Vested and Indefeasible Interest

The tax treatment of trust losses and franking credits in relation to Trusts depends on the existence of a "vested and indefeasible interest" in the capital and income of the Trust.

The meaning of the word "indefeasible" was briefly considered in the case of Colonial First State Investments Limited v Commissioner of Taxation [2011] FCA 16 (18 January, 2011).

The case is not relevant to the use of Insurance Trusts or the basis upon which the Clover Law Insurance Trust obtains a CGT exemption with respect to Insurance Proceeds.

"Vested and Indefeasible Interest"

The word "indefeasible" is generally used in the wider phrase "vested and indefeasible interest".

It is relevant to the interest of a Beneficiary in the capital or income of a Trust.

Normally, the issue is whether the interest of the Beneficiary is vested and indefeasible as against the Trustee.

The ATO explained its views with respect to the meaning of this wider phrase in ATO ID 2002/676.

Meaning of Word "Vested"

In ATO ID 2002/676, the ATO explained the word "vested" in the following terms:

"A person has a vested interest in something if the person has a present right relating to the thing.

"Stated simply, a vested interest is one that is bound to take effect in possession at some point in time.

"A vested interest is to be contrasted with a 'contingent' interest, which may never fall into possession.

"If an interest of a beneficiary in income or capital is the subject of a condition precedent, so that an event must occur before the interest becomes vested, the beneficiary does not have a vested interest to the income or capital since such an interest is instead 'contingent' upon the event occurring.

"Because vested interests include future interests, a person can have a vested interest in a thing even though the person's actual possession and enjoyment of the thing is delayed until some time in the future."

Meaning of Word "Indefeasible"

In the same Interpretative Decision, the ATO explained the word "indefeasible" in the following terms:

"A vested interest is indefeasible where, in effect, it is not able to be lost.

"A vested interest is defeasible where it is subject to a condition subsequent that may lead to the entitlement being divested.

"A condition subsequent is an event that could occur after the interest is vested that would result in the entitlement being defeated, for example, on the occurrence of an event or the exercise of a power.

"For example, where a beneficiary's vested interest is able to be taken away by the exercise of a power by the trustee or any other person, the interest will not be a fixed entitlement.

"Where the trustee exercises a power to accumulate income or capital of the trust in accordance with the trust deed, the accumulation does not result in a beneficiary's interest being taken away or defeased as long as the beneficiary nevertheless remains entitled at some future time to enjoy his or her share of the income or capital which has been accumulated.

"The members of the superannuation fund are not considered to have a vested and indefeasible interest in all of the income and capital of the fund as the trust deed provides for the following:

• A member may forfeit entitlement to benefits under the fund in certain conditions

• The trustee has a discretion with regard to the payment of forfeited entitlements.

• The trustee has discretion in applying excess funds after entitlements to members, former members or their dependants."

What Can Defeat the Beneficiary's Interest?

The ATO explanation defines the word "indefeasibility" in terms of the inability of the interest to be "lost", "divested" or "defeated".

Involuntary Defeat

There is a sense in which the interest must not be able to be terminated by:

a defined circumstance (e.g., an event specified in the Trust Deed); or
a person other than the Beneficiary itself (e.g., the Trustee).

In a sense, the "defeat" of the interest is involuntary on the part of the Beneficiary, rather than voluntary.

Something or somebody other than the Beneficary must not be able to defeat the interest.

If the Beneficiary's interest has ceased, then presumably the interest of the other Beneficiaries would be increased, so that collectively they held 100% of the interest in the Trust Assets.

It is arguable that this increase occurs by operation of law, rather than by formal assignment or transfer.

Regardless of the character of the termination, it is still possible that it would be a disposal for CGT purposes.

Voluntary Defeat

It is not clear how the termination of the Beneficiary's interest by the Beneficiary would be treated.

If the Beneficiary's interest ceased by its own action, then in the absence of the destruction of the Trust Asset, one or more other Beneficiaries of the Trust would acquire the Beneficiary's interest.

In effect, the Beneficiary would have assigned or transferred its interest to one or more of the other Beneficiaries.

There might be CGT implications with respect to such a disposal.

However, it does not mean that the Beneficiary's interest is defeasible.

If it did, then it is difficult to imagine any situation where a Beneficiary's interest was not defeasible.

It is submitted that, if the Beneficiary were to voluntarily "defeat" its own interest, it would not necessarily mean that the Beneficiary's interest was "defeasible".

It would simply mean that the Beneficiary had assigned or transferred its interest (assuming it was vested) to another Beneficiary or party.

In other words, it is submitted that the assignability or transferability of the interest by the voluntary action of the Beneficiary does not mean that the interest is "defeasible".

Colonial First State Investments Limited v Commissioner of Taxation

The decision of Stone J in Colonial First State Investments Limited v Commissioner of Taxation potentially casts some doubt on this proposition.

In this case, the Judge adopted a strict interpretation of the word "indefeasible".

She considered that, when applied to the word "interest", the word means that "the interest cannot be terminated, invalidated or annulled."

She did not discuss the meaning of any of these words, in particular the meaning of the word "termination".

In the case of the Unit Trust before her, she considered that the interest of the Beneficiary could be defeated, because section 601GC(1)(b) of the Corporations Act empowers members (i.e., Beneficaries) to modify, repeal or replace the Constitution of a Unit Trust by Special Resolution.

She quoted Barrett J in the ING Funds Management Case as follows:

"There is no kind of modification that cannot be made in exercise of the power and by the means it prescribes, although the power is no doubt subject to the implied limitations that generally attend any power enabling a majority to bind a minority."

As a result, she concluded:

"It follows that the members could vote to terminate the present right to a share of income and capital.

"Although in some circumstances such an exercise of power might be subject to the implied limitations to which his Honour refers, there it no reason to believe that this would always be so."

Absence of Discussion of Involuntary Nature of "Defeat"

It is notable that Stone J did not discuss whether the "defeat" of the interest had to be "involuntary" or against the will of the member or Beneficiary.

Existence of Power to Vary

It appeared to be sufficient that some members or Beneficiaries collectively had the requisite power to vary the Constitution or Trust Deed.

Method of Variation

It is not clear whether the method of variation was relevant to the Judge's decision.

The power to vary the Constitution or Trust Deed was exercisable by a Special Majority of the Members or Beneficaries.

This means that the resolution must be passed by at least 75% of the votes cast by members entitled to vote on the resolution.

Thus, subject to the comments about any implied limitations on the ability of a majority to bind a minority, it is possible that what matters is the ability of 75% of the members to defeat the interests of less than 25% of the members.

To this extent, the "defeat" (and therefore the "defeasibility" of the interest) would effectively be involuntary, assuming that the member or Beneficiary was in the minority.

Taking into Account the Beneficiary's Own Vote

It is arguable that, if the member or Beneficiary held 30% of the vote, their interest could not be overruled or defeated by a suffcient majority without their consent.

Thus, their interest might be "indefeasible" (unless they voted in the majority).

Similarly, if the variation had to be unanimous, each Beneficiary would effectively have a right of veto.

Thus, their interest could not be defeated without their consent.

Beneficiary Votes to "Defeat" Own Interest

If the member or Beneficiary voted for the variation, then it is arguable that they would effectively be agreeing to assign or transfer their interest to the other members or Beneficiaries (rather than defeating it).

However, it is difficult to infer the Court's views with respect to these arguments, in the absence of more detailed analysis of the issue by the Judge.

As a result, the case effectively raises more questions than it answers.

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