02/05/2011

The Federal Government has recently released a public draft of the changes to be made to the trust tax provisions.  The changes will apply to the 2010/11 and subsequent financial years. 

The changes have been released in draft form to allow a short period for public comments on the amendments to be made. The intention of the Government is that these changes will be legislated before 30 June 2011.

The changes have been described as interim measures as the long term goal of the Government is to rewrite the trust tax provisions in their entirety and to transfer them to the Income Tax Assessment Act, 1997.

The interim measures will permit trusts to stream capital gains and franked distributions derived by the trust.  Streaming is industry jargon and means being able to separately allocate all or part of the capital gains and franked distributions to any of the beneficiaries of the trust.

Why are the interim measures required?

The interim measures are required to overcome a recent High Court decision in the Bamford litigation.

The Bamford litigation involved the taxation treatment of trust distributions made by the trustee of the Bamford Trust, which was a discretionary trust of the garden variety sort.  The litigation raised two very significant issues which have been matters of (legal) controversy for 20 or more years. 

Also, the litigation raised an issue (which was not required to be considered by the High Court) as to whether certain types of income received by the trustee retained their character in the hands of the beneficiaries:  this is sometimes called the "soup" or "puree" views of trust income.  In the soup view, individual items retain their character.  In the puree view, individual items lose their separate character and are blended.

The first issue is whether the terms of the trust deed of discretionary trust can define what constitutes the "distributable income" of the trust.  In particular whether certain types of receipts can be included or can be excluded from constituting the “distributable income” of the trust.

The second issue is, essentially, whether “taxable income” of a discretionary trust must be taxed in the hands of the beneficiaries, based upon their percentage share of the “distributable income” of the trust. 

The third – soup or puree – issue is whether a capital gain derived by the trustee remains a capital gain in the hands of the beneficiary.  Equally, whether a franked distribution derived by the trustee remains a franked distribution in the hands of the beneficiary.

The tax profession and trustees of discretionary trusts have for many years acted on the basis that the taxable income of a trust is a soup, that the terms of the trust deed can modify what constitutes the distributable income of the trust and that (at least in certain circumstances) beneficiaries will be taxed on the “taxable income” of the trust based upon the dollar amount (not portion) of distributable income that is allocated to them.

The Government has made a policy decision to retain the see-through (ie soup) basis of discretionary trusts (at least for capital gains and franked distributions), and to permit the trustee to allocate (whether by percentage or dollar amounts) capital gains and franked distributions.  As a consequence of the Government’s decision, all other income derived by the trustee will be allocated on a percentage basis without a see-through (ie puree) basis.

When do they apply?

The new provisions will apply for the 2010/11 financial year and to subsequent financial years.

If and when the current trust tax provisions are removed from the Income Tax Assessment Act, 1936 to the Income Tax Assessment Act, 1997 and rewritten, the interim measures will be retained but expressed in the drafting style of the 1997 Act.

How do they operate?

The design of the interim measures will be achieved in the following manner:

1.    A new Division 5B will be introduced into the 1936 Act which will carve-out capital gains and franked distribution from the other taxable income of the trust.

This division will apply if the trust has a positive taxable income and that in determining that positive taxable income, any of the following have been taken into account: a capital gain, franked distribution or a franking credit.

As a consequence of the carving out – a trust will have two classes of taxable income:  Div 5B income (constituting of capital gains and franked distributions and franking credits) and Div 6 income (which is the residue of the taxable income).

2.    Capital gains which are allocated to specific beneficiaries will be taxed in the hands of those beneficiaries.

The taxation of capital gains allocated to the beneficiaries will be in accordance with Division 115-C.

3.    Franked distributions (and attached franking credits) which are allocated to specific beneficiaries, will be taxed in the hands of those beneficiaries.

The taxation of franked distributions allocated to the beneficiaries will be in accordance with Division 207-B.

4.    The Div 6 taxable income will be allocated on a percentage basis to each beneficiary who has received a share of the distributable income (less of amounts which have been allocated in steps 2 and 3).

In summary the interim measures will permit streaming of capital gains and franked distributions on a fixed dollar basis (sometimes called a quantum basis) and balance of the taxable income (less the amounts which have been specifically taxed on a fixed dollar basis in the hands of the beneficiaries) will be taxed on a percentage or proportionate basis.

What is the impact on Super?

The decision in Bamford does not apply to super funds.  While super funds (including SMSFs) are structured as trusts, they are not taxed on a see-through basis (like ordinary trusts) but taxed on an entity basis (rather like companies). 

Consequently the proposed changes will not apply to super funds.  Nor will they apply to Pooled Superannuation Trusts (PSTs) – again as PSTs are taxed on an entity rather than see-through basis.

Must trust deeds of discretionary trusts be amended?

For streaming of capital gains to be effective, the beneficiary must, in accordance with the terms of the trust, have a vested and indefeasible interest in trust property representing the capital gain and that that interest is recorded in the accounts of the trust.

For streaming of franked distributions to be effective, the franked distribution must, in accordance with the terms of the trust, have been specifically allocated (in its character as a franked distribution) to the beneficiary and the specific allocation is recorded in the accounts of the trust.

The critical issue is that streaming, to be effective, must be “in accordance with terms of the trust” and this requires that there must be a specific power in the trust deed conferred on the trustee and streaming is effected by the exercise of that power.

If the trust deed of the trust lacks such an express power, then an amendment will be required.

However it should be noted that the draft amendments also provide that a streaming power may arise from the operation of the current trust deed together with the operation of legislation, the common law or the rules of equity.  This is a curiously worded amendment, the meaning of which is not immediately apparent.  Possibly it may cover a situation where the trust deed lacks the relevant express power but the applicable Trustee Act supplements the powers of the trustee to allocate particular trust property to beneficiaries.

The better view is to rely on an express power in the trust deed and if the trust deed does not contain an express power, then for the trust deed to be amended.

When must they be amended?

This depends on whether the trustee wishes to take advantage of the streaming of capital gains and franked distributions.

If the trustee wishes to stream for the 2010/11 financial year, then there are two views as to when any necessary amendment must be made. 

The cautious view is that the required amendment must be made on or before 30 June 2011.

The other view is that the required amendment must be made on or before the time the income is allocated.  Given the current administrative concession that income allocations can be made up to two months after balance date (and still be effective in respect of the 2010/11 financial year), the amendment could be made on or before 31 August 2011.

In the absence of any official guidance from the ATO, the better view is if the trustee wishes to take advantage of streaming in respect of the 2010/11 financial year (and the trust deed lacks the necessary express powers) any required amendment must be made on or before 30 June 2011.

Finally it should be noted that an amendment made after 31 August 2011 but having retrospective operation to say, 20 June 2011, is unlikely to be sufficient.

Can other types of income be streamed?

The draft amendments only refer to capital gains and franked distributions as being subject to the streaming provisions.

Other types of income (eg foreign sourced income, tax advantaged income) are not mentioned in the draft amendments.  Unfortunately there omission suggests that the streaming is strictly reserved for capital gains and franked distributions.

If you would like your discretionary trust checked and if necessary amended please call us on (02) 8296 6222.