Australia: Taxation of Trusts – the Promise of Greater Clarity?


In recent times the taxation of trusts has been subject to a degree of uncertainty in the wake of court decisions such as Bamford v Commissioner of Taxation and the Colonial First State Investments Ltd case (see our legal update – Colonial First State Investments case: do you need to check your trust deed?)

It is timely that the Government this month has released a Discussion Paper on "Improving the taxation of trust income". The two key areas in which the Government proposes to amend the law relate to:

  • Seeking to better align the concept of "income of the trust estate" with the tax concept of "net income of the trust estate".
  • Ensuring that capital gains and franked distributions can be streamed to particular beneficiaries.

The Discussion Paper reviews different approaches that could be employed to achieve these results, the broad effect of which should be to better align the liability for tax on trust profits with the receipt of the benefit of the profit.

An ambitious timetable is proposed for implementation of the changes - which are intended to apply from the 2010-11 income year.

Aligning the concepts of distributable income and taxable income

Broadly, Bamford's case decided that:

  • A beneficiary of a trust is liable for tax on the proportion of the trust's taxable income which is the proportion of the "income of the trust estate" to which that beneficiary is presently entitled.
  • "Income of the trust estate" refers to distributable income determined according to trust law, which can be influenced by the terms of the trust deed.

As trust law distributable income and taxable income of a trust may differ, a consequence of Bamford is that beneficiaries may be taxed on amounts to which they are not actually entitled. It may also be possible for tax liabilities to be manipulated.

The Discussion Paper refers to 3 ways that may be employed to address the mismatch between the trust law concept of distributable income and taxable income, by providing alternative ways to define "distributable income". 

1. Defining distributable income using tax concepts

Under this approach, distributable income would be defined to equate to the taxable income of the trust.

This approach builds on an existing method used in some trust deeds with income equalisation clauses that equate the trust's distributable income with its taxable income. This option has benefits in that it will reduce the scope for beneficiaries to be subject to tax on amounts to which they are not entitled under trust law, and may avoid the trustee being assessed for tax where the trust makes a capital gain but has no other income.

The "distributable income" would, however, require adjustments to take account of the fact that taxable income can include notional income and expense amounts which are not reflected in the amount actually available for distribution to beneficiaries. Examples referred to in the Discussion Paper are amounts such as franking credits and the discount amount of a net capital gain.

This approach appears to be that preferred by Treasury.

2. Defining distributable income using accounting concepts

Under this approach, distributable income would be defined as the amount of a trust's accounting profits (determined under GAAP) for the year of income. While benefits were also seen with this option, it was thought that it could also result in increased complexity and compliance costs because GAAP is not applied by all trustees. In addition, because the approach is based on accounting principles, the risk of mismatches between distributable income and taxable income remained.

3. Defining distributable income to specifically include capital gains

Under this approach, the trust deed would continue to be determinative of what constitutes distributable income for tax purposes, except that distributable income would include any capital gains made by the trust regardless of whether the trust deed so provided.

While there were benefits seen in this option, such as less extensive legislative amendments being required, one negative aspect was the possible need for a specific anti-avoidance provision to ensure that the tax liabilities of beneficiaries of the trust could not be manipulated such that the entitlements of beneficiaries under the trust deed differed significantly from the amount of taxable income of the trust to which they were assessed.

Streaming of franked distributions and net capital gains

A welcome aspect of the Discussion Paper is the proposal that the Government will introduce amendments to ensure that franked distributions and capital gains can be streamed through a trust.

These amendments have the purpose of alleviating some uncertainty arising from the Bamford case and its endorsement of the "proportionate" approach in determining the share of a trust's taxable income on which a beneficiary is assessed. One interpretation of that approach would be that a beneficiary is to be assessed on a proportionate share of all categories of taxable income regardless of how the beneficiary's entitlements are expressed in the trust deed, hence limiting the ability to stream franked distributions and capital gains through a trust. Accordingly, it is proposed that amendments be made to the tax legislation to correct this situation.

It is hoped that legislative amendments in this regard not be limited to the streaming of franked distributions and capital gains but apply to any income derived by a trust – on the basis that the character of the income should remain the same as it flows through a trust to the beneficiaries.

The future

While the need to implement the reforms quickly is a laudable objective, there is also concern that:

  • The aggressive timetable for these changes may prove challenging for trustees considering distributions and their tax consequences for the current tax year, particularly if amendments to trust deeds are required to benefit from the reforms. There may also be difficulties if required amendments could cause a resettlement of the trust and it is hoped that any legislative amendments seek to address that issue. Stamp duty issues that could possibly arise from such amendments would also need to be considered.
  • Key uncertainties and issues in trust taxation, such as when a beneficiary is "presently entitled" to trust income, and what are the requirements for a "fixed trust" through which franking credits may be passed, are not addressed.

The Discussion Paper recognises that the measures proposed are merely of an interim nature, designed to address areas where certainty is most needed. The Assistant Treasurer has indicated that a separate discussion paper will be released in coming months in relation to a broader review to improve the taxation of trusts.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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