Contributed by Andrew O’Bryan, Partner, Michael Parker, Partner, Jacinta Bolzonello, Lawyer, Hall & Wilcox
The Commissioner has issued Draft Taxation Ruling TR 2017/D10 Income tax: Trust vesting — amending the vesting date and consequences of a trust vesting. The draft ruling does not make any major variation from the current views on the extension of vesting dates, but it is good to have some detail around trust vesting from the Commissioner and in particular a question that we continue to emphasise — what do the terms of the trust deed say?
In summary, the ATO’s view is that:
- • Prior to the vesting date, a trustee may extend the vesting date either by a power under the trust or by court application. The rule against perpetuities still applies to limit the extension to the perpetuity period provided under statute. This means a period not exceeding 80 years for most states (excluding South Australia).
- • Once the vesting date has passed, the trust has vested and extending the trust is not possible. Even if all parties continue to treat the trust as being in existence, for tax purposes, the trust property has become fixed.
- • The Commissioner does not accept the view that the vesting date may be extended by implication (by the behaviour of both trustees and beneficiaries of a trust). Note that this view is expressed in the Appendix, which sets out the Commissioner’s opinion on an alternative view and does not form part of the draft ruling.
The vesting date
The draft ruling notes that on a trust’s vesting date, the trustee no longer has any discretionary power to appoint the income and capital of the trust. It holds trust property absolutely for the residuary beneficiary (we have used this phrase to describe the beneficiary who becomes entitled to the assets on vesting of the trust). Where a trustee continues to hold property for the residuary beneficiary, the underlying trust relationship continues, even though the nature of the trust has changed.
Examples in the draft ruling
The draft ruling provides a number of basic examples of trust issues that may arise. Set out below is a summary of the conclusions.
- • If the trust deed does not include an express power to amend the definition of vesting date, then a purported amendment by a trustee would be invalid. In this case, the only way this may be done is by court order.
- • If the trust deed does include an express power to amend the definition of vesting date, then the amendment is permitted, as long as the rule against perpetuities is not breached.
- • If the trustee and beneficiaries are unaware that the vesting date has passed, any income appointed after the vesting date should be appointed to the residuary beneficiaries as they are presently entitled to the income of the trust.
- • An extension of the vesting date after this date has passed is void and ineffective.
- • For the income year in which a trust vests, income must be apportioned between the discretionary beneficiaries (pre-vesting) and the residuary beneficiaries (post-vesting). A fair and reasonable allocation is permitted.
- • A beneficiary is absolutely entitled to the trust property where, eg a trust deed required that unless a distribution is made to certain beneficiaries before the vesting date, after the vesting date it would be held absolutely and solely for another particular beneficiary.
Depending on the trust deed and how the trust property is to be distributed on vesting, a range of CGT events may occur. The draft ruling discusses two CGT events, in particular, CGT event E1: creation of a new trust, and CGT event E5: beneficiary becoming absolutely entitled.
CGT event E1: Creation of a new trust
The draft ruling states that this CGT event does not apply automatically, rather, it would apply where the parties to a trust relationship act in a manner that results in a new trust being created by declaration or settlement.
An example of this CGT event is provided in the draft ruling. A deed of extension is invalid where it is executed after a trustee becomes aware that the vesting date has passed, and has continued to manage the trust as if it had not vested. The draft ruling confirms in this situation that a deed of extension is void. However, if all of the takers on vesting agree that the trust assets continue to be held on a new trust, on the same terms as the original trust, and this was effective to create a new trust over the assets, then CGT event E1 would occur.
CGT event E5: Beneficiary becoming absolutely entitled
CGT event E5 occurs when “a beneficiary becomes absolutely entitled to a CGT asset of a trust (except a unit trust or a trust to which Div 128 of ITAA 1997 applies which may or should include a testamentary trust) as against the trustee (disregarding any legal disability the beneficiary is under)”.
CGT event E5 can result in a capital gain or loss for both the trustee and the beneficiaries.
It may seem odd or unfair that the one event triggers two capital gains (or losses). Practically, however, if that beneficiary is the one presently entitled to the trust’s income (including the capital gain to the trustee) the overlap provisions of ITAA 1997 s 118-20 should apply to eliminate the double tax.
Importantly, there are a number of other CGT events that may happen on the transfer, disposal, vesting and subsequent distribution of property from a trust — eg CGT events A1, C2, E4, E6, E7 and E8. However, if more than one CGT event happens in a taxpayer’s situation, the taxpayer is to use the CGT event that is the most specific to their situation (see ITAA 1997 s 102-25(1)).
The draft ruling also refers to Draft Taxation Ruling TR 2004/D25 — Income tax: capital gains: meaning of the words “absolutely entitled to a CGT asset as against the trustee of a trust” as used in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 in the context of CGT event E5. TR 2004/D25 sets out the Commissioner’s view of when a beneficiary becomes “absolutely entitled”. It looks like the Commissioner has dropped TR 2004/D25 back into play as the official position, even though it is still a draft ruling.
TR 2004/D25 states that the test of absolute entitlement is based on whether the beneficiary can direct the trustee to transfer the trust property to them or at their own discretion. A bare trust is not necessary and does not automatically lead to the conclusion that a beneficiary is absolutely entitled. We disagree with this — the concept of absolute entitlement is very similar to a bare trust.
The vesting date passes
So, what happens if a trust has previously vested but that is now only discovered, or it is thought that it might have vested (eg how many trusts established in the 70s and early 80s were established for managing death duties and typically had a life of only 25 to 50 years)?
Practically, the trust does not come to an end or result in a new trust being created. The draft ruling confirms that the underlying trust relationship continues, although the nature of the trust has changed.
If the trust has been carrying on as though the vesting date has not passed, then any income appointed after the vesting date has passed should be appointed to the residuary beneficiaries under the trust deed, who may be different from the general beneficiaries who are entitled to income, before the vesting date passed.
This could cause issues where the general beneficiaries and residuary beneficiaries are different, and be further complicated where there may be certain beneficiaries that are entitled to capital and not income.
Further, there could be a number of CGT events that occurred five, 10 or even 20 years ago, and income taxed in the wrong hands. Can you go back and amend that? It will depend on whether the limited amendment periods have passed.
As the residuary beneficiary has a fixed entitlement to the income of the trust, the draft ruling confirms that as long as the distributions of income or capital post-vesting are consistent with the terms of the trust deed and the beneficiaries fixed interest, then the distributions would be effective.
The Commissioner, in Appendix 1 of the draft ruling, addresses a number of alternative views which he disagrees with. Interestingly, throughout the draft ruling, he does not address the contentious issue as to whether actual vesting is delayed pending the satisfaction of the trustees right of indemnity. It was anticipated that this issue would be ventilated in the Full Federal Court in Oswal v FC of T 2013 ATC ¶20-403. In the initial decision, Edmonds J said that when the trustee purported to vest and transfer the shares, there was no CGT event E5 because the trustee still had a liability to the ANZ bank for which it had a right of indemnity out of the trust assets. The Oswal case eventually settled so the ATO only has Edmonds J’s view in the Federal Court. Interestingly, even though the Commissioner has brought in TR 2004/D25 as representing the current state of the law, this key aspect is arguably unresolved.
Further, the case of Chief Commissioner of Stamp Duties (NSW) v Buckle & Ors 96 ATC 4098, while dealing with an amendment related to the default beneficiaries of the trust, can be used as authority for the position that CGT events, E1 and E2, will only occur at the point in time when the original vesting date would have expired. This is the position because the extension of a vesting date will not affect the beneficiaries’ interests in the trust until the point in time when the trust would have vested in accordance with the original vesting date.
If the vesting date is close
The draft ruling confirms that in the income year of the vesting date, there will need to be an allocation of pre-vesting net income and post-vesting income. The net income of the trust pre-vesting must be appointed, as usual, to those beneficiaries entitled under the trust deed. In contrast, the post-vesting income must be appointed to the residuary beneficiaries, in proportion to their interests under the trust deed. The Commissioner confirms that an allocation of income for the period’s pre- and post-vesting on a reasonable basis, having regard to all the circumstances, would be acceptable.
This is why it is imperative that advisors be aware of the vesting date under the trust deed. It is important to ensure that all income both pre- and post-vesting be determined at the relevant time and be distributed to the correct beneficiary, as the income beneficiary can or may be different to the residuary beneficiary.
It is recommended that planning for the vesting of a trust begins a number of years prior to the vesting date, and that appropriate legal and accounting advice is obtained.
If a trustee is operating without looking at the trust deed, and not knowing whether a resolution it is making is in accordance with the deed, it could be considered recklessness for penalty purposes.
We always recommend that advisors and clients review the trust deed and procedures as other issues which require consideration may arise by virtue of the terms of the trust deed.
If you have a trust that is getting close to vesting, now is the time to start taking action.