6 Problems with old Family Trust Deeds and how to fix them

Your old Family Trust is like your car. It needs updating from time to time for:

1. Streaming provisions
2. Franking credits
3. Attribution to distribute capital gain
4. Extension of the Capital Gains Tax regime into Family Trusts
5. Bamford Decision defining “income” ATO’s latest determination
6. Loss Recoupment

Why Update the old Family Trust Deed?

The Court’s warning:

The law of Trusts, the tax and Trust losses are complex. An out of date Trust Deed causes serious problems. To compound the problem, the risk of resettling the Trust or amending the Trust Deed may have undesirable stamp duty and CGT consequences: Carlenka 95 ATC 4620.”

1.            The Streaming Provisions

Since November 1992, the ATO has issued rulings for the “streaming” of income. “Streaming” reduces capital and income tax. For example, you may wish to:

• stream a franked dividend only to the beneficiary George
• distribute capital losses to another beneficiary, Mary
• stream income to a separate group of beneficiaries being John’s children

For this to happen your Trust Deed, according to the ATO, must expressly allow those specific categories:  ‘franked dividends’, ‘capital losses’ and income. This is so that each category retains its individual status when it enters and then leaves the trust. Unless you have streaming everything coming into the trust merges with everything else. It is like when your child mixes the plasticine colours – it all ends up grey. Each type of income loses it individual character.

If there was no streaming in the above example, then a bit of the franked dividend, capital losses and income has to go to George. George doesn’t want and can’t use the capital losses – so it is wasted on him. Also, more income to George is a disaster because he is already suffering the highest marginal tax rate. George only wanted the franked dividend, but that category of income merge with everything else.

Streaming in your old Family Trust Deed allows each category of income to retain its own character. Each category is the distributed to exactly the desired beneficiary. With streaming, you place different income into separate accounts. Thus, it is possible to trace the source of each Trust distribution to a particular beneficiary.

The ATO states that ‘the Trustee must be validly empowered to selectively allocate each category of income’. That is, the Trust Deed itself must contain the ability to stream income. Most old Family Trust Deeds, including many brand new Family Trusts, fail to adequately deal with the full list of categories. Without proper streaming in your trust deed, the categories of income merge and can’t be untangled. The old Family Trust Deed must be updated first.

Here is one example:

Your old Family Trust sells a rental property and realises a capital gain. This capital gain is received into the Trust. It is part of the Trust’s net income. Correctly drafted, streaming provisions allow the capital gain to be distributed to one particular beneficiary. Another category received by the trust was franked dividends. They are also part of the Trust’s income. However, because of streaming the dividends don’t merge with the other categories of income, such as the capital gain. The dividends are not “mixed” with the capital gains tax income. The dividends can be distributed to another beneficiary.

Why does it matter which beneficiary gets different types of income?

Your accountant may suggest that the dividend (or foreign tax credit) be utilised by a resident individual beneficiary with high marginal tax rates. In contrast, net capital gains can be best utilised by another beneficiary with carry forward capital losses, low-income beneficiaries with carry-forward revenue losses and minor beneficiaries able to receive excepted Trust income.

Because of the marginal tax rates and myriad of rules, every taxpayer is unique and benefits from one type of income, rather than another type.

In effect your streaming allows you to distribute one type of income to one beneficiary and another type of income to a different beneficiary.

List of necessary categories

These are the necessary categories that should be in all Family Trust Deeds.

Categories a category, character, type, class, part, item or source, including (but not limited to) the categories:

1. Net Capital Gains
2. Net Capital Losses
3. gains
4. profits
5. losses of capital
6. capital profit treated as assessable income
7. allowable deductions under the ITAA
8. Tax Act for the Trust Income for any Financial Year; gains and profits or any losses of capital or of a capital nature that are not treated as assessable income or allowable deductions for taxation purposes for the Trust Income for any Financial Year; any income, receipts, gains or profits or any losses, disbursements or outgoings of income or on income account that are or are treated as assessable income or allowable deductions for taxation purposes in relation to the Trust Income for any Financial Year; any income, receipts, gains or profits or any losses, disbursements or outgoings of income or on income account whether treated as assessable income or allowable deductions for taxation purposes for any Financial Year; any income, receipts, gains or profits that are exempt or otherwise not liable to tax under the Tax Act or any other act or regulation;
9. Franked Dividends;
10. Unfranked Dividends
11. foreign income
12. foreign income tax credit
13. other tax credit
14. interest
15. royalties
16. minors
17. minors who has died
18. proceeds from deceased estates
19. superannuation funds
20. life insurance
21. additional categories set out in any minutes
22. categories mentioned in any Australian Taxation Office publication, from time to time

What categories are required?

Have a look at our ‘Sample document’ above. We have developed a unique group of categories with open classes for streaming. This list is based on the ATO audits we have attended and our legal research.

2.            Franking Credits

At times your Trust may include gross income from franked dividends. A resident beneficiary in your Family Trust (other than a Trustee of another Trust estate) is entitled to a franking rebate if:

• a share of net Trust income is included in the beneficiaries’ assessable income; and
• some or that entire share of net Trust income is attributable to a franked dividend included in the assessable income of the Trust estate.

Notwithstanding wide discretionary powers being conferred on a Trustee, a Trustee’s discretion to selectively allocate dividend income to a beneficiary to the exclusion of another may be fettered by the terms of the Trust or by Trust law operative in the relevant jurisdiction. You don’t want that. Therefore, we have inserted a clause in your Trust Deed which expressly empowers you to selectively allocate particular types of income to beneficiaries.

Your accountant may suggest that you distribute that part of the net income to those beneficiaries who are able to take the greatest advantage of franking, foreign tax and any other non-refundable tax credits and rebates available to the Trust. Those beneficiaries who have made a loss or are at a low tax rate (especially if lower than the company tax rate) may derive little benefit from these credits.

3.            Attribution to distribute capital gain to beneficiaries

When the Trust derives net capital gain in the net income of the Trust, then the Trustee needs the power to distribute that part of the net income to certain beneficiaries. The beneficiaries are treated by the Commissioner of Taxation as having accrued a capital gain. It may be that one beneficiary has carried forward capital losses and another has carried-forward revenue losses. In this case, there are tax advantages in distributing the net capital gain to the beneficiary who has suffered the prior capital losses.

For some old Family Trusts, the Commissioner may take the view that either:

• both beneficiaries are treated as having been presently entitled to a proportionate amount of the net capital gain and other net Trust income; or
• the net capital gain loses its character and therefore no part of the Trust distribution is characterised as being a net capital gain.

Both outcomes are generally unfavourable.

You now have the power to attribute.

4.            Ongoing extension of the Capital Gains Tax regime

Your Deed of Variation allows you to account separately and keep separate any funds received from different sources. Your Trust Deed is amended to allow the Trustee to account separately and keep separate any funds received from different sources. For example, sources may include:

• capital gains
• any dividend income (of all natures)
• income having an allowance for depreciation (inclusive of depreciation of buildings and plant and equipment
• any income from Superannuation investments or annuities
• income from deceased estates and Trusts (including testamentary Trusts) whether trading, investment or otherwise
• franked distributions
• credit trading income
• interest
• primary production income
• income from personal exertion
• rents and other property income
• royalties
• foreign source income

5.            Definition of Net Income

A Trust distribution often allows you to pay less tax. You normally distribute to the family members that are on the lowest tax rates. If you fail to distribute, then the Trustee (as the taxpayer) pays the tax at the highest marginal tax rate.

You distribute Trust income to the pool of potential beneficiaries. If you don’t distribute any part of the Trust income, then the Trustee is assessed on that part of the ‘net income’ at the highest marginal tax rate.

As the court in Bamford v Commissioner of Taxation [2009] FCAFC 66 said:

the only purpose of the concept of “income of the Trust estate” in section 97(1) is to determine the extent of the apportionment as between the beneficiaries and the Trustee. It is not, in itself, a metric by which tax is imposed.

There is a difference between ‘Trust income’ within the taxation legislation. Net income of the Trust estate is the taxable income of the Trust. A beneficiary is entitled to the Trust income. But they are taxed, instead, on the net income.

Your Deed of Variation allows you to:

• define Trust income appropriately; and
• make valid distributions.

6.            Loss Recoupment

The Trustee has the power to determine not to recoup carried forward losses, to have distributable income, which can be applied to various beneficiaries. If you did not have that power, there could be a situation arising where there is no income of the Trust estate to distribute. According to the ATO, the Trustee is assessed on the capital gain. To make matters worse a corporate Trustee is taxed on the grossed-up capital gain, without recourse to the tax legislation.

Any stamp duty or CGT?

If your trust owns bank accounts, shares and real-estate then you transfer these into the names of the new trustees. There is generally no stamp duty (State law) or Capital Gains Tax (Federal law) on the transfer from one trustee to another, especially if you use our Deed. However, NSW and ACT usually applies stamp duty on the transfer of real-estate.

Email us with a question or for legal advice.

Adjunct Professor, Dr Brett Davies, CTA, AIAMA, BJuris, LLB, LLM, MBA, SJD
Legal Consolidated Barristers and Solicitors
Australia wide taxation and trust law firm
National: 1800 14 16 12
Mobile: 0477 796 959
Email: brett@legalconsolidated.com
Skype: brettkennethdavies