29/08/2016

A recent High Court case has found that an unpaid present entitlement can be a debt payable by the trustee to the beneficiary.  But if the debt goes bad the beneficiary will still not be able to claim a deduction for it.

In July 1994 the trustee of the Nemes Family Trust resolved to distribute all of the trust’s asset revaluation reserve (over $3.9 million) to Mr and Mrs Nemes.  

The resolution was made pursuant to clause 4(b) of the trust deed which empowered the trustee to “advance or raise any part or parts of the whole of the capital or income of the trust funds and to apply the same as the trustee shall think fit for the maintenance, education, advancement in life or benefit of any of the specified beneficiaries …”  

No actual distribution of assets took place.  Instead a deed of charge was executed by the trustee in 1995 which recorded that the trustee was indebted to Mr and Mrs Nemes in the amount of the distribution and covenanted that the amount would be paid to the Nemes upon their demand.  Neither of the Nemes made that demand during their lifetimes.  After Mr Nemes’ death members of the Nemes extended family (and potential beneficiaries under the trust) sought to have the loan set aside as void.

For the purpose of this article the important issue considered by the High Court was whether the resolution and the subsequent recording in the trust’s accounts of a loan of $3.9 million would have entitled Mr and Mrs Nemes to bring an action for “money had and received” against the trustee, thereby categorising the money as a common law debt.  

The majority of the Court found that although there was no change in the beneficial ownership of the shares the resolution was nevertheless an effective exercise of the trustee’s power and gave rise to a creditor/debtor relationship between the Nemes' and the trustee which rendered it enforceable under common law.  In accordance with the terms of the trust deed the Court found that a debt could and did exist.

Contrast this with the attitude of the Commissioner in TD 2015/D5. In the context of discussing whether or not a beneficiary can claim a deduction for a UPE which they never received, despite having paid tax on the amount when it was first distributed to them, the ATO draws the distinction between the taxed distribution and the loan set up by the trustee immediately after the notional distribution.  The technical distinction is that the loan is not the distribution (even if it is the same amount).

The section which permits a taxpayer to write off a bad debt in these situations is s.25-35(1)(a) ITAA97.  The section requires that the amount of the relevant debt be included in the taxpayer’s income for that year or an earlier income year.

The ATO’s reasoning goes that the beneficiary does not pay tax on the amount that is allocated to them in the distribution (and which ultimately becomes the UPE and the bad debt) but rather on the amount calculated in a statutory formula (following Bamford’s Case).  Therefore the amount of the distribution (ie the amount of the UPE) is not the amount included in the taxpayer’s income even if it happens to be the same as the amount of the taxable taxpayer/beneficiary’s share of the trust’s income.

Picky, picky!

There are several examples in TD 2015/D5 which make the point clear.  The draft determination has been the subject of a number of submissions so we wait to see what the final determination will say.

In the meantime is it worth ensuring that the unpaid distribution can be characterised as a loan from the beneficiary to the trustee?  It may be that the beneficiary won’t be able to claim a deduction if the loan goes bad but there is still the benefit of setting up the loan to secure the distribution (ie prevent any claim later that it was not a real distribution, as happened in Nemes’ case) and to protect the amount from other creditors of the trust, though this may require security to gain priority.

As always the devil is in the detail …. and the trust deed.

If you’d like to discuss any aspect of this further or have your trust deed checked against Nemes’ case, please contact Townsends Business & Corporate Lawyers on (02) 8296 6222.