Government releases Discussion Paper in response to Bamford's case

The Assistant Treasurer has released a Discussion Paper in response to uncertainties concerning the taxation of trust income as a result of the decision in Commissioner of Taxation v Bamford [2010] HCA 10 (Bamford's case). In particular, the Government intends to introduce new legislation:

• to better align the concepts of 'distributable income' and 'taxable income'; and
• to provide certainty in relation to streaming of franked distributions and net capital gains.

This article discusses that Paper. It includes a link to an article on the position in light of Bamford's case for those trusts with a Cleardocs deed. Basically, those trusts are allowed the flexibility which the High Court has confirmed is valid.

Robert Green

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Background: The decision in Bamford's case

As we have reported in a previous edition of Clearlaw, the decision in Bamford's case is authority for the view that:

• the income of the trust is whatever the trust deed determines it to be. So trustee(s) and their advisors need to be aware of which definition (if any) the trust deed contains, and whether the trustee has the power to adopt a different definition in respect of a particular year of income; and
• if the beneficiaries of the relevant trust are made presently entitled to a 100% share of the "income" of the trust, then they will be required to include in their assessable income, 100% of their share of the taxable income of the trust.[1] This is known as the 'proportional approach'.

The Discussion Paper proceeds on the basis that, despite the certainty provided by Bamford's case about what is income of the trust, there is still uncertainty for all trusts. This is because the flexibility in trust deeds which the High Court found was valid (and the certainty that created) has other flow-on effects in how tax law applies depending on how the flexibility is exercised.

You can click:

• here for the position for Discretionary trusts with a Cleardocs deed; and
• here for a discussion of the ATO response to Bamford's case on Discretionary Trusts.

The Paper is discussed below.

Discussion Paper March 2011: Improving the taxation of trust income

The Discussion Paper outlines the Government's proposed responses to the uncertainty created by Bamford's case.[2]

The Discussion Paper states that the proposed changes are intended to be only an interim measure to create certainty. Ultimately to resolve all current issues, the Government intends to re-draft Division 6 of Part III of the Income Tax Assessment Act 1936 (ITAA36) and re-write these provisions into the Income Tax Assessment Act 1997 (ITAA97).

Following advice received from the Board of Taxation, the Government proposes to introduce new legislation:

• to better align the key concept of 'income of the trust estate' (which has been interpreted to mean 'distributable income') with the tax law concept of 'net income of the trust estate' (that is, taxable income), so as to reduce anomalous outcomes and opportunities to manipulate tax liabilities; and
• to ensure that capital gains and franked distributions (including the franking credits attached to distributions) can be streamed to particular beneficiaries.[3]

Differences between Distributable income and Taxable income

The primary issue after the case is that the definition of 'distributable income' (from general trusts law and the trust's deed) is often inconsistent with the definition of 'taxable income' (from tax law) in Division 6 of the ITAA36. The two primary implications of this inconsistency, which the Government wants to address, are:

• it can result in unfair outcomes &mdash for example, beneficiaries being taxed on amounts to which they are not 'presently entitled' (basically, amounts they don't receive); and
• it can be used to manipulate tax liabilities.

Current approaches to the problem

The Discussion Papers outlines the effectiveness of the current approaches to this issue &mdash for example, including in the trust deed:

• an income equalisation clause: which is an attempt to equate the trust's distributable income with its taxable income; or
• a re-classification clause: which allows the trustee to re-classify distributable amounts as either income or capital so that distributable income will be more closely aligned with taxable income.

However, the Discussion Paper demonstrates that neither of these approaches is perfect &mdash for example:

• even with an income equalisation clause, there remains uncertainty regarding amounts that are not strictly income, such as franking credits; and
• even with a reclassification clause, there remains a possibility to manipulate tax liabilities of the beneficiaries..

Possible approaches

Accordingly, the Discussion Paper discusses three possible approaches to better align distributable income and taxable income. The various approaches and the related advantages and disadvantages are discussed in this table[4]:

ATO's three possible approaches: the advantages and disadvantages

Approach	Advantages	Disadvantages
Define distributable income using tax concepts. That is, equate distributable income to 'net income of the estate' (taxable income)	will reduce the scope for beneficiaries to be subject to tax on amounts to which they are not entitled; may avoid a trustee assessment if the trust makes a capital gain for an income year but has no other income; and builds on an existing concept, which would assist tax professionals and taxpayers to better adjust to this approach.	as this approach relies on adjusting the taxable income of the trust to calculate distributable income, it may result in increased complexity and compliance costs; may also require further legislative amendments to ensure exempt and non-assessable non-exempt income is allocated appropriately among beneficiaries; and if the trust deed does not permit the trustee to distribute all distributable income, an amount of taxable income may be assessed to the trustee.
Define distributable income using accounting concepts (by generally accepted accounting principles)	may reduce the scope for beneficiaries to be subject to tax on amounts they are not entitled to under trust law; builds on existing concepts familiar to many tax professionals; and incorporates relevant expenses, meaning the defined concept of distributable income would reflect income that is available for distribution.	may result in increased complexity and compliance costs because not all trustees currently apply generally accepted accounting principles; and risk that because this approach is based on accounting principles, there may still be significant anomalies between distributable income and taxable income.
Define distributable income to specifically include capital gains	will reduce the scope for beneficiaries to experience unfair outcomes due to the proportionate approach affirmed in Bamford's case; avoids the complexity associated with adjusting the taxable income of the trust by notional income and expenses, and reflects instead the actual amount that a trustee can legally distribute to beneficiaries of a trust; and will require less extensive legislative amendments.	this approach may not fully reflect the actual amount that a trustee can legally distribute to beneficiaries; it will not address unfair tax outcomes that arise for reasons other than capital gains; and will require specific anti-avoidance provisions, which is not ideal.

Enabling the streaming of franked distributions and net capital gains

The Discussion Paper also considers the proportionate approach approved by the High Court in Bamford's case and the provisions about how certain distributions can be characterised &mdash in particular:

• Subdivision 207-B of the ITAA97 - which deals with the distribution of franked dividends and entitlements to franking credits, see below; and
• Subdivision 115-C of the ITAA97 - which deals with net capital gains of the trust, see below.

Franked distributions: Subdivision 207-B of the ITAA97

There is also uncertainty as to how to calculate a beneficiary's 'share' of a franked distribution. In order to resolve this uncertainty, the Government intends to amend Subdivision 207-B to clarify how Division 6 of ITAA36 is modified if a trustee receives a franked distribution with attached franking credits[5].

After the changes, the subdivision dealing with franked distributions[6] will operate so that:

• franking credits will be included in the beneficiary's assessable income if that beneficiary was entitled, for trust law purposes, to 100% of the dividend (and that beneficiary would then generally be entitled to the corresponding tax offset); and
• ranking credit would not be included in the assessable income of other beneficiaries that are not entitled to the dividend (and those beneficiaries would not be entitled to the corresponding tax offset).

Trust Capital Gains: Subdivision 115-C of the ITAA97

At present, the capital gains provisions in Subdivision 115-C provide that appropriate amounts of the trust's taxable income, including any net capital gain, must be treated as capital gains of presently entitled beneficiaries.

Once again, in light of the proportionate approach endorsed by the High Court in Bamford's case, there is uncertainty about how these provisions will apply to taxpayers: for instance on one view:

• If a trust deed defines income to include capital gains &mdash that will be the 'distributable income';
• Then the proportionate approach requires you to determine each beneficiary's proportional entitlement to that 'distributable income';
• Because the distributable income includes an element of capital gains, each beneficiary will be deemed to have received a proportion of the capital gains;
• However, the trustee may pay the distributable income so that all capital gains go to one beneficiary, and the remainder of the distributable (ordinary) income goes to another beneficiary &mdash perhaps to take advantage of a particular beneficiary's available capital losses;
• The 'other' beneficiary is then assessed in relation to the capital gain, even though the trustee did not distribute any part of that capital gain to them.

To resolve this possible interpretation, the Government proposes to amend Subdivision 115-C to ensure that only those beneficiaries that actually receive the capital gain, will be required to include any part of those capital gains in their assessable income. Those beneficiaries that are not entitled to a capital gain, will not need to include any capital gain in their assessable income.

Further consultation and likely implementation timing

The Discussion Paper calls for comments and feedback in relation to the approaches outlined above. The closing date for submissions was 18 March 2011. Although the Discussion Paper does not outline any timeline for the further steps after the consultation process, it does state that the proposed changes will apply from the 2010-2011 income year.

More Information from Maddocks

For more information, contact Maddocks on (03) 9288 0555 and ask to speak to a member of the Tax and Revenue or General Commercial Teams.

More Information from Cleardocs

For more information:

• about Bamford's case, see here
• about the Cleardocs Discretionary Trust, see here. You can order a trust online from that page;
• see a Guide by Maddocks dealing with:
  • a comparison table of key benefits and things to be wary of in each type of trust, here; and
  • a comparison table of the key features of each type of trust here.

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[1] Clearlaw article, April 2010, "Definition of "income" in a trust deed prevails &mdash Bamford's case approach confirmed by the High Court".

[2] The Discussion Paper also invited members of the public for their feedback and comments, however, the closing date for submissions was 18 March 2011.

[3] Commonwealth of Australia, Discussion Paper: Improving the taxation of trust income, March 2011, page 1. Please click here for a link to the Discussion Paper http://www.treasury.gov.au/contentitem.asp?NavId=037&ContentID=1981

[4] Commonwealth of Australia, Discussion Paper: Improving the taxation of trust income, March 2011, pages 9 - 12.

[5] Commonwealth of Australia, Discussion Paper: Improving the taxation of trust income, March 2011, page 13.

[6] Subdivision 207-B of the ITAA97.