Certainty for streaming of capital gains and franked distributions: interim changes after Bamford's case

Although the High Court's decision in Bamford's case1 resolved some long-debated issues about the taxation of trusts, it also highlighted the need for these issues to be dealt with.

As part of the federal government's response to Bamford's case, it has implemented interim changes to income tax legislation — via the Tax Laws Amendment (2011 Measures No 5) Act 2001 (Cth) (Bamford Amendment Act) — to:

  • enable the 'streaming' of capital gains and franked distributions; and
  • introduce anti-avoidance rules targeted at inappropriate trust distributions for exempt entities.

This article has links to summaries of Bamford's case and reviews the interim legislative changes.

 

What was the outcome in Bamford?

In Bamford, the Court considered the meaning of the terms 'income of the trust estate' and 'share' for the purposes of section 97 of the Income Tax Assessment Act 1936 (Cth). You can read an overview of the case, with links to articles on each of the key developments here.

Bamford raised a number of problems with the taxation of trusts, including:

  • a particular trust may experience a mismatch between the 'amount on which a beneficiary is assessed for tax' and 'the amount they are entitled to under trust law' — this can lead to unfair outcomes and may allow for tax manipulation; and
  • the interaction between:
    • the 'proportionate approach' (under which the amount included in a beneficiary's assessable income is the proportion of the income of the trust estate to which the beneficiary is presently entitled, applied against the trust's total taxable income); and
    • other aspects of tax legislation, some of which assume (or provide for) amounts to be treated the same when held by trustees and beneficiaries.

What amendments are made by the Bamford Amendment Act?

The amendments in the Bamford Amendment Act relate to 2 aspects of the taxation of trusts:

  • Streaming of capital gains and franked dividends: if a trustee has the power to appoint or 'stream' capital gains and/or franked distributions (including any attached franking credits) to specific beneficiaries, then this will be effective for tax purposes, subject to relevant integrity rules; and
  • Anti-avoidance: rules that prevent the inappropriate use of exempt beneficiaries to 'shelter' taxable income of a trust. These rules apply to 'exempt entities', which includes entities whose income is exempt from income tax.

Streaming: what has changed?

This table is adapted from the Explanatory Memorandum which accompanied the Bamford Amendment Act:

Streaming changes and their effect

Pre-amendment Post-amendment Effect of amendment

Net capital gains formed part of the trust's taxable income.

Beneficiaries entitled to property of the trust representing a capital gain, but who were not entitled to any income of the trust estate, were not taken to have made a capital gain.

If a beneficiary is specifically entitled to a capital gain included in the trust's taxable income, then that beneficiary is treated as having made a capital gain (or a trustee is assessed and liable to pay tax on their behalf on an equivalent amount).

A beneficiary may now be assessed based on a specific entitlement to a capital gain, even though they do not have a present entitlement to income of the trust estate.

A trustee of a resident testamentary trust could choose to be assessed on a capital gain of the trust if the capital gain would otherwise be assessed to a beneficiary who could not benefit from it (or the trustee would be assessed and liable to pay tax on behalf of such a beneficiary).

A trustee of a resident trust can choose to be assessed on a capital gain of the trust if no amount of trust property referable to the capital gain is paid or applied for the benefit of a beneficiary.

Similar to the choice available before the amendments, but no longer limited to trustees of testamentary trusts. Amendment allows for trustee to choose to pay tax on behalf of a beneficiary that is unable to immediately benefit from the gain.

Franked distributions and their attached franking credits formed part of the taxable income of the trust.

If a beneficiary is specifically entitled to a franked distribution, then that beneficiary is assessed on the amount of the franked distribution included in the taxable income of the trust estate and on the franking credits attached to that distribution.

If permitted by the trust deed, then the trust's capital gains and franked distributions can be effectively streamed to beneficiaries for tax purposes by making those beneficiaries 'specifically entitled' to those amounts.

Beneficiaries specifically entitled to franked distributions will, subject to integrity rules, also enjoy the benefit of any attached franking credits.

Double taxation was avoided in respect of extra capital gains.

Amounts otherwise assessable to beneficiaries (and, if relevant, the trustee) are adjusted to ensure that capital gains, franked distributions and franking credits dealt with under are not taxed twice.

Anti-avoidance: what has changed?

This table is also adapted from the Explanatory Memorandum which accompanied the Bamford Amendment Act:

Anti-avoidance changes and their effect

Pre-amendment Post-amendment Effect of amendment

No equivalent provision

An exempt entity is not presently entitled to any of the trust's income unless, within 2 months of the end of the income year, they have been either:

  • paid their entitlement; or
  • notified of their entitlement.

The amount that would otherwise be that beneficiary's share of taxable income is assessed to the trustee.

A new pay or notify rule: if an exempt beneficiary is not notified of, or paid, their present entitlement within 2 months, then they are treated as not being (and never having been) presently entitled to that income.

An exempt entity could be made presently entitled to all of the income of a trust estate resulting in the trust's total taxable income becoming exempt — even if the entity was not entitled to receive all of the net taxable accretions to the trust underlying that taxable income.

If an exempt entity is used to 'shelter' a share of the taxable income of a trust that exceeds the exempt entity's entitlement to the net accretions to the trust underlying that taxable income (whether 'income' or 'capital' of the trust), then that excess is assessed to the trustee.

A new benchmark percentage rule: if the exempt beneficiary's entitlement expressed as a percentage exceeds the benchmark percentage, then the beneficiary is treated as not being (and never having been) presently entitled to the percentage share of the income of the trust estate that exceeds the benchmark percentage.

From when do these amendments apply?

For a trust with a 2010-2011 financial year that began on or after 1 July 2010, the amendments apply from the 2010-2011 financial year.

For a trust with a 2010-2011 financial year that started before 1 July 2010, the amendments apply from:

  • the 2010-2011financial year if the trust recorded this in writing before 29 August 2011; or
  • otherwise from the 2011-2012 financial year.

The amendments are 'interim' — are they permanent?

The amendments are 'interim' in the sense that, although they provide certainty in relation to streaming, they have been made pending a broader review of the taxation treatment of trusts.

The government acknowledges that the amendments do not address all of the problems and uncertainties relating to the taxation treatment of trusts. The government intends to rewrite (rather than simply amend) sections of income tax legislation, although it is not yet known when this will occur.

Is my trust affected?

The streaming amendments are only relevant to trusts that make a capital gain or are in receipt of a franked distribution for the 2010-2011 (or later) income year. If your trust does not make a capital gain or receive a franked distribution in the 2010-2011 (or later) income year, then the amendments will not affect the trust.

Does this mean that all trusts can stream?

Although the Act allows for 'streaming', it does not grant a trustee the power to stream if the trustee does not have this power under the trust deed. So, as always, the deed is crucial. You can read a ClearLaw article about what the Cleardocs deeds allow here.

If you are unsure as to whether your trust deed grants the trustee a power to 'stream' capital gains and franked distributions, contact the Maddocks Tax Team in Melbourne (03 9288 0555)

More Cleardocs information on trusts — www.cleardocs.com

Read

In addition to our previous ClearLaw article on the Bamford decision, you can access various ClearLaw articles for information on discretionary, hybrid and unit trusts — including tables comparing the features and benefits of each type of trust:

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1Commissioner of Taxation v Bamford (2010) 240 CLR 481