In an exclusive Q&A session with Legalwise Seminars, Michael Bersten, Barrister, addresses key questions regarding Trusts. He will be presenting at the upcoming seminars Trust Drafting: Back to Basics and Tax Essentials for Commercial Lawyers and In-House Counsel in February and March.
How would you briefly describe the current state of basic types of trust and their tax/duty significance?
There are almost 1 million trusts in Australia, almost the same as companies. Whilst there are many types of trusts, some with special regulatory and tax rules such as superannuation, the main types are discretionary trusts and fixed trusts. Discretionary trusts, which may be the most common, involve a trustee with the power and discretion to distribute trust income and capital to beneficiaries whereas as the name says, the entitlements of a beneficiary are fixed in a fixed trust. Fixed trusts are used mainly for investments such as managed investment funds or other investment structures where investors hold units. In many ways fixed trusts can be a bit like companies.
Income tax is imposed on the beneficiary when they become presently entitled to trust income or specifically entitled to capital gains and franked dividends. A discretionary trust has flexibility as to whether there is any distribution, which beneficiary is entitled to it and for how much. By contrast, these matters are fixed in a fixed trust. Discretionary trusts, because of their flexibility, may have a number of non-tax advantages such as in providing for families including children or for vulnerable persons lacking capacity and for special disability trusts. There may also be legitimate tax planning opportunities facilitated by the flexibility in a discretionary trust. A lot of this concerns shifting the tax burden to a taxpayer beneficiary to a low tax rate rather than the burden falling on a higher tax rate taxpayer.
Capital gains tax (CGT) and stamp duty in NSW effectively tax transfers of assets. Essentially, CGT and stamp duty apply to the transfer of an asset into or out of the trust. There are differences between CGT and stamp duty. For example, duty is imposed on the transferee whereas CGT may be imposed on various taxpayers depending on the situation eg. on the creation of a trust over an asset, the settlor is the taxpayer. Another example is when a beneficiary becomes absolutely entitled to a trust asset both the beneficiary and trustee may make a capital gain or loss as the case may be.
Is it clear cut when establishing the incidence of tax/duty in establishing, administering, and winding up a trust?
The whole area is quite technical so coming up with a clear view can sometimes be challenging but less so if the overall scheme of the law is understood. Also, if trust deeds are drafted clearly and based on current trust and tax/duty law there should be less problems.
Tax/duty rules rely on general trust law. This results in the practitioner needing to be aware of a whole body of case law and to keep up to date. This of itself makes the area difficult. To give one example, lawyers should learn at Law School that a trust is a relationship and not an entity. A trust is not a legal personality capable of suing or being sued and is not an entity capable of being taxed. So, the tax question is whether the trustee or the beneficiary is taxed on trust income, capital payments and franked dividends. The rules are fairly mechanical and clearer than they used to be after amendments to the income tax law in 2011. Those amendments dealt to a fair degree with problems involving the misalignment of trust law and tax law income caused by the CGT rules.
Nevertheless, the law keeps developing. We continue to get refinements such as the High Court decision in Carter in 2022. That case decided that a trust disclaimer made after the end of the tax year was ineffective even though the beneficiary did not know about the distribution or receive it. The outcome is clearly unfair but is a logical result of the correct interpretation of present entitlement in relation to income of the trust. That is the amount which a beneficiary is presently entitled to is determined just prior to the end of the tax year and the entitlement is just that, a right to receive, not a receipt. This ruling whilst sound in law will upset the general practice of accountants making adjustments in the couple of months after the end of the tax year, a practice administratively accepted by the ATO over the years.
Also, stamp duty rules were updated in NSW in 2022 to be more comprehensive in dealing with trusts and tax avoidance. The basic principles have not changed but there are various legislative fixes that practitioners should not ignore.
What are some examples of tax avoidance rules affecting trusts?
There are several big ones.
The first is s100A, which deals with arrangements that are the purpose of securing that a person is not liable for tax (excluding an agreement in the course of ordinary family or commercial dealing). The arrangement involves paying a third party in money or another benefit. These rules have a very broad potential application but to give an idea might involve making a child beneficiary presently entitled, so taxed at a low marginal rate, rather than the taxing of the trustees, the parents at a higher tax rate. In this case the real value of the trust distribution goes to the parent. The ATO in 2022 published a major ruling and practical compliance guideline with numerous examples.
The second is Division 7A, which deems payments or loans out of a private company to members and associates to be a dividend. There are a few aspects that commonly touch trusts. One is when there is a corporate beneficiary of a discretionary trust. These are sometimes called bucket companies or cash boxes because they can accumulate cash but are only taxed at 25 or 30% on distributions. The challenge is extracting the cash without paying tax at the top rate. Division 7A may sometimes apply. Another example is where a trustee of a discretionary trust makes but does not pay a distribution, creating what is called an unpaid present entitlement. These are in effect loans by a corporate beneficiary that could be caught by Division 7A.
The third is Part IVA, the general anti-avoidance rules. The provisions are complex, and the facts are all important. As an example, the Federal Court in the Minerva case upheld Part IVA being applied where income was streamed using a somewhat complicated trust structure to a concessionally taxed beneficiary rather than to higher taxed beneficiary.
The last area are all the anti-avoidance rules in stamp duty law, including a general anti-avoidance rule.
What are some of the trends and developments you see with the amendments of trust deeds including trust resettlements?
The first is to address risks arising from out of date trust deeds. These include ensuring deeds are modernised in the light of the 2011 income tax amendments. An underlying problem is that with almost 1m trusts in Australia there is inevitably a percentage, I fear a large percentage, of trusts based slavishly on old precedents with inappropriate clauses. Amendment of trust deeds however requires a degree of caution to ensure that all the new rules and cases are considered. With unthinking amendment there is the risk of a trust resettlement that creates CGT and stamp duty costs because a new trust has technically been created.
The second is to take a more prudential approach to tax planning with trusts given the risk of anti-avoidance rules being triggered. The ATO and State Revenue are not against trusts in general, but they are sending strong signals against what they see as risky planning. Some of the legislation is very technical and expert advice may be necessary.
Michael Bersten has been in legal practice for 37 years and since 2018 as a Barrister. Michael specialises in tax and related corporate, commercial, trusts and financial crime matters. Michael’s current clients comprise mainly business and private wealth clients. Michael is also a sessional Lecturer in the UNSW Business School ATAX Masters Program. Michael is the NSW Deputy Chairman of the Law Council Tax Committee and a member of the Australian Bar Association tax committee. Michael has been regularly voted by clients as a Tax Controversy and Disputes leader in the International Tax Review Survey. Michael was a tax and legal partner from 2004 -2018 at PwC and before that a partner at Deloitte from 2001-2004. Michael founded their tax controversy and dispute resolution practices. Before that Michael Bersten was head of the ATO Tax Counsel Network and chaired the GAAR Panel amongst other senior roles. Michael was a Deputy Australian Government Solicitor (1996-1999) and national head of the tax and customs practices. Michael is ranked as a leading Tax Law Barrister with Doyle’s Guide, New South Wales, 2022 Connect with Michael via LinkedIn.
