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In brief:    Treasury this week released a Consultation Paper on the Division 7A amendments proposed to commence on 1 July 2019. There are some significant changes from what has previously been mooted, with some of the main points now proposed including:

•   a single 10 year model for complying loans, with equal annual principal repayments and interest at a Reserve Bank published indicator rate for small business overdrafts (currently 10.3%, compared to the current Division 7A rate of 5.2%)
•   except for the initial year of the advance, loan interest will be calculated for a full year regardless of when any repayment is made during the year
•   25 year loans existing on 30 June 2019 must adopt the new interest rate immediately, but the new 10 year loan rules will not apply until 30 June 2021
•   7 year loans existing on 30 June 2019 will retain their existing outstanding term, but must otherwise comply with the new loan model
•   loans made before 4/12/97 must adopt the 10 year repayment model from 30 June 2021
•   the concept of ‘distributable surplus’ will be removed, so that Division 7A will always apply to the whole value of any loan or other benefit extracted from a private company
•   all outstanding UPEs after 15/12/09 will effectively be subject to the 10 year repayment model from 1 July 2019, although no decision has yet been made to also bring in UPEs from before 16/12/09.

More:    The Consultation Paper also outlines some further amendments that the Government proposes. Perhaps the most significant is the proposal of a 14 year review period during which assessments can be amended in respect of Division 7A matters. In addition, a self-correction mechanism is proposed for taxpayers to rectify inadvertent breaches of Division 7A. Taxpayers will be permitted to self-assess their eligibility for this relief, under which they will be obligated to convert any relevant benefit into a complying loan agreement. Affected taxpayers will also need to make catch-up payments of both principal and interest (on a compound basis) that would have been required, had they properly complied with Division 7A in the first place.

Other proposed amendments include a safe harbour formula that may be adopted in the case of an asset (other than a motor vehicle) provided by a company for use by a shareholder or their associate, confinement of the exclusion for loans made in the ordinary course of an entity’s business to loans made in the ordinary course of a moneylending business, and a ‘but for’ test for the application of s 109T to loans, payments or other benefits provided to a taxpayer indirectly from a private company. (Targeted amendments to the Division 7A integrity rules: Consultation Paper, October 2018)

In brief:    In a unanimous decision from all 7 Justices of the High Court yesterday, the Commissioner has ultimately succeeded on the main, substantive issues in Thomas’ case. The trustee of a discretionary trust had purported to distribute franking credits to beneficiaries independently from, and in different proportions to, the relevant franked dividends. It is a complex case, but the controversies for the purposes of the appeal were mainly whether the court was bound by directions from the Supreme Court of Queensland to the trustee of the trust under s 96 of the Trusts Act 1973 (Qld) about the effect of the trust distributions and, if the court was not so bound, the proper application of the imputation provisions to the distributions. It was held that the directions from the Supreme Court did not bind the court (nor the Commissioner) in the proper application of tax laws.

More:    The decision makes it plain ‘that the statutory notional allocation of franking credits to beneficiaries follows the proportions which have been established with respect to their notional sharing in franked distributions’ [para 16] – that is, franking credits cannot be distributed separately from the franked dividends to which they are attached.

The High Court appears also to have finally laid to rest the notion that franking credits represent a species of property able to be dealt with as such by a trustee. The trust deed in this case did not have provisions attempting to facilitate separate dealings in franking credits but, in statements apparently intended to be of general principle, the members of the Court said that ‘… franking credits – exist[s] neither in nature nor under the general law’ (Gageler J [97]) and ‘The [assumption that franking credits can be dealt with separately] involves the notion that franking credits are discrete items of income that may be dealt with or disposed of as if they were property under the general law. That notion is contrary to the proper understanding of [the imputation provisions]. Franking credits are a creature of its provisions; their existence and significance depend on those provisions.’ (joint reasons of the other 6 Justices [9])

The Commissioner will no doubt regard those statements as supporting his views in Draft Ruling TR 2012/D1 relating to ‘notional amounts’ of trust income (see, particularly, para 112-115 in relation to franking credits). If franking credits do not constitute property under the general law, then they cannot form part of a trust fund and nor can a trustee be liable to account to beneficiaries for franking credits (although trustees in a sense do have indirect obligations, needing to take into account the impact of distributions on franking credit entitlements under the tax law). This makes income equalisation clauses in trust deeds even more problematic (those clauses will in many cases not work effectively anyway). And practitioners who include franking credits in the financial statements of trusts need to think carefully about the risks that doing so potentially create for getting the numbers wrong in the proper recording of the distributable income of the trust, beneficiaries’ entitlements to that income and consequent proportional franking credit implications. (FC of T v Thomas [2018] HCA 31)

In brief:    Much has been said about the Aussiegolfa decision (now on appeal to the Full Court), in which the Federal Court determined that an SMSF had breached the sole purpose test and also exceeded the 5% threshold for in-house assets. The relevant investment was in a unit of student accommodation, acquired under the DomaCom Fund, and a daughter of the SMSF’s sole member was one of 3 students who leased the unit. The member is a state manager for DomaCom and it was admitted that the arrangements were intended to test the use of residential property under the DomaCom system for related parties of SMSFs.

More:    The sole purpose test was breached because a purpose of the SMSF in acquiring units in the DomaCom Fund was to provide accommodation for the sole member’s daughter. But, in relation to the in-house assets breach, it was a critical finding that the sub-fund established for the property acquisition under the DomaCom Fund constituted a separate trust. The members of the sub-fund were wholly entitled to all the income and capital of the sub-fund, to the exclusion of all other members of DomaCom. Further, it was held that the DomaCom responsible entity owed no fiduciary duties to those other members in respect of the sub-fund. So the sub-fund, even though constituted under a single managed investment scheme and governed by the constitution of the scheme, was held to be a separate trust. This decision serves as a good reminder of the versatility of trusts law. Even though we are accustomed in practice to specific types of trusts (e.g. discretionary trust, child maintenance trust, etc), each typically constituted under a single document, these are not precise species recognised in trusts law. Trusts can be created in many ways and there is enormous flexibility in the terms that can be encompassed. This is part of the reason for the special place of trusts in common law countries and their particular attraction to tax practitioners. (Aussiegolfa Pty Ltd v C of T [2017] FCA 1525)

In brief:    In addition to distribution resolutions by 2 trusts in this case, variation resolutions for each provided for additional distributions ‘should the Commissioner of Taxation disallow any amount as a deduction or include any amount in the assessable income of the trust …’ Assuming each variation provision was authorised by the relevant trust deed, the Full Federal Court held that it made the trust distribution contingent (on whether the Commissioner disallowed a trust deduction or included an additional amount in assessable income). Consequently, the beneficiary taxpayer who had been assessed on adjustments to the net (taxable) trust income was not presently entitled to a share of trust income by the end of the relevant income year and was not liable for tax on amended assessments following audit by the ATO.

More:    There were a number of issues in this complex case, which arose from ATO amendments made a number of years after the relevant income years. But the big takeaway is the impact of variation clauses relating to trust distributions. They typically serve no real purpose but create very significant potential problems. It was beneficial in this case that the beneficiary assessed had no present entitlement to the trust income, but ordinarily the result of that is a liability on the trustee for tax at the maximum individual rate. Variation clauses should consequently be avoided. (Lewski v Commissioner of Taxation [2017] FCAFC 145)

In brief:    A recent NSW payroll tax case shows again the potential problems of widely drawn beneficiary classes in discretionary trusts. A company owned and controlled by Michael Gerace had been issued with payroll tax assessments of nearly $2M and was put into liquidation. The Chief Commissioner of State Revenue (NSW) was successful in an appeal to group that insolvent company with a trust controlled by Michael’s brother and one established originally for their parents, despite an apparent lack of commercial connections. Grouping was achieved because Michael was a discretionary beneficiary of both those other trusts, so he was effectively taken to have a controlling interest in each of those trusts (as well as the insolvent company that he owned). And members of a payroll tax group are jointly and severally liable for the tax payable by every group member.

More:    Having wide trust beneficiary classes is an outdated practice that potentially creates substantial tax disadvantages, yet serves no real purpose – Tax Strategies’ trusts have for several years been created on a different basis without wide beneficiary classes, substantially minimising the risk of such tax disadvantages. There was no doubt about the grouping in this case, but Michael disclaimed his interests under his brother’s and parents’ trusts in an attempt to retrospectively sever his connection with them. However, the Court held that that did not affect payroll tax liabilities that had already arisen, irrespective of its impact as between Michael and the respective trustees. It is traditional drafting practice to have wide beneficiary classes in a discretionary trust, including many family members who are not intended and will never benefit under the trust. But that can give the payroll tax Commissioners a very easy grouping mechanism. It has also caused significant problems in relation to the recently introduced duty and land tax surcharges for foreign purchasers of residential real estate in a number of States. (Chief Commissioner of State Revenue (NSW) v Smeaton Grange Holdings Pty Ltd [2017] NSWCA 184)

In brief:    In a complex case, contested both by the Commissioner of Taxation and the wife of the taxpayer who controlled the transferor trust, the taxpayer has successfully obtained a declaration in the Federal Court that CGT rollover relief under Subdivision 126-A applied. The Family Court order was for the transfer of shares in a listed public company to the wife, although they were actually transferred to the trustee of a trust at the wife’s direction. It was held that rollover relief applied to the change in beneficial ownership in favour of the wife at the time the Court orders were made. In any case, the Court would have held that a rollover under s 126-15 applied for a trust to trust transfer given that the wife was sufficiently ‘involved’.

More:    The Court’s comments about CGT rollover on divorce applying on a trust to trust transfer is controversial – it has been commonly understood that the rollover only applied for spouse to spouse transfers or those from companies and trusts to a spouse. Also, the Court was prepared to hold that a change of beneficial ownership (without transfer of the legal title) constituted a CGT event A1. In any case, an appeal by the Commissioner (and presumably the wife) seems likely. The company shares which were the subject of the Family Court’s order appear to have had a value of approximately $20M so presumably a substantial tax liability is at stake. This case (which also included complex trusts law and other legal points) illustrates the need for deep analysis and consideration of the tax issues involved in divorce and other relationship breakdowns – whatever the ultimate outcome of an appeal, one or other of the husband and wife in this case will no doubt be bitterly disappointed. (Sandini Pty Ltd v FC of T [2017] FCA 287)

In brief:    The New South Wales Supreme Court has held that a disclaimer of his interest as a discretionary trust object was valid to retrospectively end a person’s rights to benefit from the time those rights were created. This was sufficient to break the payroll tax grouping between several entities controlled by 2 brothers, the group determined by the Chief Commissioner having included a company in liquidation with substantial outstanding payroll tax assessments.

More:    This case is another that confirms the enthusiasm by State payroll tax authorities for the grouping of entities. Grouping is a very useful mechanism for those authorities since each member of a group is jointly and severally liable for the payroll tax liabilities of all group members. And discretionary trust objects are typically deemed to have more than a 50% interest, readily enabling grouping through broad beneficiary classes in discretionary trusts. That is the real issue – having extraordinarily wide beneficiary classes is an outdated practice that creates problems, rather than serving any useful purpose. And that is why Tax Strategies’ trusts are created quite differently and will not facilitate payroll tax grouping through such tenuous connections. (Smeaton Grange Holdings Pty Ltd v Chief Commissioner of State Revenue (NSW) [2016] NSWSC 1594)

In brief:    The new Small Business Restructure Roll-over has been enacted and will commence on 1 July 2016. It will be a very useful concession in the right circumstances but, as is typically the case, requires very careful thought as to the best way in which it should be applied. That is particularly the case in relation to the price (if any) for which assets are transferred. These 2 draft Law Companion Guidelines from the ATO about the operation of the new roll-over are helpful aids and very worthwhile reading.

More:    It is particularly important that note be taken of the Commissioner's views in LCG 2016/D3 about what amounts to ‘a genuine restructure of an ongoing business’ for the new roll-over. That is an essential element to engage the concession and it is evident that it will be a potential attack point if the ATO views a restructure as overly aggressive. It is also noted in the LCG that the general anti-avoidance provisions in Part IVA may still apply in appropriate circumstances, even if the 3 year ‘safe harbour’ rule for a genuine restructure is satisfied. (LCG 2016/D2 & LCG 2016/D3)

In brief:    A recent case in the Queensland Supreme Court illustrates the potential dangers involved where one spouse is intended to control a family trust after divorce. In this case, the parties had agreed that the husband take future control of the trust after their divorce, but the power given to them both under the trust deed to appoint and remove trustees was not dealt with in the Family Court consent order dealing with the property of the marriage. After the husband's subsequent death, the wife and de facto spouse of the deceased husband purported to appoint the wife as trustee of the trust in place of the corporate trustee, then controlled by the husband's daughter from an earlier marriage.

The Court refused to grant the wife's application for a declaration that she had been validly appointed. Although the wife was still named in the trust deed as a person having the joint power, it could only be exercised with the surviving spouse of the deceased husband. And, as a matter of construction of the trust deed, the husband's de facto spouse did not come within that definition. In any case, it was held that the Family Court was the appropriate forum in which any dispute about the trust should be resolved.

More:    The applicant wife was unsuccessful in this case, although not before the drama and costs of a Supreme Court action. And a lay observer might think that the wrong outcome was reached, given that it seems that the unsuccessful wife intended to administer the trust to benefit the children of her and the deceased, as well as the deceased's de facto spouse at the time of his death. So, on the face of things, there was limited estate planning for the deceased. That is one lesson from the case.

The other lesson is that it is important to have a clean, effective break if one spouse is to assume complete control of a family trust after divorce. This is the reason why Tax Strategies’ trusts now contain automatic mechanisms to remove one spouse as a beneficiary and from any other role under the trust, such as the power to appoint and remove trustees. That is achieved by only one spouse being nominated as the main beneficiary to start with (called the ‘Family Beneficiary’) – the one who will logically take control of the trust if there is a relationship breakdown. The other will still have their normal rights in relation to the trust property as a matter of family law, but it will be plain that that other is completely excluded. And that exclusion will occur right from the moment of separation, even if the parties are still legally married. (Kneipp v Annunaka Pty Ltd [2015] QSC 359)

In brief:    The Commissioner in a recent Federal Court decision was successful in denying application of the small business CGT concessions. At issue was whether a ‘loan’ from a family trust to the individual who controls the trust, and was the sole trustee of the trust, had to be counted for the $6M net asset value test. The taxpayer argued that the loan was statute barred and consequently that no value should be attributed to it.

The Court held that action to recover the loan would be one under the relevant South Australian Limitation of Actions Act 1936 ‘to recover trust property’ and that no limitation period was prescribed in that case. In any case, the Court said that a statute barred debt continues in existence. A limitation statute creates a defence that can be pleaded by the debtor, but generally does not extinguish the cause of action. Also, Courts were generally empowered to extend certain limitation periods. And the debtor in this case was the sole trustee of the trust to which the ‘loan’ was owing, so a breach of trust would likely be involved if the trustee pleaded expiry of any limitation period for his own benefit.

More:    The outcome in this case could be different in other circumstances. Although a limitation statute might not extinguish the cause of action for a debt, expiry of a limitation period would undoubtedly affect the value of the debt. And it is the market value of the debt, not its face value, that is relevant for the $6M net asset value test. However, the case appears to have been run on the basis only that the whole value of the debt should be excluded, not that its value was less than face value. And the reason for that was presumably that the total net values of other assets were agreed by the taxpayer and Commissioner to amount to $5,930,913. (Breakwell v FC of T [2015] FCA 1471)

In brief:    In Taxation Ruling TR 2015/4, the Commissioner expresses his views about how an unpaid present entitlement of a beneficiary connected with a trust is treated for the purposes of the $6M net asset value test. The view expressed is that the UPE should be counted only once – in whose hands it will be counted depends on whether or not the UPE is the subject of a so-called sub-trust arrangement or is an absolute entitlement to one or more trust assets.

In Taxation Determination TD 2015/20, issued on the same day, the Commissioner says that the release by a private company of its UPE will constitute a ‘payment’ under s109C(3)(b) of Division 7A, provided that the release represents a financial benefit to an entity.

More:    An example in TD 2015/20 involves the assets of the trust with the UPE obligation becoming worthless due to external factors without any breach of duty by the trustee. The ATO concludes in those circumstances that there is no financial benefit and consequently no ‘payment’ for Division 7A purposes. The Determination does not address the more difficult question of the circumstances in which a UPE might constitute an equitable debt, so that the release of the UPE could amount to a forgiveness of debt for Division 7A under s109F. However, the Commissioner's responses to submissions on the draft version of the Determination suggest that he may be unlikely to apply s109F.

In brief:    Despite its sympathy for the taxpayer, the Administrative Appeals Tribunal has held that she was properly assessed on trust income to which she was shown as presently entitled in the relevant tax return of the trust. The entitlement was said to relate to funds accessed by the taxpayer from a trust bank account as part of the normal living arrangements between her and her then partner who was the trustee. The taxpayer had not been aware that those funds constituted assessable income and attempted to disclaim the benefit following her separation from her partner. That disclaimer was held by the Tribunal to be ineffective, since she had already had the benefit of the trust distributions.

More:   A discretionary trust distribution amounts to a gift and no one can be forced to accept a gift. Disclaimer is possible to avoid such a trust distribution but it is legally effective until disclaimer, even if the beneficiary is unaware of it. To be effective, the disclaimer by the beneficiary of a distribution must occur before the beneficiary has received the benefit of it and, in any case, within a reasonable time of the beneficiary becoming aware of the distribution. The Tribunal in this case was critical of the way that the trustee had effectively subjected the taxpayer to a significant tax liability and 75% administrative penalty after cessation of his relationship with the taxpayer. But the Tribunal nevertheless held itself bound to uphold the tax assessed to the taxpayer. (Alderton v C of T [2015] AATA 807)

In brief:    In a complex case, the trustee of a discretionary trust failed in its attempt to allocate franking credits on a basis quite independent of the proportions in which the franked dividends of the trust were allocated (as part of the distributable trust income). The Federal Court confirmed that a taxpayer's entitlement to a tax offset for franking credits is a function solely of the statutory mechanism. In the case of franked dividends included in the assessable income of a trust, the trust beneficiary's entitlement to franking credits arises according to the beneficiary's share of the franked dividend (s 207-57 ITAA97).

The trustee had previously sought directions from the Queensland Supreme Court in relation to the disputed construction of the trustee's relevant resolutions relating to the distribution of trust income and franking credits. Nevertheless, the Federal Court held that it was obliged to form its own conclusions about the proper construction of the trust deed and the resolutions. And that the orders of the Supreme Court did not bind the Commissioner as to the proper application of the tax law in the circumstances.

More:    This decision illustrates the need to get things right in relation to trust distributions and, in more difficult scenarios, to get expert assistance. The beneficiary in this case had claimed franking credits of over $9M over the several relevant income years at issue, despite being entitled each year to only a minor share of the trust income. Interestingly, although it did not arise on the particular facts involved in this case, the Court expressed the view that franking credits might be properly regarded as a ‘category of income’ capable of being separately recorded in the trust books, if the trust deed was appropriately drafted. (Thomas v FC of T [2015] FCA 968)

In brief:   CGT roll-over relief can be obtained on the transfer of a CGT asset to a wholly owned company by an individual or trustee (s122-15) or all the partners in a partnership (s122-125). But, in both cases, the relief is limited to gains from several specified CGT events. In this case, the Federal Court held that the roll-over relief was not available to a couple who created a trust over their land for the benefit of a company wholly owned by them, pursuant to a contract with the company for it to acquire the beneficial ownership of the land. The reason was that CGT event E1 applied (creation of a trust over a CGT asset by declaration or settlement – s104-55) and, even if another CGT event also potentially applied, event E1 was the event most specific to the circumstances of the taxpayers and consequently it was the relevant event to apply (s102-25(1)). And the CGT roll-over relief sought under Division 122 simply did not apply in the case of an E1 event.

More:   So this is a further case where the desired tax outcomes failed because the intended outcome under the general law was not achieved – the case turned on matters of trust law. The critical question was whether the arrangements entered into created a trust over the taxpayers’ land by declaration or settlement, which the Court held to be the case. (Kafataris v DC of T [2015] FCA 874)

In brief:  In a recent unreported decision, the Queensland Supreme Court made a freezing order against the trustee of a discretionary trust called The Babes in Paradise Trust, restraining the trustee from disposing of trust assets. The applicant for the freezing order had successfully sued the ‘controller’ of the trust, with damages to be assessed. There was evidence that the controller had dissipated his own assets and that the trustee's brothel business on the Gold Coast was for sale. The applicant claimed that there was a real danger that the proceeds from disposal of that business would also be dissipated and that his judgement for damages, once assessed, would not be satisfied.

So the trustee had no liability itself under the primary action. The applicant for the freezing order nevertheless successfully argued that such an order should be made on the trustee, on the basis that the controller's ‘interest’ in the trust property amounted to property for the purposes of relevant provisions of the Uniform Civil Procedure Rules 1999 (Qld). The order was made on the basis of the control exercised over the trust – the controller was the sole shareholder, director and secretary of the corporate trustee, as well as being the sole appointor and guardian of the trust. The Judge relied on the reasoning of French J (in the Federal Court, before His Honour's appointment as Chief Justice of the High Court) in the Richstar decision (ASIC v Carey (No 6) [2006] FCA 814).

More:  It should be noted that, like Richstar, this case involved an interlocutory type application under specific (subordinate) legislation, rather than a case disposing of the primary legal dispute. And there is much merit in appropriate cases in the status quo being preserved until there can be full argument about primary issues, although one might say that the machinery to achieve that should be made stronger so that judges need not unnecessarily push substantive legal principles. The lengths to which trust control can tend towards the notion of property in the general law has not been authoritatively determined in modern cases and the Richstar decision itself has not been accepted as binding in other contexts.

This case nevertheless represents another warning about some straightforward, though critical, planning points in relation to the control of discretionary trusts. The first is an obvious one. If trust deeds are drafted appropriately, a trust controller is free to relinquish or take steps to reduce the level of control before a dispute reaches such a critical point – there will normally be plenty of time in the lead up to such a point. Secondly, it is essential that trust deeds are drafted so that elements of control through a person's role as a protector/appointor/guardian cease automatically in cases such as the bankruptcy of the controller. And that trust deeds actually deal with the resultant change in control in a considered, thoughtful and practical way. Thirdly, although the law has not developed to the point where this is necessarily advisable in the mainstream and it is most often contrary to the reality of the situation, trusts can be established or altered so that control is less concentrated in one person. (Leach v Ross No 5201 of 2010)