Disclaimer: The content of this Bulletin is general information only. It is not legal advice. Law Central Legal recommends you seek professional advice before taking any action based on the content of this Bulletin.
by John Wojtowicz (Director - Law Central Legal)
It’s not uncommon to find that distributions of trust income have been made to a person who is not a beneficiary under the trust deed. Often this is caused by the trustee mistakenly believing that the person is a beneficiary who was entitled to the income of the trust. This can happen for a wide variety of reasons, such as:
If you suspect that a payment from a trust might have been made to a non-beneficiary, then the first step is to determine if that person actually is a beneficiary. This can be done by a thorough examination of the trust deed. If it is determined that the person is not a beneficiary then there can be serious legal consequences. These consequences will affect the trust but can also have major tax implications for the beneficiaries and the trustees.
This issue was addressed by the Australian Federal Court in the case of Ramsden v Commissioner of Taxation. In Ramsden, conditions had to be met before another trust would become eligible as a beneficiary. These conditions had not been met, but the trustee made a trust distribution to the other trust anyway. The trustee had clearly made a trust income distribution to a non-beneficiary. The court was required to decide what the legal effect was.
The Court concluded that it was beyond the trustee’s power to make payments to a non-beneficiary. Since the trustee was acting beyond the scope of his powers, the payment was held to be void ab initio (to be treated as invalid from the outset). This means that any income distribution made to a non-beneficiary will be nullified and it is to be treated as if it never took place. This does not sound too problematic, but it can lead to some undesirable tax implications for beneficiaries and the trustees.
The Tax Consequences
A trust is not a taxable entity and therefore does not pay its own income tax. The income of a trust is taxed under Division 6 of Part III of the Income Tax Assessment Act 1936 (Cth). Under the Act all income made by the trust in the financial year will be taxed and paid by either the beneficiaries or the trustee.
The amount of tax which is allocated to each person/entity is set out in the Act. Any income which is earned by the trust in the financial year will be taxed to a beneficiary who is ‘presently entitled’ to the income. ‘Presently entitled’ has been defined as: able to make an immediate demand of the money from the trustee. It is important to note that the beneficiary doesn’t have to actually receive the income, they only have to be entitled to make a demand for it. Any income which no beneficiary is presently entitled to will be taxed to the trustee.
If a distribution of trust income becomes void ab initio because it was made to a non-beneficiary, then no beneficiary would be presently entitled to that income. Under the Act, any income which no beneficiary is presently entitled to, will be taxed to the trustee. This can be problematic for two reasons. Firstly, the trustee could receive a tax assessment which they were not expecting.
Secondly, the trustee is often taxed at the maximum rate.
It’s undesirable for the trustee to be taxed at this higher rate when beneficiaries are taxed according to their respective income tax bracket, which can be much lower. Many modern trusts insert a default beneficiary clause in the trust deed to prevent the trustee from paying the higher tax rate.
Default Beneficiary Clauses
One way to prevent the trustee paying the tax is to ensure that there is always a ‘presently entitled’ beneficiary who will be taxed instead. Many modern trusts include a default beneficiary clause which states that any unallocated income will be held on trust for a specific person or persons, the “default beneficiary”. This means that the default beneficiary will always be taxed instead of the trustee. This can be useful to lower the tax rate for trust income, but the default beneficiary will still end up with a large tax assessment for income they may not even have received.
This was the case in Ramsden. The payment to a non-beneficiary was void ab initio and the trust had a default beneficiary who then became entitled to the distribution. The default beneficiary knew she was a general beneficiary but had not received any income nor knew she was entitled to any. She was sent a notice from the Commissioner of Taxation saying she had misreported her income and was required to pay extra tax.
Understandably, she was not impressed with the prospect of paying a large amount of income tax on money that she had never received. She attempted to renounce her entitlement by affidavit. If she was successful she would no longer be a default beneficiary. That meant she would no longer be ‘presently entitled’ to the income and therefore she would not be liable to pay the tax on trust income.
On appeal, the Court held that it was possible for a default beneficiary to disclaim their entitlement. If that occurred and there was no other beneficiary who was ‘presently entitled,’ then the trustee once again became liable to pay the tax. Unfortunately for the default beneficiary in Ramsden, even though she could have disclaimed her entitlement, it was not done within a reasonable time. The Court held that since she had not effectively disclaimed, she was still a default beneficiary and therefore liable.
Gold and Platinum viewers read on for information on what is required to properly disclaim a default interest in a trust.
The above case highlights the importance of Trustees understanding the terms of the trust deed before making income distributions. Correctly identifying who are eligible beneficiaries and ensuring that the distribution minutes are properly worded can help avoid potentially costly legal issues and unwanted tax outcomes.