For those that do not otherwise have
access to the Weekly
Tax Bulletin, the further article from earlier this month by fellow View Legal Director
Patrick Ellwood and me is extracted below.
The recent
case of Thomas v FCT [2015] FCA 968, reported in this Bulletin,
considers a number of key issues relating to the distribution of franking
credits by the trustee of a discretionary trust, including the ability to
stream franking credits as a separate class of income.
It follows
the well-publicised decision of the Queensland Supreme Court in Thomas
Nominees Pty Ltd ACN 010 049 788 v Thomas & Anor [2010] QSC 417
(reported at 2010 WTB 49 [1884]), which relevantly held that franking credits
could form part of the income of a trust estate for trust law purposes and be
streamed to particular beneficiaries. The Commissioner was not a party to
that earlier decision.
The Thomas
case explores the interaction between s 95 and s 97 of the ITAA 1936 dealing
with trust income and Div 207 of the ITAA 1997 dealing with the imputation
system.
The
decision is a timely reminder of the need to ensure that trust distributions
are made in compliance with the trust deed, the ITAA 1936 and the ITAA 1997,
and of the complexities that can arise when streaming different classes of
income.
Facts
A more
detailed summary of the facts of the case are set out separately in this Bulletin,
however in brief, the trustee of Thomas Investment Trust purported to
distribute the trust's income in several consecutive financial years as
follows:
- Around
90% of the franking credits and foreign income and 1% of the remaining net
income to an individual beneficiary.
- The
balance of the net income to a corporate beneficiary.
The
Commissioner challenged the effect of the distributions and in essence, argued
that the franking credits could not be distributed to a beneficiary
independently of the franked dividend to which those franking credits related.
The
taxpayer contended that the franking credits were in fact a class of income
capable of being streamed to particular beneficiaries in accordance with the
trust instrument.
A number of
other matters relating to the trust instrument and distribution resolutions
were considered by the Court, which are beyond the scope of this article.
Outcome
The
judgment, which the Commissioner at least is likely to believe is a thorough
and well-crafted decision, rejects the earlier conclusion in Thomas Nominees
Pty Ltd ACN 010 049 788 v Thomas & Anor [2010] QSC 417 and provides
significant guidance in relation to the streaming of franked dividends and
franking credits.
It is
widely understood that Div 207-55(3) of the ITAA 1997 provides that a
beneficiary's share of a franked distribution is equal to the amount included
when determining the beneficiary's share of the trust's income under s 95 of
the ITAA 1936.
Div 207
also recognises and permits a trustee to stream some or all of a franked
dividend to one or more beneficiaries to the exclusion of others, subject to
the requisite powers under the trust deed.
Provided
the relevant trust instrument expressly permits streaming of franked dividends
as a separate class of income, a trustee can choose to make one or more
beneficiaries specifically entitled to franked dividends, while distributing
other classes of income to different beneficiaries.
Any
beneficiary who is made specifically entitled to franked dividends is then
entitled to the benefit of the franking credits attaching to those dividends.
In Thomas,
the trustee purported to stream franking credits as a separate class of income
from the dividends themselves. This approach, permitted under the trust
deed, saw one beneficiary receive the benefit of the tax offset under the
imputation system at their marginal tax rate, while another beneficiary paid
income tax on the dividend at the corporate tax rate.
The Court
held that, although franking credits will generally have a clear commercial
value to a beneficiary (as a result of the beneficiary's ability to claim a tax
offset from the credit), a franking credit is not "income" for trust
law purposes.
Specifically,
although franking credits constitute statutory income for the purposes of the
gross-up provisions, they are a notional, statutory creation in this regard and
do not constitute "ordinary income" under trust law principles.
As a
result, the operation of Div 207 makes it clear that franking credits can only
"attach" to the franked dividend and cannot be streamed as a separate
class of income, notwithstanding any other provision that may indicate to the
contrary within the trust instrument.
The outcome
of the case can perhaps be best summarised by the following quote from the
judgment:
"What
cannot occur if the tax offset is to be preserved…is an allocation of the s 95
net income amongst beneficiaries on a particular basis and a distribution of
the franking credits otherwise attached or stapled to the franked dividends on an
entirely unrelated basis, amongst the same beneficiaries."
[Court's emphasis]
Lessons
A number of
lessons can be taken from the case, including:
- As
regularly highlighted in this Bulletin, it is critical to
"read the deed" before purporting to exercise trust powers,
particularly in relation to trust distributions.
- While
reading the trust deed (including all valid variations) is necessary, it will not
be sufficient by itself. There are a myriad of related issues
that need to be considered that may impact on the intended distribution, aside
from whatever powers are set out in the trust instrument. Examples
include renunciations and disclaimers by beneficiaries, purported changes that
are not permitted under the relevant trust instrument (see for example the
article at 2015 WTB 37 [1373] in relation to amending trust deeds) and the
effective narrowing (for tax purposes) of permissible beneficiaries due to the
impact of family trust and interposed entity elections.
- The
wording of the distribution minute or resolution will be critical for determining the consequences of
the distribution. Terms like "income" and "net
income" will be defined differently depending on the trust instrument
(even deeds that have been sourced from the same provider) and failing to
understand those distinctions can result in inadvertent adverse outcomes for
the trustee and beneficiaries.
- Distribution
resolutions must also be crafted with reference to the trust instrument,
trust law principles, the ITAA 1936 and the ITAA 1997. For example, with
increasing regularity, we are seeing trust deeds that require distributions
take place before they are otherwise needed under the ITAA.
- Trustees
should act with significant care when dealing with "notional"
amounts such as franking credits, to ensure the intended tax and
commercial objectives are achieved.
- Trustees
have a duty to ensure they are aware of their rights and responsibilities
under the trust deed and the limitations under the ITAA 1936 and the ITAA
1997. A failure to discharge this duty can mean a trustee is personally
liable.
Ultimately
however the latest installment in this series of cases (so far) also highlights
the need for the Government to prioritise the long awaited re-write of the
legislation governing the taxation of trusts in order to simplify what
continues to be an unnecessarily complex area of the taxation law.
