Effective trust deeds and trust resolutions by Peter Slegers, FTIA, Partner, Tax & Revenue Group, Cowell Clarke

Transcription

1 COVER Effective trust deeds and trust resolutions by Peter Slegers, FTIA, Partner, Tax & Revenue Group, Cowell Clarke Abstract: Drafting effective trust resolutions to take account of the interface between taxation law and trust law has never been a straightforward exercise. That said, the situation has become increasingly more challenging in recent years following significant judicial decisions and the Commissioner's release of numerous practice statements, decision impact statements and other pronouncements. Treasury has now sought to intervene by developing the new trust streaming measures, and further large-scale legislative reform is now proposed. In this climate of significant uncertainty, the task remains to provide practical solutions to clients to these complex issues. This article is intended to provide some useful and practical observations on the drafting of effective trust deeds and trust resolutions. A number of case studies are provided to illustrate the key principles. The new trust streaming measures have been addressed in some detail, given their significance for the 2012, 2013 and possibly later income years. Trust distributions centre stage In the author s experience, drafting effective trust resolutions to take account of the interface between taxation law and trust law has never been a straightforward exercise. 1 That said, it is fair to say that, in recent years, this area has become increasingly more complex. Moreover, the issue of how to draft effective trust resolutions in accordance with the trust deed is now centre stage in the daily drama of difficult issues faced by tax professionals. Recent developments in this area have gathered momentum following significant judicial decisions. 2 The Commissioner of Taxation s response has been not only to test the case law, but also to issue a plethora of practice statements, decision impact statements and other ATO pronouncements. This has largely compounded the problems rather than helped. Treasury has sought to intervene by developing the new trust streaming measures, and further large-scale legislative reform is now proposed. It is in this climate of ever-increasing complexity and uncertainty that the author has been asked to comment on effective trust deeds and trust resolutions. It is hoped that this article provides some useful insights and practical observations, rather than simply adding to the confusion in this area. The trust steaming measures have been addressed in some detail, given their significance for the 2012, 2013 and possibly later income years. 3 The author would like to thank Terry Murphy, SC, for his feedback and comments in developing this article. He would also like to thank Alessar Elsayed of Cowell Clarke for her assistance with its preparation. First principles Terminology To assist with an understanding of this area, it is helpful to use consistent terminology. In this article, the term tax net income will be used to describe the net income of a trust estate as defined by s 95(1) of the Income Tax Assessment Act 1936 (Cth) (ITAA36). Broadly, this is the total assessable income of the trust estate assuming that the trustee was a taxpayer in respect of that income and was resident less allowable deductions. 4 Tax net income is essentially a proxy for the taxable income of a trust estate, remembering, of course, that a trust is not a taxpayer for the purposes of Div 6. The second important term used in this article is trust income. This term will be used interchangeably with the more exact expression of income of a trust estate, as that phrase is used in s 97(1) ITAA36 and elsewhere in Div 6. Trust income was usefully defined in the High Court decision of Bamford as income according to appropriate accounting principles and the trust deed. 5 A term often used interchangeably with trust income is distributable income. This is a useful expression in that it describes the trust income that is legally available to the trustee to distribute to beneficiaries. 6 Trust income or distributable income is generally regarded as real income, whereas tax net income is entirely a creation of the tax legislation. Two other terms are worth mentioning. These terms are commercial rather than technical terms, but are critical when reviewing trust deeds. This article uses the term income equalisation clause 7 to describe a provision in the trust deed which equates trust income with tax net income usually with some modifications. Typically (although not always), it will fall within the definitions section of the trust deed where the trust s income or net income is defined. The other important term is an income recharacterisation clause or power. This is normally a power under the trust deed for the trustee to treat capital as trust income (and vice versa) for the purposes of the trust. The Bamford decision involved the exercise of an income recharacterisation power. The court determined that the net capital gain arising from a disposal of a rental property by the trustee was trust income because it treated an income recharacterisation power as having been exercised to characterise the capital gain as income. This allowed the net capital gain to be treated as trust income and assessed to the beneficiaries rather than the trustee as was contended for by the Commissioner of Taxation. The above terms and concepts will be returned to at various points in this article. Taxation in Australia Vol 46(10) 443

2 The concept of trust income is more thoroughly explored below. Division 6 framework With the above terms in mind, it is worthwhile making a number of preliminary observations about the conventional operation of Div 6 ITAA36. Subject to the new streaming measures on capital gains and franked distributions, some of the fundamental workings of Div 6 may be summarised as follows: Div 6 does not tax trusts. Under Div 6, the tax net income is included in the assessable income either of the trustee or the beneficiary subject to tax depending on the trustee or beneficiary s respective tax positions; in this respect, s 95(1) ITAA36 acts as a gateway whereby all amounts included in the tax net income gateway must be assessed to either the trustee or a beneficiary; a beneficiary s assessment to the tax net income depends on that beneficiary s present entitlement to a share of the trust income. This is based on the underlying principle that a beneficiary can only ever be presently entitled to trust income and not tax net income; and where there is an amount of tax net income to which no beneficiary is assessed, that amount will be assessed to the trustee. A perennial issue for Div 6 is what happens if, in a particular income year, there is an excess of tax net income over trust income? The High Court decision in Bamford has confirmed, once and for all, that a proportionate approach must be adopted in these circumstances. That is to say, the excess tax net income must be assessed to the beneficiaries in the same proportion or percentage share that each beneficiary holds in the trust income. 8 The proportionate approach is simple enough as a concept. If a trust has derived $100 of trust income but has $200 of tax net income, the excess tax net income of $100 must be assessed to the beneficiaries in accordance with their percentage share of the trust income. Hence, if A was presently entitled to $50 of the trust income and B was presently entitled to the other $50, both would be assessed not only on the $50 amount that they are presently entitled to, but also on the extra $50 ($100 in total) of excess net income. In practice, the proportionate approach is often far more difficult to apply, especially given the amorphous concept of trust income an issue which we will now consider. Trust income a pivotal concept As already stated, trust income is income according to appropriate accounting principles and the trust deed. The accounting principles in question are not accounting standards. They are principles recognised by the law of equity when determining the income as opposed to the capital entitlements of trust beneficiaries. 9 A number of other observations can be made regarding the nature of trust income: while trust income is subject to the provisions of the trust deed, these provisions need to be read in the context of trust law. There must be some limitation on the ability of the trust deed to define income and capital. 10 To take an extreme example, a receipt involving the repayment of a loan made by the trustee to the borrower is unlikely to be treated as trust income simply because the trustee exercises a power under the trust deed to treat the receipt as income; there is a principle that trust income must be an accretion to the trust estate. It is on this basis that purely notional or fictional amounts arising under the tax legislation are generally not regarded as amounting to trust income, even if an income equalisation clause or income recharacterisation power is adopted; trust income is by nature a gross concept. 11 That said, trust income is often defined under the trust deed by reference to an amount of income net of expenses and outgoings; and given the significance of trust income, caution should be observed in assuming that it is the same as accounting profit. However, in practice, accounting profit and trust income may often be similar amounts or in some cases the same. If a trust deed does not define the trust s income or net income, there is no basis for a capital gain made by the trust to be treated as trust income. Trust law would, of course, regard all capital gains whether taxable or tax-sheltered by concessions or losses as capital rather than income receipts. Until introduction of the new trust streaming measures, this would mean that, unless an income equalisation clause or income recharacterisation power could be relied on under the trust deed, any taxable capital gain would need to be assessed to the beneficiaries in accordance with their proportionate share of trust income. If there was no trust income, a correct application of the law would require the capital gain to be assessed to the trustee. The new trust streaming measures, which we will now turn to, have dramatically altered that position. Streaming measures Overview The new trust streaming measures 12 were introduced following the ATO s reaction to the High Court Bamford decision. 13 In its decision impact statement on Bamford, the ATO questioned the ability of discretionary trusts to stream different sources of income or capital creating uncertainty in this area, given that streaming has long been accepted by the ATO. Treasury responded to this by developing legislation that specifically allows trusts to stream capital gains and franked distributions, provided the requirements of the legislation are met and the trustee exercises its power to do so under the trust deed. The legislation provides a legislative formula for how capital gains and franked distributions may be streamed to particular beneficiaries. It does not deal with streaming of other sources or classes of income or capital. The streaming measures may be broadly summarised as follows: beneficiaries are no longer assessed under Div 6 on net capital gains or franked distributions. Instead, beneficiaries are assessed under the capital gains tax (CGT) and imputation regimes, respectively; 14 in order to determine a beneficiary s assessment to a net capital gain or a franked distribution, it is necessary to determine the beneficiary s share of the capital gain or franked distribution; a beneficiary s share of the capital gain or franked distribution is: the amount of the capital gain or franked distribution to which the beneficiary is specifically entitled; and if there is an amount to which no beneficiary is specifically entitled (and the trustee is not specifically 444 TAXATION IN AUSTRALIA May 2012

3 entitled), the amount multiplied by the beneficiary s adjusted Division 6 percentage of the trust income. broadly, the adjusted Division 6 percentage is based on the beneficiary s percentage share of the trust estate s Div 6 income, ignoring capital gains and franked distributions to which beneficiaries are specifically entitled; to be specifically entitled to a capital gain or a franked distribution (as the case may be), the beneficiary must receive or be entitled to receive an amount equal to their share of the net financial benefit referrable to the capital gain or franked distribution, respectively; moreover, the beneficiary will only be specifically entitled to the extent that the amount is recorded in its character as referrable to the respective capital gain or franked distribution; 15 and the CGT gross-up measures 16 and the imputation measures 17 are modified to ensure that beneficiaries are assessed on the correct amount of the capital gain or franked distribution, respectively, without double counting. In the case of capital gains, the usual provisions governing the availability of capital losses and the CGT discount at beneficiary level apply 18 (with some modifications). It should be emphasised that the streaming measures are intended as an interim arrangement only. More comprehensive changes are proposed as part of the Treasury review of the taxation of trust income (see further below). However, the existing streaming measures are likely to apply until the year ended 30 June Role of trust deeds The streaming measures do not dispense with the need to have an express streaming power in the trust deed. 20 It is suggested that a streaming clause is vital. Although the legislation uses a statutory definition of specific entitlement, the creation of a right to receive a benefit from the trust will still ultimately depend on the trustee exercising its discretion to distribute income or capital. Therefore, the trust deed continues to be paramount when drafting effective trust distribution minutes. 21 Minutes prepared in accordance with the trust deed will now need to ensure that the beneficiary intended to be assessed (the designated beneficiary) has the requisite specific entitlement. Accountants preparing tax returns for trusts will need to gain an appreciation of the standard trust deeds applicable across their practices. This will allow for distribution minutes to be drafted so that they are appropriate for the particular trust deed in question. Of course, whatever precedent system is adopted, there will be no substitute for considering the precise circumstances. Trusts deeds vary enormously. However, it is suggested that four separate approaches are often typically adopted in defining trust income: (1) trust income is equated with tax net income (normally), excluding the gross-up on franked dividends. That is, the trust deed has an income equalisation clause; (2) trust income is not defined at all or is defined by reference to accounting principles; (3) trust income is defined by reference to an exercise of the trustee s discretion and may include or exclude certain receipts and outgoings as the trustee determines. That is, the trust has an income recharacterisation power either in its definition or elsewhere in the deed, allowing it to treat certain receipts as trust income; and (4) trust income includes all net profits or gains, whether of an income or capital nature. Of course, the precise wording of each trust deed always needs to be carefully considered when drafting effective trust distribution minutes. There are countless variations and additions to the above approaches. Treatment of capital gains under streaming measures Basic concepts In the context of capital gains, a beneficiary s specific entitlement will depend on whether the beneficiary receives or can reasonably be expected to receive the net financial benefit referable to the capital gain. 22 In broad terms, the net financial benefit is a reference to the net proceeds of the capital gain. 23 Significantly, the capital gain referred to in the legislation is the capital gain gross of the 50% discount (and any other CGT concessions). Therefore, if a trust makes a capital gain of $100 which qualifies for the 50% discount, it is necessary for the trustee to create a specific entitlement in the designated beneficiary of both the $50 taxable component and the $50 tax-sheltered component. The capital gain is, however, net of capital losses. Therefore, if, in the above scenario, the trust has a capital loss of $20, it would then be necessary to create a specific entitlement in the $40 taxable capital gain and the $40 tax-sheltered capital gain to ensure that the designated beneficiary is specifically entitled to the whole of the net financial benefit. This position should not be confused with beneficiaries having capital losses. 24 Trust deed s concept of income For a trust deed with an income equalisation clause, the definition of income will include the taxable capital gain. However, this definition would not normally include the tax-sheltered amount arising from the 50% discount or other CGT concessions. Therefore, if this concept of trust income is adopted under the trust deed, it will be necessary to not only create a specific entitlement in the trust income referable to the taxable capital gain, but also make a capital distribution of the tax-sheltered amount. A specific capital distribution power should be invoked when drafting the trust distribution minutes. If the trust deed adopts an accounting principles definition of income, none of the capital gain (whether taxable or taxsheltered) will be included in the definition of trust income. This is because, unless the trust deed provides otherwise, a capital gain is not income for the purposes of the accounting principles applicable under trust law. 25 In this scenario, it will be necessary to rely on the capital distribution clause to distribute the whole of the gross capital gain to the designated beneficiary. If the trust deed contains an income recharacterisation clause, it should be possible for the trustee to rely on that power to treat any net capital gain as income. It should also be possible to treat the tax-sheltered amount as income. However, this latter issue has not been tested in the courts. 26 In any event, it will be necessary to rely on the trustee exercising the income recharacterisation power to create the necessary specific entitlement. A definition of trust income that treats all income or gains (whether of an income or a capital nature) as trust income would allow the whole of the capital profit to be treated as trust income. This would mean that the specific entitlement could be created by Taxation in Australia Vol 46(10) 445

4 distributing the whole of the capital profit as trust income. The definition of specific entitlement also requires the trustee to ensure that the net financial benefit is recorded in its character in the records or accounts of the trust within two months of the end of the income year. Trustee minutes should therefore make explicit reference to the capital gain (including identifying the CGT asset and when it was disposed of) so that the amount is recorded in its character. 27 The timing issue is discussed further below. Impact of CGT concessions As noted already, it is important to consider the impact of CGT concessions. The fact that an amount is sheltered from tax by a concession does not mean that the amount is not part of the net financial benefit. Only amounts that are sheltered because of capital losses are not part of the net financial benefit. Finally, if the capital gain is entirely disregarded (such as in the case of the 50% discount and several of the small business CGT concessions eliminating the capital gain), the new streaming legislation will not have any practical impact. This is because the legislation deals with determining a beneficiary s assessment to a taxable capital gain. If there is no taxable capital gain, the legislation has no operation. There are some exceptions to this which have been explored in the case studies below. Treatment of franked distributions under streaming measures Basic concepts For franked distributions, a beneficiary s specific entitlement will depend on whether the beneficiary receives or can reasonably be expected to receive the net financial benefit referable to the franked distribution. 28 The net financial benefit takes account of the distribution or dividend amount only and not the franking credit. 29 Consistent with the existing imputation provisions, the legislation recognises that the franking credit will automatically flow in proportion to the beneficiary s share of the franked distribution. In other words, a beneficiary receiving a $70 franked dividend by way of trust distribution will include the $30 franking credit in that beneficiary s assessable income, and that beneficiary will be entitled to a $30 tax offset on the tax payable. 30 It is therefore unnecessary to refer to the franking credit in the trust distribution minutes, but it is critical to record the extent to which any dividend is franked. Specific entitlement and directly relevant expenses The concept of specific entitlement is slightly different for franked distributions compared with capital gains. One major difference is that the net financial benefit is defined as the amount of the franked distribution less directly relevant expenses. 31 This is significant in that expenses that are not directly relevant to the derivation of the franked distribution Trustee minutes should make explicit reference to the capital so that the amount is recorded in its character in the records of the trust. cannot be deducted against the amount of the distribution when determining the net financial benefit. Hence, if expenses are incorrectly deducted, there remains the risk that a designated beneficiary will not be specifically entitled and assessed on the correct amount of the dividend. The EM to the streaming legislation offers but two examples of directly relevant expenses. It provides that share portfolio management fees and interest on borrowing expenses to purchase a share portfolio are directly relevant expenses. 32 Further guidance by way of the ATO issuing a public ruling on directly relevant expenses is likely to be of much assistance to tax professionals. It should be noted that, in order to deduct directly relevant expenses against franked distributions, the trustee will need to rely on an appropriate expense allocation power. That is, the trust deed must contain a clause allowing the trustee to deduct specific expenditure against particular sources or classes of income or capital. Finally, as with capital gains, to be specifically entitled to a franked distribution, there is a need for the net financial benefit to be recorded in its character as referable to the franked distribution in the accounts or records of the trust. Again, the trust distribution minutes should, in most cases, serve this purpose. In the case of franked distributions, this must happen no later than the end of the income year in which the franked distribution was derived (two months after the end of the income year is allowed for capital gains). Imputation changes and pooling The streaming legislation is consistent with the existing imputation provisions in that a beneficiary must derive a positive amount of trust income to be entitled to the franking credits. 33 In other words, where a beneficiary does not have any positive amount of trust income even if they have positive tax net income on account of the gross up the beneficiary will not be entitled to any imputation credits. The imputation provisions are slightly amended to redefine the beneficiary s share of a franked distribution taking account of the new concepts. The beneficiary s share of a franked distribution is critical to determining that beneficiary s entitlement to franking credits. 34 As a general proposition, this will now largely depend on the sum of the beneficiary s specific entitlement to a franked distribution and, if there are amounts of the franked distribution that no beneficiary is specifically entitled to, the beneficiary s share of the adjusted Div 6 trust income. 35 These issues are considered further in one of the case studies below. One additional feature of the proposed legislation is that it allows franked distributions to be pooled. That is, the trustee may treat all franked distributions received by the trust as a single class, with the result that the provisions will apply to the total franked distributions as if they were a single distribution. Therefore, a beneficiary can be specifically entitled to all of the franked dividends of a particular class, even if particular dividend income was a negative amount due to directly relevant expenditure relating to it. This will be significant in ensuring that a trust has positive net dividend income to allow for 446 TAXATION IN AUSTRALIA May 2012

5 the flow-through of franking credits to designated beneficiaries. Timing issues 30 June deadline In the author s view, the law in this area is beyond doubt. In order to prevent a s 99A ITAA36 assessment arising to the trustee of a trust, a beneficiary s present entitlement must be created prior to the end of 30 June. 36 The Commissioner of Taxation has previously provided administrative relief from this position, stating that, provided the resolution is effected by 31 August following the income year in question, the Commissioner would not assess the trustee under s 99A (IT 328 and 329 these rulings have now been withdrawn). The streaming legislation does provide for capital gains to be recorded in their character within two months after the end of the income year. That said, the recording of amounts in their character should not be confused with the need to create the necessary present entitlement to trust income. In the author s view, the streaming measures are merely providing a basis for the record of any 30 June trust resolution concerning capital gains being documented two months later to meet the requirement of a beneficiary being specifically entitled. Practice management How practical is the 30 June deadline? Many tax agents will find it difficult, if not impossible, to comply with the 30 June deadline for all trusts across their practices. In the end, it is expected that the matter will be an issue of risk management for each practice. Certainly for trusts deriving significant tax net income, there will be a greater imperative to ensure that the trustees effect their resolutions by 30 June and no later. On balance, the trend will now be to draw resolutions in terms of percentages rather than use exact amounts. Taxpayers will need to accept that trusts cannot be used with the same precision that they may have become accustomed to in the years before the 30 June deadline was unlikely to be enforced. Of course, there may be further changes in this area on account of the various submissions and recommendations to Treasury. For the time being, the author s view is that all efforts will need to be made to comply with the existing law, as both Div 6 and the streaming measures are clear on this issue. The following case studies are intended to tease out the issues relating to the new streaming measures as discussed above. All of the trusts referred to in the case studies below should be assumed to be discretionary trusts. Case studies on streaming measures Case study 1: basic CGT case The Christopher Marlowe Trust sells a block of flats, crystallising a $1m capital gain. It qualifies for the 50% discount but no other CGT concessions. The trust has no capital losses. The trustee wishes to distribute all of the rental income to Marlowe Investments Pty Ltd 37 and the capital gain to Mr Marlowe s spouse, Ophelia. The trust deed has a streaming clause. Its trust deed has an income equalisation clause defining the trust income as the tax net income. It also contains an income recharacterisation power. How does the trustee create the necessary specific entitlement to the capital gain? In broad terms, the following action could be taken: Ophelia must receive/be reasonably expected to receive the net financial benefit referable to the capital gain in accordance with the terms of the trust. The trustee must therefore ensure that Ophelia has an entitlement to $1m. However, only $500,000 of this capital gain is included in the trust income. Therefore, the trustee will need to distribute $500,000 to Ophelia as an income distribution and distribute the remaining $500,000 as a capital distribution. This would require the exercise of a valid capital distribution power under trust deed of the Christopher Marlowe Trust. On the basis that the trust deed contains the necessary power, this can be cited in the trustee distribution minutes. An alternative approach would be for the trustee to exercise its power to recharacterise the whole $1m capital gain as trust income. It could then make an income distribution to Ophelia and no capital distribution would be required. Of course, when making the above distributions, the trustee should be invoking the streaming clause in its trust deed, and an explicit reference to the exercise of the streaming power in the trust distribution minutes is highly desirable. Finally, to ensure that the capital gain has its character recorded in the records of the trust, the trust distribution minutes should contain a resolution dealing with the distribution of the capital gain and a separate resolution dealing with the other income. These resolutions can be contained in the same minutes. Of course, in reality, the situation may be more complex than this but the above steps should at least provide a working guide on how the issues may broadly be approached. Case study 2: franked dividends and expense allocation The Shakespeare Trust owns a commercial property and a substantial share portfolio. The Shakespeare Trust has bank debt arising from the original acquisition of the share portfolio. The share portfolio generates fully franked dividends of $37,331 and franking credits of $15,599. The trust has property holding and maintenance costs, as well as interest expenses on its bank debt. It also has some general expenses (accounting fees, and superannuation contributions for the trustee s directors). The trustee, William, wishes to distribute all dividend income to his adult daughter, Susanna (who is at university, with no other income), thereby generating a refund on the franking credits. The rent will be distributed to entities elsewhere in the Shakespeare group. The trust deed contains a streaming power and provides that expenses may be allocated against any source or class of income as the trustee in its discretion determines. If the trustee wishes to create a specific entitlement in the franked dividends in favour of Susanna, how are the expenses to be allocated? To be specifically entitled, Susanna will need to receive/be reasonably expected to receive the net financial benefit referable to the franked dividend. The calculation of the net financial benefit will require that only the directly relevant expenses are subtracted from the franked dividend. The interest should be directly relevant but, of course, the property holding costs Taxation in Australia Vol 46(10) 447

6 will not be relevant to the derivation of the franked dividend. The accounting fees and superannuation are unlikely to be regarded as directly relevant expenses unless some direct nexus can be established with the derivation of the dividend. There is no suggestion of this on the above facts. Of course, on the basis that the distribution is made at 30 June, it will be difficult (if not impossible) to quantify the directly relevant expenses before then. Therefore, it may be sufficient for the trust resolution to explicitly refer to the trustee appointing all franked dividend income less directly relevant expenses to Susanna. The amount, of course, will ultimately be quantified in the drawing of the financial statements of the trust. This case study demonstrates the care that will need to be taken when offsetting expenses against franked dividend income. If Susanna received slightly less than the net financial benefit, as some expenses that were not directly relevant were netted off, then she may not be specifically entitled to the franked dividend. Case study 3: no trust income One benefit of the new legislation is that it overcomes some of the problems associated with having no trust income in a particular income year, as the following case study demonstrates. The Johnson Discretionary Trust owns a holiday house in Canberra. Ben and his spouse (the directors of the trustee) use the holiday house for the summer holidays. Apart from this use, the holiday house remains vacant. It does not generate any rent and the trust has no other income. The trustee sells the property and triggers a capital gain of $500,000 which qualifies for the 50% discount but no other concessions. The trust deed does not define trust income. Moreover, it is not possible to amend the trust deed, as the amending power requires the consent of the appointor who is deceased. No replacement appointor has been or can be nominated. There is a power under the trust deed to distribute capital to any of the beneficiaries on or at any time before the vesting day. How might the trustee ensure that the capital gain is assessed to Ben or other members of his family? Prior to the streaming measures, the above result would have been that the trustee would be assessed under s 99A ITAA Under Div 6 (as it applied prior to the streaming measures), a beneficiary s assessment to the tax net income comprising a taxable capital gain depended on their proportionate share of the trust income. Therefore, if there was no trust income, no beneficiary could be presently entitled to the tax net income comprising the $250,000 taxable capital gain. The trustee would therefore need to be assessed under s 99A. Under the new regime, the trustee could invoke its capital distribution power to ensure that the $500,000 capital gain is distributed to Ben (or whichever individual family member is to be assessed) as a capital distribution. In this case, the individual would be reasonably expected to receive the net financial benefit referable to the capital gain and could be assessed on it. Case study 4: small business CGT concessions and tax losses A burning issue is how the new regime will interface with small business CGT concessions. In most cases, if the concessions have the effect of completely disregarding the capital gain, then there may not be an issue. This is because, so far as capital gains go, the new streaming measures are all about determining who is assessed on taxable capital gains (even though tax-sheltered or disregarded capital gains will be relevant to the exercise as has already been demonstrated). The following case study demonstrates how significant the overlap between the streaming issues and the small business CGT requirements can be. The Bernard Shaw Land Trust sells farm land, making a $3m capital gain in the 2012 year. George is the sole director of the trustee company. George (56 years of age) is a widower, with no children. In practical terms, George is the only person capable of being a CGT concession stakeholder of the trust. The trustee claims the following concessions on its capital gain: Gross capital gain: $3,000,000 Less 50% discount: $1,500,000 Less 50% reduction $ 750,000 (Subdiv 152-C) Less retirement exemption $500,000 (Subdiv 152-D) Net capital gain $250,000 The trustee wishes to distribute the last $250,000 taxable capital gain to the Bernard Shaw Loss Trust which has carry-forward tax losses (from legitimate trading activities) of at least $250,000. The trust deed for both trusts has an income equalisation clause treating the trust income as the tax net income (excluding the gross-up on franked it may be sufficient for the resolution to explicitly refer to the trustee appointing all franked dividend income less directly relevant expenses. dividends). However, this is subject to an income recharacterisation power to include or exclude certain receipts from the trust income and treat them as trust capital. It should be assumed that the Bernard Shaw Land Trust and the Bernard Shaw Loss Trust have made the necessary family trust elections to allow for the income injection test to be passed under the trust loss measures. 39 How might the above distribution proposal be achieved, having regard to both the trust streaming measures and the small business CGT concessions? To access the retirement exemption (Subdiv 152-D of the Income Tax Assessment Act 1997 (Cth) (ITAA97)), the trustee would have needed to pass the significant individual test which requires that an individual has a small business participation percentage of at least 20% of the trust s income and/or capital distributions for the year in which the CGT event happens. This, in effect, 448 TAXATION IN AUSTRALIA May 2012

7 requires George to have received directly or indirectly at least 20% of all income and/ or capital distributions of the Bernard Shaw Farm Trust for the 2012 year. 40 To ensure that the Bernard Shaw Loss Trust is specifically entitled to the capital gain, it is necessary that the Bernard Shaw Loss Trust receives, or can reasonable be expected to receive, the net financial benefit referable to the capital gain. This is not $250,000 but the entire $3m the net financial benefit is only net of capital losses, not CGT concessions. Therefore, it will be necessary for the trustee to distribute not only the assessable $250,000 amount to the Bernard Shaw Loss Trust, but also the $2,750,000 tax-sheltered amount. Extreme care would need to be taken here because, if there are differences in the percentages of income and capital distributions, s (1) ITAA97 will require that the smallest percentage to be taken into account. That may result in the significant individual test being failed. Taking account of this, the trustee may wish to rely on its power under the trust deed to treat not only the $2,750,000 amount as a capital distribution, but also the $250,000 as a capital distribution (rather than a distribution of trust income). From a streaming perspective, this should not be a problem as the legislation focuses on the beneficiary receiving the net financial benefit rather than considering (as was traditionally the case) whether the receipt was trust income. On the basis that the Bernard Shaw Loss Trust included the $250,000 in its tax net income as a result of the above process, its tax losses can be offset against this amount. There remains the issue of the Bernard Shaw Loss Trust making the requisite distributions to George to ensure that he is a significant individual. The requirement of the Bernard Shaw Farm Trust to have George as its significant individual can be satisfied indirectly by considering the distributions of the Bernard Shaw Loss Trust. The Bernard Shaw Loss Trust has no trust income. Moreover, its taxable capital gain has been eliminated by virtue of the tax loss. It has no tax net income. Therefore, consideration should be given to the Bernard Shaw Loss Trust making a capital distribution. Assuming that it makes a capital distribution solely to George (perhaps of the entire $3m amount), George should have a small business participation percentage in the Bernard Shaw Loss Trust of 100%. On the basis that the Bernard Shaw Loss Trust received 100% of the Bernard Shaw Farm Trust s capital distribution (and no trust income as suggested on the above basis), George should therefore have a participation percentage in the Bernard Shaw Farm Trust of 100% and readily satisfy the requirement of having a small business participation percentage of greater than 20%. George should therefore amount to a significant individual, allowing the Bernard Shaw Farm Trust to qualify for the retirement exemption. It can be seen that a careful analysis will be required to achieve the desired outcomes in these kinds of situations. Case study 5: franked distributions and tax losses The Wilde Loss Trust has made a $699,998 tax loss as a result of its trading expenses exceeding its trading income for the 2012 year. Nearing the end of the 2012 year, the Wilde Shareholder Trust (another discretionary trust in the Wilde group) received a significant fully franked dividend from one of the private companies that it wholly owns. The amount of the fully franked dividend was $700,000 grossed up to $1,000,000 after taking account of the franking credits. It is proposed that the Wilde Shareholder Trust will inject this dividend income into the Wilde Loss Trust, with the desired result that the tax losses will be used and Oscar (an individual beneficiary of the Wilde Loss Trust) will become presently entitled to the $2 of trust income. This will entitle Oscar to all of the franking credits associated with the dividend income and potentially, depending on Oscar s other income, a substantial tax refund. The Wilde Shareholder Trust has no other sources of income for the 2012 year. It should be assumed that both trusts have made family trust elections, with Oscar as the test individual. This will allow for the income injection test to be passed under the trust loss measures and will also allow for the flow through of franking credits to the respective trusts beneficiaries. What is required under the new streaming measures to achieve the desired outcome? The existing imputation provisions determine a beneficiary s entitlement to franking credits based on that beneficiary s share of the franked distribution. 41 The franking credits available to the beneficiary are included in the beneficiary s assessable income, and the beneficiary becomes eligible for tax offsets for an amount equal to the franking credits available on the franked distribution. 42 The Wilde Loss Trust should be assessed on the $700,000 fully franked dividend in that it is reasonably expected to receive that amount from the Wilde Shareholder Trust and the amount is recorded in its character as a franked dividend. The difficult issue is to determine Oscar s share of the franked distribution. It will be critical to ensure that Oscar has a 100% share of the franked distribution derived by the Wilde Loss Trust. Section ITAA97 provides that, where a trust has a positive amount of tax net income (as is the case here), the beneficiary s share of the franked distribution is the sum of: the amount of the franked distribution to which the beneficiary is specifically entitled; and if there is an amount of a franked distribution to which no beneficiary is specifically entitled, the amount of the franked distribution multiplied by the beneficiary s adjusted Division 6 percentage of trust income. Therefore, Oscar will have a 100% share of the franked distribution if Oscar is specifically entitled to the whole of the franked distribution. Alternatively, if there is no amount of the franked distribution to which any beneficiary is specifically entitled, Oscar s share will depend on Oscar s adjusted Division 6 percentage of trust income. On the basis that the Wilde Loss Trust only has $2 to distribute (on account of its trading loss being deducted against its franked dividend income), it might be difficult to establish how to create a specific entitlement in $700,000. $700,000 is the net financial benefit referable to the franked distribution since the trading expenses are not directly relevant expenses to the derivation of the franked dividend. Therefore, Oscar must be reasonably expected to receive the $700,000. It is possible to create a present entitlement in a gross amount since, as already noted, trust income is a gross rather than a net concept. However, here we are attempting to create a specific entitlement not a present entitlement. To what extent is Oscar reasonably Taxation in Australia Vol 46(10) 449

8 expected to receive the $700,000 when there is only $2 physically available for distribution? Oscar s entitlement to 100% of the franking credits might be at risk in these circumstances. An undesirable result might also arise if a specific entitlement is only created in $2. This approach runs the risk that the adjusted Div 6 income is zero. The $2 is excluded on the basis that a beneficiary is specifically entitled to this amount. However, it is open to conjecture as to whether there is any Div 6 trust income. Oscar s share of the franked distribution may only be 2/700,000th s of the franked distribution clearly, an unacceptable outcome. A more certain outcome might be achieved by ensuring that no beneficiary is specifically entitled to the $2 but Oscar has a 100% of the Wilde Loss Trust s Division 6 percentage adjusted trust income. This might be achieved by ensuring that the $2 is trust income under the trust deed and that Oscar is presently entitled to that $2 of trust income. The trust distribution minute should avoid describing the character of the income as a franked distribution so that it is clear that the trustee is not purporting to record the franked distribution in its character and create a specific entitlement to it. Instead, the $2 can simply be noted as the net amount of trust income. On the basis that Oscar has a 100% adjusted Division 6 percentage of trust income, eg the $2, Oscar should have a 100% share of the franked distribution. This appears to be the best outcome under the legislation on this difficult (but not uncommon) factual situation. Finally, it should be noted that the legislation contains a mechanism to ensure that a beneficiary is not assessed on an amount in excess of the tax net income of the trust. In particular, s ITAA97 applies here as the tax net income will fall short of the total franked distributions that are assessable to the trust. Section (3) in effect reduces the attributable franked distribution (the franked distribution assessed to the beneficiary) so that it is no more than the tax net income of the trust. Case study 6: small business CGT roll-over relief In the 2011 year, the Samuel Beckett Trust (a discretionary trust) makes a capital gain of $2,000,000 on the disposal of internally generated goodwill from the sale of its business. The trust qualifies for the 50% discount (Div 115 ITAA36) and the 50% reduction (Subdiv 152-C ITAA97), reducing the taxable capital gain to $500,000. As Mr and Mrs Beckett (the controllers of the trust) have previously used the retirement exemption (Subdiv 152-D ITAA97) up to their respective $500,000 lifetime limits, they are unable to apply that concession here. Instead, the trustee elects to apply the small business roll-over (Subdiv 152-E ITAA97) to defer the capital gain on the $500,000 amount for two years. This is done merely as a deferral as Mr and Mrs Beckett are not wishing to go back into business. That is to say, there is no desire for the Samuel Beckett Trust to acquire active assets as replacement assets at any time in the future. As the above concessions are applied, the capital gain is entirely disregarded for the 2011 year. In the 2011 year, Mrs Beckett, a high income earner, accesses the whole $2,000,000 (tax-sheltered) amount by way of a capital distribution from the trustee. At the time, it is considered that there is no downside in the capital distribution being made to Mrs Beckett (rather than Mr Beckett a low income earner), given that the whole amount is tax-sheltered in any event. In the 2013 year (on account of the Samuel Beckett Trust not acquiring any active assets), the trust makes a CGT event J5 capital gain of $500,000. The Samuel Becket Trust has no trust income for the 2013 year. On account of the CGT event J5 capital gain, its tax net income is $500,000. To whom should the $500,000 of tax net income be assessed? This will depend on whether a beneficiary is specifically entitled to the net financial benefit referable to the J5 capital gain. Who has received or can reasonably be expected to receive the net financial benefit from the capital gain? A net financial benefit cannot be a notional amount 43 therefore, it is difficult to contemplate a beneficiary having any financial benefit referable to the J5 capital gain. The view may be taken that the trustee needs to be assessed on the $500,000 an unpalatable result. An alternative view might be that (consistent with the EM to the streaming measures 44 ) the net financial benefit needs to be determined over the life of the asset and the only relevant asset here is the goodwill. This of course relates to another CGT event (CGT event A1) from when the business was disposed of in 2012, which is a potential problem when adopting this approach. If this approach it is difficult to contemplate a beneficiary having any net financial benefit referable to a CGT event J5 capital gain. was taken, however, it might then be argued that Mrs Beckett should be assessed, given that all of the tax-sheltered capital gain was distributed to Mrs Beckett in the 2011 year (including the $500,000 amount sheltered by virtue of the small business roll-over). A more certain (and perhaps more taxeffective) outcome might have been achieved if the entire $2m had been left in the Samuel Beckett Trust until 2013 and distributed to Mrs Beckett as a capital distribution at that time. That way, Mrs Beckett could be properly regarded as having the net financial benefit referable to the capital gain for the year in which the CGT event J5 is to be assessed. There is still an issue of whether this net financial benefit is referable to the capital gain in question, but the position is arguably stronger with the CGT event and the net financial benefit being distributed in the same year. The proceeds are being removed from the trust as it is not acquiring a replacement asset and its omission to do so is triggering the J5 capital gain. If there was a commercial need to access the moneys in 2011, this could have been effected by the trustee lending the beneficiaries the moneys and being repaid the amounts in 2013 prior to making the requisite capital distribution to Mrs Beckett. Other trust distribution issues Excess tax net income As has already been noted, many of the difficulties in this area arise because there is a discrepancy between the trust income and the tax net income. 450 TAXATION IN AUSTRALIA May 2012