Improving the Taxation of Trust Income in Australia - Case Study Example

Question 1 Introduction The decision in Bamford v Commissioner of Taxation [2010] HCA 10 (Bamford) that a beneficiary should be assessed on the same share of taxable income under tax law as that to which he/she is presently entitled in the distributable income under trust law raised a number of issues. This paper seeks to analyze this approach with regard to the various the principles of taxation. Since the decision in this case it is imperative to define distributable income in order to distinguish it from taxable income. Principles of Taxation Certainty There has to be certainty, it has to be understood to be the same by every taxpayer and every Minister. Taxpayer must know what they are entitled to pay. It is supposed to be extensively and adequately publicised and every Finance Act should be publicised in simple language, clearly visible and nothing should be hidden from the taxpayer. Tax rules that are a bit complex make the taxation system quite complicated for the citizens to fully comprehend it. This is a process that makes the government to have some hard time collecting tax. Principle of Equity: All taxes should treat all taxpayers the same. People in similar situations should be treated the same in terms of rate, the amount, collection etc. The interpretation of who is a taxpayer should be the same. They should be charged in accordance with the status of their economy and also the ability to pay. Being treated equally, he terms of tax paid and the achievement from those taxes should be equal. No one should be allowed to avoid tax while enjoying the benefits that are being taxed for those services. Principle of neutrality The market economy should not be interfered with. There should be no practical interference with the market economy. Taxes should not interfere with market forces. Business communities are supposed to bear minimum impact on the spending of tax. When there is lower tax, the better it is for the business community. The Bamford Case The Bamford case brought about several issues. During the process of this Australian Taxation Office endeavored to avert the trustees of the “Bamford Trust” from giving outcome to the phrases of the “trust deed” for that conviction in the determination of how the recipients of this trust are supposed to get taxed. The High Court rejected the arguments used by the Australian Tax Office and decided that the terms of the trust deed should prevail in determining how the beneficiaries should be assessed to tax. In a victory for the Australian Tax Office however, the High Court did find against the taxpayers on the argument they had raised that they should only be assessed on the quantum of trust income that was distributed to them and not on the proportion of the trust income they were entitled to. In simple terms, the beneficiaries were assessed on a share of the taxable income of the trust in proportion to their entitlement to the trust income that was distributed by the trustee. Although the Australian Tax Office has up till now to draw round the observance approaches it shall now seize as a consequence of the decision of the High Court , it is probable that it shall take out the Practice “Statement PS LA 2005/1 (GA)” ‐ which then allows an exit from the balanced approach to duty of the beneficiary of a capital expanse although they don’t obtain any other takings. The consequence (if any) that the removal of this “Practice Statement” may contain will be dependent on the terms of the pertinent trust deed. Effect of the decision on Tax Payers As the High Court unanimously held that the trustee of a trust can, where allowed by the trust deed, determine that any capital gains made by the trust can be treated as income for the purposes of determining whether a beneficiary is "presently entitled to a share of the income of the trust estate" (which is the key requirement for a beneficiary to be assessed rather than the trustee), the decision should prevent the Australian Tax Office from being able to assess capital gains at penal rates in the hands of a trustee if the trust does not derive any other income in the year ‐ i.e. the capital gain will be taxed in the hands of the beneficiary, in accordance with the intention of the CGT rules, if the trustee has determined that any capital gains made by the trust can be treated as income. In addition to that, because the High Court decided that a beneficiary’s liability to tax is based on their proportionate interest in the income of the trust (rather than any particular dollar amount that has been distributed to them), beneficiaries may be taxed on more or less than they actually receive from a trust where there are differences ‐ as is often the case ‐ between the income of the trust as determined under the trust deed and the taxable income of the trust. Unfairness created In brief, the same set of numbers can give rise to a significantly different tax outcome dependent on whether and how income is defined in “Trust Deed” and also in some powers that the Trustee might have in the determination of the distributable incomes of that trust. In some circumstances, the trustee can end up being assessed at 46.5% even where an amount has been distributed to the beneficiaries. Examples of these situations are where there is no income but a capital gain. Another example is a situation where there is no book profit but there is a taxable income and also in situations where there are other books differences for instance, because the trustee is supposed to make good any deficiency out of the current year income1. These issues are relevant to all trusts. Issues to be addressed One of the issues that need to be addressed is the definition of income. As it was in the Bamford case the deed allowed the trustee to adopt a normal meaning of income and to determine what is included in income. There are situations where the deed is silent of the definition of income and some even define income to be equivalent to taxable income. Problems arise when a Deed does not define income and there is no accounting profit but there is taxable income. This could give rise to a trustee assessment even though cash amounts have been distributed to beneficiaries. A second question to be tackled is the advance to be used. The Bamford case also reiterates that the correct approach to present entitlement is the proportionate approach. In other words, beneficiaries will be entitled to a share of taxable income in proportion to their entitlement to the trust income that has been distributed by the trustee. The long standing Australian Tax Office practice of allowing either the proportionate or quantum approach is no longer acceptable2. A third issue to be addressed is that of capital gain. In “Case of Bamford v FCT” there were two issues that the court had to tackle. Firstly the court had to determine whether the capital gain that the trustee treated as income pursuant to a term of the trust deed represented part of the “income of the trust estate” for the purposes of section 97(1) of the ITAA 1936. Secondly, the term “share” in section 97 refers to the proportion of the income of trust. The Bamford case also brings into question the Capital Beneficiary approach. The “ATO Practice Statement PS LA 2005/1 (GA)” allows a exit from the balanced approach to tax the heir of a capital increase even while they didn’t obtain any income. Technically, this approach may not now be correct but the Practice Statement has not been withdrawn ‐ the question is how long the ATO will continue to stand by it. As a practical matter, the consequences of the removal of this performance Statement might have depended on the inclusive terms of the pertinent trust deed. For example, if a deed has been drafted so that capital gains may be included in the definition of trust income ‐ i.e. as in Bamford’s case. Conclusion In coming up with a definition for distributable income, this paper proposes a definition which would include capital gain. This is because this will give the trustee some freedom and at the same time the trust deed will remain relevant. It will also prevent conflict of the definition in the statute and that on the deed. This approach will however require an anti avoidance mechanism to deter the beneficiaries from avoiding liability. Question 2 Streaming of Franked Distributions and Net Capital Gains Introduction Following the decision on Bamford, the government has proposed several changes with a view of improving the taxation of trusts. The Government proposes released a several amendments aimed at aligning the concept if income of the trust estate with the taxable income of the trust. The amendments further seek to ensure that the trustees can stream capital gains and franked distributions to specific beneficiaries. This paper looks at the proposed changes with regard to taxation principles. The paper then makes a conclusion on whether the proposed amendments are merited and effective. The Impacts of the case of Bamford The various amendments that have been proposed in relation to trusts taxation are likely to heavily impact on many taxpayers. The industry of management funds and groups that are privately held are especially the ones likely to be affected. These proposed changes were planned to occur during the beginning of July, 2010. Though the government can be commended for their attempt to seek a solution for the various issues, skepticism still exists on what is likely to be attained within the limited available time and putting into consideration how complex this particular area is in law. Reasons for putting forward the proposal The phrase income -of a -trust estate has been regarded as being very important as it relates to the need for a trust to share all of its income as a way of ensuring the non taxation of the trustee on the income that is taxable and that is related to the trust within the top rate of marginal tax (currently 46.5%). In Bamford the High Court held that the trust deed was relevant in determining the ‘income’ of a trust and that beneficiaries are assessed on the same proportionate share of the taxable income of the trust as the proportionate share of the income of the trust to which they are entitled. According to a view by the government, this was likely to result into tax outcomes that are unfair for taxpayers and even provide the taxpayers with opportunities manipulate their various tax liabilities. Hence, the Government is proposing to insert a clear definition of ‘distributable income’ in the Tax Act that will form the basis of determining where the tax liability falls for the taxable income of a trust. It is important to note that the flexibility obtained by defining distributable income is not similar to that of determining the given distributable trust income. It is however more likely to create a higher certainty among taxpayers. Each of the proposals given below has its short comings and is directed to work in liaison with the government in ensuring that given definition is one that attains the greatest outcome for all taxpayers3. One major challenge however is that the government must ensure the definition given to the distributable income by taxpayers and that is within their trust deed falls in line with the legislation definition proposed. This will help in ensuring that they are effectively capable of abiding with the law and without breaching the trust deed. Additionally the taxpayers required to make amendments on their trust deeds to ensure that they match the legislative-definition need to be provided with concessions as a way of avoiding any form of complications. Approaches to a distributable income definition As taxable income One advantage with this proposal is that it includes items in a distributable income of trust. Such items include capital gains. Presently, beneficiaries are not entitled to any income hence a trustee is tax charged on a given capital gain at the highest marginal tax level. The proposed distributable income definition is such that beneficiaries will have taxes charged on their capital gain share provided by the trusts. Issues may rise in terms of amended- assessments given by commissioners. In instances where the commissioner gives amended assessments to raise the taxable income, the trustee is likely to be assessed on the increase at the top –marginal rate4. As accounting income The omission of trusts which have Trust-Deeds that are flexible and which provide substitute definition of distributable-income. For the majority of trusts, existing definition of distributable-income refers to the “Generally Accepted Accounting Principles”. It is to some extent strange that Government has accepted to incorporate this definition to be a choice bearing in mind that this is the inconsistency between the accounting-income and the taxable-income which has resulted to the unreasonable complexities which this reform tries to resolve. This stand-point will undoubtedly not attain the specific objective of the better-alignment of a trust’s distributable-income with its taxable-income.  It can also experience the shortcoming that the distributable-income sum will be to some extent “at the mercy of accounting standards”, such that ‘unrealised gains and losses’ put through profit and loss statement (the income statement) might significantly impact on the distribution requirement thus ensuring no assessment-falls on trustee “in the case of a positive accounting result” or “in the case of a negative result” compel the situation that an assessment for taxable-income during the year falls on a trustee. Including capital gains In this proposal, some terms used in the trust-deed may continue to have relevance in the determination of distributable-income. However, the capital-gains may also be particularly included in defining distributable-income. This could allow some trustees to make retention of flexibility in the determination of distributable-income since the provisions (terms) of the trust-deed will continue show relevance5. However, the Government has a firm believe that a particular “anti-avoidance provision” would certainly become necessary in this choice to prevent some beneficiaries from manipulating their tax-liability. This is definitely the main concern for the Government with the ‘implications of the Bamford decision’. Such anti-avoidance measures are most likely to cause a reduction in the prettiness of the alternative6. Streaming of Net -Capital Gains and Franked Distributions Before Bamford majority of the tax-payers used trust-structures to direct specific classes-of-income to specific beneficiaries. The Commissioner, however; considers that this kind of streaming as being contradictory to the proportionate-approach to trust-taxation that was authorized by the “High Court in Bamford”. Following the resolution, the Commissioner afterwards withdrew “Law Administration Practice Statement PS LA 2005/1(GA)” which had since then allowed trustees-of-trusts to direct capital-gains in appropriate circumstances. Unfortunately, the recent decisions by the court, for instance, in the case of “Colonial First State Investments Ltd Versus Commissioner of Taxation [2011] FCA 16 and Thomas Nominees Pty Ltd v Thomas [2010] QSC 417” have not succeeded to conclusively determine this issue. This paper asserts that National Government will make an amendment to the existing law to have an assurance that there is trust-deed-permitting. Trusts will better be placed in streaming both the capital-gains and the franked-distributions to certain beneficiaries. This is suitable development since it validates the exactness of a long-standing practice commonly adopted by majority of the taxpayers7. However, the discussion-paper contains only few details concerning the way this can be accomplished. Very few straight-forward examples have been provided, however; it still remains uncertain on how the proposal can apply in a more difficult situation. For instance, it is not clear on whether trustees are enabled to direct particular classes of capital-gains, for example, discountable gains, to specific beneficiaries. Conclusion From the foregoing discussion it is clear that there is need for reform in this sector. This is based on the fact that an effective tax system should be certain. There should therefore be a definition of distributable income for the tax to be certain to the taxpayer. The deeds should also conform to the definition adopted in the legislation. This paper is therefore for the proposed amendments. REFERENCES Renton. N. (2005) Income Tax and Investment: A Plain English Guide for Shareholders and Property Owners. Chicago: Irwin Professional Publishing. Xynas, Lidia "Tax Planning, Avoidance and Evasion in Australia 1970-2010: The Regulatory Responses and Taxpayer Compliance" (2010) 20 (1) Revenue Law Journal 2. Baldwin, R. and Cave, M. Understanding Regulation: Theory, Strategy and Practice. An Introduction to Regulatory Theory (Oxford: Oxford University Press, 1999) 35. Cassidy, Julie. Concise Income Tax (Federation Press, Sydney, 4th ed, 2007)80. John Braithwaite, “Meta risk Management and Responsive Regulation for Tax System Integrity” (2003) 25 Law and Policy 1, 1-2. Read More