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CHANGING FROM A TRUST TO A CORPORATE STRUCTURE

KEVIN MUNRO

MUNRO LAWYERS

Ph (02) 9256 3888

Email kevinmunro@taxlegal.com.au

SUITE 18, PIER 2 Television Education Network Pty Ltd

13 HICKSON ROAD 5th floor

WALSH BAY, NSW 2000 179 Queen Street

MELBOURNE VIC 3000

Webinar

18th July 2014

OUTLINE

Company vs Trust – pros and cons:

corporate rate vs marginal rates

do we care about the CGT discount?

tax breaks for companies not available for trusts

small business tax breaks for companies

flexibility of distributions

no Division 7A

A company owned by a discretionary trust – the ideal structure?

Transferring from a trust to a company:

using the standard rollover

using the small business CGT concessions – cost base uplift and other issues

1. APPROCHING A RESTRUCTURE

1.1 Introduction

Trusts have been and remain a legitimate structure to adopt for business and

investment purposes. In fact, I have been a keen advocate of trusts in my professional

career for the principal reason of their ability to remain flexible for tax planning

opportunities.

Generally, the tax rate applicable to the net income of a trust estate will be that of the

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beneficiary to whom the trust income is applied, or who otherwise has a fixed interest.

Accordingly, access to the corporate tax rate is obtained at the beneficiary level, through

the use of a corporate beneficiary. The opportunity to distribute the net income of a

discretionary trust, in particular, to a corporate beneficiary with a retention of the cash in

the trust for reinvestment has been a ‘standard’ applied by practitioners for many years.

The ATO’s change in interpretation of the nature of unpaid present entitlements (‘UPE’s’)

has destroyed that comfort zone. This single move by the ATO means that practitioners

in the future will need to consider the selection of new business and investment

structures with a great deal of more detail than we have been attuned to in the past. This

process will also be required in considering restructuring of existing business and

investment structures.

This does not mean that trusts are no longer an appropriate entity to use. On the

contrary, trusts have the great advantage of flexibility in tax planning. That advantage

alone is principal in significance for the retention of trusts in a business on investment

structure.

However, practitioners will I believe need to closely consider the actual position and

function that trusts play in the overall business and investment structure of clients.

This paper looks at case studies where the role played by a trust may need to be

reconsidered. In particular, whether a move from a trust to a company may be

required and how it may be achieved without significant adverse tax consequences.

1.2 What issues should a practitioner consider when advising on a business structure?

The various issues that must be considered in selecting the appropriate entity include:

(a) Is the activity a new enterprise or an existing enterprise?

An alteration to a more appropriate entity may have significant change-over costs.

For example, stamp duty on the transfer of assets; the possible impact of CGT; and

the possible loss of income taxation benefits (tax losses).

(b) What entities, if any, are currently employed?

For example, the choice of what entity to use where a client already has

companies as entities owning assets will, in part, be governed by the existing

structure. In this situation it is possible that the appropriate entity is either an

existing company or a new company.

This may be despite the fact that, for tax purposes, a company is not a structure

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that is best suited to acquire appreciating assets. While a trust is, in most cases, a

more appropriate entity to hold appreciating assets, there may be other factors

which are more important, including a desire to maintain consistency in a

structure of entities. In the case of a group of companies, profits and losses may be

distributed with relative ease amongst the group. A more significant advantage

may be that clients are probably more knowledgeable of companies than trusts if

they already use companies. This can provide significant commercial advantages.

(c) Does the activity involve the acquisition of an appreciating asset? Does it involve

the conduct of a trade or business?

Defining the scope of activities that constitute a business will be fundamental.

There are many different components that go into making a business. They

include the tangible assets (such as stock and plant and equipment), the

employees, and the intangibles (for example, goodwill) of the business.

An important aspect when advising on business structures is to remember that

each component of the business may have different legal or taxation consequences

associated with them. Different structures and considerations will need to be

considered for each component of the business. This may require multiple

structures for a business with, say, separate structures for employees, real property

assets, and trading activities.

Example Bill wishes to acquire a hotel including the real estate licences and goodwill.

(i) Should Bill acquire all of the business assets in one entity? Need to consider the issues as to asset protection.

(ii) If not, how many different entities? Need to consider whether to, say, have the hotel in one entity and the business in another. Should the business be segregated into, say, two entities – one for trading and the other for assets such as licences, stock, plant, and equipment? Where should the employees be located?

(iii) If more than one entity, then what type or types of entities? This is really the crux of the question between capital gains and income. Namely, which entity will provide the best opportunity to take advantage of the options available under the tax provisions?

(d) What is the form of the income to be generated (dividends, interest, business

income, foreign source income, capital gains)?

Example Fred is planning to acquire vacant land with the intention of obtaining a DA to develop and sell 5 residential units. Given that the enterprise is clearly on revenue

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account, does it make any difference whether the activity is conducted through a company or not?

(e) Who are the participants? Will there be arm’s length participants or is the activity

to be pursued within the family group? Will new participants be sought in future?

Example Jane and Robyn, two friends, wish to invest in a commercial real estate property

for the purpose of renting. Is it appropriate to use a discretionary trust as the entity to acquire the property – difficulties with exercising discretions need to be considered and also the possibility of needing to make a family trust election. Then compare options of having either a unit trust (the question then shifts as to who are the unit holders) or, say, a partnership of two family trusts.

(f) What are the financing requirements, and how is the security to be provided?

Example Mario has traded through a family company very successfully for a number of years. The company is cash strong with significant retained profits. Mario now intends to invest in some rent producing real estate and would like to take the opportunity of accessing the CGT discounts because he believes the property has significant potential for capital growth. However, how can Mario acquire the new investment in either personal names or a family trust when he wants to use the surplus cash in his trading company to fund the purchase?

1.3 What are the client’s objectives?

As well as the scope of the business, the motive and purpose behind using any

business or investment structure must be clarified before the most appropriate

structure can be determined. Some of the motives to be considered and which

need to be prioritised in order to choose the correct structure include:

(a) control of the business;

(b) asset protection planning (protecting personal and business assets from

creditors);

(c) family law issues;

(d) CGT issues;

(e) stamp duty issues;

(f) income tax issues;

(g) goods and services tax issues;

(h) land tax, payroll tax, and other state taxes;

(i) estate planning and succession issues;

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(j) limited liability (exposure to third party liabilities);

(k) professional/industry requirements;

(l) commercial knowledge/complexity/administrative costs and compliance.

1.4 What are the characteristics of a good structure?

The characteristics of a good business structure are:

(a) flexibility so that the structure can accommodate changing circumstances

with minimum consequences;

(b) the structure provides adequate asset protection to the principals of the

business;

(c) the structure minimises costs, particularly tax; and

(d) the structure allows for the efficient distribution of profits.

2 REASONS FOR RESTRUCTURE

There are a number of reasons why a ‘trust to company’ restructure may be

considered.

2.1 Obtaining corporate tax rate for income

Obviously, the choice of a business or investment entity often comes down to the

different treatment of capital gains and income for tax purposes. The trust entity has

been advanced as the ideal entity to hold capital appreciating assets as the trust can

benefit from the 50% discount available under Division 115 of the Income Tax

Assessment Act, 1997 (‘ITAA 1997’) and pass that benefit through to individuals as

beneficiaries of the trust. However, that benefit (advantage) must be weighed

against the advantages of a corporate structure in respect of the tax rates applying to

income and the ability of the corporate structure to retain after tax profits.

2.2 Paid up capital balance sheet

Whilst unit trusts will have some ‘capital’, discretionary trusts have none, and it is

the beneficiaries’ UPE’s and loan accounts that fulfil the role of working capital at

least, if not pseudo-equity. Many SMEs are comfortable with their effectively self-

funded trust operations, and can live with the funding constraints that can be a

reality of trust structures. Others, with the ability to provide additional security

outside the trust business structure, can also manage without the need to evolve

to a company structure.

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2.3 Financing reasons

Trusts in the SME business area are inherently controlled by small numbers of

equity participants, and this can restrict access to more significant levels of debt

funding, and access to a broader range of equity participants. If equity is not the

issue, debt management may exert pressure for a corporate restructure, via banks or

other external financiers. Unfortunately some banks have a very poor understanding

of trusts, both at a conceptual level and at a practical operating level.

2.4 Succession plan

Restructuring a trust business into a company may also be a pre-exit step for an

owner as part of a succession plan.

2.5 UPE’s and deemed dividends

As already mentioned, Division 7A ‘management’ has changed with the introduction

of Taxation Ruling TR 2009/D8 and the ATO’s changed approach to UPE’s.

2.6 CGT discount not an issue

Family groups with significant real estate portfolios are less concerned with the

possibility of obtaining a discounted taxable capital gain rate than a flat corporate rate

on income. Namely, some clients view realized capital gains as the ‘long term’ and

even if a gain is realized through the disposal of a property, the likelihood is that the

proceeds will be re-invested and not distributed.

Accordingly, a tax rate of 30% on a gain is not greatly different to a discounted rate of

23.25%. The wealth accumulation is seen then to be more desirable in a corporate

entity than a trust entity.

2.7 Estate planning issues

Clients have a concern in respect of the passing of their asset wealth to the next

generation through existing family trust structures as compared to alternate entity

structures. Namely, the trust set up during the lifetime of a family may not be

appropriate to pass to the next generation when issues such as control of the trust and

distributions of income and capital are determined. The desire for family groups to

set into operation a family agreement as part of an estate plan is increasingly popular.

In such cases the management and control of a trust structure is less regimented than

a straight corporate structure and therefore the corporate alternative is often

preferred.

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3 STRATEGIES FOR CHANGE

There are various strategies that can be examined in a restructure. These include

(a) Utilize a capital gains tax (‘CGT’) roll-over to defer immediate tax consequences of

an alteration in the structure;

(b) In appropriate cases, with a mixture of pre-CGT assets, discount capital gains

treatment and Division 152 small business CGT concessions, the restructure may be

undertaken without using roll-over relief;

(c) Adopt alternative restructuring options.

This paper proposes to consider the above matters based on a few case study examples.

There are of course other issues than income tax and CGT that need to be considered, in

particular, stamp duties. It is my intention to only refer to possible exposures to stamp

duty as such considerations (given the differences between the legislation of each of the

States and Territories) is a paper on its own.

CASE STUDY

The Staggles Family Trust operates a chicken processing plant. The business has expanded considerably and would benefit from a capital injection for further expansion purposes. For simplicity I have assumed the Trust has only two assets being goodwill and depreciating assets and there are no liabilities (other than a UPE). The market values and cost base for these two assets being Market Value Cost Base Goodwill $2 million nil Depreciating assets $1.5 million $500,000 The practice in the past has been that a portion of the profits have been distributed to a corporate beneficiary (‘Chook Co’) and the cash retained by the Staggles Family Trust for working capital purposes. As a result, Chook Co has retained profits of $500,000 represented by a UPE of $500,000. The reinvestment into the Staggles Family Trust by the corporate beneficiary is of concern to the principals of the Trust as they do not want to trigger any further UPE issues. In addition, the principals have raised the following issues (a) Asset protection – the family is concerned that a claim made by a customer would

expose the value of business;

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(b) Sale of an interest in the business – the family are considering obtaining the benefits of selling down an interest in the business to a third party investor; and

(c) Finance for capital purchase – recent approaches by the family to their bank enquiring as to finance opportunities for capital expansion has indicated a lack of understanding by the bank of the Staggles Family Trust’s balance sheet showing net assets of $20 being the settlement amount on the establishment of the Trust.

Accordingly, the continuation of the business in a discretionary trust is under review.

3.1 CGT roll-over to a company – Subdivision 122-A

There are three rollover relief provisions that defer the immediate tax consequences

of a restructure for a trust.

• subdivision 122-A

• subdivision 124-H

• subdivision 124-N

It is noted that subdivision 122-B is also applicable in the ‘trust to company’

situation. This subdivision can apply where, for example, a partnership of trusts

restructures into a company. However, this provision is not considered in this

paper. Further, it is not the purpose of this paper to examine the detail of the various

CGT roll-over provisions. For such an analysis I recommend the reader to a paper by

Craig Cooper, “Restructuring Trusts to Companies: What You Need to Know”,

Taxation Institute, 50th Victorian State Conference, 6 October 2011.

Subdivisions 124-H and 124-N only apply to a roll-over from a unit trust whereas

subdivision 122-A applies to any type of trust.

Subdivision 122-A is the first provision often considered in respect of a CGT roll-over

from a trust to a company. In this roll-over the company becomes the new operating

entity, or asset holder and the trust becomes the shareholder.

The structural consequence of an application of subdivision 122-A is to leave the

Staggles Family Trust (and the trust beneficiaries) unaffected, but with the assets

‘pushed down’ a level into a company which is wholly owned by the trust. The

income produced from the asset will be subject to corporate tax at the company level

after the restructure, with franked dividends being available for distribution up

through the structure.

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After the restructure, a family trust election will need to be made in respect of the

trust in order to satisfy the “qualifying person” requirement, and allow the passage

of the franking credits attaching the subsequent dividends through the trust to

beneficiaries. The trust will still fulfil its role as ‘distributor’ amongst the

beneficiaries; but now the net trust income will consist largely or wholly of

franked dividend income, rather than untaxed trust income as was the case pre-

restructure.

Assuming the trustee still appoints sufficient distributions in favour of individual

family members for private expenditure needs, the balance of the net income can be

appointed in favour of Chook Co as the corporate beneficiary of the trust. Chook Co

should account for the distribution as a receipt, and not as an unpaid present

entitlement. The cash can remain as working capital in the business – now

conducted by a company – and be reflected as a loan from Chook Co to the operating

company. There will not be any adverse Division 7A implications to deal with.

Staggles Family

Trust

Goodwill +

Depreciable

Assets

Staggles Family

Trust

Company

Goodwill +

Depreciable

Assets

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Loan Distribution

Dividends

As Chook Co will over time become a valuable company, it is desirable that the

shareholding be held in a trust. That is, under this structure either the Staggles

Family Trust is made the shareholder in Chook Co or a new trust is established for

that purpose.

For asset protection reasons it would be desirable for the Staggles family to consider

the dividend policy for the trading company. Namely, it would be preferable if

annual profits after tax are paid as a fully franked dividend and then distributed to

Chook Co as per the above diagram. The working capital can then be lent back to the

trading company and if felt necessary appropriate security taken for the loans. In this

way, Chook Co not only becomes a creditor but could become a secured creditor.

Accordingly, if the trading company is exposed to liabilities through its trading

activities then Chook Co will stand in a superior position to unsecured

claimants/creditors of the company.

Subdivision 122-A does not apply to the disposal or creation of rights in respect of the

following assets for both the single asset and business disposal cases:

(i) Collectable or personal use asset;

(ii) Bravery decorations (unless purchased);

(iii) Assets that become trading stock in the company just after the time of the trigger

event.

Staggles Family

Trust

Trading Company

Chook Co

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In addition, in the single asset case (either disposal or creation) the following assets

(‘precluded assets’) are excluded from the roll-over protection of subdivision 122-A:

(i) A depreciating asset;

(ii) Trading stock;

(iii) Certain film copyright (subsection 122-25 (2))

Under section 122-50, the first element of each share’s cost base is the sum of the market

values of the precluded assets and the cost base of the other assets.

Namely, in the case of the Staggles Family Trust, the cost base for the shares will take on

the market value of the depreciating assets ($1.5 million) and the cost base of the other

assets being the goodwill in the business (nil cost base).

In respect of the depreciating assets, Subdivision 40 provides a similar relief to

Subdivision 122-A. In particular, under section 40-340 there is roll-over relief if there is

a balancing adjustment because an entity (the transferor) disposes of the depreciating

assets in the income year to another entity (the transferee) and the disposal involves a

CGT event under which Subdivision 122A applies. The end result is that despite a

depreciating asset being excluded from Subdivision 122A roll-over relief there is a roll-

over relief that applies under Subdivision 40 in respect of any balancing adjustments.

The advantages of this situation is that even though the cost base of the assets held by the

company are exactly the same as what they were in the Staggles Family Trust there is

now an uplift in the cost base of the shares held by the family trust in the newly

incorporated company. This uplift may have an advantage if ultimately the Staggles

Family Trust sells the shares in the new company.

Cost base of shares = $1.5m

Cost base of assets = $0.5m

Staggles Family

Trust

Company

Goodwill +

Depreciable

Assets

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It is in my opinion worth considering the accounting issues when using the CGT roll-

over. Namely, in the case of the Staggles Family Trust the value of the assets transferred

amounts to $3.5 million. For this reason it is desirable to have that value represented on

the balance sheet of the trading company and reflected in equity as share capital.

Namely, the issued share capital of the trading company will be $3.5 million even though

the cost base for CGT purposes of those shares will only be $1.5 million.

Consideration should also then be given to the accounting treatment in the Staggles

Family Trust. For accounting purposes the trust would have triggered a capital profit in

consequence of the roll-over. That capital profit would in this case amount to $3.0

million as the assets transferred had a value of $3.5 million with a carrying cost in the

balance sheet of the trust being $0.5 million. That capital profit is an accounting profit

and not subject to tax.

The capital profit could be retained in the Staggles Family Trust as a reserve account or

could be distributed to the family members in their capacity as discretionary

beneficiaries. As there is no cash available to make such a distribution, the beneficiary

entitlements could be lent back to the Staggles Family Trust.

3.2 CGT roll-over to a company – Subdivision 124-N

As indicated before, subdivision 124-N only applies to unit trusts. What then is the

significance to the Staggles Family Trust of such a roll-over? The significance is that the

trust could be converted to a unit trust which would then allow the family members to

consider this roll-over in preference to a subdivision 122-A roll-over.

Accordingly, in considering restructure options for the Staggles Family Trust it may be

worth considering the option of first converting the trust to a unit trust.

Under this option the discretionary trust deed could be varied to allow the trustee to issue

units. In the event units are issued, then the income of the trust is distributed to the unit

holders in priority to any exercise of discretionary power of the trustees. The

consequence of this amendment is to convert the trust from a discretionary trust to a so

called hybrid trust.

CGT issues re conversion

Note that section 104-65 (CGT event E3) relates to converting a trust to a unit trust.

However that event only happens if just before the conversion, a beneficiary under the

trust was absolutely entitled to the asset as against the trustee (disregarding any legal

disability the beneficiary is under). That is, CGT event E3 does not occur on the

conversion of a discretionary trust to a unit trust.

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The CGT event relevant to a situation where a variation to the trust has the legal result of

creating a new trust over the assets is so-called CGT event E1, (‘creating a trust over a

CGT asset’) section 104-55. In “Creation of a New Trust - Statement of Principles August

2001” the Commissioner of Taxation stated “both the stamp duty and estate duty cases indicate that a new trust arises when there is a fundamental change to the trust relationship. It is a change in the essential nature and character of the original trust relationship which creates a new trust. This may mean that the original trust ceases to exist, and a new trust arises.”

There is no intention in the proposal to change the class of beneficiaries, rather the power

to issue units merely provides a mechanism for the trustee to define or fix the interests

that the beneficiaries hold in the trust.

On 20 March 2012, the ATO withdrew its Creation of a new trust – Statement of Principles August 2001, following the Full Federal Court’s decision in the Commissioner of Taxation v Clark and the High Court’s refusal to grant the Commissioner leave to

appeal. On 11 May 2012 the ATO also updated its Decision Impact Statement of Clark in

regard to the capital gains tax consequences of making amendments to a trust.

The ATO now accepts that the reasoning of the court has the effect that a valid

amendment to a trust, not resulting in a termination of the trust will not of itself result in

the happening of CGT event E1. Accordingly, this revised statement is in line with the

case law that a mere variation or change to a trust will not constitute a resettlement of a

trust, and therefore will not have capital gains tax consequences. In withdrawing the

Statement of Principles, the ATO has acknowledged that the current law is not whether

there has been a ‘fundamental’ change to the original trust relationship so as to constitute

a resettlement, but whether there is a continuity of the trust estate.

Revaluation of assets

Prior to the conversion of the Staggles Family Trust to a unit trust consideration could be

given to a revaluation of the assets of the trust.

The assets in the balance sheet of the Staggles Family Trust could be increased or revalued

by doing a revaluation of the existing assets including goodwill and the depreciating

assets in respect of the business. Any revaluation again will not have any CGT

consequences nor stamp duty consequences. The revaluation reserve created as a

consequence could be distributed to the family members as discretionary beneficiaries

(that is, prior to the conversion of the trust). Namely, the goodwill and the depreciable

assets could be revalued to market values ($3.5 million) and the revaluation amount ($3

million) distributed to the family members.

The distribution of the asset revaluation reserve amount to the discretionary beneficiaries

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is a distribution of a capital amount and not exposed to CGT or the operation of section

99B of the Income Tax Assessment Act, 1936.

Issue of units

The distributed amount could then be added back into the trust through the subscription

for units by the family members. The UPE amount ($500,000) can also be converted into

unit capital.

The steps above all have the effect of increasing the balancing sheet figures as follows.

Assets

Goodwill $2.0 million

Depreciating assets $1.5 million $3.5 million

Equity

Units – family members $3.0 million

Units – Chook Co $0.5 million $3.5 million

CGT Issues under subdivision 124-N

For post CGT assets which are transferred, the first element of the cost base (and the

reduced cost base) of each asset acquired by the transferee company under the trust

restructure is the same as the transferor trust’s cost base (and reduced cost base) just

before the transfer. (Section 124-875(2)). That is, the company inherits the position of

the Staggles Family Trust with respect to the goodwill (nil cost base).

There is no roll-over relief for items of trading stock. (Section 124-875(5). There is

however an automatic roll-over for depreciable assets under Division 40 purposes.

(Section 40-340(1) table item 2A). Accordingly, there is no uplift in respect of the

value of the depreciable assets held by the trust.

What then is the position for the unit holders in the Staggles Family Trust? Under

section 124-875 the unit holders in the Staggles Family Trust become the shareholders

in the new company and inherit a cost base in the shares acquired equal to the cost

base that the unit holders held in the Staggles Family Trust. So what did the unit

holders have as their cost base in the units?

Under the conversion of the trust to a unit trust and the issue of units it is arguable

that the cost base for the units is equal to the face value of the units (namely, $3.5

million). If that is correct then the family members will have obtained a full uplift in

their cost base for the new shares issued.

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If this is found not to be correct then what would be the position if the unit holders

retained the revaluation and distribution of capital amounts as liabilities (and not

converted to paid up amounts on the units held). That is, the family members

retained only a nominal unit holding with the Staggles Family Trust retaining two

amounts as liabilities - $500,000 owing to Chook Co as a UPE and $3.0 million owing

to the family as a consequence of a distribution of the revaluation amount. It seems

those liabilities would be inherited by the transferee company. This would then

allow a significant amount of after tax profits in the trading company to be distributed

to the family members without further tax exposure (through the repayment of such

liabilities).

A significant advantage of the roll-over under subdivision 124-N is that the trust

disappears from the structure. Namely, the unit holders of the trust become the

shareholders of the company that acquires the rolled-over assets from the trust. This may

be of significance to a family trust consisting of more than one family group – namely the

family trust which has moved to the second generation. Accordingly, it is a restructure

which provides the members of the Staggles Family Trust to divide their entitlements

under the group. That is the family members can after the restructure hold their

respective interests in the assets through shares in a corporate entity as distinct from

discretionary entitlements under the trust structure. Those shares need not be held by

individual family members but could for example be held by family trusts formed for the

respective family members.

Staggles Family

Trust

Goodwill +

Depreciable

Assets

Unit/Share

Holders

Company

Goodwill +

Depreciable

Assets

Unit Holders

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Subdivision 124-N roll-over works very well where the roll-over is to the trustee

company of the Staggles Family Trust. In this way the trading entity continues albeit

with a different ABN.

3.3 CGT roll-over to a company – Subdivision 124-H

In the case of subdivision 124-H, the Staggles Family Trust will drop to the bottom

of the structure, with a company being interposed between the unit trust and the

unit holders.

As with subdivision 124-N, it is necessary to first convert the Staggles Family Trust to a

unit trust – see discussion above. In addition, there must be more than one unit holder in

the unit trust.

With a company being the sole unit holder, it is possible to form a tax consolidated

group, with the unit trust as the subsidiary member. The Staggles Family Trust

would cease to have any significance then for tax purposes.

Staggles Family

Trust

Goodwill +

Depreciable

Assets

Company

Staggles Family

Trust

Goodwill +

Depreciable

Assets

Unit Holders Unit/Share

Holders

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Where the trust to be reorganized has significant assets, subdivision 124-H may be

preferable to the use of subdivision 124-N. There may also be stamp duty

advantages in exchanging units for shares rather than transferring assets from a trust

to a company.

The steps for calculating the “allocated cost amount” for the Staggles Family Trust are set

out in Division 705. The first step is to determine the cost to the group (the interposed

company) of the membership interest in the trust. This is the consideration paid by the

interposed company to the unit holders for the units in the Staggles Family Trust. In this

case the consideration paid would be either $3.5 million where the family members have

taken up units in the trust to this level or nominal consideration where the revaluation of

assets in the trust have been distributed and left as liabilities of the trust.

The second step is to add the liabilities of the Staggles Family Trust. In either case

mentioned in the previous paragraph, steps 1 and 2 of the consolidation ACA calculation

would give an amount of $3.5 million. This amount is allocated to the reset cost base

assets of the Staggles Family Trust in proportion to their market value. As the only reset

cost base assets held by the Staggles Family Trust are goodwill and the depreciable assets,

all of the allocated cost amount is allocated to those assets, effectively resetting the cost to

their respective market values being $2 million and $1.5 million.

3.4 CGT roll-over to a company – Subdivision 122-A with second transfer

Under point 3.1 above consideration was given to the roll-over to a corporate structure

using subdivision 122-A. Under this point consideration is given to interposing a holding

company in the structure for protection reasons. Namely, it is undesirable to have a trading

company accumulating wealth through assets or through retained profits. In the public company

environment it is common for holding companies to be passive in their activities but holds

subsidiaries carrying on trading activities. This should also be a consideration for the private

sector group.

Under point 3.1 it was shown how a step up in cost base for the shares acquired in the

trading company can be achieved where part of the assets transferred are depreciable

assets. Obviously it is possible then to consider a second transfer using a roll-over under

subdivision 122-A over again. However, as the first roll-over achieved a step up in cost

base it may be desirable to consider triggering a capital gain on the second transfer under

Divison152 small business CGT exemptions.

That is, now that the Staggles Family Trust has a higher cost base in the shares (through

the uplift and the cost base because of the depreciating assets) the transfer of the shares to

a second company will give rise to a lower CGT exposure and provided that all the other

conditions under subdivision 152-A apply then it may be desirable to trigger a capital

gain and take advantage of the exemptions applicable.

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The advantage of triggering a CGT event on the second transfer is that it will provide a

further advantage for the group if tax consolidation is then selected for the holding

company and the trading company.

Under tax consolidation the reset rules (is so called allocable cost amount – ACA) is such

that the assets held by the trading company will be deemed to reflect the cost base of the

shares acquired in that company. The reason for this reset is simple. On a consolidation

all transactions within the consolidated group are ignored tax purposes. Accordingly, the

shares acquired by the head company in the trading company lose all relevance from a tax

perspective. Under the asset reset rules, the cost base of the lost asset (shares) are shifted

to the assets within the consolidated group. As a consequence, in the example, the two

business asset being goodwill and depreciable assets will now reflect a new deemed cost

base for CGT purposes equal to the cost of the shares acquired by the holding company.

Again achieving a cost base lift up.

Using Consolidation to Obtain Small Business Concessions

The above discussion then leads to the question whether a taxpayer can use consolidation

by incorporating a new head company simply to gain an up-lift in the cost base of the

Staggles Family

Trust

Goodwill +

Depreciable

Assets

Staggles Family

Trust

Trading Company

Goodwill +

Depreciable

Assets

Holding Company

Trading Company

Goodwill +

Depreciable

Assets

Staggles Family

Trust

19

business assets in the business entity at a time when the thresholds within the basic

conditions for small business CGT relief can be met.

The obvious example where this strategy may be employed is where the shareholder (and

the business entity) currently meet the basic conditions of Division 152-A of the ITAA

1997 but the shareholder does not intend immediately to sell the business. That is, the

shareholder may be faced with the business value increasing so that eventually the value

will reach an amount where the shareholder selling the shares in the business entity (or

the company selling the business assets) cannot utilize the provisions of the small business

concessions. In this case the shareholder may be advised to trigger a CGT event in

respect of the sale of shares so that an up-lift in the cost base of the business assets is

achieved – giving some tax free threshold to say the company if ultimately the business is

sold to an arm’s length purchaser.

Using Consolidation for Retirement Exemption Amount

This option is particularly attractive for a shareholder who is 55 years or older as the

shareholder will have the option to either use the time to top up his superannuation

benefits using the retirement exemption. If, for example, the business entity had retained

profits represented by cash then the shareholder could access that cash by undertaking

the restructure through its addition to his superannuation benefits.

In this case, on the sale of his shares to the head company that company would be

indebted to the shareholder (for $2 million using the previous example). Once the head

company and the business entity consolidated then the business entity could pay cash to

the head company (without any tax consequence) and the head company could then pay

that cash to the shareholder in part repayment of the purchase price for the shares. The

shareholder if over 55 years would then have the choice to retain the cash (up to the limit

of $500,000) or apply the cash to his superannuation on a tax free basis.

Using Consolidation for Conversion of Non Deductible Debt

Another option that a shareholder in the situation of our example can consider is the

opportunity to reorganize personal borrowings as part of a restructure using the

consolidation route. Take the example of a shareholder with a non-deductible borrowing

in respect of say a home loan. If the shareholder undertook a sale of his shares to a head

company with consolidation by the head company and the business entity then the head

company could borrow an amount of cash from a financial institution and use that cash to

pay to the shareholder in whole or in part the amount it owes the shareholder for the

shares acquired in the business entity. The shareholder could then use the cash to repay

the non-deductible borrowing. The head company would then have the equivalent cost

for the interest on the borrowings but now this interest would be deductible for tax

purposes against the trading profits of the business.

20

Using Consolidation for Deemed Dividend Solution

This type of restructure can also be considered as part of a plan to minimize the client

from the adverse consequences of the deemed dividend rules under Division 7A of the

ITAA 1936.

In this case, the debt owing by the head company to the shareholder could be offset

against any moneys owing by the shareholder to the business entity.

3.5 Utilizing Licensing Arrangement

Under this approach the trustee company continues to operate as the trading entity but

now in its own right rather than as trustee of the Staggles Family Trust.

In this case, the assets constituting the business including the goodwill and depreciable

assets could be retained by the trust and simply licensed or made available to the trustee

company for the purposes of conducting its business. You would expect that in such a

reorganization the employees and contractors would move from the trust to be employed

now directly by the trustee company in its own right.

In this way the trustee company continues to trade but with a different ABN on the basis

that it is trading in its own right rather than trading as a trustee entity. In turn, the assets

are not transferred but rather retained within the trust structure allowing for the

opportunity to take advantage of the more favorable CGT treatment for trusts as opposed

to corporate entities. It should be noted that it may be necessary to change the trustee of

the trust to a different entity so that the trading entity is now no longer acting as the

trustee of the Staggles Family Trust. In addition, the shareholder in the trustee company

would need also be considered before undertaking the new trading operations. It may be

necessary in most cases for the shares to be transferred to a further trust allowing for

Staggles Family

Trust

Goodwill +

Depreciable

Assets

Trading Company

21

better flexibility in distributing retained profits as dividends to the family group.

The licensing of goodwill is used to avoid stamp duty and CGT on the restructuring of

businesses. Instead of transferring the goodwill to a more tax effective structure, that

goodwill is licensed and some agreement is reached to where further goodwill will attach.

Licensing of goodwill may also be used to maximize the tax effectiveness of a structure or

for asset protection reasons. A purchaser may buy goodwill through a discretionary trust

or partnership of individuals to maximize the tax free return. This then raises the issue as to

whether or not it is possible from a tax perspective to license goodwill.

It would first appear necessary that it be the business that must be licensed as the

goodwill is inherently attached to the business. Does this, however, permit the goodwill

to remain with the licensor? Can it be said that the licensor has ceased to operate the

business itself to which the goodwill related and commenced a new business of leasing

assets? What happens to the old goodwill? Is there a disposal of that goodwill by the

licensor which results in a capital gain? Presumably, the licensee has not acquired

goodwill as it is running a different business than that of the licensor.

Alternatively, does the licensor retain the business and the goodwill attached to it even

though somebody else runs the business for a period.

Kirby J in FC of T v Murry 98 ATC 4584 (at para 91) realises the difficulty raised with a

licensor not being able to license goodwill.

“The fact that the taxi licence was leased to another person (Mr Gower) does not preclude its being a source of goodwill. One can readily imagine instances in which an asset which is leased out accrues in value through an increase in goodwill. A franchisor, having leased premises to a franchisee for a number of years, could reasonably expect his or her business to have gained value, as a result of an increase in goodwill. Once it is accepted that goodwill can be gained whilst the asset is in the hands of the lessee, it seems absurd to conclude that such an increase would not accrue to the benefit of the lessor in the event that the lease was terminated.”

Licensing say goodwill in this manner is very popular with professional firms.

3.6 Using Limited Partnership Structures

Where stamp duty is a concern the use of a limited liability partnership (LLP) could be

considered. Namely, as LLP’s are treated as companies for tax purposes it is possible to

use an LLP rather than an incorporated company for CGT roll-over purposes. As an LLP

is treated as a partnership for all purposes other than income tax (that is for stamp duty

purposes) a reduced exposure to transfer taxes can result for certain restructures.

22

In the case of the Staggles Family Trust, if the transfer of goodwill in the business causes

an exposure to stamp duty an option is as follows

The revised proposal that we recommended is as follows:

1. A new company is incorporated (“New co”) with the Staggles Family Trust as the

sole shareholder.

2. The Staggles Family Trust transfers to New co a 1% interest in all of the assets of

the business and a partnership agreement between New co and the Staggles Family

Trust is entered into. Namely, the Staggles Family Trust would hold a 99%

interest in the partnership and New co would hold a 1% interest.

3. The Partnership is then converted to a limited liability partnership (“Staggles

LLP”) with New co as general partner (operates the business for the LLP) and the

Staggles Family Trust as the limited partner. Under this step the Staggles Family

Trust and New co as partners can elect to roll-over the assets under subdivision

122-B (see comment in point 3.1 above) as for tax purposes the assets will then be

owned by a company (the Staggles LLP) and the only shareholders will be the

Staggles Family Trust and New co (which in turn is also owned by the Staggles

Family Trust).

Transfer 1%

Staggles Family

Trust Company

Goodwill +

Depreciable

Assets

Staggles LLP

23

In summary, the Staggles LLP will enable the Business to continue operating without the

need to incur the costs of assigning the assets of the Business to a new corporate entity.

The stamp duty exposure is restricted to the transfer of a 1% interest in the assets under

step 2 above. There is no transfer of assets under step 3 since for general law puposes the

Staggles Family Trust continues to own a 99% share in the assets despite the fact that for

tax purposes the assets are ‘owned’ by the corporate entity (Staggles LLP).

The Staggles LLP is also a more attractive structure as the profits are taxed at a flat rate of

30% as Staggles LLP is considered a “company” for tax purposes.

The core taxation provisions concerning limited partnerships are contained in Division

5A of the Income Tax Assessment Act, 1936. The key provisions are:

(a) Section 94J which provides that a reference in income tax law to a company

includes a reference to a corporate limited partnership. Because of this provision a

limited partnership is treated in the same way as a company for tax purposes

which means that the tax rate of a limited partnership is the corporate rate.

(b) Section 94K prevents references in income tax law to a "partnership" from

applying to a limited partnership. This effectively excludes from Division 5,

which deals with the taxation of partnerships, applying to a limited partnership.

(c) Section 94L provides that references in income tax law to "dividends" includes a

distribution by limited partnership to its partners.

(d) Section 94M provides that amounts paid or credited to a partner by the

partnership out of existing or anticipated profits are deemed to be dividends paid

by the partnership out of profits derived by the partnership.

(e) A limited partnership is a corporate tax entity under the imputation provisions

(section 960-115 of the ITAA 1997). This means that the imputation system

applies to a limited partnership in the same way that it applies to a company. In

particular, a limited partnership is able to maintain a franking account (section

205-5) and pass on franking credits to its partners as members (section 207-5).

There is no CGT event in the ITAA 1997 that applies directly to the change in status of a

partnership to a limited liability partnership. Namely, there is no disposal or deemed

disposal when a partnership ceases to be taxed as a general law partnership and

commences to be taxed as a company on conversion to a limited liability partnership.

Accordingly, it is debatable whether step 3 above requires the election of a CGT roll-over.

If no roll-over is required (as there is no CGT event to seek exemption) then the question

is what cost base the Staggles Family Trust have in the ‘shares’ it holds in the Staggles

LLP. Arguably the cost base is the market value of the trust’s interest in the assets.

However, if the above interpretation is found not to be correct then clearly in the current

situation the roll-over provisions of Division 122-B of the ITAA 1997 would apply.

24

The roll-over consequences for the Staggles Family Trust will be

1. Any capital gain or loss made on the disposal of the Business assets to Staggles LLP

is disregarded: sections 122-150 and 122-170

2. The “shares” received in Staggles LLP by the Staggles Family Trust will be deemed

to be post-CGT assets with a cost for tax purposes equal to the current market

value of the depreciable assets (section 122-185).

The roll-over consequences for Staggles LLP will be that the assets will be taken to have

been acquired by Staggles LLP for its cost base and/or reduced cost at the time of its

disposal (section 122-70(2)).

Because the goodwill of the Business is a business asset under the various Duties Acts in

Queensland, New South Wales and Western Australia, a transfer of goodwill is a dutiable

transaction in each of those States. The liability for stamp duty, however, will be limited

by the fact that the dutiable transaction is limited to a 1% interest in the Business assets.

There are also other opportunities to use a limited liability partnership rather than an

incorporated entity in a roll-over where stamp duty is an issue. This would be relevant in

all states where for example the Staggles Trust owned real estate. That real estate could

be ‘transferred’ for tax purposes into a tax corporate environment with minimal duty

using the same 3 steps outlined above. A further example relates to land holder entities

(companies or unit trusts owning real estate over various thresholds depending on the

state jurisdiction concerned). Namely, if the transfer of shares in a company that owns

real estate is potentially exposed to ad valorem rates of duty then consideration could be

given to transferring an interest in the shares and then treating the partnership owning

the shares as a limited liability partnership.

There is no automatic ability of a limited partnership to accumulate and retain profits.

Most partnership agreements will automatically provide for the partners' entitlement to

profits in accordance with their partnership interest. It is essential that the partnership

deed of Staggles LLP is properly drafted to provide for the ability to accumulate and

retain profits. Where a business is being carried on by a registered limited partnership

under an appropriately structured partnership deed, the general partner can accumulate

income that is not required by the partners at the company rate of tax. Undistributed

profits that are retained are not treated as dividends paid to the partners.

3.7 Splitting Title in Assets

The grant of life interests in assets is much neglected.

The nature of a life estate is summarized by Professor Butt (Butt, P 2001, Land Law, 4th

edition, Lawbook Co, Sydney, paragraph 1019) as follows

25

A legal life tenant (that is, a tenant for life of a legal estate) is entitled to possession of the property, since the right to possession follows the legal estate. Whether an equitable life tenant (that is a tenant for life of an equitable estate) is entitled to possession, is more complex. It seems that an equitable life tenant is entitled to possession where the trustees have no active duties to manage the property. But where the trustees have active duties to perform - such as to maintain the property and collect the income - an equitable life tenant is not entitled to possession as of right, unless the instrument creating the life interest confers that right expressly or by implication. However, such an equitable tenant may apply to the court for an order granting possession and the right to manage the property, and the court will normally make the order if the life tenant gives security or an undertaking to indemnify the trustees and preserve the property for the benefit of those entitled after the life estate comes to an end.

It is important to note that a legal life estate means that the life tenant has a legal title –

that is, once granted the owner of the life tenancy can be registered on title or,

alternatively, obtain their own title deeds. The life estate is a freehold estate. See, for

example, the comments made by Giles JA at paragraph 52 in Trust Company of Australia

v Commissioner of State Revenue 2007 NSWCA 255

English land law was moulded by the feudal doctrine of tenure, by which all land was held directly or indirectly of the King. The common law developed freehold estates, interests in land held of the King by one whose status was free: an estate in fee simple (which could descend to the holder’s heir), an estate in fee tail (which could descend to a restricted (“tailed”) category of heirs) and a life estate (which would end on the holder’s death). The holder had “seisin”, originally meaning only possession. He was, for example, “seised for an estate in fee simple”.

It is generally accepted that on the grant of a life estate there is not two new assets that

are formed (namely, a life estate and a reversionary estate). Rather, the estate (generally

the fee simple) out of which the life estate is granted remains as the original asset (and

not a new asset) though that asset is now limited by the existence of the life interest. In

the Trust Company case Giles JA stated

The fee simple remains in the lessor, although the lessor parts with the right to possession, and the lessee’s interest (which has been described as “carved out of the freehold”, see Ingram v Inland Revenue Commissioners [1998] UKHL 47; (2000) 1 AC 293 at 310 per Lord Hutton) co-exists with the estate in fee simple. But the lessor’s freehold estate subject to the lease is regarded as an interest in the land, the reversion, and it is correct to refer to it as such. Thus in Commissioner of State Revenue v Pioneer Concrete (Vic) Pty Ltd at [49] Gleeson CJ and Gummow, Kirby and Hayne JJ said of Commissioner of State Revenue (Vic) v Bradney Pty Ltd (1996) 34 ATR 233, in which the freehold was sold subject to a long term

26

lease, “What was sold was the freehold interest subject to a pre-existing lease; the reversion”.

This view is also accepted by the Commissioner of Taxation, see paragraphs 85 and 119 of

TR 2006/14 which state

85. Bringing a legal life interest into existence involves a disposal of part of an existing CGT asset in a similar way to the disposal of a percentage interest in it. The part of the original asset that is not disposed of to the life interest owner is the legal remainder interest.

119. Together legal life and remainder interests represent the entire freehold interest in the land. By 'creating' a life interest, the original owner is actually disposing of part of the freehold interest in the land in a similar way to the disposal of a percentage interest in the property.

A life interest is generally measured by the life of the life interest owner (namely, the

person to whom the life estate was granted) although it can be measured by the life of

another individual. For example, it is possible for the owner of a real estate property to

grant to an individual a life interest based on the life of a third person or to grant a life

interest to an entity (for example, a company, trust or superannuation fund) measured by

reference to particular individuals.

The nature of a life interest is to divide the income earning rights from the capital asset.

This is a division that taxpayers desire as the income can be taxed at one rate and the

capital growth (on realisation) at another rate of tax.

In the case of the Staggles Family Trust, the grant to a company of a life estate over the

assets of the trust would have the effect of allowing the company to derive 100% of the

income from the assets whereas the trust would retain an interest in the capital (as the

reversionary owner). This would allow the trust to retain at least a portion of the

capital gain and retain the opportunity to obtain 50% general discount under Division

115.

The Staggles Family Trust in granting a life estate over the assets of the trust to a

corporate entity triggers CGT event A1 as a part disposal of an asset. This therefore

reduces the level of exposure to CGT as compared to the transfer of the full title to the

assets. At the same time though the company has entitlement to all of the income.

This therefore allows the company to pay corporate rate of tax on that income and

either retain the profits or distribute as fully franked dividend. A simple approach to

overcoming the issues relating to UPE’s.

The grant of a life estate is subject to stamp duty in most jurisdictions – New South

Wales being a notable exception. However where duty applies the amount of duty is

less than a full transfer of title as only a part of the asset value is transferred.

27

Consideration should be given to undertaking a grant of a life estate as part of a CGT

roll-over. Namely, under point 3.1 above the transfer of the assets from the Staggles

Family Trust to a wholly owned company was considered. An alternative is to grant a

life estate as part of a subdivision 122-A roll-over.

4 WHAT THEN IS THE IDEAL STRUCTURE?

There of course is no ideal structure. There will always be compromises. However if you

are going to use a company, consider the following:

(a) A trading entity should not accumulate profits. That is, income derived by the

company, and left remaining after tax, should be paid out as a dividend. The

reason for this recommendation is asset protection planning – retained profits will

be available to claims against the company made by unsecured creditors.

Example Over the years a company has made substantial profits but has not distributed

these profits to its shareholders. The profits retained in the company have been invested in assets and loans to related entities. In the course of its trading activity the company becomes embroiled in a dispute with one of its major customers. The customer makes a substantial claim against the company for damages – at risk in the resolution of the dispute is all the assets of the company. If the profits had been distributed and then invested, the trading company would have little to lose as a consequence of the litigation.

(b) The problem is: who should be the shareholder?

Obviously, the disadvantage of having individuals as shareholders will include the

following:

(i) retained profits will be exposed to higher personal rates of tax when paid

out as a dividend;

(ii) the individual will have assets in their name which therefore exposes the

assets and raises asset protection issues.

The answer therefore is that the trading company should have as its shareholder

either:

(i) another company or

(ii) a family discretionary trust

(c) The advantage of a company is that dividends (fully franked) can be paid up to

that company as a shareholder without further tax. That is, the receipt of a fully

28

franked dividend by a company is not subject to further tax. The amount

concerned can then be lent back to the trading company for working capital

purposes. The loan can be secured by the holding company taking a fixed and

floating charge over the assets of the subsidiary (trading company). In this way,

the accumulated profits can be protected and can become debts in priority to

unsecured creditors.

(d) The question then becomes who should be the shareholder of the holding

company?

The answer is simple – it should be a family trust. The reasons for this include:

(a) asset protection

(b) tax flexibility

In other words, the distribution of dividends by the holding company can be made

to the family trust as a shareholder who can then distribute those dividends on a

discretionary basis to family members.

(e) The following issue now arises: Which entity should own investment assets?

It is clear that it is undesirable for the trading company to own assets (for asset

protection reasons). It is also clear that it is undesirable for companies to own

appreciating assets (for CGT purposes).

The choice would seem to be to acquire non-appreciating tangible assets (for

example, plant and equipment) in either a second subsidiary company or the

holding company.

As for appreciating assets (e.g. real estate such as an office or factory), this should

be acquired by either an individual (or individuals) or a trust of some kind. Trusts

offer asset protection and the same tax advantages (50% CGT discount), so it is

clear that a trust would be the preferable vehicle.

Whether it is a discretionary trust or a unit trust will depend on a number of

factors, including whether there are more than one family group involved;

whether entities such as self-managed superannuation funds are to be involved;

and whether there are negative gearing issues.

On the basis that only one family group is involved it would appear that a family

discretionary trust could be the appropriate entity to acquire real estate assets.

29

The structure could then look like this:

Lease

Loans

100% dividends

The alternative to a holding company structure is to make the shareholder of the trading

company a discretionary trust. Since it will be desirable to pay regular dividends by the

trading company (for asset protection reasons), it will be necessary to set up a company as

a beneficiary under the trust (as shareholder). The company beneficiary can be described

as a “bucket company” because it will have solely a passive role in accepting distributions

from the trust and should not itself make investments. The shareholder in the bucket

company should be a second family trust (again for asset protection and tax flexibility

reasons).

Trading

Activities

Subsidiary Company

Holding Co.

Family Trust

Real Estate