Damian O’Connor, Managing Principal at Tax + Law, highlights the importance of managing the risk of disputes with the Tax Commissioner, given the number of clients that use discretionary trusts, by looking at a case study and key issues.
When the going gets tough the tax (sometimes) gets weird
Discretionary trusts are used by many of our clients for a range of reasons, including asset protection and tax flexibility.
When it comes to relationship breakdown, the way a discretionary trust is taxed can produce some very unpleasant surprises for clients and advisors alike.
Tax – it’s complicated. Get over it!
One of keys to understanding what can go wrong is that a trust beneficiary can be taxed on trust cash that they are never entitled to receive. This is different from splitting tax income amongst the kids and never paying them.
Here is the hard part – the system for taxing trust beneficiaries looks at the entitlement to a share of trust income and applies that same proportion to the trust’s tax income. If trust income and tax income are not the same there can be peculiar outcomes.
Say a trust has cash profits (and tax income) of $100 but trust law income (for whatever reason) is $10. The beneficiary entitled to all the trust law income ($10) gets taxed on all the $100 tax income. A trust capital beneficiary could potentially get the balance of trust cash ($90) tax free.
Family Law tax cases involving discretionary trusts and tax tend to focus on the effectiveness of a beneficiary disclaiming or giving up their entitlements to trust income. Beneficiaries can lose these cases because you can’t disclaim a distribution where you have spent some of it and you must disclaim a distribution as soon as you know about it.
Case Study
Let’s look at a hypothetical – Mr Engrenage is a high-flying professional who derives his income through a discretionary trust. As the trustee, he makes all the decisions and controls the bank accounts.
His current partner, Ms Gingembre, has an ATM card and they have an understanding that she will withdraw $2,000 a week for living and household expenses. Some of that money is entirely for her benefit, some for joint benefit and some is only for Mr E’s benefit.
In the last financial year the trust has a net profit of $500,000.
Prior to 30 June, Mr E does the following:
- As trustee, he determines that trust income is $50,000 (the balance of $450,000 being trust capital); and
- He distributes 100% of trust income to Ms G (giving her a legal entitlement to $50,000).
When Mr E lodges the trust tax return it shows Ms G is entitled to 100% of trust income and therefore she will be taxed on all the trust tax income ($500,000 in this example).
Some Common Assumptions
We probably know that trustees have a lot of “discretion”, potential trust beneficiaries have very limited rights, and may figure that the only way Ms G can get the right outcome is if she disclaims her trust entitlements. If we have been paying attention, we may understand that disclaiming may not work where Ms G has had the benefit of the trust income.
But, with great powers come great (or at least some) responsibilities (to paraphrase Spiderman)
A trust deed may, on the face of it, give a trustee very wide discretionary powers (and beneficiaries very few rights), however these powers and rights operate within some complicated general trust law rules.
A Trustee’s decision may be challenged “ … on a number of different bases such as that it was exercised in bad faith, arbitrarily, capriciously, wantonly, irresponsibly, mischievously or irrelevantly to any sensible expectation of the settlor, or without giving a real or genuine consideration to the exercise of the discretion”. (Trani v Trani [2018] VSC 274)
It is not uncommon in tax cases for the taxpayer (or the Commissioner) to contend that trustee actions are ineffective or for taxpayers to argue that a trust entitlement has been effectively disclaimed. (See, for example: The Trustee for the Whitby Trust and Commissioner of Taxation [2019] AATA 5637)
If a trustee has acted beyond their powers their actions may be void, so that in our example Ms G may not have become entitled to the amount of trust income that triggered her large tax liability.
Conclusion
For better or for worse, tax is almost always an important issue for advisors in Family Law matters.
Given the number of clients that use discretionary trusts and the potential for sizable and “uneven” tax liabilities it is prudent to take extra care as early as possible to manage the risk of disputes with the Tax Commissioner emerging after trust tax returns have been lodged.
Damian O’Connor (Managing Principal) has a wealth of experience in tax, commercial law and family legal issues in Melbourne and Brisbane, as a lawyer and a tax partner with national law firms.
Damian provides practical technical advice on complex tax issues, commercial and family wealth structuring advice and legal documentation. He has decades of experience in managing high risk, high stress interactions with revenue authorities.
He has been recommended as a leading Tax Lawyer in Doyle’s Guide, and contributes to the continued development of tax expertise through his involvement with the Tax Institute and presentations for Television Education Network, Legalwise, Law Central, the Law Institute of Victoria, the Queensland Law Society and other professional bodies, professional associations and universities. Damian is a contributing author on tax issues for the Australian Master Family Law Guide, and has been published in international tax journals. He is a Chartered Tax Adviser and holds a Arts Degree (Chinese language major) and an honours degree in Law. Connect with Damian via email or LinkedIn
