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 [2010] 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 [2011] FCA 16 and Thomas Nominees Pty Ltd v Thomas [2010]
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.
Recommended action
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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