BAMFORD'S CASE GETS THROUGH THE HIGH COURT

Introduction

On 30 March 2010, the High Court unanimously dismissed both appeals, by the Commissioner and the taxpayers, from the Federal Court.  It was finally confirmed that it is correct to apply the “proportionate view” where the net income of a trust for tax purposes exceeds accounting income.

Furthermore, the Court upheld that a capital gain made by a trust, but distributed as trust income, should be treated as income for tax purposes.

While the relatively quick judgement by the High Court now provides some certainty on how trust income should be treated for tax purposes, the underlying calls for reform of the law in this area remain to resolve outstanding issues.

The Judgement

The High Court handed down what could be a “landmark” decision regarding the taxation of the beneficiaries of trusts, where it unanimously upheld the decisions of the Federal Court on both of these issues, holding that:

♣    a 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; and

♣    the term “share” in section 97 refers to the proportion (or percentage) of the income of trust – thus the “proportionate approach” is the correct method for assessing beneficiaries who are entitled to the income of a trust estate.

Whilst the ATO has yet to outline the compliance approaches it will now take as a result of the High Court decision, we anticipate it is likely that it will withdraw Practice Statement PSLA 2005/1, which allows a departure from the proportionate approach to tax the recipient of a capital gain even though they do not receive any other income.

From a technical standpoint, this approach may now not be entirely correct, but still the PSLA 2005/1 has yet to be withdrawn, so it raises the question of how long the ATO will continue to stand by it.

As a practical matter, the effect (if any) that the withdrawal of PSLA 2005/1 may have will depend on the terms of the relevant trust deed.  For example, if a trust deed has been drafted so that capital gains may be included in the definition of trust income for the trust (as in Bamford’s case), the withdrawal of PSLA 2005/1 may have little impact.

What are the practical consequences for trusts now?

In short, the same set of numbers for any trust can give rise to a significantly different tax outcome dependent on whether, and how, income is defined in the trust’s deed.  Also, it will be relevant what other powers the Trustee may have in determining the distributable income of the trust.

In some circumstances, the trustee can end up being assessed at 46.5% even where an amount has been distributed to the beneficiaries.

The types of situation that can cause difficulty include the following:

♣    No income but a capital gain;

♣    Distributing the income to one beneficiary and capital gains to another;

♣    No book profit but taxable income (ie. due to booking mark to market differences and recognising provisions for trust accounting purposes); or

♣    Other book to tax differences (ie. because a Trustee is required to make good a deficiency out of current year income).

These issues are relevant to all trusts.

knp Opinion

The High Court decision is a welcome one, as the High Court has finally acknowledged the principle that the “income of the trust estate”, for the purposes of section 97, means the income under trust law concepts.

Furthermore, the High Court has endorsed the view that the proportionate approach is the correct approach to the interpretation of the phrase “that share of the income of the trust estate”.

Both these concepts have long been understood by practitioners to be the correct application of the law, however the backing of the High Court on this line of thinking is extremely useful on these issues, considering the ATO has to date disagreed on the former point.

The decision has again reminded us of the importance of the terms of trust deeds (ie. adequately defining “income”) and of minutes recording the distribution of income, ensuring the trust deed can effectively determine the income of the trust estate though the classification of income and allocation of expenses and losses.

Finally, it appears the ATO will be kept busy once again, with numerous audits, objections and appeals which were being held in abeyance pending the judgment can now be progressed.

Email your knp representative, knp@knp.com.au or call to make an appointment on +61 3 9824 8111.