On 4 March 2011 the Government released a discussion paper which
forms the first part of its highly anticipated reform to the
taxation of trusts. The paper proposes legislative amendments to
achieve two specific objectives:
- to better align the concept of the 'income of the trust estate' (generally referred to as 'distributable income') with a trust's taxable income; and
- to confirm that trustees can stream capital gains and franked distributions (together with the attached franking credits) to particular beneficiaries.
Both areas have been the source of considerable angst for
taxpayers following the decision in Commissioner of Taxation v
Bamford  HCA 10 ("Bamford") and the
Commissioner's subsequent interpretation of that decision.
As the proposed amendments go to the heart of the taxation of
trusts they will have major implications for a very large number of
taxpayers. Privately held groups and the funds management industry
are likely to be particularly affected.
The proposed changes are to take effect from 1 July 2010 (the 2011 income year).
Whilst we commend the Government in trying to resolve these issues for the current income year, there is some scepticism as to what may be able to be achieved in the limited time available given the complexities of this area of the law.
Better aligning 'distributable income' with taxable income
Why have the proposals been put forward?
The term 'income of a trust estate' is of critical importance, as, broadly speaking, a trust must distribute all its 'income' to ensure that the trustee is not taxed on the taxable income of the trust at the top marginal tax rate (currently 46.5%). In Bamford the High Court held that the trust deed was relevant in determining the 'income' of a trust and that beneficiaries are assessed on the same proportionate share of the taxable income of the trust as the proportionate share of the income of the trust to which they are entitled. The Government was of the view that this could lead to unfair tax outcomes for taxpayers as well as opportunities for taxpayers to manipulate their tax liabilities. Hence, the Government is proposing to insert a clear definition of 'distributable income' in the Tax Act that will form the basis of determining where the tax liability falls for the taxable income of a trust.
We note that a fixed definition of distributable income will not provide the same flexibility as some trust deeds currently have in determining the distributable income of the trust. On the other hand, it may provide greater certainty for taxpayers. The proposals below each have their own shortfalls and we will be working with the Government to ensure that the definition decided upon achieves the best outcome for taxpayers.
One of the challenges is that the Government will need to ensure that taxpayers that have a definition of distributable income in their trust deed that is inconsistent with the proposed legislative definition are able to abide with the law without breaching their trust deed. Furthermore, concessions should be provided for taxpayers that are required to amend their trust deed to align with the legislative definition to ensure that no resettlement issues arise.
What has been proposed?
The Government has proposed three alternative definitions of distributable income as outlined below:
1. Define a trust's distributable income as its taxable income
This proposal has the advantage of including items such as capital gains in a trust's distributable income. Under the current law (subject to the terms of the applicable trust deed), where the trustee has capital gains but no other "income", the trustee will be taxed on the capital gain at the top marginal tax rate (as there is no income to which beneficiaries are presently entitled). Under the proposed definition of distributable income (under this alternative), the beneficiaries would be taxed on their share of the capital gain derived by the trust.
However, there are some draw backs with this definition. Firstly, taxable income does include 'notional income' (i.e. franking credits) which is not available for distribution (and hence is income that arguably no beneficiary can be presently entitled to). This will give rise to a situation whereby the trustee is taxed on this notional income (at the top marginal rate). Hence, the Government is considering whether notional income and expenses should be carved out of the definition of distributable income. In our view, this would be necessary if such a definition of distributable income is adopted.
Another potential issue which may arise is with respect to amended assessments that may be issued by the Commissioner. Where an amended assessment is issued by the Commissioner to increase taxable income, it is likely that the Trustee will be assessed on this increase in taxable income (at the top marginal rate).
2. Define a trust's distributable income as its accounting income
With the exception of trusts that have flexible Trust Deeds that provide an alternative definition of distributable income, for many trusts the current definition of distributable income refers to generally accepted accounting principles.
It is somewhat strange that the Government has included this definition as an option given that it is the discrepancy between accounting income and taxable income that has given rise to the complexities that this reform is trying to resolve.
This approach will clearly not achieve the specified objective of better aligning a trust's distributable income with its taxable income. It may also suffer from the disadvantage that the distributable income amount will be somewhat at the mercy of accounting standards, such that unrealised gains and losses put through the income statement could materially impact what is required to be distributed to ensure no assessment falls on the trustee (in the case of a positive accounting result) or (in the case of a negative result) force the position that the assessment for the year's taxable income falls on the trustee.
3. Define a trust's distributable income to include capital gains
Under this proposal, the terms of the trust deed would continue to be relevant in determining 'distributable income'. However capital gains would also be specifically included in the definition of distributable income. This would allow trustees to retain some flexibility in determining distributable income as the terms of the trust deed will continue to be relevant.
However the Government believes that a specific anti-avoidance provision would be necessary under this option to prevent beneficiaries manipulating their tax liability. This is one of the Government's concerns with the implications of the Bamford decision. Such anti avoidance measures are likely to reduce the attractiveness of this alternative.
Streaming capital gains and franked distributions
Why have the proposals been put forward?
Prior to Bamford many taxpayers used trust structures to stream certain classes of income to particular beneficiaries. However, the Commissioner considers that such streaming is inconsistent with the proportionate approach to trust taxation which was endorsed by the High Court in Bamford. Following that decision, the Commissioner withdrew Law Administration Practice Statement PS LA 2005/1(GA) which had allowed trustees of trusts to stream capital gains in applicable circumstances. Unfortunately, recent court decisions such as Colonial First State Investments Ltd v Commissioner of Taxation  FCA 16 and Thomas Nominees Pty Ltd v Thomas  QSC 417 have failed to conclusively resolve this issue.
What has been proposed?
The discussion paper states that the Government will amend the current law to ensure that, trust deed permitting, trusts will be able to stream both capital gains and franked distributions to particular beneficiaries. This is a welcome development, as it confirms the correctness of a longstanding practice adopted by many taxpayers.
However, the discussion paper contains very few details of how this will be achieved. A few straightforward examples are provided but it remains unclear how the proposals will apply to more complex situations. For example, it is unclear if trustees will be able to stream certain classes of capital gains (e.g. discountable gains) to particular beneficiaries. While this would presumably be permitted, it is not explicitly dealt with in the discussion paper.
Submissions on the consultation paper are due by 18 March 2011. Moore Stephens will be engaged in the submission process and recommend that affected taxpayers do the same, or to provide us with comments, given the far reaching impact of these proposals. Please contact your Moore Stephens Relationship Partner for further details.
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