By John Wojtowicz (Director - Law Central Legal)

Many family trusts have restrictions that prohibit certain entities benefiting from the family trust. Typically this would normally include the Settlor and related entities of the Settlor. Although there is no principle in law that forbids a settlor from being a beneficiary to a trust this has become the norm in Australia due to the operation of section 102 of the Income Tax Assessment Act 1936 (Cth) (“ITAA”).

Section 102(1)(a) of the ITAA in effect disallows the Settlor to have the power to revoke or alter the trust and as a result acquire/receive income from the trust.

Section 102(1)(b) of the ITAA provides that if a person creates or settles a trust under which a child of that person under the age of 18 can benefit, then the Commissioner may assess the trustee to pay income tax on income applied for the benefit of the minor child of the settler on the basis that the income so applied is to be added to the income of the person who created or settled the trust (i.e. the settlor/parent) so that the relevant marginal rate of tax of the settlor/parent applies to the income derived by the minor child as if the settlor/ parent had earned that additional income.

Some trust deeds (normally older deeds) also restrict the trustee from receiving a benefit. Sometimes a specific person or entity is excluded to distance that person from the trust for asset protection purposes.

Amendments to trust deeds over time may, subject to the deed permitting such a power , increase the list of persons or entities to be excluded from receiving a benefit. A recent example of this relates to changes in the law in regards to state land tax and transfer duties for foreign persons acquiring residential property in a trust. To avoid this additional surcharge many trusts have been amended to exclude foreign persons from receiving a benefit or interest in the trust. (See our previous bulletin no 563 Does Your Family Trust Own Property in New South Wales)

Trustees duties

The trustee has a primary duty to administer the trust in accordance with the terms of its deed and they have a duty to ensure that trust distributions are made to eligible beneficiaries of the trust.

A distribution to a non-beneficiary will be a breach of trust and may result in adverse tax consequences for the trustee as well as exposing the trustee to a claim by the beneficiaries of the trust. (See our Bulletin 536 for more discussion on tax issues)

In the case of Re Diplock (1948) CH 465 the trustees believed provisions of the trust gave them power to distribute trust assets to various charities. After making such distributions the testator’s next of kin challenged the validity of the distributions. The Court held the trustees’ interpretation of the trust to be incorrect and the distribution invalid with the next of kin entitled to receive the assets. The trustees were held to be personally liable for breach of trust.

Challenges to income distributions by beneficiaries in a discretionary family trust are rare due to the fact that the beneficiaries’ interest in a discretionary trust are not fixed (unless an entitlement has been given by the trustee) and have often been described as a “mere expectancy”: see  Pearson v IRC [1981] AC 753.

If a Court action was taken by a beneficiary in a family trust against the trustee for a breach of trust as a result of a person or entity wrongfully receiving a trust distribution, it is unlikely in our view that the Court would order that the monies paid to the incorrect person should go to the beneficiary making the claim. The Court would likely order that:

1. distribution to the non-beneficiary would be null and void at law and liable to be set aside ab initio (see Ramsden v Federal Commissioner of Taxation [2004] FCA 632);
2. an errant distribution, would go to the default Income Beneficiaries in equal shares as tenants in common ( subject to the trust deed having default income beneficiaries); or
3. as an alternative, the errant distribution, would be paid back into the trust fund and held as capital of the trust.

Accountants as settlor

An interesting point can arise where the settlor is the accountant to the trust. If the settlor is precluded from receiving a benefit under the trust deed, does that mean that the accountant, being the settlor, cannot charge for his service for doing work on behalf of the trust as this may be construed as a benefit? We note some trust deeds refer to the settlor being excluded from having a right to receive an income or capital distribution or interest from the trust where some trust deeds have a broader clause containing the word “benefit”.

There is no case law of which we are aware that addresses this issue.

The authors in the text book “Drafting Trusts and Wills Trusts in Australia”, Second Edition 2018 by James Kessler and Michael Flynn considered this issue in paragraph 5.285 whereby they have formed the view that “[i]t is considered that the settlor exclusion clause does not prevent remuneration of a settlor or spouse. This is because (looking at the matter broadly) the settlor or spouse has gained no advantage: he has worked for his remuneration. The alternative basis for reaching this conclusion is that the payment is administrative and not dispositive. On any view, it is not necessary to say expressly that the settlor and spouse cannot charge remuneration.”

A Court may take an entirely different view on the basis that the word “benefit” (if such word is contained in the exclusion clause) includes remuneration for services provided even if the services are rendered at a market rate as the remuneration may contain an element of profit.

Interposed entities used to distribute income to prohibited persons

A trustee may want to distribute income to an excluded person via an eligible beneficiary.

The general rule of equity is that an appointment (distribution) to an object (beneficiary) for the purposes of benefiting a non-object (non-beneficiary) is void. This doctrine is often referred to as a “fraud on power”.

Accordingly an income or capital distribution to a beneficiary with the intention that the proceeds or part proceeds of that distribution pass from the beneficiary to a non-beneficiary may be found to be a fraud on power.

Platinum and gold members read on to obtain further details on this well established doctrine.

For queries on this area please contact John Wojtowicz at John@lawcentrallegal.com.au.

Disclaimer: The content of this Bulletin is general information only. It is not legal advice. Law Central recommends you seek professional advice before taking any action based on the content of this Bulletin.

Related documents:

• Family Trust
• Family Trust - Bamford & Streaming Update
• Change Trustee of Family Trust
• Family Trust - Update to Exclude Foreign Persons (NSW)
• Trust Distribution Minutes Library for 2018/2019 - Multi Use
• Trust Distribution Minutes Library for 2018/2019 - Single Use

Related webinars:

• Webinar Recording - Dealing with Mistakes and Variations in Family Trust Deeds