A recent Federal Court decision has put a major stumbling block in the path of non-resident beneficiaries of Australian discretionary trusts. The ongoing use of discretionary trusts for asset protection, flexibility and succession planning is now in jeopardy because of the unnecessary tax cost they create.
It has long been a tenet of Australian tax folklore, confirmed in the High Court’s decision in the Charles case in the 1950s, that the interposition of a trust between an income source and a beneficiary does not change character or source or timing for tax purposes. This follows as the logical corollary of the position at equity that a trust is just, ‘a relationship over identified property.’ When the Board of Taxation looked at the treatment of investment trusts, it took this treatment as axiomatic: ‘the tax outcomes for investors in a CIV should be broadly consistent with the tax outcomes of direct investment’ (the major exception being losses). And when Parliament enacted the Investment Manager Regime and the AMIT rules, it was pursuing that same approach; the pivotal section in the AMIT rules simply says that tax shall, ‘treat the member as having derived [each] determined member component … in the member’s own right …’
So the appropriate tax policy seems clear, and long-standing, and uncontentious: the tax position of a beneficiary is to be determined as if they had earned the income themselves, and the policy is no different whether the trust is a small privately-owned family trust or a large widely-held managed investment trust. All of which makes the recent Federal Court decision in the Greensill case rather disappointing. Counsel for the taxpayer had put this very argument, that ‘there existed a policy objective of not taxing foreign beneficiaries of resident trusts in respect of CGT events in relation to CGT assets which were not taxable Australian property …’ but the argument was rejected.
And so we have another case where the ATO has decided to pursue a position which challenges settled policy and accepted practice, and wins the case because the drafting miscarries. But while the result is unwelcome, it is not unexpected; the ATO now has a decision to support some elements of its thinking in TD 2019/D6 and 2019/D7, and before that in ATO ID 2007/60. Our comments on those 2 TDs are available here.
The case involved capital gains realised during the 2015, 2016 and 2017 tax years by a resident company on the sale of shares in another Australian resident company. The company held those shares as trustee of a discretionary trust and in each year resolved ‘to distribute 100% of any capital gain from [the sale of the shares] that has been added to the capital of the trust to Alexander Greensill.’ Greensill was a tax resident of the UK. It was accepted that the shares being sold were not taxable Australian property and that, ‘s. 855-10(1) would have applied [ie, Mr Greensill would have had no Australian tax liability] if Mr Greensill rather than the trust had owned and disposed of the shares …’
A second smaller transaction involved the transfer to Greensill in specie of shares in the same Australian resident company. Again, it was accepted that the shares being transferred to him were not taxable Australian property.
The ATO issued assessments to the trustee company under s. 98 claiming tax on a deemed amount: the amount included under s. 115-215(3) when calculating the capital gains of beneficiaries.
So far as the share sales were concerned, case turned on the intersection of four sets of provisions: Div 6E which removes capital gains from the ‘net income’ of a trust estate, Div 115-C which deals with the capital gains made by trustees, Div 855 which exempts non-residents from CGT unless the CGT event is happening to ‘taxable Australian property,’ and the portion of Div 6 dealing with the collection of tax owed by non-residents from resident trustees.
It was not surprising that the trustee disputed the tax liability since Greensill was a non-resident, two CGT events were happening (CGT event A1 and CGT event E5), and those events were happening to assets that were not taxable Australian property. But it was not seriously disputed that the tax, if any, would have to be paid by the trustee because s. 115-220 requires the trustee for a non-resident beneficiary to, ‘increase the amount … in respect of which you are actually liable to be assessed (and pay tax) under s. 98 … in respect of [a non-resident] beneficiary… if the … capital gain was reduced … [by] twice the amount mentioned in subsection 115-225(1) in relation to the beneficiary.’
The taxpayer’s principal argument was that when the trustee sold the shares, s. 855-10 was enlivened: it provides that a foreign resident is to ‘disregard a *capital gain or *capital loss from a *CGT event if … the CGT event happens in relation to a *CGT asset that is not *taxable Australian property.’ This propositions follows from the idea that a trust is simply a relationship: Greensill should be viewed as making the capital gain, and because he was a non-resident, the gain was disregarded by s. 855-10.
But Thawley J ruled that, ‘s. 855-10 has no relevant application to the present facts’ citing several reasons: in his view, the capital gain was made by the trust and ‘the trust was not a foreign resident’; the amount being taxed to the trustee was ‘not a capital gain and [so] cannot fall within s. 855-10’; and the amount attributed to Greensill under Subdiv 115-C was ‘not a “capital gain … from a CGT event” within the meaning of s 855-10.’ His reasoning is summed up this way:
… a capital gain which is attributed to a beneficiary, because of a CGT event happening to a CGT asset owned by a trust, was not intended to fall within the phrase “a capital gain … from a CGT event”. The capital gain deemed to have been made by a beneficiary under s. 115-215 of the ITAA 1997 is not a “capital gain … from a CGT event” within s 855-10. Section 855-10 would have applied if Mr Greensill rather than the trust had owned and disposed of the shares, but it does not operate to disregard the capital gains of the trust attributed to Mr Greensill under Subdiv 115-C.
Thawley J did note that capital gains made by a beneficiary of a fixed trust (rather than a discretionary trust) might be disregarded because of s. 855-40. Section 855-40 applies to a capital gain ‘you make in respect of your interest in a fixed trust’ where, amongst other matters, the gain ‘is attributable to a CGT event happening to a CGT asset of a trust.’ The language of this section is clearer as to the manner in which it is to apply to capital gains made by a trust to which a non-resident beneficiary is entitled.
The analysis of the tax consequences of the share distributions in specie was less detailed, but involved the same approach. The taxpayer argued that this transaction triggered CGT event E5 because the beneficiary became absolutely entitled to shares which had been assets of the trust. His Honour was prepared to accept that under s. 104-75(5), Greensill made a capital gain, ‘from a CGT event’ and this gain was disregarded under s. 855-10. But under s. 104-75(3), the trustee also made a capital gain (the amount by which the market value of the shares transferred exceeded their cost base) and this amount also fell to be dealt with under s. 115-215(3) with the same result: a capital gain is attributed to Greensill, it is not ‘from a CGT event’ although ‘it is attributable to a CGT event’, and so s. 855-10 is not available.
The mechanics of capital gains and (non-AMIT) trusts, post 2011
The background to these provisions is in the ATO’s challenge in the late 2000’s to the streaming of franking credits and capital gains via trusts, and the rebuke by the Government in May 2011, announcing it would legislate to confirm the practice. Unfortunately, these so-called ‘interim’ provisions were drafted hastily – indeed, the Second Reading speech to the Bill alluded to, ‘the short time frame involved in developing these amendments’ and the ‘scope for unintended consequences.’ The drafter adopted the expedient route of removing capital gains from Div 6 entirely so that their treatment fell exclusively within Div 115-C. The EM to the 2011 amendments took the position that, ‘for trusts that have capital gains or franked distributions but do not stream them to specific beneficiaries, the amendments apply but they will generally produce the same outcome as the current law’ but this is only accurate in a general sense. If the capital gains of trusts had remained within Div 6, or if the CGT measures had been written under other circumstances, or using different drafting devices, this dispute might never have happened.
The provisions in Div 115-C being discussed involve a drafting device used to reverse the effect of another drafting choice — to deliver CGT discount at the trust level. The calculation of capital gains from transactions effected by a trustee (other than a bare trustee) is done at the trustee level so that capital losses suffered by the trustee can be applied against capital gains. This calculation also incorporates CGT discount. This was always a somewhat problematic choice, given that not all beneficiaries are meant to enjoy CGT discount, and not all beneficiaries are meant enjoy the full 50% discount delivered to trustees by s. 115-100. Moreover, capital losses are meant to deplete undiscounted gains, not the (smaller) gain remaining after CGT discount has been claimed. Consequently the decision to deliver discount to the trustee has to be reversed elsewhere.
This post-loss, post-discount figure has to be reported by, and taxed to, someone but Div 6E has the effect that the net capital gain is excluded from the net income of the trust estate for the purposes of ss. 97 and 98. In other words, while Div 6 allocates liability to pay tax on interest and rent and depreciation recapture and CFC attributions and TOFA amounts and most other amounts earned from assets held on trust, it does not allocate responsibility to pay tax on net capital gains made from assets held on trust. This is confirmed in the Guide to Div 6 which says, ‘Division 6E modifies the operation of this Division for the purpose of excluding amounts relevant to capital gains … from the calculations of assessable amounts under sections 97, 98 …’ Allocating the tax liability on capital gains is now done exclusively by s. 115-215(3) and it represents an important change made in 2011 to the mechanics of taxing trust capital gains: prior to 2011, capital gains flowed through Div 6, that effect was then reversed (by a deduction), and Div 115-C then operated; after 2011, capital gains bypass Div 6 altogether, and Div 115-C operates exclusively.
The effect of s. 115-215(3) is to treat the beneficiary of the trust estate as if they had, ‘a capital gain equal to twice the amount mentioned in subsection 115‑225(1)’ [ie, the post-loss, post-discount capital gain]. This treatment happens ‘for the purposes of Div 102’ and the section includes the helpful deeming that if the trustee had qualified for a discount, ‘Division 102 also applies to you as if your capital gain were a *discount capital gain …’ It also includes a deeming that you have this capital gain ‘despite s. 102-20’ (the section which provides you can only make a *capital gain ‘if a *CGT event happens’). Having included this putative figure as an undiscounted capital gain of the beneficiary, the beneficiary can now apply their own personal capital losses against the undiscounted gain, and then re-instate the CGT discount if eligible.
So the amount upon which the trustee was being assessed was an entirely concocted figure; it was conceived by the drafter as the best design to achieve a number of steps (i) trust capital losses were applied by the trustee, (ii) CGT discount was reversed, (iii) personal losses were applied by the beneficiary against an undiscounted amount, but (iv) CGT discount could be reinstated in the hands of the right kinds of beneficiaries.
So the drafting accomplishes much, but it does not address one critical feature — it fails to address explicitly any jurisdictional issues of residence and source. The approach of the judge is, in effect, to treat this figure as an amorphous item of gain, without source, and assessable without reference to the residence of the owner. If capital gains had still been routed through Div 6 or if all statutory income had to be run through the prism of s. 6-10, the jurisdictional arguments would have been different and arguably clearer, though that is by no means certain. They would certainly have been more prominent.
While there are elements of the reasoning and some statements in the judgment that can (and may well) be challenged in any appeal, the lesson of the decision as it stands is to demonstrate another example of defective drafting; it fails to achieve ‘tax outcomes for investors … broadly consistent with the tax outcomes of direct investment’ which in this context means it does not accomplish the ‘policy objective of not taxing foreign beneficiaries of resident trusts in respect of CGT events in relation to CGT assets which were not taxable Australian property …’
When the interim measures were enacted in 2011, the Minister promised, ‘the operation of these amendments will be closely monitored and if unintended consequences are identified, the government will act to remedy those consequences retrospectively.’ Hopefully, the current government will honour that promise.
This article was first published on Greenwoods & Herbert Smith Freehills Website.