Trust minutes, June 2008

3. Discussion of recent cases

There was a discussion of recent cases involving trusts.

ConnectEast Management Limited v. Federal Commissioner of Taxation [2008] FCA 557 (ConnectEast)

The sole issue in ConnectEast concerned the interpretation of subsection 272-127(1) of Schedule 2F to the ITAA 1936, which allows in certain circumstances for the classification of a widely held trust to be upgraded to the classification of its parent trust for the purposes of applying the trust loss rules.

Subsection 272-127(1) provides that if:

(a) apart from Subdivision 272-J, a trust is an unlisted widely held trust, an unlisted very widely held trust or a wholesale widely held trust, and

(b) each of one or more trusts of a higher level has, directly or indirectly, fixed entitlements to all of the income and capital of the trust,

the trust is instead a trust of the same kind as the trust of the highest level.

The precise question that arose for decision in ConnectEast was whether it is possible for the subsection to apply when two higher level trusts together, but neither individually, have fixed entitlements to all of the income and capital of a subsidiary trust.

In the ConnectEast structure, all the units in the taxpayer (the subsidiary trust, an unlisted widely held trust (UWHT)) are held by two listed widely held trusts (LWHTs). Further, the units in the parent LWHTs are stapled such that the two parent trusts have the same unit holders, holding the same number of units in each trust. Of the units issued by the subsidiary, one parent holds one unit with the remaining units (some 478 million units) held by the second parent.

In the case, the taxpayer sought to be reclassified from an UWHT to a LWHT in order to ensure that, if continuity of ownership ceased to be maintained, that event would not prevent the trust recouping its carry forward losses.

His Honour held that section 272-127 did not apply to the taxpayer because the preconditions to the operation of subsection (1) were not satisfied: the subsection requires each of the relevant trusts of a higher level to hold, directly or indirectly (that is, via interposed entities), fixed entitlements to all of the income and capital of the taxpayer. In this case, neither of the higher level trusts held fixed entitlements, directly or indirectly, to all of the income and capital of the taxpayer.

Raftland Pty Ltd as trustee of the Raftland Trust v Commissioner of Taxation [2008] HCA 21 (Raftland)

In this case, the Court was asked to determine whether the appointment of the trustee of a loss trust as a beneficiary of the Raftland Trust and the appointment of income to that beneficiary were a sham, or otherwise ineffective in equity.

The Tax Office outlined its view of the High Court decision in this case noting in particular:

• sham is just one of various situations in which a court may go behind an instrument, such as a deed of trust, in order to ascertain the true intention of the parties (that is, by way of exception to the parol evidence rule) [see Gleeson CJ and Gummow and Crennan JJ at paragraphs 33-34 and Kirby J at 142-143]
• another case is where the document is 'a mere piece of machinery' for serving some purpose other than that of constituting the whole of the arrangement; in such a case the existence of the writing does not preclude the reception of other evidence as to the terms of the broader arrangement or contract (see Hoyt's Pty Ltd v. Spencer (1919) 27 CLR 133 at 144; Hawke v. Edwards (1947) 48 SR (NSW) 21 at 23 and Jervis v. Berridge (1873) LR 8 Ch 351 at 359) [see Gleeson CJ, Gummow and Crennan JJ at paragraphs 33-34 and Kirby J at 177]
• although it appears to be generally understood that the term 'sham' is an expression which refers to steps which take the form of a legally effective transaction but which the parties intend should not have the apparent, or any, legal consequences (see Equuscorp Pty Ltd v. Glengallan Investments Pty Ltd (2004) 218 CLR 471 at 486 [46]) [see Kirby J at paragraph 131 and 145], there is ambiguity and uncertainty surrounding its meaning and application [see Gleeson CJ, Gummow and Crennan JJ at paragraph 35 but compare Kirby J at paragraphs 134 and 136]
• a particular uncertainty is whether it is a prerequisite for 'sham' that the parties share a common intention to deliberately deceive third parties [see Gleeson CJ, Gummow and Crennan JJ at paragraphs 35-36, but compare Kirby J at paragraph 136 and 148 noting however paragraphs 85, 143 and 145, and Heydon J at paragraph 173], and
• sham may appear from an examination of the whole of the relevant circumstances, and these are not confined to the terms of the instrument [see Gleeson CJ, Gummow and Crennan JJ at paragraph 36] - a court may also examine the parties' explanations as to their dealings (see Kirby J at paragraph 147) and evidence describing their subsequent conduct (see Gleeson CJ, Gummow and Crennan JJ at paragraph 49 and Kirby J at paragraph 147].

In relation to section 100A of the ITAA 1936, the Tax Office noted that Gleeson CJ, Gummow and Crennan JJ cited, with apparent approval, Kiefel J's observation that, following Commissioner of Taxation v. Prestige Motors Pty Ltd (1998) 82 FCR 195 and Idlecroft Pty Ltd v. Commissioner of Taxation (2005) 144 FCR 501, a reimbursement 'agreement' does not have to be legally enforceable and it is not necessary that the beneficiary be a party to it' (see paragraph 61).

With respect to the application of prior year trust losses made by a trustee of a trust with a single class of beneficiaries, whilst the Commissioner understands the Court to be saying that there is no general rule that losses made by the trustee in a business must be made up out of profits of subsequent years and not out of capital, he does not understand the Court to be rejecting the possibility that, in any particular case, an intention that losses can or should be applied in such a manner may be disclosed by the trust instrument itself.

Members were invited to submit further comments on the draft Decision Impact Statement which had been circulated to them.

Bamford & Ors v. Commissioner of Taxation [2008] AATA 322

This case involves a number of issues central to the operation of Division 6 of Part III of the ITAA 1936 - that is, the meaning of 'income' in the introductory words in subsection 97(1) and whether it can be a deed determined amount, and the ascertainment of a beneficiary's 'share' of the 'income' and whether it can be determined on a proportionate basis.

As the Tax Office has previously advised (see Cajkusic Decision Impact Statement), the Commissioner is seeking to test the operation of subsection 97(1) in the Courts. Consistent with this, the Tax Office has offered to fund the taxpayers' appeals to the Federal Court under its test case litigation program.

While the Tax Office is seeking judicial clarification as to the proper interpretation of subsection 97(1), the Tax Office does not intend to undertake specific active compliance action directed at the measurement and assessment of trust income, however there will be cases, such as where the Tax Office is asked to rule in respect of a trustee or beneficiaries or where a trust is involved in an audit, in which the Tax Office will have no option but to apply the law as it understands it. To assist staff in these situations the Tax Office is planning to develop some administrative guidance about how staff should go about determining a beneficiary's share of the income of a trust estate. Ultimately, this may find its way into a Practice Statement, or similar product (see discussion below).

Ryan v Commissioner of Taxation [2008] AATA 383

This is another case involving the meaning of income for the purposes of subsection 97(1). It also considered the effectiveness of a trustee resolution which provided that: 'in the event of an increase or decrease in the net income of the trust as determined by the Commissioner of Taxation for any reason, such increase of decrease will be reflected in the distribution applicable to [a beneficiary who otherwise had no entitlement.]

The Tribunal approved the Commissioner's submission that the further resolution was ineffective to confer any present entitlement. The Tribunal said that the beneficiary had no present vested right to an amount that the trustee could distribute as at 30 June 1999. At best, the beneficiary's entitlement was a form of contingent entitlement dependent on events that may or may not occur later.

Calculating a beneficiary's share of income

Although the Tax Office does not accept that the 'income of the trust estate' is the distributable net income of the trust it nonetheless accepts that the ascertainment of the distributable net income of the trust can be relevant (although not necessarily conclusive) when determining whether a beneficiary is presently entitled to the income of the trust and in what 'share'.

Since the last meeting the Tax Office has been giving further consideration as to how, consistent with what was said by the Court in Totledge, the income available for distribution to beneficiaries should be calculated in particular cases.

In Totledge the Full Federal Court, in the context of what could legitimately be subtracted from income, referred to the 'payment of, or provision for, [costs] expenses and outgoings properly incurred'. In Zeta Force, Sundberg J made reference to 'expenditure written off in the trust accounts in accordance with trust law principles.' In Cajkusic the court said that in the determination of that amount [the distributable net income] 'the terms of the trust instrument prevail over any accounting principle that may otherwise be appropriate to the type of business being conducted.'

The Tax Office thinks that the following key principles appear from the leading cases:

• In order for an amount to be properly charged against income a payment or provision must be one that is authorised by the deed or relevant legislation.
• It is evident that if an amount is paid or expensed in breach of trust it would effectively be treated as if it had not been so paid or expended.
• An authorisation to charge an amount against income (or, conversely, a prohibition against charging an amount against income) may be found in deed clauses which define an item by reference to something else (e.g. a deduction allowable for tax purposes in the context of determining section 95 net income) or where the trustee is given a discretion to treat a particular amount in a particular way in determining what can be offset against income.
• A provision must relate to an existing liability or obligation, even though its timing and/or amount may not be known. That is, it must be an expense or an outgoing, rather than an accumulation or a reserve for future expenditure.
• Sections 99 and 99A are obviously designed to apply to the accumulation of income. If provisions or reserves of amounts which did not represent a reduction in distributable funds or close estimate thereof could be subtracted from income in determining the distributable net income, it seems the policy of sections 99 and 99A could readily be defeated.
   
  By way of example, if a trust had $100,000 gross income, $80,000 current expenses, and a provision for possible future expenses of $10,000, beneficiaries would have to be presently entitled to $20,000 in order to prevent sections 99/99A from applying.
• There seems to be no basis for limiting permissible trust expenses to amounts that are deductible for tax.
• If the deed permits, an expense need not be a 'revenue' expense; it may be a 'capital' expense.
• It is suggested that there is no requirement that the expense must be a current or 'revenue' expense. This is in contrast to the position in the United Kingdom (Carver v. Duncan (Inspector of Taxes) [1985] AC 1082) because section 97 does not assess the share of 'income' to which beneficiaries are entitled directly, but uses that share to assess part of the 'net income' as calculated under section 95.
• The deed must still permit or contemplate the offset of the expenditure against income.
• The trust deed may override accounting principles or standards in determining what expenses are properly offset against income.
• Accounting evidence may be relevant, but is not necessarily conclusive, in determining whether an amount has been properly expensed under the deed.
• For example, the deed may permit the trustee to resolve to treat an item of capital expenditure as a reduction against income. Financial accounts for the trust are prepared showing the capital item as a charge against income. This is consistent with the trustee having chosen to treat the item in that way, but there is no specific evidence of the trustee having resolved to treat the amount in the particular way, and the financial accounts were drawn up after 30 June.
• The Tax Office may seek to challenge whether the trustee has so resolved in circumstances such as these, and may seek to have the matter clarified judicially. In Richardson accounting evidence was not accepted as evidence of exercise of the trustee's powers, whereas in Cajkusic, the court was prepared to assume that the trustee had so resolved. The Tax Office considers that the relevance of accounting evidence will depend on the particular facts and circumstances in question, and that there is no necessary inconsistency in the Full Federal Court decisions in Richardson and Cajkusic. However the issue is not beyond doubt and careful trustees will ensure that there is satisfactory evidence of their having made necessary resolutions.
• Losses (Upton v. Brown (1884) 26 Ch D 588) - the High Court in Raftland found that the principle applied only where the trustee had a duty to act impartially between income and capital beneficiaries, which was not the case for a unit trust with one class of units and coterminous interests in income and capital. As a result, unless the deed provides otherwise or there are different income and capital beneficiaries, the particular restriction imposed by Upton v Brown won't apply so as to require capital to be recouped before income can be regarded as available for distribution. It seems that the position in any case must be determined having regard to the deed and what the trustee has done. Accounting records and financial accounts may provide evidence of this, but may not be conclusive.

Members were invited to make submissions in relation to these matters. Any submissions will be taken into account in preparing the proposed practice statement.