There are many reasons that beneficiaries of discretionary trusts may want to disclaim their present entitlements to the trust income distributions made to them. We typically see this arise in the event of a divorce or bankruptcy proceeding or in response to an ATO assessment at the conclusion of an audit or dispute. Unfortunately, numerous Tribunal and court cases in the past indicate that taxpayers and their advisers do not always get the process of disclaiming the trust distributions right and, as a result, the beneficiaries are unsuccessful in getting their tax assessments reduced.
This is again demonstrated in a recent Tribunal case, the Beneficiary and Commissioner of Taxation  AATA 3136, where the beneficiary unsuccessfully argued that she had effectively disclaimed a trust distribution from a related discretionary trust in the 2014 income year.
On the other hand, in a more recent case, Carter v Commissioner of Taxation  FCAFC 150, the beneficiaries appeal was allowed by the Full Federal Court after the Tribunal initially gave an adverse finding for the taxpayers (as reported in our February 2020 Tax Flash). In the previous Tax Flash, we discussed another aspect of the decision where the Tribunal held that the trustee resolutions were ineffective. In this article, we will discuss the issues with the disclaimers of the trust distributions made by the beneficiaries.
The Beneficiary and Commissioner of Taxation
The taxpayer and her former husband were the primary beneficiaries of a discretionary trust. The trustee company (controlled by her former husband) resolved to distribute trust income of $80,000 to the taxpayer in the 2014 income year. The trustee company also paid PAYG instalments of $31,248 on her behalf in the same income year. The taxpayer did not include the trust distribution in her income tax return and pocketed the resulting refund from the excess PAYGI. The remaining Unpaid Present Entitlement (UPE) for that income year was applied by the trustee against the taxpayer’s overdrawn beneficiary’s account.
Unsurprisingly, the taxpayer was later selected for an audit (bearing in mind the trustee would have lodged its trust tax return reporting the trust distribution to the taxpayer). However, the taxpayer objected to the amended assessment on the basis that she had disclaimed the trust distribution by executing a deed of ‘Disclaimer of Trust Income’ on 6 April 2018. The taxpayer also submitted that the distribution was disclaimed in March 2015, when the taxpayer’s counsel struck through the distribution in a draft income tax return sent to the taxpayer by the accountants who prepared her and her former husband’s individual returns and the trust’s return.
The Tribunal held that the disclaimer was ineffective on the basis of the following reasons:
- the taxpayer lodged her tax return on the basis that she was entitled to the benefit of a credit for the amount of the PAYG instalments paid to the ATO by the trustee and retaining the refund was inconsistent with the taxpayer not accepting the distribution; and
- it could be inferred from the taxpayer’s relative inaction over the period between becoming aware of the distribution by late March 2015 and finally disclaiming it in April 2018, around the time her objection was lodged, that she had accepted the distribution.
Carter v Commissioner of Taxation
In contrast to the case above, the Taxpayers in this case successfully appealed the Tribunal decision.
The taxpayers were the default beneficiaries of a discretionary trust (The Whitby Trust). The ATO originally conducted an audit of the trust’s tax affairs for the 2011-2014 income years and issued amended assessments in those income years at the conclusion of the audit. The ATO effectively disallowed the intended trust distributions on the basis that the signed trustee resolutions were invalid and issued amended assessments to the default individual beneficiaries of the trust instead.
Following the issue of the amended assessments, the individual beneficiaries then executed the ‘Deeds of Disclaimer’ to disclaim their entitlements to the trust income for the 2011-2014 income years. The ATO initially accepted the disclaimers by the adult beneficiaries for the 2011-2013 income years (the first disclaimers) but did not accept the disclaimers for the 2014 income year (the second disclaimers) even though they were in the same terms as the first disclaimers. Further Deeds of Disclaimer were executed in September and October 2016 in respect of all entitlements from the trust (the third disclaimers) as a result of the ATO deciding the second ones were ineffective. The ATO also rejected the third disclaimers as ineffective.
The ATO also disallowed the taxpayers’ objections. The Tribunal subsequently upheld the ATO’s objection decisions in relation to both the validity of trustee resolutions and the validity of the disclaimer of the trust income entitlements by the default beneficiaries. The Court was satisfied that the adult beneficiaries’ conduct was consistently directed towards one end – to reject any right to any income from the Whitby Trust. The Tribunal was wrong to conclude that the beneficiaries had implicitly or tacitly accepted the income of the trust for the 2014 income. It follows that the third disclaimers were effective to disclaim the default distribution for the 2014 income year.
In the Full Federal Court, the Tribunal’s decision regarding the validity of trustee resolutions were upheld. However, the Full Court held that the adult beneficiaries had validly disclaimed their entitlement to the income of the trust for the 2014 income year.
Finally, the Full Federal Court also stated that there was nothing in the legislative scheme to indicate that a beneficiary’s liability under section 97 of the ITAA 1936 ‘was to be determined once and for all by reference to the legal relationships then in existence’ in the income year in question. It follows that an effective disclaimer also has a retrospective effect for income tax purposes.
The Full Federal Court decision in Carter v FCT is important as it provides further clarification on the rules for trust distribution disclaimers and also confirms that an effective disclaimer can apply retrospectively for income tax purposes regardless of the general rule that requires that a present entitlement to trust income is established on or before the end of each income year.
The rules in this area are complex and evolving. The latest cases serve to remind taxpayers the importance of getting this right by involving trust law advisers as well as tax advisers early in the process. An effective disclaimer can go a long way to assist taxpayers in dealing with an ‘unexpected or unwanted trust distribution’ and the subsequent income tax liability that comes with it.
If you have any queries on the cases discussed above, please contact Peter Hong.