Contributed by Philip de Haan, Partner, George Hodson, Partner and Alexandra McCulloch, Associate, Thomson Geer Lawyers
This article discusses some of the tax problems with a wide class of beneficiaries in a discretionary trust. In view of these problems, we consider that it would often be better to have a narrower class of beneficiaries than is usually the case.
What is the usual situation?
While discretionary trust deeds vary a great deal, in our experience they generally follow a pattern. Generally only one person is named as a beneficiary of the trust (eg as “primary beneficiary”, “specified beneficiary” or similar). The class of beneficiaries will generally include certain individuals, companies and trusts that are related in some way to the named beneficiary.
John Smith is named as the primary beneficiary. The definition of beneficiary includes:
- the primary beneficiary
- parents, uncles, aunts, brothers and sisters of the primary beneficiary
- children and grandchildren of any of the above
- spouses of any of the above
- any company in which any of the above are directors or shareholders; and
- trustees of any trusts in which any of the above are beneficiaries.
Due to the wide class of beneficiaries it is possible that a discretionary trust may have hundreds or thousands of beneficiaries and more so if the class of beneficiaries also includes charities (which is not uncommon).
What are the interests of the beneficiaries?
Other than in relation to default beneficiaries (ie beneficiaries who may receive income or capital if the trustee fails to make a decision), the beneficiaries of a discretionary trust are mere discretionary objects. Such beneficiaries do have rights eg under trust law to see that the trust is being administered lawfully, even if they have no right to compel the trustee to make distributions to them.
What are the problems that arise in relation to a wide class of beneficiaries?
It seems to us that the problems occur in three main areas, being:
- merely being a beneficiary of a discretionary trust
- application of “associate” rules; and
- application of rules that treat a beneficiary as being entitled to all the assets of the trust.
Some situations where this occurs are discussed below.
Problems with merely being a beneficiary of a discretionary trust
Income tax amendment period
Any individual who is a beneficiary of a discretionary trust, whether a mere discretionary object or otherwise, may be subject to the four-year amendment period and not the two-year amendment period. This is because if an individual is a beneficiary of a trust estate at any time during a year (other than a trust that is a small business entity for that year or a trustee of a trust in that capacity that is a full self-assessment taxpayer) they are excluded from the two-year amendment period (s 170(1) item 1(d) of ITAA 1936).
It does not matter that the individual does not receive any distributions in relation to that year or that the amendment does not have anything to do with the individual being a beneficiary of the trust (Yazbek v FCT 2013 ATC ¶20-371).
Restructures of small businesses
Subdivision 328-G of ITAA 1997 provides roll-over relief for the restructure of small businesses where the relevant conditions are satisfied. One of the conditions is that the transaction does not have the effect of materially changing which individual has, or which individuals have, the ultimate economic ownership in the asset, and if there is more than one such individual, each individual’s share in the ultimate economic ownership (s 328-430(1)(c) of ITAA 97).
A discretionary trust would not be able to satisfy this condition. However, there is a specific provision that is aimed at assisting discretionary trusts. This is contained in s 328-440 of ITAA 97. This section requires that the trust be a family trust and that the class of beneficiaries of the discretionary trust must only include members of the family group.
So it seems to us that simply making a family trust election would not be sufficient. This is because it seems to us that if there is any individual who may be a beneficiary (directly or indirectly) and falls outside of the family group, s 328-440 would not be satisfied. Query whether the Commissioner would take this strict approach when looking at the beneficiaries of a trust that has made a family trust election.
Problems with application of “associate” rules
Definition of “associate” for income tax
Section 318 of ITAA 36 contains a definition of “associate” that is used for various purposes in both ITAA 1936 and ITAA 1997, ie beyond the CFC regime in which s 318 is located.
Associates of trustees are dealt with in s 318(3) of ITAA 1936. Very broadly, associates of trustees are:
- any beneficiary ie person who benefits under the trust
- if a beneficiary is an individual, associates of that individual; and
- if a company is a beneficiary or an associate of an individual who is a beneficiary, associates of that company.
Mere discretionary objects would be treated as benefiting under the trust, so it does not matter that the beneficiary has never received anything (s 318(6)(a) of ITAA 1936).
Take the example above dealing with John Smith as the primary beneficiary. Assume his cousin Peter (who falls within the class of beneficiaries) owns a share portfolio including the major banks. Then the trustee of any trust structured in a similar way where any individual beneficiary owns any shares in any of the major banks would be an associate of the trustee of John’s trust, even if they have nothing to do with each other and have never heard of each other. This is because:
- Westpac is a beneficiary of John’s trust
- the trustee of any other trust in which Westpac also fall within the definition of beneficiary would be an associate of Westpac (s 318(2)(c) of ITAA 1936); and
- the trustees are then associates of each other (s 318(3)(c) of ITAA 1936).
Some consequences of this are:
- if the trustee of John’s trust owned any shares in a private company, then if that company made any loan to the trustee of any trust that had Westpac as a beneficiary, the company would be making a loan to an associate of a shareholder, and so the loan would be caught by s 109D of ITAA 1936 (definition of “associate” in s 109ZD of ITAA 1936 refers to the definition in s 318 of ITAA 36). Such a loan would likely be on arm’s length terms. However, it would still likely be a deemed dividend under s 109D of ITAA 1936 because it would unlikely be a loan complying with the usual Div 7A rules contained in s 109N of ITAA 1936 (it not being appreciated that Div 7A could apply — would the Commissioner’s discretion in s 109RB of ITAA 1936 apply?);
- scrip for scrip roll-over in Subdiv 124-M of ITAA 97 contains many conditions that need to be satisfied. One condition requires a joint choice between the shareholder transferring their shares and the replacement entity (s 124-780(3)(d) of ITAA 1997). This is where s 124-782 of ITAA 1997 applies. An example of where s 124-782 of ITAA 1997 applies is where the original shareholder held, together with associates, 30% of the shares in the original company and the replacement entity (ie the “significant stakeholder” test is satisfied). “Associate” has the s 318 of ITAA 1936 meaning. So a joint choice would be required even if the trustee of John’s trust wanted to utilise the roll-over and only ended up with 1% of the shares in the replacement entity (having owned 30% in the original company), but other shareholders in the replacement entity were trustees of discretionary trusts that had any of the major banks as beneficiaries, and those trustees owned at least 29% of the shares in the replacement entity. But the trustee of John’s trust may never know that. Also the replacement entity itself (that also has to make the choice) would likely not know the terms of its owners’ trust deeds. (There are also cost base consequences.)
State tax example
The problems associated with the wide meaning of associate also arise in state tax legislation.
For example, under the landholder duty provisions in NSW, a relevant acquisition (giving rise to landholder duty) can occur where a person acquires an interest in a landholder that when aggregated with ‘associated persons” results in a “significant interest” (s 149(1)(b) of Duties Act 1997 (NSW)) (Duties Act). A “significant interest” for a private landholder is 50% or more (s 150(2) of Duties Act).
Trustees of trusts are associated persons where any person is a beneficiary common to both trusts (cl 2 to Dictionary of Duties Act). “Person” is not defined in the Duties Act but would include an individual, a corporation and a body corporate or politic (s 21 of Interpretation Act 1987 (NSW)).
The effect of this definition of “associate” is extremely wide. For example, the trustees of any discretionary trusts that have charities as beneficiaries would seem to be associates.
Problems with application of rules that treat a beneficiary as being entitled to all the assets of the trust
Even though mere discretionary objects have no right to any distributions, the trustee of a discretionary trust would generally have the power to distribute as much of the income and capital (up to 100%) as the trustee determines. This general feature of a discretionary trust can have significant adverse tax consequences. This is particularly seen in various state tax legislation. Some examples follow.
NSW landholder duty
Under s 159 of the Duties Act, a beneficiary of a discretionary trust who may receive capital is deemed to own or otherwise be entitled to the property the subject of the trust. So, say there is a private company, Squeaky Clean Pty Ltd and it does not own land but it is a beneficiary of John’s trust because another one of John’s cousins owns the shares in it, and John’s trust owns real estate in NSW worth $3.5m. As a beneficiary of John’s trust, Squeaky Clean Pty Ltd is now deemed to be a private landholder.
So if John’s cousin transferred his shares in Squeaky Clean Pty Ltd, the transferee would make a “relevant acquisition” in a private landholder. This transfer would give rise to a liability to landholder duty.
For the landholder provisions not to apply, the transferee would need to apply to the Chief Commissioner of State Revenue to exercise discretion under s 163H of the Duties Act to grant an exemption from landholder duty in respect of the acquisition of the shares. For the Commissioner to exercise the discretion, the Commissioner would need to be satisfied that the application of landholder duty to the acquisition would not be “just and reasonable” in the circumstances.
NSW surcharge duty and land tax
A similar problem can be seen in the NSW surcharge purchaser duty and surcharge land tax relating to residential land. Each beneficiary is deemed to have the maximum percentage of income or capital that the trustee may distribute to that beneficiary. This would usually be 100%. So if there were only one beneficiary who were a foreign person, then the surcharges potentially apply, even if that foreign person has never received a distribution and it not likely to receive a distribution. See, for example, Ruling No G 010 version 2 and Commissioner’s Practice Note No CPN 004.
While it may be a good idea and usual practice to keep your options open by having a wide class of beneficiaries, it is important to consider the effect of having a wide class. There may be good reasons to have a narrower class of beneficiaries than is usually the case that includes only persons who are intended to benefit.
[This article was originally published in CCH Tax Week on 25 October 2019. Tax Week is included in various tax subscription services such as The Australian Federal Tax Reporter and CCH iKnow. CCH Tax Week is available for subscription in its own right. This article is an example of many practitioner articles published in Tax Week.]