Child Maintenance Trusts in Family Law. Audit Tax Advisory Wealth Management. The relationship you can count on

Transcription

1 Child Maintenance Trusts in Family Law The relationship you can count on

2 Contents: Introduction 1 Why establish a CMT? 1 Who is likely to benefit and be interested in a CMT? 1 What are the requirements for a complying CMT? 1 Practical aspects 2 A typical model example 3 Case study 4 Advantages of a CMT 4 2

3 Introduction The ability to establish a child support or maintenance trust ( CMT ) following a family breakdown is a little-known and seldom-used opportunity under Australian tax legislation. The provisions enabling such a trust to be established are contained within Division 6AA section 102AG of the Income Tax Assessment Act 1997 (as amended) ( ITAA ). Family breakdown is defined in section 102AGA of the ITAA to include legal obligations arising not only from the breakdown of live-in relationships but also where parentage has occurred outside of such a relationship. A CMT is a trust set up to provide support for a child (or children) where there is an obligation to provide maintenance for the child, and income that is distributed to the child (or physically to the custodial parent) is taken to satisfy that obligation. Why establish a CMT? A CMT allows maintenance payments to be made on behalf of minor children (that is, children under the age of 18) in a taxeffective manner. Since 1 July 1979, trust income distributed to minors not in full-time employment has been tax disadvantaged. The tax-free threshold for adults (currently $6,000) is generally not available to minors, nor are the graduated marginal tax rates for incomes up to $180,000. This general tax-free threshold is $416 for minors, above which every additional non-employment income dollar (such as interest, dividends and trust distributions) is taxed at the top marginal rate of tax of 46.5% (including the Medicare Levy). Low-income earners also have the benefit of the low-income tax rebate. These 1979 anti-avoidance provisions put an end to the pre-1979 tax advantages from income-splitting arrangements, which included minors as recipients of non-employment income. A CMT complying with section 102AG of the ITAA provides excepted trust income to the minor, which will only attract the normal adult tax rates, including the larger tax-free threshold (currently $6,000), as well as lower marginal tax rates. The following table provides a simple illustration of these arrangements (ignoring the low-income tax rebate). A non-custodial parent on the top marginal tax rate, paying maintenance of $15,000 per annum for their 13-year-old child, would be faced with the following potential tax consequences: Additional gross salary required to fund $15,000 per annum maintenance Without a CMT With a CMT 28,037 16,583 Potential annual saving Tax payable (13,037) (1,583) 11,687 Required maintenance 15,000 15,000 The benefit obviously increases if there are more children, if there is a greater distribution for maintenance, or the years to age 18 increases. Other benefits that may be attractive to a family considering a CMT following a relationship breakdown include: n segregating cash or assets into a CMT separate from the parents to provide ongoing support for the children of the failed relationship; n protecting the CMT assets from external creditors who may wish to attack the parents assets; n the income tax saved by the establishment of the CMT can accumulate within the trust until the child or children as beneficiaries reach resting age (sometime after age 18); or n having the contributor borrow the funds settled on the trust on commercial terms, provided the capital is ultimately repaid and will benefit or be settled on the children. Who is likely to benefit and be interested in a CMT? A CMT is likely to be attractive in the following circumstances: n Where there has been a family breakdown ; n Where the parents can agree to establish a CMT as part of an overall property settlement between them (this requires the consent of both parents); n Where the contributing parent derives a taxable income of at least $180,000 (from 1 July 2010) per annum, and has significant assets other than the family home, superannuation, cars and personal effects; n Where the initial and/or subsequent property or cash settled on the trust has a total value of at least $500,000; n Where the child or children have a number of years of maintenance needs before reaching 18 years of age; or n Where the parents are comfortable leaving some assets to the child or children at the vesting date (even though capital may be drawn down during the term of the trust to meet maintenance needs). What are the requirements for a complying CMT? Although CMTs and Division 6AA have been around for 24 years, it would be fair to say that until 1994, many CMT structures appeared to abuse the privilege. For example, settling a nominal sum (such as $100) on a CMT, where this sum was subscribed for in units in a unit trust, for which the primary source of income comprised distributions from a pre-marital breakdown discretionary trust. This non-commercial situation often arose where, for a capital sum of $100, an income of $15,000 per child was ultimately distributed as maintenance at low tax thresholds, and virtually no substantive asset was left for the children at the end of the term. 1

4 Draft Income Tax Ruling TR94/D8 (issued on 24 February 1994) was followed by Act No. 181 of 1994, which came into effect on 19 December 1994 and introduced various anti-avoidance provisions as well as changed the wording of a number of the relevant sections. It also had some retrospective effect. On 18 March 1998, Ruling TR94/D8 was released. The ruling devotes some 28 pages to CMT arrangements and details unacceptable arrangements such as the one referred to above. For CMT trust income distributed to a minor to be characterised as excepted trust income and thereby attract the lower income tax rates, the trust and the features of the settled property, income and the terms of the Deed must satisfy the requirements of Division 6AA. These requirements must, as a minimum, comply with the following: n The income must derive from the investment of property transferred beneficially to the child. That is, the child must, under the terms of the trust, acquire the trust property, or will acquire it only as trustee, when the trust ends (this includes passing it to the child s estate, should the child die before the trust ends) (section 102AG (2)(c)(vii) and section 102AG (2A)). Unacceptable arrangements include cases where: n no property is transferred to the trustee; n the trust property will or may (perhaps as a matter of discretion) go to someone other than the child; or n the trustee is denied any power to deal with the property in the interests of the child. Accordingly, the parents or parent who initially contributed the capital or asset to the trust can never revoke that settlement, nor enable the capital to come back to them at a later date. n The income must derive from the investment of property by the trustee. Examples include the returns derived by a trustee from (s102ag(2)(c)): n a portfolio of shares retained within the trust; n rental income from real property retained by the trust; or n realising and reinvesting property at term. The arrangement described earlier involving a unit or discretionary trust would not satisfy the requirements (Case U ATC 1129; AAT Case 134 (1987) 18 ATR 3974). n The property giving rise to the future income must be transferred beneficially to the child as the result of a family breakdown. That is, there must have been a domestic relationship, between two people living as spouses, giving rise to legal obligations to each other and the child or children of the relationship, followed by a breakdown of that family relationship. So, for instance, a marriage may be taken to have broken down even if the two people do not intend to divorce (perhaps for religious reasons). It also includes adopted children and step-children (section 102AG (viii)). n The income derived from the investment of property must not exceed an arm s length return on the investment of that property. In other words, the situation described above where a nominal unit gives rise to a large income flow would be unacceptable, whereas annuity income of an amount equating to the purchase of an arm s length annuity would be acceptable (section 102AG(3)). n The income must not be derived as a result of an agreement entered into or carried out to secure the assessable income as excepted trust income. That is, the use of an existing family discretionary trust before the breakdown cannot give rise to excepted trust income after the breakdown a new trust must be established (section 102AG(4) and (5)). n For the income arising from the investment of property transferred to the minor, or the trustee for the minor beneficiary, to be deemed excepted trust income, the transfer of property must be pursuant to an order, determination or assessment of a court, person or body (whether or not in Australia). The order, determination or assessment could be administrative or judicial, and could involve maintenance, property, or other benefits for either spouse, the child, or transfer property to the child (section 102AG (2)(c)). n Under section 102AG(1), the Commissioner of Taxation is empowered to determine how much, if any, of the share of income allocated to a minor beneficiary is to be treated as excepted trust income in each year of income. No doubt the Commissioner will apply the tests detailed above and the requirements of Taxation Ruling TR98/4 in arriving at his or her discretion. Great care needs to be exercised in the establishment and ongoing administration of the CMT to ensure it complies with all of these requirements. Practical aspects To effectively implement a CMT, apart from obtaining the agreement of the parties following the family breakdown, the practitioner requires: n a suitable draft CMT Deed that complies with section 102AG; n orders from a court (whether in or out of Australia), such as consent orders of the Family Court of Australia or departure orders under child support legislation; n appropriate financial models to demonstrate the impact on the parties going forward, including specific information on the likely capital sum or property to be contributed to the trust; the likely annual income returns net of expenses; whether it meets the maintenance needs of the children or whether the income has to be supplemented by capital drawdowns or further support from the non-custodial parent; what capital sum remains when each child reaches their vesting age of, say, 18 years; and what income tax savings could be achieved over the life of the trust; 2

5 n a choice of a suitable trustee(s) to administer the trust, including practical aspects such as the regular drawing down of income (and perhaps capital); investment of funds; and acceptable expenses to be covered (such as school fees, clothing, holidays, extracurricular activities and living costs). It is unlikely that the parents would want to jointly administer the trust given that their relationship has broken down; however, either parent plus an independent third party may be acceptable trustees where appropriate deadlock provisions are built into the Deed; n whether any part of the trust property is to be applied as capital distributions for the benefit of the child during the term of the CMT. Such distributions can supplement the income distributions but obviously will result in lower future income streams (due to a lower capital base) and result in the remaining property being less when it vests in the child or children; and n as the advice is likely to come within the requirements of the Federal Government s Financial Services Reform Act ( FSRA ), only licensed competent service providers should be engaged by lawyers and clients in implementing a CMT, as it involves financial planning and investment advice. Crowe Horwath can assist by: n advising lawyers and their clients on the relevant taxation requirements; n providing alternative financial models given particular sets of circumstances, including estimated future income tax savings; n assisting in the practical steps to implement the CMT; n recommending a lawyer to provide appropriate complying CMT Deeds; and n meeting with parties to discuss the various practical possibilities. A typical model example Gift of $500,000 pursuant to court order Non-Custodial Parent $40,000 p.a. Distribution to child via custodial parent Loan Agreement CMT Operating Company of Non-Custodial Parent Tailored Trust Deed Commercial Loan at 8% interest (preferably secured) $500,000 Interest Tax Deductible $40,000 p.a. Use of $500,000 in an income producing activity, e.g.: n repay bank debt; n purchase shares; n purchase plant and equipment. 3

6 For Further Information For further information please contact: Jenny Wheatley Principal, Corporate Finance Tel jenny.wheatley@crowehorwath.com.au Patrick Giddy Principal, Wealth Management Tel patrick.giddy@crowehorwath.com.au Lauren Cusack Associate Principal, Corporate Finance Tel lauren.cusack@crowehorwath.com.au Deanna Chiang Manager, Corporate Finance Tel deanna.chiang@crowehorwath.com.au Deborah Kutcher Manager, Tax Advisory Tel deborah.kutcher@crowehorwath.com.au Advantages of a CMT Apart from the potential tax savings that should arise from establishing a CMT where maintenance payments are an obligation of the breadwinner parent, there are also the side advantages of: n asset protection; n being seen by the children as doing the right thing for them, notwithstanding the family breakdown; n leaving a nest egg for the children when they reach the vesting age of, say, 18 years or older; n securing a future maintenance arrangement that gives some certainty to all parties involved, such as an automatic monthly transfer into the account of the custodial parent to meet the children s expenses; and n being able to use the funds while they are settled on the trust, provided the arrangements are commercial (that is, as though entered into an arm s length basis). The depth of detail outlined above makes it clear establishing a CMT involves many traps that the unwary can fall into, making it necessary to seek sound financial planning, accounting, taxation and legal advice before establishing a CMT. The relationship you can count on Crowe Horwath Corporate Finance Ltd is a member of Crowe Horwath International, a Swiss verein. Each member firm of Crowe Horwath is a separate and independent legal entity. Crowe Horwath Corporate Finance Ltd and its affiliates are not responsible or liable for any acts or omissions of Crowe Horwath or any other member of Crowe Horwath and specifically disclaim any and all responsibility or liability for acts or omissions of Crowe Horwath or any other Crowe Horwath member. The information contained within this document was compiled by Crowe Horwath Corporate Finance Ltd (CHCF) based on materials from other sources and no warranty regarding the accuracy or completeness of the information is provided. All opinions, conclusions, forecasts or recommendations are reasonably held at the time of compilation but are subject to change without notice by CHCF. CHCF assume no obligation to update this document after it has been issued. Except for any liability which by law cannot be excluded, CHCF/WHK Group Limited, its Directors, employees and agents disclaim all liability (whether in negligence or otherwise) for any error, inaccuracy in, or omission from the information contained in this document or any loss or damage suffered by the recipient or any other person directly or indirectly through relying upon the information. This publication is intended to provide background information only and does not purport to make any recommendation upon which you may reasonably rely without taking further advice. This publication does not take into account any person s investment objectives, financial situation and particular needs. Should you consider the acquisition of a particular financial product as a result of the material contained, you should obtain a copy of and consider the Product Disclosure Statement (where applicable) for that product before making any decision. CHCF may receive a fee for advice and/or the implementation of an investment decision. CHCF and their representatives may have financial interests in some/any of the product(s) included within this report. Crowe Horwath Corporate Finance Ltd is the holder of an Australian Financial Services Licence No: , ABN a WHK Group firm. 4