Actions by a trustee or beneficiary that may affect the intended tax outcome.
As you know, trust taxation (including taxation of deceased estates) rests on the notion of the present entitlement of beneficiaries to trust income. Present entitlement and income are concepts founded largely in the general law of trusts (although there are legislative rules that treat certain beneficiaries as being presently entitled).
In the context of modern discretionary trusts, beneficiaries will generally become presently entitled by the making of a valid resolution to appoint income by the trustee. On occasions we see parties to a dispute enter into a settlement agreement by which they agree that the trustee of a trust will appoint income in a particular way for one or more years.
The question that arises is whether the trustee’s action in entering into the agreement is a fetter on their discretion to appoint income. If it is, the beneficiaries made entitled to income under the agreement will not be so entitled. Consequently, the taxation of the trust’s net (or taxable income) will fall to be assessed to the trustee or default beneficiaries.
You should not assume that the Commissioner is not alert to the issue of fetter, particularly in cases where a beneficiary is seeking to create a nexus between a deduction (interest on money borrowed by a beneficiary which has been provided to the trustee) and the derivation of income in the form of a trust distribution. [See for example Lambert v FCT  AATA 442]
When is a discretion fettered?
The Queensland Supreme Court in Dagenmont P/L v Lugton  QSC 272 outlined the relevant principles in respect of fetter:
 According to the Law of Trusts by Underhill and Hayton 16th edition (p 690):
‘… it is trite law that trustees cannot fetter the future exercise of powers vested in trustees ex offico … Any fetter is of no effect. Trustees need to be properly informed of all relevant matters at the time they come into exercise their relevant power’.
 Meagher and Gummow in Jacobs Law of Trusts in Australia 6th edition para 1616 say:
‘Trustees must exercise powers according to circumstances as they exist at the time. They must not anticipate the arrival of the proper period by … undertaking beforehand as to the mode in which the power will be exercised in futuro’.
 Professor Finn (as his Honour then was) in his work Fiduciary Obligations wrote (at para 51):
‘Equity’s rule is that a fiduciary cannot effectively bind himself as to the manner in which he will exercise a discretion in the future. He cannot by some antecedent resolution, or by contract with … a third party – or a beneficiary – impose a “fetter” on his discretions’.
 Finkelstein J summarised the position succinctly in Fitzwood Pty Lt v Unique Goal Pty Ltd (in liquidation)  FCA 1628 (para 121). His Honour said:
‘Speaking generally, a trustee is not entitled to fetter the exercise of discretionary power (for example a power of sale) in advance: Thacker v Key (1869) LR 8 Eq408; In Re Vestey’s Settlement (1951) ChD 209. If the trustee makes a resolution to that effect, it will be unenforceable, and if the trustee enters into an agreement to that effect, the agreement will not be enforced (Moorev Clench (1875) 1 ChD 447), though the trustee may be liable in damages for breach of contract …’
Putting the issue into context
In Dagenmont, the parties entered into an agreement to settle a dispute. Under the agreement, the trustee agreed to pay $150,000 per annum to Mr Lugton for his life. Some years later the trustee wanted to stop making the payments and sought a declaration from the Court that the agreement was invalid because it acted as a fetter on the trustee’s discretion to appoint income.
The Court observed:
There can be no doubt that the terms of the October deed constrain the trustee’s discretion as to the application of the income in each accounting period. It has bound itself to pay the first respondent $150,000 annually, indexed for inflation, for the rest of his life. To the extent that the trustee complies with that obligation its discretion to apply as much or as little of the income of the trust fund as it chooses in each financial year and, if it chooses to distribute income, to select which beneficiary or beneficiaries should be paid and the amount of the payment to the chosen beneficiaries, its discretion is restricted, or fettered. Instead, during Mr Lugton’s life, the trustee must choose, in each year, to pay the agreed amount.
The case was not a tax case but clearly it could have affected the previous tax position adopted by the parties. Had the trustee succeeded it may have found itself liable to pay tax in respect to net income previously assessed to Mr Lugton. However, the Court’s enquiry did not end with an examination of the settlement agreement:
… the instruments in question are in nature, documents recording a commercial transaction. They were meant to give effect to the agreement of the parties with a view to bringing about a division of property and the regulation of their business relationships. When construing any such document the Court should strive for a construction which will give them efficacy rather than deprive them of utility. The Court should uphold bargains where it can, rather than destroy them. The need is particularly important when the consequences for the respondents are potentially drastic.
Accordingly, the Court was prepared to construe the agreement as an exercise by the trustee of the powers conferred by clause 9 (which conferred on the trustee a general power of variation) and clause 12 of the trust deed (which conferred on the trustee a power to release any power conferred on it in whole or in part).
If entering into an agreement like the one in Dagenmont, a trustee should seek legal advice about whether it is enforceable in the context of the terms of the particular trust. Often trusts created under a Will provide the trustee with limited powers, so there may be little scope to argue that the trustees acts in entering into a settlement agreement were done under a particular power.
Beneficiary disclaiming an entitlement
A beneficiary is not required to accept a gift; they are entitled to disclaim it.
Effect of valid disclaimer
An issue arises as to how a disclaiming beneficiary’s share of net income is assessed. In Carter v Commissioner of Taxation  FCAFC 150, the Full Court of the Federal Court rejected the Commissioner’s argument that a beneficiary who validly disclaimed an entitlement after 30 June remained presently entitled to income at 30 June for the purposes of section 97.
But is it the trustee or a default beneficiary that should be assessed? The Court in Nemesis considered that the trustee should be assessed, although it was not an issue that the Court had to decide. Although a valid disclaimer has retrospective effect as between the trustee and disclaiming beneficiary, the present entitlement of a default beneficiary does not crystallise until the disclaimer is made. This means that a disclaimer made after the end of an income year does not result in a default beneficiary having a present entitlement at 30 June.
When is a disclaimer valid?
You should seek legal advice about whether a disclaimer is valid. There are a number of factors that are relevant. Most importantly the nature of the gift that the beneficiary is seeking to disclaim should be identified:
- For a discretionary object – each exercise of the trustee’s discretion creates a separate gift.
- For a default beneficiary – their default interest is one gift (created by the deed) that operates in respect of all income years.
A disclaimer must be made within a reasonable time of the beneficiary becoming aware of the particular gift. In determining the time when a beneficiary became aware of a gift the Courts have considered:
- whether the beneficiary was fixed with an agent’s knowledge
- the beneficiary’s role in relation to the administration of the trust
If a beneficiary has accepted a gift, their right to disclaim it is lost. Similarly, a beneficiary must disclaim a gift in its entirety (not just a portion of it). Because a default interest is one gift that operates in respect of multiple income years, a disclaimer confined to only on year is necessarily ineffective.
A beneficiary must take some action to show that they do not want the gift. Mere silence or inactivity is not sufficient. In some cases a beneficiary who knows of a gift and has not taken any action to disclaim it may be taken to have accepted it.
Feel free to contact our team should you want to discuss this topic further and potentially have clients who may be in this situation.
This publication is not intended to be and should not be used as a substitute for taking taxation advice in any specific situation. The information in this publication may be subject to change as taxation, superannuation and related laws and practices alter frequently and without warning. Neither BNR Partners Pty Ltd, our employees or agents are responsible for any errors or omissions or any actions taken or not taken on the basis of this publication.