Business Succession and Trust Distributions That Don't Work

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1. Introduction

This short commentary discusses some of the more common examples of purported trust distributions which fail. It also addresses some of the potential adverse tax consequences. The reader will conclude that business succession in all its forms is a specialist area, requiring attention to detail from the accountant, the financial planner, the lawyer and last but not least, the client!

2. Trust Distributions & the intended recipient

Are they actually a ‘beneficiary’?

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

2.2 Care should be taken to identify classes of specifically excluded beneficiaries. Some common examples of these excluded classes include:

(a) persons who have either renounced their beneficial interest or have been removed as a beneficiary of the trust;

(b) the settlor;

(c) any ‘notional settlor’ – discussed further below; and

(d) the trustee.

2.3 The range of documents that could impact on the potential beneficiaries is almost limitless. Some examples include:

(a) resolutions of the trustee to add or remove beneficiaries pursuant to a power in the trust deed;

(b) nominations or decisions of persons nominated in roles such as an appointor, principal or nominator; and

(c) consequential changes triggered by the way in which the trust deed is drafted (for example, beneficiaries who are only potential beneficiaries while other named persons are living – a trap for the unwary).

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

2.5 This said, the fact that beneficiaries can unilaterally take such steps highlights the care that trustees must take when determining whether an intended recipient of a distribution is in fact a valid beneficiary of the trust.

2.6 In most instances within a close family group, the trustee is likely to have personal knowledge of any changes to the range of eligible beneficiaries, however these changes will not always be apparent to a professional adviser whose knowledge is limited to the trust documentation provided to them.

Beneficiaries who are not properly appointed

2.7 An example of a clause in a trust deed defining the range of beneficiaries and permitting additional beneficiaries to be appointed as follows:

“Additional Members of the Class of General Beneficiaries:

(a) The children of the Primary Beneficiaries;

(b) The more remote issue of the Primary Beneficiaries including any grandchildren or any Trust which may be formed for any of them or for any of the Primary Beneficiaries;

(c) Any company in which any one or more of them may hold a controlling interest; and

(d) Any person, trustee or company who shall be entitled by nomination of the appointor to become a general beneficiary.”

2.8 Given the way in which this clause is drafted, if there is an intention to distribute to a beneficiary not otherwise clearly within the parameters of subparagraphs (a) to (c), then the strict requirements of subparagraph (d) must be followed and the intended beneficiary must be formally nominated by the appointor.

2.9 Obviously, there are a number of potential issues that arise in this regard including:

(a) whether the appointment needs to be made in writing;

(b) whether the appointor is validly nominated to their role as appointor;

(c) at what point the nomination needs to take place in the context of the timeframe within which a distribution must be made; and

(d) whether there are any consequential ramifications of the nomination, for example, stamp duty, resettlement for tax purposes or asset protection issues.

Exclusion of settlor: the notional settlor clause

2.10 Almost all trust deeds contain a clause excluding the settlor of a trust from being a beneficiary, in order to ensure that the trust is not a ‘revocable trust’ under section 102 of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).

2.11 Some deeds, however, take the restriction further by prohibiting distributions to any ‘notional settlor’, in addition to the actual settlor.

2.12 For example, a trust deed may include a provision along the following lines:

‘A person who has transferred property for other than full consideration in money or money’s worth to the trustee to be held as an addition to the Trust Fund (herein called ‘the excluded persons’), or any corporation in which and the trustee of any settlement or trust in or under which any excluded person has an actual or contingent beneficial interest, so long as such interest continues, is excluded from the class of General Beneficiaries.’

2.13 Where such a clause exists, a beneficiary will likely be excluded from receiving distributions if they have:

(a) made interest-free loans to the trust;

(b) sold an asset to the trust at less than market value; or

(c) gifted cash or other assets to the trust.

2.14 As the main beneficiaries of a trust will have often contributed amounts to a trust in one or more of the ways mentioned above, the risk of invalid distributions being made where such a clause exists in a deed is significant.

2.15 Furthermore, any income or capital distributions to a trust containing a clause along the lines outlined above, from another discretionary trust in the group could be considered a ‘transfer of property for other than full consideration’.

2.16 This would then prevent the trust with the notional settlor clause distributing to those other entities, which have previously distributed income or capital to it.

Distributing to a non-beneficiary

2.17 The case of Harris–v–Harris [2011] FAMCAF 245 considered the purported distributions from a trust to a recipient who was found not to be a beneficiary.

2.18 Where a distribution has been made to a wrongful beneficiary, a range of tax and commercial issues arise. Briefly, those issues include:

(a) whether there are valid default distribution provisions under a trust deed;

(b) if there are no default distribution provisions, at least in relation to capital, then there is a risk that the trust itself will be considered void.

2.19 Assuming that there is a valid default distribution provision, then the main consequences include how you recover the invalid trust distributions from the wrongful recipient, how do you re-allocation them, and what are the taxation and stamp duty implications for all parties, and what are the potential personal liability issues for the trustee. In summary, you still have a mess which will likely be very costly to fix up.

2.20 These issues are all the more relevant if there is no valid default distribution provision. However, where that situation arises, the trustee is likely to be assessed under section 99A ITAA 1936 on the basis that no beneficiary will be presently entitled.

2.21 This means the trustee is assessed at the top marginal tax rate of 45% plus the Medicare levy of 2% unless the Commission ‘is of the opinion that it would be unreasonable that section 99A’ applies. Based on publicly available information, it is extremely rare that the Commissioner will exercise his discretion in this way.

2.22 Importantly, where the trustee is taxed, the ability to access the general 50% capital gains tax discount under s 115 ITAA 97 is denied.

Family trust elections and interposed entity elections

2.23 The consequences of a trustee making a family trust election or interposed entity election in particular, is that despite what might otherwise be provided for in the trust instrument, the election will effectively limit the range of potential beneficiaries who can receive a distribution without triggering a penal tax consequence – being the family trust distribution tax.

3. Distributions to particular beneficiaries

Distributions to another trust

3.1 All Australian jurisdictions except for South Australia have a statutory perpetuity period of 80 years. In Victoria, Tasmania, Western Australia and the Northern Territory, the common law perpetuity period may also be adopted, that is ‘a life in being plus 21 years’.

3.2 Despite South Australia essentially abolishing the rule against perpetuities, most advisors are unaware that section 62 of the Law of Property Act 1936 (SA) allows the court to dispose of any remaining unvested interests after 80 years on the application of a beneficiary.

3.3 Generally, when trust to trust distributions are made, the vesting date for both trusts should be considered. Where the recipient has a vesting date which is later than the distributing trust, the risk that the rule against perpetuities is breached is a relevant issue.

3.4 The ‘wait and see’ rule (established in Nemesis Australia Pty Ltd-v-Commissioner of Taxation (2005) 225 ALR 576 means the initial distribution will not be void when made, and will not become void until such time as there is a failure to distribute out of the recipient trust before the vesting date of the original distributing trust.

4. Ramifications of failed distributions

4.1 Where a purported trust distribution is subsequently found to be invalid, there are a series of issues and potential ramifications that may need to be considered. Some of the main issues in this regard include:

distributions from trustee-knowing recipients and
effect of disallowed deductions on the trust distribution resolution

Trustee-knowing recipients

4.2 As to the former, the concept of ‘knowing recipient’ is a principle that evolved out of situations where a trustee pays a third party recipient in a purported distribution under the trust, in circumstances where the recipient has knowledge of the trust relationship and therefore knowingly assists in the wrongful distribution (or breach of trust) by the trustee.

4.3 The concept gives the ‘wronged’ beneficiaries the entitlement to make a claim against the third party for the funds wrongfully received by the third party.

Effect of disallowed deductions on the trust distribution resolution

4.4 The case of Norman-v-FC of T [2004] AATA 1164 provides an example of the ramifications of the Commissioner disallowing deductions and the additional amounts being included in the assessable income of a beneficiary due to the way in which the distribution resolution was crafted.

4.5 The trustee claimed deductions over a number of years, which the Commissioner subsequently disallowed.

4.6 The Commissioner treated the deductions disallowed as additional distributions to one of the beneficiaries. The Commissioner’s reasoning was based on the fact that the original resolution of the trustee provided that, after all deductions were properly claimed, any balance of the trust’s income should be distributed to that beneficiary.

4.7 The beneficiary taxpayer objected to this but the Tribunal held that the taxpayer was in fact the person presently entitled to the additional distribution and therefore liable for the additional tax, notwithstanding that the amounts in question had never been received by the beneficiary.

What can you do when resolutions fail?

4.8 Discretionary trust deeds can contain default income and capital beneficiary provisions designed to prevent the adverse tax consequences that can arise from an invalid distribution.

4.9 The purpose of this type of clause is to ensure that if the trustee fails to effectively exercise their power to distribute trust income or capital, the relevant amount will be automatically distributed to specific beneficiaries who have already been defined in the trust deed.

4.10 An example of this style of provision was illustrated in the case of FC of T –v- Ramsden [2005] FCAFC 39.

4.11 The main tax objective of having a default distribution clause is to ensure that the default beneficiaries will be assessed on the failed distribution, rather than the trustee being assessed under section 99A ITAA 1936 at the top marginal rate.

4.12 However, care must be taken with the drafting of default distribution clauses to ensure that they are in fact effective! The case of BRK (Bris) v Commissioner of Taxation [2001] FCA 164 is particularly relevant in this regard.

4.13 In that case, the default distribution clause required that the trustee on default ‘divide the Fund equally among the beneficiaries named in the Schedule hereto’ on a date after the end of a tax year. The court held that as the trustee would not in fact make the distribution to the default beneficiaries until after the end of a tax year, the income was accumulated for tax purposes in the previous tax year and in accordance with section 99A ITAA 1936, the trustee was taxed on the entire default amount at the top marginal rate.

5. Conclusion

A failure to methodically address each and every potential issue in a timely way will invariably lead to unintended outcomes that in most instances will be impossible to remedy once they are discovered. The ATO is acutely aware of the above issues and actively conducts compliance activity in the area.

At Owen Hodge Lawyers, we always strive to provide you with the best legal advice and guidance – no matter your issue. We specialise in a range of law matters, and have a blog that offers in-depth and comprehensive articles with further information of taxation of trusts Australia and much more.

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