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Discretionary trusts and the $5 million tax time bomb

Feature Articles

Cite as: (2003) 77(6) LIJ, p.40

Most discretionary trusts are quietly ticking away, threatening to explode, following a recent interpretative decision by the Australian Tax Office.

By Robert Warnock

The sale of a business asset, or even the sale of a business itself, by a taxpayer will often give rise to a capital gain that is assessable under the Income Tax Assessment Act 1997 (ITAA). The taxpayer may theoretically be able to reduce the taxable portion of the capital gain by applying one or more of the four small business capital gains tax (CGT) concessions in Division 152 of the ITAA. The purpose of the concessions is to provide tax relief to small business taxpayers when they sell their business.

The concessions only apply to taxpayers who satisfy the conditions contained in Division 152. One of those conditions is the maximum net asset value test. To pass this test, essentially the taxpayer’s net worth (excluding assets for personal use) must not exceed $5 million. A recent decision of the Australian Taxation Office (ATO) has thrown into doubt whether any taxpayer can pass this test and thereby obtain the concessions.

In ATO Interpretative Decision ID 2002/921, a discretionary trust conducted a business. The trust disposed of the assets of the business and realised a capital gain. The trustee sought the ATO’s interpretation as to whether the maximum net asset value test required the trust to include the net value of the assets of certain objects of the trust in the $5 million calculation.

The ATO confirmed that the net value of the CGT assets of a charity, which was an object of the trust, must be taken into account when applying the $5 million maximum net asset value test to the trust. The effect of this interpretative decision, many commentators say, is to confirm that most small businesses operating through discretionary trusts will not be able to access the CGT small business concessions in Division 152.

Sadly, the problem is not confined to small businesses operating through trusts. The problem applies to all taxpayers, including individuals. Until the law is amended it is doubtful that any individual taxpayer can honestly state that they technically comply with all the conditions required to obtain any of the four CGT small business concessions.

DIVISION 152 CONDITIONS

As explained in the interpretative decision, one of the basic conditions of eligibility for the CGT small business concessions is that the net value of CGT assets of the taxpayer and related entities, including entities connected with the taxpayer, must not exceed $5 million. A taxpayer will be connected with another entity if:

  • the taxpayer controls the other entity;
  • the other entity controls the taxpayer; or
  • the taxpayer and the other entity are controlled by the same third entity.

Trusts
Under s152–30 an object will be taken to control a discretionary trust if the trustee has the power to distribute at least 40 per cent of the income or capital to that object. Most discretionary trust deeds are drafted to give the trustee power to distribute 100 per cent of the income or capital to any one or more of the objects. As a result most, if not all, objects of a discretionary trust will be taken to control the trust, whether or not they have ever received, or will ever receive, a distribution from the trust.

This means all objects of most discretionary trusts will be connected with the trust for the purposes of the $5 million net asset value test.

In the interpretative decision, the ATO confirmed s152–30 applied in this way and so tax-exempt charities, which were objects of the particular discretionary trust in question, were connected with the trust. As such, the net value of all the charities’ assets must be included when determining whether the $5 million threshold had been exceeded.

Although the interpretative decision refers specifically to tax exempt bodies such as charities, all other objects will similarly be connected with the trust. If all objects of a discretionary trust are connected with the trust for the purposes of the $5 million net asset value test, it is highly unlikely any trust will be able to satisfy the test and obtain any of the four CGT small business concessions. This is because the value of all the assets of the objects (excluding personal assets of individuals) must be taken into account.

Individuals and companies
However, the problem does not stop with discretionary trusts. It applies to individuals and companies as well.

To pass the $5 million net asset value test, an individual or company must also include the net value of all assets owned by trusts in which the individual or company is an object. Given that most discretionary trust deeds are drafted so as to include as objects as many people as possible, it is likely that most individuals are objects of a number of discretionary trusts without even knowing it.

For example, some discretionary trusts include as a class of objects any person who has made a tax-deductible donation to a charity. This means any person who has donated $2 or more to a tax-deductible charity is likely to be the object of many discretionary trusts and thus connected with those trusts.

Further, the objects of a standard discretionary trust usually include all the relatives, including distant relatives, of the primary beneficiaries. As a result, many individuals will be an object of a relative’s trust, and so connected with that trust, even though they did not know the relative had a trust (or, in some cases, that the person was even a relative).

The problem with s152–30 is that no taxpayer can know for certain whether or not they satisfy the $5 million net asset value test, as they are simply unaware of which trusts they are an object of. It is likely that most taxpayers are objects of a number of discretionary trusts and so will technically not be able to satisfy the $5 million net asset value test, and therefore not be able to claim any of the four CGT small business concessions.

SOLUTION TO THE PROBLEM

The problem can be overcome by including a clause in the trust deed which prohibits the trustee from distributing more than 39 per cent of the income or capital to any object. As a result, none of the objects should be connected with the trust, and therefore the net value of those CGT assets will not be taken into account when determining whether or not the trust passes the maximum net asset value test.

If required, the 39 per cent limitation need not apply in respect of all objects. It may be desirable to allow a limited range of objects to receive a greater than 40 per cent distribution of income or capital. For example, a trustee may want to distribute more than 39 per cent of the income to a principal, their children or a family company.

Generally, the maximum net asset value test need only be satisfied just before the business or asset is sold. So the trust deed of an existing discretionary trust could be amended to overcome the problem. However, another problem then arises as to whether or not such an amendment constitutes a resettlement for CGT or stamp duty purposes.


ROBERT WARNOCK is legal counsel and acting president of the National Tax and Accountants’ Association (NTAA). He represents the NTAA on many ATO forums such as the National Tax Liaison Group and is a regular presenter of seminars on CGT and other tax topics.

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