Assistant Treasurer Bill Shorten's announcement on 4 March 4 2011 that the Federal Government will adopt two Board of Taxation recommendations to clarify the definition of 'distributable income' of trusts and allow streaming of capital gains and franked distributions was enthusiastically welcomed.
Yet, uncertainties remain for the 600,000 trusts in Australia. As a result, trust deed reviews are as vital as ever. Indeed, for many clients, the Assistant Treasurer's announcement gives a greater reason to review trust deeds than ever before.
Announcement and Consultation Paper
The Assistant Treasurer aims to achieve certainty for trusts in the near term, which is why the consultation paper makes it clear that the changes to the law are a 'stop gap' measure. They are really only tweaks to the existing rules before the real reform begins with a wholesale re-write of Division 6 of the 1936 Tax Act. In the coming years, this Division will be completely modernised and incorporated into the 1997 Tax Act.
The key propositions of the consultation paper are:
- Defining distributable income using tax concepts
- Defining distributable income using accounting concepts
- Defining distributable income to specifically include capital gains
- Allowing the streaming of capital gains and imputation credits
1. Defining distributable income using tax concepts
The consultation paper proposes to define 'distributable income' ('income of a trust estate') by aligning it with 'net income' (s 95 taxable income) adjusted for various amounts. Adjustments would be made 'to reflect the actual cash available for distribution' to beneficiaries. For example, when obtaining the taxable income of the trust it is established that amounts of income have been grossed up because of franked dividends received, these would need to be backed out. Similarly, if the trust received the small business tax break for depreciating assets purchased during the Global Financial Crisis (GFC), this would need to be reversed.
One key issue for consideration is what specific amounts will be included in the list of adjustment items under this proposal. If the list of items is too long, then this change will not meet its stated aim of aligning tax and trust income. If it is too short, there are likely to be occasions when the amount calculated as 'distributable income' will not reflect the amount of cash available for distribution. This is discussed further below.
2. Defining distributable income using accounting concepts
Under this proposal, distributable income is defined as equal to the trust's accounting profit as determined in accordance with Generally Accepted Accounting Principles (GAAP). If distributable income is defined in this way, there is still the possibility for significant mismatch between distributable income and taxable income. It could potentially entrench the unfairness and unintended outcomes within Division 6 that this change is intended to overcome.
3. Defining distributable income to specifically include capital gains
Defining distributable income to specifically include capital gains is a halfway house between both proposals. While it will alleviate some potential unfair outcomes – for instance, taxing income beneficiaries on distributions made to capital beneficiaries – it will continue to result in problematic outcomes.
4. Allowing the streaming of capital gains and imputation credits
For taxpayers utilising trusts, the proposal to allow the streaming of capital gains and imputation credits is welcome as it at least partially restores trustees to the position they were in before the High Court handed down the decision in the Bamford case.
With These Changes, Why is it Still Important to Review Your Trust Deed?
Although the Assistant Treasurer's announcement provides a measure of certainty, there are still compelling reasons to continue with your trust deed review:
- Streaming clauses: Now that streaming will be given the authority of legislation, it is important to review trust deeds with no streaming clauses or ineffective streaming clauses. If your trust deed falls into this category, it will be essential to incorporate appropriate streaming clauses to allow income to be distributed in the most tax effective way going forward.
- Expense clauses: Expense clauses give trustees guidance as to what sort of expenses can be set off against the various classes of income. Prior to the Bamford decision, TR 92/12 allowed trustees to reduce dividends by expenses. Provided $1 of franked dividends were distributed, the trustee could attach as many imputation credits as were available (provided the other rules were adhered to). If this position is restored to its pre- Bamford status, your trust deed will need appropriate expense clauses.
- Corpus: How flexible is your corpus clause? If, for example, your trust makes a $1 million capital gain and reduces this by prior year capital losses to $0, there are no expenses. In effect, 'distributable income' is $0 but there is $1 million to distribute to beneficiaries. If the Government adopts the proposition to define distributable income using tax concepts, it may be that the only way your trust can make distributions in the above scenario is by a distribution of corpus. Does your deed adequately define corpus to enable you to do this?
- Distribution minutes: Unfortunately, the consultation paper is silent on the effects the new definition of distributable income will have on distribution minutes. For example, if your trustee has $100 in income and pays a 'management fee' of $100 to a related company, while there is no cash left to distribute, the $100 fee is non-deductible, meaning there is $100 of 'distributable income'. If the distribution minutes indicate a distribution of $100 to Beneficiary A (to avoid an s 99A assessment), how do you stop Beneficiary A making a claim for the $100 in equity for the $100 outstanding?
- Other unpaid present entitlement Issues. If, as in the above scenario, there is $100 of 'distributable income' but no cash to pay the $100, the present entitlement to Beneficiary A is unpaid. If Beneficiary A happens to be a company, the trust is potentially within the ambit of Division 7A.
While the clarifications are welcome, uncertainties remain. On this basis, it is important to continue to have your trust deeds professionally reviewed to ensure they are flexible enough to adapt to the changes ahead.
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.