The question of whether a trustee can make an effective distribution of capital to beneficiaries from an asset revaluation reserve has been clarified by the decision of the High Court in Fischer v Nemeske Pty Ltd  HCA 11 (delivered on 6 April 2016).
- The only asset of the Nemes Family Trust consisted of shares in a company.
- In 1994 the trustee (Nemeske Pty Ltd) revalued those shares (to $3,904,300) and credited that amount to an asset revaluation reserve.
- Shortly after, the trustee resolved to make a distribution out of the asset revaluation reserve to Mr and Mrs Nemes (two of the Specified Beneficiaries of the trust).
- No amount was paid to Mr and Mrs Nemes. The amount of $3,904,300 was credited to them in the trust’s accounts and the trustee granted a charge over the shares in favour of Mr and Mrs Nemes securing the payment of the distribution amount.
- Mrs Nemes died in November 2010 and Mr Nemes passed away in September 2011.
- In Mr Nemes’ Will he effectively transferred control of the trust to ‘the Fischers’ and the residuary estate to other beneficiaries.
- The Fischers argued that the purported distribution of capital out of the revaluation reserve was ineffective and that the trust had no existing obligation to make any payment to the estate (with the consequence that the value of the residue was substantially diminished).
The High Court held (by a majority of three to two) that the resolutions to create a revaluation reserve and then make a distribution from that reserve were effective and that the trustee owed $3,904,300 to Mr Nemes’ estate.
However, the majority decision did not establish any general principle that interim distributions of capital from a trust revaluation reserve would always be effective.
Rather, the decision makes it clear that the efficacy of the distribution will be dependent on the terms of the trust deed and the resolution purporting to make the distribution.
Each of the judges delivered a separate judgment and these provide some guidelines for practitioners who are asked to advise on or implement interim capital distributions.
A trustee’s powers of distribution must be wide enough to allow the trustee to make a distribution from a revaluation reserve and create a binding obligation to pay the beneficiaries notwithstanding that no money or other property is actually distributed or set aside for the benefit of the beneficiaries.
A significant factor in the decisions of some of the majority was that the trust deed in this case gave the trustee a power to ‘advance’ capital to beneficiaries.
French CJ (one of the majority) noted that there is a distinction between ‘pay’ or ‘supply’ and ‘advancement’ and made the following comments.
- There is no principle that an advance of capital from a trust can only be effected by the removal of property from the trust.
- The creation of a debt to be satisfied out of the trust property is a means of effecting an advance and application of the capital.
- The entry of an amount owing to the beneficiaries in the accounts further demonstrated and gave effect to the advance.
The judgments also illustrate that it will be critical that any resolution purporting to make a capital distribution from a revaluation reserve is carefully drafted to ensure that the terms of the resolution are consistent with the powers of the trustee under the deed. In her dissenting judgment, Kiefel J appeared to accept that it may have been possible for the trustee to make an effective ‘advance’ of capital relying on the powers in the trust deed but said that:
Neither the terms of the Resolution nor the entries in the accounts reflect an application under a power of advancement of the property and the Shares representing the capital of the trust.
She also indicated that while:
It ‘may be accepted … that an effective exercise of (the power to make an interim distribution) does not depend upon there being cash in the trustee’s hands … . However, for a conclusion that capital was applied there should be a corresponding reduction in the capital of the trust’.
The most that can be said about the Resolution is that it sought to create the appearance of a distribution of something out of the Trust, but that something was not property. The Trustee cannot be taken by the Resolution to have intended to set aside, allocate or otherwise ‘apply’ trust property.
Similarly, Gordon J, in her dissenting judgment, said that:
Even if, contrary to the view formed, the asset revaluation reserve was capital or income of the trust Funds, the 1994 resolution was not an exercise of the power in Cl 4(b) of the Deed ‘to advance or raise any part or parts of the whole of the capital or income of the trust Funds and to pay or to apply’ that capital or income.
Implications for advisers
- You should read the trust deed to ensure it allows the trustee to revalue assets and make distributions from the resulting revaluation reserve.
- Ascertain whether the trustee has power to make a distribution that creates a binding obligation to pay the beneficiary (e.g. by debiting an amount against that revaluation reserve and crediting it to the beneficiary’s account) even if there is no specific property that is available to pay the distribution at the time of the resolution.
- If the trustee’s powers under the trust deed are not wide enough to allow it to make a distribution out of a revaluation reserve, it will generally be possible to amend the deed without triggering any tax or duty issues.
- The distribution resolution must be drafted so that it clearly identifies and is consistent with the provisions in the deed pursuant to which the resolution is being made.
- It will also be necessary to consider the potential application of the ‘CGT streaming’ provisions in subdivision 115C of the Income Tax Assessment Act 1997 (Cth) as the beneficiaries who receive the interim distribution may be ‘specifically entitled’ to (and therefore taxable on) the gain on the revalued asset when it is realised on sale (assuming they are still beneficiaries of the trust at the time).