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Debt Forgiveness and Unpaid Present Entitlements (UPEs) in Family Trust Estate Planning

Forgiveness of Debt vis-a-vis an Unpaid Present Entitlement (UPE) from a Family Trust owing to a Will-Maker.

This article specifically relates to ‘unpaid present entitlements’ (from family/discretionary trusts) and how they are dealt with in relation to relevant, contemporary estate planning and, particularly, associated Will-drafting > subsequent estate administration. In this we broadly cover the current legal positions in relation to in the context of Will-drafting as well as then the relevant application of such for the executor’s relevant duties and obligations regarding the deceased’s estate, and particularly the beneficiaries of that estate as well as of course the relevant affected family/discretionary trust in relation to:
  1. forgiveness of debt rules,
  2. unpaid present entitlements (“UPEs”),including their particular legal nature and available treatments,
  3. as well as the status quo position where a Will is silent on forgiveness of debts/rights etc. (of whatever species, including UPEs).

1. Some Background Legalities

  1. Under the s.6 of the Wills Act 1970 (WA), a testator (will-maker) can dispose of “… all his property (whether acquired before or after making his Will) to which at the time of his death he is entitled either at law or in equity.” Since that Act’s definition of property explicitly includes “any thing or chose in action,” choses in action can form part of a bequest (a gift under a Will)*.
  2. Pursuant to s.20 of the Property Law Act 1969 (WA), there is a clear statutory/legal distinction between a debt and a ‘chose in action’ – both of which can be assigned as ‘personal property’ pursuant to that Act too.
  3. As a general confirmation at law, (family/discretionary) trust beneficiaries (as opposed to estate beneficiaries) will usually only have a ‘mere expectancy’ as to the Trust Fund; such is the fundamental nature of a discretionary trust where the trustee ultimately has a discretionary power to distribute to a range of eligible beneficiaries of the Trust Fund, or not.
    1. In this sea of semantics, there is some antiquated (and potentially misleading or redundant) word usage. For example, the Latin word “corpus” (Lit. ‘body’) is often used to describe a Trust Fund or trust assets but specifically stated as such in the relevant Trust deed. We suggest modern English usage be preferred for its conciseness and accuracy.
  4.  “Debts” are (generally) monies owed or owing. Contrasted with “loans”, which are obligations to repay money.
    1. In a forgiveness of debt scenario, a debt is forgiven where the creditor forgives the debt; and
    2. a loan is forgiven where a lender forgives the borrower.

2. Unpaid Present Entitlements (UPEs)

  1. UPEs, borne out of tax artificiality, exist where the trustee of a (family/discretionary) trust, based on accounting/tax advice, has a choice to either:
    1. distribute the relevant (‘net’) income of the trust to beneficiaries; or
    2. ‘accumulate’ the income into the trust, (i.e. keep the income in the trust).
      1. Generally, trustee will want to distribute all of the income to beneficiaries (rather than accumulate the income in the trust) to avoid paying tax on undistributed income at the top marginal rate of tax of 47%.
      2. However, the trustee may need some of this income to fund the trust’s ongoing activities. This creates a fissure between the trustee having to distribute all of the income to keep the tax burden down but needing to keep some cash representing that income for working capital purposes.
      3. The (tax permissible) solution is an “unpaid present entitlement”, which arises when the trustee makes a (deemed) distribution of income to a beneficiary, but holds on to the cash of that distribution. The distribution is therefore left ‘unpaid’, but to make the distribution effective for tax purposes, the beneficiary becomes ‘presently entitled’ to the ‘unpaid’ distribution.
        1. This means that the beneficiary has the legal right to require the trustee to pay them the cash when the beneficiary asks for it (i.e. it is “on call”) and to achieve this outcome the trustee must pass a resolution before the end of the relevant financial year to irrevocably distribute the income to the beneficiary.
        2. UPEs are shown in trust accounts as specific dollar($) value amounts, and are often also referred to as “beneficiary loans”. As noted below, this is a misnomer as UPEs are not loans.
  2. Therefore, in the case of a UPE, instead of a mere expectancy, a discretionary (family) trust beneficiary is fully entitled to receive the UPE amount following the passing of the trustee’s resolution confirming the UPE. All the beneficiary needs do is call-in the debt.
  3. As an aside, though still pertinent, we note the etymology of “unpaid present entitlement” in Australia is somewhat murky.
    1. While usage of “present entitlement” gained traction in Australian trust law cases earlier last century^, and the phrase was included in the Income Tax Assessment Act 1936^^, the expounded phrase “unpaid present entitlement” does not (or does not appear to) properly appear in common usage until around 2009-2010,
      1. where it starts to crop up in Australian tax-circle commentaries; and
      2. ATO publications, where in the atter case the concept can be found in Taxation Ruling TR 2010/3, issued June 2010, following a draft published in late 2009^^^.^see, for example, FCT v Whiting (1943) 68 CLR 199 where the Court held that a beneficiary of a deceased estate cannot be presently entitled to the income of the estate until the estate has been fully administered. ^^see, for example, Section 95A of the Income Tax Assessment Act 1936, which is entitled, “Special provisions relating to present entitlement”. ^^^Paragraph 33 of TR 2010/3 states: “A beneficiary can become presently entitled to an amount from a trust pursuant to a direct term of the relevant trust deed, or as a result of the trustee of the trust exercising a power under the trust deed to make the beneficiary so entitled (usually by resolution). In situations where the funds to which the beneficiary is made presently entitled continue to be held on trust for that beneficiary until such time as the beneficiary calls for payment, the entitlement is commonly referred to as an ‘unpaid present entitlement’ (UPE).” [emphasis added]. This is the first official (ATO) published use of the phrase we have been able to locate.

3. Forgiveness of Debt vs Forgiveness of Rights

  1. For UPEs, relevant forgiveness of debt provisions apply to individuals when they are beneficiaries of relevant (family/discretionary) trusts. Only individuals can make Wills and/or exhibit “natural love and affection”.
  2. It is also always highly recommended that relevant ‘debt forgiveness’ provisions are not included in a Will without obtaining the specific advice of the Will-makers’ accountant.
    1. Forgiveness of debt can create tax adverse events unless the exceptions listed in s.245.40 of the Income Tax Assessment Act 1997 applies.In the present case, the taxing requirements do not apply if “the forgiveness is effected by Will” (s245.40(d)).
    2. Conversely, the (mere) ‘forgiveness of rights’ (whether legal or equitable), per se, will not enable those same ‘forgiveness’ tax benefits, if there is a debt also associated with such rights.
    3. Hence why it needs to be expressly stated in a will-makers’ Will as a “forgiveness of debt or monies owed”, if that UPEs debt is to be truly cleared from the trust’s accounts.
  3. In the absence of any forgiveness of debt clause in a Will, a UPE will be:
    1. treated as ‘personal property’.
      1. Examples include bequeathing a debt owed to the testator, a right to sue, or contractual entitlements like insurance proceeds or superannuation rights (subject to nomination rules).
        1. there are no general prohibitions, but practical considerations apply: some choses in action may expire on death (e.g., purely personal rights like defamation claims), while others survive and devolve to executors or beneficiaries.
      2.  *Assignment via Will is effective, and executors can enforce them.
        1. In family provision (‘inheritance dependents’) claims under the Family Provision Act 1972 (WA), choses in action in the estate may be considered for redistribution; and
      3.  payable to the deceased trust beneficiary’s estate upon their passing, and then payable to the nominated estate beneficiaries.
  4. Further, and while not often done, the executor of the estate should affirm this arrangement by formally calling-in the UPE debt from the trustee as part of their estate administration duties. In fact, it is a fundamental duty of an executor to call-in all the real and personal assets of the deceased (s.8 and 10 of the Administration Act 1903 (WA)).
  5. Also any UPEs or beneficiary loan accounts cannot be merely, unilaterally, ‘journalled away’ in the trust’s accounts/financial statements – Manzi v Smith [1975] HCA 35,  McCarthy v Saltwood Pty Ltd [2020] TASSC 19, etc.
  6. However any such calling-in of the UPE (and necessarily, actually receiving such specific ‘monie$ owed’ as a debt) has the potential to cause a liquidity event, which could adversely affect a trust’s cash flow or capital position (e.g. the relevant family trust only has one singular asset, say an investment property, and therefore the trustee being required to liquidate that property to pay that UPE to that beneficiary) or worse.
    1. So, the trust and Will-makers’ accountant should always be consulted during the estate planning process.
      1. In some cases, the deceased’s estate doesn’t require any additional assets/money, as there are already sufficient personal assets/wealth to extinguish any debts and provide for their beneficiaries.
      2. Another consideration is that, from an asset protection point of view, it might be preferable to keep the value of the UPE out of the Estate particularly if a Family Provision Claim is likely by a disgruntled beneficiary.
  7. The High Court case, Fischer v Nemeske [2016] HCA 11 addressed the nature of payments to beneficiaries and while it did not definitely address whether such payments were loans (although this was later addressed in Bendel, that they were not, much to the chagrin of the ATO) it did confirm that UPEs were equitable rights, although the common law debt position was unclear.
    1. Notably however in Fischer, French CJ, Bell J and Gageler J all upheld the principle that, once a trustee distributes trust property to a beneficiary by admitting it owes a debt to the beneficiary (e.g. pre-30 June trustee distribution minutes) the amount of the money can be recovered by the beneficiary in an action against the Trustee ‘for money had and received’.
      1. What is clear is that a UPE can only exist if the relevant trustee passes the necessary pre-30 June resolution.
      2. Importantly, the decision as to whether to pay that UPE (in form of money owing, i.e. debt rather than rights, say for example, entitlements) to a beneficiary:
        1. has nothing to do with the trustee (hence why wording about ‘UPE payments’ or similar are not included a Trust Deed); and
        2. everything to do with the trust beneficiary (or their executor if such UPE is not forgiven) who has the unilateral ability/right to call on the trustee to pay the UPE (then as an enforceable debt i.e. monies owed).

4. Specific Provisions in a relevant Will

  1. We then turn to the appropriate language to use in a relevant Will and it would appear,
    1. given the present case law uncertainties (Bendel is presently being appealed re: ‘loans’ et al),
    2. the seemingly deliberate obfuscation by tax experts and ATO/government as to the nature of such,
    3. plus the ever-present conflict in reaching a common understanding between the worlds of the ATO, tax lawyers, commercial/estate (non-tax) lawyers and the accounting profession,the most logical approach to crafting a forgiveness of debt provision in a Will is to use the widest wording possible to ensure all forms of debt, rights (including equitable rights), entitlements (UPEs and otherwise), loans and any other monies owing are caught within a wide net.
  2. We therefore such relevant ‘Forgiveness’ will-wording may include:“If at the date of my death there are any monies owing to me by any one or more:
    1. of my children or grandchildren, or
    2. trusts I am a beneficiary of (including but not limited to unpaid present entitlements from discretionary or family trusts),then I absolutely forgive and release those relevant persons or trustees from the applicable payment or repayment of the balance of any such debts, rights (including but not limited to legal and equitable rights), loans, entitlements (including but not limited to unpaid present entitlements) or other monies owing, as well as any interest then owing on such.”
  3. When there is no forgiveness of debt provision expressly included in a Will, iy is also important to ensure that the executor calls-in any UPEs as well as all other monies owing to the estate as part of their proper estate administration functions.
  4. Accordingly, if is the specific intention of the will-maker (as beneficiary) of the family trust, in consultation with the accountant, that
    1. they genuinely actually wish to forgive their UPE ; and
    2. therefore, ostensibly, ‘financially re-engorge’ the relevant (family/discretionary trust), i.e. by it never having to actually pay those UPE’s ‘monies owed’ to then-deceased will-maker’s estate/nominated beneficiary of such ‘(personal will) property’,
    3. then it remains our legal advice that such needs to be:
      1. at least expressly forgiven as a debt, and
      2. also then the accountant for the estate as well as the trust should also reciprocally address:
        1. the relevant commercial forgiveness of debt treatments flowing from section s.245.40 of the Income Tax Assessment Act 1997,
        2. together with any relevant ratification between the executor and the trustee.

Disclaimer: This article is provided for general awareness and guidance only. It does not constitute legal advice and should not be relied upon as such. Specific legal advice requires a review of the relevant legal instruments and arrangements, and the application of the law to the particular facts, parties, and circumstances.

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