Recap of Bamford's case and uncertainty which arose from it
As we have reported in previous editions of ClearLaw, the decision in Bamford's case considered two primary issues, namely:
- the meaning of 'income of the trust estate'; and
- the meaning of 'share' for the purposes of the taxation of trusts.
On those issues, the High Court clarified that:
- for the purposes of section 97(1) of the Income Tax Assessment Act 1936 the 'income of the trust estate' is determined according to trust law which mandates the primacy of the trust deed is paramount. As such the 'taxable income' of the trust often does not match the 'income' of the trust; and
- beneficiaries will be assessed on the share of 'taxable income' of the trust which corresponds to the share of the 'income of the trust' which the beneficiary is presently entitled to. For example, if a beneficiary is presently entitled to 50% of the 'income of the trust', then they need to include 50% of the 'taxable income' of the trust in their assessable income. This is known as the 'proportionate approach'.
The Bamford case highlighted problems associated:
- with the potential mismatch between the 'income of the trust' which beneficiaries are entitled to and the 'taxable income' of the trust which beneficiaries are assessed on. This can result in unfair outcomes as well as the potential for tax manipulation; and
- with the 'proportionate approach' for assessing income tax which created uncertainty as to how capital gains and franked distributions can be streamed to particular beneficiaries. This is because it is unclear as to how the proportionate approach deals with assessing amounts which have been streamed to particular beneficiaries.
The amendments in the Bill are interim measures. They deal with the uncertainty around the 'proportionate approach' that was highlighted in Bamford's case.
They seek to ensure that capital gains and franked distributions (including attached franking credits) that are received by specific beneficiaries are subject to tax in the hands of those beneficiaries.
Amounts are able to be streamed if beneficiaries are specifically entitled to a capital gain or franked distribution of the trust.
Importantly, the amendments do not give the trustee the power to stream capital gains or franked distributions. They merely set out how streaming can be done if the trust's deed gives the trustee power to stream. So that power must be in the deed. It isn't in the law.
In this light, trustees and their advisers need to review trust deeds to see if the trustee has the power to:
- classify and account for income according to its source;
- allocate expenses to a particular source; and
- distribute these amounts to particular beneficiaries.
If the trust deed does not give the trustee these powers, then trustees and their advisers should consider amending the deed to allow for such powers.
The new law has received Royal Assent and will apply to the current 2010-11 and later income years.
Cleardocs deeds The Cleardocs Discretionary Trust deed contains the powers trustees need to stream capital gains or franked distributions to particular beneficiaries. These powers are contained in clauses headed:
- Trustee's right to distribute from a class of income.
- Trustee may determine what is income and what is capital.
- Allocation of income or capital of a category.
- Allocation of expenses.
- Distributed income and capital remain in categories.
How to stream under the new law
The ability to stream amounts depends on a beneficiary being specifically entitled to a capital gain or franked distribution. So:
- The beneficiary must be 'specifically entitled'.
- There must be a 'capital gain' or 'franked distribution'.
- There must be a 'financial benefit' (and 'net financial benefit').
- You must then calculate the beneficiary's 'share of that net financial benefit'.
We now discuss each of these concepts in turn.
When is a beneficiary "specifically entitled"?
A beneficiary of a trust will be specifically entitled to an amount of a capital gain or franked distribution made by the trust equal to the amount calculated using the formula below:
An amount the beneficiary is specifically entitled to under the above formula will be assessable on a quantum basis:
- under subdivision 115-C for capital gains; and
- under subdivision 207-B for franked distributions (and attached franking credits).
The 3 elements of the formula are:
1 "Capital Gain/Franked Distribution" This means the capital gain made by the trust or the franked distribution received by the trust.
2 "Net Financial Benefit" This means the amount of the financial benefit (meaning anything of economic value) referable to the capital gain or franked distribution. However, that amount is reduced by:
- for franked distributions: expenses directly relevant to the franked distribution.
- for capital gains: the application of trust capital losses (only to the extent it is consistent with the application of tax capital losses to the tax capital gain).
You also need to consider the following about the definition of net financial benefit:
- the trustee can only stream amounts that have economic value.
- 'deemed gains' or 'notional gains' cannot be streamed — for example, those arising from the market value substitution rule.
- franking credits cannot be separately streamed from the franked distributions.
- an amount cannot be streamed if there is zero net financial benefit.
- directly relevant expenses for franked distributions may include interest incurred on money borrowed to acquire the underlying shares or a management fee incurred in respect of managing a portfolio of shares.
3 "Share of Net Financial Benefit" This means the amount of the net financial benefit which the beneficiary has received or reasonably expected to receive which has been recorded, in its character as referable to the capital gain or franked distribution.
3.1 Received or reasonably expected to receive. You also need to consider the following factors about the definition of "Received or reasonably expected to receive". A net financial benefit has been received or reasonably expected to be received if the beneficiary has:
- been credited, distributed, paid, or had the amount applied on its behalf for its benefit;
- a present entitlement to the amount;
- a vested and indefeasible interest in the trust property representing the amount; or
- had the amount set aside exclusively for it.
When considering those factors, you need to remember that:
- the trustee need not trace the actual proceeds from the capital gain or franked distribution. It is sufficient if the beneficiary receives or is reasonably expected to receive an equivalent amount.
- a notional allocation to a beneficiary in the trust's tax records is not sufficient as there is no reason to reasonably expect a beneficiary to receive this amount.
3.2 Recorded, in its character as referable to the capital gain or franked distribution. You need to record these amounts within the following time frames:
- franked distributions must be recorded by 30 June (year end) (see next paragraph for an administrative concession given by the ATO for the 30 June 2011 income year); and
- capital gains must be recorded by 31 August (two months after year end).
Concession for 30 June 11 The ATO has acknowledged the practical difficulty of recording distributions of franked distributions by 30 June 2011 given the legislation is being passed so close to the end of the income year. In light of this, the Commissioner will, as an administrative arrangement, accept a recording of distributions of franked distributions made by 31 August for the 2010-11 income year.
When recording amounts, you need to consider the following:
- review trust deeds to see if capital gains are included as income and if so who is entitled to the capital of the trust;
- pass resolutions by 30 June (by 31 August 2011 for the year ended 30 June 2011) to distribute dividends of the trust to specific beneficiaries; and
- pass resolutions by 31 August to distribute capital or profits from particular assets to specific beneficiaries.
Administrative measure for 2010-11 income year We also note that as an additional administrative measure for the 2010-11 income year, the ATO will not review or audit trusts for the sole purpose of determining whether streaming of capital gains or franked distributions by the trustee is effective for tax purposes. However, this administrative measure does not apply where there is a deliberate attempt to exploit the streaming provisions.
Distributing remaining income
After amounts have been streamed to specifically entitled beneficiaries, the remaining income of the trust is assessable to beneficiaries on a proportionate basis.
Each beneficiary's share is to be allocated on the basis of an "adjusted Division 6 percentage" — effectively, this assesses beneficiaries on the share of the remaining taxable income of the trust which corresponds to the share of the remaining income of the trust which the beneficiary is presently entitled to.
This income includes any capital gains or franked distributions which have not been streamed.
Taxation on amounts remaining with the trustee
If an amount of the trust property referable to the capital gain is not paid or applied for the benefit of a beneficiary, then the trustee can choose to be assessed on a capital gain of the trust.
Anti-avoidance provisions for exempt entities
In certain circumstances, a trustee can be treated as assessable on amounts if any of the beneficiaries of the trust are exempt from income tax, for example because they are a charity. These circumstances are outlined below:
- Notification required The exempt entity is treated as not being presently entitled to an amount if it has not been notified of its present entitlement within two months after the end of the income year. If notice is not given, then the trustee will be taxable on the entire amount.
- Excess Amounts Broadly speaking, if the amount of income an exempt entity is presently entitled to for tax purposes exceeds the actual distribution paid, then the exempt entity is taken not to be presently entitled to the excess. In that case, the trustee will be taxable on the excess — unless the Commissioner exercises his discretion on the basis that he is of the opinion that it is unreasonable for it to apply.
Given the anti-avoidance provisions, it will often not be advisable for trustees to make distributions to charities.
Carve out for Managed Investment Trusts (MITs)
The proposed new law's streaming rules will not apply to trusts that qualify as Managed Investment Trusts (MITs) or to certain trusts that are treated like MITs. However, the trustees of those trusts can choose to apply the new law. This exemption recognises that generally MITs:
- do not stream capital gains or franked distributions; and
- distribute all of their income proportionally, instead.
Notably, MITs are excluded from the anti-avoidance rules even if they choose to apply the streaming rules. This is to reflect the difficulty MITs have in engaging in the kind of tax manipulation that the anti-avoidance rules target.
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
Follow these links for more information about:
- Bamford's case
- The ATO's response to Bamford's case
- The Government discussion paper in response to Bamford's case
- about the Cleardocs Discretionary Trust, see here. You can order a trust online from that page.
- see a Guide by Maddocks dealing with: