Your old client Fred rings up in a state of some excitement. He and his golf buddie were discussing things at the 19th hole last weekend and Fred’s mate said he’d heard there was a way to avoid the land tax problem with discretionary trusts. It had something to do, he said, with converting a discretionary trust to a unit trust.Fred was right onto this because he just hates the fact that property held in a discretionary trust does not get the land tax free threshold of $406,000. Fred’s property has a value for land tax purposes of $1 million so the lack of a threshold means an extra $6,496 land tax to pay every year.
Fred is now retired and tends to forget the advice you gave him about the asset protection given by such a trust which Fred then decided was more important than the extra land tax he had to pay. Fred was a very successful property developer but over the years had several close brushes with disaster. It’s all different now as Fred does nothing more dangerous than get uptight about a missed putt.
At Fred’s urging you look into the matter.
You review the OSR ruling DUT 17 issued under the Duties Act which in essence says that provided you do not re-declare the trust when you vary the deed there are no stamp duty implications. You talk to a contact in the OSR who tells you that provided care is taken you can convert a discretionary or hybrid trust to a form of unit trust that avoids the definition of “special trust” and therefore is entitled to the land tax free threshold.
You get back to Fred and tell him the results of your research so far. Fred is excited and wants to go ahead without delay.
You duly prepare a deed to amend Fred's family trust. You carefully leave the clause declaring the trust then amend the deed comprehensively to convert it into a unit trust with all the units held by Fred.
In doing so you take into account section 3A of the Land Tax Management Act which requires, amongst other things, that to obtain the benefit of the threshold the unit holders must be "(ii) … presently entitled to the capital of the trust, and may require the trustee to wind up the trust and distribute the trust property or the net proceeds of the trust property” to them.
The deed is then duly executed and stamped. Fred looks forward to his first 31 December when he will qualify for the land tax saving.
Stung now or stung later? If that’s all you did either Fred’s Trust will be liable for capital gains tax on conversion as if he sold the property or there will be a much larger capital gains tax bill to pay when the property is eventually sold and the trust wound up.
While it is true that the Commissioner of Taxation in ruling TD 2012/21 concedes that trust deeds can be comprehensively amended without a CGT consequence provided the amendment clause so allows, the ruling refers only to CGT events E1 (creating a trust over a CGT asset) and E2 (transferring a CGT asset to a trust). It does not deal with CGT event E5 which under s.140-75 happens “if a beneficiary becomes absolutely entitled to a *CGT asset of a trust (except a unit trust…) as against the trustee”.
In a draft taxation ruling (TR 2004/D25) the Commissioner states that “absolute entitlement” means that the relevant beneficiary can insist the trust asset be transferred to them, which under the Unit Trust deed Fred can now do.
What is not clear is whether the words “except a unit trust” in s.104-75 will save the day. Hopefully they do but possibly the exclusion only applies if the trust is a unit trust before and after the variation. Arguably they do not apply if the trust is a discretionary trust before the variation and only becomes a unit trust afterwards. The only way to be sure is to obtain a private binding ruling from the ATO.
If CGT event E5 does not apply the cost base of Fred’s units in the unit trust will be nil. This is because the market value rule, which generally allocates a market value cost base to assets acquired for no cost, or on a non arm’s length basis, does not apply where the acquisition results from “another entity doing something that did not constitute a CGT event happening” (s.112-20 ITAA 1997). So, no CGT event E5 means no cost base.
This problem can be avoided but it needs to be part of what you do upfront. It’s too late if the problem is not realised until after the conversion is completed and the units issued.
Suppose Fred’s Trust bought the property for $1 million and later sold it for $2 million, then wound up the trust with all the money going to Fred. Suppose also at the time of sale the Trust had no debts.
If Fred had left the trust as a discretionary trust he would only have to worry about CGT on the capital gain on the investment property. Because he converted it to a unit trust he will also have to worry about CGT on the capital gain on the units.
With either form of trust Fred would have capital gains tax to pay on half the $1 million capital gain on the property, provided it was held for at least one year and the capital gain distributed to him.
However, because it is a unit trust he will also have capital gains tax to pay on half the difference between the $1 million capital distribution and the cost base of his units.
Because the cost base is nil this means tax on another $500,000. This does not apply to a discretionary trust because there is only one relevant asset - the investment property.
It may be of little comfort in the long run, but you did luckily dodge another bullet. Had the value of the property exceeded $2 million, land rich duty would be payable on the unencumbered value of the land under the land rich provisions of the Duties Act 1997.
This is a very simplified explanation of a very complex area and each situation needs to be considered on its own merits.
This article appeared in this month’s edition of the Law Society Journal (NSW).
Author: Jim Main
This article is general information only and should not be relied on without obtaining further specific information.