Tax Brief. 20 April The income of a trust Taxation Ruling 2012/D1. 1. The big picture

Transcription

1 Tax Brief 20 April 2012 The income of a trust Taxation Ruling 2012/D1 On 28 March, the ATO issued a draft Ruling, TR 2012/D1 ( the Ruling ) dealing with the meaning of the word income in connection with trusts. There is much in the Ruling which is controversial and not supported by legislative or judicial authority. It is likely, therefore, that it will elicit submissions ranging from calls for outright rejection to less ambitious calls to qualify just its more contentious implications. This Tax Brief is about the Ruling, especially its implications for property trusts and managed funds. The Ruling contains no carve out for trusts used in funds management or the property industry. Indeed, it contains no acknowledgement at all of the current comprehensive trust review or the Treasury project on the attribution regime for managed investment trusts. 1. The big picture The trust provisions in the Income Tax Assessment Act 1936 allocate the tax liability on income passing through trusts based on the extent to which the beneficiaries share in the income of the trust. It is important to note, therefore, that this Ruling is not ostensibly about influencing how much is taxable or not; it is instead about the mechanism for allocating the tax liability between entities. The Ruling appears to be the ATO s second attempt to constrain the meaning of the word income and its implications for allocating tax liabilities. The first attempt, of course, was the Bamford case. In that case, the ATO argued that the word income in s. 97 did not include amounts (such as a capital gain): because, while available for distribution in accordance with the Deed, the capital gain amount was not, in the sense of the 1936 Act, income according to ordinary concepts.

2 The ATO lost this argument with the High Court holding that: the undefined expression the income of the trust estate has a content found in the general law of trusts, upon which Div 6 then operates. That general law of trusts means the terms of the Trust Deed and any powers the Deed confers on trustees can and does determine the amount that is the income of each trust estate. TR 2012/D1 is a second front in the campaign to strip away the significance attaching to the terms of the Trust Deed and the trustee s powers. The ATO now proposes that there is another meaning of the word income which again operates, notwithstanding how a particular trust deed may define income [Ruling, para 13] Clearly the ATO is very concerned about this area of tax law. There appear to be two concerns. First, the ATO seems keen to constrain some of the flexibility that trust law allows to define income, since that flexibility has derivative consequences for the allocation of tax liabilities. Secondly, it seems the ATO is also concerned not to have to decipher Deeds and construe their terms. This Ruling would go some way to addressing both concerns. Income would have a more independent and less malleable meaning; a meaning that would vary less depending on the terms of a Deed. Since the High Court ruled out the possibility of a truly independent and immutable meaning ( income according to ordinary concepts ), then some other independent and immutable meaning has to be found. That is what this Ruling is trying to delineate. 2. The meaning of income of a trust estate So, if the income of a trust is not what the Trust Deed says is the income of the trust, and it is not necessarily just the ordinary income of a trust, what is it? The Ruling says that one can infer from the statutory context that the income of a trust has 3 aspects: It must be measured in respect of distinct years of income, a product of the trust estate, and an amount in respect of which a beneficiary can be made presently entitled [Ruling, para 8] These three ideas have to be inferred because none appears in the text of the legislation. The second and third points are contentious and have the potential to create a number of problems. 2 The income of a trust Taxation Ruling 2012/D1

3 It is worth noting also that these propositions are not presented as a definition of income per se. Rather, they operate as a cap on what the income of the trust estate may be for Division 6 purposes So the Ruling creates something of a hybrid system: the Trust Deed can define the amount that is the prima facie income of the trust, but that definition can never result in a figure which is more than the amount the Ruling describes. 2.1 A product of the trust estate The first aspect of the cap is this notion that the income of the trust reflects only additions to the trust which occurred during the current year. The Ruling puts this idea thus: something which formed part of the trust estate at the start of an income year cannot itself, for the purposes of Division 6, be treated by the trustee as income of the trust for that year Thus, if a trust deed empowers the trustee to treat some part of the trust corpus as income available for distribution for a particular year, the ATO would say that such a provision is ineffective in establishing the amount of income of the trust for that year. Neither the Full Federal Court nor the High Court put any such constraint on the concept of income of a trust estate in the judgments in Bamford. 2.2 Distributable amounts The next aspect is even more contentious. The Ruling proposes that the income of the trust can never be more than the amount which is available for distribution to beneficiaries or accumulation by the trustee In other words, the income of a trust estate refers, for the most part, to amounts available to be disbursed in cash and otherwise to accretions to the value of the fund. This proposition, of course, creates a serious difficulty for those trusts prevalent in the small business sector and not unknown in managed funds under which the income of the trust is defined to mean the amount of taxable income. Such a clause has the effect of adding into the income of the trust amounts (referred to below as fictitious or fictional ) such as franking credits, foreign income tax offsets, amounts attributed under the CFC regime or amounts which are accelerated under the taxation of financial arrangements rules. The ATO clearly intends that these amounts would be covered by this part of the cap as they are non-cash and are not viewed as accretive to the value of the fund. This part of the cap also has the effect of denying trust expenses such as entertainment and of adding trust expenses such as capital works allowance. Hence a large part of the Ruling and most of the Examples in it are directed at explaining to the trustees of trusts with such a clause how they should calculate the income of the trust under this Ruling. For trusts in the property sector and for managed funds, this problem may prove to be less serious. Deeds will usually attempt to align the amount defined to be income to amounts which can be distributed in cash. This suggests the efforts of 3 The income of a trust Taxation Ruling 2012/D1

4 the Ruling, which attempt to impose this as a constraint, will tend to coincide with current drafting practice. Nonetheless, there are some managed fund deeds that have such clauses and it would be opportune for trustees to review their deeds. Having said that, the Examples in the Ruling sometimes raise curious situations. One unexpected item which is treated as a fiction is the entitlement of a beneficiary to a share of the income of a trust. The Ruling takes the view that a trustee with an unmet entitlement as the beneficiary of a sub-trust, cannot treat that entitlement as income of the head trust. This is most unusual and no authority is given to support the view. 3. What does this mean? Having outlined what the Ruling says, the more important question is, what does it mean? Will it affect common transactions and business structures and how? The impact of the Ruling is to impose a cap on the amount that will be income of the trust estate. Taxable income and the amount of tax payable remains unaffected by the Ruling, but the criterion upon which the subdivision of the total tax liability is based is being moved. This will matter in two situations: where the exclusion of an amount (characterised as trust income for trust law but not income under the ATO s Ruling) results in: the trust having no income at all. In such cases, the Ruling may have the effect of shifting the tax liability on the taxable income to the trustee; and the proportion of income to which beneficiaries are entitled changes. In such cases, the Ruling has the effect of re-aligning the tax liability on the taxable income between beneficiaries. An example of the first situation would arise where a trust has an accounting loss but taxable income. For example, assume a fund has earned interest income of $80 but has interest expense of $81. The fund therefore has no income and so if the fund also had a $21 CFC amount or TOFA amount upon which tax had to be paid, the trustee would potentially have to pay the tax. There are a variety of ways in which this position might be rectified in practice. The Example in the Ruling proposes that the trustee would not be successful if it attempted to rectify the situation by treating as current year income an amount which had been income in a prior year and accumulated. This strategy seems implausible even in the absence of the Ruling, but the issue posed by the Ruling is whether other strategies are also impugned, such as revaluing assets and treating any surplus as income. Another example would be a trust with only fictional amounts in its taxable income for example, a trust with just deemed TOFA amounts or entitlements to a share of the income from a sub-trust which has yet to be paid. In such a case, the trustee would potentially have to pay the tax, even if the trust allowed other amounts to be re-characterised as income of the trust and distributed. 4 The income of a trust Taxation Ruling 2012/D1

5 Moreover, there is material in the Ruling which makes discrepancies between income in accordance with the Ruling and the amount that the Deed will define to be income more likely to arise. The Ruling goes to some pains to say that the income cannot include fictitious items of income, but the Explanations and Examples also imply that expenses can only include amounts which represent [a] depletion of the trust estate Apparently, capital allowances are such an item. Hence, a capital allowance is apparently not to be deducted in deciding whether the trust has income. An example of the second situation would arise where a trust has different unit classes, one of which happens to enjoy disproportionately more fictitious amounts than the other. For example, some retail trusts might have different unit classes which possess this problem. Assume for example that a trust has Interest Units and Property Units. The trust derived interest income of $100, and rental income of $120 less a depreciation deduction of $20. The Deed could easily define the distributable income to be $200 shared equally between the two classes of unitholders, with equal tax liabilities. However, the Ruling implies that the calculation of the income of the trust would be derived from $220 because depreciation is not [a] depletion of the trust estate If that were so, while the total tax payable would be unaffected, the allocation of the liability to tax on that amount could shift. In this context, the analysis of the situation of sub-trusts is also instructive. For example, assume an existing property trust has five equal investors. A new opportunity appears and two of the investors decide they will fund it entirely. The funds are contributed to the head trust which creates a sub-trust in order to develop the project. It seems from the Ruling that, unless the sub-trust actually disburses its net income in cash to the head trust by the end of the income year, the 5 unitholders will be liable to pay tax equally on the income of both trusts because they share equally in income of the head trust the unpaid amount from the sub-trust not yet being income of the head trust. 4. Final comments The Ruling says its scope is limited just to the general trust law provisions in Division 6 but it seems that the Ruling s effect will be read more widely into the separate capital gains and franking credit rules. While there is much in the Ruling which is surprising, it is important to recall that it is not about how much is taxable or not; it is instead about the mechanism for allocating the tax liability between entities but, importantly, it seems to result in more situations where the trustee will bear some or all of that tax liability. In this respect, it is also worth noting that the Ruling does not mean that trusts will have to distribute higher amounts of cash, and there is no feedback effect into the amount that will be distributable as a matter of trust law. The Ruling is still in draft form. Comments are sought by 11 May. 5 The income of a trust Taxation Ruling 2012/D1

6 For further information, please contact Sydney Andrew Mills phone Andrew White andrew.white@gf.com.au phone Josh Cardwell josh.cardwell@gf.com.au phone Melbourne Adrian O Shannessy adrian.o shannessy@gf.com.au phone Richard Buchanan richard.buchanan@gf.com.au phone Perth Nick Heggart nick.heggart@gf.com.au phone G&F document ID _3.DOC These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney Level 39 MLC Centre Martin Place Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax The income of a trust Taxation Ruling 2012/D1