Takeaway points
- Always be aware of the terms of Trust deeds.
- Always communicate with your client’s accountant when property is sold
- Beware that problems that can arise at the end of the financial year.
Fred is a third generation local farmer for whom you have acted for many years. His wife died 10 years ago and he has two children, Alice on the farm and Tony who works as a nurse in a city hospital. You always told them that Alice would have to get the farm to keep it in the family but assured Tony that he would be “looked after”.
Tony was not all that convinced, which often made family gatherings a little tense.
Time has gone by and Fred wants to make it all happen before his time runs out. As well as the old family farm, many years ago Fred had bought another property some distance away which he had put into their family trust. Instead of running that property they leased it out at a pretty good rent. Fred decided that the time had come to sell. It sold very well and made a capital gain of around $4 million.
You said to Fred that he must get advice from his accountant about capital gains tax. Fred was having trouble with his accountant because the person he had used for years was made redundant after reaching a compulsory retirement age and he hadn’t been able to click with any of the younger accountants. You said – but Fred – you gotta do it mate.
The sale settled, leaving the $4 million in your trust account after paying the debt that Fred incurred to purchase the property, and which he had never paid off. Fred asked you to keep it in your Trust account until things were sorted out because he didn’t have a personal bank account. All his living expenses for donkeys years had been paid out of the operating partnership’s account.
All this happened in the late summer. Then it rained – late in the season so Fred and Alice got totally involved in sowing the current year’s crop. It ended up raining too much and Fred and Alice went through the frustrations every farmer is all too familiar with.
Then June came along, the crop was in, and Fred came to see you about what to do with all the money you held for him. What I want, Fred said, is for Tony to get $1 million tax free, with the balance kept for me. But please hang onto the balance until I work out what to do about investing it.
You said – yes Fred – but have you spoken to your accountant yet? He said no, but I will do it very soon, I promise.
The $1 million was transferred to Tony before the end of the month but nothing more was heard from Fred until late July – after he’d seen his new accountant Harry. You asked how he got on and Fred said Harry was great – new ideas all over the place.
Because the trust deed was pretty old, Harry told Fred it needed updating to make it so that – if necessary – the capital gain would automatically go out to Fred as the default beneficiary. However he had a look at the deed, and this wasn’t done, he also picked up that there was no definition of income. So, Harry said to Fred – I just hope that your solicitor put the money in your name in his trust account before the payment was made to Tony and especially before 30 June.
Fred wasn’t fully aware of the significance of all this but he was clearly concerned and said why didn’t you chase me up before 30 June?
The Stings
Because the only thing you did before 30 June was to pay Tony his $1 million:
- Tony will be taxed at his marginal rates on 50% of his 25% share of the capital gain, and
- the Trust will be taxed at 45% on 100% of the balance.
Compared to what would have happened if you had transferred all the $4 million in your trust account from the Trust’s name to Fred’s name:
- Fred would pay CGT on 50% of the capital gain, and
- Tony would pay nothing.
If Tony somehow had an otherwise assessable income of $180,000 the tax on the assessable 50% of his $1 million would be $235,000 and the Trust’s 45% on $3 million = $1.35 million.
If it all went to Fred (assuming he had at least $180,000 otherwise assessable income) his tax at 47% of 50% of the full capital gain would be $940,000. So, collectively $645,000 less.
The modern definition of income in discretionary trust deeds includes assessable capital gains as “income”, which in the absence of a resolution to the contrary, means the default beneficiaries (just Fred) would be taxed on the capital gain. Without this, the capital gains remain in the Trust and taxable there unless before 30 June (A) the trustee passes a resolution to distribute the gain to the beneficiaries or (B) the money is actually paid or payable to the relevant beneficiaries. In Fred’s case there was no resolution and no transfer of the money in your trust account when Tony received his $1 million.
If on 30 June the balance in your Trust account was in Fred’s name instead of the Trust, even without the updated definition of “income”, Subdivision 115C ITAA 1997 would have applied to make Fred “specifically entitled” to the capital gain because of the financial benefit (the cash) that Fred could be reasonably expected to receive. If as of 30 June the capital of $4 million in your Trust account was in Fred’s name and the payment to Tony was made after that, he would have received his $1 million as a tax free gift – as was intended.
In Tony’s case he will be subject to tax on his $1 million share of the capital gain – but there will be only tax on 50% as he will be entitled to the general discount. The only problem is that Fred promised Tony the $1 million would be tax free. Not a happy outcome for family harmony.
The same would be the case with Fred, if the money in your trust account was in Fred’s name personally. But it wasn’t, and so the Trust will be taxed under section 99A at a flat 45% under section 12(9) of the Income Tax Rates Act 1986 – with no 50% discount. There are some exceptions to this but none applicable here.
Authors: Jim Main – Accredited Specialist Business Law & Certified Tax Advisor and Michaela Schmidt – Lawyer & Director