Tax Brief 6 October 2004 Trust losses Remain Idle The Federal Court has held in Idlecroft Pty Ltd v Commissioner of Taxation [2004] FCA 1087 that a trust stripping scheme was caught by reimbursement agreement provisions of s.100a of the ITAA 1936. Background Each applicant (Idlecroft, Dimouth, Acamae, Downville and Clurnite) was a trustee of a discretionary trust. Each trustee entered into a joint venture agreement ( JVA ), with WCC, as trustee for the Hendon Unit Trust, to develop property. Under the JVA, the applicants promised to fund the development. The agreed method of funding was for each of the taxpayers to add WCC as a beneficiary of each trust, and to appoint income to WCC. Each applicant represented to the Commissioner in its tax returns that WCC was presently entitled as a beneficiary to the appointed income. Since WCC had accumulated tax losses, it did not pay tax on this appointed income. The Commissioner accepted that the appointments of income were valid, but assessed each applicant under s.99a of the ITAA, on the basis that they had not conferred a present entitlement on WCC (because of the operation of s.100a). Each applicant objected to the assessment on grounds that included that the income to WCC was validly appointed. The Commissioner made an objection decision accepting again that the income to WCC was validly appointed. Each applicant subsequently appealed. Oddly, during the appeal process, the applicants altered their contentions. The applicants sought to argue that the appointment of WCC to each trust was ineffective, and as a result, s.100a should not have operation, since the default beneficiaries were presently entitled to the income, but not in relation to the reimbursement agreement. On appeal, the Commissioner disagreed with this approach, asserting that: In the case of Downville and Clurnite, valid appointments of income to WCC were made, and on the basis of concessions by the applicants (see below), the JVAs have to be regarded on the appeals as reimbursement agreements as that term is found in s 100A of the Tax Act, and therefore assessable under those provisions; and
in the Idlecroft, Dimouth and Acamae cases, even though the default beneficiaries may be presently entitled to the net income of the trust for the relevant years, s.100a is capable of operation in those circumstances, by virtute of the broad drafting of s.100a(5). The change in these contentions was wryly noted by Spender J: It is a curious irony that each notice of objection by each applicant asserted that it did not have a liability to tax under s 99A of the Tax Act, because WCC as trustee for the Hendon Unit Trust was properly assessed on the net income of the trust under s 97 of the Tax Act, as a beneficiary of the relevant trust presently entitled to the trust income, whereas each applicant now asserts that WCC was never presently entitled to any trust income, the appointment of WCC as trustee of the Hendon Unit Trust in each case being invalid and ineffective. It is a further irony that the second reason relied on by each applicant in its notice of objection was the contention that s 100A did not apply, because the relevant JVA did not constitute a reimbursement agreement, whereas there is now no argument that each JVA has to be regarded as constituting a reimbursement agreement. As noted above, for the purposes of the proceedings, each of the applicants made a number of concessions which had the effect that if they failed in relation to the contentions concerning primary tax, the penalties imposed would stand and that, conversely, if the won on the question in relation to primary tax, the penalties imposed would not stand. A further effect of the concessions was that each JVA was to be regarded as a reimbursement agreement as defined in s.100a(7). The Commissioner conceded in respect of three of the five applicants (Idlecroft, Dimouth and Acamae), that the resolutions of appointment of income to WCC were not authorised by the terms of the relevant trust deed. However, the Commissioner asserted that in respect of two of the applicants (Downville and Clurnite), the appointments were authorised. As regards the Clurnite appeal, Spender J found on the facts that the appointment of WCC as a beneficiary was valid. Accordingly, it was held on the basis of the concessions made that the requirements of s.100a were met and that the assessments to the trustee were correct. To this end, Clurnite s appeal was easily dismissed. As regards the Downville appeal, Spender J found on the facts, that the method used to appoint WCC as beneficiary was not authorised by its trust deed, and therefore, along with Idlecroft, Dimouth and Acamae, Spender J proceeded on the basis that the nomination of WCC as a beneficiary in each case was ineffective, and that the appointment of income to it was therefore a nullity and liable to be set aside ab initio by the Court. 2 Trust losses Remain Idle
Present Entitlement of Default Beneficiaries The Court then turned to the question of whether anyone was presently entitled to the net income of each trust during the relevant years, for the purposes of the assessment provisions in Division 6. The terms of the relevant distribution minutes and the default of appointment provisions of the relevant trust instruments (which had the effect of appointing the balance of net income to default beneficiaries) were relied on by Spender J in finding that the default beneficiaries were presently entitled to the income for the purposes of the ITAA 1936. Although not referring to his recent decision in Ramsden v FCT [2004] FCA 632 ( Ramsden ), and his detailed analysis of the decisions in BRK (Bris) Pty Ltd v Federal Commissioner of Taxation (2001)46 ATR 347 ( BRK ), Commissioner of Taxation v Marbray Nominees Pty Ltd (1985) 81 FLR 280 and East Finchley Pty Ltd v Federal Commissioner of Taxation (1989) 90 ALR 457, Spender J applied on much of the reasoning in Ramsden, in finding that the default appointment provisions of each trust instrument were drafted explicitly to operate within the year of income. In making his finding, Spender J relied on the terms of the relevant default distribution clauses in the trust deeds, which stated that the Trustees were required to distribute the income of the trust prior to the expiration of each accounting period. Although originally contending the contrary based on obiter of Cooper J in BRK, the Commissioner chose not to press this argument in the appeals. In this regard, Spender J held that (at para 85): as a matter of practical reality at the time when the default of appointment provisions are to operate, that is to say within the year of income, it seems to me that the default beneficiaries under those provisions are certain, and those default beneficiaries will be presently entitled for the purpose of the Tax Act and in the ordinary course as a consequence of s 97(1) of the Tax Act the default beneficiaries being presently entitled to a share of the net income of a trust estate, that income is assessable in the hands of the beneficiary. Section 99A does not apply to income to which a beneficiary is presently entitled, unless a provision such as s.100a applies. In emphasising the point that default beneficiaries may be presently entitled irrespective of an erroneous application of a trust s net income, Spender J gave a somewhat sardonic example: In my opinion when an appointment of income fails, the default beneficiaries under trust instruments such as the present have a present entitlement in the year of income and that present entitlement exists notwithstanding that the Trustee may have appointed income to a nonbeneficiary thinking that it was a beneficiary, or indeed may have invested the net income of the trust estate on a slow racehorse. 3 Trust losses Remain Idle
Applicability of s.100a Spender J took a wide view of the scope of s.100a. His Honour relied on obiter in Commissioner of Taxation v Prestige Motors Pty Ltd (1998) 82 FCR 195 ( Prestige Motors ), where the Full Federal Court had regard to the Parliamentary intention of s.100a, stating that (at 219): the mere fact that s 100A can be characterised as a specific antiavoidance provision does not demonstrate that it should be given a narrower approach than its ordinary meaning and grammatical sense suggest. It is clear from Cooper Brookes that a specific anti-avoidance provision (there s.80c of the ITAA) can be given its literal meaning if to do so gives effect to the intention of the legislature, although the literal interpretation will not be adopted if it results in an operation which is capricious and irrational: at 310-311, per Stephen J; at 321 per Mason and Wilson JJ. Of course, as we have said, this is consistent with s 100A being construed with an eye to the mischief it was designed to remedy: Commissioner of Taxation v Radilo Enterprises Pty Ltd (1997) 72 FCR 300 at 305; 97 ATC 4151 at 4155, per Lee J. (Emphasis added). In this regard, Spender J took the view that the intent of s.100a was wide in scope, catching not only those present entitlements which arose out of a reimbursement agreement, but also those which arose by reason of any act, transaction or circumstance that occurred in connection with a reimbursement agreement (see the language of s.100a(2)). To this end, His Honour concurred with the Commissioner s submission that the question asked by s.100a(5) was what would be the present entitlement of the takers in default be, or be reasonably expected to be, if the reimbursement agreement had not been entered into. Spender J considered that this question required each applicant to prove that the identified beneficiaries probably would have received or could have reasonably been expected to have received the trust income if there was no reimbursement agreement. Further, His Honour considered that this question required the applicant to prove that it would have appointed the income to the same beneficiaries, or that it would have defaulted in appointing the income to anyone at all, thus allowing those beneficiaries to take by default. Since there was no evidence led by any of the applicants on these matters, Spender J held that they could not satisfy the onus of proof which lay with them, and which arose from s.100a(5). To this end, His Honour stated that: Here, one act in connection with the reimbursement agreement was the purported appointment of the income to WCC. Through a circumstance (the circumstance being that WCC was not in fact nominated as a beneficiary), the appointment of income to WCC had the result that the 4 Trust losses Remain Idle
default beneficiaries became presently entitled to the income appointed to WCC. Accordingly, His Honour found that the present entitlement of the default beneficiaries arose out of, or was connected with, the purported appointment of trust income to a company which was contemplated to be a beneficiary of the relevant trust in the operation of the reimbursement agreement, but which nomination was ineffective. Therefore, the present entitlement of the beneficiaries was held to have come within s.100a(1), and the appeals were dismissed. Analysis It is considered that this decision gives a very broad scope to s.100a. It is unfortunate that Spender J, in making such a strong finding on the somewhat indeterminate terms used in s.100a, did not elaborate on the intended purpose of this anti-avoidance provision. In the present case, it was unclear from the facts as to whether the default beneficiaries were in losses, and therefore liable to tax on the income that would have been assessed to them, bar the operation of s.100a. Were this not the case, and the beneficiaries were taxable on the amounts at a rate similar to that of the trustee (bar penalties), it would seem that the present finding would be outside the Parliamentary intent of this so-called trust stripping rule. This point is of particular relevance in light of the reliance placed by Spender J in the present case, and by the Full Federal Court in Prestige Motors, on the Court s opinion of the Legislature s intent when interpreting s.100a. Section 100A is one of the various means that the ATO has used to attack schemes designed to use trust losses. The losses involved here were for the 1993, 1994 and 1995 years and so predated the trust loss rules in Schedule 2F of the 1936 Act. The ATO also utilises its trust resettlement guidelines to the same end. Appeal The taxpayers have appealed to the Full Federal Court against this decision. A hearing date had not been set at the time of writing. 5 Trust losses Remain Idle
This article written by Luke Fullagar appeared in the November 2004 edition Vol 39 (5) of Taxation In Australia, the journal of the Taxation Institute of Australia. 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 60 003 146 852) www.gf.com.au Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph +61 2 9225 5955, Fax +61 2 9221 6516 Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph +61 3 9288 1881 Fax +61 3 9288 1828 Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph +61 8 9211 7770 Fax +61 8 9211 7755 6 Trust losses Remain Idle