Australia: ATO Decision Impact of High Court Carter decision – Disclaiming an interest in a discretionary trust must be done before 30 June

The High Court case of Commissioner of Taxation v Carter [2022] HCA 10 confirmed that the right to trust income is decided by the Trustee on or before 30 June of any year and any retrospective disclaiming is of no effect in respect of income taxation liability. It is noted that this is the effect of the construction of section 97 of the Income Taxation Act 1936 that deals with trust income.

The provision set out the entitlement to income and with entitlement comes the taxation liability. This is regardless of the receipt of the income by the beneficiary, although at law the beneficiary should be able to legally recover the amount. Practical issues concerning recovery of a beneficiary entitlement from the trustee may mean this becomes an unhappy situation for the beneficiary where the process of taking action itself or the recovery of money becomes problematical. The tax debt will be real and recoverable by the Commissioner against the beneficiary regardless of the beneficiary being able to access the money.

Generally the beneficiary of a trust is connected by family to the trustee and will be aware of the decision of the trustee and their entitlement. A problem will however arise if the trustee does not advise the beneficiary. This may happen inadvertently or during family disputes.

If you believe there is a significant risk of receiving an entitlement, but not likely to receive the entitlement, being reasonably able to access the money upon request or sure that the taxation liability is to be paid, you may wish to consider disclaiming an interest in the trust.

Further, if you believe that you are a beneficiary who has not been paid their entitlement then you may consider taking legal action for recovery against the Trustee. This will especially be the case when the beneficiary first becomes aware of the beneficiary entitlement but is unhappy with the explanation of the Trustee as to how the taxation liability is proposed to be or is being attended to. If the taxation liability arises and remains unpaid against the beneficiaries expectations, the beneficiary will be personally liable and must take action against the Trustee.

The position does differ from the position of disclaimer for inherited interests in wills for capital gains tax whereby the right can be disclaimed when a beneficiary first becomes aware of the right. An effective disclaimer must be intentional and show unequivocally that the nominated life or remainder owner rejects their interest. The right to disclaim is lost if that person has engaged in positive conduct indicating an acceptance of their interest. The right may also be lost if it is not exercised within a reasonable time, in that someone who remains silent beyond the time when they may be expected to disclaim the interest may be presumed to have accepted it. If a life or remainder owner effectively disclaims their interest, they are retrospectively disentitled to it.. Further the beneficiaries may even change their entitlements to the will prior to the administration being complete – see TR 2006/14 .

Summary

The High Court held that disclaimers of the right to trust income did not operate retrospectively so as to disapply s 97(1) of the ITAA 1936.

While the majority did acknowledge that unfairness can arise where a beneficiary is not aware of its entitlement to trust income, their Honours noted that this is a function of the operation of Division 6 and the fact that subsection 97(1) is drafted to tax a beneficiary by reference to present entitlement not receipt. The High Court noted that this is similar to the apparent unfairness identified in Bamford, the High Court in that case recognising that this arises because subsection 97(1) taxes a beneficiary on a share of the trust's net income, not the distributable income to which they are entitled, and does so regardless of whether distributable income is received.

The ATO view of the decision is set out in their Decision Impact Statement .

The High Court decision settles an important practical question as to how trust income is to be brought to tax when relevant trust entitlements are disclaimed in a legally effective manner sometime after financial year end.

It tells us that such disclaimers do not disturb what would otherwise be the tax result. Beneficiaries who have an interest in, or entitlement to, trust income should now take this into account if they were otherwise considering not accepting that interest or entitlement and instead looking to disclaim it.

Background

In the 2014 income year, the trustee of the Whitby Trust failed to appoint or accumulate the income of the trust. As a result, one-fifth of the income of the trust was distributed to each of the 5 primary beneficiaries (the "respondents') pursuant to a default distribution clause (cl 3.7) in the trust deed. The combined operation of the relevant clauses of the trust deed was that "immediately prior to the end of the last day" of the 2014 income year, one-fifth of the income of the Whitby Trust was held on trust for each of the respondents.

In October 2015, the ATO issued amended assessments for the 2014 income year, assessing each respondent on one-fifth of the Whitby Trust's income on the basis that they were "presently entitled" to that income within the meaning of s 97(1) of the ITAA 1936.

After an unsuccessful attempt (In November 2015) to disclaim the default distributions, the respondents executed further disclaimers ("the Third Disclaimers") in September 2016. These disclaimers disclaimed any and all right title and interest conferred by the trust deed to any income and, without limiting the generality of that disclaimer, any and all right title and interest conferred by cl 3.7.

The respondents objected to the amended assessments. One of their contentions was that, by virtue of the Third Disclaimers, they had each validly disclaimed the default distribution.

In The Trustee for the Whitby Trust and FCT [2019] AATA 5637, the AAT decided that the Third Disclaimers were ineffective. However, in Carter v FCT [2020] FCAFC 150, the Full Court of the Federal Court allowed the respondents' appeal, finding that the Third Disclaimers operated retrospectively so as to disapply s 97(1) in respect of the 2014 income year. The sole issue for the High Court was whether the Full Federal Court had erred in coming to that conclusion.

Decision

The High Court unanimously allowed the ATO's appeal, finding that the Third Disclaimers did not operate retrospectively so as to disapply s 97(1).

This followed from the High Court's finding that a beneficiary's present entitlement under s 97(1) – the present legal right to demand and receive payment of a share of the income of a trust estate – is to be determined immediately prior to the end of a year of income by reference to the legal relationships then in existence. In reaching this conclusion, the Court rejected the respondents' contention that events after the end of the income year, which may affect or alter those legal relationships, may be considered in determining a beneficiary's present entitlement.

The Court reached this conclusion by analysing the words of s 97(1).

The phrase "is presently entitled to a share of the income of the trust estate" in s 97(1) is expressed in the present tense. "It is directed to the position existing immediately before the end of the income year for the stated purpose of identifying the beneficiaries who are to be assessed with the income of the trust – namely, those beneficiaries of the trust who, as well as having an interest in the income of the trust which is vested both in interest and in possession, have a present legal right to demand and receive payment of the income."

The criterion for liability looks to the right to receive an amount of distributable income, not the receipt. That position is expressly reinforced in s 95A(1) which makes clear that a present entitlement of a beneficiary under s 97(1) does not depend upon receipt of the income.

The fact that s 97(1) is directed to identifying the legal right of the beneficiary immediately prior to the end of the year of income is important. The "taxation liability of the beneficiaries is determined by ascertaining the proportion of the distributable income of the trust estate to which each beneficiary is presently entitled just prior to midnight at the end of the year of income and then applying that proportion to the 'net income of the trust estate".

The other relevant criteria in s 97(1) – that a beneficiary is not under any legal disability and is a resident – reinforce the conclusion that a beneficiary's present entitlement is determined immediately before the end of the income year.

The Court added that if the respondents' contention – that the question of present entitlement may be resolved after the end of the income year (and in some cases, such as the present, more than one year later) – was accepted, that would lead to uncertainties for the ATO, trustees, beneficiaries and perhaps even settlors, which would "not be fair, convenient or efficient".

Presumption of assent

The Court also rejected the respondents' contention that they were not presently entitled to the income within the meaning of s 97(1) because the presumption of assent – that the donee (the beneficiary) assents to a gift – is an evidentiary presumption or inference that may be rebutted and that the Third Disclaimers were evidence of the rebuttal.

The Court said that the presumption of assent is a presumption of law and Div 6 of Pt III of the ITAA 1936 (the main provisions assessing trust income), in particular the criterion of "is presently entitled" in s 97(1), "is consistent with, and operates on, the presumption of law of assent". On the facts in this case, that presumption applied immediately before the end of the 2014 income year to the operation at law of cl 3.7 (the default distribution clause) of the trust deed.

Edelman J went further on this issue and said that the parties in this case had wrongly assumed that the creation or increase in value of equitable rights is incomplete until affirmed by the beneficiary. "Since it is now recognised that title [to property] can pass without assent of the donee, the 'presumption' of implied assent is a fiction without any purpose at common law. There would be no basis to extend the 'presumption' to equity, even if an analogy between common law and equitable rights could be drawn."

Pointon Partners has expertise in aiding clients in discussions with the ATO or in dispute with the ATO.

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.