We were asked the other day if there is anything stopping a discretionary trust making a distribution to someone who has previously made a gift to the trust.
This may seem like a simple question, but it isn’t.
As you will probably be aware, most (if not all) trust deeds in Australia exclude the person who initially set up the trust from benefitting from the trust. This person is generally referred to as the ‘settlor’, and this person is usually a professional adviser who would ordinarily have no reason to benefit from the trust.
In these cases, it is the trust deed itself that prevents the settlor from also being a beneficiary. As a matter of trust law, there is nothing preventing a person who has settled a trust also being a beneficiary. In fact, in many countries it is very common for the settlor to also be a beneficiary. For example, a parent may set up a revocable trust for themselves and their family.
However, in Australia our tax law is such that allowing the settlor to potentially benefit is a very bad idea. This is because section 102 of the Income Tax Assessment Act 1936 provides that if the settlor is able to benefit under the trust, then the Commissioner can assess the trustee on the income from the settled property in each year, and at a rate referable to the marginal rate at which the settlor would have paid tax on that income. The reason for these tax provisions was to stop people settling a trust to alienate income from themselves, while retaining the ability to call the capital back at some later stage – in other words a ‘revocable trust’.
So in Australia, a well drafted trust deed will specifically exclude the person who settled the trust in the first place.
But the story does not end there. What you need to be particularly careful about is if the trust deed goes further than excluding just the initial settlor of the trust – and excludes any person who contributes something to the trust for less than market value, i.e. any person who makes a gift to the trust. This sort of clause is particularly common in outdated trust deeds.
Why a trust deed would exclude not only the original settlor, but anyone making a gift to the trust is not clear, and in our view, is not necessary to avoid the operation of section 102. This is because section 102 only applies when “a person has created a trust” by settling the property on the trustee. It is our view that a later gift or contribution does not fall within the concept of ‘creating a trust’ because it is already in existence.
But if your trust deed does go further than necessary, then you can be in all kinds of trouble. For example, if you gift an amount to such a trust, or if you forgive an amount owed to you by the trust, or if you deal with the trust other than on arm’s length terms, then you will automatically be excluded from benefiting from the trust in the future. Another example is if you have more than one trust, and the first trust distributes to the second trust. In this scenario the first trust is thereafter excluded from benefitting from the second trust.
So the takeaway is that you should review your trust deed to ensure that it does not exclude someone who has made a contribution to the trust. Otherwise, a later distribution of income to that person will be held to be invalid, and the trustee will be subject to a section 99 default assessment.
Another good reason to (a) buy a quality trust deed in the first place (i.e. come and see us!), and (b) check any trust deeds that you already have in place for this issue.
Need help? Call us now on 1300 654 590 or email us.
The information contained in this post is current at the date of editing – 27 March 2023.
