With the tightening of the anti-avoidance net it was time to correct a 1969 High Court decision that had opened an avenue to escape tax through use of trusts to receive foreign source income.
A decision of the High Court in 1969 - Union Fidelity Trustee Co v. Federal Commissioner of Taxation99 - upset long-held official notions about the scope of the trust provisions of the income tax law. Those provisions directed the ascertainment of the net income of a trust estate (that is, its taxable income) and its taxing to beneficiaries according to the extent of their present entitlement, with income to which no beneficiary is presently entitled, (broadly, income directed to be accumulated) being taxed in the hands of the trustee.
The case itself did not have tax avoidance implications, and involved foreign-source income of a deceased estate, the trustees of which were Australian residents.
Basically, Australia taxes an Australian resident on income from sources inside and outside Australia, while non-residents are taxable only on Australian source income. The Full High Court concluded that the trust provisions applied only to income with an Australian source.
The Asprey Committee, in its report handed down on 31 January 1975, had recommended that this position be changed, noting that this required significant restructuring of the trust provisions.
On 10 March 1978 a draft Cabinet submission on the matter was sent to Howard and after approval by him was lodged as Submission No. 2053 of 23 March 1978. Following consideration of some more technical issues, amending legislation was approved by Cabinet in Decisions 5491 of 22 May 1978 and 5652 of 1 June 1978.
With the decision taken that the new regime should apply from the beginning of 1978-79, when introducing other tax legislation on 8 June 1978, Howard took the opportunity to foreshadow the trust measures. He particularly justified what were structural measures on grounds of their contribution in dealing with tax avoidance.
There was concern that the Union Fidelity decision, if not corrected, would have the effect that foreign-source income could be accumulated for Australian residents in a trust without liability for Australian tax unless and until the trust income was distributed to a resident beneficiary.
The Treasurer told the House:
I refer now to another structural change that has as its principal purpose the prevention of tax avoidance by the use of trusts through which to derive foreign-source income. As the law stands, Australian residents can defer, or even escape altogether, the payment of tax on foreign source income of trusts accumulated for their benefit. The present situation, which the Asprey Committee has described as 'unacceptable', results from a High Court decision some years ago, to the effect that the trust provisions of the income tax law have application only to Australian-source income of trusts. Until recently, the decision had not given concern. However, because of the tax avoidance possibilities and the plain interest of tax advisers in avoidance through international activities, the Government has decided that corrective measures must now be taken.
The scheme of the amending legislation is to be very close to that recommended by the Asprey Committee. Under it, the existing trust provisions will be extended to the foreign source income of trusts that qualify as Australian resident trusts and also to the share of foreign source income of non-residents trusts to which an Australian resident beneficiary is presently entitled. The effect of the rules relating to resident trusts will be that, generally, the world income of such trusts, like the world income of resident individuals, will be liable to tax in Australia, either in the hands of the beneficiaries or the trustee. Income will be treated as taxable under the trust provisions to the beneficiaries or the trustee according to whether, under the trust deed or for other reasons, beneficiaries are presently entitled to the income. A resident trust is to be one of which at least one trustee is a resident, or which is managed and controlled in Australia.
Income flowing to a resident beneficiary from accumulated foreign source trust income not taxed in Australia while accumulating, for example, such income derived by a foreign trust, will be taxed in the hands of beneficiaries when received by them. Appropriate anti-avoidance rules will prevent beneficiaries escaping tax on a technicality that the amount or benefit is not received as income. In keeping with the basic principle of taxing non-residents only on Australian source income, a non-resident beneficiary presently entitled to foreign source income of a resident trust will not be taxed on it. In addition provision will be made to refund the appropriate amount of Australian tax paid on accumulated foreign source income of a resident trust which is ultimately distributed to a beneficiary who is beneficially entitled to it and who, when the income was derived by the trust, was not a resident of Australia. Appropriate credit will be given under the new foreign tax credit system for foreign tax paid on foreign source income which is taxed in Australia to a trustee or beneficiary. As an aid to administration, a trust carrying on business in Australia or deriving income here from property and which does not have a resident trustee is to be required to have a public officer in Australia responsible for ensuring observance of the trust's taxation obligations, in the same way as a company.
I add that the partnership provisions of the income tax law are to be amended so as to remove any possible doubt arising from the court decision to which I have referred as to their application to partnership income from sources out of Australia. These amendments to the trust and partnership provisions of the income tax law will apply to the 1978-79 and subsequent years of income. I commend the present Bill and the Government's plans for future tax reform of a most important kind to the House.
The necessary legislation was introduced into the House by the Income Tax Assessment Amendment Bill (No. 5) 1978, and in due course passed.
Telephone book trusts
Digressing just a little, in mid-1977 a particular trust income practice was mentioned in the material that had been sent to the Prime Minister100 and was seen to be one of avoidance, even evasion. The scheme involved Australian income being credited to multiple overseas beneficiaries, the amount assigned to each being below the amount which attracted tax. It was reported that, in some cases, no payment was made to the overseas beneficiaries and the income was built up in Australia without their knowledge. In other cases, where a payment was made overseas, it was doubted that the nominated beneficiaries actually received the money.
The initial tip-off indicated that the scheme was not widely used, but enquiries revealed that it had in fact been practiced on a wide scale. Within the ATO these trusts were colloquially described as 'telephone book trusts', in that lists of 'beneficiaries' supplied in trust tax returns read almost like a page taken from a foreign telephone book.
The matter was mentioned in the 1981-82 annual report:
Trusts have also been used to avoid or minimise taxation by means of overseas beneficiaries. In one kind of arrangement, trust income is allegedly distributed to a varying number of overseas beneficiaries in sums less than the minimum taxable amount. Under another method, trust income in the form of interest is "distributed" to overseas beneficiaries. It is claimed that the tax liability on the trust distribution is limited to the interest withholding tax payable. In both cases, however, the funds remain in Australia. The relevant distribution is merely credited to the non-resident beneficiary's account in the trust books and the beneficiary purportedly lends the funds back to the trustee or to individuals or entities associated with the creation of the trust. It appears in many cases that the overseas beneficiaries are unaware both of the purported distribution and the lending of the funds. These arrangements are also being challenged.
The report indicated that where the purported distribution was made other than in the form of interest, the withdrawal of the tax-free threshold for non-residents effected as part of the 1982-83 Budget operated against such arrangements.
Tax avoidance use of trusts was to be the next area for attention.
Sections within Chapters 21-30
Last Modified: Wednesday, 16 June 2010