Carter's Case - default distribution clauses mean what they say!
In possibly the most significant trust tax case since Bamford (2010), the High Court has held that the attempt to undo, by means of an “after the event” disclaimer, the tax consequences of a default distribution clause of a discretionary trust was ineffective for taxation purposes.
In short the default distribution clause was engaged and operated (as intended) to ensure that the net income of the discretionary trust for the 2014 financial year was allocated to five named default beneficiaries. The fact that the default beneficiaries attempted to disclaim the default distributions by signing disclaimers after the end of the 2014 financial year was irrelevant.
6 Significant Implications of Carter’s Case
The decision in Commissioner of Taxation v Carter  HCA 10 has six significant implications.
The first is that default allocation clauses are legally effective. The clause, once triggered, allocated the share of tax income of the trust to the five default beneficiaries in respect of the 2014 financial year and their tax liabilities were then crystallised.
The second is that a disclaimer (even if valid at general law) is not effective to undo the crystallised tax liabilities. To use the colourful language of the decision, the disclaimers were “not effective to “retrospectively expunge” the rights of the Commissioner (of Taxation) against the respondents (ie the default beneficiaries) which were in existence at midnight on 30 June 2014”.
The third is that Division 6 of the Tax Act (1936) applies as designed: if the default beneficiary is presently entitled (for example by operation of the default distribution clause) to, or to a share of, the distributable income of the trust estate, that beneficiary will have included in their assessable income (automatically by force of s97) the net income (or share of the net income) of that trust estate. This will be the case whether or not the beneficiary actually receives a trust distribution and whether or not the trustee even has the means to pay the distribution.
The fourth is that “present entitlement” of a beneficiary to the distributable income of the trust must be tested and examined at the close of the financial year, not some reasonable period of time after the end of the financial year. This was the error of the Full Federal Court.
The fifth is that “after an event” disclaimers may be effective as between the default beneficiary and the trustee but, unfortunately, so far as the Commissioner of Taxation is concerned, the taxation train has already left the station heading with double green light for Assessmentville.
The sixth is that if a default beneficiary does enter into a legally effective disclaimer after the close of the financial year, the default beneficiary could find themselves in the doubly worst position of still being assessed on the net income (or share of the net income) and having foregone their rights to enforce the trustee to pay the distribution owed to them.
What’s the story?
Carter’s case concerned The Whitby Trust established in 2005. The Whitby Trust was, it seems, a vanilla discretionary trust with the trustee conferred with the power to allocate the “distributable income” of the trust in respect of the Accounting Period (defined to be each year ended 30 June) to or amongst a class of beneficiaries with power to accumulate (ie not distribute but retain the income in the trust) if the trustee so decided. If no decision was made by the trustee before the end of the financial year, the distributable income was automatically allocated to 5 named default beneficiaries in equal shares; the default beneficiaries being the children of the creator of The Whitby Trust.
For reasons which are not presently relevant, the trustee did not make a decision (whether to allocate or retain) in respect of the financial year ended 30 June 2014. Consequently the default distribution clause automatically applied and the distributable income of the trust was allocated in equal shares to the 5 children. As the distributable income of the trust was allocated to them, it followed automatically by the terms of s97 that 1/5th of the net income of The Whitby Trust was included in their tax returns for the 2014 financial year.
For reasons which are not presently relevant, 4 of the children did not want to have their share of the net income included in their tax return. Consequently they executed instruments to “disclaim” ie reject or not accept their share of the distributable income. Again for reasons not presently relevant, the first and second disclaimers signed by them were held to be legally ineffective. But third time lucky. Or so they thought, until the Commissioner of Taxation having lost before the Full Federal Court, appealed to the High Court on the single issue, of whether the third disclaimer (made 30 months after 30 June 2014) was effective to override s97(1) of the Tax Act 1936.
The Full Federal Court held that there was nothing in the in s97(1) of the Tax Act 1936 to indicate that a beneficiary’s liability was to be determined once and for all at the end of the financial year by reference to the legal relationships then in existence. Accordingly, if a disclaimer made by a beneficiary was legally effective and made within a reasonable period after the end of the financial year, the disclaimer would be effective and override s97(1).
The High Court unanimously held that s97(1) did apply on a “once and for” basis to determine the liability of a beneficiary at the end of the financial year by reference to the then legal relationships in existence. Accordingly, anything done by the beneficiary (or trustee or both) after the end of the financial year could not undo, override or disapply the effect of s97(1). Whether the (third) disclaimer was legally effective as between the trustee and the default beneficiary was irrelevant.
What should advisers do?
First – review the default distribution clauses of their client’s discretionary trusts to assess whether the default distribution clauses are appropriate. In particular, whether the nominated default beneficiaries wish to be replaced or removed. One of the surprising things about discretionary trusts, is that there is no prior consent required before an individual or entity can be named as a beneficiary – whether a discretionary beneficiary or a default beneficiary.
Secondly – ensure that their client’s appreciate the consequences of failing to make an effective decision to allocate (or accumulate) the distributable income of the trust before the end of the financial year. Generally clients rely on their accountant to make the arrangements to record the distributions before June 30 each year. Accountants need to ensure that those arrangements are made to avoid a claim against them by the client when the distribution is not made and the default beneficiary takes the income instead.
Thirdly – ensure that their clients appreciate that if a default distribution clause is engaged, the default beneficiaries will have enforceable rights against the trustee to honour the default distribution. In particular, unpaid present entitlements do not form part of the trust corpus, though they may be invested with the trust corpus on a common fund basis where this is permitted by the trust deed.
What happens if a default beneficiary disclaims before the end of the financial year?
Presumably, the disclaimer would be effective (assuming it is legally effective) for taxation purposes as the disclaimer does not disapply s97(1) but rather removes the person as a default beneficiary before that section can apply to the beneficiary. Consequently any purported distribution to the disclaimed default beneficiary would be ineffective and, if the distribution was paid, the former default beneficiary would hold the distribution as a bare trustee for the trustee.
What happens if a default beneficiary disclaims after the end of the financial year?
The disclaimer would not override the operation of s97(1) and the allocated share of the net income would be included in the tax return of the default beneficiary. If the disclaimer was legally effective, presumably the trustee’s obligation to pay the share of the distributable income would be extinguished and if already paid to the default beneficiary, the default beneficiary would hold the distributed amount on a bare trust for the trustee.
The fact that the default beneficiary has disclaimed the distribution and either not received the distribution or repaid the distribution will not affect the operation of s97(1) and the allocated amount will be included in the tax return of the default beneficiary.
The default beneficiary may seek to have the Commissioner of Taxation waive the tax debt (to the extent it relates to the disclaimed distribution). Whether the Commissioner would accede to such a request is problematic given the Commissioner may not have a legal basis to assess the disclaimed distribution to the trustee or another default beneficiary. If so, waiving the tax debt would amount to the provision of a windfall tax benefit to the trustee or other default beneficiary.
For further information, please contact Townsends Business & Corporate Lawyers on 02 8296 6222 or email firstname.lastname@example.org.