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FORMING A DISCRETIONARY TRUST
How Does a Discretionary Trust Work?
In order to maximise the benefits available in utilising a discretionary trust it is necessary to fully understand the nature of the trust, the role of the parties involved and the capabilities of the trust in order to maximise protection of assets and minimise taxation consequences.
What is a Trust?
A trust is a relationship where a person (the Trustee) is under an obligation to hold property for the benefit of other persons (the Beneficiaries). The terms of the obligation are defined by the terms of the Trust Deed entered into between the Trustee and the Settlor.
A trust is not a separate legal entity even though a trust tax return will be required to be lodged with the Australian Taxation Office each year. The Trustee is the legal owner of the trust property and the beneficiaries hold the beneficial interest in the trust property.
What is a Discretionary Trust?
In a discretionary trust the beneficiaries do not have a fixed entitlement or interest in the trust funds. The trustee has the discretion to determine which of the beneficiaries are to receive the capital and income of the trust and how much each beneficiary is to receive. The trustee does not have a complete discretion. The trustee can only distribute to beneficiaries within a nominated class as set out in the terms of the trust deed.
What are the elements of a Discretionary Trust?
In determining how a discretionary trust works the role of each of the six elements of a discretionary trust should be known. The role of the six elements may be summarised as follows:
1. The Trustee
The trustee is the legal owner of the trust property although not the beneficial owner. The trustee carries out all transactions of the trust in its own name and must sign all documents for and on behalf of the trust. The trustee's overriding duty is to obey the terms of the trust deed and to act in the best interests of the beneficiaries.
2. The Settlor
The settlor is the person who creates the trust by "settling" a sum of money or item of property on trust for the beneficiaries.
3. The Trust Fund
The trust fund is all the property of the trust including the settlement sum, accumulated income and any other money and property held by the trustee pursuant to the terms of the trust.
4. The Beneficiaries
The beneficiaries are the people (including entities) for whose benefit the trustee holds the trust property. A discretionary trust usually has a wide range of beneficiaries, including companies and other trusts. The beneficiaries of a discretionary trust do not have an interest in the assets of the trust. They merely have a right to be considered or a mere expectancy until such time as the trustee exercises its discretion to make a distribution.
The general beneficiaries are those beneficiaries named in the trust deed who are eligible to receive a distribution of income or capital at the discretion of the trustee (subject to the approval of the Appointor). The remainder beneficiaries are the beneficiaries automatically entitled to receive a proportionate distribution of income or capital to the extent that the trustee has not exercised its discretion otherwise.
5. The Appointor
The Appointor is the person named in the Trust Deed who has the power to remove and appoint trustees. The Appointor also has the power to approve any distribution of income or capital of the Trust to the beneficiaries and appoint or remove beneficiaries of the trust.
6. The Trust Deed
The trust deed defines the relationship between the trustee and the beneficiaries. The parties to the trust deed are the settlor and the trustee. The trust deed specifically sets out the duties and powers of investment of the trustee.
CONDUCTING A DISCRETIONARY TRUST
The purpose of this Memorandum is to set out guidelines with regard to the nature and operation of a Discretionary Trust.
Nature of Trust
A discretionary trust is not a separate legal entity in the same way as an individual or a company, rather it is a relationship which exists whereby a person (Trustee) is compelled to hold property for the benefit of others (Beneficiaries).
The Trust is constituted by the payment to the Trustee of an amount called the Settled Sum which the Trustee agrees to hold, together with any other money paid or property transferred to it, in accordance with the terms and conditions of the Trust Deed of Settlement executed by the person making the initial donation (the Settlor) and the Trustee at the time that donation is made. The Settled Sum together with any other money paid or property transferred to the Trustee, is called the Trust Fund.
The Trust Deed provides that the Trust is to terminate on a day called the Vesting Day stipulated in the Trust Deed or such earlier date as the Trustee may determine.
On the Vesting Day, the Beneficiaries appointed by the Trustee in accordance with the terms of the Trust Deed are entitled to the whole of the Trust Fund.
The Trustee may, on that day, divide the whole of the Trust Fund between such of the General Beneficiaries in such proportions as it determines by an instrument in writing. In the absence of the Trustee executing such an instrument on the Vesting Day the whole of the Trust Fund is divisible between the persons named as Remainder Beneficiaries (if any).
In the most unlikely event that on the Vesting Day the Trustee has not determined to appoint the Trust Fund to any General Beneficiary and there is no Remainder Beneficiary surviving, and the Trustee has not appointed additional Remainder Beneficiaries, then the whole of the Trust Fund is payable to or for such charitable purposes as the Trustee nominates.
The Trustee's powers of investment of the Trust Fund are specifically set out in the Trust Deed, but basically, the Trustee is authorised to do all things which an individual or a company could do in respect of his or its own property.
Duties of the Trustee
The law imposes upon a Trustee a duty to act in good faith for the benefit of beneficiaries named in the Trust Deed establishing the trust, and the Trustee must administer the trust in accordance with the terms, conditions and powers enumerated in the Trust Deed and implied by law.
Provided that a Trustee acts in accordance with the terms, conditions and powers contained in the Trust Deed and implied by law, the law will protect it from any liability in respect of those actions or any claim by any beneficiary, despite the result of those actions.
All decisions of the Trustee, if a company, in relation to the trust should be made at a meeting of the directors of the Trustee properly constituted in accordance with the provisions of the Trustee's constitution. Proper minutes of each such meeting of the directors of the Trustee should be kept.
Similarly, proper accounting records should be maintained by the Trustee.
Indeed, the Trustee, if a company, must maintain two sets of financial records - one in respect of its own affairs and the other in respect of its activities as Trustee of the Trust.
If the Trustee's sole purpose is to act as Trustee of the trust constituted by the Trust Deed, and it will not be engaging in any business on its own account, the books of account and financial records in respect of its own affairs will be extremely simple and should not change from year to year.
It will be necessary for the company generally to comply with its obligations under the Corporations Law, including in relation to notification of changes in directors and share allotments.
The books of account to be maintained by the Trustee in respect of the trust must record all receipts and payments by the Trustee, all distributions of income, etc. A formal balance sheet and profit and loss account should be prepared for the trust in respect of each financial year of its operation, and if the trust has earned income during the period, an income tax return must be lodged with the Commissioner of Taxation.
Distribution of Income
The Trust Deed allows the Trustee various alternatives in relation to the net trust income earned in each financial year. These alternatives, and the taxation ramifications of each of them, are as follows.
1. The Trustee may distribute the net trust income amongst the General Beneficiaries or any one or more of them in such proportions as it determines at a meeting of the directors of the Trustee. All the trust income can be distributed to one General Beneficiary to the exclusion of others, the income can be distributed equally, or it can be distributed disproportionately.
If the whole of the trust income is distributed to adult General Beneficiaries, the amount received by each beneficiary is taxable in the hands of the recipient as an addition to the total income of that recipient. Thus, if a particular General Beneficiary received a distribution of $1,000 from the Trustee and earned salary or wages resulting in a taxable income of $10,000, his total taxable income for the year in question would be $11,000 and the tax payable by him would be the amount of tax payable on a total taxable income of $11,000.
2. Tax on income held on trust for or applied for the benefit of beneficiaries under the age of 18 is in effect paid by the Trustee on behalf of the beneficiary as if it were the income of an individual. Special provisions apply where the infant beneficiary has income from other sources. Special rates of tax apply to income held, applied or distributed to beneficiaries under the age of 18. In general, $416 in total may be safely distributed to an infant beneficiary without attracting the special rates.
3. The Trustee may determine in a particular year not to distribute any proportion of the net income of the trust but to accumulate that income as an addition to the Trust Fund. In these circumstances, the Trustee is liable to pay tax on the net income of the trust at the highest personal rate.
In exceptional circumstances, the Commissioner has a discretion not to apply the highest rate to accumulated trust income. Where his discretion is so exercised the tax rate applicable to an individual earning salary or wages of an identical amount to that of the trust income is applicable.
Income accumulated by the Trustee in this nature then forms capital of the Trust Fund, and when distributed to the beneficiaries on the Vesting Day is not taxable in the hands of those beneficiaries.
4. The Trustee may decide to distribute part of the net trust income and to accumulate the balance of that income. In these circumstances, the amounts received by beneficiaries would be taxable in their hands in the manner set forth in paragraph 1 or 2 and the balance retained by the Trustee and accumulated would be taxable in the Trustee's hands in the manner set forth in paragraph 3.
5. In the absence of any written determination by the Trustee to distribute or accumulate the net trust income in a particular year, that income is accumulated automatically as an addition to the Trust Fund and the tax consequences outlined in paragraph 3 apply.
6. With the introduction of capital gains tax, careful consideration will need to be given to the consequences for the Trust of various types of transactions which may give rise to a taxable capital gain.
If the Trustee sells a trust asset to an arm's length person and realises a gain on the disposal, the gain will be included in the assessable income of the Trust to be distributed or accumulated as any other income. Capital losses may be subtracted from the gain before a net amount is included as assessable income of the Trust.
Other situations may give rise to deemed capital gains and require careful consideration. For example, if trust assets are appointed or distributed to any specific beneficiary, the Trustee is regarded as having sold the asset to the beneficiary at its then market value and a capital gain may arise (depending on the cost base of the asset adjusted to take account of inflation). Consideration needs to be given to whether the capital gain should be allocated to the same beneficiary (usually the most appropriate person in the circumstances) or some other beneficiary. The taxable capital gain will thus form part of the income of the beneficiary to whom it is allocated.
A decision in relation to the income of the trust should be made before 30 June in each and every year by the directors of the Trustee, and recorded in a written resolution of the directors of the Trustee on or before that date.
Until accounts for the trust for the financial year have been prepared, it may well be impossible to estimate with accuracy the amount of the income of the trust. This difficulty can be overcome by the Trustee resolving to distribute the income in proportions, for example:
x 50%, y 30%, z 20%
Alternatively, if it is desired to set aside a specific sum for a beneficiary or beneficiaries, it is possible for the distribution to be as follows:
"To v - the first $5,000 of the trust income.
To w - the next $2,000 of the trust income."
As to the balance of the trust income to the following beneficiaries in the following proportions:
x 50%,y 30%, z 20%
After the exact amount of the trust income is known and the proportion to which each beneficiary is entitled has been calculated, those specific amounts should be recorded in minutes of a further meeting of the directors of the Trustee.
A distribution to a beneficiary need not entail a physical payment of the amount distributed to the beneficiary. If the Trustee wishes to retain the money which it has decided to distribute to a particular adult beneficiary it may, with the consent of the beneficiary, establish a loan account in the books of the trust in the name of that beneficiary and credit the amount of the distribution to that loan account.
The Trustee can deal with the amount of the loan in accordance with the powers given to it by the Trust Deed, but in the absence of any arrangement to the contrary, the beneficiary can call for payment of the amount credited to his account at any time. It should be noted that the amount credited to the new account is taxable income of the beneficiary.
Where the Trustee resolves to distribute part of the trust income to an infant beneficiary, most Trust Deeds provide for it to hold the amount of the distribution (and any future distributions to the same infant) in trust for the infant until the infant attains the age of 18 years.
This trust is separate to the discretionary trust from which the infant receives income. The trustee has no discretion as to the persons entitled to the income of the separate trust - it is obliged to hold the trust fund for the particular infant concerned.
The whole of the capital and income of that trust belongs to the nominated infant beneficiary when the infant reaches 18 years.
The Trustee does have certain additional powers given to it in respect of separate Trust Funds for infant beneficiaries. It may apply money held for an infant beneficiary in payment of education, clothing and other similar expenses which are for the maintenance, education or benefit of the beneficiary, reducing the actual amount due to the beneficiary.
Alternatively, it can pay the whole or any part of the money held to the parent or guardian of the infant. The receipt of a parent or guardian for money paid to him on behalf of his child is a sufficient receipt for the Trustee, and the Trustee is not required to concern itself as to the way in which the parent or guardian then deals with the money paid to him.
The Trustee may loan the separate Trust Fund back to the main trust, or invest it in any investment authorised by the Trust Deed but if any income is earned as a result of that investment, the income is taxable income of the infant beneficiary and tax is payable at higher rates than under normal circumstances (as mentioned above).
The situation could arise where an infant beneficiary approaching the age of 18 years is entitled to receive a substantial amount from the Trustee, the payment of which would be a matter of some difficulty. If this situation arises, it is possible to avert the necessity for the Trustee to actually make a payment of the amount due, and discussions with professional advisers at the appropriate time would be necessary.
Distribution of Capital
On the winding up of the trust on the Vesting Day, or at any time before the Trustee may exercise its discretion as to the manner in which the capital of the Trust Fund will be distributed to the various beneficiaries in accordance with the Trust Deed.
From the Vesting Day, any assets belonging to the Trust or constituting the Trust Fund are held by the Trustee until payment or transfer specifically for the beneficiaries and in the proportions in which the Trustee has exercised its discretion, or failing the exercise of that discretion, in accordance with the default clauses (see page 1 of these notes).
The Trustee need not realise the assets of the Trust on the Vesting Day, but may transfer those assets to the beneficiaries in specie.
Entering into Contracts
As previously indicated, a trust is represented by the Trustee, which enters into contracts and legal relationships with other persons in its own name.
It is not necessary for the Trustee to disclose to the other party to the dealing that it is acting in its capacity as Trustee of a trust.
Indeed, registers maintained by the Registrar General and company share registers cannot have recorded in them transactions which recognise that a person or company is acting in the capacity as Trustee. However, it should be noted that companies do have the power, under the Corporations Law to obtain information as to the beneficial ownership of their shares.
Documents of transfer should only name the Trustee and should not refer to the capacity in which the Trustee is contracting.
In all circumstances where the Trustee is entering into contracts or dealing with property, it is essential that the decision of the Trustee to contract or deal with the property in its capacity as Trustee should be properly recorded in minutes of a meeting of the directors of the Trustee.
Conducting the Trust Bank Account
The Trustee should conduct a current account in its own name on behalf of the Trust if there are a sufficient number of transactions. Alternatively, where only a small number of transactions will take place, a savings or building society account will suffice. All payments to or by the Trustee should be effected through the Trustee's account.
Control and Change of Trustees
The Trust Deed empowers the person named Appointor and after his death his legal personal representative or such person as he may nominate in writing or in his Will, to remove any trustee of the trust and appoint a new or additional trustee at any time by instrument in writing. Additional control of the Trustee is usually vested in the Appointor to the extent that the Appointor is a shareholder and director of the Trustee company.
Memorandum of Wishes
The assets of the trust will not form part of the estate of the "promoter" or "controller" of the Trust. Such person should execute a memorandum of wishes addressed to his executor-elect, requesting that person to use his power as Appointor of the Trust in accordance with those wishes.
This memorandum has been prepared as a general guideline, and is not intended to be an exhaustive or complete statement concerning the operation of a trust. There are many particular legal and accounting matters which have not been dealt with in this memorandum and clients are urged to discuss any aspect of the operation of the trust not discussed in this memorandum with their professional advisers.
This Information Outline is provided courtesy of Craddock Murray Neumann Solicitors who are experienced in this area of law. They are located at Level 1, 255 Castlereagh Street Sydney NSW 2000 or call them on (02) 9283 4755 if you would like more information on the legal topic, or you wish to obtain formal advice regarding your situation.
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