Tuesday, March 8, 2011

Federal Government Trust Tax Reform

Assistant Treasurer Bill Shorten released a Treasury consultation paper on Friday, 4 March 2011 which outlines proposed changes to two aspects of the trust tax laws.  These two join the 16 December 2010 announcement of a law change to ensure farmers operating through trusts will continue to have access to the primary production averaging provisions, and farm management deposits in a loss year.

These three announced changes will operate for the whole of the 2010 – 2011 income year, even though it is unlikely draft legislation will be available much before 30 June 2011.  The 4 March release of the Treasury consultation paper is consistent with the Government’s reform timetable 


The 4 March 2011 media release and the Treasury consultation paper, address two issues.

·                The trust law concept of "income of the trust estate" (i.e. distributable income) is to be more closely aligned with the tax law concept of "net income of the trust estate" (i.e. taxable income).
·                Amendments will be made to confirm the ability to "stream" capital gains and franked distributions through a trust to beneficiaries.

Both these reform measures (together with the farmer amendments) will apply for the 30 June 2011 income year and later years.

Remaining areas of uncertainty will be dealt with through the "main" trust reform process.


Trusts not to be taxed as companies

The Government made clear in its 16 December 2010 announcement that the reform process would not include any options by which trusts may be taxed as companies.  In a speech to the Tax Institute on 4 March 2011, the Minister again publicly ruled out the possibility of trusts being taxed as companies.






Trust law requires a trust’s "income" to be determined annually, so that it can be dealt with for any "income beneficiaries."  "Capital beneficiaries" may have no entitlement to income, but would have an entitlement to the trust’s corpus.  For trust law purposes, "income" is determined by reference to trust law, to accounting practice, and specific powers in the Trust Deed may also have a bearing. This results in the "distributable income."  But for tax purposes, it is the "net income of the trust estate" (i.e. taxable income of the trust) that is relevant in determining the tax liability that will arise in respect of a trust for an income year.

These two concepts can be very different, and a variety of problems arise from the inconsistency between the two.  The most significant problem arises because "net capital gains" are included in the taxable income of the trust, whilst such gains would generally not be included in the trust’s distributable income.

This can lead to anomalies – the income beneficiaries would end up with the tax liability on any distributed capital gains, but have no entitlement to the capital gains cash.  The capital beneficiaries would receive the gross capital gain in cash, without any attaching tax liability.

There are many other examples of why the trust law and tax law concepts of income will differ.  The Treasury consultation paper outlines three possible approaches to "managing" the difference between the two concepts.

·                Start with a trust’s taxable income, and "reverse engineer" the constituent elements of the taxable income to create a "notional distributable income", in order to deduce the beneficiaries present entitlement;
·                Use generally accepted accounting principles to define the "distributable income" (but this leaves the book/tax differences unaddressed);
·                Define "distributable income" so that it includes capital gains (which would still leave the other book/tax differences unaddressed).

Both the Government and the Treasury consultation paper note that this amendment is an "interim fix" only; the umbrella solution to the differences between the trust and the tax law concepts of "income" will have to await the main reform process.

From our experience, this difference is not that material.  Following Bamford, we now understand the proportionate approach is correct; that neither the quantum method nor the prescription of entitlement method is acceptable.  Whilst the trust accounting can be complicated, provided the capital gains tax liability can be somehow passed to the corpus beneficiaries, things generally "work". (The same may not be so in the case of widely held investment trusts.)

But the Government sees this as a crucial issue, effectively an integrity measure, as apparently there are practices whereby a trust’s distributable income definition is manipulated so that substantial amounts of the tax are avoided by "distributing" income to tax exempt entities.
So, we can expect the changes which will have the potential to materially increase the compliance costs of trust accounting and tax return preparation.  Exposure draft legislation has been promised following the consultation process, and we will provide an update at that point.


Proposal 2: streaming of capital gains and franked distributions confirmed

It is proposed to amend the tax law to make clear that:

·                Capital gains; and
·                Franked distributions (including the attaching franking credits);

can be "streamed" to particular beneficiaries, to the exclusion of other beneficiaries.  The attributes of the capital gains and the franked distributions will be retained as the amounts pass through the trust, and will apply in the hands of the entitled beneficiary.

This proposal puts paid to the ATO’s anti-streaming views.  However, it does leave open the broader issue of whether other amounts can still be safely streamed, e.g. interest income appointed in favour of non-resident beneficiaries.

We will be watching this issue closely during the consultation period, although we will only be able to get indirect messages on the streaming of "other amounts" as this is outside the terms of the proposal.


What to do next?


The announced proposals on farmer’s entitlements and streaming of capital gains and franked distributions simply return us to the pre-Bamford position.  The Government’s response on this measures is to be welcomed. In short, normal trust planning can continue with confidence in the lead up to 30 June 2011.

The third proposal – aligning the concepts of distributable income and taxable income – is somewhat of an unknown at this point. We anticipate:

·                For most SME trusts, there will be no adverse consequence (but watch this space on compliance costs); but
·                The familiar problems with book/tax differences will continue.

Further Tax Alerts will trace the trust tax reform process.  RSM Bird Cameron will be making submissions throughout the reform process, and we would appreciate your input in that regard.

Now is the time to identify specific issues that may exist in your own circumstances, and seek to have them addressed (it is most unlikely you will be alone).  Please raise any issues with your usual RSM Bird Cameron contact, or email us directly at trusttaxreform@rsmi.com.au


Why are these reforms necessary?

For well over 20 years, serious problems have been identified with the provisions taxing trust income. Numerous court decisions have called for a legislative solution, but until now there has been silence from succeeding Governments.  The problems became even more pronounced with the introduction of the capital gains tax provisions in 1985.

The High Court clarified some of the contentious issues in its March 2010 decision in the Bamford litigation.  However, the ATO’s response to the Bamford decision really established the need for urgent Government action when the Bamford Decision Impact Statement (Bamford DIS) concluded the High Court had overturned the long established trust law concept of amounts retaining their character, and their attributes, as they passed through the trust and into the hands of a beneficiary. Having reached this view (on an issue that was not even in dispute in the Bamford case) it followed, according to the ATO, that:

·                Farmers operating through trusts were no longer entitled to utilise the income averaging provisions, nor could they access farm management deposits in loss years; and
·                "streaming" was no longer permissible.

In the Bamford DIS, the ATO acknowledged the fundamental changes that followed from the Bamford decision, and adopted an assessing approach for the 30 June 2010 income year that trusts could apply any approach which was reasonably open before the Bamford decision. (There were some restrictions around this amnesty.)

But it was clear the ATO would look to enforce its Bamford views with effect from 1 July 2010. Hence, urgent action was required by the Government, in order that the looming 30 June 2011 trusts "bloodbath" could be avoided.


What are the proposed reforms?

The 4 March 2011 media release and the Treasury consultation paper, address two issues.

·                The trust law concept of "income of the trust estate" (i.e. distributable income) is to be more closely aligned with the tax law concept of "net income of the trust estate" (i.e. taxable income).
·                Amendments will be made to confirm the ability to "stream" capital gains and franked distributions through a trust to beneficiaries.

Both these reform measures (together with the farmer amendments) will apply for the 30 June 2011 income year and later years.
Remaining areas of uncertainty will be dealt with through the "main" trust reform process.


Trusts not to be taxed as companies

The Government made clear in its 16 December 2010 announcement that the reform process would not include any options by which trusts may be taxed as companies. In a speech to the Tax Institute on 4 March 2011, the Minister again publicly ruled out the possibility of trusts being taxed as companies.


Proposal 1: alignment of "income" concepts

Trust law requires a trust’s "income" to be determined annually, so that it can be dealt with for any "income beneficiaries."  "Capital beneficiaries" may have no entitlement to income, but would have an entitlement to the trust’s corpus.  For trust law purposes, "income" is determined by reference to trust law, to accounting practice, and specific powers in the Trust Deed may also have a bearing. This results in the "distributable income".  But for tax purposes, it is the "net income of the trust estate" (i.e. taxable income of the trust) that is relevant in determining the tax liability that will arise in respect of a trust for an income year.

These two concepts can be very different, and a variety of problems arise from the inconsistency between the two.  The most significant problem arises because "net capital gains" are included in the taxable income of the trust, whilst such gains would generally not be included in the trust’s distributable income.

This can lead to anomalies – the income beneficiaries would end up with the tax liability on any distributed capital gains, but have no entitlement to the capital gains cash.  The capital beneficiaries would receive the gross capital gain in cash, without any attaching tax liability.

There are many other examples of why the trust law and tax law concepts of income will differ.  The Treasury consultation paper outlines three possible approaches to "managing" the difference between the two concepts.

·                Start with a trust’s taxable income, and "reverse engineer" the constituent elements of the taxable income to create a "notional distributable income", in order to deduce the beneficiaries present entitlement;
·                Use generally accepted accounting principles to define the "distributable income" (but this leaves the book/tax differences unaddressed);
·                Define "distributable income" so that it includes capital gains (which would still leave the other book/tax differences unaddressed).

Both the Government and the Treasury consultation paper note that this amendment is an "interim fix" only; the umbrella solution to the differences between the trust and the tax law concepts of "income" will have to await the main reform process.
From our experience, this difference is not that material.  Following Bamford, we now understand the proportionate approach is correct; that neither the quantum method nor the prescription of entitlement method is acceptable.  Whilst the trust accounting can be complicated, provided the capital gains tax liability can be somehow passed to the corpus beneficiaries, things generally "work."  (The same may not be so in the case of widely held investment trusts.)

But the Government sees this as a crucial issue, effectively an integrity measure, as apparently there are practices whereby a trust’s distributable income definition is manipulated so that substantial amounts of the tax are avoided by "distributing" income to tax exempt entities.

So, we can expect the changes which will have the potential to materially increase the compliance costs of trust accounting and tax return preparation.  Exposure draft legislation has been promised following the consultation process, and we will provide an update at that point.


Proposal 2: streaming of capital gains and franked distributions confirmed

It is proposed to amend the tax law to make clear that:  

·                Capital gains; and
·                Franked distributions (including the attaching franking credits);

can be "streamed" to particular beneficiaries, to the exclusion of other beneficiaries.  The attributes of the capital gains and the franked distributions will be retained as the amounts pass through the trust, and will apply in the hands of the entitled beneficiary.

This proposal puts paid to the ATO’s anti-streaming views.  However, it does leave open the broader issue of whether other amounts can still be safely streamed, e.g. interest income appointed in favour of non-resident beneficiaries.

We will be watching this issue closely during the consultation period, although we will only be able to get indirect messages on the streaming of "other amounts" as this is outside the terms of the proposal.


What to do next?

The announced proposals on farmer’s entitlements and streaming of capital gains and franked distributions simply return us to the pre-Bamford position.  The Government’s response on this measures is to be welcomed. In short, normal trust planning can continue with confidence in the lead up to 30 June 2011.

The third proposal – aligning the concepts of distributable income and taxable income – is somewhat of an unknown at this point. We anticipate:

·                For most SME trusts, there will be no adverse consequence (but watch this space on compliance costs); but
·                The familiar problems with book/tax differences will continue.


Now is the time to identify specific issues that may exist in your own circumstances, and seek to have them addressed (it is most unlikely you will be alone). Please raise any issues with your usual financial advisor.

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