The ever-expanding reach of Division 7A, or High Court highlights narrow operation of sub-trust arrangements contained in TR 2010/3
The following article was written by Peter Donovan, Tax Director at Toohey Reid. It was published in the Thomson Reuters Weekly Tax Bulletin (issue 49) on the 25th of November 2016.
The marriage of the law of trusts with the taxation of trusts has made for a difficult union. From an historical perspective, as a creature of equity, the trust device is necessarily flexible in nature and arises in a variety of forms, including an expressly created trust, a resulting trust and a constructive trust.
Given the flexibility of the trust device as opposed to say a corporate citizen or an individual, the legislature has struggled to impose upon it a set of concise taxing rules that provide certainty to both trustees and beneficiaries. This state of affairs was put into sharp focus by the High Court in the decision of FCT v Bamford (2010) 75 ATR 1.
Leaving aside the issues agitated in Bamford, the treatment of an unpaid present entitlement (“UPE“) has also been somewhat problematical for the Commissioner as taxpayers have been able to efficiently cap the rate of tax to the corporate rate via the use of a bucket company with the undistributed funds being available for use by the distributing trust.
The Commissioner dealt with this issue in TR 2010/3 (“Ruling“). Whilst the Ruling was not received without criticism, it did provide a set of working rules that taxpayers could adopt in dealing with a UPE.
At the heart of the Ruling was a recognition that a UPE could, in certain circumstances, retain its equitable characteristics in circumstances where it sat on a “sub-trust” and hence was not either converted into a loan either as a matter of law or by statutory fiction pursuant to Division 7A.
On 6 April 2016, the High Court delivered its decision in Fischer v Nemeske Pty Ltd  HCA 11 (reported at 2016 WTB 14 ), which arguably demonstrates that adoption of the sub-trust position outlined in the Ruling is only available in limited circumstances. It follows that the species of arrangements that will attract the operation of Division 7A in a typical UPE scenario are necessarily wide.
Fischer v Nemeske
The Nemeske decision concerned the power of a trustee of a discretionary trust [the Nemes Family Trust (“Trustee” and “Trust“)] to advance and apply to 2 designated beneficiaries [Mr and Mrs Nemes], by resolution and entry in the trust accounts, an amount of money representing the value of unrealised trust assets comprising shares in a company, Aladdin Limited (“Aladdin“), being $3,904,300.
The value of the shares in September 1994 was recorded in an asset revaluation reserve, created as an entry in the accounts of the Trust. The entry did not describe an asset or a fund from which amounts could be withdrawn or paid. The resolution to distribute to the beneficiaries was framed as follows:
RESOLVED that pursuant [sic] to the powers conferred on the Company as Trustee in the Deed of Settlement of the Nemes Family Trust:
That a final distribution be and is hereby made out of the asset revaluation reserve for the period ending 30th September, 1995 [sic] and that it be paid or credited to: the beneficiaries in the following manner and order:
The entire reserve if any, to be distributed to:
[Mr and Mrs Nemes]
as joint tenants”.
The power relied upon by the Trustee in the deed of settlement (“Deed“) to support the resolution appeared in clause 4(b) of the Deed, which, as far as is relevant, read as follows:
“The Trustee may from time to time exercise any one or more of the following powers that is to say:
. . .
(b) At anytime or times to advance or raise any part or parts of the whole of the capital or income of the Trust Funds and to pay or to apply the same as the Trustee shall think fit for the maintenance education advancement in life or benefit of any of the Specified Beneficiaries . . .”
The balance sheet of the Trust as at 30 September 1994 showed “non-current liabilities” comprising secured loans from “EG & M Nemes” of $3,904,300.
Also in issue was the effect of a deed reciting the alleged indebtedness of the Trustee to the designated beneficiaries in that amount and purporting to charge the shares in their favour. By clause 5 of the deed of charge (“Charge“), the Trustee covenanted to pay the principal monies owed to Mr and Mrs Nemes upon demand.
Mrs Nemes died in 2010 and Mr Nemes, who was the sole beneficiary under his wife’s will, died in 2011. He bequeathed all the shares in the Trustee and in Aladdin to the Fischers. The Fischers brought an action against the Trustee seeking a declaration as to the validity of the loan and the enforceability of the Charge.
At first instance, the Equity Division of the Supreme Court of NSW held that the resolution was effective as was the Charge. The effect was that a debt was created payable on demand. Appeals by the Fischers to the NSW Court of Appeal were dismissed. By a majority of 3:2, the High Court held that the resolution was valid and that, in the circumstances, a debt was created as between the Trust and Mr and Mrs Nemes for the payment of $3,904,300.
French CJ and Bell J delivered a joint judgment in dismissing the appeal and held, at , that the question for consideration was whether:
“. . . in this case the power conferred on the Trustee by cl 4(b) of the Deed of Settlement empowered the Trustee to create a debt reflecting all or part of the value of the share capital at a particular time as a mechanism by which the capital could be said to be advanced and applied within the meaning of the provision”.
In relation to the juxtaposition of a trust and a debt, the Court, at , noted:
“It is a long established proposition that no action at common law for money had and received lies against a trustee in respect of its equitable obligations even if those obligations extend to the payment of money. The same authorities which established that proposition also established the proposition that a trustee can end a trust with respect to capital or income in whole or in part and create a creditor/debtor relationship with a beneficiary”.
The Court proceeded to consider the effect of the resolution and the accounting entries in terms of the creation of a creditor debtor relationship as between the Trustee and Mr and Mrs Nemes and stated, at :
“It was not in dispute that the resolution of 23 September 1994 was badly worded. It seems likely that it was framed by reference to declaration of dividends payable by companies, which create debts due to their shareholders. There was no fund represented by the Asset Revaluation Reserve from which to make a distribution to give effect to the resolution. The text of the resolution, however, disclosed a clear intention, indicated by the use of a form of words appropriate to the declaration of a dividend, to create a debt due by the Trustee to Mr and Mrs Nemes to the extent of the amount shown in the accounts of the Trust relating to the Asset Revaluation Reserve. The entry in the accounts was an action by the Trustee which further demonstrated and gave effect to its intention. In so doing, the Trustee adopted a mechanism which, without altering the ownership of the Aladdin shares, provided a basis for the application of the trust capital to Mr and Mrs Nemes by sale of the shares to meet the debt. The resolution and the entry in the accounts by creating a creditor/debter relationship constituted an advance and application within the meaning of cl 4(b).”
The other majority judgment was that of Gageler J. His Honour substantially agreed with the judgment of French CJ and Bell J and confirmed that the existing equitable relationship of trustee and beneficiary can be overlayed with the legal relationship of debtor and creditor, which existed on the facts.
In the minority, Gordon J held that the resolution was an ineffective exercise of the power to advance and apply in clause 4 of the Deed. Hence, it followed that there was no effective charge as there was no debt to secure. Similarly, Kiefel J held that “none of the terms of the resolution, the circumstances surrounding it or the conduct of the Trustee thereafter support an inference that the powers given by cl 4(b) of the Trust Deed were intended to be exercised by the Trustee”.
TR 2010/3 juxtaposed with the Nemeske decision
According to the Commissioner in TR 2010/3, a UPE will not be considered to be a Division 7A loan if the funds representing the UPE are held on a sub-trust for the sole benefit of the private company beneficiary, as he states at paragraph 34:
“34. When a beneficiary is presently entitled to an amount from a trust estate, it has an equitable right to that amount. That is, the beneficiary has rights in equity and not, without more, as a result of any debtor-creditor relationship.”
The Commissioner, in Example 8 of the Ruling (“Sub-trust invests in the AB Family Trust for full flow-through return for the benefit of X Co”), provides an example of the sub-trust position, with the results contained at paragraph 170 of the Ruling, as follows:
“170. Whilst the AB Family trust has retained use of the funds to which X Co is entitled, ultimately only X Co can benefit from this use. In these circumstances, X Co has not made any ordinary loan to, or provided financial accommodation or an in-substance loan to, the AB Family Trust or to the sub-trust. Rather, X Co has a UPE that is being invested under terms where the full amount of that UPE plus any benefit from its use is held for its sole benefit. Accordingly, X Co is not taken to have made a Division 7A loan under section 109D.”
In view of the decision in Nemeske, opportunities to adopt the Commissioner’s sub-trust position appear to be quite limited, by virtue of a number of factors including:
- how the trust resolution to distribute funds is framed;
- the classification of the distribution in the trust’s accounts. It is noted that it is common for a UPE to be classified as a liability item in the accounts of the distributing trust, perhaps innocuously so. If it is treated as a liability and not as a equity item in the trust’s accounts, it will assist the Commissioner in forming an inference that a legal obligation to pay the amount has been created, noting though that the accounting classification of an item of itself should not govern its legal classification, but merely reflect it;
- any other actions/circumstances that lead one to conclude that the resolution to distribute creates a debt, ie as in Nemeske, has the obligation to pay the sum been secured and in doing so, has the obligation to pay the sum been drawn as a debt?
As it stands, at the very least, the Nemeske decision may require the Commissioner to sharpen the sub-trust principles in the Ruling given that adoption of this status achieves an exemption from the rigours of Division 7A. As Nemeske demonstrates, taxpayers proceeding on the assumption that an equitable entitlement exists and is not either converted into or overlayed by a legal obligation without a thorough analysis of the true position, is fraught with danger.
Hence, there would be little utility in a taxpayer purporting to adopt the sub-trust position offered in the Ruling if the distribution is properly characterized as a debt, as no administrative guideline can work to alter the legal nature of a transaction or event. Indeed, if the UPE transforms into a debt either by virtue of the operation of the respective deed of settlement, the operation of any of the above factors or other surrounding circumstances not fully considered by a taxpayer, the Commissioner would be well within his rights to unwind the adoption of the sub-trust position taken by a taxpayer as that position was never open on the facts.
It is understood that the Commissioner is aware of the Nemeske decision. How he reacts to it and whether he is moved to alter the Ruling will be interesting to observe.
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