Due to the complexity of the income tax legislation relating to trusts, a methodical approach is needed when approaching trust distributions to ensure the intended outcomes are achieved.
This article focuses on a number of the more common scenarios where purported distributions fail.
Is the intended recipient a beneficiary?
A beneficiary is a person or entity who has an equitable interest in the trust fund. A potential beneficiary has enforceable rights against a trustee who fails to comply with their duties.
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.
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 interests under the trust.
Exclusion of settlor – the notional settlor clause
Almost all trust deeds contain a clause excluding the settlor of a trust from being a beneficiary.
Some deeds, however, take the restriction further by prohibiting distributions to any ‘notional settlor’, in addition to the actual settlor.
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.’
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.
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 are significant and anecdotally we understand this issue is one the ATO reviews regularly.
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’.
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.
Exclusion of trustee
Another commonly overlooked clause relates to the exclusion of the trustee, be that the current, former or future trustee, as a beneficiary of the trust.
These clauses are often found in deeds prepared by New South Wales advisers as section 54(3) of the Duties Act 1997 (NSW) limits the nominal duty exemption for a change of trustee to trust deeds that contain provisions ensuring:
(a) none of the continuing trustees remaining after the appointment of a new trustee are or can become a beneficiary under the trust;
(b) none of the trustees of the trust after the appointment of a new trustee are or can become a beneficiary under the trust; and
(c) the transfer is not part of a scheme for conferring an interest, in relation to the trust property, on a new trustee or any other person, whether as a beneficiary or otherwise, to the detriment of the beneficial interest or potential beneficial interest of any person.
An example of such a clause complying with the above is as follows:
‘None of the continuing Trustees remaining after the retirement of a Trustee is or can become a beneficiary under the Trust, and none of the Trustees of the Trust after the appointment of a new Trustee is or can become a beneficiary under the Trust.’
As with all the previous clauses, the impact of this type of restriction will ultimately depend on how the clause is drafted in the relevant trust deed.
Distributing to a non-beneficiary
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.
On reading the trust deed for the family trust, the trial judge noted that the recipient in question was not in fact an eligible beneficiary of the trust. This meant in the context of the case and for the purposes of a property settlement, the recipient should be ignored as a beneficiary as all of the potential value derived, was from invalid distributions.
While the ‘wrongful distributions’ (in the words of the court) were not explored further, the decision highlights the importance of reading the source documentation before any steps are taken to rely on what might otherwise be assumed to be permitted.
Where a distribution has been made to an excluded beneficiary, a range of tax and commercial issues arise.
Family trust elections and interposed entity elections
In addition to the traditional trust law related restrictions on the potential beneficiaries of a trust, it is important to keep in mind the consequences of a trustee making a family trust election or interposed entity election.
In particular, where such an election has been made, 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).
A family trust election will generally be made by a trustee for one or more of the following reasons:
(a) access to franking credits;
(b) ability to utilise prior year losses and bad debt deductions;
(c) simplifying the continuity of ownership test; and
(d) eliminating the need to comply with the trustee beneficiary reporting rules (as mentioned in more detail below).
Once a family trust election has been made, the trust will be restricted to making distributions to trust beneficiaries within the family group. Failure to do so will incur family trust distribution tax being imposed at a flat rate of 47%, which is payable by the distributing trust within 21 days after distribution is made.
Likewise, an interposed entity election for a company, trust or partnership in a test individual’s family group may be made where income is intended to be distributed to that entity from a trust that has a family trust election in place.
Operation of default beneficiary provisions when resolutions fail
One approach designed to prevent the adverse tax consequences that can arise from an invalid distribution could be that discretionary trust deeds will contain default income and capital beneficiary provisions.
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 clause.
An example of this style of provision was illustrated in the case of Ramsden (discussed above). That is, although there was an invalid distribution (due to the purported distribution to the AP Trust, which was not in fact a beneficiary), it was ultimately determined that the named specified beneficiaries were entitled.
The main objective from a tax perspective of a default distribution clause is to ensure that the default beneficiaries will be assessed on the failed distribution, rather than the trustee being assessed at the top marginal rate.
Care must, however, be taken with the drafting of default clauses that are in fact effective.
Care must also be taken to ensure that default clauses are drafted so that the recipient beneficiaries are ascertainable.
Conclusion
As highlighted by a number of aspects of this article, there are a range of issues that can potentially undermine the intentions of a trustee when attempting to make distributions.
While the starting point in any situation is always the provisions of the trust deed, trustees must also be acutely aware of a myriad of other potentially relevant issues before making any distribution.
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.
In this regard, there is increasing evidence to suggest that the ATO is acutely aware of most, if not all, of the issues set out in this article, and actively conducts compliance activity in the area.
