Based on Carter, trust disclaimers are no longer effective for tax, contrary to long standing practice as well as ATO guide in ATO ID 2010/85.

John Jeffreys summarises this watershed case.

This was presented as part of our June 2022 monthly tax update with John Jeffreys, recorded on 23 May 2022.

TRANSCRIPT

Facts of the case

So this was a long running saga to do with a trust issue. And the question of whether disclaimers of trust, entitlements by beneficiaries were effective for tax purposes. So here's the facts. So there was a trust known as the Whitby trust. And as I recall, it did property developments and made a fair amount of income.

We're not exactly told how much then what happened in the year ended 30 June, 2014 is that the trustee of the trust failed to appoint any income to a beneficiary. So they didn't make a distribution and they failed to accumulate any income. And so what happened under that trust deed is that there were default beneficiaries, and that means that certain individuals were in default.

In receipt of that income. Now, those individuals were five children of the the father involved. Four of those children were adults and one was a minor at that time. And so they became entitled to these amounts, but they didn't know about it. And so one day they went out to their mailbox and they got an assessment from the tax office.

So each of these people got 20% of the income. So that meant that the trustee was taxed on the amount that went to the minor. And the other four beneficiaries were taxed on their distributions so 27th of October. The tax office sent out these assessments just to manage. And that's you there, you are having an nice day and you walk to the post box and what's this. So the children knew nothing about this. In fact, I'm not even sure that they knew about the trust itself but anyway, this these assessments turned up and so please pay us this heap of tax. And of course they were a bit upset about.

So they went off to see some lawyers now just reading between the lines here, this wasn't said outright, but I suspect this must be the case that there must be a degree of lack of communication between the children and their father. I think we can safely assume that, although it wasn't said so but any rate the children certainly didn't know this was coming.

There's no record of them actually getting any money either. So that's a pretty bad deal. Let's pay the tax on money I haven't received. So they went off to lawyers and lawyers said, ah, we know what we can do. We'll do some deeds of disclaimer for all of you.

And you can disclaim that particular interest trust distribution that is being paid to you. Now, this is not a silly thing to do, because in fact, there was a tax office determination or an ATO ID that said, this is what you could do. And so the lawyers went ahead and said, okay, that's what we all do.

We'll do deeds of disclaimer, however, it was held for whatever reason I won't go into that, but that disclaimer was ineffective. And so what they then did sometime later is did some more deeds of disclaimer. And so this time they said, not only will we disclaim what we've got from 20 June 14, but we'll disclaim all rights entitlements forever in relation to this trust.

We don't want anything to do with it whatsoever. And therefore we disclaim all of it. And therefore we say that's effective. And therefore we don't have to be taxed and they objected. And the tax office said, no, Your rejection is denied. We still think that you are assessable. We don't care whether you've made all of these disclaimers. That's not effective. We are still going to assess you. And yes, we realize that that's unfair, but you know, that's life, right?

Full Federal Court

So now we got to the full federal court. Now it is going to the high court. So let's just talk about the full federal court decision for a moment. And the judge came in and says the disclaimers were effective.

Now you will know that under the tax law, section 97(1) of the 1936 act is the one that includes amounts in a beneficiary's assessable income, at least for the adult children. And so the full federal court said there's nothing in that section to indicate that a beneficiary's liability to tax was to be determined once and for all at the end of the income year, by reference to the legal relationships then in existence.

So in other words, if as the tax officer was saying, when we get the 30 June, that's it, we draw the line one strike before midnight, that's it all done and dusted, no more correspondence entered into. That's when we determine our tax liability, according to the tax office. But the full federal court said, no, that's not the case. You can actually change that tax liability after year end by doing, for example, a disclaimer and the tax office said, we don't agree with that full federal court and we're going to go to the high court and off they went.

High Court

So the high court said the disclaimers were irrelevant. That is, they found in favor of the tax office and the beneficiaries had to be taxed on income that they had not received. Yep. Now what the high court did was they went to the provision of section 97(1) and they said that the phrase is presently entitled, which is part of the section, to a share of the income of the trust, that's the distributable income in section 97(1) is expressed in the present tense.

Is directed to the position existing immediately before the end of the income year, for the stated purpose of identifying the beneficiaries who are to be assessed with the income of the trust, namely those beneficiaries of the trust, who as well as having an interest in the income of the trust, which is vested both in interest in the possession, have a present legal right to demand and receive payment of the income.

So that all means that one nanosecond before midnight on the 30th of June, that is when you determine who is going to be assessed under section 97(1) and no further correspondence shall be entered into. What you do after the stroke of midnight on the 30th of June tough luck, doesn't do anything to change the assessability

And so in this case, the trust deed said there were default beneficiaries in default of the trustee not making a decision. We will say these five children are the beneficiaries they're default and that's it. And you don't change it. So that's an important point and emphasizes why making distributions by the 30th of June one nano second, before midnight on the 30th of June is very important.

And, and just be warned there that it's not always the 30th of June for every trust. Some trusts require the decision to be made prior to the 30th of June. So just watch that in your deeds, you don't come across it that often, but it does happen.

So just emphasizing the point is whoever is presently entitled just prior to midnight are the beneficiaries that are assessed under 97(1). And that's it. The president entitlement must be determined there. So what they're saying is that it's directed this section by identifying the legal right of the beneficiary immediately prior to the end of the year of income.

So what happens after the 30th of June, including whether the beneficiary disclaims, whether they're paid anything or they're not made aware of the entitlement is completely irrelevant. So the tax law and other trust law cannot operate. This is the high court saying this by waiting for some period after the 30th of June to say, who's actually going to be taxed.

So this was the, one of the, the problems the high court had with this is. At what time can we say, who are the people that are really to be assessed on this trust distribution? If we have to wait until after 30 June, well, how long we gotta wait. And so, but what they were saying is look the plain reading of the section and they adopted this same approach in the Bamford case back in 2010, the plain reading of the section is beneficiaries. You work out one nano second before midnight, who is presently entitled. The formula in 97(1) then operates and you work out who gets assessed on what? And that's the decision. So if, if you have people that want to disclaim, they must disclaim prior to the the end of year or prior to the trustee doing their distribution.

ATO's decision impact statement

yep. And the decision impact statement. So most of it was just repeating the case, but it does say that it settles the important question of how trust income is to be bought to tax when relevant trust entitlements are disclaimed in a legally effective manner. So just remember those disclaimers, they were legally effective, but not for tax purposes.

And so nothing disturbs that present entitlement at 30 June. And that's why we say it. Isn't so important to get these things done. And this ATO ID, which said you could do this, that his disclaimer after your end, has now been withdrawn. So the tax office got into court and argued against their own ATO ID.

Key takeaways

So an important statement there from the high court just to note. So I've said most of this, the high court's spoken, just make sure if you have clients that have got default beneficiaries, make sure that you get your distribution done. Now I know none of you listening will be doing this doing your distributions after the 30th of June, but just per chance, you happen to pick up another client where that's happened. Just have a look at who the default beneficiaries are.

And is it unfair? Absolutely. And the high court said so. It's absolutely unfair and hint, hint, government, you better change the law. It might be in the context of the Labor Party's changes to the taxation of trusts, which they haven't announced, but I suspect there'll be something that will come.

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