Beware the Notional Settlor Clause – s 99A accumulation assessment looms large!

November, 2012

With all the recent activity concerning the taxation of trusts (the Bamford’ case (2010) 75 ATR 1), controversial ATO rulings, legislative changes and more to come), it is easy for advisors to lose track of the basics. For example, it is crucial when advising clients how to distribute income or capital from a discretionary trust that the distribution is being made to a lawful beneficiary of the trust (ie one that fits the strict definitions in the constituent trust deed).  In this regard, “notional settler” clauses can inadvertently trip advisors up.

It is customary for discretionary trust deeds to exclude the settlor of a trust from being a beneficiary.  This is to prevent any suggestion that the trust is a “revocable trust” under s 102 of the ITAA 1936.  However, some trust deeds, in particular older trust deeds, go much further.  For example, take the following clause extracted from a trust deed our firm was recently requested to review:

…a person who has transferred property for other than full consideration in money or money’s worth to the Trustee to be held as an addition to the Trust Fund (herein called “the excluded persons”), or any corporation in which and the trustee of any settlement or trust in or under which any excluded person has an actual or contingent beneficial interest, so long as such interest continues, is excluded from the class of General Beneficiaries…”

This clause would naturally exclude the original settlor of a trust from being a beneficiary, but goes much further. Any person “who has transferred property for other than full consideration in money or money’s worth” after the trust is established is also excluded.  It may also include other non-commercial transactions such as an interest-free loan or sale of an asset at less than the market value consideration.

Thus, assume Mr X lent $1,000 interest-free to the X Family Trust of which he is a principal and named beneficiary.  If the X trust had a notional settler clause similar to the one above, Mr X may be excluded from being a beneficiary of the trust.  Further, under the clause above, any other trust of which Mr X is a beneficiary or a company in which he is a shareholder would also be excluded.

At law, an income or capital distribution from a discretionary trust is also a form of gift and would likely qualify as a “transfer of property for other than full consideration”.  Therefore, if a discretionary trust (Trust 1) has made an income or capital distribution to another trust with a notional settlor clause (Trust 2), Trust 1 would be excluded from being a beneficiary of Trust 2. Further, if Trust 1 is a beneficiary of another trust (Trust 3), then both Trust 1 and Trust 3 would be excluded from being a beneficiary of Trust 2.  These issues are not solved by making valid Family Trust or interposed elections between them.

It is not difficult to imagine the havoc this could cause within a family group. If an adviser was unaware that a trust had a notional settler clause, and a gift had been made to that trust from one or more family members or other trusts, a large class of beneficiaries may be excluded from benefiting from that trust. If a distribution has inadvertently been made to an excluded beneficiary in the past, that distribution may have been invalid. This could result in a very large tax liability upon an audit. For example, the invalid distribution may be treated as an accumulation and be subject to the top tax rate (currently 46.5%) in the trustee’s hands.  If professional advice was relied on in planning such distributions, unfortunately there may be some negligence exposure for the unwitting professional.

This issue will also limit the flexibility as to how income or capital can be distributed in the future. For example, it may be desirable to distribute income from a trust to another trust that has tax losses. However, the application of the notional settler clause could mean that the loss trust is an excluded beneficiary, and thus this sensible tax planning measure cannot be implemented.  These are only the tax issues. The commercial issues concerning loss of future entitlements for intended beneficiaries and the possible claw back of invalid past distributions could be grounds for years of complex and expensive litigation.

Tax advisors should confirm whether any trust deed they are dealing with has a notional settlor or other like clause, and if it does, whether this could have any negative ramifications (for both past and future distributions).  Depending on the precise terms of the trust deed, remedial action can often be taken.  The golden rule as always is to read the trust deed well before year end to plan impending trust distributions.

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Martin Checketts
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