At last some clarity with the streaming of franking credits? But trust law re-write still urgently needed

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.

For ease of reference, an earlier post addressing a previous decision in this matter is at the following link - http://blog.viewlegal.com.au/2010/11/streaming-decision-released.html

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.

Image credit: Dwayne Bent cc

What are some of the issues with a professional partnership ‘rolling over’ into a company structure?

As set out in earlier posts, and with thanks to the Television Education Network, today’s post addresses the issue of ‘What are some of the issues with a professional partnership ‘rolling over’ into a company structure?’at the following link - http://youtu.be/pIwVOyEAeBA



As usual, a transcript of the presentation for those that cannot (or choose not) to view the presentation is below –

The rollover at face value is always the easiest way to go, because it removes one seriously significant transaction cost being the capital gains tax implications. The problem though is that when you dig a little bit deeper, that is a little illusionary at times, particularly for a group of individual partners rolling over to a company. The attraction of taking that style of rollover can be diminished by the fact that they will still individually own the shares in the company.

So if it's a standard rollover, for example a partnership to a company under Division 122B of the Tax Act, ultimately, the individuals would still actually own the shares in the company. What they will have done is taken away 100 cents in the dollar, if that’s the right way to say it, of income that they’ve historically been enjoying and replaced that with 70 cents in the dollar and an imputation credit or franking credit.

This can lead to a situation where people, having done a rollover are then looking to restructure again anyway. So effectively it's a double restructure because they'll want to divest themselves individually of shares and make those shares be owned via some sort of discretionary trust arrangement.

It can also lead into a range of other potential restructures, dividend access shares and these types of arrangements that certainly get away from the overall goal in the first place, which was to simplify arrangements and get true limited liability.

The other areas (and some of these touched on in other parts of today's program) that obviously need to be taken into account include that while there is no stamp duty on unlisted shares, there is certainly stamp duty in every state moving from an individual or partnership arrangement into a company arrangement. That's a significant transaction cost that cannot be avoided in any way, shape or form currently and needs to be paid upfront effectively to get yourself into the new structure. The other ancillary costs that go around an incorporation include issues such as payroll tax, which is inevitably a lot more expensive if you've moved into a company structure as opposed to remaining in a partnership structure.

Until next week.

ATO gives some relief in lead up to 30 June for trust distribution resolutions

Extracted below is the announcement the ATO has made this morning confirming the transitional arrangements that will apply for 30 June 2011 in relation to trust distributions.

The comments in relation to IT 328 are particularly interesting.


Other administrative arrangements

The Commissioner recognises that the passage of this legislation so close to the end of the income year to which it will first apply gives trustees and practitioners little time to familiarise themselves with its content and to determine how it might affect the circumstances of a particular trust for that income year (that is, the 2010-11 income year).

Therefore, following representations from practitioners, and in recognition of the practical difficulties faced by them and by trustees as a result of the timing of the new law, the Commissioner will put in place the following administrative arrangements in respect of the application of the new law to the 2010-11 income year.

Specific entitlement to franked distributions

As regards the timing of recording such an entitlement for the 2010-11 income year, the Commissioner has agreed to adopt a similar approach to that set out in Income Tax Rulings IT 328 and 329 in respect of ‘present entitlement’ to trust income.

That is, for trusts with a 30 June balance date the Commissioner will accept that a relevant record made in respect of a franked distribution by 31 August 2011 meets the requirements of the new law for the 2010-11 income year in any case where ITs 328 and 329 would permit the trustee to take steps within that same period to make beneficiaries presently entitled to trust income for the purpose of Division 6.

For trusts that balance earlier than 30 June 2011 (or later than 30 June 2011 but before 31 August 2011) the Commissioner will likewise accept a relevant record made by 31 August 2011.

As the new law (if enacted as passed) will permit relevant records to be made in respect of capital gains no later than two months after the end of the relevant income year, there is no need for this arrangement to be extended to a beneficiary’s specific entitlement to capital gains.

It should be noted that the arrangement outlined above concerning a beneficiary’s specific entitlement to franked distributions will apply only for the 2010-11 income year.

Further, the Commissioner intends withdrawing ITs 328 and 329 for the 2011-12 and later income years.

Compliance action

Staff will also be instructed not to select cases for review or audit in respect of the 2010-11 income year for the sole purpose of determining whether the purported streaming of capital gains or franked distributions by a trustee is effective.

This instruction will not apply where there has been a deliberate attempt to exploit weaknesses or deficiencies in the law. In those cases we will apply the law as we understand it to operate.

We will also apply the law as we understand it to operate in any case that has been selected for review or audit for other reasons, and in preparing rulings or objections, and in arguing cases before the Tribunal or the courts.


At this stage the next post will be Monday week.

Streaming decision released

There was confirmation last week from the Queensland Supreme Court that where a trust deed of a discretionary trust has appropriate powers and the trustee resolutions are appropriately crafted, a trustee can allocate franking credits differentially from net income.
For those interested the full title of the case is 'Thomas Nominees Pty Ltd ACN 010 049 788 v Thomas & Anor [2010] QSC 417' (Supreme Court of Qld, Applegarth J, 11 November 2010).
The decision turned to a large extent on the terms of the trust deed and the fact that the trustee:
(a) could treat franking credits as income of the trust capable of distribution;
(b) had discretion to distribute franking credits to different beneficiaries; and
(c) had the power to stream different categories of income between beneficiaries.
In light of the above powers, in brief terms, the key aspects of the decision were as follows:
1. selective allocation of franking credits is possible under section 207-35 ITAA 1997;
2. section 97 ITAA 1936 takes a proportionate approach to the distribution of net income (as set out in the Bamford decision);
3. section 207-35 is an exception to Division 6 (and therefore section 97) ITAA 1936;
4. franking credits need not follow the shares of net income included in a beneficiary's assessable income on an equal footing;
5. net income (under section 95 ITAA 1936) does not need to exceed the franking credits included in assessable income for those credits to pass through to beneficiaries; and
6. the ATO's comments that franking credits may not be able to form part of the income of a trust estate for trust law purposes because they are 'merely a tax concept which do not represent an accretion to the trust fund over and above the distributions to which they attach' could not be accepted;
7. ultimately, franking credits were held to have some attributes of income under the tax legislation, therefore they could be dealt with by the trustee.
Until next week.