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Unpaid Present Entitlements

A draft ruling was issued in December 2009 by the Commissioner of Taxation dealing specifically with unpaid present entitlements to companies. The ruling seeks to apply the existing Division 7A rules to amounts of income distributed by trusts to Corporate Beneficiaries that are not subsequently paid. In effect, any amounts not paid to the Company and not subject to a loan agreement meeting the requirements of Division 7A, would be treated as a deemed dividend.

This draft ruling is open for comment from interested parties until February of this year. As the ruling represents a significant change in the way in which these rules are applied in practice the industry bodies are to submit a combined response to the ruling. Once a final ruling has been issued, we will advise further on the impact this may have on your existing circumstances. In the meantime, it is relevant to consider alternative taxation strategies for the 2010 and future years where a Corporate beneficiary has been utilised in the past if the Trust does not have sufficient income to make the required repayments or to transfer the entitlements in full.

IMPORTANT DEVELOPMENT REGARDING THE TAXATION OF TRUSTS

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Early last year the Full Federal Court handed down what could be a ‘landmark’ decision regarding the taxation of the beneficiaries of trusts.

In Bamford v Commissioner of Taxation 2009 FCAFC 66 the ATO had tried to limit the ability of the trustee of the Bamford Trust to give effect to the terms of the trust deed for that trust in determining how the beneficiaries of the trust should be taxed.

The Full Federal Court rejected the arguments put forward by the ATO and decided that the terms of the trust deed should prevail in determining how the beneficiaries should be assessed to tax.

In a victory for the ATO however, the Full Federal Court did find against the taxpayers on the argument they had raised that they should only be assessed on the quantum of trust income that was actually distributed to them (rather than on the proportion of the trust income they were entitled to). In other words, the court held that beneficiaries should be assessed on a share of the taxable income of the trust in proportion to their entitlement to the income that has been distributed by the trustee.

Both the ATO and the taxpayers have sought special leave to appeal the decision of the Full Federal Court in the High Court.

The ATO has now released a Practice Statement (“PSLA 2009/7”) outlining the ATO’s compliance approaches pending the decision by the High Court.

The technical outcomes for taxpayers (subject to the High Court deciding to hear an appeal and overturning the decision of the Full Federal Court).

As the Full Federal Court unanimously held that the trustee of a trust can, where allowed by the trust deed, determine that any capital gains made by the trust can be treated as income for the purposes of determining whether a beneficiary is "presently entitled to a share of the income of the trust estate" (which is the key requirement for a beneficiary to be assessed rather than the trustee), the decision should prevent the ATO from being able to assess capital gains at penal rates in the hands of a trustee if the trust does not derive any other income in the year, ie the capital gain will be taxed in the hands of the beneficiary in accordance with the intention of the CGT rules.

Furthermore, because the Full Federal Court decided that a beneficiary’s liability to tax is based on their proportionate interest in the income of the trust rather than any particular dollar amount that has been distributed to them, beneficiaries may be taxed on more or less than they actually receive from a trust where there are differences (as is often the case) between the income of the trust as determined under the trust deed and the taxable income of the trust.

What compliance action will the ATO take pending the High Court special leave application being heard?

The ATO will not be taking any action regarding past years pending the High Court special leave application other than in the circumstances outlined below.

PSLA 2009/7 has been issued outlining the ATO’s compliance policy pending the decision by the High Court. Importantly, PSLA 2009/7:

states that active compliance work in relation to the taxation of trusts under Division 6 of the 1936 Tax Act (ie. the general provisions dealing with trusts) will be limited to identified arrangements involving deliberate attempts to exploit Division 6; and
outlines the types of arrangement (including examples) which the ATO regards as attempts to exploit Division 6.

The PSLA does go on to say however, that even in cases where there is no deliberate attempt to exploit Division 6, if the taxable income of a trust is adjusted (because, for example, a deduction is disallowed) the ATO will continue to apply its view of the operation of Division 6. In the case of a dispute the ATO will seek to defer finalisation of any objection pending the outcome of the Bamford appeal. If a case does proceed to a hearing the ATO has indicated that it will continue to argue its view of Division 6.

Finally, and most importantly, the PSLA states that the ATO will continue to apply PS LA 2005/1 (GA) (which gives effect to the long standing ATO policy that any net capital gain made by a trust should be assessed to the beneficiaries who are entitled to the capital of the trust) pending the High Court decision, provided that:

a) there is no deliberate attempt to exploit Division 6; and
b) the taxable income of the trust is not otherwise adjusted.

What are the practical consequences for affected clients?

In brief, the same set of numbers can give rise to a significantly different tax outcome dependent on whether and how income is defined in the Trust Deed and what other powers the Trustee may have in determining the distributable income of the trust.

In some circumstances, the trustee can end up being assessed at a 46.5% tax rate even where an amount has been distributed to the beneficiaries.

The types of situation that can cause difficulty include the following:

No income but a capital gain.
Distributing the income to one beneficiary but the capital gain to another.
No book profit but taxable income, eg due to booking mark to market differences and recognising provisions.
Other book to tax differences, eg because a trustee is required to make good a deficiency out of current year income.

The above comments are relevant to all trusts. However, there is a need to be particularly vigilant with Managed Investment Trusts and AIFRS accounting.

In addressing the ATOs stated policy, the following issues should be given urgent attention.

Issue 1 – Definition of Income
Overlaying each of these situations is the Trust Deed. The following are the common scenarios:

1 The Deed is silent in relation to the meaning of income.
2 The Deed allows the trustee to adopt the normal meaning of income or to otherwise determine what is included in income and/or capital.
3 The Deed defines income to be equivalent to taxable income.

Based on the Bamford case, where the Trust Deed falls into either scenario 2 or 3 there should be no trustee assessment where the trustee resolves to distribute 100% of the income. However, there may be problems if a deed does not define income and there is no accounting profit but there is taxable income. This could give rise to a trustee assessment even though cash amounts have been distributed to beneficiaries.

Issue 2 – Proportionate Approach
The Bamford case also reiterates that the correct approach to present entitlement is the proportionate approach. In other words, beneficiaries will be entitled to a share of taxable income in proportion to their entitlement to the income that has been distributed by the trustee. The long standing ATO practice of allowing either the proportionate or quantum approach is no longer acceptable.

Issue 3 –Capital Gains
The Bamford case also brings into question the Capital Beneficiary approach. The ATO’s Practice Statement PS LA 2005/1 (GA) allows a departure from the proportionate approach to tax the recipient of a capital gain even though they did not receive any income. Technically, this approach may not now be correct but the Practice Statement has not been withdrawn and the ATO has indicated that it will continue to stand by it.

What action should we be taking in respect of your clients?

Revisit the Trust Deed(s) to determine the definition of income and what other powers the Trustee may have in determining the distributable income of the trust;
Determine any likely book to tax differences;
Work out if there are likely to be any net capital gains derived in the foreseeable future;
If ‘income’ is not defined in the Deed, it may be desirable to amend the Deed to give the trustee the discretion to either determine income according to ordinary concepts or to allow the trustee to specifically determine what is to be income and what is to be capital. Note that any change to the Trust Deed must be considered in light of a possible resettlement occurring – which must be avoided at all costs;
Any Minute distributing income should refer to the specific income clause. For instance, if the trustee has a discretion to determine income, the Distribution Minute should refer to the particular clause(s) in the Deed (including any that permit the trustee to characterise amounts as income or capital) saying that income has been determined in accordance with Clause X, etc;
Be conscious of the proportionate theory when distributing capital/income;
Similarly, streaming of classes of income should be approached with care.

If in doubt, discuss your issue with the Tax Team as misapplication of the provisions of a trust deed or a misworded Minute may give rise to a significant liability to the trustee.

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The contents of this Bulletin are general in nature. We therefore accept no responsibility to persons acting on the information herein without first consulting us.