The Tax Office advised that it has discussed with Treasury the difficulties in administering the trust cloning exception to CGT events E1 and E2. Many of those difficulties are outlined in a paper by Mr Glenn Davies entitled Some CGT aspects of 'trust cloning' - a Tax Office perspective, delivered at a Taxation Institute of Australia (TIA) seminar in Melbourne on 29 April 2008.
One member said they understood the Tax Office was currently 'sitting on' private ruling requests. The Tax Office said that is not correct and that all requests are being progressed. However, the complexity of the deeds seen to date, and the fact that all cases are being escalated to senior officers because of the high risk of error, means the process is a lengthy one. The Tax Office is looking carefully and properly at these cases which is a time consuming process.
Members asked whether the Tax Office might consider providing a 'checklist' of issues that those applying for a ruling need to address. The Tax Office advised that it has been attempting to alert taxpayers to issues as they are identified (eg. via speeches and web publications).
There was a discussion as to whether disclaimers and other techniques designed to avoid the cross-holding problem caused by widely-drawn beneficiary clauses had the effect of also removing the trustee's power to transfer an asset to a newly cloned trust. Some members were of the view that an asset could be gifted to the newly cloned trust, notwithstanding that the trustee of the newly cloned trust would not be a beneficiary of the original trust, on the basis that the asset would continue to be held for the benefit of the same persons. Others were concerned that such a transfer might be in breach of trust with the possible consequence that the new trustee might hold the asset on a resulting or remedial trust in favour of the trustee of the original trust - if this were the case then the beneficiaries and terms of both trusts would not be the same.
A note prepared by the Tax Office was discussed. The note indicated that a person who acts in different capacities is considered a different entity for tax purposes when acting in their respective capacities. For example, if a person acts in a trustee capacity and a personal capacity, or in the capacity of trustee of two different trusts, they will be considered a different entity in respect of each capacity.
One significance of this issue for the trust cloning exception is that two trusts do not have the same beneficiaries if a person is a beneficiary of one in say a trustee capacity and of the other in a personal capacity.
Another concern is, if the trust cloning exception applies, whether the exception to CGT event A1 about a mere change of trustee can also apply if the same person is the trustee of both trusts. In this regard the Tax Office confirmed that its view is as set out in TD 2004/14. That is, if the exception to CGT event E2 applies, then CGT event A1 does not happen. And this is the case regardless of whether the two trusts have the same trustee or different trustees.
There followed a discussion of trust splitting - that is, the appointment of separate trustees to a part of the trust property. There is no Tax Office view on the income tax consequences of trust splitting and members' views were sought.
At issue is whether the appointment of new trustees to a part of the trust property causes a new trust to arise in respect of that property. As the driver of these arrangements is the isolation of passive assets from business assets, it follows that in practice the appointment of new trustees is usually accompanied by arrangements designed to ensure that each of the trustee's rights of indemnity are quarantined to apply only to certain assets. That is, after the appointment, each trustee's right of indemnity (in respect of both past and future expenses) is confined to the assets it holds after the appointment.
Some members were of the view that a single trust continued despite the quarantining of the rights of indemnity. Others expressed the view that the separation of assets and indemnities pointed to there being two trusts. No conclusion was reached.
There was a discussion of recent cases involving trusts.
ConnectEast Management Limited v. Federal Commissioner of Taxation  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  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 ) [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  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  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)  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.
Action item 2
Tax Office to develop a practice statement about calculating a beneficiary's share of income.
Although there was insufficient time to consider this item, the chair indicated that the Tax Office was examining arrangements whereby a taker in default of an interest in trust capital purports to claim a capital loss under CGT event E8 (about disposals by beneficiaries of their capital interest in the trust - see section 104-90 of the ITAA 1997) in respect of the assignment of that interest.
Members were invited to make submissions out of session in respect of this matter.
The chair indicated that the Tax Office has been giving further consideration to an issue raised by a member at the last meeting regarding the application of Division 6 of Part III of the ITAA 1936 where a beneficiary is a tax exempt entity.
On the view put by the member, a trustee would always be assessed on an exempt beneficiary's share of the trust's net income calculated under section 95 of the ITAA 1936. That view proceeds as follows:
- Sections 99 and 99A of the ITAA 1936 assess a trustee on so much of the net income of a trust estate that is not included in the assessable income of a beneficiary. Because an amount of trust net income that might otherwise be assessed to an exempt beneficiary under Division 6 is not included in the assessable income of that beneficiary, it appears that sections 99 and 99A have potential application.
- Subsection 6-1(5) of the ITAA 1997 (which operates as a Guide) says that an amount of ordinary income or statutory income can have only one status (that is, assessable income, exempt income or non-assessable non-exempt income) in the hands of a particular entity.
- Subsection 6-15(2) of the ITAA 1997 says that if an amount is exempt income, it is not assessable income.
- Section 6-20 of the ITAA 1997 provides that an amount of ordinary income or statutory income is exempt income if it is made exempt from income tax by a provision of this Act.
- Section 50-1 of the ITAA 1997 provides that the total ordinary and statutory income of entities covered by the tables in sections 50-5 to 50-45 is exempt from income tax.
The Tax Office and most practitioners have assumed that if an exempt beneficiary is presently entitled to a share of the income of a trust estate, that beneficiary's share of net income is not subject to tax. This approach seems to be supported by an examination of the legislative history to section 99A of the ITAA 1936. Members were invited to provide out of session comments as to how the two approaches might be reconciled.
If an interpretative solution cannot be found, the Tax Office intends to raise this matter with Treasury.
The meeting closed at 2.30pm.
The details for the next meeting are to be advised.
Last Modified: Friday, 21 May 2010