Full Federal Court held that the High Court decision in Commercial Nominees applied equally to other types of trusts and the same analysis should be applied to determine if a resettlement has occurred. Clark’s case centred on the ability of the trustee to carry forward to the 2000-01 income year capital losses from the disposal of shares in the period 1991 to 1993. There had been significant amendments in the intervening period, including changing the trustee of the relevant trust; altering the ownership of the units of that trust; extinguishing liabilities of the trust; extinguishing the former trustee’s right of indemnity out of trust assets; altering the corpus of the trust; and changing the activities of the trust from being dormant to a vehicle used by the trust’s controller to take advantage of accumulated losses in the trust. The Full Federal Court found that the fundamental obligations and objects of the trust did not change as the trust deed itself was not altered, and that the deed contemplated changes in trust property and changes in unit holdings. The case confirms that, in determining the ‘‘essential’’ nature of the trust, it is of paramount importance to examine the trust deed to identify the context and intention of the trust.

Commissioner’s current position The Statement of Principles was withdrawn in April 2012, but only after the High Court had refused to grant the Commissioner special leave to appeal the decision in Clark’s case. In Taxation Determination TD 2012/21, the Commissioner 42

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 530]

acknowledged that the approach set out in the Statement of Principles was not sustainable. The Commissioner now accepts that ‘‘continuity of trust is a function of whether the trust continues in existence under trust law in contradistinction to having terminated’’. Specifically, TD 2012/21 provides that CGT event E1 (creating a trust over a CGT asset by declaration or settlement: see [5 120]) will not happen if the terms of a trust are changed pursuant to a valid exercise of a power in the trust deed (or are varied with a court’s approval), and there is some continuity of property and membership of the trust. CGT event E2 (transferring a CGT asset to a trust: see [5 130]) will also not occur. These CGT events will, however, occur if the amendment causes the trust to terminate for trust law purposes, or leads to a particular asset being subject to a separate charter of rights and obligations, such as to give rise to the conclusion that that asset has been settled on terms of a different trust. In this respect, TD 2012/21 refers to a State duty case, Commissioner of State Revenue (Vic) v Lam & Kym Pty Ltd [2004] VSCA 204; 58 ATR 60, where it was held that a new trust arose when the trustee of a discretionary trust declared that the trust’s assets would no longer be available to some of the discretionary beneficiaries. Taxation Determination TD 2012/21 includes four examples to illustrate its operation. In three of these examples, the Commissioner accepts that a resettlement does not arise if: • the trustee of a discretionary trust amends the trust deed to insert a definition of income (equating trust income with net income) and a power to stream, and also to extend the vesting date by 30 years. In this example, the trust deed gives the trustee an unfettered power of amendment; • the trustee of a discretionary trust validly exercises the powers under the trust deed to remove an object (a company sold to a third party) and to add new objects (family members, trusts and companies that the family has a majority interest in, and an unrelated charity); • the trust deed of a unit trust is amended (pursuant to a power to amend and with the consent of the unit holders) to expand the trustee’s power to invest. In the following example, based on example 4 of TD 2012/21, the Commissioner concludes that there is a resettlement. EXAMPLE The trustee of a discretionary trust has a wide range of powers, including the power to declare that particular assets of the trust estate are to be held for one or more beneficiaries to the exclusion of the other beneficiaries. The trustee declares that one asset should be held exclusively for a particular beneficiary (B). The following month, the trustee declares that a second asset should be held exclusively for B. In the Commissioner’s view, the effect of the declarations is that the two assets are no longer held on that trust but are held on the terms of a separate trust for the benefit of B as sole beneficiary. As a result, CGT event E1 happens when the separate trust for the benefit of B is created over the first asset. CGT event E2 then happens when the second asset is transferred to that separate trust.

2016 THOMSON REUTERS

43

[2 540]

THE IMPORTANCE OF THE TRUST DEED

In Oswal v FCT [2013] FCA 745; [2014] FCA 812, the trustee of a discretionary trust exercised a special power of ‘‘appointment’’ to make two beneficiaries (the trustee and his wife) absolutely entitled to part of the corpus of the trust (being certain shares in a related company). The Federal Court found that CGT event E1 occurred because the legal effect of the appointment was to create a separate trust over that part of the corpus for the absolute benefit of the beneficiaries. The Court dismissed the taxpayers’ argument that the effect of the declaration was simply to establish a ‘‘separate fund of assets under the umbrella of the trust’’.

Proposed rewrite of trust laws and resettlements The previous Government’s 2012 policy options paper, Taxing Trust Income Options for Reform (see [16 010]), made the following remarks (at p 14) about changes to trusts deeds and possible transitional relief if the changes lead to a resettlement: “The Government is aware that decisions taken to change the taxation of trust income may lead users of trusts to alter their trust deeds. Such changes may lead to a resettlement of the trust estate … These issues will be considered further as part of the broader question of transitional relief when the final policy is settled by the Government. A number of factors will be relevant to determining whether relief might be appropriate, including, for example, the extent of any changes to the trust income tax provisions, and also whether those changes mandate or merely provide incentives to change trust deeds.”

[2 540] Applying to a court to vary the trust deed The courts have an inherent jurisdiction to vary a trust deed, but will only exercise this power if the circumstances are exceptional and urgent: Paloto Pty Ltd v Herro [2015] NSWSC 445. The various Trustee Acts of the States and Territories also allow trustees to apply to a court for an order to vary the trust deed, provided the variation is in the interests of the beneficiaries as a whole (eg s 81 of the Trustee Act 1925 (NSW), s 94 of the Trusts Act 1973 (Qld) and s 63 of the Trustee Act 1958 (Vic)). In Re Alan Synman Family Trust [2013] VSC 364, the Victorian Supreme Court refused to vary a trust deed to give the trustee a general power of variation. The Court was not satisfied that granting such a wide power would benefit those beneficiaries who were minors (and so were incapable of consenting to the changes). See also George v Kollias [2007] VSC 46 and Perpetual Trustees Victoria Limited v Barns [2012] VSCA 77. In New South Wales, the Court of Appeal has held that an order giving a trustee a comprehensive power to vary the terms of the trust deed is not authorised by s 81 of the Trustee Act 1925 (NSW): Re Dion Investments Pty Ltd [2014] NSWCA 367.

Court application to extend vesting date Trustees have successfully applied to the relevant State court to extend the vesting date of a trust so as to defer any tax liability that would arise when the trust property is distributed to the beneficiaries (see [2 510]): Stein v Sybmore Holdings Pty Ltd (2006) 64 ATR 325, Re Plator Nominees Pty Ltd [2012] VSC 284, Re Arthur Brady Family Trust; Re Trekmore Trading Trust [2014] QSC 244. 44

2016 THOMSON REUTERS

THE IMPORTANCE OF THE TRUST DEED

[2 540]

In Re Arthur Brady Family Trust; Re Trekmore Trading Trust [2014] QSC 244, the trustees of two discretionary trusts wished to extend the vesting date of each trust by up to 40 years (to the maximum statutory period of 80 years). The trusts held portfolios of commercial and industrial real estate valued at over $15 million and, if the vesting dates were not changed, nearly $2 million in CGT and State duty would be payable on the distribution of the real property assets. There were also unpaid entitlements owing to beneficiaries. The trustees submitted that the common intention of all concerned was that the trusts should be the commercial vehicle for substantial investment in continuing income streams and that this should continue for as long as possible. Further, in order to maintain the same property portfolios within the two branches of the families involved, the taxes would need to be paid with borrowed funds and this would result in extra costs and a substantial burden on each trust. The Queensland Supreme Court concluded that it had the discretion to make the orders sought, taking into account the substantial impact of taxes and duties on the trust funds, and the unanimous approval of all potential beneficiaries. In Paloto Pty Ltd v Herro [2015] NSWSC 445, however, the NSW Supreme Court refused to exercise its inherent jurisdiction to extend the vesting date of the trust in order to defer a CGT liability. The power of variation contained in the trust deed ceased to be available following the settlor’s death in 1991. The Court refused to grant the relief sought, holding that the payment of CGT on the vesting of the trust was not an ‘‘emergency … in the course of administration which needed to be resolved in the interests of preserving the trust property’’. In reaching this decision, the Court observed that because the settlor had deliberately chosen to include a definition of ‘‘vesting day’’ in the trust deed (when he amended the trust deed in 1974) and had made no subsequent changes to it following the introduction of the CGT regime, ‘‘the giving of the relief sought would be tantamount to the creation of a new trust’’. The Tax Office now accepts that merely extending the vesting date will not result in a trust resettlement (example 3 of TD 2012/21): see [2 530].

Court application to rectify trust deed to express settlor’s intention As well as the inherent jurisdiction to vary trusts, the courts have the jurisdiction to rectify a trust deed so that it expresses what the settlor intended. In Re Keadly Pty Ltd & Ors [2015] SASC 124, the South Australian Supreme Court allowed the trust deeds of three discretionary trusts to be retrospectively rectified so that the trustees could satisfy the requirements of a stamp duty exemption for inter-generational transfers of farm property (see [17 030]). The Court accepted that the settlor, an accountant, made a mistake about the wording of the trust deeds and did not intend to establish trusts that included beneficiaries who were not relatives for the purposes of the exemption. In the Court’s view, the equitable remedy of rectification was available even though the mistake may have been due to the accountant’s negligence and rectification was sought to avoid a tax liability. In Domazet v Jure Investments Pty Ltd [2016] ACTSC 33, the ACT Supreme Court agreed to rectify certain trust instruments due to a solicitor’s mistake concerning the perpetuity period applicable to the trust.

2016 THOMSON REUTERS

45

46

2016 THOMSON REUTERS

PART 2 TRUST INCOME 3 TAXATION OF TRUST INCOME – DIV 6 4 STREAMING OF TRUST INCOME 5 TRUSTS AND CAPITAL GAINS TAX 6 TRUST-RELATED DEDUCTIONS 7 TRUST LOSSES

2016 THOMSON REUTERS

47

48

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6

3

OVERVIEW OF DIV 6 Taxation of trust income ............................................................................ [3 000] Other provisions dealing with trusts ...................................................... [3 010] Key concepts in Div 6 ................................................................................ [3 020]

PRESENT ENTITLEMENT What is present entitlement? .................................................................... How does present entitlement arise? ...................................................... When does present entitlement arise? .................................................... Disclaimer of present entitlement to trust income ............................... Relevance of present entitlement to the streaming rules ....................

[3 100] [3 110] [3 120] [3 130] [3 140]

CORE TRUST INCOME ASSESSING PROVISIONS Core provisions of Div 6 ............................................................................ [3 200] Taxation of beneficiary ............................................................................... [3 210] Taxation of trustee ....................................................................................... [3 220]

INCOME AND NET INCOME OF A TRUST ESTATE Income of a trust estate .............................................................................. [3 Bamford’s case ............................................................................................. [3 The decision in Cajkusic ............................................................................ [3 Lessons from the court cases .................................................................... [3 Commissioner’s response to Bamford ..................................................... [3

300] 310] 320] 330] 340]

MAKING AN EFFECTIVE DISTRIBUTION Resolutions and distribution minutes ..................................................... [3 Step-by-step guide to making effective trust distributions ................. [3 How to determine the income of the trust ............................................ [3 How to determine the net income of the trust ...................................... [3 Differences in trust income and net income .......................................... [3 Case study .................................................................................................... [3 Drafting the distribution minute .............................................................. [3

400] 410] 420] 425] 430] 440] 450]

DISTRIBUTIONS TO TAX-EXEMPT ENTITIES Trust distributions to tax-exempt entities ............................................... [3 500] Exempt entity is not notified of present entitlement by 31 August ...................................................................................................... [3 510] Exempt entity receives disproportionate share of net income ........... [3 520] 2016 THOMSON REUTERS

49

[3 000]

TAXATION OF TRUST INCOME – DIV 6

OVERVIEW OF DIV 6 [3 000] Taxation of trust income The general rules for assessing income that has been derived through a trust structure are contained in Div 6 of Pt III of ITAA 1936 (ss 95 – 102). The object of Div 6 is to ensure that the taxable income (‘‘net income’’) of a trust estate is subject to tax, either in the hands of one or more beneficiaries or the trustee. A beneficiary’s liability to pay tax is based on present entitlement (see [3 100]) to a ‘‘share of the income of the trust estate’’ (see [3 300]). Where this liability exists and the beneficiary is not under a legal disability, the beneficiary is assessed on “that share of the net income of the trust estate” (see [3 210]). A non-resident beneficiary who is presently entitled to foreign source income is not subject to Div 6 tax. The trustee is assessed on net income to which no beneficiary is presently entitled, net income to which a beneficiary under a legal disability is presently entitled, and Australian source income to which a non-resident beneficiary is presently entitled (see [3 220]). Where capital gains or franked distributions are derived through the trust, the process of determining who is assessable on the net income of the trust estate also requires the application of the following provisions, in addition to Div 6: • Subdiv 115-C of ITAA 1997 – to work out what share of each capital gain is assessable to beneficiaries and the trustee; • Subdiv 207-B of ITAA 1997 – to determine what shares of franked distributions (including any attached franking credits) are assessable to beneficiaries and the trustee; and • Div 6E of Pt III of ITAA 1936 – to avoid double taxation by excluding capital gains, franked distributions and franking credits from various Div 6 calculations. To ensure the correct beneficiaries are made presently entitled to the trust income (and specifically entitled to any capital gains or franked distributions), the trustee of a discretionary trust needs to make a resolution by 30 June of the relevant income year (see [3 400]). This commentary focuses on the application of Div 6 to resident discretionary trusts and resident beneficiaries as these are the most common circumstances faced by advisers. The streaming rules for capital gains and franked distributions are considered in detail at [4 000], while trust-related deductions and trust losses are discussed at [6 000] and [7 000] respectively.

[3 010] Other provisions dealing with trusts As well as the general trust income tax provisions (see [3 000]), Australia’s tax legislation includes a number of specific rules dealing with income flowing through trusts. These rules are generally restricted to specialised matters or specific types of trusts. For example, special provisions apply in relation to taxing the following trusts: 50

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 010]

• public trading trusts (Div 6C of Pt III of ITAA 1936), which are taxed as companies; • superannuation funds, approved deposit funds superannuation trusts (Div 295 of ITAA 1997); and

and

pooled

• managed investment trusts and attribution managed investment trusts (see [1 200]). Closely held trusts are subject to special rules concerning the disclosure of information (see [12 000]). Specific rules (outside Div 6) apply in relation to: • streaming capital gains and franked dividends (see [4 000]); • net capital gains of trusts (see [5 000]); • trust losses (see [7 000]); • unpaid present entitlements of corporate beneficiaries (see [11 000]); • unearned income of minors derived through trusts (see [13 000]); • income of trusts that are part of a consolidated group (Pt 3-90 of ITAA 1997); and • certain income (dividends, interest and royalties) to which a nonresident beneficiary is presently entitled where the general withholding tax rules apply to that income (Div 11A of Pt III of ITAA 1936). Income taxed under the withholding tax rules or excluded from those rules is not taxed again under Div 6. The following table sets out the key provisions in the income tax legislation dealing with income flowing through a trust structure. Division or Part Div 6 Pt III ITAA 1936 (ss 95AAA to 102) Div 6AAA Pt III ITAA 1936 (ss 102AAA to 102AAZG)

Topic Trust income

Transferor rules

2016 THOMSON REUTERS

Explanation Division 6 sets out the basic income tax treatment of the net income of a trust estate trust Where an Australian resident transfers property or services to a non-resident trust and certain other conditions are met, the attributable income derived by the trustee can be included in the assessable income of the Australian resident. If both Div 6AAA and Div 6 apply, the amount of income assessed under the transferor trust rules is reduced by the amount assessed under Div 6: see [10 070].

51

[3 010]

TAXATION OF TRUST INCOME – DIV 6

Division or Part Topic Explanation Div 6AA Pt III Income of certain Special rules assess ‘‘unearned income’’ derived by a person aged ITAA 1936 (ss children under 18, either directly or through a 102AA to 102AJ) trust estate. Income derived by the beneficiary of a trust estate who is under 18 at the end of the income year and is not an ‘‘excepted person’’ (eg a full-time employee) is taxed in the hands of the trustee at penalty rates, unless that income is ‘‘excepted trust income’’ (eg income from testamentary trusts or certain child maintenance trusts): see [13 000]. unit Corporate unit trusts are treated as Div 6B Pt III ITAA Corporate companies for income tax purposes 1936 (ss 102D to trusts and pay tax at the corporate tax rate. 102L)* Distributions made by a corporate unit trust are treated as dividends and the imputation system applies to such trusts. The debt/equity rules also apply. Division 6 does not apply to corporate unit trusts. trading Public trading trusts are taxed in the Div 6C Pt III ITAA Public same way as companies. The trustee 1936 (ss 102M to trusts is taxed at the corporate tax rate and 102T) distributions to beneficiaries are taxed as dividends. The imputation system and the debt/equity rules apply to these trusts. Division 6 does not apply to public trading trusts. Div 6D Pt III ITAA Closely held trusts Trustees of closely held trusts may be required to disclose details of trustee 1936 (ss 102UA to beneficiaries who are presently 102UV) entitled to certain income of the trust and tax-preferred amounts. If an appropriate statement is not given within the required period, or an incorrect statement is given, the trustee may be liable for tax: see [12 100].

52

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 010]

Division or Part Div 6E Pt III ITAA 1936 (ss 102UW to 102UY)

Topic Adjustment of Div 6 assessable amounts

to Div 7A Pt III ITAA Distributions 1936 (ss 109B to entities connected with private 109ZE) company

Div 11A Pt III Dividends, interest ITAA 1936 (ss and royalties 128AAA to 128R) Sch 2F ITAA 1936 Trust losses (ss 265-5 to 272140)

Div 50 ITAA 1997

Exempt entities

Divs 84 to 87 ITAA Alienation of 1997 personal services income

Divs 104 to 109 CGT provisions ITAA 1997

2016 THOMSON REUTERS

Explanation Where the net income of a trust estate includes capital gains and/or franked distributions, Div 6E recalculates the income and net income of the trust estate, plus each beneficiary’s present entitlement to trust income, by assuming the trust has no capital gains or franked distributions. This enables the beneficiaries (or trustee) to be assessed under Div 6 in respect of amounts that do not represent capital gains or franked distributions (thus avoiding double taxation). Integrity rules seek to prevent private companies from making tax-free distributions of profits to shareholders (or the shareholders’ associates). Where the private company is a beneficiary with an unpaid present entitlement, a deemed dividend may arise under Div 7A: see [11 000]. Income that is dealt with under the withholding tax rules is not taxed again under Div 6. Special rules restrict the circumstances in which current year and prior year losses and certain other deductions can be utilised by trusts: see [7 000]. Income derived by the trustee of a registered charitable trust is exempt from income tax: see [1 170]. Certain income derived by an entity from the personal efforts or skill of an individual may be deemed to be the individual’s assessable income. A trust is a ‘‘personal services entity’’ if the trust’s income includes the personal services income of one or more individuals. A number of CGT events involve trusts (eg the ‘‘E’’ events): see [5 100].

53

[3 010]

TAXATION OF TRUST INCOME – DIV 6

Division or Part Topic Explanation Subdiv 115-C Capital gains made Subdivision 115-C contains the rules for taxing capital gains made through ITAA 1997 (ss 115- by trustee trust structures. It also enables the 200 to 115-230) streaming of capital gains (if permitted by the trust deed): see [4 300]. A beneficiary who is assessed on a capital gain is deemed to have made a capital gain and can apply capital losses, and then any CGT discounts, to the gain: see [5 040]. Divs 122 to 126 CGT rollover relief CGT rollover relief is provided for ITAA 1997 various CGT events involving trusts (eg trust cloning rollover relief in Subdiv 126-G): see [5 700]. Div 152 ITAA 1997 CGT small business Various concessions reduce, eliminate or provide a rollover for a capital concessions gain made on a CGT asset used in a small business: see [8 200]. Subdivision 207-B contains the rules Subdiv 207-B ITAA Franked for taxing franked distributions 1997 (ss 207-25 to distributions derived by trustee (including any attached franking 207-59) credits) derived through trust structures. It also enables the streaming of franked distributions (if permitted by the trust deed). Div 235 ITAA 1997 Instalment warrants ‘‘Look-through’’ treatment is provided for instalment warrants and instalment receipts (and limited recourse borrowing arrangements entered into by regulated superannuation funds). This ensures that most income tax and CGT consequences associated with the underlying assets of the instalment trust flow through to the investor and not to the trustee. Div 275 ITAA 1997 Managed Trustees of managed investment investment trusts: trusts can elect to apply the CGT deemed capital provisions as the primary code for account rules taxing gains and losses on disposal of certain assets held as passive investments. Eligible assets include shares, units in unit trusts, real property, and rights or options to acquire or dispose of any of those types of assets.

54

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 010]

Division or Part Topic Div 276 ITAA 1997 Attribution managed investment trusts

Explanation A special tax regime applies to eligible managed investment trusts that choose to be treated as attribution managed investment trusts. An income attribution mechanism determines tax liabilities (instead of the present entitlement system in Div 6), with amounts retaining their tax character as they flow through the trust to its members: see [1 200]. Div 295 ITAA 1997 Superannuation A special tax regime applies to funds superannuation funds, approved deposit funds and pooled superannuation trusts. Certain trust distributions to complying funds are treated as non-arm’s length income and are taxed at penalty rates. business Optional rollover relief is provided Subdiv 328-G Small ITAA 1997 (ss 328- restructure rollover for asset transfers between small business entities as part of a genuine 420 to 328-475) business restructure: see [8 300]. Fixed trusts carried on solely for the Div 415 ITAA 1997 Designated purpose of a designated infrastructure infrastructure project can uplift the projects value of carry-forward tax losses by the 10-year government bond rate. Their carry-forward losses and bad debt deductions are excluded from the trust loss and bad debt deduction tests. Div 615 ITAA 1997 Rollovers for Unit holders may qualify for optional rollover relief if their units are business exchanged for shares in an interposed restructures company.

2016 THOMSON REUTERS

55

[3 020]

TAXATION OF TRUST INCOME – DIV 6

Division or Part Topic Pt 3-90 ITAA 1997 Consolidation

Subdiv 12-E of Sch TFN withholding 1 TAA (ss 12-175 to 12-185) Subdiv 12-H of Sch PAYG withholding 1 TAA (ss 12-375 to 12-430)

Subdivs 45-I and PAYG instalments 45-N of Pt 2-10 TAA (ss 45-280 to 45-300, 45-450 to 45-535)

Explanation A trust is included in a consolidated group if all of its membership interests are owned (directly or indirectly) by a resident head company. Trust income is deemed to be income of the head company for the purposes of calculating the head company’s income tax liability and the net income of the trust (ss 701-1 and 701-65 of ITAA 1997). Division 6 does not apply to that income during the period of consolidation. Closely held trusts (including family and related trusts) are subject to the TFN withholding regime: see [12 200]. Trustees of managed investment trusts are required to withhold an amount from payments of Australian sourced net income (other than dividends, interest and royalties) to entities whose address, or place for payment, is outside Australia: see [1 200]. Custodians and other entities may also have withholding obligations under Subdiv 12-H. Beneficiaries (and in some cases trustees) may need to pay instalments against their expected tax through the PAYG instalment system.

* The Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2016 repealed Div 6B from 1 July 2016.

[3 020] Key concepts in Div 6 The general trust income tax provisions rely heavily on special concepts (like present entitlement and legal disability) to determine how the net income of a trust is assessed, who is assessed and the applicable tax rate. The following terms have a special meaning in the context of Div 6 of Pt III of ITAA 1936. Where the term is defined in the legislation, the definitional section is noted.

56

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 020]

Term

Meaning

Trust estate

The property that forms the subject of the trust or the source of the income that is subject to the trust: see [2 410]. The Div 6 ‘‘income of the trust estate’’ is the income that arises from the property (or other source) that is the ‘‘trust estate’’.

Income of the trust The amount that, under trust law principles and the relevant estate terms of the trust deed, is treated as income of the trust estate (FCT v Bamford [2010] HCA 10; 75 ATR 1): see [3 420]. A beneficiary’s Div 6 liability is determined by reference to the income of the trust estate. The income of a trust estate is commonly called trust income, distributable income or accounting income. Net income of the The total assessable income of the trust estate (including net trust estate capital gains), less all allowable deductions (subject to some minor exceptions), ie taxable income (s 95(1) of ITAA 1936): see [3 425]. The calculation of the net income is made as if the trustee is a resident taxpayer, so the net income includes income from both Australian and foreign sources. Share of the net The proportion of the net income of the trust estate (FCT v income of the trust Bamford [2010] HCA 10; 75 ATR 1): see [3 300]. estate Beneficiaries are assessed on their share of the net income. Resident trust estate

Non-resident estate

A trust estate that has, at any time during the income year, a resident trustee or central management and control in Australia (s 95(2) of ITAA 1936): see [3 200].

trust A trust estate that is not a resident trust estate, ie a foreign trust (s 95(3) of ITAA 1936): see [3 200].

Present entitlement

An indefeasible, absolutely vested, beneficial interest in possession in the income of the trust estate and the legal right to demand and receive payment of the income: see [3 100]. A beneficiary’s Div 6 liability is based on present entitlement (whether actual or deemed). A beneficiary’s present entitlement is also relevant in allocating capital gains and franked distributions that are not streamed.

Indefeasible interest

A beneficial interest that is not subject to any condition (Trustees of the Estate Mortgage Fighting Fund Trust v FCT [2000] FCA 981; 45 ATR 7).

Vested interest

An immediate fixed right to present or future enjoyment of trust property.

2016 THOMSON REUTERS

57

[3 100]

TAXATION OF TRUST INCOME – DIV 6

Term Legal disability

Meaning When a beneficiary is unable to give the trustee an immediate valid discharge in respect of a distribution of income, eg because the beneficiary is a bankrupt or a minor (ie a person under 18). A company that goes into liquidation, voluntary administration or receivership is not under a legal disability.

For ease of reference, this commentary uses the following terms: • ‘‘trust’’ and ‘‘trust estate’’ are taken as meaning the same thing; • ‘‘trust income’’ is the income of the trust estate as determined by trust law and the terms of the trust deed; • ‘‘net income’’ is the net income of the trust estate as defined in s 95(1) of ITAA 1936; and • ‘‘ordinary income’’ means income determined by trust law principles and generally accepted accounting principles. It is important to note the different concepts of income that must be considered and not to confuse them in the Div 6 context. For example, some deeds use the term ‘‘net income’’ to describe the trust income. The use of this term in a trust deed should not be confused with the use of the term in Div 6. This is perhaps one of the main causes of confusion in making effective trust distributions. For the key terms and concepts applying to the streaming rules (eg specific entitlement and net financial benefit), see [4 110].

PRESENT ENTITLEMENT [3 100] What is present entitlement? Present entitlement is a key concept as it determines whether beneficiaries or the trustee of the trust will be assessed on the trust’s net income. A beneficiary is assessed under Div 6 only to the extent that the beneficiary is presently entitled to trust income for the relevant income year (see [3 210]). To the extent that there is no beneficiary presently entitled to trust income, the trustee is assessed on the corresponding amount of net income (see [3 220]). A beneficiary of a trust is presently entitled to trust income if: • the beneficiary has an interest in the trust income that is vested in interest and vested in possession (ie a vested and indefeasible interest: see [7 020]); and • the beneficiary has an immediate or present legal right to call for and receive payment of the income. It does not matter that the trustee may be unable to meet the demand for payment or that the precise amount of the entitlement cannot be determined at the end of the relevant income year (see FCT v Whiting [1943] HCA 45; 68 CLR 199, Union Fidelity 58

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 110]

Trustee Co (Aust) Ltd v FCT [1969] HCA 36; 1 ATR 200, Taylor v FCT [1970] HCA 10; 1 ATR 582, FCT v Harmer [1991] HCA 51; 22 ATR 726, Pearson v FCT (2006) 64 ATR 109).

TIP

A beneficiary’s present entitlement under s 97 of ITAA 1936 is determined by reference to the income of the trust estate (ie trust income) and not the net income. The beneficiary must have an actual present entitlement under trust law (FCT v Bamford [2010] HCA 10; 75 ATR 1) or a deemed present entitlement under Div 6.

Various provisions of Div 6 deem a beneficiary to be presently entitled to trust income. For example, a beneficiary with a vested and indefeasible interest in trust income but no right to demand immediate payment is deemed to be presently entitled to the trust income (s 95A(2)). Where the trustee of a discretionary trust exercises a discretion to pay or apply trust income to or for the benefit of specified beneficiaries, beneficiaries in whose favour this discretion is exercised are deemed to be presently entitled to the amount paid to or applied for their benefit (s 101): eg see Thomas v FCT [2015] FCA 968. It is irrelevant whether the trustee actually distributes the income, provided it is allocated to the beneficiaries under the terms of the trust deed. Legal disability does not affect present entitlement. This means that a beneficiary who could have demanded immediate payment of trust income but for the legal disability is nevertheless presently entitled to that income (Taylor v FCT [1970] HCA 10; 1 ATR 582, FCT v Harmer [1991] HCA 51; 22 ATR 726). Present entitlement can exist even if the beneficiary is unaware of the entitlement (Vegners v FCT (1991) 21 ATR 1347). The entitlement is operative for the purposes of Div 6 from the moment it arises, notwithstanding the lack of knowledge. However, the beneficiary can disclaim the entitlement on becoming aware of it: see [3 130]. Present entitlement must arise, at the latest, by the end of the income year: see [3 120].

[3 110] How does present entitlement arise? A beneficiary may become presently entitled to trust income by: • the actions of the trustee in exercising a discretion given to the trustee to distribute income to that beneficiary (see [3 400]); or • the operation of a default beneficiary clause in the trust deed (see [2 300]). The terms of the trust deed are important in making an effective distribution of trust income. The trust deed usually sets out the mechanism that a trustee must follow to distribute income.

TIP

The annual distribution minutes prepared to evidence the trustee’s resolution to distribute income to one or more beneficiaries should be

2016 THOMSON REUTERS

59

[3 110]

TAXATION OF TRUST INCOME – DIV 6 drawn up taking into account the administrative requirements set out in the trust deed. The deed may specify when the resolution must be made, whether consents of guardians or appointors are required, and how the resolution must be evidenced.

Some deeds provide that where a trustee has not resolved to distribute some or all of the trust income, or to accumulate the income (if permitted), such trust income is automatically distributed to one or more specified beneficiaries. The same default distribution provisions in a trust deed may apply in cases where a distribution made by a trustee is ineffective (eg where the resolution was not made in accordance with the terms of the deed). In FCT v Ramsden [2005] FCAFC 39; 58 ATR 485, the default beneficiaries argued that, in the absence of any challenge by a beneficiary, the Commissioner was not entitled to question the validity of trust transactions. The Federal Court held that the Commissioner had the right to challenge the validity of a purported appointment in favour of an entity that was not a beneficiary of the trust. A similar argument was raised in Thomas v FCT [2015] FCA 968, where it was held that resolutions to distribution franking credits to a specific beneficiary were ineffective because franking credits cannot be streamed independently of the franked distributions to which they are attached (see [2 120]). While the Federal Court accepted that ‘‘it is not open to the Commissioner to propound a hypothesis which is inconsistent with a position never challenged by the trustee and the beneficiaries’’, the Court found that this principle was not ‘‘enlivened’’ on the facts of the case because the taxpayers’ submissions were inconsistent with the evidence. In Re Moignard and FCT [2014] AATA 342, the Tribunal found that a beneficiary was not presently entitled to trust income when most of the proceeds from the sale of trust property were deposited into a bank account opened in the beneficiary’s name. The beneficiary was also the trustee of the trust. In reaching this conclusion, the Tribunal observed that ‘‘the payment of trust income into a bank account which might be controlled by a trustee where the account bears the same name as a particular beneficiary does not establish that the beneficiary is presently entitled’’. However, the Federal Court overturned this decision, holding that the Tribunal made errors in law because it failed to give adequate reasons for its findings and failed to properly consider whether present entitlement arose under the terms of the trust deed: see FCT v Moignard [2015] FCA 143.

Present entitlement and unit trusts Until the High Court decision in CPT Custodian Pty Ltd v Commissioner for State Revenue (Vic) [2005] HCA 53; 60 ATR 371, it was generally accepted that unit holders in a unit trust had a present entitlement to a proportionate share of the income of the unit trust, meaning that at the end of the income year the unit holders were subject to tax on the net income of the unit trust. In the CPT Custodian case, the High Court held that the unit holders in land holding unit trusts were not the ‘‘owners’’ of the land for Victorian land tax purposes, even if they held all of the units in the trusts. 60

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 130]

In Colonial First State Investments Ltd v FCT [2011] FCA 16; 81 ATR 772, Stone J took the view that a beneficiary who redeemed units in a unit trust fund was not presently entitled to a redemption amount because the present entitlement did not arise during the relevant income year. This was because, pursuant to the fund’s constitution, the allocation of the redemption amount to one or more accounts was made after the end of the income year. Stone J also disagreed with the Commissioner’s view that present entitlement must exist at the time the income is received – present entitlement only needs to exist within the relevant income year.

[3 120] When does present entitlement arise? For Div 6 purposes, present entitlement must arise no later than the end of the relevant year of income. If the present entitlement arises before the end of the income year, the beneficiary continues to be treated as being presently entitled to that trust income even if it has actually been paid or applied for his or her benefit (s 95A(1) of ITAA 1936). The Commissioner’s administrative practice of allowing trustees to make beneficiaries presently entitled to trust income by 31 August after the close of the relevant income year no longer applies (see [2 300]).

WARNING! Where the trustee of a discretionary trust exercises a discretion to pay or apply income for the benefit of specified beneficiaries, the relevant trustee resolution must be in place by the end of the relevant income year in order to establish that a beneficiary in whose favour the discretion has been exercised is presently entitled to that income. The resolution should be in writing.

In BRK (Bris) Pty Ltd v FCT [2001] FCA 164; 46 ATR 347, a trust deed contained a power to accumulate and then apply the income not accumulated in any income year to default beneficiaries. It was held that the present entitlement of the default beneficiaries did not arise until after the income year had expired. Consequently, the trustee was assessed under s 99A for that income year.

[3 130] Disclaimer of present entitlement to trust income A beneficiary can disclaim a present entitlement on becoming aware of it, but must do so within a reasonable time of becoming so aware (JW Broomhead (Vic) Pty Ltd (in liq) v JW Broomhead Pty Ltd [1985] VR 891, Pearson v FCT [2005] FCA 250; 58 ATR 502). In FCT v Ramsden [2005] FCAFC 39; 58 ATR 485, three years was well in excess of a reasonable period within which to disclaim an entitlement as a default beneficiary. In that case, deeds of disclaimer were executed the day before the start of the court hearing. To be an effective disclaimer, the beneficiary needs to absolutely reject the whole gift under the trust (FCT v Ramsden [2005] FCAFC 39; 58 ATR 485). The disclaimer will then take effect retrospectively, from the date the present entitlement arose. 2016 THOMSON REUTERS

61

[3 140]

TAXATION OF TRUST INCOME – DIV 6

In Re Alderton and FCT [2015] AATA 807, the taxpayer and her much older lover (a doctor) were the beneficiaries of a discretionary trust set up by the doctor to provide funds for the taxpayer. The taxpayer had access to the trust bank account and regularly withdrew amounts, but was otherwise unaware of the affairs of the trust. When the relationship ended, the doctor (as trustee) lodged a trust tax return which disclosed that 100% of the trust’s net income for the year ($79,880) had been distributed to the taxpayer. The taxpayer did not lodge a tax return for that year as she claimed she was unaware of the entitlement and her other income was below the tax-free threshold. After the Commissioner made a default assessment, the taxpayer sought to disclaim her entitlement to the trust income. The AAT found that the disclaimer was ineffective because she had already accepted the benefit of the ‘‘gift’’ by withdrawing over $80,000 from the trust bank account in the relevant income year. In ATO ID 2010/85, the trustee of a discretionary trust regularly appointed income to a beneficiary and notified the beneficiary of her entitlement. However, in one particular income year, the trustee failed to inform the beneficiary of her present entitlement. The beneficiary did not include any of the trust’s net income in her income tax return for that year and only became aware of the entitlement after receiving an amended assessment. The beneficiary then advised the trustee that she wished to disclaim her entitlement to trust income. The Tax Office concluded that the disclaimer was effective. The appointment of income of the relevant income year to the beneficiary as a discretionary object was a separate gift from those made in prior income years. The beneficiary was not prevented from disclaiming this gift merely because she had accepted gifts from the trustee in the past. In Confidential and FCT [2008] AATA 927; 73 ATR 675, a beneficiary disclaimed his present entitlement shortly after becoming aware of it. However, the disclaimer was found to be ineffective because the taxpayer’s solicitor, acting as agent for the taxpayer, had been aware of the entitlement for many months before the purported disclaimer was made.

[3 140] Relevance of present entitlement to the streaming rules The streaming rules (Subdivs 115-C and 207-B of ITAA 1997) use the concept of ‘‘specific entitlement’’ to determine whether a beneficiary is assessed on a capital gain or franked distribution. While present entitlement requires a beneficiary to have both a vested and indefeasible interest in trust property and the legal right to demand immediate payment (see [3 100]), specific entitlement can be made out where there is a vested and indefeasible interest but not an immediate obligation to make the payment. A beneficiary has a specific entitlement to a capital gain or franked distribution if the beneficiary receives, or can reasonably be expected to receive, an amount equal to the net financial benefit referable to the capital gain or franked distribution, and the entitlement is recorded in the accounts or records of the trust in its character as a capital gain or franked distribution (see [4 200]).

62

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 200]

The concept of specific entitlement overrides the operation of Div 6 of Pt III of ITAA 1936, including the fundamental Div 6 requirement that a beneficiary must be presently entitled to trust income in order to be assessed on the trust’s net income.

TIP

A beneficiary who is not presently entitled to trust income can have a specific entitlement to a capital gain or franked distribution.

A beneficiary’s present entitlement to trust income becomes relevant in allocating capital gains and franked distributions to which no beneficiary is specifically entitled (see [4 600]). Where the net income of a trust estate includes a capital gain, franked distribution or franking credit, a beneficiary’s present entitlement to trust income must be ‘‘adjusted’’ under Div 6E of Pt III of ITAA 1936 before applying the assessing provisions of Div 6. This is done to avoid double taxation. The adjusted present entitlement (called the ‘‘Division 6E present entitlement’’) is the beneficiary’s present entitlement to trust income minus amounts attributable to net capital gains, net franked distributions or franking credits (see [4 500]). Any capital gains and franked distributions to which no beneficiary is specifically entitled flow proportionally to beneficiaries and/or the trustee based on their proportional share of the trust income. Importantly, in determining who is assessed on amounts to which no beneficiary is specifically entitled (and also who is assessed on other net income of the trust), a beneficiary’s specific entitlement and any amounts to which other beneficiaries (or the trustee) are specifically entitled are disregarded. Accordingly, a specifically entitled beneficiary will not be assessed on any share of the trust’s net income over and above the amount of the specific entitlement (unless the beneficiary has a present entitlement to other income of the trust).

CORE TRUST INCOME ASSESSING PROVISIONS [3 200] Core provisions of Div 6 Key defined terms Section 95(1) of ITAA 1936 defines various terms for the purposes of Div 6, including net income, exempt income and non-assessable non-exempt income. The key expressions ‘‘income of the trust estate’’ and ‘‘presently entitled’’ are not defined (see the table at [3 020]).

Net income of a trust estate Net income is the total assessable income of the trust calculated under the ITAA 1936 and ITAA 1997, as if the trust were a taxpayer, less all allowable deductions (except certain defined deductions such as farm management deposits: see [6 000]). 2016 THOMSON REUTERS

63

[3 200]

TAXATION OF TRUST INCOME – DIV 6

Net income is essentially the income subject to tax and is often referred to as taxable income or s 95 income (see [3 425]).

TIP

It is important to understand that net income is not the same as trust law income that is determined by trust law principles and the terms of the trust deed. However, in some cases, both the trust law income and the net income may be the same, such as where the trust deed defines income of the trust or distributable income to be net income as defined in s 95. This is often referred to as an income equalisation clause.

Residency of a trust Division 6 draws a distinction between resident and non-resident trust estates. The distinction is important in determining the extent to which the trustee is assessed under s 99 or s 99A on any part of the net income where no beneficiary is presently entitled to all or part of the trust income.

TIP

The concepts of residency and source are central to Australia’s income tax system. Taxpayers are classified as either Australian residents or non-residents and are taxed differently based on this classification. A guiding principle of tax law is that income should only be assessed if it has a sufficient connection with the taxing country. As a basic proposition, Australian residents are taxed on their worldwide income (because their residency establishes the necessary connection with Australia) and non-residents are taxed only on income from Australian sources. Although Div 6 requires the net income of the trust estate to be calculated as if the trustee were a resident taxpayer (thus including income from all sources), the usual concepts of residency and source remain important in determining what part of the share of the net income that is allocated to a beneficiary is actually taxed.

Resident trust estate A trust is a resident trust estate under s 95(2) if either: • the trustee of the trust estate is a resident at any time during the year of income; or • the central management and control of the trust is in Australia at any time during the year of income. The effect of being a resident trust is that: • the trustee is assessed in respect of both Australian and foreign source income to which no beneficiary is presently entitled (ss 99(2), 99(3), 99A(4) and 99A(4A)); and • a beneficiary may be entitled to a refund for tax paid by the trustee in respect of non-Australian source income where the income is later distributed to the beneficiary. 64

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 200]

Non-resident trust estate A non-resident trust estate for a year of income is defined simply as a trust estate which is not a resident trust estate in that year of income: s 95(3). In relation to a non-resident trust estate: • only Australian source income to which no beneficiary is presently entitled is assessed to the trustee (ss 99(4), 99(5), 99A(4B) and 99A(4C)); • where foreign source income to which no beneficiary is presently entitled escapes tax under Div 6, subsequent payments of that income, or application of the benefit, to a resident beneficiary may be assessed under s 99B; • various anti-avoidance provisions (in ss 100AA, 100AB and 100A) deem the trust to be a resident trust estate for the purposes of any application of s 99A; and • the transferor trust rules (Div 6AAA of Pt III of ITAA 1936) potentially attribute income to a resident person who transfers property or services to the trust (see [10 070]). Note that Div 6 uses the term ‘‘non-resident’’, whereas the expression ‘‘foreign resident’’ is used in ITAA 1997.

Section 97: presently entitled beneficiary not under a legal disability This is a key provision in Div 6 and applies where a beneficiary is presently entitled to trust income and is not under a legal disability. In such a case, the beneficiary is liable to be assessed on a proportionate share of the net income of the trust that is attributed to Australian sources and to sources outside Australia only for the period that the beneficiary is a resident: see [3 210].

Sections 98 and 98A: presently entitled beneficiary under a legal disability or a non-resident These sections provide that a trustee is assessed and liable to pay tax where a beneficiary is presently entitled to trust income but is under a legal disability or is a non-resident. If a beneficiary is a non-resident at the end of the year of income, the trustee is liable for tax on so much of the share of the net income of the trust that is attributable to the period that the beneficiary was a resident, irrespective of whether the beneficiary was under a legal disability. With respect to the period of non-residency, the trustee is only liable in relation to Australian sourced income. A non-resident beneficiary is also taxed on his/her share of the net income of the trust under s 98A, but a credit is allowed for the tax assessed under s 98(2A), (3) or (4) to the trustee.

Sections 99 and 99A: no beneficiary presently entitled These provisions apply where there is no beneficiary presently entitled to all or part of the trust income. In such a case, the trustee is assessed and liable to pay tax under s 99A. The tax payable is at the top marginal rate of tax (47% for 2015-16). Where the trust is covered by s 99A(2) (eg a testamentary trust) and the Commissioner’s discretion is exercised (see [3 220]), then the trustee is instead 2016 THOMSON REUTERS

65

[3 200]

TAXATION OF TRUST INCOME – DIV 6

assessed under s 99. The assessment under s 99 is made on the same basis as that for an individual using the progressive rates of tax applicable to individuals.

TIP

Care must be taken in making trustee resolutions to distribute income to ensure that the trust income is distributed effectively in order to avoid tax being paid at the top punitive rate for undistributed income: see [3 400]. Consideration should also be given to having a default distribution clause in a trust deed rather than a default accumulation clause to perhaps deal with any ineffective distributions.

The distribution of income to which s 99 or 99A has applied that is distributed to a non-resident beneficiary may give that beneficiary an entitlement to a refund of the tax paid by the trustee where the income on which the tax was paid was foreign sourced income (s 99D).

Sections 99B and 99C: amounts paid or applied Sections 99B and 99C were introduced to deal with foreign source income that escapes tax in the year of derivation but is subsequently paid to or applied for the benefit of a resident beneficiary. However, these provisions potentially have wide application because s 99C is very broad in setting out when an amount is taken to be applied for the benefit of a beneficiary. Amounts paid or applied for the benefit of a beneficiary that have not been assessed under another provision in Div 6 will not be assessed under these provisions either where the amounts are, or represent, among other things: • trust capital (unless attributed to amounts that if derived by a resident taxpayer would be assessable to that taxpayer); and • non-assessable income if the amount had been derived by a resident taxpayer. Where an amount is paid or applied for the benefit of a beneficiary and that amount has not been assessed, if the amount is of a type that would be assessable if it had been derived by a resident taxpayer, the beneficiary is liable to be assessed.

Sections 100AA and 100AB: distributions to tax-exempt entities These provisions are anti-avoidance rules designed to prevent tax-exempt beneficiaries (such as charities) being used to inappropriately reduce the amount of tax payable on the income of a trust. The first rule treats a tax-exempt beneficiary which has not been notified in writing of its present entitlement to trust income, within two months of the end of the relevant income year, as not being presently entitled to that amount (s 100AA): see [3 510]. The second rule applies where a tax-exempt beneficiary would otherwise be assessed on a disproportionate share of the trust’s net income relative to the exempt entity’s trust entitlement (s 100AB): see [3 520]. In such a case, the excess is assessed to the trustee. 66

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 210]

Section 100A: trust stripping Section 100A is an anti-avoidance provision negating the effect of trust stripping arrangements where a beneficiary effectively receives trust income in a non-assessable form and another beneficiary is made presently entitled to the trust income but is not assessed on the net income because of that beneficiary’s tax profile: see [10 050].

[3 210] Taxation of beneficiary Present entitlement and no legal disability A beneficiary who is presently entitled to trust income and is not under a legal disability is assessed under s 97(1) of ITAA 1936 on: • the share of the net income that corresponds to the trust income, on a proportionate basis, that is attributable to the period the beneficiary was a resident (this includes income sourced in or out of Australia); and • the share of the net income that corresponds to the trust income, on a proportionate basis, attributable to Australian sources for the period that the beneficiary was a non-resident. The beneficiary’s share of the net income is added to the beneficiary’s other assessable income and, after subtracting allowable deductions, is taxed at the rate applicable to the beneficiary. Usually this is the progressive tax rates for individual beneficiaries and the corporate rate of tax for corporate beneficiaries.

Present entitlement but under a legal disability and deriving income from other sources Where a beneficiary is presently entitled to trust income but is under a legal disability, the trustee is liable to tax on the corresponding share of the net income under s 98(1): see [3 220]. A beneficiary under a legal disability is also assessed on his or her share of the net income in the following circumstances (s 100(1)): • the beneficiary is a beneficiary of more than one trust; or • the beneficiary has other sources of income, such as interest, rent or salary and wages. This generally ensures that the beneficiary’s total income is taxed at the correct marginal rate. Double taxation is avoided by allowing a credit for tax assessed to the trustee under s 98(1) with respect to the beneficiary’s share of the net income (s 100(2)). Section 100 also applies where a beneficiary is deemed to be presently entitled to income under s 95A(2) (see [3 100]). EXAMPLE Katy is 16 years old. She is a beneficiary of the AK Testamentary Trust and receives a distribution of $5,000 from that trust. Katy is also entitled to $20,000 from the BK Testamentary Trust, this being a fixed entitlement to half of the income of that trust which cannot be paid to her until she turns 18.

2016 THOMSON REUTERS

67

[3 220]

TAXATION OF TRUST INCOME – DIV 6

Katy received $6,000 of salary and wage income from a part time job after school. Katy’s assessable income is $31,000 ($5,000 + $6,000 + $20,000). Her tax liability on this income is reduced by the tax paid by the trustees of the two trusts on her share of the net income of each of those trusts.

The credit claimed by a beneficiary for tax paid by a trustee is limited to the tax payable by the beneficiary.

Principal beneficiary of a special disability trust In the case of a special disability trust (see [1 160]), the net income of the trust is assessed in the first instance to the trustee (s 95AB). The entire net income is also included in the assessable income of the primary beneficiary, with an offset available for the tax paid or payable by the trustee in respect of the primary beneficiary (s 100). This ensures that net income of a special disability trust is not taxed at the top rate of tax under s 99A.

[3 220] Taxation of trustee No beneficiary presently entitled to trust income The net income of a trust that relates to trust income which is accumulated, whether by default or by the trustee’s resolution, is assessed to the trustee. Where the trust has no trust income but has net income, the trustee is also assessed on the net income. The trustee is taxed at the punitive rate of tax under s 99A of ITAA 1936. That is the default position. The Commissioner has the discretion to assess trustees of the following trusts under s 99 (taxation at progressive rates): • deceased estates; • certain bankrupt estates; • trusts that consist of property arising from certain compensation receipts, death benefits and insurance policies (s 99A(2)(b)).

Deceased estate The trustee of a deceased estate is assessed on: (1) income received by the trustee which would have been assessable in the hands of the deceased had it been received during his or her lifetime (s 101A); and (2) income received by the trustee from the property (including the business) of the deceased from the date of death up to the end of the administration of the deceased estate. The trustee in the first case is assessed under s 99A (punitive rates) or s 99 (progressive rates). In the second case, the trustee is assessed to the extent that beneficiaries are not presently entitled to the trust income. Generally, beneficiaries cannot have a present entitlement until the estate is fully administered (see FCT v Whiting [1943] HCA 45; 68 CLR 199), but the Commissioner does recognise present entitlement prior to the completion of the administration of the estate if 68

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 220]

payments are made to the beneficiaries (see Taxation Ruling IT 2622). In such a case, the beneficiaries are assessed on that income or the trustee is assessed on their behalf. The s 99 rate (individual progressive rates of tax) will apply for deceased estates with the tax free threshold only available in cases where the deceased taxpayer died less than three years before the deceased estate’s year of income.

Beneficiary presently entitled but under a legal disability Where a beneficiary is presently entitled to trust income but is under a legal disability, the trustee is liable to tax on the corresponding share of the net income as if it were the income of an individual and not subject to any deduction (s 98(1)). The income is assessed separately from any other income of the trust. Where the beneficiary does not derive any other income apart from the beneficiary’s share of the net income of a single trust estate that has been dealt with under s 98(1), the s 98 assessment issued to the trustee will finalise the tax assessments issued in respect of such income. The trustee will have paid tax on behalf of the beneficiary and the beneficiary will have no liability. The trustee is also assessed under s 98 in relation to beneficiary’s share of a capital gain or franked distribution if the beneficiary is under a legal disability or is a non-resident (ss 115-220 and 207-35(6) of ITAA 1997). In the case of a capital gain, the trustee must increase the assessable amount to reflect the beneficiary’s attributable gain in respect of each capital gain (s 115-220(2) of ITAA 1997). Division 6E of Pt III of ITAA 1936 does not modify this amount.

Beneficiary a non-resident at year’s end A trustee is liable for tax with respect to a presently entitled beneficiary who is a non-resident at the end of the year of income (s 98(3)). The trustee is taxed on so much of the share of the net income of the trust that is attributable to the period that the beneficiary was a resident, irrespective of whether the beneficiary was under a legal disability. With respect to the period of non-residency, the trustee is only liable for tax in relation to Australian-sourced income. Any share of the net income that is conduit foreign income is not included in the amount that is assessable to the trustee under s 98(3) (s 802-17(3) of ITAA 1997). The tax paid by the trustee under s 98(3) in relation to the non-resident beneficiary is generally not a final tax. The beneficiary remains liable for Australian tax on income derived from all sources where the income is attributable to a period when the beneficiary was a resident, and on income derived from sources in Australia during the period when the beneficiary was a non-resident (s 98A(1)). The beneficiary can deduct from this tax liability the amount of tax paid by the trustee in relation to the beneficiary’s interest in the net income of the trust. If the tax paid by the trustee exceeds the beneficiary’s tax liability, the beneficiary is entitled to a refund of the difference (s 98A(2)), although the Commissioner may offset the payment against another tax debt owed by the beneficiary. Where a non-resident beneficiary is a trustee of another trust and is presently entitled to income of a head trust, the trustee of the head trust is assessed on the net income of the trust attributable to Australian sources (but not 2016 THOMSON REUTERS

69

[3 300]

TAXATION OF TRUST INCOME – DIV 6

in respect of managed investment trust payments that are subject to the withholding tax rules in Subdiv 12-H of Sch 1 to TAA) (s 98(4)). Any later trustee in the chain of trusts is not taxed again on that net income under Div 6 (s 99E). However, an amount attributable to that net income may be taxed to the ultimate non-trustee beneficiary (under s 97, s 98A(3) or s 100), with a deduction allowed for the tax paid by the head trustee (s 98B).

Revocable trusts and trusts created for minors Income from the following types of trusts may, at the Commissioner’s discretion, be assessed to the trustee (under s 102): • a trust created by a settlor that is revocable (that is, a trust that can be altered, changed or revoked so that the settlor acquires an interest in the trust capital or income); and • a trust created for the benefit of a settlor’s minor children. The tax payable by the trustee under s 102 is the difference between the tax payable by the settlor and the tax that would have been payable but for the trust.

WARNING! The provisions of s 102 are the primary reason for having ‘‘independent’’ settlors like professional advisers establish trusts by settling a nominal amount: see [2 410]. Following the creation of the trust, the family can provide the bulk of funds by way of gift or loan.

INCOME AND NET INCOME OF A TRUST ESTATE [3 300] Income of a trust estate Much of the controversy or uncertainty played out in the courts and dealt with by the Commissioner in decision impact statements, practice statements and rulings has centred on the application of s 97(1) of ITAA 1936. Section 97(1)(a) provides: “97 Beneficiary not under any legal disability “(1) Subject to Division 6D, where a beneficiary of a trust estate who is not under any legal disability is presently entitled to a share of the income of the trust estate: “(a) the assessable income of the beneficiary shall include: “(i) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and (ii) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia; and…”

70

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 310]

The underlined parts of the section highlight the matters in dispute. The issues in contention are: • What does the composite phrase ‘‘income of the trust estate’’ mean? • How is ‘‘that share of net income’’ worked out? The decisions in FCT v Bamford and Cajkusic v FCT provide answers to these questions and are dealt with at [3 310] and [3 320] respectively.

[3 310] Bamford’s case In FCT v Bamford [2010] HCA 10; 75 ATR 1, the High Court confirmed the following propositions: • s 97(1) adopts the proportionate view where the distributable income of the trust (trust income) is different to the taxable income of the trust (ie net income as defined in s 95(1)); and • trust income is not a fixed concept tied to other concepts of income such as income according to ordinary concepts. Rather, its meaning is determined by and derived from trust law principles and its meaning may be changed by the terms of the trust deed. The facts of the case are typical of what may occur in a family discretionary trust. In one year there was a difference between the net income and the trust income for the Bamford Trust. The issue was the correct approach for determining who is taxed on the difference and how the calculation is made – the proportionate or quantum approach.

Quantum versus proportionate approach Under the quantum approach, beneficiaries take the same amount of net income as their trust income. Where there is an excess of net income over trust income, no beneficiary may be presently entitled to the excess and therefore the trustee may be assessable on the excess. Under the proportionate view, a beneficiary is assessable on the same proportionate share of the net income of the trust estate as the beneficiary’s proportionate share of the trust income. The proportionate versus quantum approach issue is illustrated in the following example. EXAMPLE Trust A has trust income of $400,000 but the net income is $300,000. Beneficiary B is entitled to $200,000 of the trust income and beneficiaries C and D are each entitled to 50% of the balance of the trust income. Under the proportionate approach, the net income attributable to each of Beneficiary B, C and D will be: Beneficiary B: $150,000 ($300,000 x $200,000/$400,000); Beneficiary C: $75,000 ($300,000 x $100,000/$400,000); and Beneficiary D: $75,000 ($300,000 x $100,000/$400,000). It does not matter that Beneficiary B’s distribution is expressed as a fixed amount whereas for the other beneficiaries it is expressed as a percentage of the trust income.

2016 THOMSON REUTERS

71

[3 320]

TAXATION OF TRUST INCOME – DIV 6

In Bamford, the taxpayers unsuccessfully argued that where a distribution of trust income is expressed as a fixed amount (as for Beneficiary B above), the quantum approach should apply to determine that the beneficiary’s net income of the trust should be that same amount (ie $200,000 for Beneficiary B in the example above). However, the High Court found in favour of the proportionate approach.

Treatment of capital gains Another issue in the case related to the treatment of a capital gain made by the trust. In one income year, the only income of the Bamford Trust was a capital gain which, under the terms of the trust deed, was treated as trust income. The Commissioner argued that ‘‘income’’ for the purposes of the opening words in s 97(1) could not be altered by the terms of the trust deed. As there was no ordinary income, the trustee – and not the beneficiaries – should be taxed on the capital gain. The High Court held that the undefined term ‘‘income of the trust estate’’ is determined by the general law of trusts and that includes the terms of the trust deed. Although not expressly stated, the High Court decision supports the earlier decision in Cajkusic (see [3 320]) that trust deed provisions can alter and determine what is trust income. Thus, trust deed provisions which allow a trustee to characterise and treat receipts and payments as being on income or capital account are effective.

TIP

With appropriately drafted trust deed provisions, trustees have a great deal of flexibility in determining what trust income is (see [2 130]). Although Bamford highlighted that there will be difficult fact scenarios, invariably leading to unpalatable or unjust outcomes, in most cases the proportionate approach along with provisions in a trust deed that adequately define income and how it is to be calculated, should give sensible outcomes.

[3 320] The decision in Cajkusic The Cajkusic case (Cajkusic v FCT [2006] FCAFC 164; 64 ATR 676) dealt with the interaction of trust and revenue law, that is, the expression ‘‘presently entitled to a share of the income of the trust estate’’ in s 97. This was considered in circumstances where the Commissioner had denied a deduction in the computation of the net income of the trust. For each of the income years in question, the Trust claimed deductions for the contributions to, and implementation costs of, an employee benefit trust arrangement of $205,425 and $197,125 respectively. The Commissioner issued assessments to each of the taxpayers increasing their net income by the amount of the deduction claimed by the Trust that was disallowed. The taxpayers argued that for an assessment to be made on the Trust’s net income, the Trust must have trust income for s 97 purposes and beneficiaries must be presently entitled to that trust income. 72

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 330]

The Full Federal Court highlighted the importance of the trust deed and its terms in the determination of distributable trust income. The Court held that the denial of the deduction for the purpose of determining the net income did not alter the ability of the trustee to characterise the outgoing as being on revenue account for the purpose of determining the ‘‘income of the trust’’ (trust income). The effect of the trustee’s exercise of its power to treat the superannuation deduction on revenue account was that there was no ‘‘income of the trust’’ (trust income) or present entitlement for the purposes of s 97(1) and no beneficiary was subject to tax on any of the trust’s net income. Rather, the trustee was liable for tax on the whole of the net income under s 99A. The Court also held that the rule in Upton v Brown (1884) 26 Ch D 588 that losses of earlier years must be met out of the income of later years meant the prior year losses could result in no trust income in those later years until the losses were recouped. In a Decision Impact Statement on this case, the Commissioner accepted the Cajkusic decision as ‘‘an application of conventional tax law principles’’. However, the Commissioner raised doubt as to the case being authority for the proposition that the terms of a trust deed can govern what is income in the hands of the trustee. This issue was finally decided in the Bamford case (see [3 310]).

TIP

The decisions of the courts highlight that there is no substitute for reading and understanding the trust deed. The deed is paramount in determining the trust income and it takes precedence over any accounting principles or industry norms. Unless there is distributable trust income, a beneficiary cannot have a present entitlement to that income, and the net income of the trust (if any) will be assessed to the trustee.

The application of the Upton v Brown rule was considered in the Raftland case (Raftland Pty Ltd v FCT [2008] HCA 21; 68 ATR 170), a case dealing with the present entitlement of a trust beneficiary in the context of a sham. The High Court held that the rule did not apply in the Raftland case as there was one class of unit holders in a unit trust with co-extensive interests in income and capital. The rule has application to trusts where successive interests exist. Successive interests exist in trusts with life interests and remainder interests. The Commissioner issued a Decision Impact Statement following the Raftland case stating that the Upton v Brown principle does not apply to a trust with only one beneficiary, or if a number of beneficiaries have the same interests or rights (eg a single class of beneficiaries under a discretionary trust). The effect of this decision on recoupment of losses is that there is no fixed rule in place that requires prior year trust losses to be made good out of income in subsequent years. The issue can only be determined on a case-by-case basis after careful consideration of the trust deed. Generally, the rule will apply where beneficiaries have successive rather than co-extensive interests.

[3 330] Lessons from the court cases • ‘‘Income of the trust estate’’ (trust income) in s 97(1) of ITAA 1936 means income according to the general law of trusts. 2016 THOMSON REUTERS

73

[3 340]

TAXATION OF TRUST INCOME – DIV 6

• ‘‘Net income’’ in s 95(1) does not necessarily correspond to trust law income. • Trust law income is ascertained by appropriate accounting principles and the trust deed. • The trust deed can override trust law distinctions between income and capital receipts and trust losses. • The word ‘‘share’’ in s 97(1) refers to the proportion of the trust income that a beneficiary is entitled to. • The proportionate approach applies in determining a beneficiary’s share of the net income of the trust. • A beneficiary’s entitlement to a share of trust income arises from being ‘‘presently entitled’’ to trust income and present entitlement arises from the trustee’s actions in administering the trust or from the operation of default provisions in the trust deed. • The terms of the trust deed are critical in determining issues that the Commissioner may consider uncertain. Such uncertain ‘‘issues’’ include the accounting methodology that should be adopted by trustees in determining distributable income and what constitutes a receipt or payment (see [3 340]). • Division 6 does not deal with the situation where the calculation of the net income of a trust estate produces a loss for income tax purposes (that is, an excess of deductions over assessable income, calculated as if the trustee were a resident taxpayer). There is no fixed rule on how prior year trust losses are to be treated in a common discretionary trust with co-extensive interests. In such trusts there is usually no separate beneficiary classes entitled to income or capital.

[3 340] Commissioner’s response to Bamford The Commissioner issued a Decision Impact Statement and Practice Statement on 2 June 2010 and a Draft Ruling on 28 March 2012. Some of the key issues which remain unresolved after the issue of these documents are noted below.

Treating income as capital The Commissioner takes the view that it is an open or unresolved question as to whether a re-characterisation clause in a trust deed can treat as capital what is otherwise income. The correctness of the Commissioner’s view or concern on this issue may be doubtful or unfounded. If – as the High Court found in Bamford – capital gains could be characterised as income pursuant to the terms of the trust deed, the opposite (re-characterising income as capital) should also hold.

Income of the trust estate In Draft Ruling TR 2012/D1 Commissioner states that it is clear from Bamford’s case ‘‘that the determination of the income of a trust is grounded in trust law and generally involves a focus on the receipts and outgoings for an income year’’. The Commissioner’s view is that the ‘‘income’’ of a trust estate must be: 74

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 340]

1. measured in respect of distinct years of income (being the same years in respect of which the net income is calculated); 2. a product ‘‘of the trust estate’’; and 3. the net amount of income to which a beneficiary could be made presently entitled or accumulated. That is, it is a reference to the income available for distribution to beneficiaries or accumulation by the trustee (ie distributable income). Cap on income of trust estate

More controversially, TR 2012/D1 then goes on to assert that the income of a trust estate for an income year cannot exceed the sum of: • the accretions to the trust estate (whether accretions of property, including cash, or value) for that year; • less any accretions to the trust estate for that year which have not been allocated, pursuant to trust law to income (and therefore cannot be distributed as income); and • less any depletions to the trust estate (whether of property or value) for that year which, pursuant to trust law have been allocated as being chargeable against income. Income equalisation clauses

If a trust deed contains an income equalisation clause, which equates ‘‘income’’ with ‘‘net income’’, the Commissioner’s preliminary view in TR 2012/D1 is that: • the trust’s income will include amounts received that would not ordinarily be considered income but which are assessable (eg net capital gains). Likewise, outgoings that may ordinarily be chargeable against capital will reduce the trust’s income if those outlays are deductible (eg deductible outlays for capital acquisitions); • amounts received that might ordinarily be considered income but which are not assessable (eg exempt income) or outgoings that are not deductible (eg entertainment expenses) will be treated as accretions to or depletions of trust capital. Notional amounts

If the trust’s net income includes what the Commissioner calls ‘‘notional’’ income amounts, TR 2012/D1 states that those amounts cannot generally be taken into account in calculating the trust’s income. This is in line with view expressed by Stone J in Colonial First State Investments Limited v FCT [2011] FCA 16; 81 ATR 772 that income must be that which is capable of distribution, which leads to a conclusion that notional amounts such as franking credits are not able to form part of trust income: see Thomas v FCT [2015] FCA 968, discussed at [2 120]. Draft Taxation Ruling TR 2012/D1 identifies the following amounts that may be included in calculating a trust’s net income, but which may not form part of the income of the trust estate: • franking credits included in the calculation of the trust’s net income under the streaming rules; 2016 THOMSON REUTERS

75

[3 400]

TAXATION OF TRUST INCOME – DIV 6

• so much of a share of the net income of one trust that is included under s 97 in calculating the net income of a second trust, but which does not represent a distribution of income of the first trust; • so much of a net capital gain that is attributable to an increase of what would otherwise be a relevant amount of capital proceeds for a CGT event as a result of the market value substitution rule; • a deemed dividend under Div 7A.

WARNING! 1. The Tax Office has indicated that it will apply the view taken in TR 2012/D1 in making assessments resulting from audits, but will not initiate compliance activity solely for the purpose of applying those views. The Tax Office also concedes that the alternative views canvassed in TR 2012/D1 may form the basis of a reasonably arguable position in defence of potential tax penalties. 2. Label 53A (income of the trust estate) and label 54W (share of income of the trust estate) on the 2016 Trust Tax Return are intended to assist with the administration of the trust assessing provisions and do not involve any implicit requirement to determine the income of the trust estate in accordance with TR 2012/D1.

MAKING AN EFFECTIVE DISTRIBUTION [3 400] Resolutions and distribution minutes The key issue faced by trustees and accountants is how to make resolutions correctly and draft distribution minutes to give effect to the desired outcome. More often than not, the desired outcome is to ensure that the correct beneficiaries are presently entitled to the trust income so that the lowest amount of tax is payable. Sometimes the mistake is made of not looking any further than the net income, determining the best allocation of that income between beneficiaries and drafting the distribution minute accordingly. Often a standard minute generated by accounting software is used to ‘‘distribute’’ the net income. By sheer accident, the correct outcome may be achieved if the terms of the trust deed define the trust income as net income. To ensure that the correct and desired result is achieved, a good understanding of the relevant terms of the trust deed is essential. The following step-by-step guide to getting trust distributions right covers the situation where distributions of trust income include capital gains and franked distributions subject to the streaming rules at [4 000] and also where distributions do not include such amounts or only distributions of capital are made. 76

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 410]

[3 410] Step-by-step guide to making effective trust distributions Step 1: Determine the trust income (see [3 420]) and the net income (see [3 425]). Consider whether the trust income of the trust is: • ordinary income; • taxable income; • modified taxable income; or • income otherwise determined according to the trust deed.

WARNING! If there is NO trust income, it is not possible to have present entitlement. Net income (if any) arising from timing differences etc will be assessed to the trustee under s 99A of ITAA 1936.

Step 2: Determine whether streaming powers in the trust deed allow for categories of income and streaming of income allocated to those categories to beneficiaries. Such powers are necessary if streaming for trust and tax purposes is required. Step 3: Where there is a distribution of a capital gain determine whether the capital gain, or any part of it, is included in the trust income (generally it will not be included under an ordinary income clause), or whether the distribution is a distribution of capital or trust corpus. If a capital gain is not included in the trust income, consider the trust deed power for the distribution of capital and any special requirements imposed by the deed. Step 4: Is there a distribution of income to a tax-exempt entity? If so: • ensure the tax-exempt entity is notified of the trust distribution in writing no later than 31 August following the close of the income year (see [3 510]); and • ensure the distribution does not result in the adjusted Div 6 percentage exceeding the benchmark percentage (see [3 520]). Step 5: If there is a requirement for particular beneficiaries to get a distribution of specific capital gain(s) or franked distribution(s), those beneficiaries must be specifically entitled to those amounts (see [4 200]). Invariably these amounts will be allocated to a category of income and distributed under the streaming provisions in the trust deed. Step 6: Prepare a resolution to distribute the income and draft the distribution minutes taking into account the following: • s 95 clause (or default position of trust income equalling net income) for potential taxation certainty; 2016 THOMSON REUTERS

77

[3 420]

TAXATION OF TRUST INCOME – DIV 6

• asset protection issues of distribution. Although there may be tax benefits, consider whether a beneficiary is at risk from creditors, estranged spouse etc; • beneficiary profile – use of franking credits, losses etc. This is particularly important for example, because a beneficiary may have capital losses and so, from a tax perspective, distribution of capital gains to that beneficiary will be advantageous; • the precise terms of the trust deed and any special requirements that must be met.

[3 420] How to determine the income of the trust To make an effective trust distribution (see [3 410]), it is first necessary to determine the ‘‘income of the trust estate’’ (ie the trust income). The trust income is the amount that, under trust law principles and the relevant terms of the trust deed, is treated as income of the trust estate. In other words, it is the trustee who ascertains the trust income according to appropriate accounting principles and the trust deed. The starting point is to look at the terms of the trust deed to see what they say about the trust income. There is no substitute for reading the trust deed. There are four primary alternatives when it comes to determining the income of the trust.

Trust income = ordinary income If the trust deed does not contain any definition of income of the trust, the income of the trust is determined according to ordinary concepts of income and in accordance with trust law and generally accepted accounting principles. This is often referred to as an ordinary income clause. This is an example of a distribution power found in a deed which, because there is nothing defining ‘‘net income’’, trust income takes its ordinary income meaning. SAMPLE ORDINARY INCOME CLAUSE The Trustees may at any time prior to the expiration of any Accounting Period which ends before or upon the Vesting Day determine with respect to all or any part or parts of the net income of the Trust fund for such Accounting Period: • to pay, apply or set aside the same to or for any one or more of the Income Beneficiaries living or in existence at the time of the determination; • to accumulate the same …

With such a deed it is not possible to treat capital gains as income. It was for this reason the Commissioner issued Practice Statement PS LA 2005/1 (withdrawn), providing taxpayers with administrative concessional treatment where a trust had net capital gains subject to tax but no income to distribute. This problem is now dealt with by the streaming measures discussed at [4 000] and following. It is important to read the terms of the trust deed because the deed may provide the trustee with a power to treat capital receipts as income, in which 78

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 420]

case ordinary income may be modified. The wording and terms of the trust deed will be critical in determining what may be treated as income or capital. Unlike the sample clause below, some clauses in deeds only apply to receipts and not profits and some clauses extend to payments and losses. SAMPLE CLAUSE TO TREAT CAPITAL RECEIPTS AS INCOME Distinguish between Income and Capital The Trustee may so choose at any time and from time to time, if the Trustee sees fit to treat as income of the Trust Fund the whole or part of any receipt, profit, gain or other amount which would not be credited to the income account for accounting purposes;

Trust income = net income Where the trust deed equates trust income with net income, the ‘‘income of the trust estate’’ and the ‘‘net income of the trust estate’’ will be the same amount. SAMPLE SECTION 95 CLAUSE Income means ‘‘net income’’ as defined in s 95 of the Income Tax Assessment Act 1936.

Trust income = modified taxable income In some cases, a trust deed might equate trust income or ‘‘income of the trust estate’’ using the language of s 97 with a modified taxable income definition. Such clauses usually add or subtract amounts from s 95 net income. Common subtractions include capital gains and franking credits. SAMPLE SECTION 95 CLAUSE WITH MODIFICATIONS ‘‘Net income’’ or ‘‘net income of the Trust Fund’’ means ‘‘net income’’ as defined in s 95(1) of the Income Tax Assessment Act 1936 (the Tax Act) excluding any net capital gain included in the assessable income of the Trustee in its capacity as Trustee of the Trust Fund pursuant to s 160Z(1) of the Tax Act, and excluding any amount which is included in the assessable income of the Trustee in its capacity as Trustee of the Trust Fund pursuant to s 160AQT of the Tax Act.

The sample clause above is taken from a deed that equates trust income with net income less capital gains and franking credits. It refers to repealed provisions now rewritten into the ITAA 1997, showing the age of the deed or perhaps that it has not been updated.

2016 THOMSON REUTERS

79

[3 425]

TAXATION OF TRUST INCOME – DIV 6

Trust income = income determined by the rules in the trust deed Most modern trust deeds allow the trustee to determine the income of the trust with a great deal of flexibility by setting out rules and discretionary powers to treat any receipt or gain, or payment or loss or any part of such amounts as income. SAMPLE TRUST DEED CLAUSE ‘‘Income’’ shall, unless the Trustee otherwise determines, mean all profits or gains taken into account in calculating the net income of the Trust as defined in s 95 of the Income Tax Assessment Act 1936 and in the event of any such determination being made, the ‘‘Income’’ means the Income as determined by the Trustee pursuant to this Deed.

This sample clause provides that the income of the trust for s 97 purposes may be determined by the trustee (this definition is accompanied by rules giving great flexibility in making the determination) in accordance with the terms of the deed. If no such determination is made, the trust income is the net income. For the purposes of the example at [3 440], this will be referred to as a Trust Deed clause and given the flexibility provided by such a clause the example does state that the trust income may be any amount as determined under the deed.

[3 425] How to determine the net income of the trust The ‘‘net income’’ of a trust is its taxable income, ie the total assessable income of the trust estate (including net capital gains), less allowable deductions (subject to some minor exceptions). Beneficiaries and/or the trustee are assessed on shares of the net income. As the trust is not a taxable entity, the net income is calculated on the assumption that the trustee is the relevant taxpayer (and a resident) in respect of that income. The following points should be noted in calculating the net income of a trust estate: • the net income can only be calculated as at the end of the income year, when the assessable income and allowable deductions can be ascertained (Union Fidelity Trustee Co (Aust) Ltd v FCT [1969] HCA 36; 1 ATR 200, Practice Statement PS LA 2012/2); • how an item is treated for trust law purposes is irrelevant, except to the extent that it may assist in determining whether the item is income according to ordinary concepts (Charles v FCT [1954] HCA 16; 90 CLR 598, Richardson v FCT [2001] FCA 1354; 48 ATR 101, Taxation Ruling TR 2005/12); • a trustee carrying on a business must use generally accepted accounting principles, including accrual accounting (Zeta Force Pty Ltd v FCT [1998] FCA 728, 39 ATR 277); • the trust loss recoupment rules (see [7 000]) need to be considered in relation to prior year losses (and some current year losses and debt deductions). 80

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 430]

[3 430] Differences in trust income and net income As the trust income (see [3 420]) and the net income (see [3 425]) are ascertained in different ways, it is common for the two amounts to be different. Differences in trust income and net income may arise for many reasons. Some of the more common are set out below. Net income will exceed trust income where: • an amount is assessable for tax purposes but is not income for trust purposes; • an amount is an expense taken into account in determining trust income but is not deductible in calculating net income; • there are timing differences in the recognition of income and expenses for tax purposes and trust purposes; and • notional amounts such as capital gains arise from the application of market value substitution rules. Where net income exceeds trust income, beneficiaries are subject to tax on amounts greater than their entitlement to trust income. This problem was particularly acute where net capital gains were included in the calculation of net income but did not form part of trust income. This problem has been addressed in relation to capital gains by the introduction of the streaming rules (see [4 000]). Trust income will exceed net income where: • an amount is treated as trust income but is not assessable or taken into account in determining net income; • an amount is deductible for tax purposes but not an expense taken into account in determining trust income; and • there are timing differences as noted above. This situation is usually the least problematic as the beneficiaries presently entitled to trust income have, on a proportionate basis, a net income that is less than their entitlement to trust income. Arguably, amounts of trust income exceeding net income may be taxed to beneficiaries under s 99B of ITAA 1936 but the Commissioner has stated that, in the absence of any tax avoidance arrangement, the excess will not be taxed under this provision. No trust income and no net income For a year where there is no trust income and no net income, Div 6 has little or no work to do. Where there are trust and trust tax losses, the implications of the trust loss provisions should be considered (see [7 000] and following). No trust income but net income is greater than zero Where there is no trust income but an amount of net income, the trustee is assessed on that amount at the highest tax rate under s 99A, or possibly s 99.

Determining the tax implications Having determined the trust income for the purposes of s 97, it is then possible to determine the tax implications based on the proportionate approach endorsed in Bamford (see [3 310]). It is important to understand that the 2016 THOMSON REUTERS

81

[3 430]

TAXATION OF TRUST INCOME – DIV 6

determination of trust income, the calculation of the net income, the resolutions made to distribute trust income and the way the resolutions are expressed will impact on the tax outcomes. In Taxation Determination TD 2012/22, the Commissioner states that the effect of applying the proportionate approach will depend on the facts and circumstances of each case, including the terms of the trust deed and the wording of any trustee resolutions to appoint distributable income. TD 2012/22 sets out 12 examples explaining the proportionate approach using the different types of trust deed clauses encountered by advisers. In Example 1 of TD 2012/22, the trust deed equates trust income with net income, but does not allow the trustee to determine a different amount to be trust income and does not contain a default clause. For the 2011-12 income year, the trustee calculated the net income to be $120,000 and, prior to 1 July 2012, had resolved to distribute $120,000 to certain beneficiaries (A, B and C). The Commissioner subsequently determines on audit that $9,000 interest income was omitted in calculating the net income. As the trustee only distributed $120,000, there is $9,000 trust income to which no beneficiary is presently entitled. The corresponding share of net income ($9,000) is therefore assessed to the trustee. The result would be different if: • the trust deed contains a default clause - the default beneficiaries would be assessed proportionately on $9,000 (Example 2 of TD 2012/22); • the trustee resolved to distribute the balance of any income to a particular beneficiary - this beneficiary would be entitled to $9,000 income and would be assessed on the corresponding share of net income ($9,000) (Example 3 of TD 2012/22); and • the trustee’s resolution expressed each beneficiary’s entitlement as a proportion (ie one-third of the trust income to each of A, B and C) - each beneficiary would be presently entitled to one-third of the trust’s income and would therefore be assessed on one-third of the net income, with no amount of the net income assessed to the trustee (Example 4 of TD 2012/22). Taxation Determination TD 2012/22 notes that a trustee may attempt to deal with an amended assessment by resolving that any additional income is treated as having been distributed to a particular beneficiary by 30 June. The Commissioner’s view is that such resolutions are not effective in creating a present entitlement to income by that date.

Artificial arrangements to exploit trust income The Commissioner has been concerned with ‘‘artificial arrangements’’ which deliberately exploit mismatches between trust income and net income and the proportionate approach that applies to such mismatches. In the past, taxpayers used artificial arrangements involving distributions to tax-exempt entities, and legislative amendments were made to close such ‘‘loopholes’’ or stop such artificial arrangements (see [3 500]). Taxpayer Alert TA 2013/1 describes an arrangement whereby a discretionary trust generates a small amount of income and a large capital gain and pursuant to the terms of the trust deed the trustee determines that the capital gain is excluded from trust income; and all the trust income is distributed to a corporate 82

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 430]

beneficiary (being a newly formed company). Although the corporate beneficiary is only entitled to receive a small amount of trust income, under the proportionate approach it is assessed on the trust’s entire net income including the large net capital gain. Given that the company’s only entitlement is to a small amount of trust income, it is unlikely to be able to meet its tax liability. Consequently, a liquidator is appointed to wind up the company. An individual beneficiary may then receive a tax-free capital distribution from the trust. A diagram of the arrangement from the Taxpayer Alert is set out below.

The Taxpayer Alert indicates that there are a number of features of this arrangement which are of concern. These include: (a) the arrangement may be caught by s 100A concerning reimbursement agreements (see [10 050]); (b) the arrangement may constitute a tax avoidance scheme pursuant to Pt IVA of ITAA 1936 (see [10 010]); (c) the arrangement or steps within the arrangement may be a sham; (d) an entity involved in the arrangement may be a promoter of a tax exploitation scheme. If the entity is a tax practitioner, a reference may be made to the Tax Practitioners Board pursuant to the Code of Professional Conduct. This type of arrangement highlights the ongoing difficulties and issues with differences in trust income and net income and the Commissioner’s concern about tax avoidance arrangements taking advantage of the differences and the proportionate approach. 2016 THOMSON REUTERS

83

[3 440]

TAXATION OF TRUST INCOME – DIV 6

The case study at [3 440] highlights and brings together these principles but again it is important to bear in mind that, depending on the factors noted above, there are numerous different possible outcomes. The examples highlight possible outcomes.

[3 440] Case study The BK Family Trust had a net profit from trading activities of $50,000. Included in the calculation of this net profit figure was an expense claim for $60,000 for superannuation deductions. In a subsequent audit undertaken by the ATO the superannuation deductions were disallowed. The net income shown on the tax return prior to the amended assessments for the superannuation adjustment was $70,000. This was because the expenses for accounting purposes included $20,000 of non-deductible expenses. The following table sets out the trust income and net income. Trust income and net income Item Trading income Less non-deductible expenses Less superannuation expense Total

Trust income $130,000 $20,000 $60,000 $50,000

Net income $130,000 $60,000 $70,000

The trustee resolved to distribute 80% of the trust income to Mrs BK and the balance of the trust income equally between Mr and Mrs BK. This was done because Mr BK already had salary and wage income of $56,000 and the trustee wanted to ensure that Mr & Mrs BK had the same net income. By working out that $56,000/$70,000 x 100 = 80%, giving Mrs BK 80% of the trust income meant that she proportionally obtained that percentage of net income as well as half of the balance. Prior to the ATO audit, 80% of the net income of the BK Family Trust was $56,000, being the same amount as Mr BK’s salary. The balance of the trust income was distributed equally to ensure the net incomes were the same. Trust income summary Clause type Ordinary income clause (trust income = ordinary income) Section 95 clause (trust income = net income) Trust deed clause (trust income = income determined trust deed)

Pre-ATO audit $50,000

Post-ATO audit $50,000

$70,000

$130,000

$70,000 or some other amount as determined in accordance with the trust deed

$130,000 or some other amount as determined in accordance with the trust deed

The following implications arise depending on the type of clause contained in the trust deed. 84

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 440]

Ordinary income clause In determining the trust income, the trustee properly deducted the amount of superannuation disallowed, as well as the non-deductible expenses. The distribution to Mrs BK was $45,000 ($50,000 x 0.8 + half the balance ($10,000/2)) and the distribution to Mr BK was $5,000 (half the balance: $10,000/2). Proportionally their net incomes from the trust distribution would be: (a) Mrs BK $63,000 ($70,000 x 0.8 + half the balance ($14,000/2) or $70,000 x $45,000/$50,000) (b) Mr BK $7,000 (half the balance: $14,000/2) or $70,000 x $5,000/ $50,000. (Combined with Mr BK’s salary, his net income would be $63,000.) After the amendment by the ATO, the trust income would not change but the net income of the BK Trust would increase to $130,000. The share of net income of each beneficiary (post-audit) would be: (a) Mrs BK - $117,000 ($130,000 x 0.8 + half the balance ($26,000/2)) (b) Mr BK - $13,000 (half of the balance: $26,000/2). (Combined with Mr BK’s salary, his taxable income would be $69,000.) In this situation, although an attempt may have been made to obtain certainty as to the tax outcome, the adjustment to the net income flows rateably to the beneficiaries, so their net incomes are no longer equal. This would also apply where a trust deed clause gives rise to trust income that is different to net income.

Section 95 clause The trust income of the BK Family Trust is the net income. Although the trust income, before the ATO amendment, would appear to be $70,000, after the amendment, the trust income would equal the correct amended net income of $130,000. By carefully drafting the resolution to distribute trust income, it may be possible to achieve tax equality post the ATO audit adjustment. Careful drafting may require a combination of fixed amounts and percentages or proportions for the balance to be used by the trustee. All that would change is the amount available for distribution to the beneficiaries (this being the corrected trust income). This view is also supported by the Commissioner’s views in TD 2012/22. Prior to the adjustment, Mrs BK would appear to be presently entitled to $63,000 and Mr BK would appear to be entitled to $7,000. The word ‘‘appear’’ is used because arguably the trust income being equated to net income is finally determined post-ATO audit, but this position is not free from doubt. The net income and trust income post-adjustment is $130,000. On the basis of Mrs BK being entitled to 80% of the trust income and each of Mr and Mrs BK entitled to the balance equally their respective net incomes from the trust will be $13,000 and $117,000. The outcome may be different if the distribution resolution had been set out in dollar terms, with a percentage for the balance, for example, a resolution to distribute the first $56,000 to Mrs BK and the balance, if any, equally between Mr BK and Mrs BK. On adjustment by the ATO, the first $56,000 would still be applied to Mrs BK and the balance of $74,000 ($130,000 - $56,000) would be applied equally to Mr 2016 THOMSON REUTERS

85

[3 440]

TAXATION OF TRUST INCOME – DIV 6

and Mrs BK. With careful drafting of the resolution and equating trust income with net income, it may be possible to maintain equality of net income amongst beneficiaries post-tax adjustments. Tax certainty post-audit requires a s 95 clause and careful drafting of the distribution minute and is dependent on the amended net income being treated as the trust income for that year ending 30 June. The position is, as stated earlier, not free from doubt but highlights: • what may be possible; • the many different ways distributions and distribution methodology may be approached; and finally • that tax certainty is not always desirable as it may compromise other strategies (eg asset protection). Given the Commissioner’s views in TR 2012/D1, tax certainty using a s 95 clause may not be desirable because of views expressed in the draft ruling with respect to notional amounts.

TIP

Careful attention should be given to how distributions of trust income are expressed. Depending on the circumstances, it may be better to use fixed amounts, proportions of a total or percentage of a total or a combination of these approaches. It may also be possible to tie the distribution of trust income to a percentage or a proportion of the net income.

Case Study – continued Assume the BK Family Trust had a net loss from trading activities of $10,000. Included in the calculation of this loss was a claim for $60,000 in superannuation deductions and there were no non-deductible expenses included in calculating trust income. The superannuation deduction was subsequently disallowed on audit by the ATO. The amount of trust income available for distribution would be: Trust income summary Clause type Ordinary income clause Section 95 clause Trust deed clause

Pre-ATO audit -$10,000 -$10,000 Could be any other amount as determined in accordance with the trust deed

Post-ATO audit -$10,000 $50,000 Could be any other amount as determined in accordance with the trust deed

The implications are described below.

Ordinary income clause In determining the trust income, the trustee would properly deduct the amount of the superannuation contribution. The resulting loss means that there is no beneficiary presently entitled to the income of the trust estate as there is no trust income. 86

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 450]

The amendment by the ATO to the net income will have no effect on trust income which remains at a loss of $10,000. As no beneficiary is presently entitled to trust income, the trustee will be assessed on the net income at the top punitive rate of tax.

Section 95 clause As the trust income of the BK Family Trust is the net income, the trust income after the amendment by the ATO will be $50,000.

Possible outcomes • The trustee made an effective resolution to distribute the income equally between Mr and Mrs BK. In that case each of them will be assessed on $25,000. • The trustee failed to make a resolution to distribute trust income. As there is no beneficiary presently entitled, the $50,000 will be assessed to the trustee at the top marginal rate. • Failure to make the resolution may trigger a default distribution clause. For example, if Mr and Mrs BK are described as the primary beneficiaries of the BK Family Trust and the default distribution clause provides that, should the trustee fail to make a resolution, the income is applied to the primary beneficiaries equally, Mr and Mrs BK will be assessed on $25,000 each as that may be their present entitlement by the operation of the default distribution clause.

[3 450] Drafting the distribution minute Although it appears from the Cajkusic v FCT decision (see [3 320]) that the way the accounts are prepared is sufficient to indicate how a trustee has resolved to allocate payments and receipts in determining trust income, there is no substitute for a correctly drafted distribution minute that is consistent with the accounts and the notes to the accounts and relates back to the terms of the trust deed.

TIP

‘‘What is the best form of distribution minute to use?’’ The simple answer to this question is that there is no such thing as a standard template distribution minute.

Each distribution minute depends on the terms of the trust deed and what is being distributed. The following are some suggestions which should make it easier to draft a minute for the distribution of income. (a) The minute should set out some or all of the following: (i) name of trustee; (ii) name of trust; (iii) date and time of meeting; (iv) indication that it is a meeting of directors of trustee company or individual trustees of the trust; 2016 THOMSON REUTERS

87

[3 450]

(b)

(c)

(d)

(e)

(f)

(g)

(h)

TAXATION OF TRUST INCOME – DIV 6

(v) parties present; (vi) purpose of meeting; and (vii) confirmation of previous meeting minutes. The minute should note that the resolutions passed at this meeting are in accordance with the powers and discretions conferred upon the trustee pursuant to the trust deed. Determination of income. The resolution should set out the basis on which the trust income has been determined. This can only be done by reference to the trust deed. If the trust deed defines trust income as net income then this is what the distribution minute should refer to. Where there is a wide discretion to determine trust income, the way that trust income has been determined should be set out. In some cases it may be wise to refer to attached documents evidencing and explaining the determination of trust income. For example, reference may be made to a set of accounts or a work paper making adjustment to a net profit figure to arrive at trust income. The minute should note the trustee’s discretion to appoint or distribute income among the beneficiaries and where appropriate the trustee’s power to create categories of trust income. The minute should set out what amounts, proportions or calculation formulae are used to determine the distribution or allocation of the total trust income to the selected beneficiaries. If different classes of income go to different beneficiaries, then that fact should be stated. What is set out as distributed to beneficiaries should refer back to the trust income determined at points (c) and (d) above. Do not set out or refer to proportions of net income if the trust income has been determined as something other than net income. This is a common mistake. A separate work paper can be kept to set out the proportional amount of the net income that is attributable to each beneficiary on the basis of their share in the trust income. Where the trustee is a corporation there are a number of ways a resolution may be passed, eg by a meeting of directors or circular resolution. In the case of sole director corporate trustees, a resolution may be passed by recording it and signing the record of it. The minute should reflect what has actually happened. The sample minute below is in respect of a meeting of directors.

SAMPLE MINUTES Sample Discretionary Trust Income Minute for the XYZ Family Trust Minutes of the meeting of XYZ Pty Ltd (‘‘Trustee’’) the Trustee of the XYZ Family Trust (‘‘the Trust’’) For the appointment of Trust Income for the year ended 30 June [Year] (‘‘Trust Year’’) Held at: [Address] On: [Date and time]

88

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 450]

Present: [Names of all persons present]: Mr XYZ (Chairperson) Mrs XYZ 1. Previous Minutes The minutes of the previous meeting of the Trustee were read and confirmed. 2. Exercise of powers The chairperson noted that the resolutions to be passed at this meeting are pursuant to the powers and discretions conferred on the Trustee as trustee at law and by the terms [or Clause(s) xx, xx, and xx] of the Trust Deed of the Trust. 3. Determination of Trust Income The Trustee has DETERMINED the Trust Income for the Trust Year pursuant to the terms [or Clause(s) xx] of the Trust Deed of the Trust. OR The Trustee has RESOLVED pursuant to the terms [or Clause(s) xx] of the Trust Deed of the Trust that the Trust Income for the Trust Year is: • the profit determined according to ordinary income concepts and generally accepted accounting principles (Ordinary Income clause); or • the net income of the Trust as defined in s 95(1) of ITAA 1936; (Section 95 clause) or • the net income of the Trust as defined in s 95(1) of ITAA 1936 but excluding [capital gains]/[franking credits] (Modified Section 95 clause); or • $ x,xxx; or • the net profit [or other description] highlighted on the attached Trust Income Statement [or other description] (suitable for an Ordinary Income clause or Trust Deed clause). 4. Categories of Trust Income The Trustee has RESOLVED pursuant to the terms [or Clause(s) xx] of the Trust Deed of the Trust that the following categories of Trust Income apply for the Trust Year: [Category] [Category] [Category]

2016 THOMSON REUTERS

89

[3 450]

TAXATION OF TRUST INCOME – DIV 6

[Category]

5. Allocation of Trust Income Under the terms of the Trust Deed the Trustee is empowered to, at its discretion, appoint the Trust Income for the Trust Year to one or more beneficiaries of the Trust. 6. Resolution to allocate Trust Income The Trustee has RESOLVED that: the Trust Income for the Trust Year be paid, applied or set aside to or for the benefit of the beneficiaries as follows: Beneficiary 1

[Amount] or [Proportion]

Beneficiary 2

[Amount] or [Proportion]

Beneficiary 3

[Amount] or [Proportion] or [Balance] or [% of Balance]

Beneficiary 4

[Amount] or [Proportion] or [Balance] or [% of Balance]

The Trustee has CONFIRMED that the above-named beneficiaries are beneficiaries of the Trust pursuant to the Trust Deed and are entitled to receive some or all of the Trust Income of the Trust. 7. Interim payments The Trustee has CONFIRMED/RESOLVED that amount paid by the Trustee to any beneficiaries during the Trust Year, pursuant to the Trust Deed represent an interim application of the Trust Income in accordance with the terms [or Clause xx] of the Trust Deed and such payments do not vary or change the appointment of the Trust Income made under these resolutions There being no further business, the meeting was declared closed. Signed as a true and correct record: Trustee:

90

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 500]

Guardian(s): (If necessary) Appointor(s): (If necessary)

DISTRIBUTIONS TO TAX-EXEMPT ENTITIES [3 500] Trust distributions to tax-exempt entities There is no doubt that the Commissioner is concerned about the flexibility given to trustees by some trust deeds to treat receipts or payments as income or capital and how such flexibility could be used to reduce tax liabilities of trustees and beneficiaries. In particular, this concern relates to the use of tax-exempt entities to avoid the payment of tax. The Commissioner’s concern is highlighted in Example 1 in Practice Statement PS LA 2010/1 below. EXAMPLE In a particular year the trustee of a family trust derives $250,000 income of which $245,000 is applied to acquire a holiday home for the family. The trust deed provides the trustee with a power to appoint income and capital amongst a single class of discretionary objects. It also confers a power upon the trustee to characterise receipts and outgoings as on income or capital account. In the relevant year one of the discretionary objects is in a loss position for tax purposes. The trustee, in purported exercise of its power under the deed, determines that the purchase of the holiday home is an outgoing on income account and that consequently the income of the trust legally available for distribution for the year is $5,000. The trustee further resolves that this amount is to be appointed to the loss beneficiary. The trustee contends that as the loss beneficiary is presently entitled to all of the income of the trust for s 97 purposes, so all of the net income of the trust is assessable to the loss beneficiary. This would have the result that the net income of the trust would be free of tax. The contended result involves a clear mismatch between the loss beneficiary’s entitlements and the tax outcomes; all of the net income is assessed to the loss beneficiary but the bulk of the income is accumulated.

To counteract the effect of having tax-exempt entities being assessed but not paying tax because of their tax-exempt status on a disproportionate share of net income compared to their present entitlement to trust income, two antiavoidance rules were introduced in 2011, when the streaming measures were enacted: 2016 THOMSON REUTERS

91

[3 510]

TAXATION OF TRUST INCOME – DIV 6

• a ‘‘pay or notify’’ rule: see [3 510]; and • a ‘‘benchmark percentage’’ rule: see [3 520]. In January 2016, the ATO warned that it was reviewing the compliance of trustees with these two anti-avoidance rules.

[3 510] Exempt entity is not notified of present entitlement by 31 August The ‘‘pay or notify’’ anti-avoidance provides that where an exempt beneficiary has not been notified in writing of its present entitlement to trust income of a trust estate within two months of the end of the year (ie by 31 August), the exempt entity will be treated as never having been presently entitled to that distribution of income (s 100AA of ITAA 1936). The written notification of the present entitlement may be in the form of a statement and does not necessarily have to show or state the dollar amount of the distribution. The statement should set out the present entitlement in a way that it is readily quantifiable, eg 10% of the trust income of the trust. The effect of this anti-avoidance rule is that the trustee will be assessed under s 99A on the trust’s net income that corresponds to the share of the trust income that the tax-exempt entity is taken as not being presently entitled to. At the same time, the tax-exempt entity would have an entitlement to that income. Payment of the present entitlement within two months of the end of the financial year is taken to constitute notification of that amount. The Commissioner has the discretion to disregard the failure to notify the tax-exempt entity of its present entitlement within two months of the close of the tax year where it would be unreasonable to treat the tax-exempt entity as not being presently entitled. In making such a decision the Commissioner must have regard to the following matters: (a) the circumstances that gave rise to the failure; (b) the extent to which corrective action was taken to correct the failure and how quickly this was done; (c) whether s 100AA has previously operated with respect to the trustee of the trust and the circumstances that gave rise to its operation; and (d) any other circumstances the Commissioner considers relevant. It has been indicated that the Commissioner may exercise this discretion where the trustee did not know, and it was not unreasonable for the trustee to not know, that the beneficiary was a tax-exempt entity, provided that action was taken to make notification as soon as the trustee became aware of the beneficiary’s tax-exempt status.

[3 520] Exempt entity receives disproportionate share of net income The , ‘‘benchmark percentage’’ anti-avoidance rule applies where an exempt entity that is a beneficiary of a trust is assessed on a disproportionate share of the trust’s net income relative to the entitlement of that beneficiary (s 100AB of ITAA 1936). 92

2016 THOMSON REUTERS

TAXATION OF TRUST INCOME – DIV 6 [3 520]

Where an exempt entity is presently entitled to trust income of a trust and that entity’s ‘‘adjusted Div 6 percentage’’ exceeds the ‘‘benchmark percentage’’, the exempt entity is treated as never having been presently entitled to the distribution of income to the extent that the adjusted Div 6 percentage exceeds the benchmark percentage. The adjusted Div 6 percentage calculation is set out at [4 260]. The benchmark percentage to which the adjusted Div 6 percentage is compared is calculated under s 100AB(3) as follows: The amount to which the exempt entity is presently entitled, to the extent that the amount forms part of the trust’s adjusted net income for the year The trust’s adjusted net income for the year Adjusted net income is calculated as follows: Section 95 net income less Capital gains and franked distributions to which beneficiaries or the trustee are specifically entitled less Amounts that do not represent net accretions of value to the trust for that year of income plus CGT discounts claimed on remaining capital gains. Amounts that do not represent net accretions of value to the trust include those that do not provide the trust with monetary additions, property or other value. They also include accretions with a corresponding depletion of value (eg loans). Examples of amounts that do not represent accretions to the value of a trust include: • franking credits included in the calculation of the trust’s net income under s 207-35(1) of ITAA 1997; • amounts taken to be dividends paid to the trust pursuant to Div 7A of Pt III of ITAA 1936 (see [11 000]); and • so much of capital gains arising from adjustments to the cost base or capital proceeds under the market value substitution rules. The rationale for reducing the trust’s net income by these amounts is that, in the absence of the reduction, the calculation of the benchmark percentage would be distorted. The following example, based on the Explanatory Memorandum to the Tax Laws Amendment (2011 Measures No 5) Act 2011 (Example 2.33), explains the benchmark percentage anti-avoidance rule.

2016 THOMSON REUTERS

93

[3 520]

TAXATION OF TRUST INCOME – DIV 6

EXAMPLE For the income year, the Bell Trust generates $100,000 of rental income and $70,000 of franked distributions (with $30,000 franking credits attached). The trust has no expenses. The net income of the trust is $200,000 (being the $100,000 rental income, $70,000 franked distributions and $30,000 franking credits). The trust deed does not define ‘‘income’’ for the purposes of the trust deed. However, there is a clause that allows the trustee to treat receipts as income or capital of the trust at its discretion. The trustee determines to exercise this power to treat $95,000 of the rental receipts as capital and so the income of the trust estate is $75,000. Casey Pty Ltd, Mark and Emma are within the class of discretionary objects. Casey Pty Ltd is an exempt entity. The trustee specifically allocates all of the franked distributions to Mark and appoints all of the remaining income of the trust estate to Casey Pty Ltd ($5,000). The trustee notifies Casey Pty Ltd of its entitlement by 31 August following the end of the income year. The trustee appoints all of the capital in respect of that year to Emma ($95,000). Casey Pty Ltd’s adjusted Div 6 percentage is 100% (($75,000 – $70,000/$5, 000) x 100) as it is presently entitled to all of the income of the trust estate after disregarding the $70,000 of franked distributions to which Mark is specifically entitled. However, Casey Pty Ltd’s benchmark percentage is 5% (($5,000/$100,000) x 100). The franked distributions to which Mark is specifically entitled and the attached franking credits (because they do not represent net accretions of value to the trust fund) are excluded from the adjusted net income for the purpose of calculating the benchmark percentage. Casey Pty Ltd’s adjusted Div 6 percentage exceeds the benchmark percentage by 95%. The trustee of the Bell Trust is therefore assessed and liable to pay tax on $95,000 (0.95 x $100,000) under s 99A of ITAA 1936. Casey Pty Ltd’s share of the Bell Trust’s net income is confined to Casey Pty Ltd’s entitlement of $5,000.

If a trust falls foul of the second anti-avoidance rule, the implications are that the trustee is assessed under s 99A on the net income of the trust estate that is attributable to the percentage by which the exempt entity’s Div 6 percentage exceeds the benchmark percentage. The Commissioner has the discretion not to apply the second anti-avoidance rule where it is not reasonable to apply it, taking into account the following matters (s 100AB(5), (6)): • the circumstances giving rise to the exempt entity’s disproportionate share of the net income relative to its trust income entitlement; • the extent to which the exempt entity’s net income was disproportionate to the trust income; • the extent of distributions received by the exempt entity; • the extent to which other beneficiaries were entitled to benefit from amounts included in the trust’s adjusted net income; and • any other matters the Commissioner considers relevant.

94

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME

4

OVERVIEW OF THE STREAMING RULES Streaming of capital gains and franked distributions ......................... [4 000] Background and context to the streaming rules ................................... [4 010]

SUMMARY OF THE STREAMING RULES Summary of the streaming rules .............................................................. [4 100] Key concepts in the streaming rules ........................................................ [4 110] How to apply the streaming rules ........................................................... [4 120] When is a beneficiary assessed on a capital gain or franked distribution? ............................................................................. [4 130] When is the trustee assessed on a capital gain or franked distribution? ................................................................................................. [4 140]

MEANING OF SPECIFICALLY ENTITLED Beneficiary must be specifically entitled to gain or franked distribution ................................................................................................... [4 Specific entitlement to net financial benefit ........................................... [4 Net financial benefit referable to capital gain ........................................ [4 Net financial benefit referable to franked distribution ........................ [4 Specific entitlement must be recorded .................................................... [4 Specific entitlement through a chain of trusts ....................................... [4 Gains or distributions to which no beneficiary ‘‘specifically entitled’’ ................................................................................. [4

200] 210] 220] 230] 240] 250] 260]

TREATMENT OF CAPITAL GAINS Effect of the streaming rules where trust has capital gains ................ [4 Calculation of extra capital gains ............................................................. [4 Assessment of trustee on capital gains ................................................... [4 Significance of the terms of the trust deed ............................................ [4

300] 310] 320] 330]

TREATMENT OF FRANKED DISTRIBUTIONS Effect of the streaming rules on franked distributions ........................ [4 400] Calculation of franked distributions ........................................................ [4 410] Pooled franked distribution ...................................................................... [4 420]

AVOIDANCE OF DOUBLE TAXATION Avoidance of double taxation on gains and distributions .................. [4 500]

2016 THOMSON REUTERS

95

[4 000]

STREAMING OF TRUST INCOME

ASSESSING TRUST INCOME WHERE AMOUNTS ARE STREAMED Step-by-step guide to assessing trust income ........................................ [4 600] Example illustrating the combined operation of the rules .................. [4 610]

OVERVIEW OF THE STREAMING RULES [4 000] Streaming of capital gains and franked distributions The trust income tax provisions include specific streaming rules for capital gains and franked distributions flowing through trust structures. The effect of these rules is that: (a) capital gains (and their tax attributes) can be streamed to specific beneficiaries on a quantum basis (Subdiv 115-C of ITAA 1997: see [4 300]); (b) franked distributions (including any attached franking credits) can also be streamed to specific beneficiaries on a quantum basis (Subdiv 207-B of ITAA 1997: see [4 400]); and (c) any non-streamed amounts flow to beneficiaries or the trustee proportionally (see [4 260]).

TIP

To take advantage of the streaming rules, the trust deed must give the trustee sufficient power to make a beneficiary “specifically entitled” to a capital gain or franked distribution (see [2 120]).

The streaming rules are very complex and also require the application of the general rules for assessing trust income (Div 6 of Pt III of ITAA 1936: see [3 000]), as well as special rules to prevent double taxation (Div 6E of Pt III of ITAA 1936: see [4 500]). To assist in understanding the interaction between the various provisions, this chapter includes a general overview of how the provisions operate (see [4 120]), a detailed step-by-step guide to applying the provisions (see [4 600]) and an example which illustrates this step-by-step approach to a trust with ordinary income, capital gains and franked distributions (see [4 610]). Trustees who do not have franked distributions or net capital gains do not need to consider the streaming measures.

[4 010] Background and context to the streaming rules Although the streaming rules have operated since 1 July 2010, they are called ‘‘interim measures’’ because their purpose is to address “key anomalous outcomes” pending the proposed rewrite of the trust income tax provisions (see [16 000]). It is anticipated that the specific streaming rules will be repealed if a new regime for taxing trust income is introduced. Prior to the 2010-11 income year, the interaction between Div 6 of Pt III of ITAA 1936 and the capital gains tax rules was problematic for several reasons, 96

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 100]

including classifying the nature of trust receipts as income or capital, determining a beneficiary’s share of the net income of a trust and using the proportionate approach where a capital gain represented an excess of net income over trust income: see FCT v Bamford [2010] HCA 10; 75 ATR 1, discussed at [3 310]). This meant, for example, that if the income of a trust estate included a capital gain, and a particular beneficiary was presently entitled (in proportionate terms) to, say, 60% of the net income, the beneficiary would be taxed on 60% of the entire net income of the trust estate, including 60% of any capital gain forming part of the calculation of that net income, even if a different beneficiary was entitled to 100% of the capital gain under the terms of the trust deed. Further, if there was net income but no trust income, such that no beneficiary had a present entitlement, the trustee would be assessed on the net income (usually under s 99A at penalty rates): see Cajkusic v FCT [2006] FCAFC 164; 64 ATR 676, discussed at [3 320]. The purpose of the streaming rules is to ensure that the tax consequences of capital gains arising in trusts are aligned, as far as possible, with the way in which capital gains are allocated to beneficiaries under the trust deed. Note that the issues raised in Cajkusic v FCT and FCT v Bamford about the meaning of income of the trust estate have not been dealt with in the streaming measures. Income of the trust estate is determined by trust law principles and the terms of the trust deed. See further [3 300] and following.

SUMMARY OF THE STREAMING RULES

[4 100] Summary of the streaming rules The rules operate by ‘‘streaming’’ capital gains and franked distributions (including any attached franking credits) to beneficiaries who are specifically entitled to them. Any non-streamed amounts are allocated proportionally to the beneficiaries (or the trustee) based on each taxpayer’s share of the income of the trust estate (adjusted by disregarding streamed amounts). In this way, the treatment of capital gains and franked distributions is effectively taken out of Div 6 of Pt III of ITAA 1936 and dealt with predominantly under Subdiv 115-C of ITAA 1997 (capital gains) and Subdiv 207-B of ITAA 1997 (franked distributions). The amount otherwise included in a beneficiary’s assessable income under Div 6 is then adjusted to effectively ignore any capital gains or any franked distributions brought to tax under Subdivs 115-C and 207-B. For streaming to be effective for tax purposes, the beneficiary must be ‘‘specifically entitled’’ to the capital gain or franked distribution: see [4 200]. The terms of the trust deed will be critical in determining if this requirement can be met. In relation to capital gains, a beneficiary may be specifically entitled to a capital gain that is included in trust income or a capital gain distributed under a capital distribution power. 2016 THOMSON REUTERS

97

[4 110]

STREAMING OF TRUST INCOME

The streaming rules do not apply to managed investment trusts (see [1 200]), unless such trusts specifically elect to apply them. The election needs to be in writing and must be made within two months of the end of the relevant income year.

WARNING! The streaming rules are restricted to franked distributions and capital gains. They do not extend to other classes of income. Further, the Commissioner takes the view that the tax attributes of other types of income cannot be separately streamed to different beneficiaries in the way that capital gains and franked distributions may be streamed.

[4 110] Key concepts in the streaming rules The streaming rules rely on a number of specific terms and concepts. The Div 6 of ITAA 1936 concepts of income, net income and present entitlement (see [3 020]) are also relevant because a beneficiary’s present entitlement to trust income is the basis for allocating the share of capital gains and franked distributions to which no beneficiary is specifically entitled (see [4 260]). Term Specific entitlement

Net financial benefit Div 6 percentage

98

Meaning A beneficiary’s entitlement to a capital gain or franked distribution where the amount is effectively streamed to the beneficiary: see [4 200]. A beneficiary can have a specific entitlement to a capital gain or franked distribution in the absence of a present entitlement to the income of a trust estate. An amount equal to the financial benefit referable to the capital gain (see [4 220]) or franked distribution (see [4 230]) as reduced by various expenses. A taxpayer’s percentage share of the income of a trust estate. A beneficiary’s Div 6 percentage is the percentage share of the trust income to which the beneficiary is presently entitled. The trustee’s Div 6 percentage is the percentage share of the trust income to which no beneficiary is presently entitled.

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 120]

Term Adjusted Div 6 percentage

Div 6E income

Div 6E net income

Div 6E present entitlement

Meaning A taxpayer’s percentage share of the income of a trust estate, disregarding capital gains and franked distributions to which any beneficiary (or the trustee) is specifically entitled: see [4 260]. In other words, amounts that are streamed are disregarded if they form part of the trust income in the first place. Where no capital gains or franked distributions are streamed, each taxpayer’s adjusted Div 6 percentage will generally equal the taxpayer’s Div 6 percentage. The adjusted Div 6 percentage is used to determine a taxpayer’s “share” of a capital gain or franked distribution. The income of the trust estate, recalculated under Div 6E of ITAA 1936 to exclude amounts attributable to net capital gains, “net” franked distributions and franking credits: see [4 500]. The Div 6E income is used to work out each beneficiary’s ‘‘Div 6E present entitlement’’. The Div 6E income cannot be less than nil, even where the amounts attributable to capital gains, franked distributions and franking credits exceed the trust income. The net income of the trust estate, worked out under Div 6E of ITAA 1936 by ignoring net capital gains, ‘‘net’’ franked distributions and franking credits: see [4 500]. The Div 6E net income is the amount brought to tax under Div 6 of ITAA 1936. A beneficiary’s present entitlement to Div 6E income (ie the entitlement to trust income, excluding amounts attributable to net capital gains, ‘‘net’’ franked distributions and franking credits): see [4 500].

[4 120] How to apply the streaming rules There are four key steps involved in applying the trust income tax provisions to ensure that capital gains and franked distributions are effectively streamed and dealt with for taxation purposes.

Step 1: Start with the general trust rules in Div 6 Division 6 of Pt III of ITAA 1936 determines the amount of the net income of a trust estate to include in a beneficiary’s assessable income (based on that beneficiary’s share of the trust income on the proportionate approach) and assesses the trustee on the net income of the trust corresponding to the trust 2016 THOMSON REUTERS

99

[4 130]

STREAMING OF TRUST INCOME

income to which no beneficiary is presently entitled. If there is no taxable income, capital gains or franked distributions, no further consideration is necessary. Where there is trust income, the Div 6 percentage for each beneficiary and possibly the trustee must be calculated.

Step 2: Determine specific entitlement to capital gains and franked distributions Calculate each beneficiary’s share of the capital gains and franked distributions of the trust. To do this, determine amounts of capital gains and franked distributions to which beneficiaries are specifically entitled and calculate the beneficiaries’ adjusted Div 6 percentage. Where there has been no streaming, the Div 6 percentage and the adjusted Div 6 percentage will be the same.

Step 3: Allocate the amounts under the streaming rules Allocate the capital gains and franked distributions under Subdivs 115-C and 207-B of ITAA 1997. Capital gains and franked distributions to which beneficiaries are ‘‘specifically entitled’’ are streamed on a quantum basis to those beneficiaries, along with their tax attributes (eg franking credits). Capital gains and franked distributions to which no beneficiaries are specifically entitled flow to beneficiaries or the trustee proportionally.

Step 4: Apply Div 6E to avoid double taxation Division 6E of Pt III of ITAA 1936 then applies to adjust amounts otherwise assessable to the beneficiary (or the trustee) under Div 6 to avoid double taxation. Effectively this means that Div 6 amounts are recalculated on the assumption that the trust had no capital gains and no franked distributions. For a detailed step-by-step guide to applying these trust income tax provisions, see [4 600] and the example at [4 610].

[4 130] When is a beneficiary assessed on a capital gain or franked distribution? A beneficiary is liable to be assessed in relation to a franked distribution or capital gain if: • the beneficiary is specifically entitled to some or all of the franked distribution or capital gain (unless the trustee elects to be assessed on the gain); and/or • part or all of the franked distribution or capital gain has not been streamed to an entity. In this case, a ‘‘share’’ of the capital gain or franked distribution is allocated to the beneficiary based on the beneficiary’s share of the income of the trust estate (adjusted by disregarding streamed amounts).

[4 140] When is the trustee assessed on a capital gain or franked distribution? The trustee is assessed in relation to a franked distribution or capital gain where: 100

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 200]

• the trustee is allocated a ‘‘share’’ of the franked distribution or capital gain (because the trustee has an adjusted Div 6 percentage); • the trustee elects to be assessed on the whole of a capital gain (see [4 320]); or • a beneficiary with a share of a capital gain or franked distribution is under a legal disability or is a foreign resident.

MEANING OF SPECIFICALLY ENTITLED [4 200] Beneficiary must be specifically entitled to gain or franked distribution The streaming rules use the concept of ‘‘specific entitlement’’ to determine whether a beneficiary is assessed on a capital gain or a franked distribution. For streaming to be effective for tax purposes, the beneficiary must be specifically entitled to all or part of the capital gain or franked distribution and the terms of the trust deed must give the trustee the power to stream the amount. The tests for specific entitlement to capital gains and franked distribution are essentially the same (ss 115-228 and 207-58 of ITAA 1997): • the beneficiary must receive or reasonably expect to receive an amount equal to the beneficiary’s share of the net financial benefit referable to the capital gain or franked distribution in the trust (see [4 210]); and • the entitlement to the amount must be recorded in its character as such in the accounts or records of the trust (see [4 240]).

WARNING! Any resolution to make a beneficiary specifically entitled to a capital gain or franked distribution must be made by the last day of the income year (ie by 30 June). A beneficiary’s specific entitlement to a franked distribution must be recorded by the end of the income year (ie by 30 June). A beneficiary’s specific entitlement to a capital gain must be recorded no later than two months after the end of the income year in which the capital gain is made (ie by 31 August). This extra two months should be viewed as extra time to document a resolution already made.

Receive or reasonably expected to receive The amount received by the beneficiary only needs to be equivalent to the beneficiary’s share of the net financial benefit (see [4 210]) arising from the capital gain or franked distribution. It is not necessary that a beneficiary receive an amount equal to the share of the net financial benefit of a capital gain or franked distribution that can be traced to the actual trust proceeds from the 2016 THOMSON REUTERS

101

[4 200]

STREAMING OF TRUST INCOME

capital gain or franked distribution. For example, the proceeds of a capital gain may be re-invested and the distribution paid out of another bank account. The amount the beneficiary receives does not have to be expressed as a dollar amount. It may be expressed as a share of the trust gain or franked distribution or an amount by reference to a formula, for example: • 10% of the capital gain arising on the sale of asset X; • the amount of the franked distribution remaining after attributing directly relevant expenses to it and distribution of $100 to beneficiary Y. A beneficiary receives an amount when it has been distributed, paid or credited to, or applied on behalf of or for the benefit of, the beneficiary.

TIP

The terms of the trust deed set out the powers of the trustee in dealing with payments and distributions to beneficiaries and distributions should be made in accordance with the terms of the deed. For example, beneficiary X receives an amount when it is paid to Y to meet beneficiary X’s rent expense, where the deed permits payment to be made to a third party for the benefit of X.

A beneficiary can be reasonably expected to receive an amount if: • the beneficiary is presently entitled to the amount; • the beneficiary has a vested and indefeasible interest in the trust property representing the amount; • the amount has been set aside exclusively for the beneficiary (even if the beneficiary does not have a present entitlement); or • the trustee enters into a contract for the sale of a trust asset and resolves to distribute the trust profit to the beneficiary (even if settlement occurs in a later income year, ie a straddle contract).

TIP

Care needs to be taken when dealing with straddle contracts because a beneficiary may be specifically entitled to a capital gain but the contract giving rise to that capital gain may later be terminated.

Taxation Determination TD 2012/11 provides that it is not necessary for the gain itself to be reasonably certain, merely that if a gain arises, it is reasonably certain that the beneficiary will receive a share of the gain. EXAMPLE Tammy is the sole capital beneficiary of a trust. On 1 March 2016, the trustee enters into a contract for the sale of trust property. Settlement is due to take place on 31 July 2016. Any capital gain made from the sale forms part of the net income of the trust for the 2015-16 income year.

102

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 220] Tammy is specifically entitled to the capital gain in 2015-16 because, as the sole capital beneficiary, she can reasonably be expected to receive the profit on the sale of the property.

A notional allocation of an amount in the records of the trust is not enough to show that the beneficiary has a reasonable expectation of receiving that amount because it is not usually supported by the trustee exercising a power to allocate the amount to the beneficiary.

Differences between specific entitlement and present entitlement Present entitlement requires a beneficiary to have a vested and indefeasible interest in trust property and the legal right to demand immediate payment. Specific entitlement can be made out where there is a vested and indefeasible interest but not an immediate obligation to make the payment. As such, specific entitlement may be viewed as a subset of present entitlement. A beneficiary may be specifically entitled to an amount because of a vested and indefeasible interest in the amount, even if payment is conditional upon certain events occurring (ie there is no present legal obligation to make the payment).

[4 210] Specific entitlement to net financial benefit The amount of the capital gain or franked distribution to which a beneficiary is specifically entitled is calculated using the following formula (ss 115-228(1) and 207-58(1) of ITAA 1997): Gain/franked distribution

x

Share of net financial benefit net financial benefit

Financial benefit means anything of economic value (s 974-160 of ITAA 1997). This includes cash, property, services, the forgiveness of a debt obligation of the trust and any other accretion of value to a trust (eg the revaluation of a trust asset). A beneficiary cannot be specifically entitled to zero or negative amounts, or to ‘‘notional’’ capital gains (see [4 220]). Net financial benefit is defined differently for capital gains (see [4 220]) and franked distributions (see [4 230]).

[4 220] Net financial benefit referable to capital gain For capital gains, net financial benefit means the financial benefit referable to the gain less trust losses and expenses, provided tax capital losses were applied in the same way (s 115-228(1) of ITAA 1997).

2016 THOMSON REUTERS

103

[4 220]

STREAMING OF TRUST INCOME

WARNING! As a beneficiary’s specific entitlement must be to a net financial benefit, it is not possible to stream the non-discount (taxable) portion of a capital gain to one beneficiary and the discount component to another. If the trustee resolves to distribute the (tax) capital gain remaining after the CGT discount has been applied, the beneficiary will be specifically entitled to only half of the capital gain (made up equally of the taxable and discount components of the gain). In order to distribute all of the taxable amount to a beneficiary, the trustee needs to make the beneficiary specifically entitled to the whole gain.

Generally, it is not possible to have a specific entitlement to a deemed or notional capital gain for tax purposes as there is no economic benefit referable to the gain, for example, the capital gain that arises when a trust ceases to be a resident trust. Care needs to be taken in dealing with deemed capital gains because in some cases an economic benefit may be found and a beneficiary may be specifically entitled to an asset that represents that economic benefit. A good example is when a beneficiary becomes absolutely entitled to a trust asset, giving rise to CGT event E5. In such a case, it is reasonable to say that the beneficiary will receive the net financial benefit referable to the CGT event (see ATO ID 2013/33). The net financial benefit referable to the capital gain will usually be trust proceeds from the transaction that gave rise to the CGT event, reduced by costs incurred in respect of the relevant asset (cost base) and further reduced by capital losses applied against the capital gain to the extent that the application of the capital losses is consistent with the application of losses for tax purposes. The financial benefit of an asset to the trust is considered over the life of the asset, not just in the income year of the CGT event. In cases where an asset is re-valued and the re-valued amount is treated as income and distributed, the beneficiaries in receipt of the income distributions will have received part of the net financial benefit of the capital gain and may therefore be specifically entitled to a share of the capital gain. The following example (from the Explanatory Memorandum to the streaming rules) highlights how revaluation of an asset and distribution of the revaluation amount as income determines, in part, who receives the net economic benefit of a capital gain and who may be specifically entitled to the gain. EXAMPLE The Collins Trust buys an investment property in 2000 for $100,000. The trustee of the trust has the power under the terms of the deed to revalue the property according to generally accepted accounting principles and to treat any increase in its value as income of the trust. In 2005, the trustee revalued the investment property upwards by $100,000, treated this amount as income and distributed $100,000 representing the revaluation to Sally, a beneficiary of the trust.

104

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 240] In April 2016, the trustee sells the property for $300,000. The trust makes an accounting gain of $100,000 ($300,000 less the revalued amount of $200,000) and a capital gain for tax purposes of $200,000 ($300,000 capital proceeds minus the cost base of $100,000). The trustee distributes the $100,000 accounting gain to Chloe, a beneficiary of the trust. There are no losses or expenses. The net financial benefit referable to the gain (over the life of the asset) is $200,000. After applying the CGT discount, the taxable capital gain is $100,000. Sally received a $100,000 share of the net financial benefit referable to the gain as a result of the revaluation in 2005 and is therefore specifically entitled to half of the $200,000 capital gain. Chloe also received a $100,000 share of the net financial benefit referable to the gain (one payment of $100,000 from the sale of the investment property) and is also specifically entitled to half of the $200,000 capital gain.

[4 230] Net financial benefit referable to franked distribution For franked distributions, net financial benefit means the financial benefit referable to the franked distribution less direct expenses relating to the franked distribution (eg interest expenses incurred in acquiring the shares that gave rise to the franked distribution): s 207-58(1) of ITAA 1997. If the whole of a franked distribution is sheltered at the trust level because directly relevant expenses exceed the amount of the franked distribution, the ‘‘net financial benefit’’ component of the formula will be zero and no beneficiary will be specifically entitled to any part of the franked distribution.

WARNING! It is not possible to make a beneficiary specifically entitled to franking credits or to stream franking credits separately from franked distributions.

[4 240] Specific entitlement must be recorded For a beneficiary to be specifically entitled to a capital gain or franked distribution, the beneficiary’s share of the net economic benefit must be recorded in the accounts or records of the trust in its character as referable to the capital gain or franked distribution (ss 115-228(1)(c) and 207-58(1)(c) of ITAA 1997). Accounts and records encompass a very wide range of documents and include the trust deed, distribution minutes or statements, explanatory notes or schedules attached to distribution minutes, and financial accounts and ledgers. The recording of a capital gain or franked distribution in its character in the accounts and records of the trust requires consistent recording across all records. Tax notes or records merely for tax purposes are not sufficient in themselves.

2016 THOMSON REUTERS

105

[4 240]

TIP

STREAMING OF TRUST INCOME

The minute recording the trustee resolution, made in accordance with the terms of the deed, will perhaps be the most important document in satisfying the requirement that a beneficiary’s share of a capital gain or franked distribution is recorded in a way that is referable to the capital gain or franked distribution.

In the case of a testamentary trust, the will which created the trust can serve as a record: see ATO ID 2013/33. The following trust entitlements are consistent with recording a capital gain or franked distribution so that the beneficiary is specifically entitled to the capital gain or franked distribution: • pursuant to the terms of the trust deed (or clause X of the trust deed), Beneficiary A is entitled to the capital gains derived from Asset Y; • in accordance with the terms of the trust deed (or clause X of the trust deed), Beneficiary B is entitled to all (or X%) of the capital gains or franked distributions of the trust; • pursuant to the terms of the trust deed (or clause X of the trust deed), Beneficiary C is entitled to capital of the trust representing the profit or gain from the sale of Asset Z. (This type of distribution may be used where capital gains are not included as part of the income of the trust); • pursuant to the terms of the trust deed (or clause X of the trust deed), Beneficiaries D and E are entitled to capital of the trust representing the profit or gain from the sale of Asset Z equally. Entitlements to unspecified amounts, such as the following, are not sufficient to give a beneficiary a specific entitlement: • $1,000 of the trust income; • all of the trust income; • X% of the trust income; • the balance of the trust income. Such distributions do not give rise to a specific entitlement because the entitlements have not been recorded in their character with reference to the capital gain or franked distribution. It does not matter that the entitlement includes the capital gain or franked distribution. The following example is based on an example in the Tax Office document Interim Changes to the Taxation of Trusts (November 2013 version). EXAMPLE The income of a trust is $200,000 (comprising $120,000 interest income and a $80,000 non-discount capital gain). On 30 June, the trustee resolves to distribute the income of the trust equally between X and Y. On 1 August, the trustee draws up the trust accounts. The words ‘‘$80,000 capital gain’’ and ‘‘$20,000 interest’’ are added to Y’s beneficiary account.

106

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 260] In this situation, the Tax Office accepts that, read together, the trustee resolution and the trust accounts make Y specifically entitled to the $80,000 capital gain.

[4 250] Specific entitlement through a chain of trusts Specific entitlement can be created through a chain of trusts provided the requirements for specific entitlement can be made out at each step of the chain. Alternatively, where capital gains flow from Trust 1 to Trust 2 it may be possible for Trust 2 to create a specific entitlement to its share of the capital gain provided Trust 2 received a referable financial benefit from Trust 1 that can then be specifically allocated or applied to a beneficiary of Trust 2. EXAMPLE The GV Property Trust makes a capital gain of $50,000 from the sale of Greenacre. The GV Family Trust is specifically entitled to half of the capital gain. The GV Family Trust distributes the capital gain as trust income equally to Gregory and Victoria. They are presently entitled (and specifically entitled) to the capital gain. Through the two trusts, the GV Property Trust and the GV Family Trust, Gregory and Victoria have specific entitlement to 25% each of the capital gain on the sale of Greenacre.

[4 260] Gains or distributions to which no beneficiary ‘‘specifically entitled’’ If a trustee does not stream part or all of a capital gain or franked distribution, the amounts not streamed flow proportionally to the beneficiaries (or trustee). This proportion is based on the taxpayer’s ‘‘adjusted Div 6 percentage’’ and not the taxpayer’s original share of the income of the trust estate (ie trust income) under Div 6 of Pt III of ITAA 1936. Where no capital gains or franked distributions have been streamed to specific beneficiaries, each taxpayer’s adjusted Div 6 percentage will generally equal the taxpayer’s share of the trust income. A beneficiary’s adjusted Div 6 percentage is calculated as follows: Beneficiary’s present entitlement to trust income (excluding specific entitlements) Total trust income (excluding amounts any entity is specifically entitled to) In calculating the adjusted Div 6 percentage, only those capital gains and franked distributions that are part of, or included in, the trust income are excluded from the beneficiary’s share of the trust income and the total trust income respectively.

2016 THOMSON REUTERS

107

[4 300]

STREAMING OF TRUST INCOME

WARNING! Capital gains distributed under a capital distribution power that have not been included in trust income are not taken into account in this calculation even if beneficiaries are specifically entitled to those amounts. This is because such amounts do not form part of the trust income.

Where the sum all of the beneficiaries’ adjusted Div 6 percentages is less than 100%, the difference is the trustee’s adjusted Div 6 percentage. If there is no trust income, after excluding capital gains and franked distributions to which beneficiaries are specifically entitled, the trustee’s adjusted Div 6 percentage is 100%. EXAMPLE The income of the Lucas Trust for trust law purposes (trust income) comprises: • $100,000 of business income; and • $70,000 of fully franked distributions. The trust has no other expenses. Its trust income is $170,000 and its net income is $200,000 (ie including the $30,000 franking credit attached to the franked distribution). The trust has two beneficiaries, Nick and Mary. The trustee of the Lucas Trust, in accordance with a power under the trust deed, makes: • Nick presently and specifically entitled to $40,000 of the franked distributions and additionally entitled to so much of the remainder of the trust’s income as to make his total present entitlement equal to 50% of the trust income; and • Mary presently entitled to 50% of the trust income. Both Nick and Mary’s Div 6 percentage is 50% as they are both entitled to half of the trust income. However, Nick’s adjusted Div 6 percentage is 34.62% ($85,000 – $40,000)/ ($170,000 – $40,000). This is his entitlement to trust income (disregarding his specific entitlement to $40,000 of the distribution) divided by the adjusted trust income of $130,000 (disregarding the $40,000 of the income to which Nick is specifically entitled). Mary’s adjusted Div 6 percentage is 65.38% ($85,000/$130,000).

TREATMENT OF CAPITAL GAINS [4 300] Effect of the streaming rules where trust has capital gains The streaming rules are designed to ensure that taxable capital gains of a trust are taken into account in working out the net capital gain/loss of a 108

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 310]

beneficiary specifically entitled to the trust amounts representing the gain, regardless of whether the amounts form part of the income of the trust estate (ie trust income). To the extent that beneficiaries are ‘‘specifically entitled’’ to specific capital gains, the capital gains are allocated on a quantum basis (Subdiv 115-C of ITAA 1997). Beneficiaries not specifically entitled to an amount of a capital gain are allocated a proportionate share of the gain based on their share of the trust income. Where no beneficiary is ‘‘specifically entitled’’ to a capital gain, to the extent that there is a share of trust income (including the capital gain) to which no beneficiary is presently entitled, the trustee will be assessed pursuant to s 99 or 99A of Div 6 of ITAA 1936. Capital beneficiaries specifically entitled to an amount representing a capital gain of the trust are treated as having an extra capital gain under Subdiv 115-C even if they are not presently entitled to income under Div 6. The amount of the capital gain is grossed up for any CGT concessions applied at the trust level: see [4 310].

[4 310] Calculation of extra capital gains The calculation of the extra capital gains involves four steps.

Step 1: Determine share of capital gain Determine the beneficiary’s ‘‘share of the capital gain’’. This is defined as the ‘‘amount’’ of the gain. The amount of the gain for a beneficiary is made up of specific entitlements and a share of amounts to which there is no specific entitlement (s 115-227 of ITAA 1997) and is calculated as follows (s 115-228): Beneficiary’s specifically entitled capital gain + (beneficiary’s adjusted Div 6 percentage x amount of capital gain to which no one is specifically entitled) For example, if a beneficiary is specifically entitled to half of the profit from the sale of a CGT asset, the amount of the capital gain is 50% of the (tax) capital gain realised on the asset.

Step 2: Divide the share by the total capital gain Determine the beneficiary’s ‘‘fraction’’ of the total capital gain made by the trust. This fraction is calculated as follows (s 115-225): Specifically entitled capital gain + proportionate share of capital gain to which no beneficiary is presently entitled (ie result of Step 1) Total capital gain

Step 3: Calculate the attributable gain Multiply the fraction determined at Step 2 by the net income of the trust representing or relating to the capital gain. This is the ‘‘attributable gain’’. This amount will be rateably reduced if: 2016 THOMSON REUTERS

109

[4 310]

STREAMING OF TRUST INCOME

The total net income of trust < (net capital gain + (franked distributions - directly relevant deductions)) The rateable reduction is calculated as follows: Net income of trust (excluding franking credits) Net capital gains + net franked distributions

x

net capital gain

The net income of the trust is calculated after applying losses and discounts.

Step 4: Gross up the attributable gain for any CGT concessions applied at the trust level To ensure that the extra capital gain is recreated properly at the beneficiary level, Step 4 involves grossing up the result from Step 3 for the CGT general discount (see [5 030]) and/or the 50% small business CGT concession that the trustee may have applied to the capital gain (s 115-215). It is important to note that this four-step calculation applies on a gain by gain basis. Each capital gain of the trust is determined before offsetting capital losses or applying any discounts. EXAMPLE A trust has $22,500 of investment income, a $60,000 discount capital gain and a capital loss of $10,000. The trust also qualifies for the small business 50% reduction. The taxable income relating to the capital gain is $12,500, calculated as follows.

Amount Capital gain Capital loss Net position Less 50% CGT discount Less small business 50% reduction Net capital gain

$ 60,000 (10,000) 50,000 (25,000) 25,000 (12,500) 12,500

The trust deed does not treat capital gains as income, so the income of the trust estate is $22,500 while its net income is $35,000 (ie $22,500 investment income + $12,500 net capital gain). On 30 June, the trustee resolves: • to make Sara specifically entitled to $30,000 related to the capital gain (after absorbing the capital loss); and • to distribute the $22,500 investment income to X Co. Sara can reasonably be expected to receive the economic benefit of $30,000 out of the $50,000 capital gain remaining (after applying the $10,000 capital loss). She is therefore specifically entitled to 60% of the $60,000 capital gain. Sara’s share of the capital gain is $36,000 (60% of $60,000).

110

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 320] There is an amount of the capital gain ($60,000 – $36,000 = $24,000) to which no one is specifically entitled. X Co is presently entitled to trust income and has an adjusted Div 6 percentage of 100%. X Co’s share of the capital gain is therefore $24,000. Sara’s adjusted Div 6 percentage is 0%, so she is not allocated a share of the remaining capital gain. Each beneficiary’s extra capital gain is calculated as follows: Step Step 1a: specific entitlement Step 1b: adjusted Div 6 percentage Share of capital gain (amount) Step 2: fraction of capital gain

Sara $36,000 0% $36,000 6/10 ($36,000/ $60,000) Step 3: attributable gain (Step 2 x net $7,500 (6/10 x capital gain) $12,500) Step 4: Gross up for CGT discount and $30,000 ($7,500 x concessions 4)

X Co $0 100% $24,000 4/10 ($24,000/ $60,000) $5,000 (4/10 x $12,500) $20,000 ($5,000 x 4)

Amount included in assessable income Assume Sara is a resident for tax purposes and has her own current year capital losses of $6,000 and a prior year net capital loss of $2,000. X Co does not have any losses. The beneficiaries include the following amounts in their assessable income as a result of the extra capital gains: Amount Extra capital gain Current year losses Prior-year net losses Net position Less 50% CGT discount Less small business 50% reduction Assessable amount

Sara $30,000 ($6,000) ($2,000) $22,000 ($11,000) $11,000 ($5,500) $5,500

X Co $20,000 0 0 $20,000 0 $20,000 ($10,000) $10,000

X Co is also assessed under Div 6 of ITAA 1936 in relation to its present entitlement to the investment income. Sara does not have a Div 6 assessment.

[4 320] Assessment of trustee on capital gains Although Subdiv 115-C of ITAA 1997 contains the basic rules for determining whether a trustee is assessed in respect of a capital gain, the trustee’s liability to pay tax is determined under the general trust rules in Div 6 of Pt III of ITAA 1936 (ie ss 98, 99 or 99A). Division 6E of Pt III of ITAA 1936 does not modify the amount of the trustee’s liability as a result of the application of the streaming rules. 2016 THOMSON REUTERS

111

[4 320]

STREAMING OF TRUST INCOME

Where a trustee is assessed under s 98 in respect of a beneficiary who is a non-resident or under a legal disability, the trustee increases the assessable amount to reflect the beneficiary’s share of each capital gain of the trust under s 115-220. The attributable gain is calculated in the same way as set out in Steps 1 to 3 at [4 310]. The effect of the CGT discount is removed by doubling the attributable gain where the beneficiary is a company, a non-resident individual or a non-resident trustee of another trust (s 115-220(1)(b)). This is consistent with the tax treatment that would have applied had the beneficiaries made the capital gain directly. Where a trustee is assessed under s 99 or 99A, the trustee increases the amount subject to assessment to take into account the trustee’s share of the net capital gain. For s 99 assessments, the amount is calculated as shown in Steps 1 to 3 at [4 310]. For s 99A assessments, Step 4 is included in the calculation (ie the gross up), therefore removing the benefit of the CGT discount for s 99A assessments.

Election to be assessed on a capital gain The trustee of a resident trust has the option to be assessed on all or part of a capital gain that a beneficiary is specifically entitled to, where the beneficiary has not received that amount within two months of the end of the income year in which the capital gain arose (s 115-230 of ITAA 1997). The trustee may be assessed on the gain under either s 99 or 99A of ITAA 1936 as the trustee is deemed to be specifically entitled to the capital gain if the trustee chooses to be assessed on the gain (s 115-222 of ITAA 1997). For such a choice to be made, the following conditions have to be satisfied: • the trust deed must permit the trustee to be taxed on a capital gain that a beneficiary is entitled to; • the trust must be a resident trust estate within the meaning of Div 6; and • trust property representing all or part of the capital gain must not have been paid or applied to the beneficiary by the end of two months after the close of the year of income. This choice allows trustees to be assessed and pay tax on behalf of an income beneficiary who cannot benefit from the gain, or on behalf of a capital beneficiary who may not be able to immediately benefit from the gain or benefit at a time earlier than the time at which the tax liability attaching to the gain is due for payment. Note that this choice is similar to the election available to testamentary trusts before the introduction of the streaming rules, but is not limited to such trusts (ie it applies to both testamentary and inter vivos trusts).

TIP

112

The trustee needs to make the choice within two months after the last day of the income year (ie by 31 August). The Commissioner can extend this period.

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 330]

EXAMPLE Tom is the sole capital beneficiary of a resident trust. He has a vested and indefeasible interest in the capital gains made by the trust, although he cannot demand payment until the happening of certain events. For the income year, the trustee makes a capital gain of $1,600,000 which qualifies for the 50% CGT discount. Tom is specifically entitled to the capital gain, but cannot immediately benefit from it and does not have the funds to pay the associated tax liability. If the trustee elects to be assessed on the capital gain and makes the choice by 31 August, the trustee will be treated as being specifically entitled to the full amount of the gain. The trustee will be assessed on either: • $1,600,000 – if assessed under s 99A; or • $800,000 – if assessed under s 99.

[4 330] Significance of the terms of the trust deed The streaming rules highlight the importance of the terms of the trust deed, especially when dealing with capital gains. Consideration should be given to whether capital gains are included in trust income or whether the capital gain is distributed pursuant to a capital distribution power in order to determine how a beneficiary will be made specifically entitled to a capital gain. If the capital gain is included in trust income the adjusted Div 6 percentage calculation will be relevant. The streaming of capital gains for tax purposes can only arise where there is a ‘‘net capital gain’’ included in the trust’s net income and the capital gain has not been reduced to nil before CGT concessions apply under the CGT method statement in s 102-5 of ITAA 1997 (see [5 020]). Where a trust deed has an equalisation clause that equates trust income with net (taxable) income and the trust has a capital gain to which the 50% CGT discount has been applied the following issues arise: • creating a specific entitlement with respect to the amount included as income only provides specific entitlement to half the capital gain and therefore to half of the net capital gain included in net income; • where the trustee wants a beneficiary to be specifically entitled to all of the net capital gain included in the net income careful attention must be paid to the terms of the trust deed to ensure that specific entitlement to the non-discount portion of the capital can be made out; • in order to have the beneficiary specifically entitled to the whole of the capital gain, and consequently, to all of the net capital gain included in net income it may be possible if permitted by the deed to adopt a different definition of trust income by including the capital gain in trust income. This may be possible where the default trust income equates net income if the trustee fails to determine otherwise. Alternatively, specific entitlement may only be made out to the whole of the gain where a beneficiary has specific entitlement to the net capital gain (discount portion) pursuant to an income distribution power and to the non-discount 2016 THOMSON REUTERS

113

[4 400]

STREAMING OF TRUST INCOME

amount pursuant to a capital distribution power. Again, careful attention must be given to the terms of the trust deed to ensure that this is possible. If specific entitlements to capital gains are not effectively made and the trust income does not include those capital gains and the trust has no other trust income, the trustee of the trust will be assessed under s 99A (at penalty rates) or in some cases under s 99 of ITAA 1936. For further details on the importance of the trust deed, see [2 000] and following.

TREATMENT OF FRANKED DISTRIBUTIONS [4 400] Effect of the streaming rules on franked distributions Subdivision 207-B of ITAA 1997 contains complex rules for taxing franked distributions (including any attached franking credits) derived through trust structures. It also allows franked distributions to be streamed if permitted by the trust deed. Where beneficiaries have a specific entitlement to a share of a franked distribution, those beneficiaries include, on a quantum basis, their share of the distribution included in the net income of the trust. Where there is no specific entitlement to a share of a franked distribution, the share of the franked distribution assessed to presently entitled beneficiaries is in proportion to their share of the trust income where that share of the trust income is calculated disregarding capital gains and franked distributions to which beneficiaries are specifically entitled.

[4 410] Calculation of franked distributions There are three steps in calculating an attributable franked distribution (a franked distribution subject to tax).

Step 1: Determine share of franked distribution The first step requires the determination of the beneficiary’s and/or trustee’s share of the franked distribution (the ‘‘amount’’ of the distribution). The amount of the franked distribution is calculated as (s 207-55(4) of ITAA 1997): Amount of franked distribution beneficiary is specifically entitled to + Amount of beneficiary’s proportionate entitlement to any part of the franked distribution to which no beneficiary is specifically entitled

EXAMPLE Application of Step 1 The trustee of the ASC Trust has the following amounts included in trust income:

114

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 410] • a franked distribution of $70,000; • interest income of $100,000; and • interest expense of $50,000 on the borrowings used to purchase the share which gave rise to the $70,000 distribution. The trust income is therefore $120,000 ($70,000 + $100,000 - $50,000). The net income of the trust is $150,000 (including the $30,000 franking credit attached to the distribution). The trust has two beneficiaries: • Andrea is presently entitled to 40% of trust income; • Travis is presently entitled to 60% of trust income. Neither beneficiary is specifically entitled to any portion of the distribution. Using the formula set out in Step 1, the share of each beneficiary’s entitlement to the franked distribution is their proportionate share of the franked distribution to which no beneficiary is specifically entitled. If there was a specific entitlement, that specific entitlement would be added to the proportionate share of the franked distribution to which no beneficiary is specifically entitled to determine each of Andrea and Travis’ share of the franked distribution. As it stands: • Andrea’s share of the franked distribution is $28,000 calculated as (0.4 x $70,000); • Travis’ share of the franked distribution is $42,000 calculated as (0.6 x $70,000).

Step 2: Divide by the total franked distribution The second step involves determining the beneficiary’s or trustee’s fractional share of the total franked distribution. The fraction is calculated as follows: Share of franked distribution Total franked distribution

EXAMPLE Application of Step 2 Continuing from the above example Andrea’s fraction of the franked distribution is calculated by dividing her share of the franked distribution ($28,000) by the total franked distribution ($70,000). Her fraction of the franked distribution is therefore $28,000/$70,000 or 2/5ths. Travis’ fraction of the franked distribution is calculated in the same way by dividing his share of the franked distribution ($42,000) by the total franked distribution ($70,000). His fraction of the franked distribution is therefore $42,000/$70,000 or 3/5ths.

2016 THOMSON REUTERS

115

[4 410]

STREAMING OF TRUST INCOME

Step 3: Calculate attributable franked distribution The third step is to calculate the ‘‘attributable franked distribution’’ or the franked distribution subject to tax as follows: Fractional share x (total franked distribution - directly related deductions)

EXAMPLE Application of Step 3 Continuing the above example The amount of the franked distribution remaining after reducing it by the $50,000 directly relevant interest deduction is $20,000 ($70,000 – $50,000). Andrea’s attributable franked distribution is $8,000, calculated by multiplying 2/5ths by $20,000. Travis’ attributable franked distribution is $12,000, calculated by multiplying 3/5ths by $20,000.

Rateable reduction A rateable reduction to the ‘‘attributable franked distribution’’ is allowed under s 207-37(2) and (3) where: Net income of trust (excluding franking credits) < (total net capital gains + (franked distributions – directly relevant deductions)) The rateable reduction works in the same way as the rateable reduction for capital gains and is calculated as follows: Net income of trust (excluding franking credits) x franked distribution Net capital gains + net franked distributions The calculation of the share of a franked distribution (ie Step 1) under the streaming rules is calculated by adding: (a) the amount of the franked distribution to which a beneficiary is specifically entitled that is included in the net income of a trust; and (b) the beneficiary’s proportionate entitlement to any part of the franked distribution that forms part of the net income of the trust to which no beneficiary is specifically entitled. In relation to (b) above, the proportionate entitlement to a share of a franked distribution to which no beneficiary is specifically entitled is that part of the franked distribution included in the net income of the trust multiplied by the entity’s adjusted Div 6 percentage (see above). The adjusted Div 6 percentage is

116

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 500]

essentially the beneficiary’s share of the income of the trust for Div 6 purposes after excluding capital gains or franked distributions that beneficiaries are specifically entitled to.

WARNING! If a franked distribution is reduced to nil because of directly relevant expenses, the franking credit will be trapped in the trust if there are no beneficiaries with an adjusted Div 6 percentage.

[4 420] Pooled franked distribution Where a trustee distributes all of the franked distributions received in an income year within a single class of income, the streaming rules operate as if all of the franked distributions were pooled into one single franked distribution which can be streamed to different beneficiaries (s 207-59 of ITAA 1997). In this case it is not possible to stream individual franked dividends to different beneficiaries.

TIP

The pooling of franked distributions is useful where some of the franked distributions are completely sheltered by expenses and cannot be distributed. Where some shares are negatively geared, pooling with positively geared or other shares means that beneficiaries can be made specifically entitled to the pooled distribution without losing the benefit of the franking credits on negatively geared shares.

AVOIDANCE OF DOUBLE TAXATION [4 500] Avoidance of double taxation on gains and distributions To avoid double taxation where the streaming measures apply, a special provision (Div 6E of Pt III of ITAA 1936) modifies the operation of the general trust rules by excluding capital gains, franked distributions and franking credits from various Div 6 calculations. Division 6 then operates to determine who is assessed on the remainder of the net income of the trust estate. Division 6E applies where a trust’s net income is greater than nil and includes a capital gain, franked distribution or franking credit. Both the income and the net income of the trust estate are recalculated under Div 6E before applying the assessing provisions of Div 6. The recalculated income (called ‘‘Div 6E income’’) is the income of the trust estate excluding amounts attributable to net capital gains, net franked 2016 THOMSON REUTERS

117

[4 600]

STREAMING OF TRUST INCOME

distributions or franking credits. The Div 6E income is then used to work out each beneficiary’s ‘‘Div 6E present entitlement’’. The recalculated net income (called ‘‘Div 6E net income’’) is the net income of the trust estate minus any capital gains, franked distributions and franking credits. This is the amount brought to tax under Div 6. The practical effect of Div 6E is that beneficiaries are assessed under the streaming rules in respect of capital gains and franked distributions, and are assessed under Div 6 in relation to other income of the trust to which they are presently entitled. Division 6E does not affect a trustee’s liability (under Div 6) as a result of the application of the streaming rules. EXAMPLE A trust estate has net business income of $200,000 and a net capital gain of $400,000 for the income year. The net income of the trust estate is $600,000, while its Div 6E net income is $200,000. Dean, a capital beneficiary, is specifically entitled to the capital gain, while Maria is presently entitled to the balance of the income of the trust. Dean is assessed under the streaming rules while Maria is assessed under Div 6.

For a detailed example of how Div 6E applies to modify the amounts assessed under Div 6, see [4 610]. It should be noted that Div 6E was enacted as a separate division (with effect from 1 July 2010) to avoid making direct changes to Div 6 pending the proposed rewrite of the trust provisions (see [16 000]).

ASSESSING TRUST INCOME WHERE AMOUNTS ARE STREAMED [4 600] Step-by-step guide to assessing trust income The following steps outline how the Income Tax Assessment Act operates to assess income (including capital gains and franked distributions) derived through trust structures. All legislative references are to the ITAA 1936, unless otherwise stated. For ease of reference, the terms ‘‘trust income’’ and ‘‘net income’’ are used instead of ‘‘income of the trust estate’’ and ‘‘net income of the trust estate’’ respectively.

Step 1: Determine trust income Determine the ‘‘income’’ of the trust estate. This is the amount that, under trust law principles and the relevant terms of the trust deed, is treated as income of the trust estate. 118

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 600]

Step 2: Determine net income Determine the ‘‘net income’’ of the trust estate for income tax purposes (ie assessable income less allowable deductions).

Step 3: Determine present entitlement to trust income Determine whether any beneficiary is presently entitled to a share of the trust income.

Step 4: Determine specific entitlement to capital gains and franked distributions Determine amounts of capital gains and franked distributions to which beneficiaries are specifically entitled (ie amounts that are effectively streamed to particular beneficiaries). Note that if the trustee is assessable on behalf of a beneficiary under s 98, or chooses to be assessed under s 99 or 99A in respect of a capital gain, the trustee is treated as being specifically entitled to the whole of the capital gain.

Step 5: Calculate adjusted Div 6 percentage if part of gain or franked distribution not streamed If there is a share of a capital gain or franked distribution to which no beneficiary is specifically entitled (ie because part or all of the capital gain or franked distribution has not been streamed), calculate the ‘‘adjusted Div 6 percentage’’ of each beneficiary and the trustee. A beneficiary’s adjusted Div 6 percentage is their share of the trust income, excluding capital gains and franked distributions to which any beneficiary or the trustee is specifically entitled (ie disregarding amounts streamed). Importantly, these amounts are excluded only to the extent they form part of the Step 1 trust income. If the sum of the beneficiaries’ adjusted Div 6 percentages is less than 100%, the difference is the trustee’s adjusted Div 6 percentage. The trustee has an adjusted Div 6 percentage of 100% if no trust income remains after disregarding amounts to which any entity is specifically entitled. Generally, if no capital gains or franked distributions are streamed to specific beneficiaries, each taxpayer’s adjusted Div 6 percentage will equal their Step 3 share of trust income.

Step 6: Allocate capital gains Allocate capital gains under the streaming rules (Subdiv 115-C of ITAA 1997) based on each taxpayer’s specific entitlement to a capital gain and their Step 5 adjusted Div 6 percentage. Capital gains to which beneficiaries are specifically entitled are streamed on a quantum basis to those beneficiaries, along with their tax attributes. Capital gains to which no beneficiary is specifically entitled are allocated proportionally to beneficiaries (and/or the trustee) based on their Step 5 adjusted Div 6 percentage. A capital gain allocated to a beneficiary through the above process is deemed to be a capital gain made by the beneficiary (called an ‘‘extra capital gain’’) and 2016 THOMSON REUTERS

119

[4 600]

STREAMING OF TRUST INCOME

is calculated by grossing up the beneficiary’s ‘‘attributable gain’’ for any CGT concessions applied by the trustee to that capital gain. Any capital gain to which no beneficiary is entitled is assessed to the trustee under s 99 or 99A. The trustee is also assessed under s 98 in respect of beneficiaries who are under a legal disability or are non-residents. The benefit of any CGT discount is removed for s 99A assessments and also for some s 98 assessments (eg in respect of corporate beneficiaries and non-resident individuals). Any increase in the trustee’s liability under Div 6 as a result of the application of Subdiv 115-C of ITAA 1997 occurs after the Step 8 Div 6E adjustments.

Step 7: Allocate franked distributions and any attached franking credits Allocate franked distributions under the streaming rules (Subdiv 207-B of ITAA 1997) based on each beneficiary’s specific entitlement to a franked distribution and their adjusted Div 6 percentage. Consider the application of the integrity rules in Subdiv 207-F of ITAA 1997 (eg the dividend washing rule in s 207-157) to determine whether a beneficiary can receive the benefit of franking credits. Franked distributions to which beneficiaries are specifically entitled are streamed on a quantum basis to those beneficiaries, along with any attached franking credits. Franked distributions to which no beneficiary is specifically entitled flow proportionally to beneficiaries based on their Step 5 adjusted Div 6 percentage. The trustee is assessed (under s 99 or 99A) on any franked distribution to which no beneficiary is entitled. The trustee is also assessed under s 98 in respect of beneficiaries who are under a legal disability or are non-residents. Any increase in the trustee’s liability under Div 6 as a result of the application of Subdiv 207-B of ITAA 1997 occurs after the Step 8 Div 6E adjustments.

Step 8: Apply Div 6E to prevent double taxation Adjust the amounts assessable to the beneficiaries under Div 6 by calculating: • the ‘‘Div 6E income’’ (the Step 1 trust income excluding amounts attributable to net capital gains, ‘‘net’’ franked distributions and franking credits); • the ‘‘Div 6E net income’’ (the Step 2 net income excluding net capital gains, ‘‘net’’ franked distributions and franking credits); and • each beneficiary’s ‘‘Div 6E present entitlement’’ (present entitlement to trust income as modified by Div 6E).

Step 9: Allocate Div 6E net income Allocate appropriate proportions of the Div 6E net income to each beneficiary and the trustee on the basis of whether the beneficiary: • has a Div 6E present entitlement to trust income during the income year; • is a resident or non-resident at the end of the income year; and • has legal capacity. 120

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 610]

The Div 6E net income is allocated to beneficiaries in proportion to their Div 6E present entitlement to trust income. Note that if an appointment of income is invalid (eg because it breaches the perpetuity rule or the beneficiary is not an eligible beneficiary), the Div 6E income may be assessed to the default beneficiary or, if no beneficiary is presently entitled, the trustee. Also allocate to the trustee amounts assessable under Div 6 as a result of Step 6 (capital gains) or Step 7 (franked distributions).

[4 610] Example illustrating the combined operation of the rules The combined operation of the streaming rules and Divs 6 and 6E is illustrated in the following example. The example applies the step-by-step approach set out at [4 600] where a trust estate has ordinary income, capital gains and franked distributions. The example highlights the importance of the distinction between income and capital for trust and taxation purposes and how the terms of the trust deed, particularly the income definition clauses, impact on the outcome. EXAMPLE Alex and her children (Bob, Cass and Dee) are the beneficiaries of a discretionary trust. All of the beneficiaries are residents for tax purposes. The trust deed has a streaming clause but does not define the income of the trust and does not give the trustee the power to reclassify receipts. The following amounts are recorded in the trust’s accounts for the income year: • net interest income of $10,000; • a franked distribution of $7,000, with $3,000 franking credits attached and deductible borrowing expenses of $5,000; • a discount capital gain of $20,000; and • a non-discount capital gain of $10,000. The trust has a prior year net capital loss of $5,000, which the trustee chooses to apply against the $10,000 non-discount capital gain. The trustee decides to retain the other $5,000 of the non-discount capital gain to replenish the trust corpus. On 30 June, the trustee resolves to make the following distributions: Beneficiary Alex Bob Cass Dee

Distribution $5,000 of ‘‘income’’ $10,000 capital attributable to the discount capital gain $5,000 capital attributable to the non-discount capital gain $2,000 of ‘‘income’’, specified to be wholly attributable to the franked distribution The balance of the income of the trust (being $5,000)

2016 THOMSON REUTERS

121

[4 610]

STREAMING OF TRUST INCOME Step 1: Determine trust income under Div 6

The income of the trust for Div 6 purposes is $12,000 ($10,000 net interest income + $7,000 franked distribution - $5,000 borrowing expenses). The capital gains are not counted because the trust deed does not define income. Step 2: Determine net income under Div 6 The net income of the trust is $30,000 ($10,000 net interest income + $7,000 franked distribution + $3,000 franking credits - $5,000 borrowing expenses + 50% of $20,000 discount capital gain + $10,000 non-discount capital gain - $5,000 net capital loss). Step 3: Determine present entitlement under Div 6 The beneficiaries are presently entitled to the following shares of the trust income and net income under Div 6 (ignoring the effect of Div 6E): Div 6 concept Present entitlement to $12,000 trust income Percentage share of $12,000 trust income Proportionate share of $30,000 net income

Alex $5,000

Bob $0

Cass $2,000

Dee $5,000

42%

0%

16%

42%

$12,600

$0

$4,800

$12,600

Step 4: Determine specific entitlement to capital gains and franked distributions Bob is specifically entitled to all of the $10,000 non-discount capital gain because he receives all of the net financial benefit relating to the gain (s 115-228 of ITAA 1997). Alex is specifically entitled to 50% of the $20,000 discount capital gain ($10,000). There is $10,000 of the discount capital gain to which no beneficiary is specifically entitled. Cass is specifically entitled to all of the ‘‘net’’ franked distribution ($2,000). Step 5: Calculate adjusted Div 6 percentage The adjusted income of the trust estate is $10,000 (ie the $12,000 trust income excluding the $2,000 ‘‘net’’ franked distribution to which Cass is specifically entitled). Alex and Dee are each presently entitled to $5,000 of the adjusted income so they each have an adjusted Div 6 percentage of 50%. Bob and Cass are not presently entitled to the adjusted income, so their adjusted Div 6 percentage is 0%. Step 6: Allocate capital gains under Subdiv 115-C Capital gains are allocated to Alex, Bob and Dee based on each beneficiary’s specific entitlement (Step 4) and adjusted Div 6 percentage (Step 5). Cass is not assessable in relation to the capital gains because she does not have a specific entitlement to a capital gain and her adjusted Div 6 percentage is 0%.

122

2016 THOMSON REUTERS

STREAMING OF TRUST INCOME [4 610] The capital gains of the trust are allocated as follows (applying Subdiv 115-C of ITAA 1997): Concept Specific entitlement to capital gain

Adjusted Div 6 percentage share Share of capital gain (amount) Fraction of capital gain

Tax related to gain Attributable gain Gross up? Extra capital gain

Alex $10,000 (50% of discount gain) $5,000

Bob $10,000 (nondiscount gain) $0

Cass $0

Dee $0

$0

$5,000

$15,000

$10,000

$0

$5,000

75% of discount gain ($15,000 ÷ $20,000) $10,000 $7,500 Yes $15,000

100% of 0% non-discount gain

25% of discount gain ($5,000 ÷ $20,000)

$5,000 $5,000 No $5,000

$10,000 $2,500 Yes $5,000

$0 $0 NA $0

Step 7: Allocate franked distributions and attached franking credits under Subdiv 207-B Cass is specifically entitled to all of the franked distribution, so she is assessed under Subdiv 207-B in relation to the (net) franked distribution ($2,000) and attached franking credits ($3,000). Step 8: Apply Div 6E to prevent double taxation The Div 6 assessable amounts are recalculated on the assumption that the trust has no capital gains and no franked distribution. The Div 6E income of the trust is $10,000 (the net interest income, disregarding the taxable income attributable to the franked distribution). The Div 6E net income is also $10,000 (the net interest income, disregarding the franked distribution and related borrowing expenses, the franking credits, the two capital gains and the net capital loss). Alex’s Div 6E present entitlement is $5,000 (ie her present entitlement to trust income of $5,000, noting that her share of the capital gain is not part of trust income). Dee’s Div 6E present entitlement is $5,000 (ie the balance of the Div 6E income). Bob and Cass both have a Div 6E present entitlement of nil so they are not assessed under Div 6. Step 9: Allocate Div 6E net income to assess beneficiaries under Div 6 The tax treatment of the amounts received by the beneficiaries is as follows. This example assumes that the beneficiaries have no other capital gains, capital losses or net capital loss, that Cass is eligible for the franking credit, and that Alex and Dee have applied the CGT discount. Amount Amount assessed under Div 6 Net capital gain assessed under Subdiv 115-C

Alex $5,000

Bob $0

Cass $0

Dee $5,000

$7,500

$5,000

$0

$2,500

2016 THOMSON REUTERS

123

[4 610]

STREAMING OF TRUST INCOME

Attributable $0 franked distribution assessed under Subdiv 207-B Franking credit $0 attached to franked distribution Total assessable $12,500 income

$0

$2,000

$0

$0

$3,000

$0

$5,000

$5,000

$7,500

The sum of the beneficiaries’ assessable income ($30,000) equals the net income (Step 2) of the trust.

124

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

5

CAPITAL GAINS MADE THROUGH TRUST STRUCTURES Application of CGT to trusts .................................................................... [5 How to calculate a capital gain or loss made via a trust estate ........ [5 How to determine the net amount of capital gains accruing to a trust estate ........................................................................... [5 CGT general discount ................................................................................ [5 Assessing beneficiaries on net capital gains .......................................... [5 Foreign resident beneficiaries and CGT .................................................. [5

000] 010] 020] 030] 040] 050]

CGT EVENTS AND TRUSTS Triggers for the application of CGT ........................................................ [5 100] CGT events specific to trusts .................................................................... [5 110] Creating a trust over a CGT asset: CGT event E1 ................................ [5 120] Transferring a CGT asset to a trust: CGT event E2 .............................. [5 130] Converting a trust to a unit trust: CGT event E3 ................................. [5 140] Capital payment for a trust interest: CGT event E4 ............................. [5 150] Beneficiary becoming entitled to a trust asset: CGT event E5 ........... [5 160] Disposal to beneficiary to end income right: CGT event E6 .............. [5 170] Disposal to beneficiary to end capital interest: CGT event E7 ........... [5 180] Disposal by beneficiary of capital interest: CGT event E8 .................. [5 190] Creating a trust over future property: CGT event E9 .......................... [5 200] Life and remainder interests ..................................................................... [5 210] Other CGT events relevant to trusts ....................................................... [5 220]

CGT CONSEQUENCES OF DEATH Special rules setting out the CGT consequences of death ................... [5 The role of the legal personal representative or administrator .......... [5 CGT gain or loss on death is disregarded ............................................. [5 No capital gain or loss on transfer from LPR to beneficiary .............. [5 Situations where rollover or exemption does not apply ..................... [5 Where deceased is a foreign resident ...................................................... [5 Cost base rules and other calculation issues for deceased estates .... [5 Time of acquisition and availability of CGT discount ......................... [5 Availability of small business concessions ............................................. [5 Collectables and personal use assets ....................................................... [5 Unused capital losses of the deceased .................................................... [5 Record keeping ............................................................................................ [5

2016 THOMSON REUTERS

300] 310] 320] 330] 340] 350] 370] 380] 390] 400] 410] 420]

125

[5 000]

TRUSTS AND CAPITAL GAINS TAX

DWELLINGS ACQUIRED FROM DECEASED ESTATE Exemption for dwellings acquired from deceased estate .................... Dwelling disposed of within two years of the deceased’s death ...... Disposal after occupation by surviving spouse or beneficiary .......... Use of absence concession to claim full exemption ............................. Use of building concession to claim full exemption ............................ Partial exemption rules for deceased’s main residence ....................... Dwelling acquired by LPR for occupation by beneficiary .................. Life estates and remainders ...................................................................... Death of a joint tenant ............................................................................... Integrated example illustrating CGT consequences on death ............

[5 [5 [5 [5 [5 [5 [5 [5 [5 [5

500] 510] 520] 530] 540] 550] 560] 570] 580] 590]

CGT ROLLOVERS CGT rollover relief ...................................................................................... [5 700] Transfer of assets from fixed trusts to companies ................................ [5 710] Transfer of assets between fixed trusts ................................................... [5 720]

CAPITAL GAINS MADE THROUGH TRUST STRUCTURES [5 000] Application of CGT to trusts The net income of a trust estate includes any net capital gains made through the trust structure (s 95(1) of ITAA 1936). These net capital gains are calculated in the same manner as they are for other entities (using the method statement in the CGT rules): see [5 020]. A key tax advantage of the trust structure is that the 50% CGT discount applies on the disposal of a CGT asset held by the trustee for at least 12 months: see [5 030]. Various CGT small business concessions may also be available if the trust qualifies as a small business entity: see [8 100]. There are specific rules (in Subdiv 115-C of ITAA 1997) for assessing capital gains made through a trust structure. These include rules for streaming capital gains (if permitted by the trust deed) to specifically entitled beneficiaries. The streaming measures are considered in detail at [4 000] and following. Note that managed investment trusts can elect that gains and losses on the happening of CGT events be dealt with under the CGT regime (Div 275 of ITAA 1997). However, the election is restricted to CGT events involving certain assets (primarily shares, units and real property). Managed investment trusts are generally excluded from the capital gains streaming rules but can elect to use them: see [1 200].

[5 010] How to calculate a capital gain or loss made via a trust estate The amount of a capital gain or a capital loss made by a trustee from a CGT event is calculated in accordance with the specific rules set out in the relevant CGT event (see [5 100] and following). 126

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 020]

For example, the capital gain or loss arising from CGT event A1 (disposing of a CGT asset) is the difference between the “capital proceeds” from the disposal and the “cost base” of the CGT asset.

Capital proceeds Capital proceeds are the money or market value of any property that the trustee receives or is entitled to receive (s 116-20 of ITAA 1997). Where the disposal is a gift or no consideration is received, the capital proceeds are usually deemed to be the market value of the asset (s 116-30).

Cost base The cost base comprises the following five elements (s 110-25): • acquisition costs – the price paid, or the market value of the property given, to acquire the CGT asset; • the incidental costs of acquiring the CGT asset or that relate to a CGT event that occurs in relation to the asset – these may include State duty, search fees, advertising costs, borrowing expenses, and costs and fees paid for the services of a surveyor, valuer, auctioneer, accountant, broker or agent; • non-capital costs of ownership, such as interest on money borrowed to acquire the CGT asset, where the asset was acquired after 20 August 1991; • capital expenditure designed to increase or preserve the value of the CGT asset or which relates to installing or moving the asset (other than expenditure in relation to business goodwill); and • capital expenditure to establish or defend title to or a right over the CGT asset. Where the trustee has not incurred any expenditure to acquire the CGT asset (eg, it was a gift), the cost base is generally deemed to be the market value of the asset at the time of acquisition (s 112-20(1)).

[5 020] How to determine the net amount of capital gains accruing to a trust estate To determine the ‘‘net’’ amount of the capital gains accruing to a trust estate, the trustee applies the method statement in s 102-5(1) of ITAA 1997 as follows: Step 1: reduce the capital gain(s) made during the income year by any current year capital losses of the trust; Step 2: apply any prior year net capital loss(es) to any capital gain(s) remaining after Step 1; Step 3: apply the 50% CGT discount (see [5 030]) to any qualifying capital gain(s) remaining after Step 2; Step 4: apply any small business concession(s) (see [8 100]) to any qualifying capital gain(s) remaining after Step 3; and Step 5: add the adjusted gain amounts to determine the trust’s net capital gain for the income year. 2016 THOMSON REUTERS

127

[5 030]

TRUSTS AND CAPITAL GAINS TAX

If the trust has a net capital loss for the year, the capital loss is carried forward and taken into account in determining the trust’s net capital gain of the following income year. The capital loss cannot be allocated or distributed to beneficiaries. The trust loss recoupment rules (in Sch 2F to ITAA 1936) do not need to be considered as they do not apply to capital losses.

[5 030] CGT general discount Resident individuals and trusts can claim a discount of 50% on any taxable capital gain relating to a CGT asset held for at least 12 months (Subdiv 115-A of ITAA 1997). A capital gain made via a trust estate qualifies for the CGT discount if the trustee acquired the CGT asset at least 12 months before the CGT event that caused the capital gain (ss 115-10(c) and 115-25(1) of ITAA 1997). In the case of a post-CGT asset acquired from a deceased estate, the time of acquisition by the beneficiary or LPR for the purpose of the 12-month holding rule is when the beneficiary acquires the asset (s 115-30(1), items 3, 4 and 7). The CGT discount is not available if the trustee is assessed under any of the following provisions: • s 98(3)(b) of ITAA 1936 (where the beneficiary is a non-resident company); • s 98(4) of ITAA 1936 (where the beneficiary is a non-resident trustee beneficiary); or • s 99A of ITAA 1936 (where no beneficiary is presently entitled because income of the trust has been accumulated). The CGT discount is not available to companies and to individuals who are foreign residents or temporary residents (see [5 050]). This means that where the beneficiary is a company or an foreign or temporary resident, the effect of the CGT discount is reversed at the beneficiary level.

How the CGT discount applies to beneficiaries The CGT discount is available to the beneficiaries of a trust in relation to their share of the trust’s discounted capital gain. Each beneficiary must first gross up any discount capital gain received by 100%, and then reapply the CGT discount if they are entitled to it (ie they are resident individuals). The reason for this is to enable personal capital losses of the beneficiary to be first applied to the gain before the application of the CGT discount. Where the trust has also applied the small business 50% reduction to the gain (see [8 140]), the beneficiary must first gross up the gain by 200% (see example at [5 040]). EXAMPLE The Jones Discretionary Trust generates a capital gain of $600,000 that qualifies for the 50% CGT discount. At the trust level, the trustee applies the discount to reduce the gain to $300,000. The trustee distributes the gain to James and Sarah in equal proportions.

128

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 040]

James has no capital losses. In his personal return, he includes his share of the full capital gain, being $300,000 (ie double the $150,000 shown as a distribution in the trust return) and then claims his own 50% discount to reach a $150,000 taxable gain. In this case, the whole grossing exercise appears futile. Sarah has capital losses of $90,000. In her personal return, she grosses up her share of the full trust gain to $300,000 and then offsets her capital losses to reduce the gain to $210,000. She then claims her own 50% discount against this amount, with the result that $105,000 is a taxable capital gain.

CGT discount not available for certain CGT events Capital gains realised from certain CGT events (D1, D2, D3, E9, F1, F2, F5, H2, J2, J5, J6 and K10) do not qualify for the discount (s 115-25(3)). As an anti-avoidance measure, the CGT discount is not available where the CGT event giving rise to the gain occurs under an agreement made within 12 months of acquiring the asset, even though the CGT event itself occurs outside the 12 months (s 115-40). The CGT discount is also not available for capital gains arising from certain CGT events happening to equity interests in a company or trust with less than 300 members unless certain conditions are met (s 115-45).

[5 040] Assessing beneficiaries on net capital gains A beneficiary is liable to be assessed on a capital gain of a trust estate if: • the beneficiary is specifically entitled to some or all of the capital gain (unless the trustee elects to be assessed on the gain); and/or • part or all of the capital gain has not been streamed to an entity - a ‘‘share’’ of the capital gain is allocated to the beneficiary based on the beneficiary’s share of the income of the trust estate (adjusted by disregarding streamed amounts). The rules (in Subdiv 115-C of ITAA 1997) operate by deeming the beneficiary to have made the capital gain (called an ‘‘extra capital gain’’). If the 50% CGT discount has been applied at the trust level, the extra capital gain is also deemed to be a discount capital gain. To work out the beneficiary’s net capital gain or loss for the income year, the amount of the extra capital gain must first be grossed up for any CGT concessions applied by the trustee. The beneficiary’s own current and earlier year capital losses can then be applied against the extra capital gain. Finally, the CGT discount and the small business reduction (if available) can be applied to the extra capital gain: see further [4 310]. EXAMPLE A trust makes a capital gain of $100,000 when the trustee disposes of an active asset. The trust has no capital losses. After applying the 50% CGT discount and the 50% active asset reduction, the trust’s net capital gain is $25,000. Nicola is the sole capital beneficiary of the trust and is specifically entitled to 100% of the capital gain. Nicola also has a separate capital loss of $16,000 and a prior year net capital loss of $4,000.

2016 THOMSON REUTERS

129

[5 050]

TRUSTS AND CAPITAL GAINS TAX

Before applying the s 102-5 method statement, Nicola must gross up her share of the trust net capital gain ($25,000) by multiplying the amount by 4 (because the trust has applied both the CGT discount and the 50% active asset reduction). The grossed-up amount is then used to calculate Nicola’s net capital gain as follows: Method statement Extra capital gain ($25,000 x 4) Step 1: apply current year capital losses Step 2: apply prior year capital losses Net position Step 3: less 50% CGT discount – Step 4: less 50% active asset reduction Step 5: Nicola’s net capital gain

Net capital gain $100,000 ($16,000) ($4,000) $80,000 ($40,000) $40,000 ($20,000) $20,000

[5 050] Foreign resident beneficiaries and CGT Foreign resident and temporary resident beneficiaries – individuals Where an individual is a foreign resident or a temporary resident, the benefit of the 50% CGT discount (see [5 030]) is removed if, from 8 May 2012 (ss 115-105 to 115-120 of ITAA 1997): • the individual makes a discount capital gain directly or indirectly as a beneficiary of a trust; or • a trustee makes a discount capital gain and is taxed under s 98 of ITAA 1936 in respect of the individual. The CGT discount is apportioned if the individual was an Australian resident during part of the period of ownership of the CGT asset. The portion of any capital gain that accrued before 9 May 2012 remains eligible for the full CGT discount, provided the individual obtains market valuation of the CGT asset as at 8 May 2012. Where a resident individual becomes a foreign resident during the ownership period, these rules only apply if the CGT asset is taxable Australian property.

Foreign resident beneficiary – companies and trustees Where the trustee is assessed under s 98(3) of ITAA 1936 in respect of a foreign resident beneficiary, the effect of any CGT discount is reversed in calculating the amount of net income on which the trustee is assessed (s 115-220 of ITAA 1997).

Foreign resident beneficiaries – offshore assets of fixed trusts A foreign resident beneficiary who holds an interest in an Australian fixed trust can disregard a capital gain made through the trust on the disposal of a CGT asset if (s 855-40 of ITAA 1997): 130

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 110]

• the CGT asset is not taxable Australian property; or • the CGT asset is Australian property, but it is an interest in a fixed trust and at least 90% (by market value) of the assets of the trust are not taxable Australian property. In addition, the trustee of the fixed trust is not liable to pay tax on the taxable income relating to the gain (ss 115-220 and 855-40(3) of ITAA 1997).

CGT EVENTS AND TRUSTS [5 100] Triggers for the application of CGT Most dealings in capital assets acquired on or after 20 September 1985 give rise to a taxable capital gain or capital loss under the capital gains tax provisions. The trigger for a capital gain or loss to arise is the occurrence of a ‘‘CGT event’’ (Div 104 of ITAA 1997). The most common CGT event is the disposal of a CGT asset, known as CGT event A1 (s 104-10). Various CGT events (in particular, the ‘‘E’’ events) are specific to trusts: see [5 110]. Almost all transfers of assets give rise to CGT event A1, but a concession applies to CGT events that occur as a result of the death of an individual, which in effect exempts gains and losses on death from CGT (see [5 300] and following).

TIP

For CGT event A1 to occur, there must be a change of ownership from one entity to another entity. A change in the legal ownership of an asset does not constitute a change in the ownership of the asset for this purpose unless there is also a change in beneficial ownership. For example, the mere change in the trustee of a trust does not result in CGT event A1 occurring. The ATO takes the view that there is change of ownership of a CGT asset under CGT event A1 where a trustee ceases to hold an asset on trust and commences to hold it in a personal capacity (ATO ID 2010/72).

[5 110] CGT events specific to trusts There are nine CGT events (CGT events E1 to E9) that are specific to trusts. Not all of these events apply to all forms of trust, and the relevant taxpayer for each event may vary. The following table summarises the relevant taxpayer(s) and the types of trust that are excluded from their operation. Note that the specific provisions for each event should be considered closely to understand the requirements, the effect on all relevant parties and the specific exceptions that apply to each event.

2016 THOMSON REUTERS

131

[5 110]

TRUSTS AND CAPITAL GAINS TAX

Events: relevant taxpayer CGT event CGT event E1 – a trust is created over a CGT asset by declaration or settlement (s 104-55): see [5 120] CGT event E2 – a CGT asset is transferred to an existing trust (s 104-60): see [5 130] CGT event E3 – a non-unit trust over a CGT asset is converted into a unit trust (s 104-65): see [5 140] CGT event E4 – the trustee makes a capital payment to a beneficiary and the payment is not otherwise included in assessable income (s 104-70): see [5 150] CGT event E5 – a beneficiary becomes absolutely entitled to a trust asset as against the trustee (s 104-75): see [5 160]

CGT event E6 – the trustee disposes of a trust asset to a beneficiary to end an income right (s 104-80): see [5 170]

132

and excluded trusts Taxpayer Creator/settlor

Excluded trusts –

Transferor

–

Beneficiary

Unit trusts

Beneficiary

Discretionary trusts

Trustee and/or beneficiary

Unit trusts

Trustee and/or beneficiary

Trusts to which Div 128 applies (deceased estates) Discretionary trusts Special disability trusts (if the asset is the beneficiary’s main residence) Employee share trusts Unit trusts

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

CGT event

Taxpayer

CGT event E7 – the trustee disposes of a trust asset to a beneficiary to end a capital interest (s 104-85): see [5 180]

Trustee and/or beneficiary

Beneficiary CGT event E8 – a beneficiary disposes of a capital interest in a trust which was not acquired for consideration or by assignment (s 104-90): see [5 190]

CGT event E9 – a trust is created over future property (s 104-105): see [5 200] CGT event E10 – AMIT: cost base reduction exceeds cost base (s 104-107A): see [1 200]

Creator

Member of AMIT

[5 120]

Excluded trusts Trusts to which Div 128 applies Discretionary trusts (unless there are default objects with income rights) Unit trusts

Trusts to which Div 128 applies Discretionary trusts Unit trusts

Trusts to which Div 128 applies Discretionary trusts –

All trusts other than managed investment trusts that elect to be AMITs

[5 120] Creating a trust over a CGT asset: CGT event E1 CGT event E1 is triggered if a taxpayer creates a trust over a CGT asset by declaration or settlement (s 104-55 of ITAA 1997). As this event requires the trust to be created by declaration or settlement, trusts other than express trusts will rarely, if ever, fall within the scope of this event. The time of the event is when the trust over the asset is created – usually this will be on execution of the trust deed.

2016 THOMSON REUTERS

133

[5 120]

TRUSTS AND CAPITAL GAINS TAX

Declaration A declaration of trust means that the asset can be held by the original owner on trust for one or more beneficiaries. The beneficiaries may have specified rights under the terms of the declaration of trust or they may be discretionary beneficiaries where no one holds the beneficial interest. In Oswal v FCT [2013] FCA 745; [2014] FCA 812, CGT event E1 was triggered when the trustee of a discretionary trust exercised a special power of appointment to make two beneficiaries (the trustee and his spouse) absolutely entitled to part of the corpus of the trust. Although there was no express declaration of trust and no transfer of property, the Federal Court concluded that the relevant resolution was a declaration of trust as ordinarily understood. The Court also found that the appointment would have amounted to a settlement in any event. In Kafataris v DCT [2015] FCA 874 (on appeal to the Full Federal Court), a company offered to acquire the equitable interest in its directors’ investment property in exchange for the allotment of 9 million shares. The directors (a married couple) accepted the offer by signing a share application and, pursuant to the terms of the transfer, agreed to hold the property on trust for the company. The Federal Court held that CGT event E1 was triggered when the share application was signed.

Settlement A trust is created by settlement if the original owner transfers title to an asset to another person. That person could be a company owned by the original owner. The beneficiaries may have specified rights under the deed of settlement or they may be discretionary beneficiaries. In Taras Nominees Pty Ltd as Trustee for the Burnley Street Trust v FCT [2015] FCAFC 4, the taxpayer (in its capacity as a trustee) acquired four lots of land by the Yarra River in Melbourne. The taxpayer and adjacent landholders subsequently agreed to combine their lots with the idea of commercially developing the lots and selling them off. The parties executed a joint venture agreement for the creation of a “joint venture” trust over all the combined lots. A trust deed was also executed. Pursuant to the joint venture agreement and trust deed, the taxpayer conveyed its lots to the joint venture trustee. The Full Federal Court held that CGT event E1 occurred as a trust was created over the taxpayer’s lots by the combined operation of the joint venture agreement, the trust deed and the transfer executed by the taxpayer five days later. The exception to CGT event E1 for no change in beneficial ownership (see below) did not apply as the taxpayer divested itself of legal title to the land and subjected its equitable interests in the land to the joint venture trustee for the benefit of others (in addition to itself). A resettlement of a trust can potentially fall within CGT event E1 where it has the effect that one trust comes to an end and a new trust is created: see [2 530].

Creation of life and remainder interests While the creation of life and remainder interests under a will involves the creation of a trust over the original asset (thus triggering CGT event E1), the effect of Div 128 of ITAA 1997 (deceased estates) is that any capital gain or 134

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 130]

capital loss made by the deceased on the creation of the interest is disregarded (see [5 300]). However, subsequent dealings in the life and remainder interests may have CGT consequences (Taxation Ruling TR 2006/14).

Consequences for the creator of the trust and the trustee If CGT event E1 is triggered, then the person who created the trust over the asset will make a capital gain if the capital proceeds from the creation of the trust are more than the asset’s cost base, or a capital loss if the capital proceeds are less than the asset’s reduced cost base. The asset will be treated as having been acquired by the trustee for its market value at the time the trust was created, provided no beneficiary is absolutely entitled to the trust asset (disregarding any legal disability).

Exceptions CGT event E1 does not happen to an asset where the creator of a trust (not being a unit trust) is the sole beneficiary of the trust and is absolutely entitled to the asset as against the trustee (s 104-55(5)). The reason for this exclusion is that CGT event E1 is concerned with the effective disposal of the beneficial ownership of a CGT asset. The creation of a non-unit trust over an asset where the taxpayer is the sole beneficiary and ‘‘absolutely entitled to the asset as against the trustee’’ does not cause a change in the beneficial ownership of the asset. In Kafataris v DCT [2008] FCA 1454; 73 ATR 531, CGT event E1 happened when the joint owners of a commercial property (a husband and wife) each executed identical trust deeds over their respective interests in the property for the purpose of establishing superannuation funds for themselves. One month later, the property was sold on arm’s length terms. The Federal Court held that the sole beneficiary exception did not apply because the husband and wife did not have absolute entitlement over the trust assets (ie their half interests in the property) as each trust deed gave the trustee a discretion to deal with trust assets and other investments in order to pay benefits to members or their dependants. The husband and wife were not entitled to their half interest in the property once it became subject to a trust. Their only entitlement was to require the trustee to pay money when the conditions for entitlement arose. The sole beneficiary exception does not include any tracing rules that ‘‘look through’’ any sole corporate beneficiary to the actual underlying interests held in the company. In other words, the sole beneficiary of the trust could be a company in which the interests of the shareholders change over time without restriction. Where there is a change of shareholders after the declaration or settlement, CGT event E1 would not be triggered. Previously, CGT event E1 also did not apply where an asset was transferred between identical trusts (‘‘trust cloning’’) – this exclusion was abolished for CGT events occurring from 1 November 2008. Despite the abolition of the trust cloning exception, the mere change of trustee will continue not to trigger a potential capital gain or loss.

[5 130] Transferring a CGT asset to a trust: CGT event E2 CGT event E2 is triggered if a taxpayer transfers a CGT asset to an existing trust (s 104-60 of ITAA 1997). The term ‘‘transfer’’ is not confined to a 2016 THOMSON REUTERS

135

[5 140]

TRUSTS AND CAPITAL GAINS TAX

conveyance by way of gift or settlement, but includes a conveyance by way of sale: Healey v FCT [2012] FCA 269; 87 ATR 848. The transfer of an asset to an existing trust also gives rise to CGT event A1 (disposal of a CGT asset), but CGT event E2 would usually be the more specific event. It is important to determine the correct event, as the two events have different timing rules. The time of CGT event A1 is when the contract for the disposal is entered into, whereas CGT event E2 happens at the transfer date. In ATO ID 2003/559, the Tax Office decided that CGT event A1 is the more specific event where land is transferred to a trust under a standard contract of sale and the parties are unconnected and dealing with each other at arm’s length. In Healey v FCT [2012] FCA 269; 87 ATR 848, a trustee had acquired shares through a related entity for $3 million under a ‘‘standard transfer’’ arrangement. However, there was an 18-month delay in transferring the shares to the trust. On their transfer, the shares were immediately sold to a third party for $18 million. At issue was whether the trust had held the shares for over 12 months (in order to qualify for the 50% CGT discount). The Federal Court held that CGT event E2 applied to the transfer of the shares to the trust, so the event occurred on the date of transfer. As a result, the trustee held the shares for less than 12 months and the CGT discount was not available. This decision was upheld on appeal in Healey v FCT [2012] FCAFC 194.

Consequences for the transferor and the trustee If CGT event E2 is triggered, the transferor will make a capital gain if the capital proceeds from the transfer are more than the asset’s cost base. Conversely, a capital loss will arise if the capital proceeds from the transfer are less than the asset’s reduced cost base. The trustee will be treated as having acquired the asset for its market value on the date of the transfer, provided no beneficiary is absolutely entitled to the trust asset (disregarding any legal disability): s 104-60(4).

Exceptions CGT event E2 does not happen to an asset where the creator of a trust (not being a unit trust) is the sole beneficiary of the trust and is absolutely entitled to the asset as against the trustee (s 104-60(5)). Previously, the event also did not apply where an asset was transferred between identical trusts (‘‘trust cloning’’) – this exclusion was abolished for CGT events occurring from 1 November 2008. The Commissioner accepts that CGT event E2 is not triggered if the terms of the trust are changed, either pursuant to a valid exercise of a power contained in the trust deed or with a court’s approval, unless the change results in a particular asset being ‘‘subject to a separate charter of rights and obligations such as to give rise to the conclusion that that asset has been settled on terms of a different trust’’: see Taxation Determination TD 2012/21.

[5 140] Converting a trust to a unit trust: CGT event E3 CGT event E3 happens when a non-unit trust over a CGT asset is converted to a unit trust and, just before the conversion, a beneficiary under the trust was absolutely entitled to the asset (disregarding any legal disability) (s 104-65 of ITAA 1997). 136

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 150]

“Absolutely entitled” means the beneficiary had a vested, indefeasible and absolute entitlement in the property of the original trust and could require the trustee to deal with that property at the beneficiary’s direction: Oswal v FCT [2013] FCA 745. The time that CGT event E3 happens is when the conversion occurs. Presumably, this is when the relevant amendments to the trust deed take effect.

Consequences for the beneficiary If CGT event E3 is triggered, the beneficiary will make a capital gain if the market value of the asset when the trust is converted is more than the asset’s cost base, or a capital loss if the market value is less than the asset’s reduced cost base. The beneficiary’s capital gain or loss is disregarded if the asset is a pre-CGT asset. Where no capital proceeds are received, or the parties are not dealing with each other at arm’s length (which will often be the case), then the market value substitution rule for capital proceeds (s 116-30) will apply.

[5 150] Capital payment for a trust interest: CGT event E4 CGT event E4 happens if the trustee of a trust estate makes a payment to a taxpayer in relation to the taxpayer’s unit or interest in the trust where some or all of the payment is not assessable to the taxpayer (s 104-70 of ITAA 1997). Units in a unit trust are specifically covered in CGT event E4. Clearly beneficiaries in fixed trusts have an interest in the trust. In the case of a discretionary trust, it is generally accepted that discretionary beneficiaries do not have an ‘‘interest’’ in the trust (apart from a right to be considered for a distribution), so that CGT event E4 cannot apply to them (Determination TD 97/15). Similarly, a default beneficiary is not considered to have an ‘‘interest’’ in a trust for the purposes of CGT event E4 unless the interest was acquired for consideration or by way of assignment (Determination TD 2003/28). CGT event E4 is intended to apply to any payment made by the trustee to a beneficiary that is not assessable income of the beneficiary so that it reduces the cost base of the beneficiary’s unit or interest in the trust. A payment for this purpose includes giving property (s 104-70(2)). For example, CGT event E4 would apply to distributions of accounting income in excess of trust income and the non-assessable ‘‘small business 50% reduction’’ component of a capital gain (Determination TD 2006/71). It would also apply if a unit holder receives a distribution for an income year which exceeds the trust’s net income, and the difference results from an expense being deductible for income tax purposes in that year which was properly charged against income for trust law purposes in an earlier income year (ATO ID 2012/63). The time of CGT event E4 will ordinarily be just before the end of the income year in which the trustee makes the payment to the beneficiary (s 104-70(3)). However, if another CGT event (other than E4) happens in relation to the unit or trust interest after the trustee has made the payment but before the end of that income year, the time of the event will be just before the time of that other CGT event. Hence, it is necessary to determine the cost base adjustments to the unit or trust interest as a consequence of triggering CGT event E4 prior to determining the CGT consequences of that other CGT event. 2016 THOMSON REUTERS

137

[5 160]

TRUSTS AND CAPITAL GAINS TAX

Consequences for the beneficiary If CGT event E4 is triggered, the unit holder/beneficiary will either realise a capital gain and/or incur a reduction in the cost base and reduced cost base of the unit or interest in the trust. Where the payment of non-assessable amounts in an income year is more than the cost base, the beneficiary derives a capital gain of the difference and the cost base and reduced cost base is reduced to nil. Where the payment is less than the relevant cost base, then the cost base will be reduced by the non-assessable amount and there will be no other CGT consequences at that time. A unit holder/beneficiary cannot incur a capital loss as a result of triggering CGT event E4.

Exceptions There are various exclusions from CGT event E4 (s 104-71). Importantly, distributions of the non-assessable CGT discount component of a capital gain to an individual beneficiary are treated as excluded payments (s 104-71(4)). Likewise, payment of a non-assessable CGT concession amount through a chain of trusts is excluded.

[5 160] Beneficiary becoming entitled to a trust asset: CGT event E5 CGT event E5 occurs if a beneficiary becomes absolutely entitled to a CGT asset of a trust as against the trustee (disregarding any legal disability of the beneficiary) (s 104-75 of ITAA 1997). ‘‘Absolutely entitled’’ means the beneficiary has a vested, indefeasible and absolute entitlement in trust property and can require the trustee to deal with that trust property as the beneficiary directs: Oswal v FCT [2013] FCA 745. Typically, CGT event E5 would happen when a beneficiary reaches a certain age and under the terms of the trust becomes absolutely entitled to an asset held in trust. The event applies to both the trustee and beneficiary.

Consequences for the trustee When CGT event E5 occurs, the trustee is taken to have received market value as the capital proceeds for the asset. The capital gain or loss is the excess or the deficiency of the market value capital proceeds when compared with the relevant cost base.

Consequences for the beneficiary The beneficiary is treated as having received the market value of the asset as the capital proceeds for the interest in the trust. The capital gain or loss is the excess or deficiency of the market value capital proceeds when compared with the cost base of the beneficiary’s interest. If the beneficiary acquired the interest for no expenditure, then the legislation specifically provides that any capital gain or loss from CGT event E5 is disregarded (s 104-75(6)). In the vast majority of discretionary trusts and/or family trusts there will have been no expenditure by the beneficiary because the trust will have been established by the settlor to provide a benefit for the 138

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 160]

beneficiary. This provision has the effect of avoiding the double application of the CGT provisions because CGT event E1 will have applied on the creation of the trust. EXAMPLE In 2000, Mrs Jones established a trust with Melissa (her daughter) as one of the beneficiaries. As part of the settlement, Mrs Jones transferred a house with a market value of $190,000 to the trust. The trustee was required to hold the house for Melissa absolutely upon her attaining the age of 25. On 27 June 2016, Melissa turned 25 and, pursuant to the terms of the trust deed, she became absolutely entitled to the house. At that time, the house had a market value of $900,000. The capital gain to the trustee on Melissa becoming absolutely entitled to the house is calculated as follows. Market value capital proceeds .......................................................... $900,000 Cost base .......................................................................................... $190,000 Capital gain ....................................................................................... $710,000 The CGT general discount would apply as the asset has been held for more than 12 months by the trustee. Any capital gain or loss made by Melissa with respect to her interest in the trust will be disregarded because she incurred no expenditure to acquire it.

Exceptions CGT event E5 does not apply where: • the trust is a unit trust; • the trust is an employee share trust and the distribution is made as part of an employee share scheme arrangement; • the beneficiary becomes absolutely entitled to a dwelling from a special disability trust or a related implied trust and the dwelling is eligible for the main residence exemption; or • a beneficiary of a deceased estate becomes absolutely entitled to an asset of the estate – any capital gain or loss in such a case is disregarded due to the operation of Div 128 (see [5 320]).

TIP

The exclusion of deceased estates from CGT event E5 is not a general exclusion given to all assets held by such estates. The exclusion is limited to assets that were held by the deceased just before he or she died (Determination TD 2004/3). If the trustee of a deceased estate acquires an asset after the testator’s death and a beneficiary becomes absolutely entitled to that asset, CGT event E5 may still be triggered in relation to that asset.

2016 THOMSON REUTERS

139

[5 170]

TRUSTS AND CAPITAL GAINS TAX

In ATO ID 2013/33, a trust was created over a deceased father’s estate in favour of his wife for life, with his daughter taking the remainder. The trustee acquired shares after the father’s death. The daughter became absolutely entitled to the shares when her mother (the life tenant) died. The trustee made a capital gain from the shares by reason of CGT event E5. No capital gain arose in the hands of the daughter because she acquired the interest for no consideration. However, the Tax Office then concluded that the daughter was specifically entitled to the capital gain for the purposes of the streaming rules (see [4 220]).

[5 170] Disposal to beneficiary to end income right: CGT event E6 If a trustee disposes of a CGT asset of the trust to a beneficiary in satisfaction of the beneficiary’s right to receive income from the trust, CGT event E6 is triggered (s 104-80 of ITAA 1997). Both the trustee and the beneficiary have notionally disposed of a CGT asset in such a case – the trustee has disposed of the subject CGT asset and the beneficiary has disposed of the right to receive income from it or part of it.

Consequences for the trustee Where CGT event E6 is triggered, the trustee will make a capital gain if the market value of the asset at the time of disposal is more than the asset’s cost base, or a capital loss if the market value is less than the asset’s reduced cost base.

Consequences for the beneficiary The beneficiary will make a capital gain if the market value of the asset at the time of disposal is more than the cost base of the beneficiary’s right (or part of it), or a capital loss if the market value is less than the reduced cost base of the beneficiary’s right (or part of it). If the beneficiary did not pay or give anything for the right to income, or did not acquire the right via an assignment from another entity, then the market value substitution rule does not apply (s 112-20(3), item 1). Therefore, the acquisition costs of a beneficiary’s right to income may be nil.

Exceptions CGT event E6 specifically does not apply to unit trusts or to deceased estates to which Div 128 applies.

TIP

For CGT event E6 to be triggered, it is implicit that the beneficiary has a pre-existing right to the income before the disposal by the trustee. As the mere object of a discretionary trust has no right to receive income of the trust until the trustee has appointed income that person, CGT event E6 is generally inapplicable to such a trust. CGT event E6 can, however, apply to the default objects of a discretionary trust from the time they each become takers in default under the trust.

140

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 190]

[5 180] Disposal to beneficiary to end capital interest: CGT event E7 CGT event E7 is triggered if the trustee disposes of a CGT asset of the trust to a beneficiary in satisfaction of the beneficiary’s interest, or part of it, in the trust capital (s 104-85 of ITAA 1997). CGT event E7 has consequences for both the trustee and the beneficiary.

Consequences for the trustee The trustee will make a capital gain if the market value of the asset at the time of disposal is more than the asset’s cost base or a capital loss if the market value is less than the asset’s reduced cost base.

Consequences for the beneficiary The beneficiary will make a capital gain if the market value of the asset at the time of disposal is more than the cost base of the beneficiary’s interest (or part of it) being satisfied. The beneficiary will make a capital loss if the market value is less than the reduced cost base of the beneficiary’s interest (or part of it) being satisfied.

Exceptions Unit trusts and also deceased estates to which Div 128 applies are specifically excluded from CGT event E7. It is unlikely that CGT event E7 can apply where the trust is a discretionary trust because s 104-85(1) requires the beneficiary to have a pre-existing right to the trust capital. However, in ATO ID 2002/365 (withdrawn for being a simple statement of the law), CGT event E7 applied to the sale of a trust asset (a house) to the beneficiaries in order to offset an amount in the beneficiaries’ loan accounts. The Tax Office treated the interest in each beneficiary’s loan account as a capital interest in the trust.

[5 190] Disposal by beneficiary of capital interest: CGT event E8 CGT event E8 deals with the disposal of a capital interest by a beneficiary to a third party (s 104-90 of ITAA 1997). This event applies where the beneficiary has an interest in the capital and disposes of the interest or part of it to a person other than the trustee. The beneficiary must have been the original owner of the interest and not given any money or property to acquire it. This would be the position of a beneficiary in a fixed trust established for the benefit of the beneficiary.

Consequences for the beneficiary The determination of the capital gain or loss in such a case varies depending on whether the beneficiary is the sole beneficiary of the trust and whether he or she is disposing of the whole or part of the capital interest (s 104-95). As CGT event E8 is triggered by the disposal of a beneficiary’s interest in a trust to a person other than the trustee, there are no consequences to the trustee arising out of this event. 2016 THOMSON REUTERS

141

[5 200]

TRUSTS AND CAPITAL GAINS TAX

Exceptions Unit trusts and also deceased estates to which Div 128 applies are specifically excluded from CGT event E8. It is implicit that the beneficiary has a pre-existing right to the trust capital before the disposal. It follows that CGT event E8 would not ordinarily apply to mere objects and default objects of a discretionary trust. CGT event E8 also does not apply to a taker in default of trust capital as the taker does not have an ‘‘interest in the trust capital’’ and that only those interests which constitute a vested and indefeasible interest in a share of the trust capital fall within the scope of CGT event E8 (Determination TD 2009/19).

[5 200] Creating a trust over future property: CGT event E9 CGT event E9 is triggered if a taxpayer agrees for consideration that, when property comes into existence, he or she will hold it on trust (s 104-105 of ITAA 1997). CGT event E9 only occurs if, at the time of the agreement, no potential beneficiary under the trust has a beneficial interest in the rights created by the agreement.

Consequences for the creator of the trust Where CGT event E9 occurs, the person who created the trust over the asset will make a capital gain if the market value the property would – if it had existed at the time of the agreement – be more than any incidental costs the taxpayer incurred in relation to the event. A capital loss will be made in the reverse situation. While determining market value can be a difficult task at best, determining the market value of future property at the time of the event is arguably more a matter of guesswork than any calculation of real amounts. There are no specific exceptions from the scope of this event. Also, a capital gain from CGT event E9 is not a discount capital gain. CGT event E9 was originally introduced as an anti-avoidance measure covering situations where a prospective interest in a partnership is assigned – these assignments are known as pre-admission Everett assignments (see [10 020]).

[5 210] Life and remainder interests The Tax Office views on the treatment of life and remainder interests arising from deceased estates (and inter vivos trusts) are set out in Taxation Ruling TR 2006/14. The Commissioner considers that such interests are ‘‘created’’ interests and are not ‘‘carved out’’ of the original assets of the estate – with the result that a CGT event will apply to any dealings with them. For example, if a testamentary trust is created under a will, CGT event E1 happens when administration of the deceased’s estate is completed, but any capital gain or loss will be disregarded by virtue of the exemption that applies to deceased estates: see [5 300]. However, subsequent dealings in such life and remainder interests may have CGT consequences (Taxation Ruling TR 2006/14). 142

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 220]

[5 220] Other CGT events relevant to trusts Renouncing an interest in a discretionary trust CGT event C2 is triggered if a taxpayer’s ownership of an intangible asset ends by the asset being redeemed, cancelled surrendered, forfeited, discharged, released, satisfied, abandoned or by the asset expiring (s 104-25 of ITAA 1997). A beneficiary’s renunciation of an interest in a discretionary trust would fall within this event (Determination TD 2001/26), as would the redemption of units in a unit trust (Determination TD 40; Colonial First State Investments Limited v FCT [2011] FCA 16; 81 ATR 772).

Trust ceasing to be a resident CGT event I2 happens if a trust stops being a resident trust for CGT purposes (s 104-170(1)). The effect of the event is that, subject to certain exceptions, CGT will apply to all of the CGT assets of the trust. A non-unit trust will cease being a resident trust estate for CGT purposes if at any time during the relevant income year the trustee stops being an Australian resident or the trust’s central management and control is no longer in Australia. A unit trust will cease being a resident trust for CGT purposes if: (a) none of the trust property is situated in Australia and the trust does not carry on business in Australia; (b) one of the elements in (a) is satisfied but the central management and control is no longer located in Australia and Australian residents do not hold more that 50% of the beneficial interests in income or property of the trust. CGT event I2 does not apply to the following items of taxable Australian property that the trust owns just before the event (s 104-170(3)): • taxable Australian real property (s 855-20); • an asset used in carrying on a business in Australia (s 855-15, item 3 of Table); • an option or right to acquire any of the above assets (s 855-15, item 4 of Table).

Pre-CGT interest in a trust CGT event K6 is an anti-avoidance measure which prevents a ‘‘pre-CGT’’ trust being used as a repository to hold or accumulate post-CGT assets. Where CGT event K6 applies, the taxpayer is deemed to have made a capital gain on a pre-CGT interest in a trust (or shares in a company) to which a relevant CGT event happens where the market value of the underlying post-CGT property of the entity is 75% or more of the net value of the entity (s 104-230). The relevant CGT events that trigger event K6 are CGT events A1, C2, E1, E2, E3, E5, E6, E7, E8, J1 or K3. CGT event K6 does not apply where CGT rollover is available. Importantly, this includes the Div 128 ‘‘rollover’’ available on the death of an owner of pre-CGT shares or an interest in a trust (see [5 320]). Although CGT event K6 2016 THOMSON REUTERS

143

[5 300]

TRUSTS AND CAPITAL GAINS TAX

will not be triggered by death, the trust interest or shares will acquire a post-CGT status in the hands of the legal personal representative and/or beneficiary. This has the result that CGT will apply to any subsequent CGT event that affects the trust interest or shares in their hands. CGT event K6 cannot give rise to a capital loss.

Other CGT events Other CGT events that may be relevant in a trust situation include: • CGT event C1: loss or destruction of a CGT asset or part of an asset (s 104-20); • CGT event C3: an option granted by a company or unit trust over its shares, units or debentures ends by being cancelled, released, abandoned or not exercised (the event applies to the issuer of the option (ie the company or unit trust), not the holder of the option (s 104-30); • CGT event J2: a capital gain rolled over under the small business replacement asset rollover (see [8 130]) is reinstated if the replacement asset acquired under the rollover (eg a trust interest) ceases to be a replacement asset (s 104-185). This may occur if a connected entity ceases to be a CGT concession stakeholder or the CGT concession stakeholders cease to have a small business participation percentage (see [8 240]) of at least 90%; • CGT event J4: the effect of the trust to company rollover (see [5 710]) is reversed if the trust does not cease to exist within six months from the transfer of the first asset to the company (as required for the rollover) (s 104-195); • CGT event K3: a CGT asset passes to a tax-advantaged entity on the taxpayer’s death (s 104-215: see [5 340]).

CGT CONSEQUENCES OF DEATH [5 300] Special rules setting out the CGT consequences of death Special rules (in Div 128 of ITAA 1997) set out the CGT consequences on death. In most cases, a capital gain or loss arising on death is disregarded. This is the result of an automatic ‘‘rollover’’ or ‘‘exemption’’ which applies where a CGT asset owned by the deceased at the date of death passes to his or her executor or legal personal representative (see [5 310]) and then to a beneficiary of the estate (see [5 330]). However, a CGT liability may arise if the asset is disposed of outside this chain of succession (see [5 320]).

[5 310] The role of the legal personal representative or administrator On the death of a person, the ownership of his or her assets passes to a legal personal representative (LPR) or an administrator of the estate. 144

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 320]

The LPR is responsible for administering the estate according to the terms of the will of the deceased. Usually the LPR will be nominated in the deceased’s will and often will be a family member, a close friend or sometimes one of the trustee companies. An administrator is granted administration of the estate by a court where there is no LPR (for example, under intestacy). This may be because the deceased did not leave a will or because the LPR is unable or unwilling to act. Generally, the administrator will be someone with a close interest in the estate, such as a surviving spouse or other close relative.

Grant of probate or letters of administration Both for executors and administrators, there are formalities to be satisfied before they can deal with the assets of the deceased. A will must be ‘‘proved’’ and then probate is granted to the executor. Where there is a whole or partial intestacy, a person wishing to be an administrator must apply to the relevant State or Territory court for the ‘‘grant of letters of administration’’. The effect of the grant of probate or letters of administration is to vest the legal ownership of the assets of the deceased in the LPR or administrator who is then charged with the responsibility of administering those assets in accordance with either the terms of the will or the statutory rules relating to the distribution of an estate on intestacy.

Administered and unadministered estates Before the administration of an estate is completed, no beneficiary has any interest in the assets of the estate. Beneficiaries only have a personal claim for due administration of the estate. On the other hand, once administration is completed, the beneficiary obtains an equitable interest in the property of the deceased estate. At this time, a beneficiary who has been left a specific asset under the will can call for its transfer.

Legal personal representative The CGT relief provisions in Div 128 of ITAA 1997 for deceased estates refer to a ‘‘legal personal representative’’ or LPR. The Commissioner has had a longstanding practice of treating the trustee of a testamentary trust as an LPR for the purposes of Div 128 and accordingly those provisions apply to such trustees in the same way as they apply to LPRs (Practice Statement PS LA 2003/12, as updated on 27 August 2015). In the 2011-12 Budget, the previous Government announced that this administrative practice would be embedded in legislation to remove any concerns about its sustainability. However, on 14 December 2013, the Coalition Government indicated that it would not proceed with this proposed measure. A testamentary trust arises after administration of an estate is finalised generally for the purpose of holding assets to give effect to the deceased’s intentions (for example, to hold assets for a life tenant or until a beneficiary has satisfied a contingency for the vesting of a gift or bequest).

[5 320] CGT gain or loss on death is disregarded Generally, no CGT consequences are triggered where a CGT asset owned by the deceased at his or her date of death passes to the LPR and then to a beneficiary of the estate. 2016 THOMSON REUTERS

145

[5 330]

TRUSTS AND CAPITAL GAINS TAX

This is the effect of a CGT ‘‘rollover’’ or exemption for assets passing through a deceased estate (Div 128 of ITAA 1997). Any CGT consequences will only be attracted when the asset is disposed of outside this chain of succession, for example, by the trustee under a power of sale or by the beneficiary after acquiring the asset. The deceased estate exemption is automatic in the sense that the LPR cannot elect to bring about a different outcome, such as the realisation of capital gains or losses in the deceased’s final year tax return. To come within the exemption, the assets must be ‘‘CGT assets’’ that the deceased owned just before dying. This would include CGT assets such as real estate, shares, a main residence, personal use assets (eg boats, jewellery and furniture), joint interests in property and a partner’s interest in a partnership. Cash is not a CGT asset and bequests of cash are not subject to the CGT regime. This would include cash proceeds from life insurance realised on the death of the deceased. This may give rise to legitimate tax planning in the writing of wills. Likewise, while a car is a CGT asset, a capital gain or loss made by the LPR or beneficiary on the disposal of a car owned by the deceased is disregarded under a specific exemption (s 118-5).

[5 330] No capital gain or loss on transfer from LPR to beneficiary Any capital gain or loss made by an LPR on the transfer or ‘‘passing’’ of an asset of the deceased to a beneficiary is disregarded (s 128-15(3) of ITAA 1997). This provision applies in the usual situation where an asset is transferred to a beneficiary in the course of administration of the deceased estate. It would also apply where an estate asset passes to a remainder interest owner on the death of a life tenant or where the LPR acquires an asset for the purpose of giving effect to a specific bequest in the will. To attract the benefit of the CGT exemption, the asset must have passed from the LPR to the beneficiary. An asset will be taken to have ‘‘passed’’ to a beneficiary when the beneficiary becomes the owner of the asset in any of the following circumstances (s 128-20): • under a will or a will varied by a court order; • by operation of an intestacy law; • by appropriation to a beneficiary; • under a deed of arrangement; • by absolute entitlement (Determination TD 2004/3). Note that the fact that an asset can ‘‘pass’’ to a beneficiary under a ‘‘deed of arrangement’’ without any CGT consequences can also give rise to planning opportunities (see TR 2006/14). Generally, a beneficiary becomes ‘‘absolutely entitled’’ to an asset where, for example, the LPR acquires an asset for a beneficiary to satisfy a specific bequest under the will or where the administration of the estate has been finalised and there is a sole beneficiary entitled to the residue of the estate. A CGT asset will not ‘‘pass’’ to a beneficiary if the beneficiary becomes the owner of the asset because the LPR transfers it under a power of sale 146

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 340]

(s 128-20(2)). In this situation, CGT event A1 (see [5 100]) will apply to the trustee in relation to the transfer and a capital gain or loss will accrue to the estate.

TIP

Note again that the CGT exemption on death is limited to assets that form part of the estate of the deceased and does not apply to assets acquired by the estate after the death of the testator.

[5 340] Situations where rollover or exemption does not apply CGT assets passing to tax-advantaged entities CGT rollover relief on death does not apply where a CGT asset owned by the deceased at the date of death passes to a beneficiary who is a ‘‘tax-advantaged entity’’ (s 104-215 of ITAA 1997). A tax-advantaged entity is: • a tax-exempt entity (eg a charity); • the trustee of a complying superannuation entity; or • a foreign resident. A beneficiary’s status as a tax-advantaged entity is determined at the time the asset “passes” to the beneficiary, not at the time of the deceased’s death. Where a CGT asset passes to a tax-advantaged entity, a capital gain or loss is deemed to arise just before the death of the taxpayer (CGT event K3) and must be taken into account in the deceased’s final year return. The capital gain or loss is calculated as the difference between the market value of the asset at the date of death and the cost base of the asset (Determination TD 2004/3). Any capital gain returned in the date of death return can be offset by capital or income losses of the deceased which otherwise would have expired on death (but otherwise unused capital losses cannot be used and lapse on the deceased’s death: see [5 410]). Where a CGT asset passes to a foreign beneficiary, CGT event K3 will apply if the deceased was an Australian resident just before dying and the asset in the hands of the beneficiary is not taxable Australian property (s 104-215(2)). The exclusion of taxable Australian property reflects the fact that such property is subject to Australian CGT on its disposal regardless of the residency status of the taxpayer. Note, however, that a bequest of cash to a foreign resident will have no CGT consequences as cash is not a CGT asset (see also [5 320]). A capital gain or loss is also disregarded where a testamentary gift of property is made to a deductible gift recipient (s 118-60). However, if property in a deceased estate is sold by the LPR during the period of administration and cash, rather than the property, is subsequently donated to a deductible gift recipient under the terms of the will, then the LPR may derive a taxable capital gain or loss as a result of the sale. 2016 THOMSON REUTERS

147

[5 350]

TRUSTS AND CAPITAL GAINS TAX

Assignment of interest in deceased estate On completion of the administration of a deceased estate, the beneficiary obtains an equitable interest in the property of the deceased. Accordingly, this interest can be sold or assigned as it is a CGT asset. In these circumstances, there will be CGT consequences for the beneficiary as the deceased estate exemption does not apply to such transactions and a sale or disposal will trigger CGT event A1.

Buy-sell agreements The sale of business assets of the deceased by the LPR to a surviving business partner under a buy-sell agreement does not come within the scope of Div 128 rollover relief. This is because the assets do not pass to a beneficiary of the deceased estate under the rules in that Division but rather under a contractual arrangement. The exercise of the relevant options under the agreement would result in a CGT event A1 disposal of the asset by the LPR to the surviving business owner/s under a contract which would give rise to a capital gain or loss to the deceased estate. The Commissioner takes the view that the granting of the options will have no independent CGT consequences (ATO ID 2003/1190). Note the CGT small business concession may be available for any capital gain or loss arising on the bequest of business assets of the deceased, if certain conditions are met (see [5 390]).

[5 350] Where deceased is a foreign resident The CGT rollover on death also applies where the deceased is a foreign resident and a resident beneficiary inherits an asset from the deceased. This has the following effect (ss 128-10 and 128-15 of ITAA 1997): • any gain or loss arising on the death of the foreign resident will be disregarded; • any capital gain or loss on the transfer of the asset from the executor to a resident beneficiary will be disregarded. As in other cases, the LPR or beneficiary will be taken to have acquired the asset for a cost base determined under the rules in s 128-15(4) (see [5 370]).

[5 370] Cost base rules and other calculation issues for deceased estates The following rules (in s 128-15(4) of ITAA 1997) apply in determining the cost base or reduced cost base of an asset in the hands of an LPR or beneficiary where there is a subsequent event which attracts CGT (other than an event which attracts the rollover – see [5 330]): • a pre-CGT asset is taken to have been acquired for its market value at the deceased’s death (thus protecting any gain in the asset that accrued before death); • a post-CGT asset is taken to have been acquired for the cost base or reduced cost base of the asset in the hands of the deceased at the date of death; 148

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 390]

• a dwelling which was the main residence of the deceased at the date of his or her death (including under the ‘‘absence’’ concession in s 118-145), and was not then being used to produce assessable income, is treated as having been acquired for a cost base equal to its market value at the date of death. See also [5 500] for the CGT rules which apply to the disposal of dwellings acquired from deceased estates; • assets that were trading stock in the deceased’s hands immediately before his or her death will be taken to have been acquired for their market value at the date of death; • any asset that was not taxable Australian property of a deceased foreign resident will be taken to have been acquired by the LPR or beneficiary for its market value at the deceased’s date of death. Where an LPR purchases an asset to satisfy a specific bequest to a beneficiary, the beneficiary will be taken to have acquired the asset at that time for the amount paid by the LPR (Determination TD 93/36). If the LPR incurs expenditure on an asset of the deceased, the cost base of the asset in the beneficiary’s hands can include any amount that would have been included in the cost base of the asset in the hands of the LPR (s 128-15(5)). This could include legal costs incurred in establishing or defending title to the asset or in confirming the validity of the will, capital expenditure to make inherited property habitable and costs of ownership (for example, council rates on land (ATO ID 2001/729). Where a post-CGT improvement is made to a pre-CGT asset, the improvement is not deemed to be a separate CGT asset on the person’s death (s 108-70(2)). In this case, the LPR or administrator will be treated as having acquired the ‘‘whole’’ asset, together with the improvement, for its market value at the date of the deceased’s death (s 128-15(2) and (4); Determination TD 96/18).

[5 380] Time of acquisition and availability of CGT discount A CGT asset of the deceased devolving to the LPR or beneficiary is taken to have been acquired on the day the taxpayer died (s 128-15(2) of ITAA 1997). This means that if the deceased died prior to 20 September 1985, then the LPR and/or beneficiary will be considered to have acquired it before that date also and that as a result it will not be subject to CGT on its subsequent disposal. However, in determining whether a disposal of the asset by the LPR or beneficiary that is subject to CGT has been held for more than 12 months for the purposes of qualifying for the 50% CGT discount, the LPR or beneficiary will be considered to have acquired a post-CGT asset of the deceased when the deceased acquired it (s 115-30(1), items 3 and 4 of Table). In the case of a pre-CGT asset of the deceased, the 12-month holding rule is measured from the deceased’s date of death (s 115-30(1)), items 5 and 6 of Table).

[5 390] Availability of small business concessions The LPR or beneficiary of a deceased estate will be eligible for the small business CGT concessions (see [8 100] and following) for capital gains realised from ‘‘active’’ business assets of the deceased. The availability of the concessions in this situation is subject to the following conditions (s 152-80(1) of ITAA 1997): 2016 THOMSON REUTERS

149

[5 400]

TRUSTS AND CAPITAL GAINS TAX

• the deceased must have been eligible for the concession just prior to his or her death (ie the deceased would have satisfied the active asset test and either the maximum net asset value test or the small business entity test); and • the CGT event must happen within two years of the deceased’s death or such further time as the Commissioner allows. Note that the concessions are also available to surviving spouses or joint tenants in this situation.

[5 400] Collectables and personal use assets Where an asset of the deceased was a collectable or ‘‘personal use’’ asset at the date of his or her death, it will retain the same character in the hands of the LPR or beneficiary (s 128-15(6) of ITAA 1997). It will therefore attract the special rules that apply to such assets — including the following: • collectables acquired for $500 or less are exempt from CGT (s 118-10(1)); • a capital loss on a collectable can only be used to reduce capital gains from collectables (s 108-10(1)); • a capital gain from the disposal of a personal use asset will be disregarded if the asset was acquired for $10,000 or less (s 118-10(3)); • a capital loss on the disposal of a personal use asset is disregarded and cannot be offset against any capital gain, even when realised on the disposal of another personal use asset (s 108-20(1)). A ‘‘collectable’’ covers such things as artwork, jewellery, antiques, a rare folio, manuscript or book and a postage stamp or first day cover (s 108-10)). An asset can only be a collectable if it is used or kept mainly for personal use or enjoyment of the taxpayer or an associate. A ‘‘personal use’’ asset is a CGT asset (other than a collectable) that is used or kept mainly for the personal use or enjoyment of the taxpayer or associates, for example, a boat or household furniture and appliances (s 108-20(2)). Note also the existence of ‘‘integrity’’ measures to avoid CGT where sets of collectables are sold as separate items in order to come under the $500 threshold for collectables (see s 108-25). EXAMPLE Diane dies leaving her furniture to her daughter, Rosie. Rosie sells the furniture after it is transferred to her by Diane’s executor. None of the assets has a cost base of more than $10,000. As the items are treated as personal use assets in Rosie’s hands, any capital gain or loss is disregarded.

[5 410] Unused capital losses of the deceased Any tax losses of a taxpayer unused at the date of death cannot be used by the LPR or passed on to a beneficiary by the LPR (Taxation Determination TD 95/47). In other words, capital losses lapse with the deceased’s death. However,

150

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 510]

capital losses can be used against a gain arising under CGT event K3 if an asset is bequeathed to a tax-advantaged entity: see [5 340].

[5 420] Record keeping It is important for the LPR or beneficiary to maintain accurate records of the cost base of the inherited asset for the purposes of the tax record keeping rules in Div 121 of ITAA 1997. It would therefore have been prudent that the deceased retained accurate records of the date of acquisition of assets and their cost of acquisition, together with details of any capital expenditure on that asset. The use of a CGT asset register may assist in this process.

DWELLINGS ACQUIRED FROM DECEASED ESTATE [5 500] Exemption for dwellings acquired from deceased estate A full or partial exemption from CGT may apply on the disposal of a dwelling by a beneficiary or LPR who acquired it from a deceased estate, ie where a ‘‘relevant’’ CGT event happens to the dwelling in the LPR or beneficiary’s hands (ss 118-195 to 118-210 of ITAA 1997). The full exemption is available where a dwelling acquired from a deceased estate is disposed of: (1) within two years of the deceased’s death (see [5 510]); or (2) after occupation by a surviving spouse, a beneficiary or a person with a right to occupy (see [5 520]). This full exemption rule applies provided the dwelling was either a pre-CGT dwelling or was the deceased’s main residence at the date of death that was not being used at that time to produce assessable income. A partial exemption may be available if the requirements for a full exemption have not been met: see [5 550]. There is no residency restriction on the application of the exemption provisions and they therefore would apply regardless of the residency status of the relevant parties (ie the deceased, the LPR or the beneficiary) as long as the dwelling is located in Australia. The exemption rules extend to an interest in a dwelling acquired by a surviving joint tenant. This is the case even if that interest was not acquired under the deceased’s will or through the estate, but instead under the ‘‘survivorship’’ rule.

[5 510] Dwelling disposed of within two years of the deceased’s death A full exemption from CGT applies to the disposal of a pre-CGT or post-CGT dwelling by an LPR or beneficiary of a deceased estate if the dwelling is disposed of within two years of the deceased’s death (s 118-195(1) of ITAA 2016 THOMSON REUTERS

151

[5 520]

TRUSTS AND CAPITAL GAINS TAX

1997). In the case of the sale of the dwelling, this two-year period is measured from the date of death until settlement of the contract (and not its ‘‘making’’). In the case of a post-CGT dwelling, the full exemption will only apply if the dwelling was the deceased’s main residence at the date of death and was not then being used to produce assessable income (or is taken to have been the deceased’s main residence under the ‘‘absence’’ concession in s 118-145: see [5 530]). However, note that it does not matter how the dwelling was used in the two-year period after death or if it was used as a place of business or for rental purposes before the date of death, provided the dwelling was either the deceased’s main residence at the date of death and was not then being used to produce income, or was a pre-CGT asset. The Commissioner has a limited discretion to extend the two-year period in which the LPR or beneficiary must dispose of the dwelling for the full exemption to apply. EXAMPLE Susan acquired her home in 1995. Until her retirement in 2006, she used part of the home as a surgery for her medical practice. On her death on 1 June 2014, the dwelling was her main residence and was not used for any income-producing purposes. If the LPR or a beneficiary of Susan’s estate sells the house before 1 June 2016, the full exemption from CGT will apply. The income-producing use of the house before 2006 can be ignored.

[5 520] Disposal after occupation by surviving spouse or beneficiary A full exemption from CGT also applies on the disposal of a dwelling by the LPR or beneficiary of a deceased estate where the dwelling was occupied as a main residence from the deceased’s death until its disposal (s 118-195 of ITAA 1997) by: • the surviving spouse (but not a surviving spouse who was living permanently and separately apart from the deceased); and/or • a person with a right to occupy under the will; and/or • a beneficiary of the estate who inherited the dwelling or an interest in it. Where the dwelling is a post-CGT dwelling of the deceased, the full exemption under this rule will only apply if the dwelling was the deceased’s main residence at the date of death and was not then being used to produce assessable income (or is taken to have been the deceased’s main residence under the ‘‘absence’’ concession in s 118-145: see [5 530]). The exemption extends to situations where there is successive occupation by different such people, for example, where the dwelling is first occupied by a life tenant such as a surviving spouse and then by the remainder beneficiary. The requirement to occupy the dwelling as a main residence from the date of the deceased’s death attracts the benefit of the concession for moving into a dwelling which allows occupation to occur as soon as first practicable (s 118-135). 152

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 540]

[5 530] Use of absence concession to claim full exemption The ‘‘absence’’ concession in the CGT main residence rules (s 118-145 of ITAA 1997) can be used to satisfy the requirement that a dwelling be the deceased’s main residence at the date of death in order to apply the full exemption for either disposal within two years or after occupation by a surviving spouse, a beneficiary or a person with a right to occupy. However, the Commissioner takes the view that the absence concession cannot be used for this purpose if the dwelling is, for example, rented at the time of death as the dwelling would not satisfy the requirement of being the deceased’s main residence at the date of death and ‘‘not then being used for producing assessable income’’. However, the full exemption would be available if the absence concession was applied and the dwelling was not being used for income-producing purposes. EXAMPLE Tony acquired his home in 2001. In the year before his death it remained vacant while he lived in a nursing home. The LPR of his estate sold the house within two years of his death in order to distribute the proceeds among his three children. As the dwelling was not Tony’s main residence at the date of death, the full CGT exemption is not available as such. However, this can be rectified by the LPR choosing to apply the ‘‘absence’’ concession so that the house is treated as Tony’s main residence as at the date of his death.

Likewise, a surviving spouse, a beneficiary or a person with a right to occupy the deceased’s dwelling could use the absence concession to continue to treat a dwelling as a main residence for the purpose of applying the full exemption for subsequent ‘‘occupation’’ by such a person (see [5 520]). EXAMPLE David acquired a main residence before 20 September 1985. He died in 2005, leaving the house to his wife. She continued to live in the house for three years after his death, and then rented it out for several years, after which time she sells it. If David’s wife makes a choice to treat the house as her main residence, she will be entitled to a full CGT exemption on any capital gain on the sale.

[5 540] Use of building concession to claim full exemption An LPR or a surviving joint tenant can choose to apply the CGT concession for building or repairing a dwelling (s 118-150 of ITAA 1997) to treat the dwelling as a main residence where the owner dies before satisfying the conditions for the concession to apply (s 118-155). As a result, the LPR or surviving joint tenant will be able to access the full exemption for disposal of a dwelling within two years of the deceased’s death or after occupation by a surviving spouse, beneficiary or person with a right to occupy.

2016 THOMSON REUTERS

153

[5 550]

TRUSTS AND CAPITAL GAINS TAX

EXAMPLE Emma and David jointly buy a block of land in 2010 and complete construction of a dwelling on it in December 2015. David dies before he can satisfy the condition in the ‘‘building concession’’ that requires him to occupy the dwelling as his main residence for three months. However, the trustee of his estate, or his wife as the surviving joint tenant, can choose to treat the land and dwelling as David’s main residence from its acquisition until his death. If his wife occupies the dwelling from the date of David’s death until its disposal, the disposal of both her interest and the interest she acquired as a surviving joint tenant will be exempt from CGT. (A surviving joint tenant is treated as a beneficiary for the purposes of the exemption).

[5 550] Partial exemption rules for deceased’s main residence If a full CGT exemption is not available for the disposal of an inherited dwelling (see [5 510] to [5 540]), a partial exemption may be available (s 118-200 of ITAA 1997). Where, for example, the deceased was not living in the residence at the time of death and the dwelling was acquired on or after 20 September 1985, a full exemption would not ordinarily be available. A full exemption would also not be available if the residence was sold more than two years after the deceased’s death and it was unoccupied at the time. The partial exemption is calculated using the formula: Capital gain or loss x Non-main residence days Total days Non-main residence days Non-main residence days are calculated as the sum of the following: (a) the number of days in which the dwelling was not the deceased’s main residence (if it was a post-CGT asset); and (b) the number of days from the deceased’s date of death until the relevant disposal during which the dwelling was not the main residence of a beneficiary, spouse or a person with a right to occupy it under the deceased’s will. If the deceased’s dwelling is a pre-CGT asset, ‘‘non-main residence days’’ is simply the amount specified in (b).

TIP

154

Certain periods of time can be ignored in calculating non-residence main days. These are any days before the deceased’s death if the dwelling was the deceased’s main residence just before death and was not being used to produce assessable income at that date (s 118-200(4)).

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 550]

Total days If the deceased’s dwelling is a pre-CGT asset, then the ‘‘total days’’ equals the number of days in the period from the deceased’s date until the LPR’s or beneficiary’s ownership ends. If the dwelling is a post-CGT asset, total days are the number of days from the acquisition by the deceased until the LPR’s or beneficiary’s ownership ends. Capital gain or loss The amount of the capital gain or loss subject to the partial exemption calculation is the capital gain or loss that the LPR or beneficiary would otherwise have made on the disposal. For these purposes, the rules in s 128-15(4) (see [5 370]) will apply to determine the cost base for which the LPR or beneficiary acquired the dwelling. EXAMPLE Partial exemption: post CGT asset Mrs J purchased a house in June 2006 for $325,000 which was her main residence at the time she died in June 2011. Its market value at the date of her death was $400,000. Carol, her daughter, inherited the house and rented it out for two years. After the two years, Carol moved into the house and made it her home for the next three years. She then sold it (in June 2016) for $700,000, resulting in a capital gain of $300,000. Carol is not entitled to a full CGT exemption (no sale within two years and no main residence use by Carol during all of her period of ownership). She is however entitled to a partial exemption as follows: $300,000

x 2 years of non-main residence days 10 years of total ownership days*

= $60,000 *Total number of days from the date Carol’s mother purchased the house (June 2006) until the dwelling is sold by Carol (June 2016). The capital gain subject to the partial exemption is calculated on the basis that it was acquired by Carol for its market value on the date of her mother’s death as it was her main residence and was not being used to produce income at that time. The 50% CGT discount is also available as the dwelling was held for more than 12 months, including the period of ownership by the deceased. As a result, Carol will only need to include $30,000 in her assessable income.

EXAMPLE Partial exemption: pre-CGT asset Mr K purchased a house in June 1984 for $200,000 which was his main residence at the time he died in June 2011. Its market value at the time of his death was $400,000.

2016 THOMSON REUTERS

155

[5 560]

TRUSTS AND CAPITAL GAINS TAX

Mark, his son, inherited the house and rented it out for two years. After the two years, Mark moved into the house and made it his home for the next three years. He then sold it (in June 2016) for $700,000, resulting in a capital gain of $300,000. Mark is not entitled to a full CGT exemption (no sale within two years and no main residence use by him throughout his period of ownership). He is however entitled to a partial exemption as follows: $300,000

x 2 years of non-main residence days 5 years of total ownership days*

= $120,000 *

Total number of days from the date of Mr K’s death (June 2011) until the dwelling is sold by Mark (June 2016). The 50% CGT discount is also available as the dwelling was held for more than 12 months so Mark will only need to include $60,000 in his assessable income.

TIP

If a partial exemption applies and the LPR or beneficiary sells the dwelling within two years of the deceased’s death, then the LPR or beneficiary can choose to calculate the partial exemption by reference to the capital gain or loss that accrued to the date of death only, ie the number of days from the deceased’s death to disposal are excluded from ‘‘non-main residence’’ and ‘‘total days’’ (s 118-200(3)).

[5 560] Dwelling acquired by LPR for occupation by beneficiary A CGT exemption is available on the disposal by a trustee of a dwelling acquired by the trustee for occupation by a beneficiary under the terms of the deceased’s will (s 118-210 of ITAA 1997). The exemption applies for the period that the beneficiary occupies the dwelling. If the dwelling is later transferred to the beneficiary for no consideration, any capital gain or loss by the trustee is disregarded. If the dwelling is sold to a third party, no gain or loss will arise provided the dwelling is the main residence of the beneficiary from the time the dwelling was acquired by the LPR until the disposal time.

[5 570] Life estates and remainders Where a life interest is created on the death of the deceased in relation to a dwelling owned by the deceased, the disposal of the remainder interest will qualify for the main residence exemption for deceased estates, where the conditions for the exemption are met (s 118-195(1) of ITAA 1997). Thus, the exemption is available where the life interest in the dwelling is created in favour of the deceased’s spouse and the dwelling is occupied by the surviving spouse from the deceased’s death until disposal. The exemption 156

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 580]

would also be available if the remainder interest is disposed of within two years of the deceased’s death (as the remainder beneficiary is considered to have acquired his or her interest in the home at the deceased’s date of death — regardless of the intervening life interest). Where the exemption applies in these situations, the cost base of the dwelling will be the market value at the date of death (Div 128). This is subject to a reduction for the effect of the life tenancy which prevents the immediate taking of the remainder interest by the remainder beneficiary. EXAMPLE Andrew died in 2006. Under his will, a life estate was created over his home in favour of his wife, Colleen, with remainder interests in favour of his two daughters, Felicity and Joanna, in equal shares. Andrew acquired the house in 1974 and, at the date of his death, it had a market value of $700,000. In May 2016, Colleen died and the LPR of Andrew’s estate transferred the home to Felicity and Joanna. They sold it two months later in July 2016 for $1.5 million. Felicity and Joanna will be treated as having acquired their interests in the home on their father’s death for its market value at that time ($700,000). The market value will need to be reduced to, say $600,000, to reflect the existence of the life tenancy. As the dwelling was the main residence of Andrew’s wife from his date of death until its sale (apart from two months) Felicity and Joanna can rely on the exemption for disposal after occupation by a surviving spouse to disregard the capital gain of $900,000 ($1.5 million less $600,000).

[5 580] Death of a joint tenant If a CGT asset is owned by joint tenants and one of them dies, the survivor is taken to have acquired the deceased’s interest in the asset at the date of the deceased’s death (s 128-50(1) of ITAA 1997). If the interest in the jointly owned asset was acquired by the deceased on or after 20 September 1985, the surviving joint tenant will be treated as having acquired the deceased’s interest for the cost base of the asset in the hands of the deceased on the date of death (s 128-50(3)). Where the interest in the jointly owned asset was acquired by the deceased before 20 September 1985, the cost base of the asset in the hands of the survivor is the market value of the asset at the date of death (s 128-50(4)). This means that the inherited fraction of the asset is no longer exempt from CGT as a pre-CGT asset in the hands of the survivor. If there is more than one surviving tenant, the cost base is apportioned accordingly (s 128-50(3)).

2016 THOMSON REUTERS

157

[5 580]

TRUSTS AND CAPITAL GAINS TAX

EXAMPLE Death of joint tenant: post-CGT asset Sarah and James acquired a block of land as joint tenants on 1 December 2001. They each have a 50% interest in the land. Sarah dies on 1 May 2016. The cost base of the land at that date is $100,000. James will be taken to have acquired Sarah’s 50% interest on 1 May 2016 for its cost base at that date ($50,000). James now has: (1) his 50% interest in the land acquired on 1 December 2001 with a cost base of $50,000; and (2) Sarah’s former 50% interest, which James is taken to have acquired on 1 May 2016, also with a cost base of $50,000.

EXAMPLE Death of joint tenant: pre-CGT asset Jill and Barry acquired a block of land as joint tenants on 1 December 1984. They each have a 50% interest in the land. Barry dies on 1 May 2016. The market value of the land at that date is $800,000. Jill will be taken to have acquired Barry’s 50% interest in the land on 1 May 2016 for its market value at that date ($400,000). Jill now has: (1) her 50% pre-CGT interest in the land; (2) Barry’s former 50% interest, which is now a post-CGT interest taken to have been acquired by Jill on 1 May 2016 with a cost base of $400,000.

NOTE

158

In the 2011-12 Budget, the previous Government announced that it would introduce amendments in this area to, among other things, confirm that when an interest in a pre-CGT asset passes by survivorship, the interest in the asset will be taken to be acquired by the surviving joint tenant(s) when the deceased died to ‘‘ensure consistency between joint tenants and deceased estate cases’’. It will also be relevant for the purposes of the CGT discount. However, on 14 December 2013, the Coalition Government indicated that it would not proceed with these proposed changes.

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 590]

[5 590] Integrated example illustrating CGT consequences on death EXAMPLE Pamela dies in January 2016. Her will provides for her children, Andrew and Karen, and her husband, David, to be appointed joint executors (LPRs). The will makes the following bequests: (1) Pamela’s diamond necklace and gold ring that she acquired in 1990 for $20,000 (plus her own mother’s jewellery that she inherited in 1970) – to her daughter, Karen; (2) her Renault car – to her son, Andrew; (3) a block of land in the country acquired in 1990 for $10,000 – to the local church; (4) cash of $30,000 held in a bank account – to her children in equal shares; (5) her holiday home built in 1995 (at a cost of $150,000) on land she acquired in 1984 – to Andrew; (6) her share portfolio of 1,500 pre-CGT and 3,000 post-CGT shares (acquired at various times from 1985 till her death) – to her children in equal shares; and (7) any residue of the estate – to her husband, David. Background facts • The matrimonial home was acquired jointly with her husband in 1960. • At the time of her death there was an outstanding mortgage of $60,000 on her holiday home. • Pamela had a life insurance policy worth $100,000. • Pamela had net capital losses on her death of $20,000 from previous share sales. • Part way through administration of the estate her husband, David, retires as LPR due to ill health. • The executors incur $1,000 in legal fees in obtaining probate. • During the course of administration, a family provision claim is made by a child Pamela had as a teenager before she was married. The court orders that the will be varied so that her share portfolio be split three ways with each of her children. The executors spend $10,000 defending the claim. CGT consequences for Pamela’s estate and beneficiaries General – ‘‘rollover’’ effect There will be no CGT consequence to Pamela or her estate in respect of assets she owned at her death (subject to an exception for the land bequeathed to the local church – see below) (s 128-10). There will also be no CGT consequences in relation to her assets being transmitted or passed from her executors to the beneficiaries of the estate (s 128-15(3)).

2016 THOMSON REUTERS

159

[5 590]

TRUSTS AND CAPITAL GAINS TAX

Executors The exemption in s 128-10 would also apply to any CGT consequences arising from the change in ownership of the assets on the retirement of her husband as an LPR of the estate. The probate costs of $1,000 incurred by the executors would be apportioned to form part of the cost base of each CGT asset of the deceased (s 128-15(5)). Life insurance proceeds The proceeds of $100,000 from the life insurance policy would not be subject to CGT or income tax and could be used to pay the debts of the estate, including funeral expenses and the outstanding mortgage on the holiday home. Any balance would be paid to David as the residuary beneficiary with no CGT consequences. Matrimonial home David acquires Pamela’s joint interest in the family home as a surviving joint tenant for its market value at the date of her death. Accordingly, he now has two interests in the home – one acquired pre-CGT, the other post-CGT with a cost base of its market value at the date of Pamela’s death (s 128-50(4)). If he disposes of this interest within two years of Pamela’s death or continues to occupy it as his home until its disposal he will be entitled to the main residence exemption: see [5 500]. Jewellery Both the post-CGT and pre-CGT jewellery items are ‘‘collectables’’ at the time of Pamela’s death and will, therefore retain their character as collectables in Karen’s hands as a beneficiary. Accordingly, any capital gains or losses arising from their disposal will be subject to the rules for collectables (eg the quarantining of losses on collectables). In addition, Karen will be taken to have acquired the pre-CGT jewellery items for their market value at the date of Pamela’s death and the post-CGT jewellery items for Pamela’s cost base at her death (s 128-15(4)). Car Pamela’s car is a ‘‘CGT asset’’ but there are no CGT consequences in connection with any disposal of the car (s 118-5). Block of land bequeathed to church This bequest would trigger CGT event K3, giving rise to a capital gain or capital loss in Pamela’s date of death return (by reference to the market value of the land at her date of death). However, Pamela’s prior unused net capital losses could offset any capital gain – otherwise, these capital losses cannot be used by the executors or beneficiaries. Cash The cash of $30,000 is not a CGT asset and will not be subject to any CGT provisions. Therefore, any dealing with the cash by the LPRs and/or beneficiaries will have no CGT consequences. Holiday home Although the building comprising the holiday home is a ‘‘separate CGT asset’’ in Pamela’s hands, the land and building will be considered to have been acquired by the LPRs and Andrew (as the beneficiary) at the date of Pamela’s death for the market value at that time (Determination TD 96/18). Share portfolio The transfer of shares to Pamela’s three children (including the child she had before her marriage as a result of the successful family provision application) will qualify for the ‘‘rollover’’ under s 128-15(3) for assets ‘‘passing’’ to beneficiaries of the estate in accordance with a ‘‘will varied by a court order’’.

160

2016 THOMSON REUTERS

TRUSTS AND CAPITAL GAINS TAX

[5 710]

The three children will be considered to have acquired their share of the pre-CGT shares for their market value at the date of Pamela’s death, while their share of the post-CGT shares will be considered to have been acquired for Pamela’s cost base. The costs incurred by the LPRs in defending the family provision claim would be allocated to all the assets of the estate (s 128-15(5)). In terms of satisfying the 12-month holding rule for the purposes of the CGT discount, the LPR or beneficiary will be considered to have acquired the post-CGT shares when Pamela acquired them, while the 12-month holding rule for the pre-CGT shares is measured from Pamela’s date of death.

CGT ROLLOVERS [5 700] CGT rollover relief CGT rollover relief is provided for various CGT events involving trusts. Subject to satisfying the conditions for the rollover, relief is available for: • asset transfers from a non-discretionary trust to a company, where the beneficiaries’ interests in the trust are exchanged for shares in the company (Subdiv 124-N): see [5 710]; • asset transfers between fixed trusts (Subdiv 126-G): see [5 720]; • asset transfers between small business entities, including discretionary trusts (Subdiv 328-G): see [8 300]; • the disposal of small business assets (Subdiv 152-E): see [8 130]; • asset transfers by a trustee to a wholly-owned company (Subdiv 122-A); • the exchange of shares or units for new shares in the company or new units in the trust (Subdiv 124-E); • the exchange of rights or options to acquire shares in a company or units in a unit trust (Subdiv 124-F); • the exchange of units in a unit trust for shares in interposed company (Subdiv 124-H); • the exchange of stapled interests for units in a unit trust (Subdiv 124-Q); • the exchange of units in a unit trust for shares in a company (Div 615). Generally, the effect of these rollover concessions is that any capital gain is disregarded. If the asset is a pre-CGT asset, the pre-CGT status of the original asset is maintained. If the asset is a post-CGT asset, the original cost base of the asset rolled over is retained. There are also important rollover relief provisions for assets passing through a deceased estate to beneficiaries: see [5 300] and following.

[5 710] Transfer of assets from fixed trusts to companies Optional CGT rollover relief is available where, under a scheme to reorganise a trust’s affairs, all of the assets of the trust are transferred to a company, and the beneficiaries’ interests in the trust are exchanged for shares in 2016 THOMSON REUTERS

161

[5 720]

TRUSTS AND CAPITAL GAINS TAX

the company (Subdiv 124-N of ITAA 1997). A key condition for the rollover is that the trust must cease to exist within six months of the disposal of the first asset to the company (subject to an extension of time in limited circumstances). Both the trust and its beneficiaries can access the rollover. The effect of the rollover is to defer any capital gain or capital loss made by the trust in disposing of its assets and by the beneficiaries on the exchange of their interests. The benefits of the rollover are removed if the trust does not cease to exist within six months. This is done by way of reversal of the rollover under CGT event J4 (see [5 220]). Discretionary trusts cannot access this rollover, but may qualify for small business restructure rollover relief (Subdiv 328-G): see [8 300].

[5 720] Transfer of assets between fixed trusts Optional CGT rollover relief is available where a fixed trust transfers a CGT asset to a cloned trust (Subdiv 126-G of ITAA 1997). To be eligible for the rollover, the following conditions must be satisfied (s 126-225): • the receiving trust is an ‘‘empty’’ trust (being either a newly created trust or an existing trust with no CGT assets, apart from a small amount of cash or debt, just before the transfer time); • both trusts have the same beneficiaries with the same entitlements; • both trusts are effectively ‘‘fixed’’ trusts with no material discretionary elements; and • both trusts have the same (‘‘mirror’’) tax choices. The trustees of both trusts must choose to obtain the rollover. Broadly, the effect of Subdiv 126-G rollover is to disregard any capital gain or loss made from the transfer, although there are other consequences for the trusts. There are also adjustments to the cost base of the beneficiaries’ interests in the trusts.

162

2016 THOMSON REUTERS

TRUST-RELATED DEDUCTIONS

6

TRUST DEDUCTIONS Treatment of deductions incurred through trust structures ................ [6 Borrowings to pay trust distributions ..................................................... [6 Loans settled on trust ................................................................................. [6 Service entity arrangements ...................................................................... [6

000] 010] 020] 030]

EXPENDITURE INCURRED BY BENEFICIARIES Expenses incurred by beneficiaries of discretionary trusts ................. [6 100] Borrowings to acquire units in property unit trusts ............................. [6 110] Home loan unit trust arrangements ........................................................ [6 120] Legal costs incurred by beneficiaries ....................................................... [6 130] Unpaid present entitlements written off as bad .................................... [6 140]

TRUST DEDUCTIONS [6 000] Treatment of deductions incurred through trust structures The ‘‘net income’’ of a trust estate is defined in s 95(1) of ITAA 1936 as the total assessable income of the trust estate, less ‘‘all allowable deductions’’ (subject to two exclusions – for farm management deposits and certain prior year losses recouped from corpus). ‘‘Allowable deductions’’ comprise: • general deductions – losses and outgoings incurred in gaining or producing assessable income or in carrying on a business for that purpose (s 8-1 of ITAA 1997); and • specific deductions available under a provision outside of Div 8 of ITAA 1997. Losses and certain debt deductions (bad debts and debt for equity swap deductions) are subject to the trust loss recoupment rules: see [7 000] and following. Losses of previous years which have been recouped from corpus are not deductible in calculating the net income of a trust estate in the case of life tenants and beneficiaries who have no beneficial interest in the corpus of the trust estate. Deductions incurred by an entity in the capacity of trustee are not personally deductible to the entity (see Re Lambert and FCT [2013] AATA 442). 2016 THOMSON REUTERS

163

[6 010]

TRUST-RELATED DEDUCTIONS

[6 010] Borrowings to pay trust distributions The trustee of a trust estate is generally not able to claim a deduction for interest on funds borrowed to pay distributions to beneficiaries, even where the borrowing allows income-producing assets to remain part of the estate. However, interest incurred by a trustee on a loan to refinance a returnable amount is deductible. For example, interest on borrowed funds to repay an amount lent by a beneficiary to the trustee and which is used in income earning activities of the trust would be deductible (see FCT v Roberts; FCT v Smith [1992] FCA 363; 23 ATR 494). Amounts attributable to internally generated goodwill or unrealised revaluations of assets are not returnable amounts as they are not amounts provided to the trustee by or on behalf of a beneficiary (see Taxation Ruling TR 2005/12). In TR 2005/12, the Tax Office accepts that there may be practical difficulties in establishing that a returnable amount is used to produce assessable income, particularly where funds are mixed and a portion of the funds is used for private purposes or to gain exempt income. However, the Commissioner does not require a rigid tracing if all of the funds have been used as part of the recurrent operations of the trustee’s business.

[6 020] Loans settled on trust The Tax Office takes the view that interest on a loan taken out by a taxpayer and used to settle moneys on trust to benefit the taxpayer and others will not qualify for a full deduction under the general deduction provision. In the Commissioner’s view, the interest will only be deductible to the extent that the loan has been used to gain or produce assessable income of the taxpayer. It will not be deductible to the extent that it is used to benefit others (Taxation Determination TD 2009/17). The terms of the trust will usually provide an objective basis for determining the extent to which the taxpayer has used the borrowed moneys to benefit others – this will be the case whether the moneys are settled on the trust on its creation or later. In the Commissioner’s opinion, an interest deduction is not available if the trustee has the discretion to appoint the income of the trust to the borrower (see TD 2009/17, example 4). In a Decision Impact Statement on Forrest v FCT [2010] FCAFC 6; 78 ATR 417 (discussed at [6 110]), the Tax Office said that a review of TD 2009/17 was not warranted. EXAMPLE Paul arranges for his accountant to set up a trust for himself and his family. Paul and his wife control the corporate trustee. Paul borrows $1 million from a bank in his own name and settles it on the trust. The trustee issues 500,000 units to Paul and 500,000 units to Paul’s wife. The trustee uses the $1 million to purchase a rental property. The trust deed provides that unit holders are entitled to a proportionate share of the income of the trust based on their unit holdings.

164

2016 THOMSON REUTERS

TRUST-RELATED DEDUCTIONS

[6 030]

The units Paul and his wife acquire are redeemable at the trustee’s discretion. The units are redeemable for an amount equal to each unit holder’s proportionate share of the trust fund, calculated by reference to the net asset value of the fund as at the date of redemption. Only 50% of Paul’s interest expense is deductible. The terms of the trust indicate that Paul has used the borrowed money, in part, to benefit his wife and, in part, to acquire an interest in the trust which is likely to be productive of assessable income. Note: This example is from TD 2009/17 (example 3).

[6 030] Service entity arrangements It is common for professionals who operate a business individually or in partnership (eg accountants, lawyers and doctors) to engage associated ‘‘service’’ entities to provide premises, equipment and a range of clerical and administrative services. Such service arrangements protect assets, develop wealth independently (eg in a family discretionary trust) and facilitate tax minimisation by income splitting. A service arrangement typically involves a trust structure controlled by the professional. The trustee provides services at cost plus a commercial mark-up. In FCT v Phillips [1978] FCA 28; 8 ATR 783, the Full Federal Court said that the use of service entities is explicable on commercial grounds. In that case, the service entity, a fixed unit trust, was effectively owned by trusts established for the benefit of each partner’s spouse and family members. The Commissioner’s views on service entities, and in particular whether service fees are deductible, are set out in Taxation Ruling TR 2006/2 and the ATO guide Your service entity arrangements (updated May 2013). The Commissioner accepts that expenses incurred under a service arrangement are deductible if the benefits conferred by the arrangement provide an objective commercial explanation for the whole of the expenditure. However, if the service fees and charges are disproportionate or grossly excessive in relation to the benefits conferred on the business, the Tax Office expects taxpayers to review their arrangements. Service entity arrangements should also be properly documented. The Commissioner may (and has) applied the general anti-avoidance rules in Pt IVA of ITAA 1936 (see [10 010]) to disallow deductions for service fees paid to related entities. The Tax Office generally looks at cases where service fee expenses exceed $1 million and represent over 50% of the gross fees or business income earned, and where the net profit in the service entity is more than 50% of the combined net profit of the entities involved. The Tax Office also examines cases where there are serious questions as to whether the services are in fact provided by the service entity.

2016 THOMSON REUTERS

165

[6 100]

TRUST-RELATED DEDUCTIONS

EXPENDITURE INCURRED BY BENEFICIARIES [6 100] Expenses incurred by beneficiaries of discretionary trusts To qualify for a deduction under the general deduction provision (s 8-1 of ITAA 1997), the expense needs to have a connection (“nexus”) with assessable income. Where a beneficiary receives a distribution from a discretionary trust, the beneficiary is not entitled to claim a deduction against the trust distribution for expenditure incurred before the present entitlement arose (Case 11 (1980) 24 CTBR (NS) 386; Re Lambert and FCT [2013] AATA 442; Taxation Ruling IT 2385). In Re Antonopoulos and FCT [2011] AATA 431; 84 ATR 311, a husband and wife were the beneficiaries of a discretionary trust through which a building business was operated. The AAT found that there was an insufficient nexus between the distribution of trust income and certain interest expenses incurred by the beneficiaries (interest on loans made to the trustee and interest on their investment properties which they made available to the trustee). In particular, a resolution requiring the trustee to give ‘‘due consideration’’ to applying income to the beneficiaries did not create a present entitlement.

[6 110] Borrowings to acquire units in property unit trusts The Tax Office takes the view that interest on money borrowed to purchase income, growth or combined units in a split property unit trust is generally fully deductible under the general deduction provision (s 8-1 of ITAA 1997). This is so even where the interest exceeds the assessable income from the units or where the trust distribution consists of both assessable and non-assessable amounts (Taxation Ruling IT 2684). If growth units in a split property unit trust are expected to produce only negligible income, or their expected return (both income and capital growth) does not provide an obvious commercial explanation for incurring the interest expense, interest on borrowings to purchase the units are deductible only up to the extent of the assessable income actually received. Interest on funds used to buy units in a property trust that produces no assessable income and is not expected to produce any assessable income in the future is not deductible. Where units produce only capital growth, a deduction will be denied by s 51AAA of ITAA 1936 for any interest expenses relating to the purchase of the units. If a split property trust has both Australian and overseas investments, deductions in respect of foreign income are limited to the amount of the relevant foreign income derived. Consequently, if unit holders received assessable distributions made up of both foreign and Australian income, it is necessary to apportion the interest to determine the extent to which it relates to the earning of the foreign income. Where a unit holder is a foreign resident, a deduction is only available for that amount of interest that can be attributed to assessable unit trust distributions derived from Australian sources (see ATO ID 2004/175). 166

2016 THOMSON REUTERS

TRUST-RELATED DEDUCTIONS

[6 120]

In Forrest v FCT [2010] FCAFC 6; 78 ATR 417, a unit holder was entitled to a full deduction for interest payments on a loan used to purchase units in a hybrid unit trust (where the trustee had the power to determine whether amounts received by the trust were income or capital). The Commissioner argued that the interest was not deductible because the beneficiary was not presently entitled to income of the trust estate at the time the interest payments were made. The Full Federal Court held that the interest was deductible because the occasion for the interest payments was an investment expected to produce assessable income (distributions from the unit trust). The question of present entitlement under Div 6 of ITAA 1936 was not relevant to deductibility under s 8-1 of ITAA 1997. Note that for procedural reasons, the Court in Forrest v FCT did not entertain the Commissioner’s ‘‘last minute’’ argument that the deduction should be apportioned between income and capital.

[6 120] Home loan unit trust arrangements These arrangements involve a taxpayer and/or spouse using a unit trust to acquire a residential property for their private or domestic use in an attempt to access tax deductions generally available for investment properties. The main features of the arrangement are set out below. • A unit trust is established. The taxpayer may be a director of the corporate trustee of the trust (or a trustee of the unit trust). • The trustee enters into a contract to acquire a residential property. • The taxpayer borrows money which is used to subscribe for units in the trust, with the borrowings being guaranteed by the trustee. • The trustee uses the trust funds to complete the purchase and grants a mortgage over the property to the financier as security for the taxpayer’s borrowings. • The trustee then leases the property to the taxpayer (or family) at market rent. • The trustee claims deductions for expenses on the residential property (water, council rates, insurance, depreciation and other capital allowances). • The trustee makes a distribution to the taxpayer in accordance with the taxpayer’s unit holdings and the taxpayer includes the distribution in assessable income. As the trust distribution is much less than the interest deduction claimed by the taxpayer, the resulting loss is offset against other income of the taxpayer. The Tax Office considers that interest on the taxpayer’s borrowed funds is not deductible under the general deduction provision (s 8-1 of ITAA 1997) because it is a private or domestic outgoing. Alternatively, the taxpayer’s interest deductions are limited to the amount of the assessable trust distribution returned each year by the taxpayer (Taxation Ruling TR 2002/18). Furthermore, as the arrangement involves a scheme implemented with the dominant purpose of obtaining tax benefits, the Tax Office considers the general anti-avoidance provisions in Part IVA of ITAA 1936 (see [10 010]) would apply to deny any deductions otherwise allowable. 2016 THOMSON REUTERS

167

[6 130]

TRUST-RELATED DEDUCTIONS

In Re Tabone and FCT [2006] AATA 466; 62 ATR 1210, a deduction was denied for interest on a loan used to acquire units in a unit trust which constructed the taxpayer’s home.

[6 130] Legal costs incurred by beneficiaries The Tax Office accepts that a beneficiary of a testamentary trust can deduct legal expenses incurred in defending court proceedings which seek to reduce the amount of the beneficiary’s entitlement to income of the trust (ATO ID 2004/214). In Re Cachia and FCT [2005] AATA 479; 59 ATR 1056, a unit holder was not entitled to deduct legal expenses incurred in suing Westpac over its decision to redeem units in one of its unit trusts and merge it with another. The unit holder argued that the legal costs were deductible because he took legal action in order to increase his income from the unit trust. However, the AAT found that the legal costs were capital in nature and therefore not deductible under s 8-1 of ITAA 1997.

[6 140] Unpaid present entitlements written off as bad According to the Tax Office, the right arising on the creation of a present entitlement is not a debt (see Taxation Ruling TR 2010/3, Taxation Ruling TR 2015/4, Draft Determination TD 2015/D5). In TD 2015/D5, the Commissioner takes the preliminary view that a beneficiary is not entitled to a bad debt deduction for an unpaid present entitlement that is written off as bad. This is because the unpaid present entitlement has not been ‘‘included’’ in the beneficiary’s assessable income, as required by the relevant bad debt provision (s 25-35 of ITAA 1997). Rather, the Commissioner argues, the unpaid present entitlement is used to determine the amount (if any) of the net income of the trust that is included in the beneficiary’s assessable income under Div 6 of Pt III of the ITAA 1936 (which may be more or less than the amount of the entitlement). In Re Pope and FCT [2014] AATA 532, the trustee of a family discretionary trust determined to distribute some of the income of the trust to the taxpayer in the 2005, 2006 and 2007 income years. Some of the distributions were actually paid to the taxpayer, but the bulk of the money was credited to an account in his name in the trust’s books of account. A few years later, the taxpayer decided that the trustee would not be able to pay him the amount then standing to his credit in the trust’s accounts, and claimed a bad debt deduction. The AAT decided that the amount was not deductible because the debt that was written off as bad was different in character to the trust distributions that the taxpayer had declared in his tax returns for the relevant years. The Tribunal stated (at paras 20 and 21): “What, relevantly, was included in Mr Pope’s assessable income in those years had as its source the share of the trust income to which he became presently entitled. What was written off was of an entirely different character; it was an investment Mr Pope chose to make in the business of the Trust.

168

2016 THOMSON REUTERS

TRUST-RELATED DEDUCTIONS

[6 140]

There is nothing anomalous or unusual in the result. Mr Pope, who was the alter ego of the Trust in any event, chose to leave the bulk of the amounts distributed to him invested in the business of the Trust. Once he chose that course the ‘debt’ thereby created was of an entirely different character to his entitlement to the distribution from the Trust.”

2016 THOMSON REUTERS

169

170

2016 THOMSON REUTERS

7

TRUST LOSSES TRUST LOSS RECOUPMENT PROVISIONS Restrictions on deductibility of trust losses ........................................... [7 Summary: categories of trusts and applicable tests ............................. [7 Fixed trusts ................................................................................................... [7 Non-fixed trusts ........................................................................................... [7 Additional test: the income injection test ............................................... [7

000] 010] 020] 030] 040]

FAMILY TRUSTS The special position of family trusts ....................................................... [7 100] Making a family trust election .................................................................. [7 110] Family trust elections: nomination of test individual .......................... [7 120] Family trust elections: family group ....................................................... [7 130] Family trust elections: family control test .............................................. [7 140] Interposed entity election .......................................................................... [7 150]

FAMILY TRUST DISTRIBUTION TAX Family trust distribution tax – trustee’s primary liability ................... Family trust distribution tax – interposed entity’s liability ................ Family trust distribution tax – secondary liability ............................... Extended definition of ‘‘distribution’’ .....................................................

[7 [7 [7 [7

200] 210] 220] 230]

TRUST LOSS RECOUPMENT PROVISIONS [7 000] Restrictions on deductibility of trust losses Unlike a partnership, a trust cannot distribute an overall tax loss to its beneficiaries. This means that a net deductible income loss sustained by a trust is never available to a beneficiary to reduce the beneficiary’s income from other sources. The losses of the trust in one year remain within the trust and may be carried forward and claimed as a deduction against its assessable income in future years. However, a trust cannot automatically recoup its carried forward tax losses – losses of a trust in one year can only be carried forward and claimed as a deduction against its assessable income in future years if it satisfies the trust loss recoupment rules in Sch 2F of ITAA 1936. These rules are designed to prevent the transfer of the tax benefit of losses to persons who did not bear the economic loss when the tax losses were incurred by the trust – a practice known as ‘‘loss trafficking’’. 2016 THOMSON REUTERS

171

[7 010]

TRUST LOSSES

The trust loss recoupment rules restrict not only the recoupment of earlier year and current year losses but also bad debts when calculating the net income of the trust under Div 6. They do not apply to restrict the utilisation by a trust of its capital losses. The rules operate by imposing tests that must be satisfied before losses and debt deductions can be used – tests that vary depending on the type of trust (see the table at [7 010]). All trusts that are subject to the rules must pass an income injection test (see [7 040]). Some trusts are excluded from these rules (these are referred to as ‘‘excepted trusts’’). These include deceased estates and complying superannuation funds.

WARNING! Deceased estates are granted a reasonable period for completion of administration of the estate before the trust loss provisions apply. They qualify as an excepted trust from the date of death of the deceased until the end of the income year in which the fifth anniversary of death occurs.

Special provisions apply to family trusts, ie trusts that have made a family trust election (see [7 100]). Family trusts are classified as excepted trusts. However, unlike other excepted trusts, the income injection test applies to family trusts, but only in relation to injections from outsiders. In addition, a special tax – family trust distribution tax – may be imposed if distributions are made to non-family members (see [7 200]).

[7 010] Summary: categories of trusts and applicable tests The trust loss recoupment rules target two types of arrangements pursuant to which the tax benefit of trust losses or debt deductions may be transferred: • changes in the underlying ownership or control of a trust; and • income injection schemes. These two types of arrangements form the basis of specific conditions and tests that a trust may need to satisfy in order to utilise tax losses and bad debt deductions. These tests are: • for changes in ownership – a 50% stake test for trusts with fixed entitlements (see [7 020]) and a pattern of distributions test for discretionary trusts and other non-fixed trusts (see [7 030]); • for changes in control – a control test for non-fixed trusts (see [7 030]); • for income injection schemes – an income injection test for all trusts that are subject to the rules (see [7 040]).

172

2016 THOMSON REUTERS

TRUST LOSSES [7 010]

Whether a particular test applies, and how it is applied, depends on the type of trust seeking to recoup its losses or debt deductions. The following table summarises the different categories of trusts for the purposes of the trust loss recoupment rules and the tests that must be satisfied for trust losses or debt deductions to be utilised. Type of trust

Definition

Applicable tests

Fixed trust

A trust in which persons have fixed entitlements* to all of the income or capital of the trust (s 272-65 of Sch 2F to ITAA 1936): see [7 030]. For the purpose of applying change in ownership or control arrangements, fixed trusts are further categorised into:

For all fixed trusts (other than excepted trusts):

• ordinary fixed trusts – these are closely held trusts where up to 20 individuals have between them fixed entitlements to 75% or more of the income or capital of the trust (s s 272-105); and

• 50% stake test (the same individuals have fixed entitlements to more than 50% of the income/capital of the trust); • income injection test. For ordinary fixed trusts, an alternate 50% stake test is available if non-fixed trusts directly or indirectly hold fixed entitlements in the trust. Listed widely held unit trusts that fail the 50% stake test can apply a same business test.

• various widely held fixed trusts (listed widely held, unlisted widely held, unlisted very widely held and wholesale widely held trusts: ss 272-110 to 272-125).

2016 THOMSON REUTERS

173

[7 010]

TRUST LOSSES

Type of trust

Definition

Applicable tests

Non-fixed trust

A trust in which there is no fixed entitlement* to all of the income and capital of the trust (s 272-70): see [7 040]. Discretionary trusts and hybrid trusts are non-fixed trusts (unless they are excepted trusts).

For discretionary trusts (other than excepted trusts) with no fixed entitlements: • control test (no group begins to control the trust during the test period); • pattern of distributions test for prior year losses and debts (50% of distributions of income/capital are distributed to the same individuals); • income injection test. Hybrid trusts need to satisfy the above tests plus a 50% stake test.

Family trust

A trust that satisfies a Modified income injection family control test and has test (with injections from a valid family trust election family members allowed). in force (s 272-75): see [7 100].

Excepted trust

Any of the trusts listed in s 272-100, including: • a family trust;

No test applies to excepted trusts (other than family trusts).

• a complying superannuation fund, complying approved deposit fund or pooled superannuation trust; • a deceased estate in the first five years of administration; • a unit trust where tax-exempt bodies have fixed entitlements, directly or indirectly, to all the income and capital of the trust. * ‘‘Fixed entitlement’’ means a vested and indefeasible interest in a share of the income or capital of a trust under the trust instrument (s 272-5(1)): see [7 020]. The Commissioner has the discretion to treat an interest as a fixed entitlement in certain circumstances (s 272-5(3)).

174

2016 THOMSON REUTERS

TRUST LOSSES [7 020]

[7 020] Fixed trusts A fixed trust is a trust in which persons have fixed entitlements to all of the income or capital of the trust (s 272-65 of Sch 2F to ITAA 1936).

Fixed entitlements A beneficiary must have a vested and indefeasible interest in a share of income or capital under the trust deed for the interest to qualify as a fixed entitlement (s 272-5(1) of Sch 2F). In other words, there can be no discretion vested in the trustee as to who will be entitled to the income or capital or what a beneficiary’s share should be. The fixed entitlement can be held directly or indirectly by the beneficiary. An indirect entitlement is held when a company, partnership or another trust holds the entitlement and the beneficiary has a fixed entitlement in that company, partnership or trust. Alternatively, the entitlement could be held by several levels of companies, partnerships or trusts before it can be traced to the beneficiary. The important point is that the beneficiary must have a fixed entitlement which cannot be defeated by, for example, a contingency or the exercise of a discretion in favour of another beneficiary. A trustee’s power to determine the timing of distributions does not breach the vested and indefeasible requirement. Thus, a power to accumulate income or capital under the terms of the trust deed is permissible, provided specified beneficiaries have a vested and indefeasible interest in the accumulated amounts that they will receive at some time in the future (ATO ID 2015/8). The Tax Office has confirmed that the residuary beneficiaries of a trust created by a will – once an individual bequest has been satisfied – have fixed entitlements to all of the income and capital of the deceased estate (ATO ID 2006/279). The mere fact that units in a unit trust may be redeemable, or that new units may be issued, also does not breach the vested and indefeasible requirement, provided certain criteria are satisfied (s 272-5(2) of Sch 2F). The requirement that a beneficiary must have an ‘‘indefeasible’’ interest can be difficult to satisfy. In Colonial First State Investments Ltd v FCT [2011] FCA 16; 81 ATR 772, the Federal Court held that a provision of the Corporations Act 2001 (s 601GC(1)(a)) which allowed the unit holders of a unit trust to amend the trust deed by special resolution meant that their entitlements were ‘‘defeasible’’ rather than indefeasible. Accordingly, the trust did not qualify as a fixed trust. This decision clearly has adverse implications for all unit trusts to which the Corporations Act 2001 applies. Many trusts need to apply to the Commissioner to exercise the discretion (in s 272-5(3) of Sch 2F) to treat an interest as a fixed entitlement.

TIP

Since the introduction of the trust loss recoupment rules, the “fixed entitlement” concept has been incorporated into other tax provisions, eg the closely held trust rules (see [12 000]), the CGT scrip-for-scrip rollover provisions in Subdiv 124-M of ITAA 1997 and the superannuation rules in s 295-550 of ITAA 1997 concerning non-arm’s length income.

2016 THOMSON REUTERS

175

[7 020]

TRUST LOSSES

In July 2012, the previous Government released a discussion paper on fixed trusts, A More Workable Approach for Fixed Trusts, as part of its proposed rewrite of the trust income tax provisions (see [16 000]). The discussion paper reviewed the current concepts of ‘‘fixed trust’’, ‘‘fixed entitlement’’ and ‘‘vested and indefeasible’’, and their relevance in different tax contexts. It then considered various options for developing a ‘‘more workable approach’’ to fixed trusts, so that taxpayers can satisfy the definition of ‘‘fixed trust’’ without relying on the Commissioner’s discretion. In releasing the discussion paper, the previous Government acknowledged the uncertainty and complexity faced by fixed trusts following the Federal Court’s narrow approach in Colonial First State Investments Ltd v FCT.

50% stake test Fixed trusts can deduct tax losses and debt deductions if there is continuity of majority beneficial ownership of the trust. This is referred to as the 50% stake test. A fixed trust will pass this test if the same individuals (directly or indirectly) beneficially hold between them fixed entitlements to more than 50% of the income and capital of the trust (ss 269-50 and 269-55(1) of Sch 2F). The test is applied separately to income and capital so the individuals used to satisfy both tests do not need to be the same. The time at which the 50% stake test must be passed differs depending on the type of trust (ie whether it is a ordinary fixed trust or one of the four classes of widely held unit trusts: see [7 010]). Due to the practical difficulties in tracing the underlying ownership of fixed trusts which qualify as widely held trusts, it is generally assumed that there has been no change unless there has been abnormal trading. A widely held trust need only test for continuity of ownership when there is abnormal trading in the trust’s units such as a takeover or merger (s 269-55(2) of Sch 2F). However, in addition, an unlisted widely held trust must apply the test at year’s end. The circumstances in which abnormal trading may occur are defined in ss 269-15 to 269-49 of Sch 2F. If a listed widely held trust fails the 50% stake test, it may, as an alternative, satisfy the same business test (s 269-100 of Sch 2F). The test is similar to the test which applies to company carry forward losses.

WARNING! An ordinary fixed trust (a fixed trust which is not otherwise a widely held unit trust) can apply an alternative to the 50% stake test where fixed entitlements are ultimately held by non-fixed trusts or by companies with non-fixed trusts as shareholders (s 266-45 of Sch 2F). The alternative 50% stake test is met in the following circumstances: • where interests in the fixed trust are held by non-fixed trusts, there is no change in the persons directly holding fixed entitlements to shares of the income or capital of the fixed trust, or to the percentage of their shares; or • where interests in the fixed trust are held directly or indirectly by a holding entity, there is no change in the persons directly holding fixed entitlements to the income or capital of the holding entity; and

176

2016 THOMSON REUTERS

TRUST LOSSES [7 030] • every non-fixed trust (that is not a family trust or other excepted trust) that holds fixed entitlements in the fixed trust, directly or indirectly, must satisfy the relevant tests that would apply to non-fixed trusts if they stood in place of the loss trust.

[7 030] Non-fixed trusts A non-fixed trust is a trust in which there is no fixed entitlement to all of the income and capital of the trust (s 272-70 of Sch 2F to ITAA 1936). For the purposes of the trust loss provisions, the concept of a non-fixed trust is not limited to purely discretionary trusts; rather it is a default category that can include trusts with both fixed and discretionary elements (often called hybrid trusts). A non-fixed trust can only deduct tax losses and debt deductions if there is continuity of control of the trust. There may also need to be continuity of majority beneficial ownership of the trust if individuals held (directly or indirectly) fixed entitlements to more than 50% of the income or capital of the trust at some stage during the test period. There also needs to be less than a 50% change in the pattern of distributions of the income or capital of the trust if relevant distributions have been made by the trust (Div 267 of Sch 2F).

The control test The control test provides that no group must begin to control the trust, directly or indirectly, during the relevant test period (s 267-45 of Sch 2F). Thus, while a trustee may be controlled by another person or a corporate trustee may be controlled by persons who control the company, that control must not change. A group is either a person, a person and one or more associates, or two or more associates of a person (s 269-95(5) of Sch 2F). A group controls a non-fixed trust if the group, for example, can control the application of income or capital, obtain beneficial enjoyment of the income or capital, remove or appoint the trustee, influence the trustee to act in accordance with its instructions or wishes or acquires more than a 50% stake in the income or capital of the trust (s 269-95(1) of Sch 2F).

Pattern of distributions test The pattern of distributions test only applies in relation to the deductibility of prior year losses or debt deductions (not current year losses) of a non-fixed trust. The test does not mean that distributions have to be made, only that if certain distributions are made, then the test must be satisfied in relation to them. The test applies if distributions of either income or capital are made during the income year (or within two months of its end) and in at least one of any of the preceding six income years (s 267-30 of Sch 2F). A non-fixed trust will pass the pattern of distributions test if, within two months of the end of the income year, it has distributed, either directly or 2016 THOMSON REUTERS

177

[7 040]

TRUST LOSSES

indirectly, to the same individuals for their own benefit more than 50% of all test year distributions of income or capital (s 269-60 of Sch 2F). The test is applied separately to income and capital, so the individuals used to satisfy both tests do not need to be the same.

[7 040] Additional test: the income injection test Even where a trust satisfies any applicable ownership or control test (see [7 010]), it may not be able to make full use of its tax losses or debt deductions if it fails to satisfy what is called the income injection test (Div 270 of Sch 2F to ITAA 1936). This is the case for fixed trusts (see [7 020]) and non-fixed trusts (see [7 030]) alike. The only trusts not subject to the income injection test are excepted trusts (other than family trusts). Family trusts (see [7 100]) are subject to the income injection test, but in a modified form. The income injection test deals with schemes to take advantage of tax losses and other deductions of the trust. The schemes targeted are those under which assessable income is injected into or derived by the trust with the aim of sheltering it from tax by the losses or other deductions and where an outsider to the trust provides the trustee, beneficiary or associate with a benefit and a return benefit is given to the outsider or associate. For a trust that is not a family trust, an outsider is a person other than the trustee of the trust or a person with a fixed entitlement to income or capital of the trust (s 270-25(2) of Sch 2F). For a family trust, an outsider is a person other than (s 270-25(1) of Sch 2F): • the trustee; • persons with fixed entitlements to income or capital; • the test individual specified in the family trust election and his or her family members; • a trust with the same individual specified in its family trust election; and • any interposed entity that had made an interposed entity election to take effect before the scheme began. The broad effect of breaching the income injection test is that the assessable income derived as part of the scheme will be assessable in full in the year in which it is derived.

WARNING! The income injection test is an anti-avoidance measure. However, it is important to note that it is determined objectively in that there is no need for a finding that the trust or its controllers themselves had a tax avoidance motive.

178

2016 THOMSON REUTERS

TRUST LOSSES [7 110]

FAMILY TRUSTS [7 100] The special position of family trusts A family trust is subject to special treatment under the trust loss rules. A family trust has a particular meaning for the purposes of the rules and does not mean a discretionary family trust as ordinarily understood (see [1 020]). Instead, a trust is defined as a family trust if it has made a valid family trust election (s 272-75 of Sch 2F to ITAA 1936). A trust that has made a family trust election has the advantage of being excluded from all of the tests, apart from a modified income injection test (see [7 040]), that would otherwise have to be met for its trust losses and debt deductions to be utilised. Other advantages of making a family trust election include: • company losses – concessional tracing rules apply if ownership interests in a company are held by the trustee of a family trust (s 165-207 of ITAA 1997); • franking credits – beneficiaries of the family trust are ‘‘qualified persons’’ for the purposes of the 45-day holding period rule (an anti-franking credit trading rule); • trustee beneficiary reporting rules – trusts that are covered by a family trust election, as well as trusts covered by an interposed entity election and trusts owned by the family group of the individual specified in the family trust election, are excluded from the rules (see [12 100]); and • rollover relief for small business restructures – assets can be transferred to or from discretionary trusts that have made a valid family trust election (see [8 300]). On the downside, making a family trust election exposes the trustee to a punitive tax – family trust distribution tax – where the trustee (see [7 200]) or an interposed entity (see [7 210]) distributes income or capital to someone outside the family group (see [7 130]). The requirements for making a valid family trust election are set out at [7 110].

[7 110] Making a family trust election To be able to make a family trust election, the trustee must nominate a test individual (see [7 120]) for the purpose of identifying the relevant family group (see [7 130]) and the trust must satisfy the family control test (see [7 140]). Only one family trust election can be made by a trustee in relation to the trust. A family trust election applies from the start of the specified income year in relation to which it is made (s 272-80 of Sch 2F to ITAA 1936). The trust is then automatically a family trust for all subsequent years. The election can be revoked in certain circumstances (s 272-80(6)(6A) of Sch 2F). A family trust election may be made at any time in relation to an earlier income year (but generally not a year before 2004-05), provided at all times in 2016 THOMSON REUTERS

179

[7 120]

TRUST LOSSES

the period from the beginning of the specified income year until 30 June in the income year before the one during which the election is made (s 272-80(4A) of Sch 2F): • the trust passes the family control test; and • the trust has made no distributions of income or capital to persons other than the individual specified in the election, or members of that individual’s family group. The family trust election needs to be made using a specific Tax Office form (Family Trust Election, Revocation or Variation), irrespective of whether a return is required to be lodged (s 272-80(2) of Sch 2F). Factors which should be taken into account in deciding whether to make a family trust election include the following: • whether the trust has or is expected to have losses or debt deductions that it wants to utilise; • whether the trust is unlikely to satisfy the fixed or non-fixed trust tests that would need to be satisfied if no election were made; • whether the trust has a history of making distributions outside the family group that might attract family trust distribution tax.

[7 120] Family trust elections: nomination of test individual To make a valid family trust election, the election must specify a test individual whose family group is the subject of the election (s 272-80(3) of Sch 2F to ITAA 1936). Determining the most appropriate test individual is important because it is the test individual who determines the size of the ‘‘family group’’ to whom a trust distribution can be made without the imposition of family trust distribution tax (see [7 130]) and also determines who will be outsiders to the family trust for the purposes of the income injection test (see [7 040]). There has been some debate as to whether the test individual must be a living person. The Tax Office view is that the individual specified in a family trust election must be alive when the election is made: see ATO ID 2014/3 and the minutes of a meeting of the Trust Consultation Sub-group on 24 April 2012. The Tax Office notes in ATO ID 2014/3 that the death of a test individual will not prevent any other trust, company or partnership from making an interposed entity election (see [7 150]) to be included in the individual’s family group.

Changing the test individual A family trust election may be varied once only and then only to replace the test individual with another test individual. However, the test individual can only be changed if (s 272-80(5A) of Sch 2F): • the new test individual was a member of the original test individual’s family when the family trust election commenced; • there have been no distributions of (or conferrals of present entitlement to) income or capital made by the trustee (or an interposed entity) outside the new test individual’s family group while the election has been in force; and 180

2016 THOMSON REUTERS

TRUST LOSSES [7 140]

• the family trust election has been in force for less than five years. The test individual can also be changed where, as a result of a family law obligation arising from a marriage breakdown, control of the family trust passes to the new individual and members of the new individual’s family (s 272-80(5C) of Sch 2F).

[7 130] Family trust elections: family group The ‘‘family group’’ of the test individual is not the same as the individual’s ‘‘family’’ but is defined very widely to include the following (s 272-90 of Sch 2F to ITAA 1936): • family members of the individual (see box below); • certain former family members – former spouses, widows/widowers and step-children; • the family trust in respect of which the election is made; • another trust with the same test individual specified in its family trust election; • interposed entities that have made an interposed entity election which is still in force at the relevant time; • 100% family-owned entities (ie entities that have fixed entitlements to all of their capital or income held by the test individual or family members or family trusts of those individuals); • certain funds, registered charities or other institutions covered by the gift deduction provisions or other tax-exempt bodies; • estates of the test individual or family members if all are dead; and • certain persons holding interests in small and medium enterprises that have made interposed entity elections. The test individual’s ‘‘family’’ consists of (s 272-95 of Sch 2F): (i) the test individual’s spouse; (ii) any parent, grandparent, brother, sister, nephew, niece, or child of the test individual or the test individual’s spouse; (iii) any lineal descendant of a nephew, niece, or child of the test individual or the test individual’s spouse; (iv) the spouse of any lineal descendant of a person in (iii) above. ‘‘Spouse’’ includes a de facto spouse (including a same sex partner) and ‘‘child’’ includes an adopted child, step-child and an ex-nuptial child. Importantly, a person does not cease to be a family member merely because of the death of any other family member.

[7 140] Family trust elections: family control test To be eligible to make a family trust election, the trust must pass the family control test (s 272-80(4) of Sch 2F to ITAA 1936). An interposed entity must also pass that test if it wishes to make an interposed entity election (see [7 150]). In both cases, the test must be passed at the end of the income year to which the election relates. 2016 THOMSON REUTERS

181

[7 150]

TRUST LOSSES

A trust will pass the family control test at a particular time if certain persons control the trust at that time. Those persons can be (s 272-87 of Sch 2F): • the test individual specified in the family trust election (see [7 120]); • family members of the test individual (see [7 130]); • the legal or financial advisers of the test individual or family member; or • any other family trusts that have the same test individual. A number of control possibilities exist for satisfying the test, including control of the application or beneficial enjoyment of income or capital of the trust, control of the trustee and a majority stake in the income or capital (s 272-87(2) of Sch 2F). A trust will also pass the test if persons in the relevant group are the only persons under the terms of the trust who can obtain the beneficial enjoyment of the income and capital of the trust (s 272-87(2)(g) of Sch 2F). In this context, control as such is not relevant. A legal or financial adviser to a family can be part of the controlling group because such an adviser might often act as a director of the trustee company. However, the adviser must be acting in his or her professional capacity and not in a personal capacity. EXAMPLE John and Julie have three children and set up a family trust with Max (a family friend) as the trustee. The only beneficiaries of the trust will be the children whose only rights under the trust is to collectively share in all the income and capital of the trust. Neither John nor Julie (as settlors of the trust) nor the children have control over the application or accumulation of the income and capital and have no decision-making power in relation to the administration of the trust. Max, as trustee, wishes to make a family trust election for the trust with John as the test individual. The trust passes the family control test – even though a family member may not control the trust as such, the only persons who can benefit from the income or capital of the trust are John’s children. If John had instead set up a discretionary trust with his financial adviser as trustee, the trust would also satisfy the family control test.

If a company or partnership wants to make an interposed entity election, it will pass the family control test if any of the following hold fixed entitlements to more than 50% of the income or capital of the company or partnership: • the test individual; • family members of the test individual; • any other family trusts that have the same test individual; or • any combination of the above.

[7 150] Interposed entity election Family trust structures may involve other trusts, partnerships or companies being interposed between the family trust and ultimate family members to whom a distribution is intended to be made. 182

2016 THOMSON REUTERS

TRUST LOSSES [7 150]

However, unless these interposed entities are included in the test individual’s family group (see [7 130]), family trust distribution tax may be imposed on any present entitlements conferred on the entities or distributions made to them by the family trust. Other trusts with the same test individual as the family trust and 100% family-owned entities are automatically included in the family group without any form of actual election. However, other interposed entities are included in the family group only if they have made an interposed entity election (s 272-90(4) of Sch 2F to ITAA 1936).

WARNING! In ATO ID 2004/876, the Tax Office confirms that a company that is wholly owned by a trustee of a family trust is automatically within the family group of the individual specified in the family trust election. In addition, two family trusts that have each specified the same individual in their family trust elections are within the same family group and do not need to make an interposed entity election to become members of the same family group.

The major requirement for an entity to be allowed to make an interposed entity election is that it passes the family control test (s 272-85(4) of Sch 2F). If the entity is a trust, the test is the same as used in determining whether a family trust election can be made (see [7 140]), but obviously applied to a different trust. The test is slightly different if the entity is a company or partnership. As a general rule an interposed entity cannot make an interposed entity election in respect of more than one family trust. The exception is if the individual specified in the family trust elections of each family trust is the same.

Timing and operation An interposed entity election has to be in writing and in the approved form, irrespective of whether a return is required to be lodged (s 272-85(2) of Sch 2F). The effect of the election is that, at all times after the specified date, the entity will be included in the family group of the specified individual in the family trust election to which the interposed entity election relates (s 272-85(6A)(a) of Sch 2F). Entities may make an interposed entity election at any time in relation to an earlier income year (but generally not a year before 2004-05), provided that at all times in the period from the beginning of the specified income year until 30 June in the income year before the one in which the election is made (s 272-85(4A) of Sch 2F): • the entity passes the family control test; and • the entity has made no distributions of income or capital to persons other than the individual specified in the family trust election, or members of that individual’s family group. There is no requirement that an interposed entity election is made in the same year as the relevant family trust election; it can be a later income year. 2016 THOMSON REUTERS

183

[7 200]

TRUST LOSSES

However, only distributions to the entity after the date from which the election takes effect will escape family trust distribution tax (see [7 200]). If a partnership, company or trustee that is not required to lodge a tax return wants to make an election, it must be made within two months of the end of the year in which the specified starting date occurs. An interposed entity election can only be revoked in two circumstances (s 272-85(5A) of Sch 2F): • where the election has been made for an entity already included in the test individual’s family group; or • where the election relates to an entity that has became part of the family group as a result of being wholly owned by family members of the test individual. The Commissioner’s view is that an interposed entity election is not revoked if the trust in respect of which the relevant family trust election was made has vested (ie has ceased to exist): see ATO ID 2013/21. This means that if the interposed entity makes a distribution outside the family group, it is liable for family trust distribution tax, despite the family trust ceasing to exist (see [7 210]).

FAMILY TRUST DISTRIBUTION TAX [7 200] Family trust distribution tax – trustee’s primary liability A trustee that has made a family trust election (see [7 110]) is liable for family trust distribution tax if the trustee confers a present entitlement, or distributes income or capital of the trust, to a person who is neither the test individual nominated in the election (see [7 120]) nor a member of the test individual’s family group (see [7 130]): Div 271 of Sch 2F to ITAA 1936. The term ‘‘distribution’’ is given an extended meaning and includes any form of benefit which exceeds the consideration given in return (see [7 230]). The tax is payable by the trustee on the amount or value of the capital or income which is distributed or to which the entitlement relates at a rate equal to the top personal marginal rate plus Medicare levy (49% for 2015-16). The tax is imposed by the Family Trust Distribution Tax (Primary Liability) Act 1998. EXAMPLE Paul sets up a discretionary trust with the class of beneficiaries including himself, his family, any company in which a family member may own shares and any superannuation fund in which a family member is a member. The trustee makes a family trust election and nominates Paul as the test individual. Distribution 1: To the superannuation fund The trustee of the trust makes a distribution of income to Paul’s self-managed superannuation fund, the only two members of which are Paul and his spouse. The superannuation fund has not made an interposed entity election. Under the terms of

184

2016 THOMSON REUTERS

TRUST LOSSES [7 220] the superannuation fund, Paul and his spouse do not have fixed entitlements to all of the capital and income of the superannuation fund – therefore the superannuation fund does not fall within the trust’s family group. The trustee will be liable for family trust distribution tax on the distribution to the superannuation fund. Distribution 2: To the company The trustee also makes a distribution to a company in which Paul and his spouse are shareholders. The company has made an interposed entity election and so is a member of the trust’s family group. The distribution by the trust does not therefore attract family trust distribution tax. However, the company pays a dividend to a shareholder who is not a member of the trust’s family group and that distribution will attract liability for the tax.

Payment of tax Family trust distribution tax is generally due and payable: • if the conferral or distribution (giving rise to the liability to pay the tax) was made on or before the day on which the relevant family trust election or interposed entity election was made – 21 days after the election was made; • if the conferral or distribution was made after the day the relevant election was made – 21 days after the conferral or distribution day.

[7 210] Family trust distribution tax – interposed entity’s liability It is possible for family members of the individual specified in the family trust election or that individual to receive distributions from the family trust through other trusts, partnerships or companies without exposing the family trust to family trust distribution tax, provided those entities have made interposed entity elections. This is because the effect of the interposed entity election is to include the entity in the family group (see [7 130]). Family trust distribution tax may, however, be imposed at the level of the interposed trust, partnership or company, in respect of which such an election has been made, if it confers a present entitlement on or makes a distribution to persons other than the specified individual or members of the family group (ss 271-20 to 271-30 of Sch 2F to ITAA 1936). Liability is imposed on the interposed trustee, corporate trustee directors, partners, corporate partner directors, company or company directors, as the case may be.

[7 220] Family trust distribution tax – secondary liability If a non-resident trust is liable to pay family trust distribution tax, the liability can be effectively transferred to the connected resident family trust if the Commissioner believes that the tax cannot be collected from the trust or entity that incurred the primary liability (ss 271-60 and 271-65 of Sch 2F to ITAA 1936). The Commissioner may impose an equivalent tax liability on certain connected resident trusts or, if the trustee is a company, the directors of the 2016 THOMSON REUTERS

185

[7 230]

TRUST LOSSES

company, if the primary family trust distribution tax liability of the non-resident entity remains unpaid after becoming due and payable and the Commissioner has made a determination in writing that the amount due by the non-resident is unlikely to be paid. The secondary liability may be imposed on a resident company in which a non-resident family trust that does not pay the primary liability has an interest and has benefited from the trust loss provisions only because the non-resident family trust held the interest (applicable wherever the primary liability arises). The transferred liability is equal to the amount of the unpaid family trust distribution tax of the relevant non-resident entities. It is imposed by the Family Trust Distribution Tax (Secondary Liability) Act 1998.

[7 230] Extended definition of ‘‘distribution’’ For the purpose of family trust distribution tax, the term ‘‘distribution’’ is given an extended meaning in s 272-45 of Sch 2F to ITAA 1936. That section provides that a trustee distributes income or capital of the trust to a person if the trustee does any of the following in the person’s capacity as a beneficiary of the trust: • pays or credits the income or capital in the form of money to the person; • transfers the income or capital in the form of property to the person; • reinvests or otherwise deals with the income or capital on behalf of the person or in accordance with the person’s directions; or • applies the income or capital for the person’s benefit. Distributions can be made indirectly through interposed entities (s 272-63 of Sch 2F). In ATO ID 2004/162, the redemption of trust units for more than their market value was a distribution of the excess for the purposes of family trust distribution tax. The forgiveness of a debt owed to a family trust by a non-family member may constitute a distribution by the trustee in favour of the debtor and potentially give rise to family trust distribution tax (s 272-60(1) of Sch 2F). However, in ATO ID 2012/12, a trustee who wrote off a trade debt did not make a distribution because the debtor was not a beneficiary of the trust and was not associated with any beneficiary of the trust. Crucially, the Tax Office emphasised that the extended meaning of ‘‘distribution’’ only applies in relation to a person in the capacity as a beneficiary of the trust.

186

2016 THOMSON REUTERS

PART 3 TAX CONCESSIONS 8 TRUSTS AND SMALL BUSINESS RELIEF 9 PRIMARY PRODUCER CONCESSIONS FOR BENEFICIARIES

2016 THOMSON REUTERS

187

188

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF Tax relief for small business entities Concessions for small business entities .................................................. Small business entity test .......................................................................... Meaning of affiliate ..................................................................................... Meaning of connected entity ....................................................................

8 [8 [8 [8 [8

000] 010] 020] 030]

CGT concessions for small businesses Small business CGT concessions .............................................................. [8 100] Small business retirement exemption ...................................................... [8 110] 15-year exemption for small business ..................................................... [8 120] Small business replacement asset rollover ............................................. [8 130] Small business active asset reduction ..................................................... [8 140] CGT concessions – basic conditions for relief Basic conditions for CGT small business relief ..................................... [8 Meaning of active asset .............................................................................. [8 Trust interests and shares as active assets: additional requirements ............................................................................. [8 CGT concession stakeholder test .............................................................. [8 Small business participation percentage ................................................. [8 Maximum net asset value test .................................................................. [8

200] 210] 220] 230] 240] 250]

Small business restructure rollover Small business restructure rollover relief ............................................... [8 300] Requirements for the small business restructure rollover ................... [8 310] Consequences of choosing small business restructure rollover relief ................................................................................................ [8 320]

TAX RELIEF FOR SMALL BUSINESS ENTITIES [8 000] Concessions for small business entities There are a number of tax concessions for entities, including trusts, that qualify as ‘‘small business entities’’ (see [8 010]). The following table sets out the small business concessions available under the income tax laws. The GST and fringe benefits tax laws also include their own small business concessions.

2016 THOMSON REUTERS

189

[8 000]

TRUSTS AND SMALL BUSINESS RELIEF

Concession Income tax An immediate deduction for start-up costs (eg the costs of creating a trust, incorporating a corporate trustee or registering a business name). An immediate deduction for prepaid business expenses if the eligible service period for the expenditure is 12 months or less. Simplified depreciation rules, including an immediate deduction for depreciating assets under a threshold amount ($20,000 for 2015-16 and 2016-17) and a general small business pool for all other depreciating assets. Simplified trading stock rules, which give businesses the option to avoid an end of year stocktake if the value of the stock changes by less than $5,000. An income tax offset for individuals who are small business entities. The offset is also available to individuals who are the beneficiaries of a trust that is a small business entity (see [14 140]). Adjustments under the indirect value shifting rules are not required. A lower corporate tax rate applies to companies that are small business entities, including corporate beneficiaries (28.5% for 2015-16). Capital gains tax CGT 15-year asset exemption (see [8 120]). CGT 50% active asset reduction (see [8 140]). CGT retirement exemption (see [8 110]). CGT replacement asset rollover (see [8 130]). Small business restructure rollover (also applies to depreciating assets, revenue assets and trading stock) (see [8 300]). Administration PAYG instalments are based on GDP-adjusted notional tax, which removes the risk of incurring penalties from under- or over-estimating PAYG instalments. A two-year period for amended assessments (see [14 010]).

190

Provision s 40-880(2A) ITAA 1997 ss 82KZM and 82KZMD ITAA 1936 Subdiv 328-D ITAA 1997

Subdiv 328-E ITAA 1997 Subdiv 328-F ITAA 1997

Div 727 ITAA 1997 s 23(2)(a) Income Tax Rates Act 1986

Subdiv 152-B ITAA 1997 Subdiv 152-C ITAA 1997 Subdiv 152-D ITAA 1997 Subdiv 152-E ITAA 1997 Subdiv 328-G ITAA 1997

s 45-130 of Sch 1 TAA s 170 ITAA 1936

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 020]

[8 010] Small business entity test An entity is a ‘‘small business entity’’ if it is carrying on a business and its aggregated turnover is less than $2 million (Subdiv 328-C of ITAA 1997). One of three methods can be used to work out whether the aggregated turnover test is met (s 328-110): (a) for the previous income year, the entity’s aggregated turnover was less than $2 million; (b) for the current income year, the entity’s aggregated turnover is likely to be less than $2 million (an objective test) and the entity’s aggregated turnover for each of the two previous income years was under $2 million; or (c) at the end of the current income year, the entity’s aggregated turnover is less than $2 million. An entity’s ‘‘aggregated turnover’’ is the accumulated annual turnover of the entity, its affiliates (see [8 020]) and connected entities (see [8 030]) (s 328-115). This requirement to aggregate the turnover of the entity, affiliates and connected entities is designed to stop larger businesses from artificially splitting their operations to gain access to the small business concessions. An entity’s ‘‘annual turnover’’ for an income year is the total ordinary income (with some exclusions) that the entity derives in that year in the ordinary course of carrying on a business (s 328-120). If the entity operates more than one business activity within the same business structure, the ordinary income from each of these business activities forms part of the entity’s annual turnover. Statutory income (eg capital gains and trust distributions) is not included in annual turnover. Eligibility as a small business entity is a year-by-year proposition, ie the entity must evaluate these requirements each income year.

[8 020] Meaning of affiliate An ‘‘affiliate’’ is an individual or company that acts, or could reasonably be expected to act, in accordance with the directions or wishes of the entity, or in concert with the entity, in relation to the business affairs of the individual or company (s 328-130(1) of ITAA 1997). The following non-exclusive list of factors will be relevant in determining whether an individual or company is an affiliate of another entity: (a) family or close personal relationships; (b) financial relationships or dependencies; (c) relationships created through links such as common directors, partners, or shareholders; (d) the degree to which the entities consult with each other on business matters; or (e) whether one of the entities is under a formal or informal obligation to purchase goods or services or conduct aspects of their business with the other entity. A spouse or a child under 18 may also be an affiliate in certain circumstances (s 152-47). 2016 THOMSON REUTERS

191

[8 030]

TRUSTS AND SMALL BUSINESS RELIEF

An individual or company is not automatically an affiliate of the taxpayer merely because of the legal nature of their business relationship, eg co-directors or partners (s 328-130(2)).

TIP

☞

Only individuals and companies can be affiliates of the taxpayer, and only if they carry on a business. An affiliate does not include an individual or company acting in the capacity of a trustee (although a trustee can be a connected entity: see [8 030]).

[8 030] Meaning of connected entity An entity is ‘‘connected with’’ another entity if one entity controls the other, or if each is controlled by a third party in accordance with the ‘‘control’’ rules (s 328-125(1) of ITAA 1997). For these purposes, ‘‘control’’ is generally measured by reference to voting, income and capital distribution rights in the entity of 40% or more.

Control test for non-discretionary trusts and companies – 40% control test An entity directly controls a fixed trust or company if the entity and/or its affiliates between them own, or have the right to acquire the ownership of, interests in the trust or company that between them give the right to receive at least 40% of any distribution of income or capital (s 328-125(2)(a)). An entity can also control a company if the entity alone, or together with affiliates, owns, or has the right to acquire ownership of, interests in the company with at least 40% of the voting power in the company (s 328-125(2)(b)). Two unconnected entities, each with a 40% interest, are both controllers of a trust. Moreover, as the relevant rights are to any distribution of income or capital, this could result in an entity potentially having up to four controllers. Where control is established under this rule, the net value of all the CGT assets of the connected entity is taken into account for the purposes of the $6 million maximum net asset value test (see [8 250]), even though the taxpayer’s interest in the connected entity may be less than 100%. The same principle applies in relation to the small business entity test (see [8 010]). EXAMPLE Stella is entitled to 50% of the distributions of income from ABC Unit Trust. The net value of ABC Unit Trust’s assets is $7 million and its annual turnover is $4 million. Stella cannot access the small business concessions under either the $6 million maximum net asset value test or the small business entity test because the entire net value of the assets or turnover of ABC Unit Trust (a connected entity) are taken into account, and not just Stella’s 50% interest. An entity will ‘‘indirectly’’ control a fixed trust or company if the entity directly controls a second entity, and that second entity also controls (whether directly or

192

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 030] indirectly) a third entity. In this case, the first entity is taken to control the third entity (s 328-125(7)). However, this rule does not apply if the interposed entities are public companies or similar entities (s 328-125(8)).

EXAMPLE Zoi owns 60% of the shares in ABC Pty Ltd. The company owns 50% of the units in XYZ Unit Trust. Zoi controls XYZ Unit Trust under the indirect control rule, even though her indirect interest in the XYZ Unit Trust is 30%.

Control tests for discretionary trusts There are two alternative control tests for discretionary trusts. An entity will control a discretionary trust if the trustee acts, or can be reasonably expected to act, in accordance with the directions of the entity and/or its affiliates (s 328-125(3)). An appointor with the power to replace the trustee can control a discretionary trust. In Re Gutteridge and FCT [2013] AATA 947; 96 ATR 472, a daughter who was the sole director of the corporate trustee and the public face of the businesses of the trust was found not to be a controller of the trust. This was because the trust was not accustomed to act in accordance with her wishes independently of the wishes of her father. Instead, the daughter acted in circumstances where the corporate trustee could be removed at the will of the appointor (the father’s professional adviser). The AAT concluded that the father alone was the trust’s controller. The effect of this decision was that entities connected with the daughter were not relevant in determining the trust’s entitlement to the CGT small business concessions. An entity will also be taken to control a discretionary trust for an income year if, for any of the four previous income years, the trustee paid any income or capital of the trust for the benefit of the beneficiaries and/or its affiliates and the amount paid was at least 40% of the total amount of income or capital paid by the trustee for that income year (s 328-125(4)). A trustee of a discretionary trust can nominate up to four beneficiaries as being controllers of the trust for this purpose in years in which it had no income or capital to distribute (s 152-78). However, the trust and the nominated beneficiaries would then need to aggregate the market value of their CGT assets (for the purposes of the maximum net asset value test) or their turnovers (for the purpose of the small business entity test).

Commissioner’s discretion Where an entity’s interest in another entity is at least 40% but less than 50%, the Commissioner has the discretion to determine that the first entity does not control the other entity if the Commissioner is satisfied that a third entity (not including any affiliates of the first entity) controls the other entity (s 328-125(6)).

2016 THOMSON REUTERS

193

[8 100]

TRUSTS AND SMALL BUSINESS RELIEF

CGT CONCESSIONS FOR SMALL BUSINESSES [8 100] Small business CGT concessions The CGT provisions (Div 152 of ITAA 1997) include four generous concessions to eliminate, reduce or roll over a capital gain made on a CGT asset that has been used in a small business: (1) the retirement exemption – a small business entity can disregard up to $500,000 of a capital gain from a CGT event happening to its CGT assets (see [8 110]); (2) the 15-year exemption – a small business entity can disregard a capital gain arising from an active CGT asset owned for at least 15 years (see [8 120]); (3) the replacement asset rollover – a small business entity can defer the making of a capital gain from a CGT event happening to its CGT assets (see [8 130]); and (4) the active asset reduction – the capital gain made by a small business entity is reduced by 50% (see [8 140]). The 15-year exemption eliminates the whole of a capital gain in its own right. The other three concessions are in addition to the 50% CGT discount (if applicable – see [5 030]) and can be applied successively to reduce or even eliminate a capital gain (see [5 020]). The availability of these small business concessions is subject to satisfying a range of ‘‘basic’’ conditions (see [8 200]). The concessions themselves also include specific conditions. In addition to the CGT concessions in Div 152, the small business entity rules in Div 328 provide optional rollover relief for small business entities that transfer assets to or from other small business entities as part of a genuine business restructure (see [8 300]).

[8 110] Small business retirement exemption The small business retirement concession is one of the most important tax concessions. It provides an exemption from CGT if the proceeds of sale of assets of a small business are used in connection with the person’s retirement. The exemption has a lifetime limit of $500,000 for any individual (Subdiv 152-D of ITAA 1997). It is not necessary for the taxpayer to have actually retired or to retire at the time of the sale to take advantage of the exemption. However, if the taxpayer is under 55, the amount must be contributed to a complying superannuation fund or retirement savings account (s 152-305(1)(b)). The amount is treated as a personal contribution for which no deduction is allowed. The contribution is therefore not included in the taxable income of the fund and does not form part of the tax-free component when paid from the fund. The taxpayer must exercise a choice to claim the retirement exemption and that choice can be made in relation to all or part of the capital gain. The part of 194

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 110]

the gain that the taxpayer chooses to disregard – called the CGT exempt amount – must be specified in writing (s 152-315(4)). If a company or trust is selling the asset, the following rules apply (s 152-305(2); s 152-325): (i) the basic conditions for small business CGT relief must be satisfied (see [8 200]); (ii) the company or trust must satisfy the ‘‘significant individual’’ test (see [8 230]); (iii) where a company or trust chooses the retirement exemption and has more than one CGT concession stakeholder (see [8 230]), it must specify in writing the percentage of the CGT exempt amount that is attributable to each stakeholder (s 152-315(5)); (iv) the company or trust must make a payment to at least one of its CGT concession stakeholders. The payment is exempt from income tax for the stakeholder and is not deductible from assessable income for the company or trust; (v) if the payment is made to more than one CGT concession stakeholder, the amount of each payment is worked out by reference to each person’s percentage of the retirement exemption as specified by the company or trustee; (vi) if the CGT concession stakeholder is under 55, the company or trust must make the payment by contributing it to a complying superannuation fund. No deduction can be claimed for the contribution (s 290-150(4)); and (vii) the payment must be made by the later of seven days after choosing to apply the exemption and seven days after receiving capital proceeds. Payment made by a company or trust of an amount represented by the retirement concession is not an employment termination payment. However, it may be treated as such to the extent that it exceeds the $500,000 lifetime CGT retirement exemption limit.

Availability of exemption to assets acquired from deceased A legal personal representative or beneficiary of a deceased estate or surviving joint owner who acquired an asset from the deceased is also entitled to the benefit of the retirement exemption in relation to gains made on the asset. However, there is no need for the amount to be paid to a complying superannuation fund, even if the deceased was less than 55 years of age when he or she died (s 152-80(2)(b)).

Interaction with other CGT concessions The retirement exemption generally applies after the small business 50% reduction for active assets (see [8 140]), but the taxpayer can choose for that concession not to apply. Making such a choice may be beneficial where a unit trust or company makes the capital gain by allowing it to make larger tax-free payments under the small business retirement exemption. The retirement exemption applies only to the balance of any capital gain remaining after applying the CGT general discount and therefore the general discount takes priority over the retirement exemption (see [5 020]). 2016 THOMSON REUTERS

195

[8 120]

TRUSTS AND SMALL BUSINESS RELIEF

If a taxpayer is eligible for both the retirement exemption and the small business rollover relief (see [8 130]), then the taxpayer may choose in which order to apply them.

[8 120] 15-year exemption for small business Under the 15-year exemption, a small business can disregard a capital gain arising from the sale of a CGT asset that it has owned for at least 15 years (Subdiv 152-B of ITAA 1997). This exemption is one of the most valuable forms of CGT relief for small business as there is no ceiling on the amount of the exemption. As the CGT regime has been operating for over three decades, the instances where the 15-year exemption can be of benefit are increasing. To qualify for the 15-year exemption (s 152-105, s 152-110): • the basic conditions for small business CGT relief must be satisfied (see [8 200]); • the asset must have been continuously owned for the 15-year period leading up to the sale; • if the CGT asset is a share or trust interest, the company or trust must have had a significant individual (see [8 230]) for at least 15 years during which the share or trust interest was owned – even if the 15 years was not continuous and even if it was not the same significant individual; • where the entity selling the asset is an individual, that person must be 55 or over and the sale must relate to his or her retirement, or the person must be permanently incapacitated at the time of the sale; and • if the entity selling the asset is a trust or company, the entity must have had a significant individual throughout the 15-year ownership period. Further, the person who is the significant individual just before the sale must be 55 or over just before the sale and the sale must relate to the person’s retirement or permanent incapacity. Where the seller is an individual, the capital gain is not subject to tax (s 152-105). If the seller is a company or trust, the gain is also not subject to CGT and a distribution made within two years of the sale by the company or trust out of the exempt CGT gain is also not taxable in the hands of a shareholder or beneficiary who is a CGT concession stakeholder (s 152-125). The Commissioner has a discretion to extend the two-year period (s 152-125(4)). The 15-year exemption requires there to be an actual retirement (unlike the retirement exemption which does not require a retirement: see [8 110]). The CGT event and the retirement do not have to be at the same time – the CGT event could be in anticipation of retirement or after retirement. Although there is no definition of ‘‘retirement’’ for the purposes of the exemption, there does not need to be a complete withdrawal from the workforce – for example, a taxpayer may stay on for a limited period to help a new owner during a transitional period. It may also be permissible for a taxpayer who has genuinely retired from the workforce to later take up another full time position or become involved in a new business. The 15-year exemption has priority over the other small business concessions because it provides a full exemption for the capital gain.

196

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 130]

TIP

☞

Benefits of utilising the 15-year exemption • There is no ceiling or lifetime cap on the amount of the exemption – the full gain is exempt. • It does not require capital losses or the 50% CGT discount to be applied first against the capital gain. • The capital proceeds can be paid tax-free to shareholders of a company or beneficiaries of a trust. • The capital gain can be used as a contribution to a complying superannuation plan up to the full amount of the CGT cap ($1.395 million for 2015-16) and will be treated as a non-concessional superannuation contribution. (The use of the capital gain in this way is not available to deceased estates.)

[8 130] Small business replacement asset rollover The small business CGT rollover relief allows tax on a capital gain from the disposal of a small business asset to be deferred (Subdiv 152-E of ITAA 1997). The capital gain is deferred on an automatic basis for two years. The taxpayer does not need to have acquired a replacement asset before choosing the rollover. However, if a replacement asset is not acquired during the period of one year before the capital gain is derived and two years after that date, the deferred capital gain will be reinstated (s 104-197). The gain will also be reinstated if the replacement asset is not an active asset by that time or ceases to be an active asset or the taxpayer has not incurred sufficient expenditure on a replacement asset to cover the amount of the rolled over gain (ss 104-185 and 104-198). In short, in any of these situations, the gain will be reinstated in the year in which the relevant ‘‘failure’’ occurs pursuant to CGT events J2, J5 or J6 (as the case may be). A taxpayer can choose to roll over all or part of the gain. If only part is rolled over, a capital gain will arise immediately in relation to the excess (s 152-415). The requirements for the rollover are as follows (s 152-410): (a) the basic conditions for small business CGT relief must be satisfied (see [8 200]); (b) the taxpayer must make a choice to access the rollover relief; (c) the taxpayer must acquire one or more CGT assets as replacement assets or make capital improvements to one or more existing CGT assets; (d) the taxpayer must acquire the replacement asset(s) or incur the capital improvement expenditure within the replacement asset period – generally the period commencing one year before and ending two years after the capital gain is derived (the Commissioner has a discretion to extend this period – s 104-185(1)(a)); (e) the replacement asset must be an active asset (see [8 210]) when acquired or by the end of two years after the rollover is chosen; and (f) if the replacement asset is an interest in a company or trust, the taxpayer must be a CGT concession stakeholder or an entity connected with a 2016 THOMSON REUTERS

197

[8 140]

TRUSTS AND SMALL BUSINESS RELIEF

CGT concession stakeholder or the company or trust must have a small business participation percentage in the entity of at least 90% (see [8 230]). A replacement asset would include (s 104-185): (i) a newly acquired asset and/or capital expenditure on an existing asset incurred for the purpose or intended effect of increasing or preserving the asset’s value or that relates to moving or installing the asset; (ii) an asset that is otherwise exempt from CGT, for example, a car, a depreciating asset or trading stock; (iii) replacement shares and trust interests.

TIP

☞

1. A replacement asset does not have to be the same category of asset or serve the same function as the original asset. It is acceptable, for example, to dispose of a trust interest and acquire a business asset (or vice versa). 2. Any prior year losses and the CGT discount apply before the rollover. 3. If the 15-year exemption applies, it has priority over the rollover (s 152-215).

In ATO ID 2002/753, the acquisition of an interest in a property from which the taxpayer would carry on a business satisfied the active replacement asset requirement. The property included a house, and the taxpayer estimated that approximately 30% of the house would be used for business purposes, with the remaining interest in the property held by several individuals who intended to use the house as their main residence.

[8 140] Small business active asset reduction The active asset reduction effectively reduces a capital gain made by a small business entity by 50% (Subdiv 152-C of ITAA 1997). It applies after the 50% CGT general discount (available to individuals and trusts) and in this way a small business taxpayer can secure a 75% reduction for an eligible capital gain made on disposal of an active asset. EXAMPLE

Capital gain on active asset Less CGT general discount of 50% Notional capital gain Less 50% active asset reduction Taxable capital gain

198

$ 20,000 (10,000) 10,000 (5,000) 5,000

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 200] To qualify for the active asset reduction, the basic conditions set out at [8 200] must be met. Where a company or trust is claiming the 50% reduction in relation to the disposal of an asset (other than a share or trust interest), there is no requirement for it to have a significant individual. A taxpayer can choose not to apply the active asset reduction to a particular capital gain. Making this choice may allow a company or trust to make larger tax-free payments under the small business retirement exemption (where that exemption is available: see [8 110]). The 50% reduction is also available to a beneficiary of a trust in respect of a capital gain distributed to the beneficiary if the trust was eligible for the 50% reduction (s 115-215(3)).

TIP

☞

Where a company or trust is eligible for the small business retirement exemption it may be beneficial not to choose the 50% active asset reduction where the shareholder or unit holder is retiring or close to retirement. Although the capital gain is tax-free to the company or the trust, the value of the active asset concession may be washed out when the concessionally-taxed amount is distributed to the stakeholder. By not using the active asset reduction, a greater tax-free payment may be made by the company or trust under the retirement exemption.

CGT CONCESSIONS – BASIC CONDITIONS FOR RELIEF [8 200] Basic conditions for CGT small business relief The availability of CGT small business concessions (see [8 100]) is subject to satisfying a range of ‘‘basic’’ conditions (Subdiv 152-A of ITAA 1997). In addition, the specific concessions themselves impose their own conditions. The basic conditions to be met for CGT small business relief to apply are as follows (s 152-10): (a) a CGT event (such as a sale) happens in relation to a CGT asset owned by the taxpayer; (b) the event would have resulted in a capital gain (other than under CGT event K7 concerning balancing adjustments to depreciating assets); (c) the taxpayer, or an ‘‘affiliate’’ (see [8 020]) or ‘‘connected entity’’ (see [8 030]) of the taxpayer, used the asset in carrying on a business for the relevant period; (d) the CGT asset is an ‘‘active asset’’ (see [8 210]). An active asset can include trust interests and shares (see [8 220]), provided the CGT concession stakeholder test is satisfied (see [8 230] and [8 240]); and (e) the taxpayer satisfies one of two threshold tests: (i) the $6 million maximum net asset value test (see [8 250]); or 2016 THOMSON REUTERS

199

[8 210]

TRUSTS AND SMALL BUSINESS RELIEF

(ii) the $2 million aggregated turnover small business entity test (see [8 010]).

TIP

☞

The availability of two alternative threshold tests means that taxpayers who are asset rich but income poor (eg farmers during floods or droughts) can potentially access the small business concessions by relying on the small business entity test, while taxpayers who are income rich but asset poor may be able to access the concessions by relying on the maximum net asset value test.

The CGT small business concessions are potentially available to entities carrying on a small business through all forms of business vehicles, including trusts. They are also available to the legal personal representative or beneficiary of a deceased estate, a surviving joint tenant and the trustee of a testamentary trust, provided the deceased would have qualified for the concessions just before his or her death and the relevant CGT asset is sold within two years of the date of death (or any extended period allowed by the Commissioner) (s 152-80).

TIP

☞

In seeking to apply the CGT small business concessions to a capital gain, it is crucial to identity the following from the outset: (1) the CGT asset that has given rise to the gain – eg is it a trust interest or a business asset of a trust? (2) the taxpayer who owns the CGT asset – eg is the taxpayer an individual or the trustee of a trust?

[8 210] Meaning of active asset The active asset test is a basic condition (see [8 200]) that must be satisfied for a taxpayer to qualify for the small business CGT concessions (s 152-10(1)(d) of ITAA 1997). An active asset is an asset that is used or held ready for use in the taxpayer’s business or a business carried on by an affiliate (see [8 020]) or connected entity (see [8 030]) (s 152-40(1)). The asset must have been an active asset for at least half of its period of ownership by the taxpayer or, for at least seven and a half years, where it has been owned for more than 15 years (s 152-35). Land owned by the trustee of a discretionary trust and used in a beneficiary’s business will be an active asset if the parties are connected entities or affiliates. An intangible asset (eg goodwill, a trade debt or the benefit of a restrictive covenant) can be an active asset (s 152-40(1)(b)).

Assets excluded from being active assets The following assets are not active assets (s 152-40(4)): (1) trust interests and shares in connected entities (other than those qualifying as active assets under the 80% market value test: see [8 220]); 200

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 230]

(2) trust interests and shares in widely held entities (unless held by CGT concession stakeholders); (3) financial instruments (eg loans, debentures, bonds, promissory notes, futures contracts, currency swap contracts, and rights or options over shares, securities, loans or contracts); and (4) assets used mainly to derive interest, annuities, rent, royalties or foreign exchange gains. The ‘‘main use to derive rent’’ exclusion precludes commercial property investors from qualifying for the small business concessions, even where a business of leasing commercial properties is carried on: see Re Jakjoy Pty Ltd and FCT [2013] AATA 526; 96 ATR 185. This places commercial investment at a relative disadvantage to other active forms of investment. A property that is initially used to derive rent can still qualify as an active asset if it subsequently becomes business premises (or vice versa). This is because the property only needs to be an active asset for half the period of ownership by the taxpayer (or seven and a half years if owned by the taxpayer for over 15 years).

[8 220] Trust interests and shares as active assets: additional requirements Trusts interests in resident trusts and shares in resident companies held by an individual can qualify as active assets for the purposes of small business CGT relief where the following conditions are met: (a) the market value of the active assets of the company or trust (ie the object company or trust that carries on the business) account for at least 80% of the market value of all the assets of the company or trust (s 152-40(3) of ITAA 1997). The share or trust interest can also qualify as an active asset if the company or trust owns interests in another entity that satisfies the 80% test; (b) the assets of the company or trust must have been active assets for at least half their period of ownership or for at least seven and a half years where they have been owned for more than 15 years (s 152-35); and (c) the CGT concession stakeholder test is satisfied (s 152-10(2): see [8 230]).

TIP

☞

The application of the small business concessions to trust interests allows taxpayers who operate a business through a trust structure to qualify for the concessions without having to separately sell the assets of the trust. Further, trust interests can qualify as active assets regardless of whether they are owned by an individual or by a company or trustee. This means that all the parties in a chain of entities that hold interests in a trust can potentially qualify for the small business concessions.

[8 230] CGT concession stakeholder test For a trust interest to qualify as an active asset, it is necessary to identify an individual who is a ‘‘CGT concession stakeholder’’ in the ‘‘object’’ trust in which 2016 THOMSON REUTERS

201

[8 240]

TRUSTS AND SMALL BUSINESS RELIEF

the trust interest is held (s 152-10(2) of ITAA 1997). Similarly, for a company share to qualify as an active asset, a CGT concession stakeholder in the object company needs to be identified (s 152-10(2) of ITAA 1997). The CGT concession stakeholder test ensures that the small business relief provisions apply in relation to trust interests (or shares) of those individuals and their spouses who in effect own the business being carried on through the trust (or by the company). The test is satisfied where: (1) the taxpayer claiming the small business concession is a CGT concession stakeholder in the company or trust; or (2) CGT concession stakeholders in the company or trust together have a small business participation percentage (see [8 240]) in the taxpayer claiming the concession of at least 90%. If the trust interests or shares are owned directly by an individual, the CGT concession stakeholder test will be met if the individual is a ‘‘significant individual’’ or his or her spouse has a ‘‘small business participation percentage’’ in the trust or company greater than zero (s 152-60). An individual is a ‘‘significant individual’’ in the trust (or company) if the person has a small business participation percentage in the trust (or company) of at least 20% (s 152-55). In turn, ‘‘small business participation percentage’’ generally refers to the control and ownership of the trust (or company) by reference to capital and income distribution rights (or voting rights). This reflects the fact that the small business concessions are, in effect, only available for trust interests (or shares) in entities that are ‘‘closely held’’ – as measured by reference to individual taxpayers with an ‘‘ownership’’ or ‘‘controlling’’ interest of at least 20% in the entity.

[8 240] Small business participation percentage The ‘‘small business participation percentage’’ (SBPP) is used to measure whether a taxpayer has a sufficient ownership interest in a trust or company (20% or more) to qualify as a ‘‘significant individual’’ (see [8 230]). This in turn enables an individual taxpayer (and his or her spouse) to qualify as a CGT concession stakeholder (in determining whether trust interests or shares as active assets). The SBPP can consist of both direct and indirect interests in the object trust or company. For example, where a trust interest holder has both direct and indirect SBPPs in a trust, the total SBPP will be the sum of the direct and indirect percentages (s 152-65 of ITAA 1997).

Fixed trusts – direct small business participation percentage For interest holders with entitlements to all of the income and capital of a trust, their direct SBPP will be the percentage of any distribution of income or capital to them that the trustee may make or, if they are different, the smaller of the two percentages (s 152-70(1), item 2 of Table).

Discretionary trusts – direct small business participation percentage For interest holders in a discretionary trust, their direct SBPP will generally be the actual percentage of the distributions of income or capital they are entitled to in an income year or, if they are different, the smaller of the two percentages (s 152-70(1), item 3). 202

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 240]

If the trustee has not made a distribution for the income year because the discretionary trust has a tax loss or no net income for the year, an interest holder’s direct SBPP is determined using the percentage of the distributions the interest holder was beneficially entitled to in the last income year a distribution was made (s 152-70(4), 152-70(5)). An interest holder’s SBPP in a discretionary trust will be zero if (s 152-70(6)): (a) the trustee decides not to distribute any net income (and the discretionary trust is not in a loss situation); or (b) the trustee did not make any distributions in the income years up to and including the current year (even if the discretionary trust had no net income or had a tax loss in these income years). ‘‘Income’’ and ‘‘capital’’ distributions are determined according to trust law principles, consistent with FCT v Bamford [2010] HCA 10; 75 ATR 1 (see ATO ID 2012/99). This means that, depending on the terms of the trust deed and/or the actions of the trustee, an amount that is not ordinary income (eg a capital gain) can be income for the purposes of s 152-70, item 3. The indirect SBPP of a shareholder or trust interest holder is calculated by multiplying his or her direct SBPP in an interposed entity by the entity’s total SBPP (both direct and indirect) in the company or trust (s 152-75). In ATO ID 2012/99, the trustee of a discretionary trust owned 50% of the shares in a company. In the 2011-12 income year, the trustee sold the shares, making a capital gain of $90,000. The trustee also derived ordinary income of $10,000. The trust deed did not define ‘‘income’’, but the trustee had the power to determine whether receipts were on capital or revenue account. The trustee validly resolved to treat the $90,000 capital gain as income of the trust estate and to distribute it to one beneficiary (B1). The ordinary income was appointed to another beneficiary (B2). Applying the CGT concession stakeholder test: (1) B1’s direct SBPP in the trust was 90%; (2) B2’s direct SBPP was 10%; and (3) B1’s indirect SBPP in the company was 45% (because the trust held 50% of the shares in the company immediately before the sale). B1 was therefore a CGT concession stakeholder in the company (by virtue of holding an indirect SBPP in the company of at least 20%). B2 was not a CGT concession stakeholder as B2’s indirect SBPP was 5%. However, the additional basic condition in s 152-10(2)(b) was satisfied because B1 was a CGT concession stakeholder in the company with a SBPP in the trust of 90%. The Tax Office noted that the result in ATO ID 2012/99 would have been different if the trustee had not resolved to treat the capital gain as income of the trust and had instead distributed the capital gain to B1 as a capital distribution. The additional basic condition under s 152-10(2)(b) would not have been satisfied because each beneficiary would have had a direct SBPP in the trust of zero (being the smaller percentage of the distributions of capital and income to which each beneficiary was beneficially entitled).

Indirect small business participation percentage An individual’s indirect SBPP in a trust or company held through one or more interposed entities is counted in determining whether the person is a significant individual of the object trust or company. 2016 THOMSON REUTERS

203

[8 240]

TRUSTS AND SMALL BUSINESS RELIEF

The indirect SBPP of an interest holder is calculated by multiplying his or her direct SBPP in an interposed entity by the entity’s total SBPP (both direct and indirect) in the trust or company (s 152-75). EXAMPLE Tammy receives 50% of the distributions from a discretionary trust. The trust owns 80% of the shares in a company. Tammy’s indirect SBPP in the company is 40%, being her direct SBPP in the trust (50%) multiplied by the trust’s SBPP in the company (80%). Tammy qualifies as a significant individual of the company (and is a CGT concession stakeholder).

Interposed entities - 90% test For an interposed entity to be entitled to the CGT small business concessions in relation to shares or trust interests it holds in another company or trust that carries on a business (the ‘‘object’’ company or trust), the following requirements must be satisfied (s 152-10(2)): (a) the market value of the active assets of the object company or trust must be at least 80% of the market value of all the assets of the company or trust (s 152-40(3)); (b) there must be at least one CGT concession stakeholder in the object company or trust; and (c) the CGT concession stakeholder, or stakeholders between them, must have a SBPP in the interposed entity of at least 90%. In relation to this last requirement, this means that 90% or more of the SBPP in the interposed entity must be directly or indirectly held by individuals who are also CGT concession stakeholders in the object company or trust. In these circumstances, whether a person is a CGT concession stakeholder in the object company or trust is determined by tracing his or her participation percentage in the object company or trust through any interposed entities and adding it to any direct SBPP in the object company or trust. In this way, the 90% test allows an interposed entity to qualify for the small business concessions even though it is not an individual. EXAMPLE An interposed discretionary trust owns 50% of the shares in the object company and sells some of these shares during the income year. In that period, 90% of the trust distributions are made to Nikos. The trust can qualify for CGT small business relief in relation to the sale of the shares in the object company under the 90% test because: (1) Nikos is a CGT concession stakeholder in relation to the object company as he is a significant individual with a SBPP in the company greater than 20%, namely 45% (ie 50% x 90%); and (2) Nikos’ SBPP in the trust (the interposed entity) is 90% or more.

204

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 250]

EXAMPLE All of the shares in ABC Pty Ltd are held by a discretionary trust. The trustee makes 50% of its distributions to Sarah and 40% of its distributions to Harry (beneficiaries of the trust) during the income year. During that period, Sarah and Harry are CGT concession stakeholders in ABC via their indirect SBPP of 50% and 40% respectively. In addition, the discretionary trust (ie the interposed entity) satisfies the 90% test as Sarah and Harry (the CGT concession stakeholders) have a 90% or more SBPP in the interposed entity via the distributions made to them. Accordingly, if the trust sells its shares in ABC Pty Ltd, it could qualify for the small business concessions, provided the company satisfies: (a) the 80% active asset test; and (b) the $6 million maximum net asset value test or the $2 million small business entity test.

Discretionary trusts and planning In the case of a discretionary trust, as an individual’s SBPP in the trust is measured by reference to distributions the trustee makes to the individual in the year (or in the previous year if the trust had no net income or had a tax loss for the current year), the trustee can satisfy the 90% test by making appropriate distributions in the relevant income year. In other words, a discretionary trust can qualify for the concession in respect of shares or trust interests it owns in another entity by planning distributions in the relevant year.

[8 250] Maximum net asset value test A taxpayer can qualify for the CGT small business concessions by satisfying the $6 million maximum net asset value test. A taxpayer who fails this test can still access the small business concessions if the small business entity test is satisfied (see [8 010]). The maximum net asset value test is satisfied if the taxpayer’s net asset position is $6 million or less (s 152-15 of ITAA 1997). This means that the ‘‘net value’’ of assets owned by the taxpayer, affiliates of the taxpayer (see [8 020]) and entities connected with the taxpayer (see [8 030]) must not exceed $6 million (s 152-20). The assets to be valued under the maximum net asset value test are ‘‘CGT assets’’, including pre-CGT assets. The Commissioner takes the view that Australian currency is a CGT asset for the purposes of the maximum net asset value test (ATO ID 2003/166), even though it is not a CGT asset under the general CGT when it is used as legal tender (s 108-5, Determination TD 2002/25). Shares and trust interests in affiliates or connected entities, personal use and enjoyment assets, and superannuation and life insurance policy assets are excluded assets and do not need to be valued (s 152-20(2)). 2016 THOMSON REUTERS

205

[8 250]

TRUSTS AND SMALL BUSINESS RELIEF

Meaning of net value of the CGT assets The net value of the CGT assets of an entity (the taxpayer, an affiliate or a connected entity) is the amount (whether positive, negative or nil) by which the market value of each CGT asset exceeds the following (s 152-20(1) of ITAA 1997): (a) the liabilities of the entity that are related to the assets – these include liabilities that relate to the entity more generally (eg a bank overdraft that provides working capital for a business: see Determination TD 2007/14); and (b) any provisions made by the entity for annual leave, long service leave, unearned income or tax liabilities. Liabilities that do not relate to any particular asset, or to the assets of the entity as a whole, cannot be taken into account. In Bell v FCT [2013] FCAFC 32; 90 ATR 7, a $2 million debt owed by a discretionary trust (a connected entity of the taxpayer beneficiary) to a unit trust could not be counted because it did not relate to any CGT asset of the family trust. Similarly, in Re Phillips and FCT [2012] AATA 219; 88 ATR 297, a liability incurred in respect of a loan made to a discretionary trust, secured via a mortgage over assets owned by a related entity, did not relate to any CGT asset of the trust. In Bell’s case, the discretionary trust made a gross capital gain of over $6 million on the sale of units held in the unit trust and in another related trust. The taxpayer was both the director of the corporate trustee and a beneficiary of the discretionary trust. The trustee resolved to make a $2 million capital distribution to the taxpayer, to enable him to contribute $1 million to his superannuation fund and to pay off a $1 million debt on his wife’s principal residence. The discretionary trust had insufficient cash resources to pay the distribution, so a bank loan facility available to the unit trust was made available to the discretionary trust to the extent of $2 million. The Full Federal Court observed that no loan money had passed through the discretionary trust to effect the distribution and that, in these circumstances, the trust never had an asset to which the loan related. Even if there were such an asset (the loan), it had been disposed of to the taxpayer beneficiary just before the CGT event (see below) and that therefore there was no asset to which the liability related. In Re Track and Ors and FCT [2015] AATA 45, the AAT distinguished the Full Federal Court’s decision in Bell v FCT and found that unpaid present entitlements and loans take out by a trustee to fund capital distributions were related to the CGT assets of the trust as ‘‘the strategy seems to have been to avoid actually disposing of cash until after settlement of the sale [of the trust’s business] in the following financial year’’ (see further [10 010]). The Tribunal also noted that the ‘‘liabilities’’ of the trust needed to reflect the economic value of the business and that, in the ordinary course of events, the balance sheet of a business should demonstrate the economic value of a business. The Commissioner’s views as to whether an unpaid present entitlement (UPE) of a connected beneficiary is a liability of a trust are set out in Ruling TR 2015/4. The Ruling provides that the market value of the UPE must be included in the trust’s net asset value calculation, although it only needs to be included once, as part of the net value of the CGT assets of either the connected beneficiary or any sub-trust that holds the UPE for the connected beneficiary. 206

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 310]

When the maximum net asset value test must be satisfied The maximum net asset value test must be satisfied ‘‘just before’’ the CGT event. In the case of the sale of land under a contract, this means just before the time of entering the contract for the sale and not just before the time of the settlement of the contract: ATO ID 2003/744. As the test does not need to be satisfied throughout the period of ownership of the CGT asset that gave rise to the gain, this provides clear planning opportunities to sell down assets or enter into other transactions in order to meet the threshold test (although such transactions may themselves trigger CGT events).

SMALL BUSINESS RESTRUCTURE ROLLOVER [8 300] Small business restructure rollover relief From 1 July 2016, there is optional rollover relief for certain small business restructures, including restructures involving discretionary trusts (Subdiv 328-G of ITAA 1997). The rollover is available where a resident small business entity transfers an active asset of the business to another resident small business entity and the transfer is part of a ‘‘genuine restructure’’ of an ongoing business (see [8 310]). The rollover may also apply to affiliates or entities connected with a small business entity, where the assets are passively held CGT assets and are used by the small business entity in its business. The transferred assets can be CGT assets, depreciating assets, trading stock or revenue assets. The general effect of the rollover is that no direct income tax consequences arise from the transfer of the assets and their tax costs are rolled over to the transferee (see [8 320]). Subdivision 328-G does not specify how the choice to apply the rollover must be made, other than requiring both the transferor and each transferee to make the choice (s 328-430(1)(f)). Presumably, the way in which the parties’ income tax returns are prepared is sufficient evidence of the making of the choice.

[8 310] Requirements for the small business restructure rollover Small business restructure rollover relief is optional. The transferor and transferee(s) can choose to apply the rollover in relation to an asset transferred under a transaction if each of the following conditions is satisfied (s 328-430(1) of ITAA 1997): (a) the transaction is, or is a part of, a genuine restructure of an ongoing business (see below); (b) each party to the transaction is a small business entity, an affiliate of a small business entity, connected with a small business entity or a partner in a small business partnership; (c) the ultimate economic ownership of the asset is not materially changed as a result of the transaction. Where a party to the transaction is a discretionary trust, this condition will be satisfied if a family trust 2016 THOMSON REUTERS

207

[8 310]

TRUSTS AND SMALL BUSINESS RELIEF

election (see [7 110]) has been made and the transferred asset continues to be held for the benefit of the same family group (s 328-440) – see example below; (d) the transferred asset is an active asset; and (e) the transferor and each transferee are Australian residents for tax purposes. The residency test for trusts is: (a) for a discretionary trust or other non-unit trust – that a trustee of the trust is an Australian resident or that the central management and control of the trust is in Australia (para (a) of the definition of ‘‘resident trust for CGT purposes’’ in s 995-1); (b) for a unit trust – that any property of the trust is situated in Australia or that the trust carries on a business in Australia, and that either its central management and control in Australia or Australian residents hold over 50% of the beneficial interests in the income or property of the trust (para (b) of the definition of ‘‘resident trust for CGT purposes’’ in s 995-1). Whether a restructure is ‘‘genuine’’ as opposed to ‘‘artificial or inappropriately tax-driven’’ is determined having regard to the facts and circumstances surrounding the restructure. Factors that may indicate a genuine restructure include that it is a bona fide commercial arrangement undertaken to enhance business efficiency, that the business continues operating under the same ultimate economic ownership, that the transferred assets continue to be used in the business, that the arrangement results in a structure likely to have been adopted had the business owners obtained appropriate professional advice when setting up the business, and that the transaction is not a preliminary step to facilitate the economic realisation of assets. A safe harbour rule treats a restructure as genuine if the transferred assets continue to be used in the business for three years following the transfer, there is no significant or material use of those assets for private purposes and there is no change in their ultimate economic ownership (s 328-435). EXAMPLE Adela and her sister Francesca are the directors and shareholders in a private company. The company, a small business entity, runs a nursery business from a property it acquired in 2011. The directors receive legal advice that ownership of the property should be transferred to a trust, which will then lease the property back to the company. Acting on that advice, they cause a discretionary trust to be settled. A family trust election is made, naming Adela as the test individual. Adela and Francesca are the beneficiaries of the trust. If the business premises are transferred from the company to the discretionary trust, the ultimate economic ownership test will be satisfied because Adela and Francesca have ultimate economic ownership of the property just before and just after the transfer and they are members of the same family group.

208

2016 THOMSON REUTERS

TRUSTS AND SMALL BUSINESS RELIEF [8 320]

[8 320] Consequences of choosing small business restructure rollover relief Where the transferor and transferee(s) choose to apply the small business restructure rollover, the choice affects the tax consequences of the transaction for all parties. No direct income tax consequences arise from the transfer of the assets (s 328-450) and the tax costs of the transferred assets are rolled over to the transferee (s 328-455). Pre-CGT assets of the transferor retain their pre-CGT status in the transferee’s hands (s 328-460). In determining eligibility for the 15-year CGT exemption for small business (see [8 120]), the transferee is deemed to have acquired the asset when the transferor acquired it (s 152-115(3)). However, for the purposes of the 50% CGT discount (see [5 030]), the transferee is treated as having acquired the asset at the transfer time (ie the transferee will not qualify for the CGT discount if it disposes of a transferred asset within a year of the transfer). Where a transferred asset was a replacement asset under the Subdiv 152-E small business rollover (see [8 130]), the transferee inherits the transferor’s choice to apply Subdiv 152-E (s 328-475). The cost base of any membership interests (eg units or shares) issued in consideration for the transferred assets is the sum of the rollover costs and adjustable values of the transferred assets (excluding pre-CGT assets), less any liabilities that the transferee undertakes to discharge in respect of those assets, divided by the number of new membership interests (s 328-465). EXAMPLE A partnership transfers the following assets to a unit trust as part of a genuine small business restructure: • a pre-CGT property with a market value of $800,000 and a cost base of $80,000; • a post-CGT property with a market value of $900,000 and a cost base of $300,000; • goodwill with a market value of $30,000 and a cost base of $0; and • a depreciating asset with an adjustable value of $70,000. The trustee also assumes the liabilities of the partnership, being $10,000 in unpaid taxes and $15,000 owing to trader creditors. The trustee issues 40 units to the partners in exchange for the transfer. If the partners and the trustee choose to apply the small business restructure rollover: • no capital gain or loss arises from the transfer of the CGT assets; • no amount is included in the partners’ assessable income, and no deduction is allowed, as a result of a balancing adjustment event from the transfer of the depreciating asset; • the pre-CGT property retains its pre-CGT status in the trustee’s hands;

2016 THOMSON REUTERS

209

[8 320]

TRUSTS AND SMALL BUSINESS RELIEF • the trustee can deduct the decline in value of the depreciating asset using the same method and effective life that the partnership was using; • the trustee is deemed to have acquired the post-CGT property for its cost base of $300,000; • the trustee is deemed to have acquired the goodwill for its cost base of $0; and • the cost base of each new unit in the trust is $8,625 [($300,000 + $70,000 - $10,000 - $15,000) ÷ 40 = $23,900].

Subdivision 328-G includes a loss integrity rule that disregards capital losses on membership interests if the losses are attributable to the restructure (s 328-470). EXAMPLE As part of a genuine small business restructure, a company transfers, for no consideration, a $700,000 property to the trustee of a discretionary trust. The company and the trustee choose Subdiv 328-G rollover relief, so no direct income tax consequences arise from the transfer. The company’s shareholders do not need to adjust the cost base of their shares to reflect the rollover transaction. However, if a shareholder subsequently disposes of her or his shares for a capital loss, the loss denial rule requires the shareholder to disregard the loss unless it can be demonstrated that the loss was attributable to something other than the rollover transaction.

Rollover relief under Subdiv 328-G does not extend to any non-income tax liability arising from the transfer (eg GST, FBT or State duty), and the general anti-avoidance rule in Pt IVA of ITAA 1936 is still relevant. Where assets are transferred as part of a company to trust restructure, no dividend arises (under s 44 or Div 7A of ITAA 1936) as a result of the transfer. However, the Tax Office considers that the subsequent application of the deemed dividend rule in Div 7A is not ‘‘turned off’’ if Subdiv 328-G rollover is chosen. Law Companion Guideline LCG 2016/D2 includes an example of a company to discretionary trust restructure, where an asset is transferred for consideration but the trustee enters into a Div 7A compliant loan (see [11 220]). The Guideline provides that a deemed dividend may arise if the company subsequently forgives the loan or the trustee fails to make the minimum yearly repayments.

210

2016 THOMSON REUTERS

PRIMARY PRODUCER CONCESSIONS FOR BENEFICIARIES

9

TRUST CARRYING ON PRIMARY PRODUCTION BUSINESS Primary producer concessions available to beneficiaries .................... [9 000]

PRIMARY PRODUCTION AVERAGING AND TRUSTS When a beneficiary is eligible for averaging ......................................... [9 100]

AVERAGING WHERE NO TRUST INCOME Averaging in a trust loss situation ........................................................... [9 200] Averaging and discretionary trusts ......................................................... [9 210] Averaging and fixed trusts ........................................................................ [9 220]

FARM MANAGEMENT DEPOSITS AND TRUSTS Farm management deposit scheme ......................................................... [9 Beneficiary can be owner of farm management deposit ..................... [9 Deeming rule where primary production business carried on by trust ................................................................................................................ [9 Discretionary trust with no trust income ............................................... [9 Interaction with general trust rules ......................................................... [9

300] 310] 320] 330] 340]

TRUST CARRYING ON PRIMARY PRODUCTION BUSINESS [9 000] Primary producer concessions available to beneficiaries Primary producers are entitled to various tax concessions, which are not available to other businesses. Where a primary production business is carried on through a trust structure, a beneficiary may be treated as a primary producer for the purposes of the following concessions: • the primary producer income averaging rules (see [9 100]); and • the farm management deposit scheme (see [9 300]).

2016 THOMSON REUTERS

211

[9 100]

NOTE

PRIMARY PRODUCER CONCESSIONS FOR BENEFICIARIES

To access the primary producer concessions, the beneficiary must be an individual.

PRIMARY PRODUCTION AVERAGING AND TRUSTS [9 100] When a beneficiary is eligible for averaging The primary producer averaging provisions smooth out the income tax liability of primary producers from year to year by providing a tax offset where income is higher than average and applying a surcharge or extra tax where the income is lower than average (Div 392 of ITAA 1997). To be eligible for averaging, a taxpayer must be an individual (not a company) carrying on a business of primary production in Australia for at least the last two years, including the current year (s 392-10). Where the primary production business is carried on through a trust structure, a beneficiary who is an individual will be treated as carrying on that primary production business if the beneficiary has a present entitlement to a share of the income of the trust estate for the income year (s 392-20). An anti-avoidance measure applies where the beneficiary is presently entitled to income of less than $1,040 from the trust. In such a case, the beneficiary will be treated as carrying on the primary production business only where the Commissioner is satisfied that the beneficiary’s interest was not acquired or granted to enable access to the averaging provisions (s 392-20(2)). If there is no income of the trust estate (see [9 200]), the beneficiary will be treated as carrying on the primary production business if: • for a discretionary trust – the individual is a chosen beneficiary (see [9 210]); • for a fixed trust – assuming there is trust income, the beneficiary would have had a present entitlement (see [9 220]).

AVERAGING WHERE NO TRUST INCOME [9 200] Averaging in a trust loss situation Before the High Court’s decision in FCT v Bamford [2010] HCA 10; 75 ATR 1, the Tax Office treated a beneficiary as presently entitled to a share of the income of the trust estate (trust income) provided there was some gross trust income and the trustee exercised the discretion in favour of the beneficiary (or the trust income had fallen to the beneficiary as a default beneficiary). Further, if the trust made a loss, a beneficiary with a vested and indefeasible interest in trust income would be treated as being presently entitled to trust income (Taxation Ruling TR 212

2016 THOMSON REUTERS

PRIMARY PRODUCER CONCESSIONS FOR BENEFICIARIES

[9 300]

95/29, withdrawn on 30 June 2010). In these circumstances, the beneficiary continued to be eligible for averaging (and the benefits of the farm management deposit provisions: see [9 300]). However, Bamford’s case held that a beneficiary cannot be presently entitled to a share of the trust income if there is no income legally available for distribution. This meant that the Tax Office’s practice was unsupported in law. Amendments were subsequently made to the averaging provisions (and to the farm management deposit provisions) to effectively reinstate the Tax Office pre-Bamford practice from the 2010-11 income year. The rules differ depending on whether the individual is a beneficiary of a discretionary trust (see [9 210]) or a non-discretionary trust (see [9 220]).

[9 210] Averaging and discretionary trusts Beneficiaries who are the ‘‘chosen beneficiaries’’ of a discretionary trust are eligible for income averaging in a year where there is no trust income to which the beneficiaries could be presently entitled (s 392-20(4) of the ITAA 1997). The trustee can choose a certain number of beneficiaries to be taken to be carrying on the primary production business. This choice can be the higher of (s 392-22): • 12 beneficiaries; or • the number of individual beneficiaries that for the previous income year were taken to carry on the primary production business. The choice is made for an income year and must be in writing signed by the trustee and beneficiary. The choice must be made before the trust’s income tax return is lodged for that income year (although the Commissioner can grant an extension of time). It cannot be revoked or varied. EXAMPLE Mr and Mrs Brown are the beneficiaries of the Brown Family Trust, a discretionary trust carrying on a primary production business. For the 2015-16 income year, the trust is in a loss situation. On 1 July 2016, the trustee chooses to treat Mrs Brown as carrying on the primary production business. Mrs Brown’s primary production income for the income year is nil.

[9 220] Averaging and fixed trusts A beneficiary of a fixed trust will be eligible for income averaging in a year where there is no trust income, provided the beneficiary’s interest is not capable of being affected by the exercise or non-exercise of a power and his or her rights to present entitlement are retained (s 392-20(3) of ITAA 1997).

FARM MANAGEMENT DEPOSITS AND TRUSTS [9 300] Farm management deposit scheme The farm management deposit scheme allows eligible primary producers to make farm management deposits (FMDs) and to claim deductions for the 2016 THOMSON REUTERS

213

[9 310]

PRIMARY PRODUCER CONCESSIONS FOR BENEFICIARIES

deposits, thereby reducing their PAYG instalment income (Div 393 of ITAA 1997). There is a cap on the amount that can be deposited ($400,000 for the 2015-16 income year; $800,000 from 1 July 2016). The scheme is limited to individuals, including beneficiaries of a trust who are under a legal disability (s 393-35, item 3). To qualify for a deduction, the individual must be the owner of the FMD (see [9 310]) and must be carrying on a primary production business in Australia when the deposit is made (see [9 320]). The individual’s non-primary production income must not exceed a threshold amount ($100,000 for 2015-16) (s 393-5). The purpose of the scheme is to enable primary producers to carry over income from years of good cash flow and to draw down on that income in years when they require the cash. This enables the income tax on primary production income to be deferred from the income year in which the deposit is made until the income year in which the deposit is repaid. When an amount is withdrawn from an FMD, the amount of the deduction previously allowed is included in the primary producer’s PAYG instalment income and assessable income in the repayment year. From 1 July 2016, a primary producer who experiences severe drought conditions can withdraw an amount held in an FMD within 12 months of its deposit, without affecting the deduction for the amount deposited in the previous income year. For this purpose, a rain deficiency test must be satisfied. Also from 1 July 2016, an FMD can be linked to a loan or other debt account relating to a primary production business carried on by the owner (directly or through a partnership). This does not apply to loans held by trustees, companies or persons other than the owner.

[9 310] Beneficiary can be owner of farm management deposit The owner of the farm management deposit is the individual who makes the deposit (s 393-25(1)(a) of ITAA 1997). If a deposit is made by a trustee on behalf of a beneficiary who is under a legal disability (eg a person under 18), the beneficiary is taken to be the owner (s 393-25(1)(b)). Where the beneficiary subsequently ceases to be under a legal disability (eg by turning 18), the beneficiary is treated as having made the deposit personally (s 393-28).

[9 320] Deeming rule where primary production business carried on by trust Where a trust carries on the primary production business, a beneficiary will be treated as carrying on the primary production business in the following circumstances (s 393-25(3) of ITAA 1997): 1. the beneficiary is presently entitled to a share of the income of the trust for the income year (s 393-25(4)); 2. the trust is a fixed trust with no trust income for the income year, but the beneficiary would have been presently entitled to trust income had there been trust income legally available for distribution (s 393-25(5)); or 214

2016 THOMSON REUTERS

PRIMARY PRODUCER CONCESSIONS FOR BENEFICIARIES

[9 340]

3. the trust is a discretionary trust with no trust income for the income year, and the beneficiary is a “chosen beneficiary” (s 393-25(6): see [9 330]).

[9 330] Discretionary trust with no trust income If a discretionary trust has no trust income for an income year, a beneficiary will only be treated as carrying on the trust’s primary production business if the trustee makes a choice in favour of the beneficiary (s 393-27 of ITAA 1997). Like the equivalent choice in the primary producer averaging rules (see [9 210]), the choice must be in writing (signed by the trustee and beneficiary) and needs to be made before the trust’s income tax return is lodged for the income year (although the Commissioner can extend the time). More than one beneficiary can be chosen, provided the total number of beneficiaries does not exceed the higher of 12 individuals or the number of individuals to which the deeming rule applied (see [9 320]) in the previous income year. EXAMPLE Bronnie and her 16 year old daughter Amber are the beneficiaries of a discretionary trust that carries on a primary production business. The trustee has made farm management deposits on behalf of Amber. For the 2015-16 income year, the trust is in a loss situation. On 1 September 2016, the trustee chooses to treat Amber as carrying on the primary production business. As a result, Amber is able to retain her farm management deposits for the 2015-16 income year.

[9 340] Interaction with general trust rules Where a beneficiary who is under a legal disability is deemed to be the owner of a farm management deposit (see [9 310]), the general trust rules in Div 6 of Pt III of ITAA 1936 treat the beneficiary as having legal capacity (s 97A of ITAA 1936). This allows the beneficiary to be assessed under s 97A and to claim a deduction for the deposit.

2016 THOMSON REUTERS

215

216

2016 THOMSON REUTERS

PART 4 INTEGRITY MEASURES 10 ANTI-AVOIDANCE RULES 11 TRUSTS AND DEEMED DIVIDENDS – DIV 7A 12 CLOSELY HELD TRUSTS 13 UNEARNED INCOME OF CHILDREN

2016 THOMSON REUTERS

217

218

2016 THOMSON REUTERS

ANTI-AVOIDANCE RULES

10

Summary of tax avoidance measures .................................................... [10 General anti-avoidance provisions of Pt IVA ...................................... [10 Splitting of business or professional income via a trust .................... [10 Personal services income regime ........................................................... [10 Revocable trusts ......................................................................................... [10 Trust stripping – reimbursement agreements ...................................... [10 Income diverted to tax-exempt entities ................................................ [10 Transferor trust rules ................................................................................ [10

000] 010] 020] 030] 040] 050] 060] 070]

[10 000] Summary of tax avoidance measures Various anti-avoidance rules (both general and specific to trusts) may have an impact on the tax treatment of trust income. These rules cover: • schemes entered into for the dominant purpose of securing a tax benefit: see [10 010]; • the splitting of business or professional income via trusts: see [10 020]; • the alienation of personal services income: see [10 030]; • revocable trusts: see [10 040]; • trust stripping: see [10 050]; • income diverted to tax-exempt entities: see [10 060]. (The specific rules in Div 6 of Pt III of ITAA 1936 that target the use of tax-exempt entities to inappropriately reduce the tax otherwise payable on the taxable income of a trust are discussed at [3 500]); • the transfer of property or services to non-resident trust estates: see [10 070]; • disguised and informal distributions of private company profits: see [11 000]; • the recoupment of trust losses: see [7 000]; and • closely held trusts: see [12 000]; and • the unearned income of children: see [13 000].

[10 010] General anti-avoidance provisions of Pt IVA The general anti-avoidance provisions of Pt IVA of ITAA 1936 target schemes that are entered into for the sole or dominant purpose of securing a tax benefit for the taxpayer in connection with the scheme. For Pt IVA to apply, the tax benefit must otherwise be available under tax law. This means that Pt IVA is concerned with arrangements that are legitimate (in the sense that they comply with the ordinary provisions of the Assessment Act) but go against the spirit of 2016 THOMSON REUTERS

219

[10 010]

ANTI-AVOIDANCE RULES

the law. There is no role for Pt IVA where the arrangement involves tax evasion (ie it is illegal) or the transaction is a sham (ie it is not intended to have legal effect).

Elements of Pt IVA For Pt IVA to apply, three inter-related elements need to be present: 1. a ‘‘scheme’’ – this is very broadly defined to include unilateral conduct, eg a single action by a trustee (s 177A(1), (3)); 2. a ‘‘dominant purpose’’ of securing a tax benefit for a taxpayer in connection with the scheme (ss 177A(5) and 177D(1)) – this is determined objectively by reference to eight statutory factors, including the manner in which the scheme was entered into, its form and substance, timing issues and the changes in the financial positions of the taxpayer and any connected persons (s 177D(2)); and 3. a ‘‘tax benefit’’ in connection with the scheme where, but for the scheme, the relevant tax outcome would not have happened or it is reasonable to expect it would not have happened (ss 177C and 177CB). The tax benefit must be one of the tax advantages or outcomes listed in s 177C(1) (eg not including an amount in assessable income, incurring a deduction or capital loss, including a discount capital gain in assessable income, obtaining a foreign income tax offset or avoiding withholding tax). These three elements are determined objectively. In other words, an objective enquiry is required as to whether a reasonable person would conclude that a scheme was entered into or carried out (by the taxpayer and/or others) for the sole or dominant purpose of obtaining a tax benefit for the taxpayer. The actual purpose of the taxpayer or any other scheme participant is not relevant. Part IVA can apply to arrangements with wider family or commercial purposes (see FCT v Hart [2004] HCA 26; 55 ATR 712, Cumins v FCT [2007] FCAFC 21; 66 ATR 57). It is therefore prudent to consider the potential application of Pt IVA before entering into such arrangements if they may have the effect of reducing a tax liability. Part IVA does not apply if the tax benefit is obtained through exercising a statutory choice expressly provided for by the Assessment Act, provided the scheme was not entered into or carried out for the purpose of creating the conditions necessary for this choice to be made (s 177C(2)). In relation to the choice of business structure, the AAT has said that while the tax law recognises trusts, companies and partnerships, the use of such vehicles for income splitting is not a choice ‘‘expressly provided for’’ by the Assessment Act (see TT87/153 and 199 and FCT [1989] AATA 152; 20 ATR 3777). Where the Commissioner is satisfied that the requirements of Pt IVA have been met, the Commissioner has the discretion to apply Pt IVA to the scheme and cancel the tax benefit, make any necessary compensating adjustments and impose penalties (s 177F). One or more assessments may be issued to give effect to that decision. The taxpayer then has the burden of proving that the Commissioner’s assessment is excessive. 220

2016 THOMSON REUTERS

ANTI-AVOIDANCE RULES

[10 010]

Schemes involving trusts Part IVA can apply to trustees, even though in some situations they may not be the ‘‘taxpayer’’ as such (where for example the beneficiaries are assessable on the net income of the trust (Grollo Nominees Pty Ltd v FCT [1997] FCA 659; 36 ATR 424). In FCT v Mochkin [2002] FCA 675; 52 ATR 198, Pt IVA did not apply to a scheme where the taxpayer used discretionary trusts to carry on a stockbroking business. The Full Federal Court concluded that the taxpayer’s dominant purpose was not to obtain a tax benefit but to limit his own personal liability (even though the arrangement also involved distributions to beneficiaries with tax losses). In Cumins v FCT [2007] FCAFC 21; 66 ATR 57, Pt IVA applied where a capital loss was generated by the transfer of listed shares between family trusts and the arrangement was entered into one day after a $790,000 capital gain had been made by the transferor trust. In Re Track & Ors and FCT [2015] AATA 45, Pt IVA applied to a scheme carried out by various trustees and beneficiaries to enable a hybrid trust to qualify for the CGT small business concessions. The scheme involved restructuring the business of the hybrid trust (one week before its sale) in order to ‘‘create’’ liabilities for the purpose of passing the maximum net asset value test (see [8 250]). The taxpayers whose tax benefits were cancelled were the beneficiaries of four ‘‘protection’’ trusts that received capital distributions from the hybrid trust and then made loans to the hybrid trust to finance the distributions (which were repaid after the sale of the business). The Tax Office has issued various rulings and taxpayer alerts on the application of Pt IVA to specific transactions involving trusts, including: • Taxation Ruling TR 2002/18 (home loan unit trust arrangements): see [6 120]; • Taxation Ruling TR 2006/2 (excessive service fees paid to associated service entities): see [6 030]; • Taxation Determination TD 2005/34 and Taxpayer Alert TA 2005/1 (profit washing arrangements using a trust and loss company): see also Re Mack and FCT [2014] AATA 367; • Taxpayer Alert TA 2013/1 (discretionary trust arrangements where there is a deliberate mismatch between the amounts beneficiaries are entitled to receive and the amounts they are taxed on): see [3 430]; and • Taxpayer Alert TA 2013/3 (assignment of partnership interests to discretionary trusts): see [10 020].

TIP

Part IVA operates on the basis of objective tests, so it is not possible to categorically state whether a particular trust arrangement is caught by Pt IVA. This will depend on carefully weighing all the relevant facts and surrounding circumstances.

2016 THOMSON REUTERS

221

[10 020]

ANTI-AVOIDANCE RULES

[10 020] Splitting of business or professional income via a trust In the past, it was quite common for a taxpayer – usually a professional person – to restructure his or her working arrangements to provide services through a family trust (or other entity). Under these arrangements, the taxpayer’s personal exertion income is treated as income of the family trust available for distribution to family members who are beneficiaries and the taxpayer is paid a salary by the trust. In addition to potentially falling within the scope of the personal services income regime (see [10 030]), these arrangements may also be caught by the general anti-avoidance provisions of Pt IVA (see [10 010]) where the taxpayer is using the arrangement to split his or her income and reduce tax liability. The Commissioner takes the view that Pt IVA may apply where salary is paid to a taxpayer as the principal worker by his or her trust (or company), the salary is not commensurate with the value of the services and the remaining income is distributed to the family member. In most cases, a salary commensurate with the taxpayer’s duties and responsibilities will be the gross amount received by the trust less allowable deductions, other than deductions associated with income splitting (Taxation Ruling IT 2121). In line with his or her view in relation to the incorporation of professional practices, the Commissioner will not challenge an arrangement whereby a professional practitioner wants to operate a practice through a trust structure, provided the trust structure does no more in relation to income tax than reduce a professional’s income by the amount of appropriate superannuation cover and the practitioner is the sole beneficiary of the trust (Taxation Ruling IT 2503).

Professional practices operating through discretionary trust partnerships During 2013, the Tax Office began targeting arrangements where professional persons operate through partnerships of discretionary trusts. The Tax Office indicated that while professional practices may legitimately operate in this manner, it was seeing people misuse these structures to avoid their tax obligations (see Taxpayer Alert TA 2013/3 and the media release of Second Commissioner, Bruce Quigley, dated 22 November 2013). The Tax Office considers that Pt IVA ‘‘has potential application’’ if a practitioner arranges for business profits or income to be distributed to associates without regard to the value of the services provided to the firm (see the ATO guidelines Assessing the risk: allocation of profits within professional firms, updated March 2016). However, the risk of being audited is low if any of the following apply and there are no other compliance issues (like trust reimbursement agreements: see [10 050]): 1. the practitioner receives income from the firm as an appropriate return for the services provided; 2. the practitioner is assessed on at least 50% of the income to which the practitioner and the associates are collectively entitled; or 3. the practitioner and the associates each have an effective tax rate of 30% or higher on the income received from the firm. Prior to the release of TA 2013/3, the Commissioner accepted that the assignment of a partnership interest is effective for tax purposes if the assignment is ‘‘on all fours’’ with the High Court decisions in FCT v Everett 222

2016 THOMSON REUTERS

ANTI-AVOIDANCE RULES

[10 020]

(1980) 10 ATR 608 and FCT v Galland (1986) 18 ATR 33 (see Taxation Rulings IT 2330 and IT 2501). However, the assignee of a partnership interest does not become a partner – the assignee only acquires a right to receive the portion of the partner’s income attributable to that interest. In FCT v Everett, a partner in a law firm validly assigned to his spouse part of his right to a share of the net partnership income. In FCT v Galland, a father and son carried on a law firm in partnership. The son assigned 49% of his 50% interest in the partnership to a discretionary family trust. The High Court held that the assignment was effective, even though the son was a potential beneficiary of the trust and had the power to remove the trustee. In Kelly v FCT [2013] FCAFC 88, several partners in a law firm validly assigned a 30% ‘‘collective’’ interest in the partnership to a holding trust for the benefit of each partner’s family trust. The assignment was held to be effective in equity because the partners’ intention was clear, the assignment was properly documented and the holding trust paid consideration of $637,500, which was recorded in the partnership general ledger. However, a purported transfer of 20% of the partnership interests pursuant to a Retirement Deed was ineffective as there was insufficient evidence of any transfer and no consideration paid by the holding trust. Taxpayer Alert TA 2013/3 describes an arrangement where an individual seeks to make the trustee of a discretionary trust a partner in a professional practice, either by assigning an existing partnership interest or by creating a new interest. The individual may then fail to report any capital gain associated with the assignment, or may understate the capital gain, and does not declare any income from the professional practice, except to the extent (if any) that such income is part of his or her entitlement as a beneficiary of the trust. The taxpayer alert provides that the Commissioner may examine any arrangement which is considered to be a sham or is not legally effective in alienating the individual’s personal services income. The Tax Office’s attention may be attracted if the arrangement includes some of the following features: • the trustee does not actively engage in the conduct of the firm’s practice and may not hold professional qualifications; • the practice is carried on in much the same way as it was before the trustee purportedly become a partner, or would have been if the trustee had not purported to become a partner; • the remuneration payable to the individual is considerably lower than the income which he or she formerly received from the practice (or would have derived if he or she had been a partner); • the individual has the power to remove the trustee, revoke or alter the trust arrangement, or otherwise control the trustee’s interest in the partnership; • there are inconsistencies in the documentation which make it unclear who is a partner in the firm; • the individual contracts with third parties on the basis that the individual is the partner in the firm; • the firm or the individual represents to the public that the individual is a partner; 2016 THOMSON REUTERS

223

[10 030]

ANTI-AVOIDANCE RULES

• there is no employment or other contractual relationship between the trustee and the individual; • the documentation purports to provide a corporate trustee with entitlements (eg leave) which can only be enjoyed by a natural person; • the trustee has no employees (whether in its capacity as partner or otherwise); • the trustee does not hold any significant assets (whether in its capacity as partner or otherwise) and/or does not contribute any capital to the partnership; • the individual purports to make drawings from partnership equity for his or her personal use; • the firm directs distributions of net profits to the trustee as partner of the firm and the trustee resolves to distribute most or all of the income to lower-taxed beneficiaries of the trust (eg family members of the individual). Note that, for CGT purposes, the assignment of a partnership interest to a trust is treated as a disposal of the relevant fraction of that partner’s interest in the partnership assets, even though the trustee only receives an equitable interest in the partnership interest and legal title to the partnership assets continues to vest in the partner (Taxation Ruling IT 2540). The cost base is limited to money paid and/or the market value of any property given for acquiring the partnership interest (s 110-25(2) of ITAA 1997). If the assignment is not made at arm’s length, the market value substitution rule will apply, requiring the value of the right to future partnership income to be taken into account (s 112-20 of ITAA 1997).

[10 030] Personal services income regime While Pt IVA of ITAA 1936 has been used to deal with situations where taxpayers attempt to divert personal services income (see [10 020]), its application has to be made on a case-by-case basis and does not specifically address the adverse revenue implications which can result when income is alienated. The alienation of personal services income regime (Divs 84 to 87 of ITAA 1997) was enacted some years ago to provide specific anti-avoidance rules to cover the situation where an individual provides personal services through a closely controlled entity such as a family trust or company. The broad effect of the regime where the personal services entity is a trust is set out below. • The personal services income of a person which has been gained or produced through the trust structure must be paid over to that person promptly, with a deduction for certain losses or outgoings associated with producing it. In the absence of prompt payment by the trustee, the income will be attributable to that person for income tax purposes. • Restrictions apply to the deductions which may be claimed by the individual or trustee to ensure that they are comparable to the deductions that could be claimed by an employee providing the same services. 224

2016 THOMSON REUTERS

ANTI-AVOIDANCE RULES

[10 050]

• The trustee must remit tax to the ATO in relation to the personal services income.

[10 040] Revocable trusts The normal method of establishing a trust is for a person (the settlor) to pay money or transfer property to a trustee for the benefit of certain beneficiaries: see [2 410]. Where the settlor has created a revocable trust in the sense that he or she has the power to revoke the trust to acquire a beneficial interest in the trust income or trust property, the Commissioner can apply a punitive tax. The effect is to tax the trustee on the difference between the tax actually payable by the settlor and the tax that would have been payable by him or her in the absence of the trust (s 102 of ITAA 1936). This punitive tax can also be applied where the settlor has created a trust under which income is payable or accumulated for the benefit of the settlor’s children under 18. To avoid the application of this provision, the usual practice is to have an independent third party act as the settlor (see Truesdale v FCT (1970) 1 ATR 667). For example, a person who wishes to make a settlement in favour of his or her children will usually have someone outside the family establish the trust with a small settlement, with gifts or loans made later by the parents providing the bulk of the trust property.

[10 050] Trust stripping – reimbursement agreements Trust stripping arrangements involve trust income being diverted to third parties and away from the truly intended beneficiaries and, in return, those beneficiaries or associates receiving what is hoped to be a non-taxable amount or benefit. To counter these sorts of arrangements (called reimbursement agreements) a special anti-avoidance measure treats the beneficiaries as not being presently entitled to the diverted income with the result that the trustee is assessed under s 99A of ITAA 1936 on the diverted income at the top marginal tax rate (s 100A). This anti-avoidance measure applies where a beneficiary is presently entitled to a share of trust income and that present entitlement has arisen out of a ‘‘reimbursement agreement’’ or by reason of ‘‘any act, transaction or circumstance that occurred in connection with, or as a result of, a reimbursement agreement’’ (s 100A(1)). A reimbursement agreement is an agreement (broadly defined in s 100A(13)) that provides for ‘‘the payment of money or the transfer of property to, or the provision of services or other benefits for, a person or persons other than the beneficiary or the beneficiary and another person or persons’’ (s 100A(7)). It is not necessary for the beneficiary to be a party to the reimbursement agreement (Raftland Pty Ltd v FCT [2008] HCA 21, 68 ATR 170). In Re McCutcheon and FCT [2006] AATA 535; 63 ATR 1323, the taxpayers entered into a complicated arrangement structured to avoid s 100A. The arrangement involved the use of gifts, the subscription for units, the vesting of trusts and the making of loans through a chain of entities, to enable the proceeds 2016 THOMSON REUTERS

225

[10 050]

ANTI-AVOIDANCE RULES

from the sale of a business to be directed to the taxpayers in non-taxable form. The AAT found that the general anti-avoidance rules in Pt IVA (see [10 010]) applied. Practice Statement PS LA 2010/1 advises Tax Office staff to consider the possible application of either s 100A or Pt IVA where an arrangement alters the manner in which a trust’s net income is allocated between the trustee and the beneficiaries, for example by: • amending the trust deed to admit a tax-exempt charity into the class of income beneficiaries; • re-characterising part of an income receipt as a capital receipt; • appointing the income that has been re-characterised as capital to a capital beneficiary; and • appointing the income that has not been re-characterised to the charity. See also Taxpayer Alert TA 2013/1, discussed at [3 430].

Exclusion for ordinary family or commercial dealings There is an important exclusion from the operation of s 100A. An arrangement entered into in the course of ordinary family or commercial dealings is not a reimbursement agreement (s 100A(13)). It follows that a discretionary trust would not generally come within s 100A if funds are appropriated for the benefit of certain family members to the exclusion of others.

WARNING! The general anti-avoidance provisions of Pt IVA do not have an exclusion for ordinary family or commercial dealings.

Interaction of s 100A with deemed dividend rules: unpaid present entitlements The Tax Office accepts that s 100A does not generally operate if an unpaid present entitlement (UPE) conferred on a company beneficiary is covered by a complying Div 7A loan agreement (see [11 220]) or a prescribed sub-trust arrangement (see [11 320]), and the trustee uses the UPE funds as working capital in the trust’s business. The situation may be different if the trustee owns shares in the beneficiary company, although mere ownership of a corporate beneficiary does not trigger s 100A (see the ATO guide Trust taxation – reimbursement agreement, May 2016). The ATO guide includes an example of a ‘‘washing machine’’ arrangement, where a trustee confers a UPE on a company that is wholly owned by the trustee. The trustee pays out the UPE before the company lodges its tax return for the relevant tax year (thus avoiding the application of the deemed dividend rules in Div 7A of Pt III of ITAA 1936). The UPE is paid on the understanding that the company will pay a dividend to the trustee equal to UPE funds less company tax. That dividend forms part of the trust income which the trustee distributes as a UPE to the company, and the arrangement is then repeated. The 226

2016 THOMSON REUTERS

ANTI-AVOIDANCE RULES

[10 070]

Tax Office view is that this arrangement is a reimbursement agreement designed to secure a reduction in tax that would otherwise be payable had the trustee simply accumulated the income. The agreement does not come within the ‘‘ordinary commercial dealing’’ exclusion because the ownership structure and perpetual circulation of funds serve no commercial purposes.

CASE EXAMPLE Under an arrangement to shelter the business profits of three brothers, a trust was set up (the Raftland Trust) and an unrelated trust with $4 million in accumulated losses was acquired for $250,000. The trustee of the loss trust was appointed a beneficiary of the Raftland Trust (the three brothers were primary and default beneficiaries). Over the next three income years, the trustee of the Raftland Trust resolved to distribute around $4 million to the loss trust. The High Court held that the appointment of the loss trust as a beneficiary was a sham and the purported allocations of income to the loss trust were of no effect. Therefore the income was to be allocated to the default beneficiaries. But as their entitlements were connected with a trust stripping arrangement, the default beneficiaries were deemed not to be presently entitled to the income and the trustee was accordingly assessed under s 99A (Raftland Pty Ltd v FCT [2008] HCA 21, 68 ATR 170).

[10 060] Income diverted to tax-exempt entities To counter arrangements under which otherwise assessable income is diverted to a tax-exempt entity in return for payment by that entity of a non-taxable amount, usually in the form of a capital sum, the entity is taxed on the diverted income at the maximum personal rate of tax (Div 9C of Pt III of ITAA 1936). Where a trustee has acquired property under such an arrangement and the income from the property would otherwise be exempt but the consideration for the property is considered to be excessive, the income can be treated as assessable income and taxable at the maximum personal rate. This would also be the situation where the property acquired by the trustee is an interest in a partnership or an interest in another trust estate or where the property is an interest in a trust estate acquired by a taxpayer (not being a taxpayer in the capacity of a trustee).

[10 070] Transferor trust rules The transferor trust rules (Div 6AAA of Pt III of ITAA 1936) are complex and were introduced to combat arrangements under which Australian residents avoided Australian tax by accumulating income in offshore trusts, usually in low tax jurisdictions. The effect of the rules is to attribute the income of the non-resident trust to the Australian resident who transferred property or services to the trust. The circumstances under which an Australian resident taxpayer will be treated as an attributable taxpayer differ according to whether the relevant transfer of 2016 THOMSON REUTERS

227

[10 070]

ANTI-AVOIDANCE RULES

property or services was to a discretionary or non-discretionary trust. Furthermore, the amounts included in attributable income vary depending on whether the non-resident trust is in a listed or non-listed country. Where both the transferor trust rules and the general trust rules in Div 6 of Pt III of ITAA 1936 apply, the amount of income assessed under the transferor trust rules is reduced by the amount assessed under Div 6 (s 102AAU).

228

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

11

SCOPE OF DIV 7A Deemed dividends paid by private companies ................................... [11 Taxpayers subject to Div 7A ................................................................... [11 Trust transactions caught by Div 7A ..................................................... [11 Board of Taxation review of Div 7A ...................................................... [11

000] 010] 020] 030]

GENERAL APPLICATION OF DIV 7A Private company transactions ................................................................. [11 100] Loans as deemed dividends .................................................................... [11 110] Payments as deemed dividends ............................................................. [11 120] Forgiven debts as deemed dividends .................................................... [11 130]

DIVISION 7A COMPLIANT LOANS AND REPAYMENTS Preventing a deemed dividend from arising ....................................... Loan repayments ....................................................................................... Division 7A compliant loans ................................................................... Calculation of minimum yearly repayment ......................................... Prior year loans as deemed dividends ..................................................

[11 [11 [11 [11 [11

200] 210] 220] 230] 240]

Unpaid present entitlements of private company beneficiaries ....... [11 Unpaid present entitlements as ‘‘loans’’ ............................................... [11 Using sub-trusts to prevent a deemed dividend ................................. [11 Creation of sub-trusts: practical issues .................................................. [11 Unpaid present entitlements between trusts ........................................ [11

300] 310] 320] 330] 340]

DIVISION 7A AND UNPAID PRESENT ENTITLEMENTS

TRUSTEE LOANS, PAYMENTS AND FORGIVEN DEBTS Specific measures treating trust amounts as dividends ..................... [11 Loans, payments and forgiven debts caught by Subdiv EA ............. [11 Trustee payments: present entitlement attributable to unrealised gain ........................................................................................... [11 Meaning of ‘‘present entitlement’’ and ‘‘net income’’ ........................ [11 Amounts assessable under Subdiv EA ................................................. [11

400] 410] 420] 430] 440]

DIVISION 7A TRACING RULES Transactions involving interposed entities ........................................... [11 500] Company payments and loans through interposed entities ............. [11 510] Trustee payments and loans through interposed entities .................. [11 520] 2016 THOMSON REUTERS

229

[11 000]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

CONSEQUENCES OF DIV 7A APPLYING Consequences of deeming a dividend .................................................. [11 Assessable amounts limited to distributable surplus ......................... [11 Commissioner’s discretion and Div 7A ................................................ [11 Disregarding Div 7A for honest mistakes and inadvertent omissions ............................................................................... [11

600] 610] 620] 630]

SCOPE OF DIV 7A [11 000] Deemed dividends paid by private companies Division 7A in Pt III of ITAA 1936 contains a range of complex rules that treat disguised and informal distributions of private company profits as deemed dividends. The rules are far reaching and can extend to trustees and beneficiaries (see [11 020]), particularly where a private company is a beneficiary with an unpaid present entitlement (see [11 300] and [11 400]). The key situations which attract Div 7A are certain payments, noncommercial loans and forgiven debt transactions (see [11 100]), made by a private company to a current or former shareholder or a shareholder’s associate (see [11 010]). The relevant transaction can be made directly by the private company, or indirectly through one or more interposed entities like trusts (see [11 500]). A wide range of entities and transactions are potentially caught by Div 7A, due to the nature of the provisions and the broad and extended definitions of key terms like ‘‘entity’’, ‘‘associate’’, ‘‘payment’’ and ‘‘loan’’.

WARNING! A trust is an entity for Div 7A purposes and can therefore be the recipient of a Div 7A deemed dividend. If a shareholder is a beneficiary of a trust, the trust is the shareholder’s associate. If the trust is a shareholder, a person who benefits or is capable of benefiting under the trust is a shareholder’s associate.

Where Div 7A applies, the private company is deemed to have paid an assessable dividend to the shareholder or associate (see [11 600]). The amount of the payment, loan or debt is generally treated as an unfranked dividend, to the extent that the company has realised and unrealised profits (ie a ‘‘distributable surplus’’: see [11 610]). Division 7A generally operates automatically, within the context of the self-assessment system. This requires all relevant entities (the private company, its shareholders, the shareholders’ associates and any related trusts) to be fully aware of the provisions and their consequences.

230

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 010]

The Commissioner is provided with various powers and discretions (see [11 620]), including a general discretion to disregard the operation of Div 7A or allow the dividend to be franked if Div 7A is triggered by an honest mistake or inadvertent omission (see [11 630]). Division 7A also includes general and specific exclusions for each category of deemed dividend. In the case of a payment or loan (including through an interposed entity), the operation of Div 7A can be avoided by repaying the amount in full or putting the loan on an acceptable commercial footing within the required time (see [11 200]). However, a deemed dividend may arise in a subsequent year if the shareholder or associate fails to make the minimum yearly repayment required by Div 7A (see [11 240]). The key date for preventing the application of Div 7A by repaying an amount or putting it on a commercial footing is the day before the private company’s ‘‘lodgment day’’. This is the earlier of (s 109D(6)): • the due date for lodging the company’s tax return for the income year in which the loan or payment is made; and • the company’s actual lodgment date.

[11 010] Taxpayers subject to Div 7A Division 7A of Pt III of ITAA 1936 is primarily concerned with transactions between a private company and an ‘‘entity’’, where the entity is: 1. a current shareholder in the private company; 2. an ‘‘associate’’ of a shareholder in the private company; 3. a former shareholder and the relevant transaction occurs because of this former status; or 4. a former associate of a shareholder (eg an ex-spouse) and the relevant transaction occurs because of this former status. The definitions of ‘‘entity’’ and ‘‘associate’’ can link trusts, trustees and beneficiaries to Div 7A risks. Division 7A does not apply to prospective shareholders (unless they are associates of current shareholders). Where a payment or loan is made, or a debt is forgiven, to an existing shareholder or a current associate, a nexus is not required between the transaction and the shareholding relationship. In the case of a former shareholder or former associate, there is a reasonable person test as to whether the transaction occurs because of the former status. The private company and the shareholder/associate are still the relevant taxpayers if entities like trusts are interposed between them (see [11 500]).

Private companies A company is a private company if it does not satisfy one of the public company tests in s 103A of ITAA 1936. Most proprietary companies under the Corporations Act 2001 are private companies for Div 7A purposes. 2016 THOMSON REUTERS

231

[11 010]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

Public companies are not caught by Div 7A, unless they are treated as private companies for tax purposes. The Commissioner has an overriding discretion to treat any company as either a public company or a private company (s 103A(5)(6)). For the purposes of Div 7A, closely-held corporate limited partnerships are treated as private companies, while closely-held corporate limited partners and non-share equity holders are shareholders. Transactions between foreign private companies and resident shareholders (or their associates) can also be caught by Div 7A.

Entities can include trusts ‘‘Entities’’ for Div 7A purposes are not limited to legal entities like individuals and companies, but can include flow-through vehicles like partnerships and trusts (s 960-100 of ITAA 1997): eg see D Marks Partnership by its General Partner Quintaste Pty Ltd v FCT [2016] FCAFC 86. Further, if a provision refers to an entity of a particular kind, it refers to the entity in its capacity as that kind of entity (s 960-100(4) of ITAA 1997). This means, for instance, that a payment or loan to a corporate trustee is not exempt from Div 7A (which generally excludes inter-company transactions): see Di Lorenzo Ceramics Pty Ltd v FCT [2007] FCA 1006; 67 ATR 42. Division 7A does not apply to an entity in its capacity as a company director: see 3-D Scaffolding Pty Ltd v FCT [2009] FCAFC 75; 75 ATR 604. In ATO ID 2012/77, the Tax Office treated the legal personal representative of a deceased shareholder as an entity for Div 7A purposes in circumstances where title to the shares had passed to the legal personal representative and a company loan to the shareholder was forgiven while the shareholder’s estate was in administration. This raises the possibility that Div 7A could extend to the beneficiaries of a deceased estate.

Associates can include anyone benefiting under a trust The term ‘‘associate’’ of a shareholder is defined by reference to s 318 of ITAA 1936. The breadth of the definition in s 318 means that a private company transaction in favour of any of the following entities is potentially caught by Div 7A: • relatives of an individual shareholder; • trusts under which a shareholder is a beneficiary; • beneficiaries of a trust that is a shareholder in the private company, plus the relatives of these beneficiaries; and • partners of a partnership in which a shareholder is a partner. A trust can be brought within this definition even though it is ostensibly not related to the shareholder. As a result, trusts can increase the spread of taxpayers who may be exposed to Div 7A. Where the primary entity is a trust, the following are associates of the trust (s 318(3)): 1. any entity that benefits under the trust; 2. an associate of a natural person who benefits under the trust; and 232

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 010]

3. an associate of a company that benefits under the trust. An entity benefits under the trust if the entity benefits or is capable of benefiting under the trust, either directly or through any interposed companies, partnerships or trusts. Any beneficiary who is a potential beneficiary of a discretionary trust is capable of benefiting under the trust, even if the trustee’s discretion is not exercised in the beneficiary’s favour at a particular time (s 318(6)(a)): see also Yazbek v FCT [2013] FCA 39; 88 ATR 792. Arguably, the s 318 definition of ‘‘associate’’ extends Div 7A beyond what was intended. In the following example, the risks are clearly evident with the benefit of hindsight but may not have been so clear at the time of entering into the arrangement. EXAMPLE The Green Family (including Private Company A and Discretionary Trust A) is presented with an arm’s length commercial opportunity. It decides to take up a 5% interest in a venture via a unit trust (Trust X). The Green Family subscribes for 5% of the units to be held by a new trust (Trust 2A) to benefit and be controlled by one part of the Green Family. During the course of the venture, there is an opportunity to advance funds on commercial terms to obtain a return in excess of what is available from comparable investments. Private Company A advance funds at a rate 6% above the bank bill rate for a period of three years interest only. As Trust 2A benefits under Trust X, it is an associate of Trust X. Look through provisions deem potential Beneficiary A to benefit from Trust X. Trust X is an associate of Trust A as potential Beneficiary A benefits from both Trust A and Trust X and therefore is exposed to any deemed dividend from Private Company A.

2016 THOMSON REUTERS

233

[11 020]

TIP

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

Trace all transactions from a private company to any related person or entity and apply the associate tests under s 318.

[11 020] Trust transactions caught by Div 7A Trustees and beneficiaries can have various dealings with private companies and, as such, may be caught by Div 7A of Pt III of ITAA 1936. First, a trust can be a shareholder or a shareholder’s associate (see [11 010]), so Div 7A can directly apply to distributions by a private company to a trust (see [11 100]). Second, where a trust is a shareholder in a private company, beneficiaries of the trust and their relatives are associates for Div 7A purposes. Third, the Tax Office treats a private company’s present entitlement to an amount from an associated trust as a loan under the general Div 7A rules if the trustee retains the funds for ‘‘trust purposes’’ (Ruling TR 2010/3: see [11 300]). Fourth, trustee payments, loans or forgiven debts in favour of a shareholder or associate are subject to specific rules (in Subdivs EA and EB of Div 7A) if the private company is a beneficiary with an unpaid present entitlement to income of the trust (see [11 400]). Fifth, trusts can be used by private companies to make indirect payments and loans to shareholders or their associates (see [11 500]). Complexity of structures can add to the risks of trusts being caught by Div 7A. For example, what might be regarded as a simple inter-entity transaction could be traced back to a distributable surplus of a private company within the group structure.

TIP

Despite the far reaching nature of Div 7A, some transactions are exempt from the operation of Div 7A, including: • loans made in the ordinary course of a private company’s business on usual arm’s length terms; • payments of genuine debts; and • payments and loans that are otherwise assessable.

234

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 030]

The following table outlines some of the Div 7A risks for trusts. Situation Private company: • makes a payment; • makes a loan; or • forgives a debt, to a trust

Private company has an unpaid present entitlement (UPE) to a trust distribution

Division 7A risk areas If the trust is a current or former shareholder, or a current or former associate of a shareholder, of the private company, the general Div 7A operative rules (ss 109C, 109D and 109F of ITAA 1936) apply (see [11 100]). If the trust is not such a shareholder or associate, but it then makes a payment or loan to a shareholder or associate, the tracing rules in Subdiv E apply (see [11 500]). The Tax Office considers that the general loan rules (s 109D) apply (see [11 300]). Specific rules in Subdivs EA and EB deal with UPEs (see [11 400]). The trust is required to take certain steps to ensure: • the UPE does not become a loan; and • transactions are avoided that could lead to a shareholder or associate being assessed.

Private company releases the UPE Private company makes a loan, subscribes for equity, or forgives a debt to a trust predominantly owned by unrelated third parties

The Tax Office considers that the general payment rules (s 109C) apply (see [11 120]). The s 318 definition of ‘‘associate’’ (see [11 010]) could potentially bring such transactions within Div 7A. Where an associate of a private company shareholder has any equity in the trust (even a minority interest held indirectly through a discretionary trust) this will be a Div 7A risk.

[11 030] Board of Taxation review of Div 7A In 2012, the Board of Taxation commenced a review of Div 7A of Pt III of ITAA 1936. The main purpose of the review was to consider whether Div 7A can be simplified, while maintaining the integrity and fairness of the tax system. The Board of Taxation’s terms of reference were subsequently extended to allow it to specifically examine the broader taxation framework in which private businesses operate. An initial discussion paper, Post Implementation Review of Division 7A of Part III of the Income Tax Assessment Act 1936, was released in December 2012. The discussion paper emphasised that Div 7A is ‘‘part of a broader and complex tax 2016 THOMSON REUTERS

235

[11 030]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

framework and must operate in the context of what can be complex private group structures involving trusts, companies and potentially other tax entities’’. A number of concerns were raised about Div 7A, including that: • the requirements of Div 7A are often misunderstood, particularly by business owners, resulting in frequent and unintended breaches of the provisions; • there are high compliance and administrative costs associated with Div 7A; • both the Tax Office and tax practitioners have concerns about a range of administrative issues. While various amendments have been made to Div 7A to clarify the provisions and reduce compliance costs, the Board said there are still technical difficulties, uncertainties and compliance difficulties with the rules. Many any of these difficulties relate to the interpretation of defined terms, the multiple conditions, the reasonable person tests, the calculation of the minimum yearly repayment amount, how various amounts (involving trusts and interposed entities) are determined by the Commissioner and how the Commissioner exercises the Div 7A discretions. A second discussion paper, also called Post Implementation Review of Division 7A of Part III of the Income Tax Assessment Act 1936, was released in March 2014. In its executive summary, the Board of Taxation remarked that Div 7A fails in achieving its policy objectives and can be a significant source of compliance costs for businesses, even for those operating in accordance with the policy intent of the provisions. : In the Board’s view, Div 7A does not provide an adequate response to the different ways that private businesses are structured, and fails to acknowledge the many tax and non-tax considerations that dictate those structures (see [1 100]). In particular, the Board noted that while the use of trusts as active trading entities is controversial, it is an embedded feature of the Australian small business landscape and needs to be factored into any approach to reforming the current system. (The Productivity Commission came to a similar conclusion in its September 2015 report Business Set-up, Transfer and Closure.) The Board of Taxation’s final report to the Government was presented in November 2014 and released in June 2015. The Board made 15 recommendations, including a general recommendation that profits should receive consistent tax treatment, for example by: • taxing business accumulations at a business tax rate, irrespective of the business structure chosen; and • lowering the tax rate on undistributed trust income tax (47% for 2015-16) (recommendation 1). The Board also proposed a number of significant changes to Div 7A, including: • for complying loans – adopting a reform model called the amortisation model, with a single loan period of ten years, a statutory interest rate fixed at the start of the loan and greater flexibility in repaying the principal and interest (recommendation 6); 236

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 100]

• for unpaid present entitlements – aligning their treatment with the treatment of loans for Div 7A purposes in conjunction with either the amortisation model or an interest only model (recommendations 8 to 10): see [11 300]; and • enacting safe harbour rules (Recommendation 4) and self-correcting mechanisms (recommendations 11 and 12). In the 2016-17 Federal Budget, the Government drew on a number of these recommendations when it announced that, subject to the outcomes of a consultation process with stakeholders, it planned to amend Div 7A with effect from 1 July 2018 to include: • new rules for complying Div 7A loans, including a single compliant loan period of 10 years and better aligning the calculation of the minimum interest rate with commercial transactions; • new safe harbour rules, such as for the use of assets, to provide certainty and simplify compliance; • a self-correction mechanism to give taxpayers the opportunity to voluntarily correct their arrangements without penalty if Div 7A is inadvertently triggered; and • technical amendments to improve the overall operation of Div 7A. The Government’s announcement did not specifically mention unpaid present entitlements.

GENERAL APPLICATION OF DIV 7A [11 100] Private company transactions There are three key transactions which can result in a deemed dividend under Div 7A of Pt III of ITAA 1936: 1. loans – a private company lends an amount to a current or former shareholder or shareholder’s associate, and the amount is not fully repaid before the company’s lodgment day, or is not subject to a written loan agreement that satisfies certain conditions (see [11 110]); 2. payments – a private company makes a payment, credits an amount or transfers property to a current or former shareholder or shareholder’s associate, or provides an asset for the shareholder/associate’s use (see [11 120]); 3. forgiven debts – a private company forgives a debt owed to it by a current or former shareholder or a shareholder’s associate (see [11 130]). These provisions can apply even where entities like trusts are interposed between the private company and the shareholder or associate (see [11 500]). Division 7A is not generally concerned with the reason for the transaction or the purpose to which the recipient puts the funds. For example, the Tax Office considers that Div 7A can apply where: • a private company is a beneficiary of a trust and the trustee makes a notional distribution to the company but retains the funds as working capital (Taxation Ruling TR 2010/3: see [11 300]); 2016 THOMSON REUTERS

237

[11 110]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

• a private company is a beneficiary of a trust and releases its unpaid present entitlement (Taxation Determination TD 2015/20): see [11 120]; • a private company transfers a property to a shareholder’s ex-partner pursuant to a Family Court order (Taxation Ruling TR 2014/5).

[11 110] Loans as deemed dividends When a private company makes a ‘‘loan’’ to an entity (whether directly or indirectly) during an income year, a deemed dividend will arise under s 109D of ITAA 1936 if: • the entity is a shareholder or a shareholder’s associate when the loan is made, or it is reasonable to conclude that the loan is made because the entity has been a shareholder or associate at some time (see [11 010]); • the loan is not excluded from the operation of Div 7A; • the Commissioner does not exercise the discretion to disregard the operation of s 109D where it has been triggered by an honest mistake or inadvertent omission (see [11 630]); and • the loan is not fully repaid, or put on an acceptable commercial footing, before the company’s lodgment day for the income year (see [11 200]).

Meaning of ‘‘loan’’ The definition of ‘‘loan’’ in s 109D(3) is wide and inclusive, extending well beyond the ordinary meaning of the word. ‘‘Loan’’ is defined to include: (a) an advance of money (s 109D(3)(a)); (b) a provision of credit or any other form of financial accommodation (s 109D(3)(b)); (c) a payment of an amount for, on account of, on behalf of, or at the request of, an entity, where there is an express or implied obligation to repay the amount (s 109D(3)(c)); and (d) a transaction (whatever its terms or form) which in substance effects a loan of money (s 109D(3)(d)). The Commissioner’s treatment of an unpaid present entitlement as the provision of financial accommodation under s 109D(3)(b) exemplifies the breadth of this definition (see [11 310]). In Di Lorenzo Ceramics Pty Ltd v FCT [2007] FCA 1006; 67 ATR 42, the Federal Court held that a private company made a s 109D loan to a unit trust, in which the company was a unit holder, when it made funds available to the unit trust to construct business premises for the company’s use. This decision was arrived at despite the accountants for the Di Lorenzo group seeking to characterise the loan as an ‘‘investment’’. Where the conditions in s 109D are satisfied, a deemed dividend arises on the last day of the income year in which the loan is made. The Tax Office view is that a private company ‘‘makes a loan’’ under s 109D by ‘‘bringing [it] into existence; or causing, occasioning, effecting or giving rise to such a loan’’: Further, making a loan ‘‘need not necessarily involve positive action on the part of the private company but may be inferred from all the surrounding circumstances’’: Ruling TR 2010/3, para 6. When TR 2010/3 was issued in draft 238

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 120]

form (TR 2009/D8), the Commissioner went so far as to say that a private company can cause a loan to occur by the ‘‘conscious non-doing of an act’’, eg by ‘‘intentionally’’ not calling for payment of an unpaid present entitlement.

Excluded loans A loan by a private company to a shareholder or shareholder’s associate (whether made directly or indirectly via an interposed entity) is not treated as a dividend under s 109D if the loan: • is made to another company, other than a company acting in the capacity of trustee (s 109K), or an interposed company (s 109X(1)(a)); • would be included in, or specifically excluded from, the assessable income of the shareholder or associate under a provision other than Div 7A (s 109L), but subject to s 109X where interposed entities are involved; • is made in the ordinary course of the private company’s business on usual arm’s length terms (s 109M); • is made by a liquidator in the course of winding up the private company (s 109NA), provided it is repaid by the end of the following income year; or • funds the purchase of certain employee share scheme interests (s 109NB).

[11 120] Payments as deemed dividends When a private company makes a ‘‘payment’’ to an entity (whether directly or indirectly) during an income year, a deemed dividend will arise under s 109C of ITAA 1936 on the last day of the income year if: • the entity is a shareholder or a shareholder’s associate when the payment is made, or it is reasonable to conclude that the payment is made because the entity was a shareholder or associate at some time; • the payment has not been converted into a loan before the company’s lodgment day; • the payment does not come within one of the general or specific exclusions contained in Div 7A; and • the Commissioner does not exercise the discretion to disregard the operation of s 109C where it has been triggered by an honest mistake or inadvertent omission (see [11 630]).

Meaning of ‘‘payment’’ The concept of ‘‘payment’’ is broadly defined for Div 7A purposes and covers transactions which are beyond the normal meaning of the term. Four types of ‘‘payment’’ can give rise to a deemed dividend under s 109C: 1. a payment to, on behalf of, or for the benefit of, a shareholder or associate (s 109C(3)(a)); 2. the crediting of an amount to, on behalf of, or for the benefit of, a shareholder or associate (s 109C(3)(b)). The Tax Office considers that the term ‘‘credit’’ takes a wide meaning and includes the release by a corporate beneficiary of its unpaid present entitlement (UPE). A deemed 2016 THOMSON REUTERS

239

[11 120]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

dividend may arise if the trustee is either a shareholder of the private company or an associate of a shareholder and the release represents a financial benefit to the trustee. However, if the trustee cannot satisfy the UPE due to circumstances beyond its control (and the beneficiary has no cause of action against the trustee to recover that loss), the Tax Office accepts that the release of the UPE will not confer a financial benefit (Determination TD 2015/20); 3. the transfer of property where ownership passes to a shareholder or associate (s 109C(3)(c)). The Tax Office treats a property transfer from a private company to a shareholder’s ex-spouse pursuant to a Family Court order as a Div 7A payment (Ruling TR 2014/5); or 4. the provision of an asset for use by the shareholder or associate (s 109CA). Section 109CA covers arrangements where the shareholder or associate uses, or has the right to use, a company asset under a lease (where the asset is not real property), a licence or another right to use. The payment is made in the income year in which the shareholder or associate first uses the asset with the permission of the private company (s 109CA(2)(a)) or first has a right to use the asset to the exclusion of the private company (s 109CA(2)(b)). If the entity’s use or right to use continues into a second income year, the provision of the asset for use in that subsequent year is treated as a separate payment made at the start of that income year (s 109CA(3)). It is important to distinguish between transfers of property (s 109C(3)(c)) and the provision of an asset (s 109CA) as there are specific exclusions for the provision of an asset, which are not available for other types of ‘‘payments’’. For example, the transfer of a main residence constitutes a payment under s 109C(3), whereas the use of a main residence may be covered by a specific exemption.

TIP

Where the payment is a transfer of property or the provision of an asset for use, the amount of the deemed dividend is the amount that would have been paid for the transaction by parties dealing at arm’s length, less any consideration given by the entity (and subject to the company’s distributable surplus). If the consideration for the transfer or provision equals or exceeds the amount that would have been paid for the transfer or provision at arm’s length, the amount of the dividend is nil. Accordingly, it is crucial to ensure that any transaction involving the transfer of property or the provision of an asset between a private company and its members is conducted on an arm’s length basis, because if it is undervalued, then the difference may well be caught by Div 7A.

Excluded payments A payment by a private company to a shareholder or shareholder’s associate (whether made directly or indirectly via an interposed entity) is not a dividend under s 109C if the payment: • discharges a monetary obligation by the private company to the shareholder/associate, and does not exceed an arm’s length amount (s 109J); 240

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 120]

• is made to another company (s 109K), other than a company in the capacity of trustee or an interposed company (s 109X(1)(a)); • would be included in, or specifically excluded from, the assessable income of the shareholder/associate under a provision other than Div 7A (s 109L), but subject to s 109X where interposed entities are involved; • is a distribution made in the course of winding up a company (s 109NA); • is a demerger dividend (s 109RA); • is made to the shareholder/associate in her or his capacity as an employee or employee’s associate (ie the payment remains subject to fringe benefits tax: s 109ZB(3)); • is a retirement exemption payment made to a CGT concession stakeholder under s 152-325(1) of ITAA 1997. In addition to the above exclusions, a number of specific exclusions apply in relation to a payment that is the provision of an asset. The operation of s 109C can also be avoided by converting the payment to a loan before the private company’s lodgment day (s 109D(4A)). The effect of this is that the converted payment is governed by s 109D, so the loan can be repaid or placed on an appropriate commercial footing (thereby avoiding a deemed dividend). Providing an asset for use: specific exclusions

The provision of an asset for use is not a payment for Div 7A purposes if (s 109CA(4) to (9)): • the provision of the asset would, if done in respect of a person’s employment, be a minor benefit for fringe benefits tax purposes; • the shareholder/associate incurred and paid expenditure for the provision of the asset, and a once-only deduction would have been allowable to the entity; • the asset is a dwelling, provided to the shareholder/associate in connection with the use of land, water or a building for the purpose of carrying on a business of the entity or the entity’s associate (eg a family trust). This is referred to as the ‘‘farmhouse’’ exception; • the asset is a main residence acquired before 1 July 2009; or • the asset is a company title flat or home unit. EXAMPLE Patrick and Rose are shareholders in a private company and beneficiaries of a family trust. The trust operates a hotel business. The company owns the hotel building and land. Patrick and Rose reside in the hotel. They do not pay rent to the company. Their use of the hotel as a dwelling is for private purposes (ie the use does not meet the otherwise deductible rule). However, the provision of the dwelling by the company to

2016 THOMSON REUTERS

241

[11 130]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

its shareholders is in connection with the trust’s use of the hotel to carry on a business. The farmhouse exception applies so that the provision of the dwelling is not caught by Div 7A.

[11 130] Forgiven debts as deemed dividends When, during an income year, a private company ‘‘forgives’’ all or part of a debt owed by an entity, a deemed dividend will arise under s 109F of ITAA 1936 on the last day of the income year if: • the amount is forgiven when the entity is a shareholder or associate of a shareholder in the private company, or it is reasonable to conclude that the amount is forgiven because the entity has been a shareholder or associate at some time; • the debt forgiveness transaction does not come within one of the exclusions in s 109G; and • the Commissioner does not exercise the discretion to disregard the operation of s 109F (where it has been triggered by an honest mistake or inadvertent omission). Crucially, the private company is deemed to make a payment rather than a loan because of the use of the term ‘‘pay’’ in s 109F(1). This means that, once forgiven, the debt is not capable of repayment by the shareholder/associate.

Meaning of ‘‘forgives a debt’’ ‘‘Debt’’ is not defined for Div 7A purposes so the term takes its ordinary meaning. The Board of Taxation, in its December 2012 report on Div 7A (see [11 030]) noted (at para 4.47) that because ‘‘loan’’ has an extended meaning (s 109D(3)) but ‘‘debt’’ does not, it is unclear how the debt forgiveness rules can apply if certain ‘‘loans’’ are forgiven. For example, the provision of financial accommodation is a loan for Div 7A purposes but is not a debt within the ordinary meaning of the word. A debt owed by an entity (ie a shareholder or associate) to a private company is treated as ‘‘forgiven’’ for Div 7A purposes if (s 109F(3) to (6)): • the entity’s obligation to pay the debt is released, waived or otherwise extinguished, other than by repaying the debt or transferring property; • the entity subscribes for shares in the private company and the company applies some or all of the money subscribed to discharge the debt; • the private company assigns the debt to a new creditor, who is either associated with the entity or is a party to an arrangement with the entity, and it is reasonable to conclude that the new creditor will not enforce the debt; • it is reasonable to conclude that the private company will not rely on the entity’s obligation to pay the debt; or • the private company loses its right to sue for recovery of the debt because the debt becomes statute barred (due to the operation of a State or Territory statute of limitations).

242

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 130]

TIP

A six-year limitation period for the recovery of debts applies in all States and the ACT, while the Northern Territory has a three-year limitation period. Where the action is based on a deed or the debt is a specialty debt, the limitation period is 15 years in Victoria and South Australia, and 12 years in all other jurisdictions.

Further, if a private company forgives a debt resulting from a Div 7A compliant loan (see [11 220]), and the loan comprises or forms parts of an amalgamated loan, the amalgamated loan is treated as forgiven to the extent of the forgiveness of the loan (s 109F(7)). The Tax Office considers that a deemed dividend may arise under s 109F if a shareholder (debtor) dies and the debt is forgiven during the administration of the deceased’s estate, with the dividend taken to be paid to the deceased’s legal personal representative: ATO ID 2012/77. In that ATO ID, a private company made a Div 7A compliant loan to a shareholder and the required minimum yearly payments were made. However, the shareholder died before the loan had been fully repaid. The NSW Supreme Court gave a nominated legal personal representative a Grant of Probate to administer the shareholder’s estate. During the course of the administration of the estate, the private company forgave the loan. The Tax Office concluded that the private company was deemed to have paid a dividend to the shareholder’s legal personal representative. In the Tax Office’s view, the legal personal representative was the relevant shareholder for the purposes of s 109F because title to the shares in the private company had passed to the legal personal representative following the death of the shareholder. Where the private company is a beneficiary of a trust estate and the trustee forgives a debt owed by the shareholder or associate (in circumstances where there is an unpaid company beneficiary entitlement), a deemed dividend arises under Subdiv EA.

Excluded debt forgiveness transactions The forgiveness of a debt will not give rise to a Div 7A dividend in the following circumstances listed in s 109G: • the debt is owed by another company, other than a debt owed by a company in its capacity as trustee; • the debt is forgiven because the debtor entity becomes bankrupt or subject to Pt X of the Bankruptcy Act 1966; • the forgiven loan has already been treated as a deemed dividend under Div 7A; or • the Commissioner exercises a discretion in the case of undue hardship.

2016 THOMSON REUTERS

243

[11 200]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

DIVISION 7A COMPLIANT LOANS AND REPAYMENTS [11 200] Preventing a deemed dividend from arising Where a payment or loan is caught by Div 7A of Pt III of ITAA 1936, the parties can prevent a deemed dividend from arising by doing any of the following before the private company’s lodgment day for the income year in which the loan or payment is made: • fully repay the amount (see [11 210]); or • put the loan or converted payment on a commercial footing in accordance with s 109N (see [11 220]). If a private company loan (including a converted payment) is placed on a commercial footing in accordance with s 109N of ITAA 1936, the loan is governed by the amalgamated loan rules in s 109E and minimum yearly repayments (see [11 230]) will need to be made to avoid the future operation of Div 7A (see [11 240]).

[11 210] Loan repayments The repayment of a loan that is caught by Div 7A of Pt III of ITAA 1936 can be made in a number of ways, including by cash payments or by setting off a dividend or some other amount owing to the entity (eg salary and wages), where journal entries represent the underlying transactions. The repayment can be made by a third party on behalf of the entity (ie the shareholder or associate). The Commissioner’s view is that a repayment cannot be made by way of a back-dated journal entry: see ATO document Division 7A – answers to frequently asked questions (September 2010 version). The Tax Office makes the following comment (at question 39): “[A] private company resolves in October to pay its director sufficient fees to set off the minimum yearly repayment required for the income year ended on the previous 30 June. The private company purports to credit the set off on 30 June by way of a back-dated journal entry. The ATO will not accept that there has been a repayment for Division 7A purposes as the underlying transaction, being the decision to pay the director, took place after 30 June.”

Non-genuine loan repayments disregarded To ensure that Div 7A is not circumvented by making repayments with the intention of re-drawing the same amount in the subsequent income year, certain repayments are disregarded under s 109R of ITAA 1936. Subject to certain exceptions, a loan repayment is disregarded if it is reasonable to conclude that (s 109R(2)): (a) when the repayment was made, the entity intended to obtain a loan or loans from the private company of a total amount similar to, or larger than, the repayment; or (b) before the repayment was made, the entity obtained a loan or loans from the private company of a total amount similar to, or larger than, the repayment, in order to make the repayment. 244

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 220]

Section 109R also applies in relation to trustee loans caught by Subdiv EA (s 109XC(6)).

Genuine payments not disregarded The following repayments are not disregarded, even if the entity intended to obtain a loan from the private company of a similar amount (s 109R(3) to (7)): • dividends paid by the private company to the entity; • work and income support related withholding payments and benefits paid by the private company to the entity (eg payments to employees, company directors and office holders); • amounts withheld from a payment pursuant to a voluntary agreement; • transfers of property to the private company. The value of that property (determined on an arm’s length basis) less any amount which the private company has paid the entity for the transfer (by way of set off or otherwise) can be set off against the loan; • amounts owing to the entity by a third party, which the third party pays to the private company, provided such amounts are assessable income of the entity for the income year in which the payment was made, or an earlier income year; • refinancing where the old loan becomes subordinated to an arm’s length loan (eg with a bank), provided the subordination arises from circumstances beyond the entity’s control; • refinancing from an unsecured loan (ie maximum seven-year term) to a secured loan, enabling the entity to add security and get the benefit of a longer term; and • refinancing from a secured loan (ie 25-year term) to an unsecured loan, enabling security to be released in return for a reduction in the loan term. EXAMPLE A private company has an unpaid present entitlement to an amount from the net income of a trust. Billy is a shareholder in the company and an employee of the trust. The trust makes a $30,000 loan to Billy. The trustee agrees to set off 9% of Billy’s fortnightly salary against the outstanding loan. The amount set off is treated as a repayment for Div 7A purposes.

[11 220] Division 7A compliant loans A private company loan (including a converted payment) is placed on a commercial footing in accordance with s 109N of ITAA 1936 if the following criteria are satisfied before the company’s lodgment day: 1. the loan agreement is in writing; 2. the interest rate charged on the loan for subsequent income years equals or exceeds the ‘‘benchmark interest rate’’; 3. the maximum term of the loan is: 2016 THOMSON REUTERS

245

[11 220]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

a. 25 years for a loan fully secured by a registered mortgage over real property with a market value at the time the loan is made of at least 110% of the loan amount; or b. seven years for all other loans. There is no prescribed format for a written loan agreement, although the Commissioner expects the entire agreement to be in writing (see Determination TD 2008/8). The benchmark interest rate is the bank variable housing loan interest rate last published by the Reserve Bank before the start of the relevant income year (5.95% for 2014-15, 5.45% for 2015-16 and 5.40% for 2016-17). The Tax Office sets out the relevant rate each year in a ruling (eg Determinations TD 2014/20, TD 2015/15 and TD 2016/11).

Amalgamated loans Once a loan has been placed on a commercial footing in accordance with s 109N, it becomes subject to the amalgamated loan rules in s 109E. An ‘‘amalgamated loan’’ is defined in s 109E(3) as one or more loans (referred to in Div 7A as ‘‘constituent loans’’) made by a private company to the same entity during an income year, where each constituent loan: • has not been fully repaid before the company’s lodgment day for the income year in which the loan was made; • would give rise to a deemed dividend under s 109D were it not for s 109N (ie the loan is in writing, is subject to the minimum prescribed interest rate and its term does not exceed the prescribed maximum term); and • has the same maximum term (ie 25 years for a secured loan and seven years for any other loan). The requirement that each constituent loan must have the same maximum term means that if a private company makes both secured and unsecured s 109N compliant loans to the same entity in an income year, two amalgamated loans arise, one with a 25-year term and the other with a seven-year term. Loans made in different income years cannot be amalgamated. The amount of the amalgamated loan for the income year in which it arises is the total of the unpaid loan balances of the constituent loan(s) on the day before the company’s lodgment day for the income year (s 109E(3)). EXAMPLE During the 2015-16 income year, PC Pty Ltd makes two unsecured loans to an associated trust, a $4,000 loan on 1 August 2015 and a $10,000 loan on 30 June 2016. Both loans are subject to written loan agreements, containing terms regarding minimum interest rate and maximum term (seven years). On 1 August 2016, the trustee repays $1,000 of the $4,000 loan. On 1 September 2016, the trustee repays $2,000 of the $10,000 loan. The two loans form part of an amalgamated loan for the 2015-16 income year. The amount of the amalgamated loan is $11,000 (ie the sum of the two loans ($14,000) less the repayments made before the company’s lodgment day for 2015-16 ($3,000)).

246

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 230] To avoid the operation of Div 7A in the 2016-17 income year (as well as in subsequent income years), the trustee will need to make the minimum yearly repayment for the amalgamated loan by the end of the income year.

TIP

Separate accounts should be maintained for each amalgamated loan so the private company can readily identify the loans that form an amalgamated loan and what repayments have been made.

[11 230] Calculation of minimum yearly repayment The minimum yearly repayment for an amalgamated loan is calculated in accordance with the following formula in s 109E(6) of ITAA 1936:

This formula effectively provides for a repayment of both principal and interest. It applies the benchmark interest rate for the income year for which the minimum yearly repayment is being calculated to the outstanding balance on the amalgamated loan at the end of the previous year, and then discounts the resulting amount by reference to the number of years remaining in the term of the loan. This calculation needs to be made for each income year in which the amalgamated loan remains unpaid.

Working out the first minimum yearly repayment To work out the first minimum yearly repayment (ie for the income year immediately after the amalgamated loan comes into existence), the Tax Office accepts that the ‘‘amount of the loan not repaid by the end of the previous year of income’’ component in the s 109E(6) formula includes repayments made after year end but before the company’s lodgment day for the previous year (ATO ID 2010/82). EXAMPLE On 1 January 2013, a private company lends an associated trust $120,000 under an unsecured loan that complies with s 109N. The trustee makes a $20,000 repayment on 25 October 2013 (before the company’s lodgment day for the 2012-13 income year).

2016 THOMSON REUTERS

247

[11 240]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

To work out the first minimum yearly repayment for 2013-14, the amount of the amalgamated loan not repaid is $100,000 (ie $120,000 less $20,000 paid after year end but before lodgment day). If the remaining term of the loan is 5 years and the benchmark interest rate is 6.2%, the trust’s minimum yearly repayment for 2013-14 is: ($100,000 x 0.062) / (1 - ((1/(1 + 0.062))5)) = $23,869

Minimum yearly repayment for subsequent year When determining the minimum yearly repayment for the second or later years, a calculation is made of the opening balance that takes account of repayments during the first or a prior year. Under s 109E(7), the amount of an amalgamated loan repaid by the end of an income year is equal to the difference between the actual repayments during the year and the amount of notional interest. Notional interest is calculated by applying the benchmark interest rate for the income year to the amounts outstanding from time to time in the year. It is imperative that sufficient documentation be maintained to clearly show the nature of any repayment, how it is treated by the private company, and what the intention of the directors was. However, the Tax Office view is that every repayment contains interest and principal components, with the interest calculated at the prevailing benchmark rate, together with the balance of the outstanding amalgamated loan, so that the residual amount of the repayment is offset against the principal owing. Where there is a shortfall in a minimum yearly repayment and a deemed dividend arises under s 109E (see [11 240]), the capital component of the shortfall does not reduce the ‘‘amount of the loan not repaid’’ component in the s 109E(6) formula (ATO ID 2013/36).

[11 240] Prior year loans as deemed dividends An amalgamated loan is not a deemed dividend in the year in which it arises (s 109P of ITAA 1936), even if no repayments are made before the company’s lodgment day for that initial year (ATO ID 2010/206). A deemed dividend will arise in a subsequent income year if the entity (ie the shareholder or shareholder’s associate) fails to make any repayments in that subsequent year or if any repayments fall short of the minimum yearly repayment (s 109E(1)). The amount of the deemed dividend is the amount of the shortfall, namely the difference between the amount paid (if any) and the minimum yearly payment (see [11 230]), but subject to the company’s distributable surplus (s 109E(2)). Section 109E(1) can apply to deem a dividend in more than one income year for the same amalgamated loan. This is because a dividend arises for each income year in which the minimum yearly repayment is not properly made. Where there is a shortfall in one income year, the minimum yearly repayment will be higher in the following income year, which can lead to cumulative shortfalls in excess of the loan amount. 248

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 240]

The amount of the shortfall remains a debt owed by the entity pursuant to the terms of the written loan agreement. If the private company forgives that debt, the amount of the deemed dividend arising because of the debt forgiveness is reduced by the amount of any repayment shortfalls previously treated as dividends in relation to the loan (ss 109G(3A) and 109G(3B)). Further, if a later dividend is offset against the shortfall debt, the later dividend is not included in the shareholder’s assessable income to the extent it is unfranked (s 109ZC). EXAMPLE In Year 1, a private company lends $100,000 to a trust. The trust is an associate of the company’s director and sole shareholder. Prior to the lodgment of the company’s tax return for Year 1, the loan is subject to a written agreement which complies with s 109N. The trustee is required to make a minimum yearly repayment on the loan of $20,000, being $13,000 of principal and $7,000 of interest. In Year 2, the trustee fails to make the first minimum repayment and is taken to have received an unfranked dividend from the private company of $20,000 (subject to the company’s distributable surplus). In Year 3, the outstanding balance of the loan is $107,000, and the minimum yearly repayment is $20,500, ie $13,010 of principal and $7,490 of interest. The trustee makes a repayment of $15,000 and is taken to have received an unfranked dividend in that year of $5,500. In Year 4, the company forgives the outstanding loan ($99,490). The forgiveness gives rise to a deemed dividend. The amount of the deemed dividend is reduced by the amount of the repayment shortfall previously treated as a dividend ($20,000 plus $5,500), so that a dividend of $73,990 is taken to be paid to the trustee (subject to the company’s distributable surplus).

WARNING! To avoid the operation of s 109E(1), the entity has until the end of the income year to make the minimum yearly repayment. This is to be contrasted with s 109D, where the entity has until the day before the private company’s lodgment day to repay the loan so as to prevent a deemed dividend from arising.

The Commissioner can extend the period for repaying an amalgamated loan if the repayment was not made by year end due to circumstances beyond the entity’s control (s 109RD). The Commissioner also has the discretion to disregard a s 109E deemed dividend if the failure to make the minimum yearly repayment was due to circumstances beyond the entity’s control and the entity would suffer undue hardship if s 109E were to apply (s 109Q).

2016 THOMSON REUTERS

249

[11 300]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

DIVISION 7A AND UNPAID PRESENT ENTITLEMENTS [11 300] Unpaid present entitlements of private company beneficiaries Family businesses are often structured using a combination of discretionary trusts and private companies. As trustees have to distribute all of the trust’s net income to avoid paying tax at the highest marginal tax rate (under s 99A of ITAA 1936), it has become common practice for trustees of family discretionary trusts to declare a distribution of income to a private company beneficiary, thereby capping the applicable tax at the company tax rate. However, the declared distribution frequently remains unpaid (ie an unpaid present entitlement or UPE). In such a case, the Commissioner takes the view in Ruling TR 2010/3 that the UPE may amount to a loan from the private company to the trustee, giving rise to a deemed dividend under the general rules in s 109D (see [11 310]) rather than the specific provisions in Subdivs EA and EB dealing with UPEs (see [11 400]). The Board of Taxation, in its review of Div 7A (see [11 030]), the Board of Taxation proposed that the current uncertainty surrounding UPEs could be addressed by clarifying that all UPEs are Div 7A loans. The Board also proposed that trading trusts should be allowed to elect to exclude company loans from the operation of Div 7A. As a trade-off, trusts making this election could be denied the 50% CGT discount (as companies are). Further, there would remain a clear obligation for the excluded loan (including UPE) amounts to ultimately be repaid to the company.

[11 310] Unpaid present entitlements as ‘‘loans’’ The Commissioner considers that the general loan provisions in s 109D of ITAA 1936 apply where: (a) there is an unpaid present entitlement (UPE) from a trust to an associated private company; and (b) the company does not call for payment of the UPE (or its investment), thereby ‘‘agreeing’’ that the funds representing the UPE can be used for trust purposes. The rationale for this view is that a UPE is a form of ‘‘financial accommodation’’ and therefore a loan as defined in s 109D(3) (see [11 110]). The Commissioner’s position is set out in Ruling TR 2010/3, with Practice Statement PS LA 2010/4 providing guidance on how the Ruling is to be applied. The ATO’s approach on this issue leaves little scope for the operation of the specific UPE rules in Subdiv EA and EB (see [11 400]). Note that prior to 2009, the Tax Office did not seek to apply Div 7A to UPEs of private company beneficiaries, unless the trustee actually lent the funds to a shareholder or shareholder’s associate. The Commissioner accepted that a UPE from an associated trust did not, of itself, give rise to a loan from the private company to the trustee under s 109D. 250

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 310]

Application of Ruling TR 2010/3 It is common practice for funds representing a UPE to be held on trust for the beneficiary in a separate ‘‘sub-trust’’. The Commissioner accepts that a private company’s UPE does not give rise to a loan if it is held on sub-trust and the funds are used only for the company’s sole benefit (and not for any benefit of the main trust or any other entity). Where, however, the trust deed allows the trustee to mix funds and invest the mixed funds in composite assets, the Tax Office’s attention may be attracted. Ruling TR 2010/3 considers the application of s 109D where a private company and a trust are part of the same family group and: (a) the company is a beneficiary of the trust; (b) the trust is an associate of any shareholder of the company; (c) the company has a present entitlement to an amount from the trust which remains unpaid (ie a UPE); and (d) funds representing the UPE remain ‘‘intermingled’’ with other funds of the trust, or otherwise can be used for ‘‘trust purposes’’. The Ruling distinguishes between ordinary loans (which it calls ‘‘Section two loans’’) and loans in relation to subsisting UPEs (which it calls ‘‘Section three loans’’). The reason for this distinction is that the Commissioner’s view in relation to ‘‘Section two loans’’ applies both before and after the date of issue of the Ruling (2 June 2010), whereas the view in relation to ‘‘Section three loans’’ applies only to UPEs arising on or after 16 December 2009 (when the draft ruling, TR 2009/D8, was issued). In both cases, the private company will be taken to make a loan under s 109D and will have no outstanding UPE in the trust in respect of that amount. The loan will be a deemed dividend (to the extent of the company’s distributable surplus), unless the loan is fully repaid before the company’s lodgment day, or is covered by a written loan agreement with interest and prepayments over seven years in accordance with s 109N (see [11 220]).

Section two loans: loans within the ordinary meaning The private company makes an ordinary loan to the trust in the following situations: • the UPE is satisfied and loaned back to the trustee under an express or implied agreement between the parties (including an agreed set-off). In the absence of evidence to the contrary, the Tax Office treats the company as having the requisite knowledge of the trust crediting a loan account in its name because the parties are part of the same family group; or • the trustee makes a loan on behalf of the company, by acting pursuant to a term of the trust deed that permits the trustee to pay or apply money to or for the company’s benefit.

Section three loans: Div 7A loans within the extended meaning In certain circumstances, a private company makes a loan by providing ‘‘financial accommodation’’ to the trust, or by entering into a transaction with the trust which effects an ‘‘in-substance loan’’ in respect of a subsisting UPE (including where an amount is held under a sub-trust arrangement). 2016 THOMSON REUTERS

251

[11 310]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

In the Commissioner’s view, this occurs if there is a ‘‘consensual agreement’’ where: • the company supplies or grants some form of pecuniary aid or favour to the trust; and • a principal sum or equivalent is ultimately payable to the company. A consensual agreement arises if the company authorises (including by ‘‘acquiescing with knowledge of’’) the trustee’s continued use for trust purposes of the funds representing the company’s UPE, by not calling for the UPE to be paid or for the funds to be invested for the company’s sole benefit. Again, the Commissioner’s view is that because the parties are part of the same family group, the company has the requisite knowledge of the trustee’s use of funds (unless there is sufficient evidence to the contrary). The Ruling states (at paras 22 and 23): “In these circumstances the private company provides pecuniary support to the trustee equal to the whole amount of the UPE that the private company beneficiary has allowed the trustee to use (including by knowledgeably acquiescing to this use) for trust purposes. Accordingly, if a private company beneficiary has knowledge that funds representing its UPE are being used by the trustee for trust purposes (rather than being held and/or used for that private company’s sole benefit), in not calling for payment of its UPE the private company provides the trustee with financial accommodation and, by extension, makes a Division 7A loan to the trustee.”

The loan is ‘‘made’’ when the funds representing the UPE are first used other than for the company’s sole benefit. The Commissioner accepts that a distribution may be taken to have been made at year end if it is actually made within two months into the following income year: see paras 111 and 112 of TR 2010/3. In ATO ID 2012/74, a loan did not arise under s 109D where all UPEs in an income-producing fixed trust were mixed with the trust fund, but the UPEs were used to benefit all unit holders (by retiring trust debt) in the same proportion as each UPE bore to the total of all UPEs. The Tax Office accepted that the retention of profits to retire debt did not amount to the provision of financial accommodation or an in substance loan to the trustee. However, in a meeting of the Div 7A working party on 30 October 2012, the Tax Office advised that its position in ATO ID 2012/74 might have been different if some of the unit holders had acted differently (eg by demanding payment of their distribution).

Pre-16 December 2009 UPEs which are not ordinary loans Pre-16 December UPEs which are not ordinary loans should be quarantined and disclosed separately from 2010 UPEs and future year UPEs. However, to avoid the operation of Subdivs EA and EB (see [11 400]), it is important to ensure that trusts that have pre-16 December 2009 UPEs owing to private companies (either directly or indirectly) which are not ordinary loans do not provide loans, payments or forgiven debts to shareholders or associates, either directly or indirectly through interposed entities. 252

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 320]

[11 320] Using sub-trusts to prevent a deemed dividend An unpaid present entitlement (UPE) will not be considered by the Commissioner to be a loan to which Div 7A of Pt III of ITAA 1936 applies if the funds representing the UPE are held on sub-trust for the sole benefit of the private company beneficiary. The Tax Office accepts that funds are held on sub-trust where the creation of the sub-trust is evidenced by a resolution of the trustee, or where the trustee exercises a power pursuant to a trust deed to hold the funds on trust for the beneficiary. The existence of the sub-trust may be evidenced where: • the amount representing the UPE is set aside separately in the accounts of the main trust as being held on trust for the private company beneficiary; • separate accounts are prepared for the sub-trust; or • a separate bank account is opened in the name of the trustee as trustee for the private company beneficiary in respect of the funds within the sub-trust. The Tax Office considers that the funds in the sub-trust are held for the sole benefit of the private company beneficiary where (PS LA 2010/4): • the trustee of the sub-trust invests the funds representing the UPE in the main trust on commercial terms; • all the benefits from the investment flow back to the sub-trust and the private company beneficiary; and • all the benefits (eg the annual return on investment) are actually paid to the private company beneficiary by the lodgment day of the tax return of the main trust for the year in which the return arises. Taxpayers can determine the appropriate terms of the investment or can adopt one of the three safe harbour investment options put forward by the Tax Office in Practice Statement PS LA 2010/4 (at para 61): 1. Option 1: invest the funds representing the UPE on an interest-only seven-year loan at the Div 7A benchmark interest rate; 2. Option 2: invest the funds representing the UPE on an interest-only 10-year loan at the prescribed interest rate (the Reserve Bank’s indicator lending rate for small business variable (other) overdraft); or 3. Option 3: invest the funds representing the UPE in a specific income-producing asset or investment. Under Options 1 and 2, the corporate beneficiary must pay the annual interest before the lodgment day of the main trust’s tax return. Under Option 3, a separate sub-trust tax return is required. In its March 2014 discussion paper (see [11 030]), the Board of Taxation observed that these safe harbour terms are significantly more generous than the complying loan terms, so that PS LA 2010/4 preserves the incentive for using UPEs for purposes other than to fund active business operations. For example, ‘‘well advised’’ taxpayers are able to attain unintended benefits by placing a UPE on a sub-trust and then using the funds to acquire investment assets such as real 2016 THOMSON REUTERS

253

[11 330]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

property: see paras 2.53 and 6.26. The Board also noted that Div 7A may be avoided entirely by certain leasing, factoring and consignment arrangements.

Documentation The Tax Office requires the main trust and the ‘‘sub-trust’’ to document the sub-trust arrangement. In an information paper (Division 7A – unpaid present entitlement, June 2011) the Tax Office considers that a document containing the following details will be sufficient evidence of a ‘‘legally binding loan agreement between the main trust and the sub-trust’’: (a) the names of the parties; (b) the loan terms, including the amount of the loan, the date the loan amount is drawn, the requirement to repay the principal amount of the loan, the period of the loan and the interest rate payable on the loan; (c) that interest payment is to be made annually (with the ATO document stating that the payment is due on the last day of the income year); (d) that the parties named have agreed to the terms; (e) the date the agreement was made.

[11 330] Creation of sub-trusts: practical issues The following points should be borne in mind when considering whether to hold a UPE on sub-trust. • If the UPE is not held on sub-trust for the sole benefit of the private company, a Div 7A loan will arise on the relevant date (30 June 2016 for a 2015 UPE) unless the loan is put on a commercial footing in accordance with s 109N (see [11 220]). Minimum yearly repayments which constitute both interest and repayments will then need to be made in the following year (by 30 June 2017 for a 2015 UPE), and in subsequent years, to avoid a deemed dividend arising. This may cause cash difficulties for the operating trust. • If the UPE is held on sub-trust, interest payments are required to be made on an annual basis but repayment of the UPE will only be required to be made at the end of the relevant term (seven or 10 years). This may provide a cash flow advantage for the trust. • Where a UPE is held on sub-trust, Subdiv EA (see [11 400]) can potentially apply to payments, loans or debts forgiven from the trust. • The deductibility of interest under Option 1 or Option 2 where the UPE is held on sub-trust may be restricted if the trust does not hold any income-producing assets. PLANNING OPPORTUNITIES For new trading activities (ie where no capital assets are expected to be required), consider using a company rather than a trust structure.

254

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 330] One of the main advantages of using a trust structure to conduct a business is that the 50% CGT discount is available on the disposal of capital assets (which is not available to companies). Therefore, if a new trading business is to be conducted with no capital assets, a company may be used instead of a trust. This will ensure that there are no Div 7A consequences as a result of unpaid trust distributions owing from trusts to corporate beneficiaries. It is important to remember that there are other advantages of using a trust (as opposed to a company) that may be lost by adopting this strategy (ie streaming income to low income beneficiaries). Consider distributing more to individuals in the family group. Unpaid trust distributions owing to individuals will not be subject to the Div 7A implications noted above. It may be worthwhile to consider distributing more income to individual beneficiaries of the trust rather than the corporate beneficiary. It may be possible to distribute up to $80,000 to individuals which will be taxed at a marginal tax rate. Consider providing funding through equity rather than loans which should not be subject to Div 7A provided: • market value consideration is paid for the additional units; • regard is given to the fact that any new equity will be a post-CGT asset. Another alternative to providing funding to unit trusts in a group is via equity subscription rather than providing debt from another member in the group which may be subject to Div 7A. There should be no Div 7A implications if market value consideration is paid for the units. Consider setting up a finance company for large groups. If the company also provides loans to outside parties, an exemption may be available to ensure intra-group loans are not captured by Div 7A. An exemption from the application of Div 7A applies where loans are provided to intra-group entities on the same terms as to external arm’s length parties (s 109M). Where the group provides funding to external arm’s length entities, it may be worthwhile to set up a finance company that provides both intra-group loans and loans to external parties. If certain criteria in s 109M are satisfied, the loans to intra-group entities should not be subject to Div 7A. Where the same person(s) are the directing mind or controller of both the private company beneficiary and the trust then, subject to any contrary evidence, the Commissioner will take the view that both the company and trustee know what the other knows because they have the same directing mind and will. For example, where units in a unit trust are held by three discretionary trusts (all with different trustees controlling each trust), it may be difficult for the Commissioner to argue that the trustee of the unit trust and the trustees of each discretionary trust have the same directing mind and will. Therefore, the distribution from the unit trust to each discretionary trust should not be subject to Div 7A. However, where each discretionary trust distributes to a corporate beneficiary, the

2016 THOMSON REUTERS

255

[11 340]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

Commissioner may take the view that each discretionary trust and its corporate beneficiary have the same directing mind and hence this distribution is likely to be subject to Div 7A.

[11 340] Unpaid present entitlements between trusts An unpaid present entitlement (UPE) between two trusts that has not been paid out by the required time may be treated by the Tax Office as a provision of financial accommodation and a loan under s 109D of ITAA 1936. While the UPE is a loan, Div 7A will only apply where the arrangement is captured by Subdiv EA of Div 7A (UPEs owing to private companies: see [11 400]) or Subdiv E of Div 7A (interposed entities: see [11 500]). Ordinarily, this would mean that a private company will need to be involved somewhere in the arrangement for any of these provisions to apply.

Potential Subdiv EA risk An example of how Div 7A can apply to UPEs between trusts is shown below.

In the above arrangement, Trust 2 is taken to make a Div 7A loan under the extended definition (financial accommodation) to Trust 1. Trust 2 also has a UPE held on sub-trust to Company A. Accordingly the UPE/loan between Trust 2 and Trust 1 can potentially be treated as an assessable dividend under Subdiv EA. Subdivision EA has residual effect where: • a private company (eg Company A) is owed a UPE from a trust (eg Trust 2) that arose before 16 December 2009/ alternatively a post-16 December 2009 UPE that is held on sub-trust; • the trust (eg Trust 2) makes a loan to a shareholder or associate (eg Trust 1) of the private company. 256

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 340]

Potential Subdiv E risk Below is an example of how Div 7A can apply to UPEs between trusts arising post-16 December 2009 not held on sub-trust.

In the above example, the UPE between Trust 2 and Company A is not placed on sub-trust. Accordingly, the UPE is a Section 3 loan (see [11 310]) as Company A is providing financial accommodation to Trust 2 by not calling for the payment of the UPE or calling for the amount to be set aside and used for Company A’s sole benefit. Accordingly, Div 7A would apply to the UPE between Trust 2 and Company A, subject to the distributable surplus available in Company A. The subsequent UPE between Trust 1 and Trust 2 is also a loan under the extended definition. This loan can potentially be treated as a deemed dividend under Subdiv EA, as there is a UPE owing to a company (eg Trust 2 to Company A) and the Trust 2 has made a loan to a shareholder/associate (eg Trust 1). However, in this example, as Div 7A has been applied to the UPE between Trust 2 and Company A, the UPE between Trust 1 and Trust 2 is not an assessable dividend under Subdiv EA. Practice Statement PS LA 2010/4 (at paras 207 to 211) confirms that the Tax Office applies this treatment to such arrangements. In addition, the UPE between Trust 1 and Trust 2 (a deemed Section 3 loan) may be captured under Subdiv E (interposed entity loans). However, if the UPE between Trust 2 and Company A has been converted to a s 109N complying loan in order to avoid a deemed dividend (and the amount of the UPE from Trust 1 to Trust 2 was the same or less than the amount of the UPE from Trust 2 to Company A) there may be some merit in applying para 11 of TD 2011/16, which would suggest that the loan from Trust 2 to Trust 1 would be nil and hence there are no Div 7A consequences with respect to that loan.

2016 THOMSON REUTERS

257

[11 400]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

TRUSTEE LOANS, PAYMENTS AND FORGIVEN DEBTS [11 400] Specific measures treating trust amounts as dividends Specific measures in Subdiv EA of Div 7A of Pt III of ITAA 1936 are designed to prevent a trustee sheltering trust income at the company tax rate by declaring a present entitlement to a private company which is not paid (ie an unpaid present entitlement or UPE) and then distributing the underlying cash to a shareholder of the company or an associate of the shareholder (see [11 410]). The trustee is treated as a private company for the purpose of determining whether the shareholder or associate is assessed under Div 7A. Tracing rules in Subdiv EB of Div 7A ensure that Subdiv EA is not circumvented by interposing entities between the trustee and the private company or between the trustee and the shareholder/associate (see [11 520]).

Commissioner’s view that general loan rules apply to UPEs Although Subdivs EA and EB deal specifically with UPEs, the Commissioner considers that the general loan rules in Div 7A (s 109D) can apply to treat a UPE as a deemed dividend where a corporate beneficiary does not call for payment of the entitlement, thereby ‘‘consenting’’ to the funds being used for ‘‘trust purposes’’ (see [11 310]). The Tax Office has applied this view since 16 December 2009 (see TR 2010/3). Accordingly, where s 109D applies to a UPE, Subdivs EA and EB will have no subsequent operation in respect of that UPE. Many commentators argue that the specific UPE rules should apply rather than the general rules. The Commissioner’s response is that Subdivs EA was formulated on the assumption that a UPE is held on a ‘‘sub-trust’’ for the sole benefit of the corporate beneficiary, which has proven not to be true in practice. The distinction is significant, as s 109D has broader application. Subdivision EA requires a payment, loan or debt forgiveness from the trust to the private company’s shareholder or shareholder’s associate. Subdivision EA is not so much directed to strategies to reduce tax on trust accumulation – rather to the interposition of a trust to disguise the channelling of benefits to shareholders or associates – in a way which would otherwise fall outside the scope of Div 7A. There is no such requirement where s 109D is applied.

[11 410] Loans, payments and forgiven debts caught by Subdiv EA Subdivision EA of Div 7A of Pt III of ITAA 1936 applies where a trustee makes a payment or a loan to, or forgives a debt owed by, a non-corporate shareholder (or the shareholder’s associate) of a private company in circumstances where (s 109XA): • the private company is, or becomes, presently entitled to an amount from the net income of the trust; and • all or part of the present entitlement remains unpaid before the trust’s lodgment day for the income year in which the transaction occurs. 258

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 420]

In the case of a trustee payment, Subdiv EA only applies if the payment discharges or reduces a present entitlement of the shareholder/associate that is wholly or partly attributable to an unrealised gain (see [11 420]). Section 109XC modifies various provisions in Div 7A as they apply to trusts, to ensure that transactions undertaken by trustees are effectively treated in the same way as if they had been undertaken by a private company.

TIP

The application of Subdiv EA can be avoided by doing any of the following before trust’s lodgment day: • paying in full the entitlements owing to the corporate beneficiary; • repaying the amount in full (see [11 210]); • putting the loan on a commercial footing in accordance with s 109N (see [11 220]).

In the case of payments, the unpaid present entitlement requirement does not apply if the shareholder/associate receives a payment due and all or part of the amount is subsequently loaned back to the trust (s 109XA(1A)). Any loan repayment made by the trustee in subsequent years may then give rise to a deemed dividend (where there is an unpaid present entitlement). To ensure that the loan agreement between the trust and shareholder/associate cannot be used to avoid the application of s 109XA(1A), the exemption for genuine debts in s 109J is disregarded. Trustee payments and loans to a corporate shareholder/associate are expressly excluded from Subdiv EA, consistent with the position reflected elsewhere in Div 7A that inter-company transactions are not generally targeted by Div 7A.

[11 420] Trustee payments: present entitlement attributable to unrealised gain While Subdiv EA of Div 7A of Pt III of ITAA 1936 applies to trustee payments, loans and forgiven debts, a payment will only be caught if it discharges or reduces a present entitlement of a shareholder/associate of the private company that is ‘‘wholly or partly attributable to an amount that is an unrealised gain’’ (s 109XA(1)(b)). The term ‘‘payment’’ is not specifically defined in Subdiv EA. It should be assumed that ‘‘payment’’ is given a very broad meaning in accordance with s 109C(3) and 109CA (see [11 120]). For example, the constructive payment and loan back of a present entitlement is a ‘‘payment’’ for Div 7A purposes.

Present entitlement attributable to an ‘‘unrealised gain’’ The Tax Office states in ATO ID 2005/359 that a present entitlement is attributable to an unrealised gain if the trust deed empowers the trustee to declare present entitlement to an amount representing the unrealised gain and the trustee has declared present entitlement to that amount. Its position can be 2016 THOMSON REUTERS

259

[11 420]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

summarised as follows: “A gain is unrealised when an item which has increased in value has not been ventured, either in whole or part, in a transaction to obtain a return that reflects that increase in value; or has been ventured into such a transaction but the return is yet to convert into a recoverable debt.”

The mere creation or recording of a present entitlement is not a payment for this purpose. In ATO ID 2005/359, units in a unit trust were transferred from one trust to another. There was no ‘‘unrealised gain’’ as the transfer was for market value consideration, with this consideration taking the form of a debt due from one trust to the other. The definition of ‘‘unrealised gain’’ is quite broad and includes not only unrealised profits on capital assets, but also unrealised gains that are of a revenue nature (s 109XA(7)). For example, accrued income, profits on long-term construction contracts calculated on the emerging profits basis and the recognition of work in progress in professional services firms could come within the definition. However, unrealised gains representing timing differences that will be reversed in the income year after the unrealised gain is derived are specifically excluded from the definition. The effect of this exclusion is that the payment of a corpus distribution by a trust out of an asset revaluation reserve does not come within Subdiv EA if the relevant gain is realised and included in the trust’s assessable income by the end of the income year following the year of payment.

Composite payments Most beneficiary entitlements are not separated into their realised and unrealised components in the trust’s financial statements. It appears that it is open to the trustee to determine the extent to which the payment is treated as a reduction in entitlements to realised or unrealised gains but issues might arise where, for example, the trustee is unable to identify the nature of the entitlement to which a payment is being applied. Tax practitioners should therefore advise clients to keep accurate accounts and carefully word distribution resolutions so they can show whether the payment is sourced from realised assets or reserves. It may also be necessary to review past records to determine the components of a beneficiary’s entitlements.

Payments only partly related to unrealised gains If the amount of the present entitlement is only partly attributable to an unrealised gain, only the portion that is the unrealised gain is assessable. The following examples are taken from the Explanatory Memorandum to the Tax Laws Amendment (2004 Measures No 1) Act 2004. EXAMPLE A private company has a present entitlement to $10,000 of accounting income of a trust estate that remains unpaid. The trustee creates an entitlement to a shareholder of the private company comprising $7,000 of unrealised gains and $3,000 of realised gains.

260

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 430] The trustee then makes a payment of $5,000 towards the beneficiary’s entitlements. The trustee is permitted to determine the extent to which the payment is treated as a reduction in entitlements to realised or unrealised gains and determines that, of the $5,000 paid, the first $3,000 discharges the entitlement to the realised gain and the remaining $2,000 reduces the entitlement to the unrealised gain. The payment will attract the operation of Subdiv EA. Subject to the other rules in Div 7A, $2,000 will be assessable in the hands of the shareholder.

EXAMPLE A private company has a present entitlement to $10,000 of accounting income of a trust estate that remains unpaid. At the end of the income year the trustee creates an entitlement to a shareholder of the private company comprising $10,000. The entitlement is entirely attributable to interest income that has been accrued for accounting purposes, but is nonetheless an unrealised gain. Shortly after the end of the income year, the trustee makes a payment of $10,000 towards the beneficiary’s entitlement. However, at the time the payment is made, the accrued interest has been received, converting the profit entitlement to an entitlement to a realised gain. The Explanatory Memorandum notes that even if the interest is not regarded as realised at the time of payment, provided the unrealised gain would be included in the trust’s assessable income no later than the income year following the year in which the payment is made, the payment would also not attract the operation of Subdiv EA.

[11 430] Meaning of ‘‘present entitlement’’ and ‘‘net income’’ Central to the operation of Subdiv EA of Div 7A of Pt III ITAA 1936 is the requirement that the private company must be, or will become, ‘‘presently entitled to an amount from the net income of the trust estate’’. The terms ‘‘presently entitled’’ and ‘‘net income’’ are not defined for Div 7A purposes. Under the general trust rules in Div 6 of Pt III of ITAA 1936, present entitlement is determined by reference to the ‘‘income’’ of the trust estate (not the net income). Accordingly, a beneficiary’s liability to pay tax depends on whether the beneficiary is presently entitled to a ‘‘share of the income of the trust estate’’. Where this liability exists (and the beneficiary is not under a legal disability), the beneficiary is assessed on ‘‘that share of the net income of the trust estate’’ (s 97(1)): see [3 100]. For Div 6 purposes, the ‘‘income of the trust estate’’ is a trust law concept, being income ascertained by the trustee according to appropriate accounting principles and the trust deed (if any): Zeta Force Pty Ltd v FCT [1998] FCA 728; 39 ATR 277, FCT v Bamford [2010] HCA 10; 75 ATR 1. ‘‘Net income’’ is defined in s 95(1) as the total assessable income of a trust estate (including net capital gains), less all allowable deductions (subject to certain exceptions). As the expression ‘‘net income’’ is not expressly defined for Div 7A purposes, it takes its ordinary meaning. In ATO ID 2005/58, the Tax Office stated 2016 THOMSON REUTERS

261

[11 440]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

that ‘‘net income’’ is to be read to mean ‘‘accounting income’’: that is, income less all expenses. However, the fact situation in ATO ID 2005/58 related to a trust deed that required income to be determined on the basis of accounting standards, so the trust deed referred to accounting income. In a series of fact sheets titled Division 7A – Trust amounts treated as dividends (updated in June 2010) and at question 87 of ATO document Division 7A – answers to frequently asked questions (September 2010 version), the Tax Office stated that ‘‘net income means the income less expenses of the trust for the income year as determined by the trustee in accordance with the trust deed and applicable accounting standards’’. The calculation of net income affects the amount of any unpaid present entitlement, which in turn affects the amount that is assessable, and the amount required to be repaid to avoid assessment. Therefore, the trustee needs to word resolutions carefully and maintain accounts and records that establish the character of the payments and their components.

[11 440] Amounts assessable under Subdiv EA Where a transaction is caught by Subdiv EA of Div 7A of Pt III of ITAA 1936 (including via Subdiv EB), an amount is included in the assessable income of the shareholder or associate ‘‘as if it were a dividend’’ paid by the corporate beneficiary at the end of the income year in which the actual transaction occurs (s 109XB(1)). The assessable amount is the lesser of (ss 109XA; 109XB): • the amount involved in the actual transaction (which, in relation to payments, is limited to the amount attributable to unrealised gains); • the unpaid present entitlement, less any amounts previously treated as deemed dividends; • the company’s distributable surplus. The assessable amount is included in the assessable income of the shareholder or associate as an unfranked dividend (s 109XB(2)). Section 109ZCA allows a later dividend, distributed by the corporate beneficiary to the shareholder/associate, to be set off against some or all of an amount received from a trustee, where that amount has already been assessed under s 109XB. EXAMPLE The trustee of the Brown Trust transfers property valued at $200,000 to Xanthe, the spouse of a shareholder in White Pty Ltd. White Pty Ltd has a present entitlement of $70,000 to the net income of the Brown Trust that remains unpaid before the lodgment due date of the tax return. The company’s distributable surplus is $65,000. The following consequences follow: • the transfer of the property to Xanthe constitutes a Div 7A payment; • as property only is transferred, the gain is unrealised and falls within the scope of Subdiv EA; • the amount of the transaction is $70,000, being the lesser of the unpaid present entitlement ($70,000) and the actual amount in the transaction ($200,000); and

262

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 440] • the $70,000 amount is limited by the company’s distributable surplus ($65,000). Xanthe will need to include an unfranked dividend of $65,000 in her income tax return. There will be no debit to the franking account of White Pty Ltd.

Multiple trustee loans Where there are a number of different trustee loans to shareholders (or associates) of a private company with an unpaid present entitlement during an income year, there can be a proportionate reduction of the assessable amounts. In a series of interpretative decisions concerning trustee loans to different shareholders of a corporate beneficiary with an unpaid present entitlement, the Tax Office states that: • if the aggregate of these loans exceeds the company’s distributable surplus, the Div 7A amount for each shareholder is proportionately reduced so the total does not exceed the distributable surplus: ATO ID 2005/297; • if a loan equal to the amount of the unpaid present entitlement is repaid or put on a commercial footing by the lodgment day, any loan not repaid or put on a commercial footing by that time may give rise to an assessable amount under s 109XB: ATO ID 2005/298; • none of these loans gives rise to ‘‘previous transactions’’ for the purposes of applying s 109XA(4) in that same income year: ATO ID 2005/299. EXAMPLE There are five $100,000 loans to different shareholders of the private company. The private company has present entitlement to net income of $100,000 which is unpaid at the due date and lodgment date of the tax return. The private company’s distributable surplus is $100,000. As a result of s 109XB(2), the assessable amount for each loan is $100,000. Section 109XC(7) then operates to pro-rata the unfranked dividend against the company’s distributable surplus, calculated in accordance with the formula in s 109Y(3): Provisional dividend ($100,000)

x

= $100,000

x

Distributable surplus for the year of income ($100,000) Total of provisional dividends ($500,000) $100,000 $500,000

ie $20,000

The assessable amount for each shareholder is proportionately reduced to $20,000 so that the total does not exceed the private company’s distributable surplus.

2016 THOMSON REUTERS

263

[11 500]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

In the above example, if one of the loans is put on commercial terms by the relevant date, only this loan will not give rise to an assessable amount. The remaining four loans will not be excluded loans and will be brought to account based on a revised proportion of the unpaid present entitlement as deemed dividends to the shareholders (or associates) per ATO ID 2005/298. The most appropriate solution is to place all loans on excluded terms.

DIVISION 7A TRACING RULES [11 500] Transactions involving interposed entities Subdivision E of Div 7A of Pt III of ITAA 1936 contains general tracing rules to ensure that Div 7A is not circumvented by making payments and loans to shareholders or their associates through interposed entities (see [11 510]). The approach adopted in Subdiv E is, in essence, to treat the private company as having made the payment or loan directly to the shareholder or associate. The Commissioner determines the amount of the deemed payment (s 109V) or notional loan (s 109W). In this way, s 109C (payments) and s 109D (loans) can apply to assess the shareholder or associate. Subdivision EB contains corresponding tracing rules for the purposes of Subdiv EA, where a private company has an unpaid present entitlement to trust income and an entity is interposed between the trust and the target entity (see [11 520]). In determining whether the tracing rules apply, it is important to remember that Div 7A applies not only to direct transactions with the shareholders of the private company, but also to transactions entered into with their associates (a broadly defined term: see [11 010]). If the interposed entity is associated with the shareholder, it may not be necessary to have regard to the interposed entity rules as there will be a direct application of either s 109C (payments: see [11 120]) or s 109D (loans: see [11 110]). Note that Subdiv E also includes rules dealing with interposed entity loan guarantee arrangements where: • a private company with distributable profits guarantees a loan with the intention or understanding (objectively viewed) that there will be a distribution to its shareholder (or associate via an interposed private company with nil or little distributable surplus (s 109U); or • a private company guarantees a loan made by an interposed entity (eg a bank) to the shareholder or associate and a liability to pay the interposed entity arises where the shareholder or associates defaults on the loan (s 109UA).

[11 510] Company payments and loans through interposed entities Where a private company makes a payment or loan to an entity that is interposed between the private company and a shareholder (or a shareholder’s 264

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 510]

associate), the payment or loan is treated as a deemed dividend of the shareholder or associate if (s 109T(1) of ITAA 1936): (a) it is reasonable to conclude that the payment or loan to the interposed entity is made solely or mainly as part of an ‘‘arrangement’’ involving a payment or loan to the shareholder or associate; and (b) the interposed entity, or a further interposed entity, lends or pays an amount to the shareholder or associate. Differences in the timing or amount of the payment or loan made by the private company to the interposed entity, and by the interposed entity to the shareholder/associate, do not prevent the application of Subdiv E (s 109T(2)). The fact that an arrangement may not have been entered into for the purpose of circumventing Div 7A does not prevent s 109T from applying: Determination TD 2012/12. However, evidence of a purpose or intent to avoid Div 7A may help establish that the distribution to the interposed entity was part of an arrangement involving a payment or loan to the target entity: Determination TD 2011/16. In Taxpayer Alert TA 2010/6, the Commissioner warns taxpayers about arrangements where a private company invests in an unrelated trust and the trustee then lends funds to a shareholder or shareholder’s associate. In these circumstances, Subdiv E may apply to give rise to a deemed dividend. In Re NR Allsopp Holdings Pty Ltd and FCT [2015] AATA 654, the AAT found that payments and loans from a private company to a partnership were deemed dividends under the interposed entity rules because a reasonable person would conclude that they were mainly part of an arrangement (over several years) whereby the partnership (as interposed entity) also made loans to a related trust (the target entity). See also Taxpayer Alert 2015/4. Where the payment or loan to the interposed entity is already dealt with under Div 7A (ie it is treated as a deemed dividend of the interposed entity under the general provisions in s 109C, 109D or 109F), Subdiv E does not apply (s 109T(3)). For example, if an amount is paid or lent to a shareholder or associate through a trustee that is an associate of the paying company, the amount would be a deemed dividend to the trustee in its own right and the tracing rules do not apply. EXAMPLE A private company makes a $30,000 loan to a family trust. The trust then pays $20,000 to Beatrice, who is a shareholder in the company and a beneficiary of the trust.

As the family trust is Beatrice’s associate for Div 7A purposes, the $30,000 loan from the private company to the trust is a deemed dividend under the general rules (s 109D). This means that the $20,000 payment to Beatrice is not subject to Div 7A.

2016 THOMSON REUTERS

265

[11 520]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

Where the shareholder or associate makes a repayment on the loan from the interposed entity, the shareholder is taken to have paid a proportion of the notional loan from the private company. If the loan between the interposed entity and shareholder/associate is on acceptable commercial terms (which satisfies s 109N: see [11 220]), the notional loan will be an excluded loan (s 109X(3)). Section 109X(4) then treats the notional loan from the private company to the target entity as an amalgamated loan. There should be no Div 7A consequences in the subsequent income years should the minimum yearly repayments be made.

[11 520] Trustee payments and loans through interposed entities Subdivision EB of Div 7A of Pt III of ITAA 1936 deals with payments and loans made by trustees through interposed entities, and entitlements through interposed trusts. The purpose of Subdiv EB is to ensure that the unpaid present entitlement (UPE) rules in Subdiv EA are not circumvented where a private company beneficiary has a UPE to an amount from the net income of a trust estate, and an entity is interposed between the trust and the company’s shareholder (or shareholder’s associate). Subdivision EB applies where (ss 109XF and 109XG): (a) it is reasonable to conclude that the payment or loan from the trustee to a interposed entity was made solely or mainly as part of an arrangement involving a payment or loan to the shareholder/associate; and (b) the interposed entity, or another interposed entity, makes a payment or loan to the shareholder/associate. Any differences in the timing or amount of the loan or payment made by the trustee to the interposed entity, and by the interposed entity to the shareholder/ associate, are ignored. Where Subdiv EB applies, the trustee is treated as having directly made the payment or loan to the shareholder/associate, with Subdiv EA then operating to determine whether the payment or loan is assessable to the shareholder/ associate as a deemed dividend. The Commissioner determines the value of the payment or loan made by a trustee through an interposed entity. The value cannot exceed the private company’s UPE. The time of the loan or payment is when the loan or payment is made by the interposed entity to the shareholder/associate. This is regardless of the timing of the actual payment or loan made by the trustee to the interposed entity. The operation of Subdiv EA can be avoided by fully repaying the amount or putting it on a commercial footing in accordance with s 109N (see [11 200]). If the shareholder/associate makes a repayment on the actual loan from the interposed entity, this is treated as a repayment of the deemed loan from the trustee. For the purposes of putting the deemed loan on a commercial footing (in accordance with s 109N), the written agreement under which the actual loan is made can be treated as the agreement under which the deemed loan is made (s 109XG(5)). 266

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 600]

Unpaid present entitlement through interposed trusts Subdivision EB also deems a private company to be presently entitled to an amount from the net income of a trust in certain circumstances involving interposed trusts, namely where (s 109XI(1)): (a) the company is or becomes presently entitled to an amount from the net income of a trust that is interposed between the target trust and the company; (b) it is reasonable to conclude (having regard to all the circumstances) that the present entitlement to the net income of the interposed trust arises or will arise solely or mainly as part of an arrangement involving an entitlement to an amount from the target trust; and (c) the interposed trust, or a further interposed trust, is or becomes presently entitled to an amount from the net income of the target trust. Any differences in the timing or amount of the present entitlements are ignored (s 109XI(2)). Where the requirements of s 109XI are satisfied, the company is deemed to be entitled to an amount from the net income of the trust that actually makes the payment, loan or forgiveness (with Subdiv EA then operating as if the company has that entitlement). However, the private company is not deemed to be presently entitled to an amount already assessed to a shareholder/associate under Subdiv EA (s 109XI(3)). As with payments and loans to target entities, the Commissioner determines the amount of the company’s deemed present entitlement. EXAMPLE A private company has a UPE of $5,000 from the net income of the Trust 1. Trust 1 has a UPE of $5,000 from the net income of the Trust 2. A shareholder in the private company receives a $1,000 payment from Trust 1. This amount is included in the shareholder’s assessable income under s 109XA. The shareholder also receives a payment from Trust 2, which is attributable to an unrealised gain. Applying s 109XI, the company is taken to be presently entitled to $4,000 from Trust 2 (ie the $5,000 UPE from Trust 1, minus the $1,000 payment assessed to the shareholder).

CONSEQUENCES OF DIV 7A APPLYING [11 600] Consequences of deeming a dividend The general effect of Div 7A of Pt III of ITAA 1936 applying is that: (a) the private company is deemed to have paid an assessable dividend out of the company’s profits; (b) the deemed dividend is unfranked, unless it has arisen from a family law obligation or the Commissioner exercises a discretion to allow the deemed dividend to be franked; and 2016 THOMSON REUTERS

267

[11 610]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

(c) the deemed dividend is treated as having been paid to the recipient entity as a shareholder in the private company. This characteristic applies even if the entity is a former shareholder, or an associate or former associate of a shareholder. The deemed dividend is paid on the last day of the income year in which the relevant transaction occurred (ie the year in which the payment or loan was made, the minimum repayment was required or the debt was forgiven). The amount of the deemed dividend is the amount paid, the unpaid loan balance, the repayment shortfall or the amount forgiven, but subject to the private company’s distributable surplus for the income year (see [11 610]). This amount is included in the assessable income of the shareholder or associate for the income year in which the relevant transaction occurs. An entity can object to an assessment based on the operation of Div 7A, including on the ground that the Commissioner’s discretion was not properly exercised (PS LA 2011/29; Re Building Company Owner and FCT [2012] AATA 755; 91 ATR 186). A four-year amendment period applies to the shareholder/associate if the private company or trust has a four-year amendment period.

[11 610] Assessable amounts limited to distributable surplus The amount of all deemed dividends paid by a private company in an income year is limited to the private company’s distributable surplus for that year (s 109Y(1) of ITAA 1936). If a private company has no distributable surplus in an income year, the amount of any deemed dividend for that income year is nil. The distributable surplus is the company’s realised and unrealised accumulated profits, calculated using the formula in s 109Y(2). The distributable surplus is ascertained at the end of the income year, not at the time when the payment, loan, shortfall or debt forgiveness transaction occurs. Where a private company is deemed to have paid more than one Div 7A deemed dividend for an income year, the sum of which exceeds the company’s distributable surplus for the year, the amount of each deemed dividend is proportionately reduced (s 109Y(3)).

Distributable surplus formula The distributable surplus for an income year is calculated as follows (s 109Y(2)): Net assets plus Div 7A amounts Less: Paid-up share value Less: Non-commercial loans Less: Repayments of non-commercial loans

Each component of the distributable surplus is defined in s 109Y(2).

268

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 610] Net assets

The calculation of a private company’s distributable surplus starts with a determination of its net assets. ‘‘Net assets’’ is the amount (if any) by which the company’s assets exceed the sum of: (a) the present legal obligations of the company to persons other than the company; and (b) provisions (as shown in the company’s accounting records) for depreciation, annual leave, long service leave, and amortisation of intellectual property and trademarks. The company’s net assets are determined as at the end of the company’s income year, in accordance with its accounting records. It follows that off-balance sheet assets, such as internally generated goodwill, are disregarded. The debtors of a private company, as recorded in invoices, cashbooks and accounting software, are included in the company’s assets if the company accounts on a cash basis: ATO ID 2003/731.

WARNING! The Commissioner has the power to revalue assets if the company’s accounting records significantly undervalue or overvalue its assets, or undervalue or overvalue its provisions.

In Re Kocic and FCT [2011] AATA 47; 82 ATR 211, the AAT determined that a company’s distributable surplus should be reduced by cash wages paid to staff, as evidenced in an incomplete, handwritten book of accounts. However, the Commissioner correctly added back undisclosed cash sales of the company for the purpose of determining its net assets. A company’s net assets are reduced by the amount of its ‘‘present legal obligations’’. Present legal obligations include: • a present obligation of a legal nature under AASB accounting standards (eg a trade invoice which has been rendered but is not yet payable, or a dividend that has been declared but not yet paid): Determination TD 2007/28; • the obligation to pay income tax at the end of the income year in respect of which the income is derived (at an amount subsequently properly assessed): FCT v H [2010] FCAFC 128; 85 ATR 357. An amended assessment is a present legal obligation of the year to which it relates, rather than the year in which it is made: Determination TD 2012/10; and • general interest charge and shortfall interest charge liabilities, which are present legal obligations on each day on which tax that should have been paid remains unpaid. To the extent that PAYG instalments remain unpaid and amounts payable under an assessment or amended assessment remain payable at the end of a subsequent income year, they are present legal obligations at the end of that later income year: Determination TD 2012/10. 2016 THOMSON REUTERS

269

[11 610]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

For a full self-assessment taxpayer, any amount due and payable under a deemed assessment is a present legal obligation for the income year to which the deemed assessment relates. Before the Full Federal Court decision in FCT v H, the Commissioner’s view was that a present legal obligation to pay income tax does not arise until an assessment has been issued in respect of the relevant amount: see Determination TD 2008/28 (withdrawn). In particular, the Commissioner treated the amount of a PAYG instalment remaining unpaid at year end as a present legal obligation, but not the difference between the PAYG instalments paid and the self assessed amount of tax for an income year, or amounts payable under an amended assessment. A shortfall penalty does not become a present legal obligation until it has been quantified and notified to the taxpayer: Re Waffles & Anor and FCT [2010] AATA 78; 75 ATR 376. Prior to quantification, the amount of penalty cannot be objectively determined in the same way that the amount of income tax payable is, because shortfall penalties are subject to various contingencies (eg voluntary disclosures and the Commissioner’s power to remit the penalty). Division 7A amounts

“Division 7A amounts” means the total of any payments (under s 109C) or forgiven debts (under s 109F) deemed to have paid as dividends in the income year. The purpose of this component is to capture amounts paid out by the private company before the end of the income year (eg property transferred to a shareholder/associate during the income year). Paid-up share value

‘‘Paid-up share value’’ is the amount paid up on the company’s shares, plus the balance of the share premium account, as at the end of the company’s income year. Non-commercial loans

‘‘Non-commercial loans’’ means the total of: • loans remaining outstanding in the company’s accounting records at the end of the income year, which were deemed dividends in earlier income years under s 109D (loans), s 109E (amalgamated loans) or former s 108 (the predecessor to Div 7A); and • any trust amounts treated as dividends in prior income years under Subdiv EA (reduced by the unfranked parts of any later dividends set off under s 109ZCA). This means that the amount deducted is not the sum of the non-commercial loans shown in the accounting records, but the total of the amounts taken to have been paid as a dividend. Repayments of non-commercial loans

‘‘Repayments of non-commercial loans’’ means the sum of: • repayments made to the private company of loans or amounts that have been taken by s 109D, s 109E or former s 108 to be dividends; and 270

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 630]

• any amounts set off against such loans, other than amounts set off because of subsequent dividends being paid (but only to the extent unfranked), or a loan, or part of a loan, being forgiven.

[11 620] Commissioner’s discretion and Div 7A The Commissioner has a general discretion to disregard a Div 7A deemed dividend, or to allow the dividend to be franked, if the dividend has arisen due to an honest mistake or inadvertent omission (s 109RB of ITAA 1936): see [11 630]. The Commissioner is also provided with the following specific discretions to disregard, or otherwise negate, the effect of Div 7A: • allow a deemed dividend to be franked if it arises because of a family law obligation (s 109RC); • disregard a deemed dividend arising under s 109E (amalgamated loans) where there is ‘‘undue hardship’’ (s 109Q); • extend the period to repay an amalgamated loan, if the failure to make the minimum yearly repayment is due to circumstances beyond the control of the shareholder/associate (s 109RD); • disregard a deemed dividend arising under s 109UA (liabilities under guarantees) in ‘‘undue hardship’’ cases (s 109UA(3)).

Applying for the exercise of the Commissioner’s discretion An entity should apply to the Tax Office in writing for the exercise of the Commissioner’s discretion. There is no prescribed or standard application form, but the entity should include all the information necessary for the Commissioner to make a decision. For example, if applying for the Commissioner to exercise the general discretion under s 109RB, the application should set out: (a) sufficient information to demonstrate to the Commissioner that the failure to comply with Div 7A was the result of an honest mistake or inadvertent omission; (b) details of when and how the entity tried to rectify the mistake or omission; and (c) details of any previous applications of Div 7A. Where the entity was mistaken about the effect of particular Div 7A provisions (eg concerning unpaid present entitlements), evidence demonstrating that the mistake was of a type that was commonly made at the time, having regard to the prevailing understanding and interpretation of the provision among the tax profession, should be provided. For this purpose, the entity may need to refer to tax publications or expert commentary which is consistent with the approach taken (Practice Statement PS LA 2011/29, para 50).

[11 630] Disregarding Div 7A for honest mistakes and inadvertent omissions The Commissioner may exercise the general discretion to disregard a Div 7A deemed dividend, or allow it to be franked, if the dividend has arisen because of an honest mistake or inadvertent omission by any of the following entities (s 109RB(1)(b) of ITAA 1936): 2016 THOMSON REUTERS

271

[11 630]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

• the recipient entity (ie the shareholder or shareholder’s associate); • the private company; • any other entity whose conduct contributed to the deemed dividend (eg an interposed trust or a professional adviser: see Ruling TR 2010/8). If the discretion is exercised, the Commissioner will usually impose certain conditions, like requiring the recipient to make specified payments to the private company or another entity within a specified time. These conditions give taxpayers the opportunity to take corrective action to put them in the same position as if Div 7A had been complied with (eg by putting loan documentation in place). If a condition is not satisfied, the Commissioner’s decision to disregard the operation of Div 7A will be reversed (s 109RB(5)).

Honest mistakes and inadvertent omissions The expression ‘‘honest mistake or inadvertent omission’’ is not defined in Div 7A. It is an objective question to be determined by reference to all the relevant facts and circumstances. The Commissioner’s view (in Ruling TR 2010/8) is that the honest mistake or inadvertent omission must relate to the operation of Div 7A and facts relevant to Div 7A. In the Commissioner’s opinion, a mistake or omission about a particular matter that is subsequent to, or otherwise irrelevant to the particular result of, the operation of Div 7A is irrelevant. The mistakes or omissions that may be relevant for the purposes of the Commissioner’s discretion, provided they are considered to be honest or inadvertent, include: • failing to put a written loan agreement in place within the specified time (eg before the trust’s lodgment date for the income year); • mistakenly believing that written loan documentation is not necessary because the interest charged is commercial in nature; • miscalculating the minimum yearly repayment on an amalgamated loan; • incorrectly specifying the interest rate payable on an amalgamated loan; • restructuring group affairs, resulting in the private company making a loan to a trust which is associated with shareholders in the private company; • misinterpreting or ignoring a provision of Div 7A or its interaction with another area of law, unless there is ‘‘deliberate’’ behaviour to remain ignorant up to the time when Div 7A is triggered, and the taxpayer is (or is made) aware of the provision before that time. Practice Statement PS LA 2011/29 emphasises that ignorance of Div 7A is not in itself a mistake or omission, but can be the reason for the mistake or omission. The Explanatory Memorandum to the Tax Laws Amendment (2007 Measures No 3) Act 2007 (which introduced s 109RB) includes an example of a private company making funds available to an associated trust for use as working capital, mistakenly believing that only loans to individual shareholders are caught by Div 7A. Note, however, that the Commissioner’s view on loans to trusts in Ruling TR 2010/3 has received extensive publicity since December 2009. The fact that a mistake or omission recurs does not automatically disqualify a taxpayer from satisfying the ‘‘honest mistake or inadvertent omission’’ 272

2016 THOMSON REUTERS

TRUSTS AND DEEMED DIVIDENDS – DIV 7A [11 630]

requirement. The Tax Office examines each mistake or omission separately. However, if Div 7A previously applied to any of the entities involved in similar facts and circumstances, then it is less likely that the recurring mistake or omission will be treated as honest or inadvertent.

Matters relevant to exercise of s 109RB discretion The making of an honest mistake or inadvertent omission does not automatically give rise to the exercise of the Commissioner’s discretion under s 109RB – it is merely a threshold test. The Commissioner must then have regard to a number of additional factors in deciding whether to exercise the discretion in favour of the taxpayer. Those factors are (s 109RB(3)): • the circumstances that led to the mistake or omission; • the extent to which the recipient, the private company or any other entity that contributed to the deemed dividend took any corrective action and, if so, how quickly that action was taken; • whether Div 7A operated previously in relation to the recipient, the private company, or any other entity that contributed to the deemed dividend and if so, the circumstances in which this occurred; and • any other matters that the Commissioner considers relevant. Practice Statement PS LA 2011/29 instructs Tax Office staff to have regard to a number of factors, including: • the nature of the transactions and the conduct of all entities involved (ie not just the recipient and private company); • the knowledge and experience of the parties; • any evidence of attempts to comply with Div 7A; • the recording of transactions and accounting systems in place; • the complexity of the relevant Div 7A provisions, including the availability of guidance material containing an ATO view and whether it was reasonable for the parties to obtain professional tax advice but failed to do so.

Extent to which corrective action is taken Sufficient action to correct a mistake or omission may include: • where the mistake was a failure to enter into a Div 7A compliant loan agreement – entering into a loan agreement which satisfies the requirements of s 109N; • where the mistake was a failure to pay the full amount of the minimum yearly repayment – repaying the outstanding amount, and ensuring the correct amount is repaid in the future. Corrective action taken before any audit activity weighs more favourably than corrective action taken following an ATO audit. However, if the taxpayer was unaware of the breach until after the audit commenced, prompt corrective action is more likely to be viewed favourably (PS LA 2011/29).

Previous breaches of Div 7A A previous breach of Div 7A weighs against the exercise of the Commissioner’s discretion, unless there has been a major change in the provisions of Div 7A. For example, a taxpayer who has been assessed under 2016 THOMSON REUTERS

273

[11 630]

TRUSTS AND DEEMED DIVIDENDS – DIV 7A

Div 7A in previous income years is expected to show greater vigilance in relation to Div 7A generally. If the current breach arises in substantially the same circumstances as previous breaches, greater weight is placed on this factor.

Any other relevant matters Practice Statement PS LA 2011/29 indicates that the scope of ‘‘any other matters’’ in s 109RB(3)(d) is very wide ranging, although regard must be had to the purpose of Div 7A as an integrity measure. According to the Tax Office, relevant matters are those which ‘‘shed light’’ on whether the mistake or omission ‘‘deserves’’ the exercise of the Commissioner’s discretion (eg unforeseen circumstances like a party’s sudden illness or a good compliance history). For example, if Div 7A is triggered by an honest mistake, but the taxpayer or tax agent turns a blind eye to it after discovering the breach, such conduct weighs against exercising the discretion. The Practice Statement adds that the longer the period of inaction without a satisfactory explanation, the greater the weight that is given to the inaction. The application of the s 109RB discretion was considered in Re Building Company Owner and FCT [2012] AATA 755; 91 ATR 186, where the AAT treated as relevant the extent and timing of loan repayments. In that case, this factor weighed in favour of exercising the discretion because, although no one seemed to know at any one time how much of the loans had been paid off, the evidence showed that the minimum annual repayments were being made.

274

2016 THOMSON REUTERS

CLOSELY HELD TRUSTS

12

CONCEPT OF CLOSELY HELD TRUST What is a closely held trust? ................................................................... [12 000]

REPORTING RULES FOR CLOSELY HELD TRUSTS WITH TRUSTEE BENEFICIARIES Trustee beneficiary reporting rules ........................................................ [12 100] Trustee beneficiary non-disclosure tax .................................................. [12 110]

TFN WITHHOLDING RULES FOR CLOSELY HELD TRUSTS Tax file number withholding arrangements ......................................... [12 200] TFN withholding events .......................................................................... [12 210] Trustee’s reporting and payment obligations ...................................... [12 220]

CONCEPT OF CLOSELY HELD TRUST

[12 000] What is a closely held trust? A ‘‘closely held trust’’ is purely a tax concept and is defined in the trustee beneficiary reporting rules as (s 102UC of ITAA 1936): (1) a discretionary trust (including a hybrid trust where some entitlements are fixed); or (2) a fixed trust where up to 20 individuals have between them fixed entitlements to 75% or more of the income or capital of the trust. In the case of a fixed trust, an individual and all of his or her relatives and nominees are counted as a single individual (s 102UC(3)). The trustee of a discretionary trust is also treated as an individual, provided the trustee holds a fixed entitlement to a share of the income or capital of a trust and no person holds that fixed entitlement directly or indirectly through the discretionary trust (s 102UC(2)). A trust which qualifies as a closely held trust may be subject to the trustee beneficiary reporting rules (see [12 100]) and tax file number withholding arrangements (see [12 200]). The purpose of these rules is to allow the Tax Office to check whether a beneficiary’s share of the net income of a closely held trust has been correctly included in the beneficiary’s income tax return. 2016 THOMSON REUTERS

275

[12 100]

CLOSELY HELD TRUSTS

REPORTING RULES FOR CLOSELY HELD TRUSTS WITH TRUSTEE BENEFICIARIES [12 100] Trustee beneficiary reporting rules The trustee beneficiary reporting rules apply where a beneficiary of a closely held trust is a beneficiary in the capacity of the trustee of another trust (a ‘‘trustee beneficiary’’) (Div 6D of Pt III of ITAA 1936). The trustee of the closely held trust must supply the Commissioner with information about each trustee beneficiary who is entitled to a share of the trust’s net income or tax-preferred amounts in a Trustee Beneficiary Statement (TB Statement) (s 102UA). This information can be lodged as part of the trust tax return, by completing the required information in the statement of distribution. A tax-preferred amount is income of the trust that is not included in its ‘‘assessable income’’ in working out the net income or capital of the trust (s 102UI). The TB Statement must be lodged by the due date for lodging the trust’s tax return (or any later time allowed by the Commissioner). An extension of time may be granted if the trustee is unable to obtain the required information from a third party by the due date. Various trusts are excluded from these particular reporting requirements. Excluded trusts include trusts which are covered by a family trust election or an interposed entity election and trusts owned by the family group of the individual specified in the family trust election (see [7 100] and following).

TIP

The trust of a deceased estate is excluded from the reporting rules until the end of the income year in which the fifth anniversary of the death occurs.

[12 110] Trustee beneficiary non-disclosure tax In relation to a share of the net income for which there is no correct TB Statement, a liability to trustee beneficiary non-disclosure tax arises (s 102UK of ITAA 1936). The tax is imposed on the trustee (and its directors in the case of a corporate trustee). A director may be excused from liability in certain circumstances (s 102UL). Generally this will only occur if the director was unaware of the decision to make an incorrect statement and that director took reasonable steps to ensure that a correct TB Statement would be made. The trustee may be able to recover the tax from a trustee beneficiary who refused or failed to give information or gave incorrect information (s 102USA). Trustee beneficiary non-disclosure tax is imposed at the top marginal rate plus Medicare levy (49% for 2015-16).

276

2016 THOMSON REUTERS

CLOSELY HELD TRUSTS [12 200]

EXAMPLE A trustee beneficiary is presently entitled to 50% of the income of a closely held trust. For the relevant income year, the net income of the trust is $20,000. The trustee of the closely held trust fails to make a correct TB Statement about the trustee beneficiary’s share of the net income. As a result, the trustee of the closely held trust is liable to trustee beneficiary non-disclosure tax on that share of the net income (ie $10,000).

TFN WITHHOLDING RULES FOR CLOSELY HELD TRUSTS [12 200] Tax file number withholding arrangements Tax file number (TFN) withholding arrangements apply to closely held resident trusts, including trusts which have made a family trust election or an interposed entity election (Div 4B of Pt VA of ITAA 1936; ss 12-175 to 12-185 of Sch 1 to TAA). Under these provisions, beneficiaries of a closely held trust are encouraged to quote their TFN to the trustee (s 202DO of ITAA 1936). While it is not compulsory to do so, the failure to give the trustee a TFN may result in the trustee being required to withhold an amount from an income distribution or share of net income of the trust: see [12 210]. A trustee’s TFN withholding obligations generally apply in relation to all resident beneficiaries of closely held trusts, including individuals and corporate beneficiaries, but not tax-exempt entities or persons under a legal disability (eg minors). Beneficiaries who quote their TFN to the trustee need to do so in a manner approved by the Commissioner. The quotation need not be made personally – a person acting on the beneficiary’s behalf can advise the trustee of the beneficiary’s TFN. The Tax Office document TFN withholding for closely held trusts (May 2016) provides that the TFN can be quoted verbally or in writing (including electronically). The beneficiary’s full name, date of birth (individuals only), postal and residential addresses and ABN (non-individuals only) must also be provided. EXAMPLE Nicola and Tom are presently entitled beneficiaries of a closely held trust. On 28 June, the trustee emails both beneficiaries and asks them to provide their TFN. Tom calls the trustee on 29 June and quotes his TFN (and other relevant information) over the phone. Nicola responds to the email on 30 June, providing her TFN and other information electronically. Both beneficiaries have quoted their TFNs in a manner approved by the Commissioner. The trustee does not have a TFN withholding obligation in relation to either beneficiary.

2016 THOMSON REUTERS

277

[12 210]

CLOSELY HELD TRUSTS

Trusts excluded from TFN withholding rules The TFN withholding rules for closely held trusts do not apply to: • trusts of deceased estates (but only for the first five years after the individual’s death); • non-resident trust estates; • employee share trusts; • complying superannuation funds, complying approved deposit funds and pooled superannuation trusts; • unit trusts where exempt entities have fixed entitlements (directly or indirectly) to all of the income and capital of the trust; • unit trusts where the units are listed on the Australian Stock Exchange; • discretionary mutual funds; • funds providing lawyers with professional indemnity insurance or insurance-like cover; and • law practice trusts.

[12 210] TFN withholding events The trustee of a closely held trust (including a family or related trust) has a TFN withholding obligation in two situations: 1. Trust distribution – the trustee makes a distribution from trust income but the recipient beneficiary has not quoted a TFN to the trustee by the time the distribution is made. The trustee is required to withhold an amount from the distribution (s 12-175 of Sch 1 to TAA). 2. Present entitlement – a beneficiary is presently entitled to trust income but has failed to quote a TFN to the trustee by the end of the income year. The trustee is required to withhold an amount from the beneficiary’s share of the net income of the trust (s 12-180). The trustee must withhold the amounts at the top marginal rate plus Medicare levy (49% for 2015-16). The beneficiary can then claim, via the income tax return, a credit equal to the amount withheld.

WARNING! It is common for beneficiaries to be unaware of their present entitlement until the following income year (ie after the withholding event). The unfairness of this situation was raised during the consultation process on the design of the TFN withholding rules. However, as no amendments were made to address this issue (and s 12-180 is silent on the matter), it would appear that a beneficiary’s lack of knowledge about an entitlement to trust income does not prevent the imposition of withholding tax.

278

2016 THOMSON REUTERS

CLOSELY HELD TRUSTS [12 220]

EXAMPLE Sara, an age pensioner, and Bob, her 16 year old grandson, are presently entitled to the income of a discretionary trust. Both beneficiaries are unaware of their present entitlement by 30 June and have not provided their TFN to the trustee. As an age pensioner, Sara is specifically excluded from various TFN withholding rules. However, she does not come within one of the classes of excluded beneficiaries in the rules for closely held trusts. Accordingly, the trustee is required to withhold an amount from Sara’s share of the net income of the trust. It is irrelevant that Sara learns of her present entitlement after year end. In her tax return, Sara will need to claim a credit for the amount withheld. The trustee does not have a withholding obligation in relation to Bob because he is an excluded beneficiary (ie he is under a legal disability).

[12 220] Trustee’s reporting and payment obligations The trustee must be registered for PAYG withholding and report and remit amounts withheld on an annual basis. The trustee must lodge an annual TFN withholding report if amounts have been withheld from payments made to beneficiaries who have not quoted their TFN. The report is due within three months after year end (30 September). The amounts withheld must be remitted by 28 October. The trustee has the following additional reporting obligations in relation to withheld amounts and beneficiaries’ TFNs: (a) the trustee must report on an annual basis amounts distributed to beneficiaries that would have been subject to TFN withholding had the relevant beneficiary failed to quote their TFN. This can be lodged as part of the trust tax return by completing the required information in the statement of distribution; (b) the trustee must give beneficiaries an annual payment summary within 14 days of the due date for lodging the TFN withholding report (ie 14 October); (c) any TFNs quoted by beneficiaries must be reported to the Commissioner on a quarterly basis (within one month after the end of the quarter in which the TFN is quoted). Administrative penalties may be imposed if the trustee fails to do any of the above. EXAMPLE George and Gigi are the beneficiaries of a discretionary trust. George quotes his TFN to the trustee on 30 August, while Gigi provides her TFN on 1 September. The trustee is required to lodge two TFN reports – one in respect of George for the September quarter and the other in respect of Gigi for the December quarter.

2016 THOMSON REUTERS

279

280

2016 THOMSON REUTERS

UNEARNED INCOME OF CHILDREN

13

APPLICATION OF DIV 6AA TO UNEARNED INCOME OF MINORS Outline of Div 6AA .................................................................................. [13 000] Classes of minors excluded from Div 6AA ......................................... [13 010] Tax rate under Div 6AA .......................................................................... [13 020]

APPLICATION OF DIV 6AA TO TRUSTS Trust income derived by minors ............................................................ [13 100] Excepted trust income resulting from death ........................................ [13 110] Excepted trust income: indirect receipts resulting from death ......... [13 120] Excepted trust income: damages ............................................................ [13 130] Excepted trust income: employment income ....................................... [13 140] Other excepted trust income ................................................................... [13 150] Anti-avoidance measures ......................................................................... [13 160]

CHILDREN’S BANK ACCOUNTS Bank account opened in name of minor .............................................. [13 200]

APPLICATION OF DIV 6AA TO UNEARNED INCOME OF MINORS [13 000] Outline of Div 6AA There are special tax rules (in Div 6AA of Pt III of ITAA 1936) to discourage adults splitting their income and diverting it to their children or grandchildren (aged under 18). Where these rules apply, diverted income over $416 is taxed at penalty rates: see [13 020]. This is often referred to as the ‘‘children’s tax’’ which applies to the ‘‘unearned income’’ of the child, whether derived directly or through a trust. Unearned income essentially covers passive income such as dividends, interest, royalties, rent and other income from property. Certain categories of income are excluded from the application of Div 6AA, including income from a job or business, income from a deceased estate and income derived from the investment of money received from certain legal or moral claims. A child under the age of 18 at the end of the relevant income year falls within the scope of Div 6AA unless he or she qualifies as an ‘‘excepted person’’: see [13 010]. 2016 THOMSON REUTERS

281

[13 010]

UNEARNED INCOME OF CHILDREN

All income derived by the beneficiary of a trust estate who is under 18 at the end of the income year and is not an excepted person is subject to Div 6AA, unless that income is ‘‘excepted trust income’’: see [13 100].

TIP

Exemptions from the children’s tax apply to income from: • testamentary trusts (see [13 110]); and • child maintenance trusts (see [13 150]). This gives rise to planning opportunities as the benefit of the normal full tax-free threshold is available so that (for 2015-16) $18,200 of income is tax-free and income above that level is taxed at normal marginal rates, not punitive Div 6AA rates.

For Div 6AA to apply, the income in question must belong to the child. The ownership of interest income accruing to children’s savings accounts is considered at [13 200].

[13 010] Classes of minors excluded from Div 6AA Division 6AA does not apply to income derived during an income year by a minor who is an ‘‘excepted person’’ in relation to that year. An ‘‘excepted person’’ is (s 102AC(2) of ITAA 1936): • a minor engaged in a full-time occupation on the last day of the income year (provided the Commissioner is satisfied the person intends to remain in full-time occupation for a substantial part of the following income year and does not intend to engage in full-time study); • a minor engaged in a full-time occupation for at least three months of the income year; • a minor to whom, or in respect of whom, a disability support pension, carer allowance or double orphan pension was payable under the Social Security Act 1991 in respect of a period that included the last day of the income year; • a minor who, under the Social Security Act 1991, is disabled, has a continuing inability to work or is permanently blind (a medical certificate to that effect must be provided to the Commissioner); • a minor who, because of a permanent disability, is unlikely to be able to engage in a full-time occupation (a medical certificate to that effect must be provided to the Commissioner); or • a minor who is the principal beneficiary of a special disability trust (see [1 160]).

[13 020] Tax rate under Div 6AA A flat tax rate equal to the highest individual marginal rate generally applies to the unearned income of a minor (47% for 2015-16). There is a nominal tax-free 282

2016 THOMSON REUTERS

UNEARNED INCOME OF CHILDREN

[13 110]

threshold ($416), with shading-in provisions applying to income marginally in excess of the tax-free threshold: see table 15.2 at [15 000].

WARNING! The low-income tax offset does not reduce the tax payable on Div 6AA unearned income.

Where the minor also has assessable income outside the scope of Div 6AA, that income is taxed at normal rates (and the low-income tax offset is available). EXAMPLE Stella is 16 years old. In the 2015-16 income year, she receives $1,500 unearned income and $19,000 wages from part-time employment. Stella cannot use the low-income tax offset to reduce the tax on her unearned income. However, the offset is available to reduce the tax on her employment income to zero. Stella’s Div 6AA income of $1,500 is taxed at 47%. Her income tax liability is therefore $705.

APPLICATION OF DIV 6AA TO TRUSTS [13 100] Trust income derived by minors Division 6AA is relevant where trust income is derived by a minor, other than a minor who is an ‘‘excepted person’’: see [13 010]. Where the unearned income of the child is derived through a trust, the trustee is liable to pay tax on that income on behalf of the beneficiary at Div 6AA rates. If the child is a beneficiary of more than one trust, he or she is also taxed directly on the income at the top marginal tax rate but is entitled to an offset for any taxes paid on his/her behalf by the trustee (s 100 of ITAA 1936). Certain types of trust income (‘‘excepted trust income’’) are excluded from Div 6AA and these are outlined at [13 110] to [13 150]. Division 6AA includes anti-avoidance rules to ensure its operation is not circumvented: see [13 160].

[13 110] Excepted trust income resulting from death An exemption from Div 6AA applies to so much of the share of a child beneficiary’s income from assessable income of the trust estate that resulted from a will or intestacy (s 102AG(2)(a) of ITAA 1936). Such income is treated as excepted trust income. As this exemption only requires that the income arise from a will or intestacy, it applies not only to income from assets that originally formed part of 2016 THOMSON REUTERS

283

[13 120]

UNEARNED INCOME OF CHILDREN

the trust estate, but also to income from assets acquired by the trustee after the commencement of the trust (Trustee for the Estate of the late A W Furse No 5 Will Trust v FCT [1990] FCA 470; 21 ATR 1123). Income derived from property held by a trustee that was received through the death of a person other than under a will or the rules of intestacy will qualify as excepted trust income in certain circumstances. This applies if the property has been received from a life insurance policy, the proceeds of a provident, benefit, superannuation or retirement fund, a payment by the employer of a deceased person to a trust for the benefit of the beneficiary and/or a pension from a superannuation or provident fund (s 102AG(2)(c)(iv)-(vi)). Under the terms of the trust, the minor must acquire the relevant trust property in her or his own right when the trust ends (s 102AG(2A)). In ATO ID 2004/264, a trust was created for the benefit of the young children of a deceased parent. The proceeds of a life insurance policy were paid into the trust as a result of the parent’s death. Under the terms of the trust deed, each beneficiary would only be entitled to a proportional interest in the trust fund upon turning 18. The Tax Office decided that the exception in s 102AG(2A) did not apply to trust income derived from the life insurance policy because a child’s proportional interest in the trust fund would devolve to another beneficiary if the child died before the age of 18.

[13 120] Excepted trust income: indirect receipts resulting from death An exemption from Div 6AA applies to investment income derived through an inter vivos trust from property which had its origin in a deceased estate. The exemption is available in the following two situations (s 102AG(2)(d)(i) and (ii) of ITAA 1936): (1) where income is derived by the trustee of an inter vivos trust from the investment of property which devolved for the benefit of the child beneficiary from a deceased estate; and (2) where income is derived by the trustee of an inter vivos trust from the investment of property that was transferred to the trustee for the benefit of the beneficiary out of property that devolved on that other person from a deceased estate and the transfer took place within three years of the date of death of the deceased. The second provision provides a three-year window in which the beneficiary under the will of a deceased estate may transfer property to a trust that can attract the same concessional treatment as a testamentary trust. There are however the following limitations: • the exemption only applies to the amount of the income which, in the opinion of the Commissioner, the child would have received from assets had the deceased person died intestate (s 102AG(7)). Any income in excess of that amount is subject to Div 6AA; and • the beneficiary must be entitled to acquire the property under the terms of the trust (s 102AG(2A)).

284

2016 THOMSON REUTERS

UNEARNED INCOME OF CHILDREN

[13 150]

[13 130] Excepted trust income: damages Income from property received by the trustee in satisfaction of a damages claim for loss of parental support or a claim for personal injury, disease or impairment of the beneficiary’s physical or mental condition is excepted trust income excluded from Div 6AA (s 102AG(2)(c)(i) of ITAA 1936). Where the property is transferred other than under a court order, the Commissioner can apply ordinary marginal rates of tax to so much of the income as is considered fair and reasonable. Income from property received as a result of actions under workers’ compensation law or criminal injuries compensation law is also excepted trust income (s 102AG(2)(c)(ii), (iii)). To qualify as excepted trust income in these situations, under the terms of the trust, the child beneficiary must acquire the trust property when the trust ends (s 102AG(2A)).

[13 140] Excepted trust income: employment income Employment income qualifies as excepted trust income (s 102AG(2)(b) of ITAA 1936). Employment income is defined as salary or wages (within the definition in s 221A) and payments for services rendered or to be rendered. The latter payments will not be taken to be employment income unless the services are rendered or to be rendered by the beneficiary (s 102AG(5A)). If the child is engaged in full-time employment on the last day of the income year, the child qualifies as an excepted person (see [13 010]) and Div 6AA has no application.

[13 150] Other excepted trust income ‘‘Excepted trust income’’ includes assessable income derived from a variety of sources if property has been settled for the benefit of the beneficiary and income is distributed from such property by the intervention of third parties or in circumstances beyond the control of the beneficiary and persons related to the beneficiary (s 102AG(2)(c)-(e) of ITAA 1936). Examples of this are: (a) distributions from public funds established for the benefit of persons in necessitous circumstances and maintained exclusively for that purpose; (b) income derived from the investment of property held as a result of winnings in a legally authorised and conducted lottery if the beneficiary was the beneficial owner of the prize; and (c) income derived from the investment of property transferred to the trustee for the benefit of the beneficiary as a result of ‘‘family breakdown’’. (That term is widely defined in s 102AGA.) In relation to (a) and (c), under the terms of the trust, the minor must acquire the relevant trust property in her or his own right when the trust ends (s 102AG(2A)).

2016 THOMSON REUTERS

285

[13 160]

UNEARNED INCOME OF CHILDREN

CHILD MAINTENANCE TRUSTS The Tax Office takes the view in Taxation Ruling TR 98/4 that income derived from the investment of property transferred to a child maintenance trust (see [1 150]) for the benefit of the child as a result of family breakdown is excepted trust income under Div 6AA unless any of the following situations apply: • property is not transferred beneficially to the child; • the income is not derived from the investment of the property; • property has not been transferred beneficially to the child as a result of family breakdown; • the income derived from the trust exceeds an arm’s length return on the investment; or • income is derived as a result of an agreement entered into by the parent to ensure that otherwise assessable income will become excepted trust income.

Accumulations of income If income is derived by a trustee from property which represents an accumulation of past income, that income is treated as excepted trust income provided the accumulation is of (s 102AG(2)(e)): (a) income that, in relation to the beneficiary concerned, was excepted trust income; (b) income that, if accumulated before 1 July 1979, would have been excepted trust income if Div 6AA had been operative; and (c) exempt income that would have qualified under (a) and (b) above.

[13 160] Anti-avoidance measures As an anti-avoidance measure, if any persons connected with the derivation of trust income otherwise excluded from Div 6AA are not dealing at arm’s length, then the amount of trust income treated as excepted trust income is limited to the arm’s length amount (s 102AG(3) of ITAA 1936). In addition, assessable income derived by a trustee as a result of an agreement entered into and carried out for the purpose of deriving excepted trust income is excluded from the definition of “excepted trust income” (s 102AG(4)). EXAMPLE The trustee of a child maintenance trust borrows money from a company associated with the child’s mother at an interest rate of 1.5%, which the trustee on-lends to a third party at an interest rate of 5%. The interest earned by the trustee that is treated as excepted trust income is limited to the interest that would have been earned if the loan from the related company had been made on an arm’s length basis.

286

2016 THOMSON REUTERS

UNEARNED INCOME OF CHILDREN

[13 200]

Mere differences in interest rates on borrowings do not necessarily mean the parties to one of the transactions are not dealing at arm’s length, as the terms of the loans may vary (eg one loan may be at call and the other loan may be for a fixed period). In AAT Case 5515 (1989) 21 ATR 3065, a corporate trustee held 50% of the units in a unit trust as trustee for five family trusts established by the deceased’s will. The unit trust was the sole unit holder in a trading trust that provided services to a law firm. The corporate trustee was controlled by the deceased’s daughter and son-in-law and the unit trust was controlled by the son-in-law and another person, who were both partners in the law firm. The partners arranged the firm’s affairs to diminish its profitability, to the benefit of the family interests in the service trust. The AAT determined that the various parties were not dealing at arm’s length, with the result that distributions by the corporate trustee to the deceased’s grandchildren did not qualify as excepted trust income.

Discretionary trusts If a trustee has a discretion to distribute income to one or more beneficiaries (either specifically referred to or of a specified class), the property of the trust is deemed to have been transferred to the trust for the benefit of either the named beneficiary or the specified class (s 102AG(8) of ITAA 1936). This will apply if income is derived by the trustee in two forms: in a form that is subject to Div 6AA and in a form that qualifies as excepted trust income. A trustee may receive property as part of an inter vivos settlement and the income derived by that trust on distribution to minors will be subject to tax under Div 6AA. If subsequently property is settled on that trust by the will of a deceased person, the income derived from that property will be excepted trust income, provided it satisfies the requirements of s 102AG(2)(c). A distribution of the income to the beneficiary or beneficiaries will therefore include income both subject to and not subject to Div 6AA. If there is more than one beneficiary or if the trustee does not distribute the whole of the income, the allocation of the two classes of income is on a proportional basis.

CHILDREN’S BANK ACCOUNTS [13 200] Bank account opened in name of minor Taxation Ruling IT 2486 considers the ownership of interest income accruing to a bank account opened by a parent in the name of a child (a minor) and conducted by the parent, ie whether it belongs to the child or the parent (as trustee on behalf of the child). Where an account is made up of money from presents, pocket money or casual work performed by the child, the money will be regarded as belonging to the child. If any interest income is included in a tax return lodged by the child, the Tax Office does not require a trust tax return to be lodged by the parent. If, however, a parent provides the money and can spend it as he or she pleases, the parent will be assessed on the interest earned (even if the money is intended for the child’s benefit). 2016 THOMSON REUTERS

287

[13 200]

UNEARNED INCOME OF CHILDREN

Where a child’s account contains a large sum of money, the Tax Office will carefully examine the question of ownership.

288

2016 THOMSON REUTERS

PART 5 ADMINISTRATION 14 ADMINISTRATION, TAX RETURNS, TAX RATES 15 RATES OF TAX

2016 THOMSON REUTERS

289

290

2016 THOMSON REUTERS

ADMINISTRATION, TAX RETURNS, TAX RATES

14

ADMINISTRATIVE MATTERS AND TAX RETURNS Trust tax returns ........................................................................................ Trustee assessments .................................................................................. Time limits for amending assessments ................................................. Trustee’s liability to pay tax .................................................................... GST registration and ABN ...................................................................... Public officers ............................................................................................. Substituted accounting periods ..............................................................

[14 [14 [14 [14 [14 [14 [14

000] 010] 020] 030] 040] 050] 060]

TAX RATES Rates of tax applicable to income derived through trust structures ........................................................................................... [14 100] Rate of tax payable by beneficiaries ...................................................... [14 110] Rate of tax payable by trustee ................................................................ [14 120] Medicare levy ............................................................................................. [14 130] Tax offsets and rebates ............................................................................. [14 140] Worked example ........................................................................................ [14 150]

ADMINISTRATIVE MATTERS AND TAX RETURNS [14 000] Trust tax returns Although a trust is not a taxpayer as such, the Commissioner requires a trust tax return to be lodged each year for every trust. If a tax agent is not used, the trust tax return needs to be lodged by 31 October. Trustees of closely held trusts have additional reporting obligations: see [12 220]. The ATO’s High Wealth Individuals Taskforce may ask a trustee to complete an expanded trust tax return. Generally, a separate trust tax return is required for each trust in respect of which the trustee has a liability under s 98 of ITAA 1936: see [3 220]. Resident custodians who hold separate accounts for unrelated clients of a foreign global custodian can lodge a streamlined trust tax return in respect of the non-resident beneficiaries: see the ATO fact sheet Streamlined Trust Tax Return for Custodians with Non-resident Beneficiaries (May 2016). Public trading trusts (which are taxed like companies) lodge company tax returns. 2016 THOMSON REUTERS

291

[14 010]

ADMINISTRATION, TAX RETURNS, TAX RATES

[14 010] Trustee assessments The trust itself is not assessed to tax. Instead, the trustee is assessed on the net income of the trust in respect of which the trustee is liable to pay tax (in effect if a presently entitled beneficiary is under a legal disability or if no beneficiary is presently entitled: see [3 220]). However, in practice, a notice of assessment is not issued to a trustee unless there is a positive amount of tax payable by the trustee (Practice Statement PS LA 2015/2). When a trustee is assessed on an amount of net income of the trust estate, the assessment is separate and distinct from an assessment of income in the trustee’s personal capacity, as well as from any other assessment of income as a trustee or agent (s 254(1)(b) of ITAA 1936). If the Commissioner considers that a trust is being used for tax avoidance purposes, alternative assessments may be issued to the beneficiaries, assessing them both in their own right without reference to the trust and as beneficiaries of the trust (although only one amount of tax may be recovered). A trustee may object to an assessment in accordance with the normal objection provisions.

[14 020] Time limits for amending assessments The Commissioner has the power to amend the assessment of a trustee or beneficiary, subject to any time limits imposed by the law (s 170 of ITAA 1936). There is an unlimited amendment period if fraud or evasion is suspected. An assessment may be amended at the Commissioner’s discretion (eg following an audit) or at the request of the taxpayer.

Amendment period for trustee A standard two-year amendment period applies to the trustee of a trust that qualifies as a small business entity. A trust is a small business entity if a business is carried on through the trust and the aggregated annual turnover of the trust and of affiliates or entities connected with the trust is less than $2 million (see [8 010]). A four-year amendment period applies if the trust is not a small business entity or where the Commissioner relies on an anti-avoidance provision (see [10 000]).

Amendment period for beneficiaries An individual who is a beneficiary of a trust will not qualify for the standard two-year amendment period for individuals unless the trust is a small business entity or the trustee (in that capacity) is a full self-assessment taxpayer. Full self-assessment taxpayers include companies and superannuation funds. In the Commissioner’s view, a corporate trustee is not a full self-assessment taxpayer when acting in its capacity as trustee, unless the trust is a corporate unit trust, public trading trust or superannuation fund (ATO ID 2010/42). A ‘‘beneficiary of a trust’’ in this context means a person for whose benefit a trust is to be administered and who is entitled to enforce the trustee’s obligation to administer the trust according to its terms (Yazbek v FCT [2013] FCA 39; 88 292

2016 THOMSON REUTERS

ADMINISTRATION, TAX RETURNS, TAX RATES [14 030]

ATR 792). This means that a person with no actual interest in trust income or property can be a beneficiary for tax purposes. In Yazbek v FCT, the four-year amendment period applied to an individual named as a potential object of a discretionary trust, even though the person received no distributions from the trust. However, in a Decision Impact Statement on Yazbek v FCT, the Tax Office indicated that it does not intend to change its compliance approach for individuals, which is generally to complete audit activities and amend assessments within two years. The Commissioner may rely on the four-year amendment period where high wealth individuals and family groups are audited, or where a beneficiary’s taxable income is adjusted because of compliance action in respect of the trust.

[14 030] Trustee’s liability to pay tax Trustees are answerable as taxpayers in relation to the payment of tax. Although trustees are assessed in their representative capacity, they are personally liable for tax debts assessed to them on behalf of a trust estate. Where there is a change of trustee during an income year, the entity with the income tax liability is the entity which is the trustee at the end of the income year (Practice Statement PS LA 2012/2). This is because the ‘‘trustee’’ is the same entity even if there has been a change in the person who holds the office of trustee (s 960-100(2) of ITAA 1997; Re Lambert and FCT [2013] AATA 442). In an example contained in PS LA 2012/2, a trustee who did not appoint any income to the beneficiaries of the trust and then retired in the following year was liable to tax in respect of the net income of the trust estate, even though the liability became payable after the trustee’s retirement. Under trust law, trustees are entitled to be indemnified out of the trust property in respect of liabilities incurred in the proper exercise of their powers (unless there is a breach of trust): see [2 450]. The tax law (s 254(1)(d) of ITAA 1936) specifically authorises and requires the trustee to retain - from money received in the trustee’s representative capacity - ‘‘an amount sufficient to pay tax which is or will become due in respect of the income, profits or gains’’. The obligation to retain an amount arises after an assessment or deemed assessment has been made in respect of the income, profits or gains (FCT v Australian Building Systems Pty Ltd (liq); FCT v Muller and Dunn as Liquidators of Australian Building Systems Pty Ltd (in liq) [2015] HCA 48). However, the legislation then provides that the trustee is personally liable for the tax payable in respect of the income, profits or gains to the extent of any amount that is or should have been retained, but ‘‘shall not be otherwise personally liable for the tax’’ (s 254(1)(e)). In Barkworth Olives Management Ltd v DCT [2010] QCA 80; 78 ATR 827, the Tax Office took proceedings against the trustee of four trusts to recover over $80 million in unpaid tax (assessed at penalty rates under s 99A). The trustee argued that the effect of s 254(1)(e) was that it was not personally liable for the tax because it did not receive any funds from the trusts. The Queensland Court of Appeal said that s 254(1)(e) ordinarily limits a trustee’s liability to any amount of money received by the trustee after the due date for lodging a return (ie after the assessed income has been derived). However, because there was ‘‘substantial conflict’’ between s 254(1)(e) and the trust assessment rules in Div 6, the specific provisions in Div 6 prevailed. Accordingly, the Court held that s 254(1)(e) did not 2016 THOMSON REUTERS

293

[14 040]

ADMINISTRATION, TAX RETURNS, TAX RATES

limit the trustee’s personal liability as assessed under Div 6. The High Court refused to grant the trustee special leave to appeal.

[14 040] GST registration and ABN A trust is an entity for GST purposes (s 184-1(1) of the GST Act) and needs to be registered for GST if it carries on an enterprise in Australia and its GST turnover is $75,000 or more (or $150,000 in the case of non-profit entities). The GST Act also treats the trustee as an entity, and that entity consists of the person who is the trustee at any given time (s 184-1(2)). Accordingly, the GST law identifies a trust entity both by the trust relationship itself (the trust) and by reference to a legal person (the trustee). This does not create two separate entities for GST purposes. Rather, the relevant entity is the trust, with the trustee standing as that entity if legal personality is required (Taxation Ruling MT 2006/1, Re Anderson and FCT [2015] AATA 167). The consequences of treating a trust as a separate GST entity include the following: • one Australian business number (ABN) is issued to the trust, even if it has more than one trustee; • the trust has all the rights and obligations under the GST Act that apply to legal entities generally; • the trust makes supplies, acquisitions and importations as a separate GST entity; • if the trustee is a registered GST entity in its own right and, through this enterprise, makes supplies to the trust, it must account for the GST implications of both those supplies, ie in its own capacity and in its trustee capacity (s 184-1(3) of the GST Act). If the trust’s GST turnover is under the $75,000 threshold, the trustee can still apply for an ABN if the trust is carrying on an enterprise in Australia or, in the course of carrying on an enterprise, makes supplies that are connected with Australia. The term ‘‘enterprise’’ is widely defined for these purposes and covers all business and trading activities, including activities done in the course of commencing or terminating the enterprise. Activities undertaken to establish a trust (eg drawing up the trust deed and settling trust property) are not commencement activities for these purposes (see MT 2006/1). It is the entity (ie the trust/trustee) and not the enterprise that is entitled to an ABN and therefore an entity carrying on more than one enterprise is only entitled to one ABN. However, an entity may be entitled to separate ABNs if it is acting in more than one capacity (eg as trustee of more than one trust, or as a corporate trustee and a company). The trustee applies for an ABN and registers for GST in its capacity as trustee of the trust. The name shown in the Australian Business Register is ‘‘The Trustee for the [name of trust]’’. The trustee’s name is also recorded in the Australian Business Register. The trustee holds the ABN for the trust and is obliged to meet obligations under the GST and ABN laws. Where there is a change of trustee, the trust remains the same entity for GST purposes, with the same ABN. However, the Tax Office must be advised of the change so that the relevant details in the Australian Business Register can be updated. 294

2016 THOMSON REUTERS

ADMINISTRATION, TAX RETURNS, TAX RATES [14 100]

Note that the transfer of assets to the new trustee is not a supply for GST purposes. To reduce the administrative burdens associated with the GST, trusts, companies and/or partnerships with common ownership or membership are able to form or join a GST group if each entity meets the relevant membership requirements (Div 48 of the GST Act). Individuals who are associated with such entities, and their family members, may also qualify for inclusion in a GST group. A GST group is treated as a single entity for most GST purposes (eg intra-group transactions are generally ignored and one member deals with the Tax Office and accounts for the group’s total GST liability).

[14 050] Public officers A trust that carries on a business in Australia or derives income from property and does not have a resident trustee is required to appoint a person resident in Australia as its public officer. The appointment is required to be notified in writing to the Commissioner (s 252A of ITAA 1936). The public officer is answerable for the doing of all things required to be done by the trustee under the tax laws (eg lodging a trust tax return) and, in the case of default, is liable for the same penalties as the trustee would have been. A public officer is not required if the trust only derives income that is subject to withholding tax (mainly unfranked dividends, interest and royalties). The Commissioner has power to exempt a trust from the need to appoint a public officer.

[14 060] Substituted accounting periods A trustee can apply for permission to adopt an accounting period for a trust estate ending on a date other than 30 June each year. The Tax Office will generally only give permission for large investment or property trusts to adopt substituted accounting periods if the trust’s circumstances are ‘‘out of the ordinary run’’ (Practice Statement PS LA 2007/21). The Practice Statement seems to imply that such circumstances are only likely to exist in the case of widely held trusts.

TAX RATES [14 100] Rates of tax applicable to income derived through trust structures The applicable rate scale depends on a number of factors, in particular: • whether the trustee or beneficiary is assessed (see [3 210] and [3 220]); • the provision under which the assessment is made (see [14 120]); • whether an anti-avoidance provision applies (see [10 000]); or • whether the beneficiary is under the age of 18 and the income is unearned income under Div 6AA of ITAA 1936 (see [13 000]). 2016 THOMSON REUTERS

295

[14 110]

ADMINISTRATION, TAX RETURNS, TAX RATES

[14 110] Rate of tax payable by beneficiaries If the beneficiary is assessed under s 97 or s 100 of ITAA 1936 (see [3 210]), the relevant share of the net income of the trust estate is merely aggregated with other assessable income of the beneficiary and the normal tax rates applicable to that beneficiary apply. Section 97 applies if the beneficiary is presently entitled, has legal capacity and is a resident at year end. Where the beneficiary is a company, the corporate tax rate applies. Section 100 applies if the beneficiary is presently entitled, is under a legal disability and has either derived income from other sources or is a beneficiary of other trust(s). The beneficiary is entitled to a credit for tax paid by the trustee under s 98 (because the beneficiary is under a legal disability): see the example at [14 150]. This will not affect withholding tax arrangements for dividends, interest and royalty income distributed to non-residents through trusts (Div 11A of Pt III of ITAA 1936). From the 2015-16 income year, presently entitled beneficiaries can qualify for a 5% tax offset if the trust is a small business entity (see [14 140]).

[14 120] Rate of tax payable by trustee If the trustee is assessed, different rates scales apply (see Pt II, Div 3 of Income Tax Rates Act 1986). The relevant rate scales are set out at [15 000] and following. Where a trustee is assessed under s 98 of ITAA 1936 (eg because the beneficiary is under a legal disability or is a non-resident), the rate of tax depends on the profile of the beneficiary. Where no beneficiary is presently entitled to the whole or part of the income of a trust estate, the trustee is assessed under either s 99 at progressive rates or under s 99A at the top marginal rate of personal tax (47% for 2015-16). Such income is automatically taxed under s 99A unless the Commissioner considers that it is unreasonable for the section to apply where the trust has resulted from a will, intestacy, from property being vested in the Official Receiver as a result of a bankruptcy or from administration of a bankrupt estate under Pt XI of the Bankruptcy Act 1966. If the trustee of a deceased estate is assessed under s 99, the rate of tax is increased if, at the end of the income year, three years or more has elapsed since the death of the deceased.

[14 130] Medicare levy A trustee assessed under s 98 of ITAA 1936 in respect of a presently entitled beneficiary under a legal disability is liable for the Medicare levy where the beneficiary was a resident at any time during the income year. The rate of the levy is the same as for other taxpayers. However, the levy payable cannot exceed the amount that would be payable by the beneficiary if the amount of that share were the taxable income of the beneficiary. A trustee of a trust estate liable to be assessed under s 99 or s 99A of ITAA 1936 is also liable for the Medicare levy (except where the trust is a deceased 296

2016 THOMSON REUTERS

ADMINISTRATION, TAX RETURNS, TAX RATES [14 140]

estate). In relation to a s 99 assessment, no Medicare levy is payable if the net income assessed to the trustee is $416 or less. Where the net income exceeds $416 but not $520, the levy is shaded in at the rate of 10% of the excess over $416 (s 7 of the Medicare Levy Act 1986). A trustee assessed under s 98 in relation to a resident beneficiary may also be liable for the Medicare levy surcharge if: • the beneficiary does not have an appropriate level of private patient hospital cover; • the beneficiary’s income for surcharge purposes exceeds the relevant surcharge threshold. If the beneficiary has other taxable income or is subject to s 98 through more than one trust, any amounts subject to s 98 are also included in the beneficiary’s own taxable income through s 100 of ITAA 1936, meaning the Medicare levy surcharge is payable by the beneficiary in her or his own right. This ensures that beneficiaries cannot potentially escape the surcharge through the splitting of income. If the beneficiary’s trust income, in respect of which the trustee is assessed under s 98, does not exceed the relevant low income threshold below which no Medicare levy is payable, the surcharge does not apply to the trustee. Any amount that is not assessable because family trust distribution tax was paid in relation to it is added back to both the beneficiary’s taxable income and the net income of the trust estate (s 3(2A) of the Medicare Levy Act 1986).

[14 140] Tax offsets and rebates A trustee assessed on behalf of a beneficiary under s 98 of ITAA 1936 is entitled in that assessment to the same concessional tax offsets/rebates to which that beneficiary would be entitled. These include: • the small business tax offset, but not in respect of the unearned income of a minor (see below); • the low-income tax offset, but not in respect of the unearned income of a minor (s 159N(6) of ITAA 1936); and • the senior Australians and pensioners tax offset (s 160AAAB of ITAA 1936). A trustee is not entitled to these tax offsets/rebates in respect of an assessment under s 99 or s 99A, which is consistent with the fact that such an assessment is not on behalf of any particular beneficiary.

Small business tax offset Where a trust qualifies as a small business entity (see [8 010]), presently entitled beneficiaries who are individuals can access the small business tax offset from the 2015-16 income year (s 328-355(b) of ITAA 1997). The amount of the offset is equal to 5% of the income tax payable on that part of the individual’s taxable income that represents ‘‘total net small business income’’, but subject to a $1,000 cap. ‘‘Total net small business income’’ comprises the individual’s ‘‘net small business income’’ as a sole trader, plus any share of the net small business income of a trust or partnership that is included in the individual’s assessable 2016 THOMSON REUTERS

297

[14 150]

ADMINISTRATION, TAX RETURNS, TAX RATES

income. A small business entity’s net small business income is basically its taxable income from carrying on a business, subject to certain exclusions like net capital gains. Where the individual is under the age of 18 and is subject to Div 6AA of ITAA 1936 (see [13 000]), trust distributions are not included in the individual’s ‘‘total net small business income’’ (s 328-375 of ITAA 1997). The small business tax offset is not available to an individual in his or her capacity as a trustee (s 960-100(4) of ITAA 1997).

[14 150] Worked example The following example illustrates how beneficiaries and trustees are assessed.

Facts A trust created by will has net income for the 2015-16 income year of $80,000 (comprising rental income). The testator died two years ago. The net income is divided as follows: Division of net income Widow Son (aged 14) Accumulated until daughter (aged 10) marries, otherwise for son or his estate Other income of beneficiaries: Widow – bank interest Son (aged 14) – newspaper delivery

50% 25% 25%

$3,000 $1,000

Assessments issued Widow: Assessable under s 97(1)(a)(i) on $40,000 trust income. Assessable under s 6-5 on $3,000 bank interest. Total: $43,000 taxed under general rates scale. Widow entitled to low-income tax offset of $355. Tax payable on $43,000 = $5,522. Trustee Assessable under s 98(1)(a) on $20,000 trust income as son is (s 98): presently entitled but under legal disability. Division 6AA penalty rate does not apply as the income is excepted trust income (being from a will trust). Trustee entitled to low-income tax offset of $445. Tax payable on $20,000 = $342. Son: Assessable under s 100(1) on $20,000 trust income as has income from another source. Assessable under s 6-5 on $1,000 income from newspaper deliveries.

298

2016 THOMSON REUTERS

ADMINISTRATION, TAX RETURNS, TAX RATES [14 150]

Trustee (s 99):

Division 6AA penalty rate does not apply as the trust income is excepted trust income (being from a will trust) and the newspaper delivery income is excepted assessable income (being employment income). Total: $21,000 taxed under general rates scale. Son entitled to low-income tax offset of $445. Tax payable on $21,000 = $532. Son receives $342 tax credit under s 100(2) for tax paid by trustee. Assessable on $20,000 accumulation as no beneficiary is presently entitled to it. There is no deemed present entitlement under s 95A(2) as neither son’s nor daughter’s interests are vested and indefeasible; they are both contingent on daughter marrying. Assessment is separate to s 98 trustee assessment above. As it is a will trust, $20,000 assessable under s 99 (and not at penalty rate under s 99A). Trustee not entitled to low-income tax offset as assessment is not on behalf of a particular beneficiary. Tax payable on $20,000 = $787.

2016 THOMSON REUTERS

299

300

2016 THOMSON REUTERS

15

RATES OF TAX TRUSTEE ASSESSED UNDER DIV 6

Section 98 assessment – resident beneficiary under legal disability ................................................................................ [15 Section 98 assessment – non-resident beneficiary ............................... [15 Section 99 assessment – resident trust of deceased estate ................ [15 Section 99 assessment – resident trust of non-deceased estate ........ [15 Section 99 assessment – non-resident trust; no present entitlement ............................................................................. [15 Section 99A assessment – no presently entitled beneficiary ............. [15 Medicare levy – non-deceased estate .................................................... [15

000] 010] 020] 030] 040] 050] 060]

OTHER TAXES Family trust distribution tax ................................................................... [15 100] Trustee beneficiary non-disclosure tax .................................................. [15 110]

TRUSTEE ASSESSED UNDER DIV 6 [15 000] Section 98 assessment – resident beneficiary under legal disability Ordinary income Share of net income Up to $18,200 $18,201 $37,000 $37,001 $80,000 $80,001 $180,000 $180,001 and over

2015-16 tax payable1, 2 Nil 19% of excess over $18,200 $3,572 + 32.5% of excess over $37,000 $17,547 + 37% of excess over $80,000 $54,547 + 47% of excess over $180,000

1 These rates apply where a presently entitled beneficiary is under a legal disability. 2 The trustee is liable to pay the Medicare levy (2% for 2015-16) plus the Medicare levy surcharge if the beneficiary would have been liable to the surcharge.

Div 6AA unearned income of child under 18 Div 6AA income – resident minor 2015-16 tax payable1 Up to $416 Nil $417 $1,307 66% of excess over $416

2016 THOMSON REUTERS

301

[15 010]

RATES OF TAX

Div 6AA income – resident minor $1,308 and over

2015-16 tax payable1 47% of entire amount

1 These rates apply where a minor beneficiary is only entitled to Div 6AA income from one trust estate. The low-income tax offset is not available to reduce the tax payable: see [13 020].

[15 010] Section 98 assessment – non-resident beneficiary Ordinary income Share of net income Up to $80,000 $80,001 $180,000 $180,001 and over

2015-16 tax payable1 32.5% $26,000 + 37% of excess over $80,000 $63,000 + 47% of excess over $180,000

1 These rates apply where a presently entitled beneficiary is a foreign resident. Note that foreign residents are not entitled to the low-income tax offset.

Div 6AA unearned income of non-resident child under 18 Div 6AA income – non-resident 2015-16 tax payable1 minor Up to $416 32.5% of entire amount $417 $6632 $135.20 + 66% of excess over $416 $664 + 47% of entire amount 1 These rates apply where a foreign resident beneficiary, who is a minor, is only entitled to Div 6AA income from one trust estate. Note that foreign residents are not entitled to the low-income offset.

Non-resident corporate beneficiary Net income 0+

2015-16 tax payable1 30% of entire amount

1 The rate is 28.5% if the corporate beneficiary qualifies as a small business entity: see [8 010].

[15 020] Section 99 assessment – resident trust of deceased estate Less than three years since death Share of net income Up to $18,200 $18,201 $37,000 $37,001 $80,000 $80,001 $180,000 $180,001 and over

302

2015-16 tax payable1 Nil 19% of excess over $18,200 $3,572 + 32.5% of excess over $37,000 $17,547 + 37% of excess over $80,000 $54,547 + 47% of excess over $180,000

2016 THOMSON REUTERS

RATES OF TAX

Share of net income

[15 040]

2015-16 tax payable1

1 These rates apply where a trustee is assessed under s 99 in respect of the net income (or part of the net income) of a resident trust estate of a deceased person who died less than three years before the end of the income year. The same rates apply to resident individual beneficiaries.

Three years or more since death Share of net income Up to $416 $417 $670 $671 $37,000 $37,001 $80,000 $80,001 $180,000 $180,001 and over

2015-16 tax payable1 Nil 50% of excess over $416 $127.30 + 19% of excess over $670 $7,030 + 32.5% of excess over $37,000 $21,005 + 37% of excess over $80,000 58,005 + 47% of excess over 180,000

1 These rates apply where a trustee is assessed under s 99 in respect of the net income (or part of the net income) of a resident trust estate of a deceased person who died three or more years before the end of the income year.

[15 030] Section 99 assessment – resident trust of non-deceased estate Share of net income Up to $416 $417 $670 $671 $37,000 $37,001 $80,000 $80,001 $180,000 $180,001 and over

2015-16 tax payable1 Nil 50% of excess over $416 $127.30 + 19% of excess over $670 $7,030 + 32.5% of excess over $37,000 $21,005 + 37% of excess over $80,000 $58,005 + 47% of excess over $180,000

1 These rates apply where there is no beneficiary presently entitled to a share of the net income of the trust and the Commissioner considers it unreasonable for the s 99A penalty rates to apply.

[15 040] Section 99 assessment – non-resident trusts; no present entitlement Share of net income Up to $80,000 $80,001 - $180,000 $180,001 and over

2015-16 tax payable1 32.5% $26,000 + 37% of excess over $80,000 $63,000 + 47% of excess over $180,000

1 These rates apply where there is no beneficiary presently entitled to a share of the net income of a non-resident trust and the Commissioner considers it unreasonable for the s 99A penalty rates to apply.

2016 THOMSON REUTERS

303

[15 050]

RATES OF TAX

[15 050] Section 99A assessment – no presently entitled beneficiary 2015-16 tax payable1 47% of entire amount

Net income 0+

1 These rates apply where there is no beneficiary presently entitled to a share of the net income of the trust (and the Commissioner has not exercised the discretion to assess the trustee under s 99 at the progressive tax rates).

[15 060] Medicare levy – non-deceased estate Section 99 assessment Net income 0 $417 $521 +

$416 $5202

2015-16 levy payable1 Nil 10% of excess over $416 2% of entire amount

1 There is no Medicare levy liability for a s 99 assessment in respect of a deceased estate. 2 Although the legislation specifies $520, the full levy is less at that point than the shade-in limit, so the full levy applies.

Section 99A assessment Net income 0+

2015-16 levy payable1 2% of entire amount

1 There is no Medicare levy liability for a s 99A assessment in respect of a deceased estate.

OTHER TAXES [15 100] Family trust distribution tax Category Primary liability Secondary liability

2015-16 tax payable 49% of non-family group distribution1 100% of unpaid amount2

1 Imposed on amount or value of income or capital to which non-family member is presently entitled or which is distributed to non-family member: see [7 200]. 2 Imposed on amount of unpaid family trust distribution tax of certain non-resident entities: see [7 220].

304

2016 THOMSON REUTERS

RATES OF TAX

[15 110]

[15 110] Trustee beneficiary non-disclosure tax Category Primary liability

2015-16 tax payable 49% of relevant share of net income1

1 Imposed on a share of the net income for which there is no correct Trustee Beneficiary Statement: see [12 100].

2016 THOMSON REUTERS

305

[15 110]

306

RATES OF TAX

2016 THOMSON REUTERS

PART 6 OTHER ISSUES 16 REVIEW OF TRUST TAX PROVISIONS 17 STATE AND TERRITORY TAXES

2016 THOMSON REUTERS

307

308

2016 THOMSON REUTERS

REVIEW OF TRUST TAX PROVISIONS

16

Proposals to rewrite the trust income tax provisions ........................ [16 Possible models for taxing trust income ............................................. [16 Key features of any new model for taxing trust income ................... [16 Other proposed reforms affecting trusts ............................................... [16

000] 010] 020] 030]

[16 000] Proposals to rewrite the trust income tax provisions The taxation of trust income has long been a source of uncertainty and confusion, made all the more so after the introduction of capital gains tax in 1985. Since that time, various attempts have been made to rewrite the rules. In 1999, the Howard Government endorsed a proposal by the Ralph Committee Review of Business Taxation to tax trusts like companies. However, this proposal was abandoned in 2001, after the release of exposure draft legislation in relation to non-fixed trusts. Following consultations and advice from the Board of Taxation, the then Treasurer, Peter Costello, accepted that the draft provisions were ‘‘not workable’’. In 2008, the Board of Taxation was asked to review the tax arrangements applying to managed investment funds. In conducting the review, the Board was also directed to consider whether any recommended changes could be applied to the tax arrangements for trusts in general. In its discussion paper on managed investment funds (released in October 2008), the Board of Taxation commented that the Assessment Act does not encode a single coherent policy for the taxation of trusts and that there has been no systemic approach to align the tax laws with modern practice and the use of trusts as commercial vehicles. In 2009, the Board of Taxation formally recommended that the general trust income tax rules in Div 6 of Part III of ITAA 1936 be the subject of a wider review, in order to consider various options for determining tax liabilities, such as the distribution model (which would assess beneficiaries on a receipts basis) or the patch model (amending Div 6 to overcome the problems with its operation). Dr Ken Henry’s 2010 Australia’s Future Tax System review also recommended that the trust rules be updated and rewritten to reduce complexity and uncertainty. In March 2010, the High Court handed down its decision in FCT v Bamford [2010] HCA 10; 75 ATR 1, which exposed a number of longstanding issues with the taxation of trusts. In particular, it highlighted that the amounts on which beneficiaries are assessed do not always match the amounts they are entitled to under trust law because of the differences between the Div 6 concepts of the ‘‘income’’ and ‘‘net income’’ of a trust estate (see [3 300] and following). The 2016 THOMSON REUTERS

309

[16 010]

REVIEW OF TRUST TAX PROVISIONS

decision also raised concerns about the extent to which income of a particular character (such as capital gains or franked distributions) could be streamed to specific beneficiaries. Following Bamford’s case, the Gillard Government acknowledged that the rules do not deal satisfactorily with several important issues and announced its intention to rewrite Div 6: see Media Release No 25 of then Assistant Treasurer, Bill Shorten (16 December 2010). It was initially proposed that the start date of the rewritten trust income tax provisions would be 1 July 2013. However, as an interim measure, amendments were introduced to allow streaming of capital gains and franked distributions to specified beneficiaries, with effect from the 2010-11 income year (see [4 000] and following). The proposed start date of the rewritten trust income tax provisions was subsequently extended to 1 July 2014: see Media Release No 80 of then Assistant Treasurer, David Bradbury (30 July 2012). Progress on the rewrite of the trust income tax provisions stalled with a change in Government in 2013. At the time of calling the 2016 Federal election, no legislation had been released and the Coalition Government made no official announcements concerning the proposed rewrite of Div 6. However, the Government’s March 2015 tax discussion paper, Re:think, did acknowledge the ‘‘longstanding problems with the legal framework for the taxation of trusts’’ and noted that while changes had been made to address some specific issues (ie the 2011 streaming measures), wider reform had not occurred and the underlying problems remained.

[16 010] Possible models for taxing trust income The following papers were released by the Gillard Government as part of its proposal to rewrite the trust income tax provisions: • a discussion paper, Improving the Taxation of Trust Income, which focused on how to better align the concepts of the ‘‘income’’ and ‘‘net income’’ of a trust estate, and proposed a legislative basis for streaming capital gains and franked distributions, released on 4 March 2011; • a consultation paper, Modernising the Taxation of Trust Income - Options for Reform, released on 21 November 2011; • a discussion paper, A More Workable Approach for Fixed Trusts, on the definition of ‘‘fixed trust’’, released on 30 July 2012; and • a policy options paper, Taxing Trust Income - Options for Reform, released on 24 October 2012. The November 2011 consultation paper presented three models for reforming the trust income tax provisions - a ‘‘patch’’ model (ie amending Div 6 of Pt III of ITAA 1936), a proportionate assessment model and an economic benefits model. The October 2012 policy options paper expanded on the design of the proportionate assessment and economic benefits models and set out certain core features that any new model for taxing trust income should have. The Gillard Government ruled out taxing trusts like companies. The economic benefits model uses tax concepts to determine how different amounts should be taxed. Broadly, this model would assess beneficiaries on taxable amounts distributed or allocated to them, with the trustee assessed on any remaining taxable income. 310

2016 THOMSON REUTERS

REVIEW OF TRUST TAX PROVISIONS

[16 010]

The proportionate assessment model relies on general concepts of profit to determine tax outcomes. This model would assess beneficiaries on a proportionate share of the trust’s taxable income equal to their proportionate share of the ‘‘trust profit’’ of the relevant class. As currently occurs, the concept of present entitlement would form the basis for attributing the trust profit or class amounts to beneficiaries. During consultations, a number of concerns were raised about each of the three models. The following table (adapted from the October 2012 policy options paper Taxing Trust Income - Options for Reform, p 5) compares the operation of the current law with the proposed models.

What is a beneficiary assessed on?

What is the trustee assessed on?

What amounts can be streamed to beneficiaries? What amounts retain their character when assessed to beneficiaries? When does the trustee determine entitlements by?

Current law

Proportionate assessment model

Economic benefits model

A share of the trust’s net income, based on the beneficiary’s present entitlement to a share of the income of the trust estate Net income not assessed to beneficiaries

A share of the trust’s taxable income, based on the beneficiary’s present entitlement to a share of the trust profit or class amounts Taxable income not assessed to beneficiaries

Amounts distributed or allocated to the beneficiary that represent amounts of the trust’s taxable income

Capital gains and franked distributions

All amounts

Capital gains and franked distributions

Classes of taxable income

Amounts representing the trust’s taxable income

30 June

31 August

31 August

2016 THOMSON REUTERS

Amounts representing taxable income not distributed or allocated to beneficiaries All amounts

311

[16 020]

REVIEW OF TRUST TAX PROVISIONS

[16 020] Key features of any new model for taxing trust income Treasury’s October 2012 policy options paper, Taxing Trust Income - Options for Reform, provided that any new model for taxing trust income should treat trusts as flow-through vehicles and should operate as follows: • amounts flowing through a trust should retain the character they had in the trustee’s hands when assessed to beneficiaries (unless another part of the tax law requires a different treatment); • all amounts flowing through a trust could be streamed in a tax effective way to particular beneficiaries in accordance with the trust deed (subject to any other rules in the tax laws); • deductions should be allocated on a ‘‘fair and reasonable basis’’; • beneficiaries should be taxed on capital gains made through the trust to the extent that they are entitled to gross capital gains (ie before the CGT discount and any other CGT concessions are applied, but after the application of relevant losses). Capital losses would only be available to reduce gross capital gains; • the gross up for franking credits and foreign income would automatically attach to an entitlement or distribution; • the time for determining entitlements should be extended to 31 August (if the trust deed permits); • if the trust tax return indicates that the trustee is not liable to tax, this would be deemed to be a nil assessment, with the Commissioner’s power to issue an amended assessment limited to two or four years.

[16 030] Other proposed reforms affecting trusts Trusts and deemed dividends In 2014, the Board of Taxation completed a review of the deemed dividend rules in Div 7A of Pt III of ITAA 1936, including how the rules interact with the trust income tax provisions and other income tax rules: see [11 030]. In its final report to the Government (released in June 2015), the Board recommended that, irrespective of the business structure chosen, business accumulations should be taxed at a ‘‘business’’ tax rate. In addition, the Board specifically recommended that the punitive tax rate applying to trustees under s 99A of ITAA 1936 on undistributed trust income (47% for 2015-16) should be lowered, while preserving the flow-through treatment on distributed trust income. In the 2016-17 Federal Budget, the Coalition Government announced that it proposed to consult with stakeholders before making targeted amendments to Div 7A, to provide clearer rules for taxpayers and to assist in easing their compliance burden, while maintaining the overall integrity and policy intent of Div 7A.

Small business entities: proposed increase in turnover threshold A key announcement in the 2016-17 Federal Budget was the proposal to lift the small business entity threshold from $2 million to $10 million, with effect from 1 July 2016. This would allow businesses with an aggregated annual 312

2016 THOMSON REUTERS

REVIEW OF TRUST TAX PROVISIONS

[16 030]

turnover of under $10 million to access most of the small business tax concessions (see [8 000]), other than the CGT concessions in Div 152 of ITAA 1997 (see [8 100]).

2016 THOMSON REUTERS

313

314

2016 THOMSON REUTERS

STATE AND TERRITORY TAXES

17

State and territory taxes ........................................................................... [17 New South Wales ...................................................................................... [17 Queensland ................................................................................................. [17 South Australia .......................................................................................... [17 Tasmania ..................................................................................................... [17 Victoria ........................................................................................................ [17 Western Australia ...................................................................................... [17 Australian Capital Territory .................................................................... [17 Northern Territory .................................................................................... [17

000] 010] 020] 030] 040] 050] 060] 070] 080]

[17 000] State and territory taxes Transactions involving trusts and trust property may be subject to tax under the laws of New South Wales (see [17 010]), Queensland (see [17 020]), South Australia (see [17 030]), Tasmania (see [17 040]), Victoria (see [17 050]), Western Australia (see [17 060]), the ACT (see [17 070]) or the Northern Territory (see [17 080]).

Duties Duty (traditionally called stamp duty) is generally payable if a trust is declared over land or any other dutiable property. Transfers of trust property also attract duty (although there are exemptions). The amount of duty payable varies between jurisdictions, but in all cases depends on the nature of the transaction, the type of dutiable property and the value of the property. Generally, duty is either charged at a flat rate or is based on the value of the transaction (‘‘ad valorem’’ duty). The states and territories also have special rules concerning landholding unit trusts. Generally, the purchase of a significant parcel of units in a unit trust that holds land above a threshold value ($2 million in New South Wales, Queensland and Western Australia; $1 million in South Australia and Victoria; $500,000 in Tasmania and the Northern Territory) is subject to duty as though there was a direct purchase of land.

Land tax Land tax is generally payable by a trustee as the ‘‘owner’’ of land held on trust (subject to any applicable tax-free threshold or exemptions, such as the principal place of residence exemption or the primary production exemption). In New South Wales and Victoria, beneficiaries may also be subject to land tax in certain situations. In CPT Custodian Pty Ltd v Commissioner for State Revenue (Vic) [2005] HCA 53; 60 ATR 371, the High Court held that unit holders in a landholding unit trust were not the owners of the land for Victorian land tax purposes (see [3 110]). 2016 THOMSON REUTERS

315

[17 010]

STATE AND TERRITORY TAXES

Subject to the application of aggregation rules, trustees are generally assessed separately for land tax in respect of each separate trust they administer and separately in respect of land they hold in their personal capacity. Victoria is the only jurisdiction with a specific land tax regime for trusts, which includes the imposition of a surcharge (see [17 050]).

[17 010] New South Wales In New South Wales, the Duties Act 1997 (NSW) imposes duty on dutiable transactions of dutiable property. ‘‘Dutiable property’’ includes land situated in the State, units in a unit trust scheme and business assets such as goodwill and intellectual property (s 11). A dutiable transaction includes (s 8): • a declaration of trust; • an agreement to sell or transfer dutiable property; • the surrender of an interest in land; and • the vesting of dutiable property by statute or court order. Nominal duty of $50 applies to certain transfers following a change of trustee (s 54). A transfer from the trustee to a beneficiary for no consideration may also qualify for nominal duty (s 57).

Declaration of trust A declaration of trust over dutiable property attracts ad valorem duty. Declarations of trust over non-dutiable property, or over unidentified property, are subject to fixed duty. Nominal duty is payable if the trust is a resulting trust (s 55). Exemptions apply to special disability trusts (s 65(22)). From 1 July 2016, a declaration of trust over business assets (other than land) is not subject to duty.

Resettlements A variation to a trust is subject to duty at ad valorem rates if the NSW Chief Commissioner treats the variation as a transfer of dutiable property or a new declaration of trust over the trust property (see Revenue Ruling DUT 17). However, the Chief Commissioner accepts that the following variations to discretionary trusts do not attract duty: • adding a beneficiary to, or deleting a beneficiary from, the class of persons who are takers in default or discretionary objects; • changing the interests of beneficiaries without altering the identity of the beneficiaries; and • inserting or amending administrative powers without affecting beneficial interests in the trust property. For detailed commentary on trust resettlements, see [2 530].

New South Wales land tax In New South Wales, land tax is payable by the trustee as the ‘‘primary’’ taxpayer (s 24 of the Land Tax Management Act 1956 (NSW)). 316

2016 THOMSON REUTERS

STATE AND TERRITORY TAXES [17 020]

Beneficiaries may also be liable in respect of land tax as ‘‘secondary taxpayers’’, unless the trust qualifies as a ‘‘special trust’’ (s 25). Special trusts are broadly non-fixed trusts and include discretionary trusts, deceased estates still in existence 12 months after the testator’s death, and non-complying superannuation trusts. In addition, some hybrid trusts satisfy the definition of ‘‘special trust’’, where the beneficiaries are not the equitable owners of the land as a result of discretionary powers in the trust deed. A trust that satisfies the fixed trust requirements in s 3A(3B) of the Land Tax Management Act 1956 (NSW) qualifies for a tax-free threshold ($482,000 for the 2016 land tax year). The tax-free threshold does not apply to special trusts, which are taxed at a flat rate, being 1.6% of the taxable value up to the premium threshold ($2,947,000 for 2016), then 2% thereafter. Special disability trusts are treated as concessional trusts for land tax purposes (s 3B).

[17 020] Queensland In Queensland, the Duties Act 2001 (Qld) imposes duty on various transactions involving trusts, including the transfer, surrender or vesting of dutiable property held on trust (s 9). ‘‘Dutiable property’’ is defined to include land in Queensland, an existing right and a Queensland business asset (s 10). The trustee pays ad valorem duty on the creation or termination of a trust over dutiable property (s 64). If the trustee fails to pay the duty, the beneficiaries are jointly and severally liable. A beneficiary is generally liable to pay ad valorem duty for the acquisition or surrender of a trust interest, where the trustee holds, or has an indirect interest in, dutiable property (ss 55 to 67). A ‘‘trust interest’’ is a person’s interest as a beneficiary of a trust, other than a life interest (s 57(1)). For discretionary trusts, only takers in default can have a trust interest (s 57(2)). Trust acquisitions or surrenders in family trusts (s 118), superannuation funds (s 119) and unincorporated associations (s 120) are exempted, provided the requirements of the relevant provision are satisfied. Duty is not imposed on transfers to give effect to a change of trustee (s 117) and transfers to a beneficiary to the extent that it represents the beneficiary’s trust interest (s 123), provided the specific requirements of those provisions are satisfied. An exemption also applies where the only dutiable property of the trust are existing rights of the holder of a mortgage, charge, bill of sale or other security over dutiable property located in Queensland, and the existing rights have been given in favour of the trustee for the sole purpose of being held for the benefit of the beneficiaries of the trust who have provided, or will provide, financial accommodation (s 121). Corporate trustee duty is payable on certain acquisitions of shares in corporations that directly or indirectly hold property on trust for a discretionary trust (s 205).

Queensland land tax A trustee is liable to pay land tax if the taxable value of the trustee’s total land holdings in Queensland is $350,000 or more (for 2015-16). An exemption applies if all of the beneficiaries of the trust use the land as their principal place of residence. 2016 THOMSON REUTERS

317

[17 030]

STATE AND TERRITORY TAXES

For land tax purposes, the beneficiaries of a discretionary trust are the persons in whose favour a power of appointment is exercised during the 12-month period ending when the land tax liability arises (s 24(1) of the Land Tax Act 2010 (Qld)). If the power of appointment is not exercised by 30 June of the relevant financial year, the beneficiaries of the discretionary trust are the default beneficiaries. Where the trust deed contains no express default clause, any class of beneficiaries given preference under the trust deed may be treated as the default beneficiaries (see Public Ruling LTA041.1.2). To claim the land tax exemption, a trustee must complete form LT13 Exemption Claim – Land Used as a Home (Trustees) (available on the Queensland Office of State Revenue website). The trustee of a discretionary trust must provide written evidence of all appointments made during the 12 months prior to the relevant 30 June, plus the names and addresses of those beneficiaries.

[17 030] South Australia In South Australia, duty is charged on transfers, sales and conveyances (Stamp Duties Act 1923 (SA)). Declarations of trust over dutiable property and transfers of trust property are subject to duty at ad valorem rates, unless an exemption applies (s 71). Transactions that are exempt from duty include: • transfers arising from a change of trustee; • the distribution of trust property to a beneficiary where the beneficial interest arises under a trust deed that has been stamped; • variations to a trust that do not result in creating or changing any beneficial interest or potential beneficial interest in trust property; • a transfer of property to a special disability trust for no consideration, where the property is used as the beneficiary’s principal place of residence (s 71CCA); • interfamilial transfers of farm property (s 71CC); • distributions of trust property or beneficial interests in trust property to an object of a discretionary trust, where the trust was created wholly or principally for the benefit of that beneficiary or her/his family group and the trust deed was stamped; and • transfers of potential beneficial interests in property subject to a discretionary trust between family members. If the trustee of a discretionary trust varies a trust deed to redeem, cancel or extinguish the interest of an object of the trust, or to add a beneficiary in respect of capital, the variation is assessed at ad valorem rates (see Revenue Ruling SDA003).

South Australian land tax A trustee is liable to pay land tax if the taxable value of South Australian land held on trust exceeds $323,000 (for 2015-16). The trustee can apply to have the land held on trust assessed separately from other land owned by the trustee in another capacity (s 13 of the Land Tax Act 1936 (SA)). The trustee must lodge a Notification of Land Held on Trust form 318

2016 THOMSON REUTERS

STATE AND TERRITORY TAXES [17 050]

(available on the RevenueSA website), together with evidence that the land was acquired on behalf of the trust or otherwise vested in the trust. Land held by a trustee on separate trusts may be aggregated where the land is held on trust for the same beneficiaries (see Revenue Ruling LT004).

[17 040] Tasmania In Tasmania, the Duties Act 2001 (Tas) charges duty on various transactions concerning dutiable property, including (s 6): • the transfer of dutiable property, including land in Tasmania; • declarations of trust over dutiable property; and • any other transaction resulting in a change of beneficial ownership of dutiable property. A declaration of trust over dutiable property attracts ad valorem duty. A declaration of trust over unidentified or non-dutiable property is subject to nominal duty of $50 (s 42). Nominal duty also applies to certain transfers as a consequence of a change of trustee. A transfer from the trustee to a beneficiary for no consideration may also qualify for nominal duty (s 41).

Tasmanian land tax A trustee is liable to pay land tax if the assessed land value of Tasmanian properties held on trust is $25,000 or more (for 2015-16). Land held by a trustee on behalf of multiple trusts is aggregated for land tax purposes (unless the trustee is appointed by a court or is a registered trustee company, executor, administrator, guardian, committee, receiver or liquidator). Land held by an individual trustee in his or her own right is not aggregated. A land tax exemption is available if a beneficiary occupies the land as his or her principal place of residence and the trustee is a specific type of trustee (a registered trustee company, executor, administrator, guardian, committee, receiver, liquidator, court-appointed trustee, the trustee of a special disability trust or the trustee of a fixed trust in which all of the beneficiaries are individually named or are descendants of individually named beneficiaries). The exemption is not available if the beneficiary owns any other principal residence land (s 6 of the Land Tax Act 2000 (Tas)). .

[17 050] Victoria In Victoria, the Duties Act 2000 (Vic) charges duty on a range of transactions concerning dutiable property, including (s 7): • transfers and surrenders of land in Victoria; • declarations of trust over dutiable property; • the vesting of dutiable property by court order; and • any other transaction that results in a change in beneficial ownership of dutiable property. 2016 THOMSON REUTERS

319

[17 050]

STATE AND TERRITORY TAXES

‘‘Dutiable property’’ is defined broadly to include estates or interests in land in Victoria, units in a unit trust scheme and interests under a will or codicil (s 10). Various transactions involving trusts are exempt from duty, including: * transfers arising from a change of trustee, unless the trustee becomes beneficially entitled to the trust property (s 33); * transfers of dutiable property to and from a trustee or nominee if there is no change in the beneficial ownership of the dutiable property (s 35); and * transfers to beneficiaries of fixed trusts (s 36), discretionary trusts (s 36A), unit trusts (s 36B), superannuation funds (s 41A) and testamentary trusts (s 42), where there is no consideration provided by the beneficiary and the transfer is not part of a sale.

Declaration of trust A declaration of trust over dutiable Victorian property is chargeable with ad valorem duty (s 7(1)(b)(i)). The duty is payable by the person who declares the trust (ie the settlor). The liability arises when the declaration takes effect. Duty at a flat rate of $200 is chargeable for a declaration of trust over non-dutiable property (eg money) if the instrument is executed in Victoria (s 37). An exemption is available for a declaration of trust that establishes a special disability trust (s 38A).

Victorian land tax Land tax is levied annually on the owner of land in Victoria. Certain land is exempt from land tax, including an individual’s principal place of residence and land used for primary production. The Land Tax Act 2005 (Vic) makes trustees liable for land tax in their capacity as trustees. As a general rule, land held in a trust is subject to land tax at surcharge rates, unless an exclusion applies. In some circumstances, where certain nominations or notifications of unit holdings are provided to the Victorian State Revenue Office, the beneficiaries may also be liable for land tax. The normal exemptions from land tax can apply to particular land held by the trustee of a trust where that land is used in a way that qualifies for an exemption, such as the principal place of residence exemption and the primary production land tax exemption. From 1 January 2016, an absentee owner surcharge of 0.5% applies to Victorian land owned by an ‘‘absentee owner’’. An absentee owner can be an individual, company or the trustee of an absentee trust. An individual who is not an Australian citizen, permanent resident or New Zealand citizen holding a special category visa will qualify as an ‘‘absentee’’ if the individual does not ordinarily reside in Australia and is absent from Australia on 31 December in the year before the land tax year, or was absent from Australia for at least six months of that previous year. An absentee trust is a trustee where at least one absentee beneficiary is a specified beneficiary of a discretionary trust, has a beneficial interest in land subject to a fixed trust or is a unit holder in a unit trust scheme. An absentee beneficiary includes a natural person absentee, an absentee corporation or another trustee of an absentee trust. 320

2016 THOMSON REUTERS

STATE AND TERRITORY TAXES [17 060]

Land tax regime for trusts Victoria has a specific land tax regime for trusts (Div 2A of Pt 3 of the Land Tax Act 2005 (Vic)). Landholding trusts are required to pay a land tax surcharge if the value of their aggregate Victorian land holdings is $25,000 or more. The surcharge applies as a disincentive for using a trust to hold land. Certain trusts are excluded from the application of the land tax surcharge, including (s 46A(3)): • a discretionary trust where a nominated beneficiary for the trust is appointed; • a discretionary trust or a unit trust scheme where a nominated ‘‘principal place of residence’’ beneficiary is appointed and the trust is not used to carry on a substantial business activity; • a trust over child maintenance land; and • an excluded trust (defined in s 3(1) as a charitable trust, concessional trust, public unit trust scheme, wholesale unit trust scheme, superannuation fund, administration trust or a trust for which the beneficiaries are a specified type of club or the members of such a club). Importantly, some of these nominations must be provided to the Victorian Revenue Office within a specified time frame. In some cases, a better land tax result may be achieved by paying land tax at the surcharge rates and avoiding aggregation of the trust’s land with land held by a beneficiary or unit holder. Accordingly, trustees should take great care when deciding whether to make certain nominations or notifications. Trustees have various immediate and ongoing obligations in respect of Victorian land. Details in respect of these obligations can be found on the Victorian State Revenue Office website (http://www.sro.vic.gov.au).

[17 060] Western Australia In Western Australia, the Duties Act 2008 (WA) imposes duty on dutiable transactions involving ‘‘dutiable property’’. Dutiable property includes land, rights, chattels and business assets in the State. Various transactions involving trusts are dutiable transactions. These include: • declarations of trust; • amendments to trust deeds; and • discretionary trust acquisitions and trust surrenders.

Declarations of trust A declaration of trust over dutiable Western Australian property is chargeable with ad valorem duty. The duty is payable by the person who declares the trust (ie the settlor). Declarations of trust over non-dutiable property, such as money, are not dutiable.

Amendments to trust deeds Ad valorem duty is payable on an amendment to a trust deed which results in the addition or removal of beneficiaries who are takers in default. A ‘‘taker in default’’ is a beneficiary with an interest in the trust in default of an appointment 2016 THOMSON REUTERS

321

[17 070]

STATE AND TERRITORY TAXES

by the trustee(s) (s 54). Duty is payable on the higher of the consideration paid or the percentage interest acquired in the dutiable property held by the trust. An amendment to a trust which is so extensive as to give rise to a new trust (ie a trust resettlement: see [2 530]) is treated as a declaration of trust and ad valorem duty is payable on the value of the dutiable property held by the trust.

Transactions attracting nominal duty A transfer of dutiable property to or from a trustee attracts nominal duty ($20) if there is no change in the beneficial ownership of that property (s 118). Where dutiable property is transferred to a trustee as a consequence of the retirement of a trustee or the appointment of a new trustee, nominal duty is chargeable (s 119). Duty is chargeable at ad valorem rates if the transfer is a scheme or arrangement to confer an interest, on a new trustee or any other person, to the detriment of the beneficial interest or potential beneficial interest of any person. Nominal duty is chargeable on a transfer of, or an agreement to transfer, dutiable property to a taker in default, for no consideration, on the vesting or termination of a discretionary trust (s 114). The transfer, for no consideration, of dutiable property to a beneficiary in conformity with the terms of the trust attracts nominal duty (ss 115 and 116).

Western Australian land tax A trustee is liable to pay land tax if the taxable value of Western Australian land held on trust exceeds $300,000 (for 2015-16). However, the trustee is not personally liable for the tax to any greater extent than to the amount of any funds or securities for money of the beneficiary that the trustee holds, or of which the trustee has the controlling power, after receiving a land tax assessment notice (s 9 of the Land Tax Assessment Act 2002 (WA)). The principal place of residence exemption is restricted to property held on behalf of a disabled beneficiary who uses the property as his or her principal place of residence (s 26).

[17 070] Australian Capital Territory In the Australian Capital Territory, the Duties Act 1999 (ACT) charges duty on various transactions, including: • the transfer, agreement for sale, or grant of dutiable property; • the declaration of trust over property; and • the acquisition of interests in landholding unit trust schemes. The person liable to pay the duty is the transferee or the person to whom the property is to be transferred under the agreement. When a trust is established, duty is payable on the value of the trust property. A concessional rate of $200 is payable if the trust is declared over non-dutiable property. Nominal duty applies to certain transfers as a consequence of a change of trustee. The transfer of dutiable property to beneficiaries for no consideration 322

2016 THOMSON REUTERS

STATE AND TERRITORY TAXES [17 080]

and in conformity with the terms of the trust deed may also qualify for nominal duty if the ACT Commissioner is satisfied of certain matters. The transfer or grant of dutiable property to a special disability trust is exempt from duty if the property is the beneficiary’s principal place of residence.

ACT land tax Land in the ACT is owned by the Commonwealth Government, so land tax is imposed on leases. Land tax generally applies to residential properties that are rented or are owned by a trustee. For the purpose of the Land Tax Act 2004 (ACT), ‘‘trustee’’ does not include an executor of a will or an administrator of a deceased estate.

[17 080] Northern Territory In the Northern Territory, duty is imposed on dutiable instruments and conveyances of dutiable property. ‘‘Conveyance’’ is defined widely to include a declaration of trust (s 56BA of Stamp Duty Act 2007 (NT)). The person liable to pay the duty is generally the transferee or the person to whom the property is to be transferred under the agreement. Ad valorem duty is payable on the agreement to transfer property, with no duty payable on the transfer document. Land tax is not payable in the Northern Territory.

Conveyances involving discretionary trusts The following transactions involving discretionary trusts also attract duty, unless all of the beneficiaries (whether existing or new) are members of the same family and the Northern Territory Commissioner is satisfied that no tax avoidance is involved (s 56BAB): • the addition of a person or class of persons as a beneficiary; • the sale of a beneficial interest by a beneficiary; and • an amendment or variation to the terms of a non-discretionary trust that has the effect of creating a discretionary trust. The trustee and any person who becomes a beneficiary as a result of the conveyance are jointly and severally liable for the duty payable on the conveyance. The conveyance is assessed for duty as a conveyance of all the dutiable property subject to the trust. Certain changes in the control of a corporate beneficiary and the trustee of a discretionary trust are treated as a conveyance for the reconstitution of a trust (s 56BAC). For this rule to apply, the changes in control must occur within a 12-month period and the changes must substantially arise from one transaction or one series of transactions. The trustee and corporate beneficiary are jointly and severally liable for the duty imposed on the conveyance. However, duty is not payable if the Northern Territory Commissioner is satisfied that the changes are not part of a tax avoidance scheme.

2016 THOMSON REUTERS

323

324

2016 THOMSON REUTERS

INDEX A Absence concession deceased estate – capital gains tax ...................................... [5 530] Accounting periods substituted ................................................. [14 060] Active asset reduction meaning ...................................................... [8 210] reduction – small business relief, CGT ..................... [8 140] Administrative penalties closely held trusts – trustee, reporting and payment obligations .............................................................. [12 220] Administrator role .............................................................. [5 310] Affiliate meaning ...................................................... [8 020] Amalgamated loans compliant loans ......................................... [11 220] deemed dividends ..................................... [11 240]

– specific exclusions ................................ [11 120] Attribution managed investment trusts (AMITs) elective regime ........................................... [1 200] Australian business number (ABN) application from a trust ............................ [14 040] Australian Capital Territory duties ......................................................... [17 – declaration of trust ............................... [17 – nominal duty ......................................... [17 land tax ..................................................... [17

070] 070] 070] 070]

Australian Tax Office (ATO) administration – substituted accounting periods ............. [14 060] borrowings – property unit trust ................................... [6 110] family trust elections – family group ........................................... [7 130] – nomination of test individual ................. [7 120] deemed dividend – sub-trusts, use ....................................... [11 320]

B

Amendment of assessments time limit .................................................. [14 020]

Bad debt unpaid present entitlement – beneficiary .............................................. [6 140]

Amendment to trust deed court application ......................................... [2 540] power to amend or vary ............................. [2 520]

Bare trusts common types of trusts .............................. [1 180]

Beneficiaries CGT event E5 – becoming entitled to trust asset ............. [5 160] Anti-avoidance provisions CGT event E6 ............................................ [5 170] elements of Pt IVA ................................... [10 010] CGT event E7 ............................................ [5 180] CGT general discount ................................ [5 030] deductibility income diverted – expenses .................................................. [6 100] – tax-exempt entities ............................... [10 060] – legal costs ............................................... [6 130] income splitting via trust ......................... [10 020] – unpaid present entitlement ..................... [6 140] – partnerships of discretionary trusts ...... [10 020] discretionary trust ....................................... [2 460] personal services income regime ............. [10 030] – averaging ................................................ [9 210] Pt IVA, provisions .................................... [10 010] disposal by beneficiary of revocable trusts ......................................... [10 040] capital interest ...................................... [5 190] rules .............................................. [3 510], [3 520] eligible trust ................................................ [2 460] schemes involving trusts .......................... [10 010] excluded ...................................................... [2 460] tax avoidance measures ............................ [10 000] farm management deposits ........................ [9 310] tax-exempt entities fixed trust – distributions .............................. [3 510], [5 520] – averaging ................................................ [9 220] transferor trust rules ................................. [10 070] key elements of trust .................................. [2 460] trust stripping ............................................ [10 050] legal costs ................................................... [6 130] legal disability Application triggers – trust income ............................................ [3 220] CGT events ................................................. [5 100] legal personal representative (LPR) Appointor – capital gain or loss, transfer ................... [5 330] removal and replacement ........................... [2 470] non-resident beneficiaries — see Non-resident trust deed .................................................... [2 470] beneficiaries Assets occupation by, provision for use – LPR acquired .......................................... [5 560] All references are to paragraph numbers Annual distribution minutes beneficiary ................................................... [3 110]

2016 THOMSON REUTERS

325

INDEX Beneficiaries — cont

present entitlement ....................... [3 100]–[3 120] primary producer concessions .................... [9 000] primary production ..................................... [9 100] relationship in trust .................................... [1 000] resident ...................................................... [15 000] rights ........................................................... [2 460] streaming rules – franked distribution, assessment ............ [4 130] tax rates ..................................................... [14 110] taxation – present entitlement ................................. [3 210] – trust income ............................................ [3 000] trust income – assessment .............................................. [5 210] – gains or distributions .............................. [4 260] trustee – distributions and resolutions .................. [2 300] – relationship between ............................... [1 000] Board of Taxation Div 7A review .......................................... [11 030] Borrowings property unit trust – to acquire units ....................................... [6 110] – to pay trust distributions ........................ [6 010] Breaches Div 7A – application consequences ..................... [11 630] Building concession capital gains tax – deceased estate ....................................... [5 540] Business structures involving trusts — see Structures Buy-sell agreements rollover ........................................................ [5 340]

C Capital income – characterisation as .................... [2 110], [3 340] Capital advancement power .......................................................... [2 130] trustee .......................................................... [2 430]

trust estate income ...................................... [3 310] unused – deceased .................................................. [5 410] Capital gains tax (CGT) application to trusts .................................... [5 000] CGT concession stakeholder test ............... [8 230] CGT event E1 ............................................ [5 120] general discount .......................................... [5 030] creator, consequences ................................. [5 120] death consequences – discount ................................................... [5 380] – collectibles and personal use items ....... [5 400] – cost base rules ........................................ [5 370] – deceased foreign resident ....................... [5 350] – gain or loss disregarded ......................... [5 320] – integrated example ................................. [5 590] – LPR and administrator, role ................... [5 310] – non-application of rollover or exemption ............................................. [5 340] – record keeping ........................................ [5 420] – small business concessions .................... [5 390] – special rules ............................................ [5 300] – tax-advantaged entities ........................... [5 340] – time of acquisition .................................. [5 380] – unused capital losses .............................. [5 410] deceased estate – absence concession ................................. [5 530] – building concession ................................ [5 540] – dwelling disposed of within two years .............................................. [5 510] – dwellings acquired, exemption .............. [5 500] – joint tenant, death ................................... [5 580] – life estates and remainders ..................... [5 570] – main residence ........................................ [5 550] – surviving spouse or beneficiary ............. [5 520] declaration .................................................. [5 120] discretionary trust – renouncing an interest ............................ [5 220] exceptions ................................................... [5 120] – dwellings acquired .................................. [5 500] life and remainder interests, creation ........ [5 120] legal personal representative (LPR) – occupation by beneficiary ...................... [5 560] – role .......................................................... [5 310] rollover relief .............................................. [5 700] – transfer of assets from fixed trusts to companies ................................................................ [5 710] – transfer of assets between fixed trusts ........... [5 720] settlement .................................................... [5 120] small business relief – 15-year exemption .................................. [8 120] – active asset reduction ............................. [8 140] – concessions ............................................. [8 100] – maximum net asset value test ................ [8 250] – replacement asset rollover ...................... [8 130] – retirement exemption .............................. [8 110] – shares and trusts interests ...................... [8 220] – small business entity test ....................... [8 010] – small participation percentage ............... [8 240] trust deed inclusions ................................... [2 130]

Capital gains and losses capital proceeds .......................................... [5 010] cost base ..................................................... [5 010] foreign resident beneficiary ........................ [5 050] foreign residents ......................................... [5 050] managed investment trusts ......................... [5 000] net amount .................................................. [5 020] streaming rules ........................................... [4 000] – beneficiary .............................................. [4 130] – trustee ...................................................... [4 140] temporary residents .................................... [5 050] treatment – beneficiaries ............................................ [5 040] – extra capital gains, calculation ............... [4 310] – streaming rules ....................................... [4 300] – trust deed terms, significance ................. [4 330] – trustee, assessment ................................. [4 320] Capital payment for trust interest All references are to paragraph numbers

326

2016 THOMSON REUTERS

INDEX Capital payment for trust interest — cont

CGT event E4 ............................................ [5 150] Capital proceeds cost base elements ...................................... [5 100] Case study trust income ................................................ [3 440]

FCT v ElecNet (Aust) Pty Ltd (Trustee) [2015] FCAFC 178 .......................................... [1 120] FCT v Everett (1980) 10 ATR 608 .......... [10 020] FCT v Galland (1986) 18 ATR 33 .......... [10 020] FCT v Mochkin (2003) 52 ATR 198 ....... [10 010] FCT v Ramsden (2005) 58 ATR 485 ........ [3 110], [3 130] Forrest v FCT (2010) 78 ATR 417 ........... [6 110] Gutteridge and FCT, Re [2013] AATA 947 ....... [8 030] Howard v FCT [2014] 92 ATR 38 ............ [1 010] Healey v FCT (2012) 87 ATR 848 ............ [5 130] Kafataris v DCT (2008) 73 ATR 531 ........ [5 120] Kafataris v DCT [2015] FCA 874 ............. [5 120] Keadly Pty Ltd & Ors, Re [2015] SASC 124 ................................................................ [2 540] Kelly v FCT [2013] FCAFC 88 ............... [10 020] Kocic and FCT, Re (2011) 82 ATR 211 .......... [11 610] Korda v Australian Executor Trustees (SA) Ltd [2015] HCA 6 ....................................... [1 010] Lambert and FCT, Re [2013] AATA 442 ................................. [2 520] McCutcheon and FCT, Re (2006) 63 ATR 1323 .............................................................. [10 050] Mercanti v Mercanti [2015] WASC 297 ............ [2 470] NR Allsopp Holdings Pty Ltd and FCT [2015] AATA 654 ........................................... [11 510] Moignard and FCT, Re [2014] AATA 342 ........ [3 110] Oswal v FCT [2013] FCA 745 .................. [5 120] Paloto Pty Ltd v Herro [2015] NSWSC 445 .... [2 540] Phillips and FCT, Re [2012] AATA 219; 88 ATR 297 ........................................................ [8 250] Pope and FCT, Re [2014] AATA 532 ....... [6 140] Raftland v FCT (2008) 68 ATR 170 ......... [3 320] Saunders v Vautier (1841) 49 ER 282 ...... [2 460] Tabone and FCT, Re (2006) 62 ATR 1210 ............................ [6 120] Taras Nominees Pty Ltd v FCT [2015] FCAFC 4 ................................................................ [5 120] Thomas v FCT [2015] FCA 968 .......... [2 100], [2 120], [3 100], [3 110], [3 340] Track and FCT [2015] AATA 45 ....... [8 250], [10 010] Wooster v Morris [2013] VSC 594 ........... [2 450] Yazbek v FCT (2013) 88 ATR 792 .......... [14 020] Zobory v FCT (1995) 30 ATR 412 ............ [1 010]

Cases Alan Synman Family Trust, Re [2013] VSC 364 ................................................................ [2 540] Alderton and FCT, Re [2015] AATA 807 .......... [3 130] Andtrust Pty Ltd v Andreatta [2015] NSWSC 38 ................................................................ [2 520] Antonopoulos and FCT, Re (2011) 84 ATR 311 ................................................................ [6 100] Arthur Brady Family Trust; Re Trekmore Trading Trust, Re [2014] QSC 244 ................... [2 540] Bamford’s case, FCT v Bamford (2010) 75 ATR 1 .... [16 000], [2 100], [2 110], [3 310], [3 340] Barkworth Olives Management Ltd v DCT (2010) 78 ATR 827 ........................................ [14 030] Bell v FCT [2013] FCAFC 32 ................... [8 250] BERT Pty Ltd and FCT, Re [2013] AATA 584 ................................................................ [1 120] BRK (Bris) Pty Ltd v FCT (2001) 46 ATR 347 ................................................. [2 300], [3 120] Bruton Holdings Pty Ltd (in liq) v FCT (2011) 83 ATR 864 ............................................... [2 450] Building Company Owner and FCT, Re (2012) 91 ATR 186 .............................................. [11 630] Cachia and FCT, Re (2005) 59 ATR 1056 ............................ [6 130] Cajkusic v FCT (2006) 64 ATR 676, ........ [3 320] Chief Commr of Stamp Duties (NSW) v Buckle (1998) 37 ATR 393 .............................. [2 450] Colonial First State Investments Ltd v FCT (2011) 81 ATR 772, [2011] FCA 16 .............. [2 300], [3 340], [7 020] Confidential and FCT (2008) 73 ATR 675 ........ [3 130] CPT Custodian Pty Ltd v Commissioner for State Revenue (Vic) (2005) 60 ATR 371 ....... [3 110] CSR (Vic) v Lam & Kym Pty Ltd (2004) 58 ATR 60 .......................................................... [2 530] Cumins v FCT (2007) 56 ATR 57 ............ [10 010] D Marks Partnership by its General Partner Quintaste Pty Ltd v FCT [2016] FCAFC 86 .............................................................. [11 010] Dion Investments Pty Ltd [2014] NSWCA 367 ................................................................ [2 540] CGT events application triggers ..................................... [5 Domazet v Jure Investments Pty Ltd [2016] CGT event E1 ............................................ [5 ACTSC 33 ............................................ [2 540] CGT event E2 ElecNet (Aust) Pty Ltd (Trustee) v FCT [2015] – CGT asset, transferring to trust ............. [5 FCA 456 ............................................... [1 120] CGT event E3 FCT v Australian Building Systems Pty Ltd (in – trust converting to unit trust .................. [5 liq); FCT v Muller and Dunn as Liquidators of CGT event E4 Australian Building Systems Pty Ltd (in liq) – capital payment for trust interest ........... [5 [2015] HCA 48 ................................... [14 030] FCT v Clarke (2011) 79 ATR 550 ............ [2 530] CGT event E5 FCT v Commercial Nominees of Australia (2001) – beneficiary becoming entitled 47 ATR 220 .......................................... [2 530] to trust asset .......................................... [5 All references are to paragraph numbers 2016 THOMSON REUTERS

100] 120] 130] 140] 150]

160]

327

INDEX CGT events — cont

CGT event E6 – disposal to beneficiary to end income right .................................. [5 170] CGT event E7 – disposal to beneficiary to end capital interest ............................... [5 180] CGT event E8 – disposal by beneficiary of capital interest ...................................... [5 190] CGT event E9 – trust creation over future property ......... [5 200] trusts ............................................................ [5 110] trusts excluded ............................................ [5 110] CGT general discount foreign residents – denial ...................................................... [5 050] Chain of trusts business structures ...................................... [1 100] specifically entitled ..................................... [4 250] Charitable trusts separate legal entity .................................... [1 000] tax concessions ........................................... [1 170] Children — see Minors Closely held trusts common types of trusts .............................. [1 100] non-disclosure tax – trustee beneficiary ................................. [12 110] reporting rules .......................................... [12 000] TFN withholding rules – trusts excluded ...................................... [12 200] – withholding arrangements .................... [12 200] – withholding events ............................... [12 210] trustee – reporting and payment obligations ...... [12 220] trustee beneficiary – reporting rules ...................................... [12 100] Collectibles and personal use items death consequences – capital gains tax ...................................... [5 400] Commissioner of Taxation amalgamated loans – repayment period extension ................. [11 powers ....................................................... [11 public officer ............................................. [14 trust estate income ...................................... [3 trusts resettlement ....................................... [2 unpaid present entitlements – debt ......................................................... [6 – general loan rules ................................. [11

240] 000] 050] 340] 530] 140] 400]

Commissioner’s discretion Division 7A ............................................... [11 000] – application consequences ..................... [11 620] – applying ................................................ [11 620]

fixed trusts .................................................. [1 120] hybrid trusts ................................................ [1 130] managed investment trusts ..... [1 200] — see also Attribution managed investment trusts (AMITs) special disability trusts ............................... [1 160] superannuation funds .................................. [1 190] testamentary trusts ...................................... [1 140] Company bucket company arrangement .................... [1 100] Division 7A, taxpayers subject ................ [11 010] payments and loans – interposed entities ................................. [11 510] private — see Private companies Compliant loans and repayments amalgamated loans ................................... loan repayments ........................................ minimum yearly payment – calculation ............................................. prior year loans – deemed dividends .................................

[11 220] [11 210] [11 230] [11 240]

Composite payments trustee loans, payments, forgiven debts ........... [11 420] Constructive trust non-express trusts ....................................... [1 010] Control test non-fixed trusts ........................................... [7 030] Corpus/income trust law distinction .................................... [1 000] Current law/proposed models comparison ................................................ [16 010] Custodians foreign global – tax return .............................................. [14 000]

D Damages minors – unearned income .................................. [13 130] Death capital gains – gain or loss disregarded ......................... [5 capital gains tax .......................................... [5 – collectibles and personal use items ....... [5 – small business concessions .................... [5 unearned income of minors – Division 6AA ........................................ [13

320] 300] 400] 390] 120]

Debts forgiven debts — see Forgiven debts Deceased foreign resident ........................................... [5 350] unused capital losses .................................. [5 410]

Common types of trusts bare trusts ................................................... [1 180] Deceased estates capital gains tax charitable trusts .......................................... [1 170] – absence concession ................................. [5 530] child maintenance trusts ............................. [1 150] – building concession ................................ [5 540] closely held trust ........................................ [1 100] – consequences on death ........................... [5 590] discretionary trusts ...................................... [1 110] All references are to paragraph numbers

328

2016 THOMSON REUTERS

INDEX Deceased estates — cont

– dwelling disposed of within two years ................................... [5 – joint tenant, death ................................... [5 – life estates and remainders ..................... [5 – main residence ........................................ [5 CGT – dwellings acquired, exemption .............. [5 CGT event E5, exclusion ........................... [5 closely held trusts – reporting rules, exclusion ..................... [12 cost base rules ............................................ [5 rates of tax payable by trustees ............... [15 trust losses .................................................. [7 trustee – trust income ............................................ [3

510] 580] 570] 550] 500] 160] 100] 370] 020] 230] 220]

Declaration of trust CGT asset ................................................... [5 120] Deemed dividends arising prevention ..................................... [11 200] forgiven debts ........................................... [11 130] loans .......................................................... [11 110] prior year loans – deemed dividends ................................. [11 240] private companies ..................... [11 000], [11 120] proposed reforms ...................................... [16 030] Default beneficiaries trustee .......................................................... [2 300] Definitions adjusted Div 6 percentage .......................... [4 110] affiliate ........................................................ [8 020] associate of a shareholder ........................ [11 010] beneficiaries ................................................ [2 460] closely held trusts ..................................... [12 000] connected entity .......................................... [8 030] discretionary beneficiaries .......................... [2 460] distribution .................................................. [7 230] Div 6 percentage ........................................ [4 110] Div 6E income ............................................ [4 110] Div 6E net income ..................................... [4 110] Div 6E present entitlement ........................ [4 110] excepted person ........................................ [13 010] excluded class ............................................. [2 460] forgiven debts ........................................... [11 100] forgives a debt .......................................... [11 130] income ........................................................ [2 130] income of the trust estate ........................... [4 110] loan ............................................................ [11 100] net financial benefit .................................... [4 110] net income ................................................ [11 430] net income of the trust estate ..................... [4 110] net value of the CGT assets ...................... [8 250] payment ..................................... [11 100], [11 120] present entitlement ..................... [4 110], [11 430] share of the net income of the trust estate ........ [4 110] specific entitlement ..................................... [4 110]

common types of trusts .............................. [1 110] deductibility – expenses .................................................. [6 100] drafting objectives ...................................... [2 000] express trusts .............................................. [1 010] key issues .................................................... [2 000] minors – unearned income .................................. [13 160] small business ............................................. [8 030] primary production business – no trust income ....................................... [9 330] Discretionary unit trust common types of trusts .............................. [1 100] Distributable surplus formula ...................................................... [11 610] net assets ................................................... [11 610] Distribution Minute drafting ........................................................ [3 450] resolutions ................................................... [3 400] Dividend washing Franking credits .......................................... [4 600] Division 6 present entitlement – timing ...................................................... [3 taxation of income ...................................... [3 – beneficiary .............................................. [3 – core provisions ....................................... [3 – key concepts ........................................... [3 – trust losses .............................................. [7 – trustee ...................................................... [3 trust estate – income .................................................... [3 trust income, taxation – determination .......................................... [3 – key concepts ........................................... [3 – net (taxable) income, differences ........... [3 trusts ............................................................ [3 Division 6AA minors, unearned income – classes excluded ................................... – outline ................................................... – tax rate .................................................. trusts – damages ................................................ – discretionary trusts ............................... – employment income ............................. – income derived by minors ................... – income resulting from death ................ – indirect receipts from death ................. – excepted trust income ..........................

300] 420] 020] 430] 010]

[13 010] [13 000] [13 020] [13 130] [13 160] [13 140] [13 100] [13 110] [13 120] [13 150]

Division 7A application consequences – Commissioner’s discretion ................... [11 – distributable surplus .............................. [11 – dividend deeming ................................. [11 – honest mistakes ..................................... [11 Discretionary trusts – inadvertent omissions ........................... [11 – previous breaches ................................. [11 CGT event compliant loans and repayments – renouncing an interest ............................ [5 220] – amalgamated loans ............................... [11 closely held trusts ..................................... [12 000] All references are to paragraph numbers 2016 THOMSON REUTERS

120] 000] 210] 200] 020] 000] 220]

620] 610] 600] 630] 630] 630] 220]

329

INDEX Division 7A — cont

– deemed dividend arising, prevention ............ [11 200] – loan repayments .................................... [11 210] – minimum yearly payment, calculation ........................................... [11 230] – prior year loans as deemed dividends ............................... [11 240] dividend deeming ..................................... [11 600] debt forgiveness – excluded transactions ............................ [11 130] forgiven debts as deemed dividends ........ [11 130] loans – deemed dividends ................................. [11 110] – within extended meaning ..................... [11 310] – within ordinary meaning ...................... [11 310] payments as deemed dividends ................ [11 120] private company transactions ................... [11 100] review, Board of Taxation ........................ [11 030] scope – deemed dividends ................................. [11 000] – taxpayers subject .................................. [11 010] – trust transactions ................................... [11 020] Subdiv EA risk – unpaid present entitlements .................. [11 340] tracing rules – company payments and loans .............. [11 510] – interposed entities ................................. [11 500] – trustee payments and loans .................. [11 520] trust transactions caught ........................... [11 020] trustee loans, payments, forgiven debts – Subdiv EA ............................................. [11 410] – Subdiv EA, amounts assessable ........... [11 440] – trust amounts, treatment as dividends ........................................ [11 400] – trustee payments, unrealised gain ........ [11 420] unpaid present entitlements – as loans ................................................. [11 310] – pre-16 December 2009 UPEs .............. [11 310] – private company beneficiaries .............. [11 300] – sub-trusts, creation ................................ [11 330] – sub-trusts, use ....................................... [11 320] – between trusts ....................................... [11 340] Documentation sub-trusts, use – deemed dividend ................................... [11 320] Double taxation avoidance .................................................... [4 500]

E Employment income minors – unearned income .................................. [13 140] Entity trust inclusion ........................................... [11 010] Events specific to trusts .......................................... [5 110] Excepted person minors ....................................... [13 000], [13 010]

Excluded payments deemed dividends ..................................... [11 120] Exemptions death consequences – non-application of rollover .................... [5 340] deceased estate – absence concession ................................. [5 530] – building concession ................................ [5 540] – disposal after occupation ........................ [5 520] – dwelling acquired ................................... [5 500] – dwelling disposed of .............................. [5 510] – main residence ........................................ [5 550] small business relief – 15 year .................................................... [8 120] – retirement ................................................ [8 110] Expenses power to determine .................................... [2 130]

F Family trust distribution tax trust losses – interposed entity’s liability .................... [7 210] – payment .................................................. [7 200] – secondary liability .................................. [7 220] – trustee’s primary liability ....................... [7 200] Family trusts distribution – rates of tax payable by trustees ........... [15 100] family trust election – family control test .................................. [7 140] – family group ........................................... [7 130] – test individual, nomination ..................... [7 120] income injection test, ................................. [7 040] trust losses – family trust election ................................ [7 110] – interposed entity election ....................... [7 150] – interposed entity’s liability .................... [7 210] – payment .................................................. [7 200] – secondary liability .................................. [7 220] – special position ....................................... [7 100] – test individual, nomination ..................... [7 120] – trustee’s primary liability ....................... [7 200] Farm management deposits and trusts beneficiary – owner ...................................................... [9 deeming rule ............................................... [9 discretionary trust – no income ............................................... [9 general trust rules ....................................... [9 schemes ....................................................... [9

310] 320] 330] 340] 300]

Fiduciary relationship key trust concept ........................................ [1 000] duties of the trustee .................................... [2 440] 15 year exemption small business relief, CGT ......................... [8 120] 50% stake test fixed trusts – recoupment provisions ........................... [7 020]

First minimum yearly repayment Excluded loans working out ............................................... [11 230] private companies ..................................... [11 110] All references are to paragraph numbers

330

2016 THOMSON REUTERS

INDEX Fixed discretionary trust common types of trusts .............................. [1 120] Fixed entitlement trust losses .................................................. [7 020] Fixed trusts common types of trusts .............................. [1 120] primary production averaging provisions ............................ [9 100] recoupment provisions ............................... [7 020] Foreign residents beneficiaries ................................................ [5 capital gains and losses .............................. [5 CGT general discount – denial ...................................................... [5 deceased ...................................................... [5 trust tax return, streamlined ..................... [14

050] 050]

– diverted to tax-exempt entities ............ [10 060] – splitting via trust .................................. [10 020] capital gains – streaming and matching ......................... [2 120] tests – trust losses .............................................. [7 010] – injection test ........................................... [7 040] resulting from death – trusts ...................................................... [13 110] trust estate ................................................... [3 300] – cap on ..................................................... [3 340] Income/net income differences – trust deed ................................................ [2 100]

050] 350] 000]

Indemnity right trustee .......................................................... [2 450]

Forgiven debts deemed dividends ..................................... [11 130] Subdiv EA ................................................. [11 410] private company transactions ................... [11 100]

Interest deductibility loans relating to trust – borrowings to acquire units .................... [6 110] – loans settled on trust .............................. [6 020] – trust distributions .................................... [6 010]

Franked distributions assessment – beneficiary .............................................. [4 – trustee ...................................................... [4 net financial benefit – referable .................................................. [4 streaming rules ........................................... [4 treatment – pooled franked distribution .................... [4 – streaming rules, effect ............................ [4 – calculation ............................................... [4 trust deed inclusions ................................... [2

130] 140] 230] 000] 420] 400] 410] 130]

G Gains or distributions specifically entitled ..................................... [4 260] General powers trustee .......................................................... [2 430] Goods and services tax (GST) registration of a trust ................................ [14 040] Guardians trust deed .................................................... [2 480]

H Home loan unit trust arrangement interest deductibility ................................... [6 120] Honest mistakes inadvertent omissions ............................... [11 630] Hybrid trusts common types of trusts .............................. [1 130]

Interposed entities Division 7A – company payments ............................... [11 – tracing rules .......................................... [11 – trustee payments and loans .................. [11 election – timing and operation .............................. [7 liability – family trust distribution tax ................... [7

510] 500] 520] 150] 210]

Interposed trusts tracing rules – trustee payments and loans .................. [11 520]

J Joint tenant death – capital gains tax ...................................... [5 580] surviving – CGT building concession ....................... [5 540]

K Key concepts streaming rules ............................................ [4 110] taxation of income ...................................... [3 020] Key elements trust ............................................................. [2 400] – settlor ...................................................... [2 410] – trustee ...................................................... [2 420]

I

Key trust concepts common types of trusts .............................. [1 100] fiduciary relationship .................................. [1 000] taxation of trusts ......................................... [1 020]

Inadvertent omissions Division 7A application ............................ [11 630]

L

Landholding trusts Income state of Victoria ........................................ [17 050] accumulated in trust – taxation ................................................... [1 020] Legal costs beneficiaries ................................................ [6 130] anti-avoidance provisions All references are to paragraph numbers 2016 THOMSON REUTERS

331

INDEX Legal personal representative (LPR) capital gain or loss – transfer to beneficiary ............................ [5 – legal costs ............................................... [6 capital gains tax – death consequences ................................ [5 CGT building concession ........................... [5 occupation by beneficiary .......................... [5 role .............................................................. [5

330] 130] 310] 540] 560] 310]

Life and remainder interests creation ....................................................... [5 120] treatment ..................................................... [5 210] Life estates and remainders capital gains tax .......................................... [5 570] Loan repayments genuine ...................................................... [11 210] non-genuine .............................................. [11 210] Loans Division 7A – deemed dividends ................................. [11 110] – private company transactions ............... [11 100] – unpaid present entitlements .................. [11 310] interest deductibility – home loan unit trust arrangement .......... [6 120] – loans settled on trust .............................. [6 020] – trust distributions, payment .................... [6 010] – units in property, acquisition .................. [6 110] Loss trafficking deductibility restrictions ............................. [7 000] Losses family trust distribution tax – interposed entity’s liability .................... [7 210] – payment .................................................. [7 200] – secondary liability .................................. [7 220] – trustee’s primary liability ....................... [7 200] family trusts – family trust election ................................ [7 110] – interposed entity election ....................... [7 150] – special position ....................................... [7 100] – test individual, nomination ..................... [7 120]

M Managed investment trusts — see also Attribution managed investment trusts (AMITs) capital gains and losses .............................. [5 000] new elective tax regime ............................. [1 200] type of trusts ............................................... [1 200] Medicare levy rates of tax payable by trustees ............... [14 130] – non-deceased estates ............................ [15 060] Minimum yearly payment calculation ................................................. [11 230] Minors beneficiaries ................................................ [2 460] bank accounts ........................................... [13 200] child maintenance trusts ............................. [1 150] Division 6AA – classes excluded ................................... [13 010] – outline ................................................... [13 000] All references are to

332

– tax rate .................................................. [13 020] excepted person ........................................ [13 010] excepted trust income .............................. [13 150] trustees – trust income ............................................ [3 220] trusts – child maintenance ................................. [13 150] – damages ................................................ [13 130] – discretionary trusts ............................... [13 160] – employment income ............................. [13 140] – income derived by ................................ [13 100] – income resulting from death ................ [13 110] – indirect receipts from death ................. [13 120] – excepted trust income .......................... [13 150] Multiple trustee loans trustee loans, payments, forgiven debts – amounts assessable ............................... [11 440]

N Net capital gains and losses taxation of trusts ......................................... [1 020] Net financial benefit franked distribution, referable .................... [4 230] specifically entitled ..................................... [4 210] – capital gain, referable ............................. [4 220] Net income calculation ................................................... [3 425] trustee distributions and resolutions .......... [2 300] trust income – core assessing provisions ....................... [3 200] trustee loans, payments, forgiven debts ........... [11 430] Net taxable income trust income, differences ............................ [3 430] New models trust income, taxing .................................. [16 010] – key features ............................................ [16 020] New South Wales duties ......................................................... [17 – declaration of trust ............................... [17 – resettlements ......................................... [17 land tax ..................................................... [17

010] 010] 010] 010]

Nomination of test individual family trust ................................................. [7 120] Non-commercial loans repayments ................................................ [11 610] Non-deceased estates rates of tax payable by trustees – Medicare levy ....................................... [15 060] Non-fixed trusts trust losses, recoupment provisions – control test .............................................. [7 030] – pattern of distributions test .................... [7 030] Non-resident beneficiaries rates of tax payable by trustees ............... [15 010] Non-resident trusts rates of tax payable by trustees ............... [15 040] Northern Territory paragraph numbers 2016 THOMSON REUTERS

INDEX Northern Territory — cont

duties ......................................................... [17 080] – discretionary trusts ............................... [17 080] land tax ..................................................... [17 080]

O Offshore trusts transferor trust rules ................................. [10 070]

P

Private companies beneficiaries – unpaid present entitlements .................. [11 deemed dividends paid ............................. [11 Division 7A application ............................ [11 – payments as deemed dividends ............ [11 – transactions ........................................... [11 unpaid present entitlements – as debt ..................................................... [6 – as loans ................................................. [11

300] 000] 010] 120] 100] 140] 310]

Paid up share value assessable amounts ................................... [11 610]

Professional practices splitting income ........................................ [10 020]

Particular powers trustee .......................................................... [2 430]

Property unit trust borrowings to acquire units ........................ [6 110]

Passive income unearned income ...................................... [13 000]

Proprietary companies Div 7A purposes ....................................... [11 010]

Pattern of distributions test trust losses, recoupment provisions – non-fixed trusts ....................................... [7 030]

Pt IVA anti-avoidance provisions ......................... [10 010] personal services income regime ............. [10 030]

Payments trustee’s liability ....................................... [14 030] private company transactions ................... [11 100] Personal services income regime anti-avoidance provisions ......................... [10 030] Planning opportunities unpaid present entitlements – sub-trusts, creation ................................ [11 330] Pooled franked distribution distributions ................................................ [4 420] Power to amend trust deed .................................................... [2 520] Pre-16 December 2009 UPEs unpaid present entitlements – Division 7A ........................................... [11 310] Pre-CGT interest in trust CGT events ................................................. [5 220] Present entitlements beneficiary ................................................... [3 110] disclaiming .................................................. [3 130] key concept ................................................. [3 100] streaming rules ........................................... [3 140] timing .......................................................... [3 120] unpaid – as debt ..................................................... [6 140] – as loans ................................................. [11 310] – private company beneficiaries .............. [11 300] – sub-trusts, creation ................................ [11 330] – sub-trusts, use ....................................... [11 320] – Subdiv EA risk ..................................... [11 340] – between trusts ....................................... [11 340] unit trusts .................................................... [3 110]

Q Queensland duties ......................................................... [17 020] land tax ..................................................... [17 020]

R Rates of tax payable by trustees family trust distribution ............................ [15 100] Medicare levy – non-deceased estates ............................ [15 060] non-resident beneficiaries ......................... [15 010] non-resident trusts .................................... [15 040] resident beneficiaries ................................ [15 000] resident trust of deceased estate .............. [15 020] resident trust of non-deceased estate ....... [15 030] s 99A assessments .................................... [15 050] trustee beneficiary non-disclosure ............ [15 110] Re-characterisation trust deed inclusions ................................... [2 130] Records specific entitlement ..................................... [4 240] Recoupment provisions trust losses – applicable tests, summary ...................... [7 010] – fixed trusts .............................................. [7 020] – income injection test .............................. [7 040] Reimbursement agreements trust stripping — see trust stripping Replacement asset rollover small business relief, CGT ......................... [8 130] Reporting rules closely held trusts ..................................... [12 000] – trustee beneficiary ................................ [12 100]

Primary production concessions Resettlement – availability .............................................. [9 000] changes to a trust ....................................... [2 530] discretionary trusts ..................................... [9 210] fixed trusts .................................................. [9 220] Resident averaging ........................ [9 100], [9 210], [9 220] beneficiaries – trust loss situation .................................. [9 200] – rates of tax payable by trustees ........... [15 000] All references are to paragraph numbers 2016 THOMSON REUTERS

333

INDEX Resident — cont

foreign resident — see Foreign resident trust ceasing to be ...................................... [5 220] Resident trust estates rates of tax payable by trustees – deceased estate ..................................... [15 020] – non-deceased estate .............................. [15 030] residency ..................................................... [3 200] Retirement small business exemption ........................... [8 110] Returns and assessments administration ........................................... [14 000] amending assessments – time limit .............................................. [14 020] foreign beneficiaries ................................. [14 000] substituted accounting periods ................. [14 060] Review of trust tax other proposed reforms affecting trusts ............ [16 030] proposals to rewrite the trust income tax provisions ............................................ [16 000] Revocable trusts anti-avoidance provisions ......................... [10 040] trustee – trust income ............................................ [3 220]

S S 99A assessments rates of tax payable by trustees ............... [15 050] S 109RB discretion matters relevant ........................................ [11 630] Secondary liability trust losses – family trust distribution tax ................... [7 220] Service entity arrangements trust deductions .......................................... [6 030] Settlement CGT asset trust ........................................... [5 120] Settlor key elements of trust ................... [1 000], [2 410] Shares capital gains tax – small business relief ............................... [8 200] Simple settlement trust ............................................................. [1 Small business concessions death consequences – capital gains tax ...................................... [5 general ........................................................ [8 50% reduction discount .............................. [1

000]

390] 000] 020]

– – – – – –

maximum net asset value test ................ [8 250] replacement asset rollover ...................... [8 130] restructure rollover relief ....................... [8 300] retirement exemption .............................. [8 110] shares and trusts interests ...................... [8 220] small business entity test ....................... [8 010]

Small business restructure rollover relief consequences .............................................. [8 320] requirements ............................................... [8 310] Small business tax offset 5% discount – calculation ............................................. [14 140] South Australia duties ......................................................... [17 030] land tax ..................................................... [17 030] Special disability trusts common types of trusts .............................. [1 100] trust income – core assessing provisions ....................... [3 210] Specific entitlement net financial benefit .................................... [4 210] present entitlement, differences ................. [4 200] trust record .................................................. [2 120] Specifically entitled beneficiary .................................................. [4 chain of trusts ............................................. [4 definition ..................................................... [2 gains or distributions .................................. [4 net financial benefit – capital gain, referable ............................. [4 – franked distribution, referable ................ [4 recorded ...................................................... [4 streaming measures .................................... [2 trust record .................................................. [2

200] 250] 120] 260] 220] 230] 240] 120] 120]

State and territory taxes — see New South Wales — see Queensland — see South Australia — see Tasmania — see Victoria — see Western Australia — see Australian Capital Territory — see Northern Territory duties ......................................................... [17 000] land tax ..................................................... [17 000] Step-by-step guide trust income – assessing ................................................. [4 600] Streaming and matching clause .......................................................... [2 120] specifically entitled – core concept ............................................ [2 120] trust deed inclusions ................................... [2 130]

Streaming rules application .................................................. [4 120] Small business entities beneficiary, assessment time ...................... [4 130] proposed increase in turnover threshold .......... [16 combined operation .................................... [4 610] 030] double taxation – avoidance ................................................ [4 500] Small business relief franked distributions, effect ....................... [4 400] capital gains tax – 15-year exemption .................................. [8 120] franking credits – active asset reduction ............................. [8 140] – dividend washing .................................... [4 600] – concessions ............................................. [8 100] key concepts ............................................... [4 110] All references are to paragraph numbers

334

2016 THOMSON REUTERS

INDEX Streaming rules — cont

present entitlement ..................................... [3 trust income – background and context ......................... [4 – capital gains ............................................ [4 – franked distributions ............................... [4 – summary ................................................. [4 trustee, assessment time ............................. [4 Structures bucket company arrangement .................... [1 chain of trusts ............................................. [1 Sub-trusts creation ...................................................... [11 unpaid present entitlements ........................ [2 – use ......................................................... [11

140] 010] 000] 000] 100] 140] 100] 100] 330] 320] 320]

Subdiv EA trustee loans, payments, forgiven debts ........... [11 410] – amounts assessable ............................... [11 440] Subsequent year minimum yearly repayment – calculation ............................................. [11 230] Successor trust deed .................................................... [2 470] Superannuation funds common types of trusts .............................. [1 190] Surviving spouse or beneficiary capital gains tax – disposal after occupation ........................ [5 520]

T Tasmania duties ......................................................... [17 040] land tax ..................................................... [17 040] Tax-advantaged entities CGT consequences of death ...................... [5 340] Tax avoidance summary of measures .............................. [10 000] Tax-exempt entities, distributions anti-avoidance provisions ............ [3 510], [3 520] trust income, taxation ................................. [3 500] Tax File Number (TFN) closely held trusts – trustee, reporting and payment obligations .............................................................. [12 220] – withholding arrangements .................... [12 200] – withholding events ............................... [12 210] Tax offsets and rebates tax rates .................................................... [14 140] Tax rates beneficiaries .............................................. [14 110] Div 6AA ................................................... [13 020] tax offsets and rebates .............................. [14 140] – small business ....................................... [14 140] – worked example ................................... [14 150] trust structures .......................................... [14 100] trustee ........................................................ [14 120]

administration ........................................... [14 000] Taxation avoidance — see Anti-avoidance provisions capital gains tax — see Capital gains tax (CGT) double – streaming of tax income ........................ [4 500] offsets and rebates .................................... [14 140] – worked examples .................................. [14 150] passive income ......................................... [13 000] trusts ............................................................ [1 020] Taxpayers Div 7A, subject ......................................... [11 010] Temporary residents capital gains and losses .............................. [5 050] Testamentary trusts common types of trusts ............... [1 000], [1 140] Tracing rules company payments and loans .................. [11 510] interposed entities ..................................... [11 500] trustee payments and loans ...................... [11 520] Transferor trust rules anti-avoidance provisions ......................... [10 070] Transfers of property trustee change ............................................. [2 420] Trust amounts treatment as dividends .............................. [11 400] Trust creation over future property CGT event E9 ............................................ [5 200] Trust deed capital advance, power ............................... [2 expenses, power to determine .................... [2 importance .................................................. [2 income/net income – differences ............................................... [2 income determination ................................. [3 power to amend .......................................... [2 – court application ..................................... [2 re-characterise, power ................................ [2 rectify .......................................................... [2 significance – capital gains, treatment .......................... [4 stream income, capital gains and franked distributions, power .............................. [2

100] 420] 520] 540] 130] 540] 330] 130]

Trust distributions guide to making .......................................... [3 410] interest deductibility – loans settled ............................................ [6 020] Trust estate income ........................................................ [3 300] – quantum v proportionate approach ........ [3 310] – tax and trust cases .................................. [3 330]

Trust income assessing – combined operation of rules .................. [4 – step-by-step guide .................................. [4 capital gains, treatment – effect ....................................................... [4 – extra capital gains, calculation ............... [4 Tax returns and assessments All references are to paragraph numbers

2016 THOMSON REUTERS

130] 130] 000]

610] 600] 300] 310]

335

INDEX Trust income — cont

– trust deed terms, significance ................. [4 330] core assessing provisions ........................... [3 200] – beneficiary .............................................. [3 210] – trustee ...................................................... [3 220] distributions – tax-exempt entities ................................. [3 500] excepted .................................................... [13 150] – damages ................................................ [13 130] – employment income ............................. [13 140] – indirect receipts resulting from death .......... [13 120] minors – damages ................................................ [13 130] – derived by ............................................. [13 100] – employment income ............................. [13 140] – indirect receipts resulting from death .......... [13 120] – resulting from death ............................. [13 110] net financial benefit – specifically entitled ................................. [4 220] proposed reforms affecting trusts ............ [16 030] rate of tax ................................................. [14 100] rewrite of provisions ................................ [16 000] specifically entitled – recorded .................................................. [4 240] – net financial benefit ................................ [4 210] streaming rules – application .............................................. [4 120] – assessing trust income ............................ [4 600] – background and context ......................... [4 010] – capital gains ............................................ [4 000] – chain of trusts ......................................... [4 250] – double taxation, avoidance ..................... [4 500] – effect ....................................................... [4 300] – extra capital gains, calculation ............... [4 310] – franked distributions ........... [4 000], [4 230], [4 410] – key concepts ........................................... [4 110] – net financial benefit ................................ [4 230] – specifically entitled .................. [4 200], [4 260] – summary ................................................. [4 100] – trust deed terms, significance ................. [4 330] – trustee, assessment ................................. [4 320] taxation – anti-avoidance rules ................. [3 510], [3 520] – beneficiary ............................................... [3 110] – case study ............................................... [3 440] – distribution minute, drafting .................. [3 450] – distribution minutes ................................ [3 400] – income determination ............................. [3 420] – key concepts ........................................... [3 020] – of income ................................................ [3 000] – present entitlement ................................. [3 100] – resolutions ............................................... [3 400] – tax-exempt entities ................................. [3 500] – timing ...................................................... [3 120] – trust income/net (taxable) income, differences ................................................................ [3 430] – losses ....................................................... [7 000] taxing – new models, key features ..................... [16 020] – possible models .................................... [16 010] All references are to

336

tax provisions – government review ............................... [16 000] trustee – streaming rules ....................................... [4 140] Trust losses family trust distribution tax – interposed entity’s liability .................... [7 210] – payment .................................................. [7 200] – secondary liability .................................. [7 220] – trustee’s primary liability ....................... [7 200] family trusts – family group ........................................... [7 130] – family trust election ................................ [7 110] – interposed entity election ....................... [7 150] – special position ....................................... [7 100] – test individual, nomination ..................... [7 120] primary production averaging provisions – no trust income ....................................... [9 200] recoupment provisions – applicable tests, summary ...................... [7 010] – deductibility restrictions ......................... [7 000] – fixed trusts .............................................. [7 020] – income injection test .............................. [7 040] – non-fixed trusts ....................................... [7 030] Trust stripping anti-avoidance provisions ......................... [10 050] deemed dividend rules ............................. [10 050] exclusion for ordinary family or commercial dealings ............................................... [10 050] reimbursement agreement ........................ [10 050] trust income – core assessing provisions ....................... [3 200] washing machine arrangement ................. [10 050] Trustee beneficiary non-disclosure tax – rate ........................................ [12 110], [15 110] reporting rules .......................................... [12 100] Trustee distributions and resolutions taxation ....................................................... [2 300] Trustee loans, payments, forgiven debts composite payments ................................. [11 420] multiple trustee loans ............................... [11 440] payments only partly related to unrealised gains .............................................................. [11 420] Subdiv EA ................................................. [11 410] – amounts assessable ............................... [11 440] trust amounts – treatment as dividends .......................... [11 400] trustee payments ....................................... [11 420] unrealised gains ........................................ [11 420] Trustees administration – amendment of assessments .................. [14 – liability to pay tax ................................ [14 – tax returns ............................................. [14 assessment – capital gains, treatment .......................... [4 capital advancement ................................... [2 CGT event E5, consequences .................... [5 closely held trusts – reporting and payment obligations ...... [12 paragraph numbers

010] 030] 000] 320] 430] 160] 220]

2016 THOMSON REUTERS

INDEX Trustees — cont

Div 6 – taxation of trust income ......................... [3 duties ........................................................... [2 family trust distribution tax – primary liability ...................................... [7 indemnity right ........................................... [2 key elements – trust ......................................................... [2 loans .......................................................... [11 payments ................................................... [11 – liability .................................................. [14 powers ......................................................... [2 relationship ................................................. [1 streaming and matching clause .................. [2 streaming rules – franked distribution ................................ [4 tax rates .................................................... [14 taxation of trusts ......................................... [1 – flow-through vehicles ............................. [1 – like companies ...................................... [16 transfers of property ................................... [2 trust income ................................................ [3 trustee distributions and resolutions .......... [2 vesting obligations ...................................... [2

000] 440] 200] 450] 420] 520] 520] 030] 430] 000] 120] 140] 120] 020] 020] 000] 420] 220] 300] 510]

Trusts ABN application ....................................... [14 040] CGT application ......................................... [5 000] CGT events ................................................. [5 110] CGT events, exclusion – asset transfer to trust .............................. [5 130] – beneficiary entitlement to assets ............ [5 160] – capital interest, disposal ......................... [5 190] – end capital interest ................................. [5 180] – capital payment for trust interest ........... [5 150] – conversion to unit trust .......................... [5 140] – creation ................................................... [5 120] – end income right .................................... [5 170] – future property, trust creation ................ [5 200] – life and remainder interests .................... [5 210] – other events ............................................ [5 220] capital gains tax – small business relief ............................... [8 200] changes made, effect .................... [1 000], [2 530] creation ....................................................... [1 000] discretionary ............................................. [13 160] farm management deposit schemes ........... [9 300] flow-through vehicles ................................. [1 020] GST registration ....................................... [14 040] inter vivos trust .......................................... [1 000] key elements ............................................... [2 400] key trust concepts ....................................... [1 000] life span ...................................................... [2 500] minors – trust income ............................................ [3 220] ownership division ..................................... [1 000] pre-CGT interest in trust ............................ [5 220] primary production – averaging ................................................ [9 100] primary production business – deeming rule ........................................... [9 320] property ....................................................... [2 410] All references are to 2016 THOMSON REUTERS

public officer ............................................. [14 relationship – parties involved ...................................... [1 resettlement ................................................. [2 simple settlement ........................................ [1 taxation of trusts ......................................... [3 – flow-through vehicles ............................. [1 – provisions ................................................ [3 testamentary trust ....................................... [1 transactions ............................................... [11 types ............................................................ [1 vesting ......................................................... [2

050] 000] 530] 000] 010] 020] 010] 000] 020] 100] 510]

U Unadministered estates capital gains tax – death consequences ................................ [5 310] Unit trust CGT event E3 ............................................ [5 140] express trusts .............................................. [1 010] Unpaid present entitlements as debt ......................................................... [6 as loans ..................................................... [11 between trusts ........................................... [11 private company beneficiaries .................. [11 sub-trusts – creation .................................................. [11 – use ......................................................... [11 Subdiv EA risk ......................................... [11 trust deed .................................................... [2

140] 310] 340] 300] 330] 320] 340] 320]

Unrealised gains trustee loans, payments, forgiven debts ........... [11 420]

V Valid trust key elements ............................................... [2 400] Validity of trust beneficiaries ................................................ [2 460] Vesting date extension – Court application .................................... [2 540] Vesting of trust liabilities ..................................................... [2 510] Victoria duties ......................................................... [17 – declaration of trust ............................... [17 land tax ..................................................... [17 landholding trusts ..................................... [17

050] 050] 050] 050]

W Western Australia duties ......................................................... [17 – amendments to trust deeds ................... [17 – declaration of trust ............................... [17 – nominal duty ......................................... [17 land tax ..................................................... [17

060] 060] 060] 060] 060]

Withholding closely held trusts paragraph numbers

337

INDEX Withholding — cont

– TFN arrangements ................................ [12 200]

– TFN events ........................................... [12 210]

All references are to paragraph numbers

338

2016 THOMSON REUTERS