The Carter case: disclaimer finally works!


Posted By and on 28/09/20 at 2:00 PM

The recent Full Federal Court decision in Carter v FCT  [2020] FCAFC 150 (Carter), reported at 2020 WTB 37 [[]], highlights the important issues to be considered in the management of trust distributions and where appropriate, disclaimers. These issues are generally brought into acute focus in ATO audits.

Carter - last disclaimer finally works

In Carter, significant defects in the distribution of income from the Whitby Trust for the 2011 to 2014 financial years resulted in the primary beneficiaries challenging unexpected assessments they had received.

The primary beneficiaries of the Whitby Trust were the adult children of the principal of the trust being Mr AC, a director of the corporate trustee of the Whitby Trust and joint Guardian of the Trust whose credibility had been challenged by the Commissioner.  The Court noted “it was repeatedly put to Mr AC that he had engaged in dishonest conduct, including that he had altered company documents and forged other peoples’ signatures and committed criminal offences involving dishonesty. Mr AC admitted some of these matters.”

Despite the beneficiaries being unsuccessful in the Administrative Appeals Tribunal  (in The Trustee for the Whitby Trust and FCT [2019] AATA 5637), on appeal, the Court unanimously held that the third round of disclaimer documents signed by the Primary Beneficiaries approximately 27 months after receiving notice of the income entitlements were effective.

Facts

In respect of the 2011 to 2014 financial years, the Primary Beneficiaries, being Christina, Alisha, Nicole and Natalie, had disclaimed default beneficiary income distributions made to each of them by operation of the Whitby Trust Deed (First Disclaimers).  The First Disclaimers were accepted by the Commissioner as effective, but not for the 2014 financial year.

The Primary Beneficiaries challenged their assessments for the 2014 financial year and had again sought to disclaim default income distributions made to them on similar terms to the First Disclaimers (Second Disclaimers).  However, the Commissioner perversely rejected that the Second Disclaimers were effective and consequently did not withdraw the relevant assessments for the 2014 financial year.

Shortly after, learning of the Commissioner’s rejection, the Primary Beneficiaries subsequently signed further deeds of disclaimer seeking to disclaim not only the default income distributions made to them in the 2014 financial year but additionally, their entire entitlements as default beneficiaries forever(Third Disclaimers).

The Primary Beneficiaries challenged the 2014 assessments based on 2 contentions:

  • first, that 100% of the Whitby Trust income had been validly appointed to a beneficiary named the Bernguard Trust, such that the Primary Beneficiaries could not take in default; and
  • secondly, that if the Whitby Trust had made no valid appointment of income to a beneficiary, they had each effectively disclaimed the relevant distribution either by the Second Disclaimers or by the Third Disclaimers.

The Tribunal did not accept either contention.

Only Alisha, Nicole and Natalie appealed to the Full Federal Court. No reasons were provided in the judgment as to why Christina did not appeal.

The Commissioner also argued that the decision of the Tribunal should be affirmed on the ground that the Second and Third Disclaimers did not have retrospective operation for the purposes of s 97 of the ITAA 1936.

What is a disclaimer?

It is well established that a person cannot be compelled to accept a gift. The general principle is that unless or until the time a beneficiary has accepted a gift, subject to certain conditions, it may be rejected. In the context of trusts, if a person chooses not to accept a trust distribution, they are said to be disclaiming it, with the rejection of the trust distribution referred to as a disclaimer.  Based on Ramsden’s case [2005] FCAFC 39, for the act of disclaimer to be effective, it must be done within a reasonable time of the beneficiary becoming aware of the relevant present entitlement or gift. Further, the beneficiary must not do any act, matter or thing inconsistent with its rejection after such awareness. Such an inconsistent act would include calling for the money due to that beneficiary.

The Tribunal likewise summarised the relevant principles applicable to the disclaimer of gifts which were restated by the Court including that “a beneficiary may disclaim an entitlement on becoming aware of it, with the effect that the disclaimer operates retrospectively as if the entitlement never arose, and not as an acceptance and disposition at the time of the disclaimer: [Ramsden at [30]]”.

The Primary Beneficiaries of the Whitby Trust had 2 pathways by which they could receive distributions from the trust – first, as discretionary objects, where the trustee could determine to distribute a portion of the trust’s annual income to them and secondly, as default beneficiaries if  the trustee had not made an effective income distribution determination whereupon Clause 3.7 of  the trust deed made the default beneficiaries equally entitled to the annual income of the trust [Carter at 73].

The Court confirmed that “as discretionary objects each distribution is a separate gift capable of being disclaimed year by year” [Carter at 73]. However, for default beneficiaries, “there is a single gift able to be disclaimed within a reasonable time of becoming aware of it”.  Having regard to the facts and circumstances of a particular case, failure to disclaim an entitlement within a reasonable period of time can be treated as tacit or inferred acceptance of the gift or entitlement [Ramsden at [53] and [55], Lewski v FCT (2017) 254 FCR 14 at [141]]. If so, any “late” disclaimer becomes ineffective for ITAA 1936 purposes.

What went wrong?

The Primary Beneficiaries and their lawyers were under the misapprehension that the First and Second Disclaimers were effective.  The Full Federal Court noted as follows:

“On the Tribunal’s construction of the First and Second Disclaimers at [129(h)] each applicant’s understanding of the effect of the First and Second Disclaimers was wrong. …. The Commissioner filed no cross-appeal or notice of contention with respect to those conclusions. As such, they stand. In particular, it must be accepted that each of the applicants acted on the basis of advice. From their evidence it is apparent that, in so doing, each applicant (wrongly) believed that they were disclaiming the entirety of their interest in the Trust.” [Carter at 73].

Erroneously, the first 2 disclaimers only disclaimed the annual entitlement to income upon which the assessments from the Commissioner were based.  They did not disclaim the entirety of the Primary Beneficiaries’ rights and interests as takers in default.  The latter being a separate head of entitlement or gift arising normally on the date the trust deed of the Trust is signed. Many beneficiaries are unaware that they are both discretionary beneficiaries and as well as default beneficiaries of a discretionary trust.

Third Disclaimers

The additional clauses and drafting of the Third Disclaimers were found to be wide enough to effectively disclaim the entirety of the Primary Beneficiaries’ interests under the default beneficiary clause, being clause 3.7

As the Third Disclaimers were legally effective in wholly disclaiming the default beneficiaries’ rights and interest, by a process of inferential reasoning from the material and evidence available, the Court had to decide whether the conduct of the Primary Beneficiaries (including signing the First and Second Disclaimers) amounted to tacit acceptance of the distributions in the 2014 financial year.

On the facts, the Court on appeal found there was only one conclusion reasonably open to the Tribunal, which was that the Primary Beneficiaries’ conduct “was consistently directed towards one end – to reject any right to any income from the Trust” [Carter at 92] and “… that the applicants had not lost their right to disclaim any income from the Trust.  Accordingly, the Third Disclaimers were effective”. [Carter at 92].

The Commissioner further argued the Second and Third Disclaimers did not have retrospective operation for the purposes of s 97 of the ITAA 1936 [Carter at 100].  .  However, the Full Federal Court held that “the effect of a disclaimer is that the beneficiary must be treated as never entitled to the income for the purposes of s 97 in respect of the relevant income year” [Carter at 109].  The Court noted a different outcome was however possible under different taxing statutes.

The Court ordered that the objections of each of the applicants to the assessments for the 2014 income year be allowed.

Conclusion

Ultimately, Carter highlights the importance of understanding the trust deed – what is required for an effective distribution and what happens if no effective distribution is made (i.e. is there a default beneficiary clause)? Where these issues arise, so long as one acts quickly and effectively when put on notice, present entitlements from distributions (especially where the trust cannot financially satisfy them) can be managed.  However, these situations must be handled with extreme care as disclaimers can have unintended consequences.  For instance, the default beneficiaries disclaiming their rights and interests as takers in default may result in the Trustee being assessed under s 99A of the ITAA 1936. Further, where not all default beneficiaries effectively disclaim their rights and interests, the remaining default beneficiary or beneficiaries who did not effectively disclaim their income entitlements may receive an adverse assessment for the amounts the subject of effective disclaimers from other default beneficiaries if the former are still within the relevant 4-year amendment period, absent fraud or evasion.

ATO period of review

The practice of many discretionary trusts is to distribute 100% of their income each financial year. In doing so, the trust itself does not receive an assessment. Practice Statement PS LA 2015/2 outlines the ATO’s administrative and we stress not formal legal practice of limiting the period within which the ATO will raise an original trustee assessment to 2 or 4 years, as relevant to the entity concerned. With no issued assessment, in theory, the ATO has an unlimited period of review.  To ensure the Commissioner is limited to a strict 2 or 4-year period of review, some trustees will accumulate a modest amount of income in the trust, such as $100, in order to receive an assessment under s 99A and have the period of review strictly confined to the relevant 2 or 4-year period, absent fraud or evasion.

Record keeping/compliance with the deed

Carter also highlights the importance of ensuring corporate trustees keep a record of validly constituted meetings and properly passed resolutions. Had the corporate trustee of the Whitby Trust properly complied with its own constitution and the Whitby Trust deed, the first contention, being that 100% of the trust income had been validly appointed to a beneficiary, would have succeeded.  The Court highlighted the issues of compliance with the Constitution and the Corporations Act regarding directors’ minutes and issues with the validity of the trust distribution as a result of the Guardians lack of consent (a requirement in the Whitby trust deed). Such issues can arise in practice where a determination is made in an oral resolution to distribute income in June before the end of the financial year but is not recorded until April the following year.  Such circumstances may undermine the legal effectiveness of the distribution, as until such a resolution is recorded in writing, it is not valid in certain circumstances and in particular for a sole director trustee company.

There are “slip rules” provided under the Corporations Act and mentioned in Carter to overcome procedural irregularities of directors and shareholders meetings such as quorums and the like. However, their application depends on judicial consensus, which can never be assured. Hence the best course for valid distributions is to check and ensure full compliance with the constitution of the trustee company and the trust deed concerned, including any deeds of variation before implementing income and/or capital distributions from the subject trust.

If you have any questions in relation to this case, please don’t hesitate to contact us.

This article first appeared in Thomson Reuters Weekly Tax Bulletin (Issue 38, 25 September 2020).

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