Key messages
- New legislation will allow streaming of capital gains, franked dividends and franking credits through trusts.
- The trustee must make a beneficiary "specifically entitled" to an amount of a capital gain, franked dividend and franking credit.
- This "specific entitlement" must be capable of being created under the terms of the trust deed and must be supported by the presentation of the trusts accounts.
- The priority for June 2011 is to ensure that the trust deed provides the trustee with the ability to account for and deal with different classes of income, gains and receipts.
Background
In March, Treasury released a Discussion Paper canvassing options to address the consequences of the High Court's decision in Bamford (Discussion Paper). Its focal issues were the definition of trust "income" for tax purposes and the effective streaming of capital gains and dividends through trusts. After consultation, Treasury has decided to prioritise the streaming issues and defer its consideration of the definitional issues to a broader review of Division 6 later in the year.
Amendments to address the streaming issues have been set out in Tax Laws Amendment (2011 Measures No. 3) Bill 2011 (Bill), which was released together with a preliminary explanatory memorandum (EM) on 13 April 2011. A more detailed EM was released last night.
Capital gains and dividends will not be taxed under Division 6 if they are "streamed" to particular beneficiaries: ie, they will be "backed out" of the calculation of the income of a trust estate upon which the beneficiaries will be assessed on a proportionate basis. Instead, they will be taxed under two existing subdivisions that will also be amended: Subdivision 115-C for capital gains and Subdivision 207-B for franked dividends and franking credits. Division 6 remains relevant, as it is part of the legislative process set out for getting from the distributions made by the trustee to the final outcome under Subdivisions 115-C and 207-B, but it is now more of a machinery provision that a taxing provision.
This means that capital gains and dividends to which a beneficiary is made "specifically entitled" by the trustee can now be streamed through the trust to that beneficiary, and taxed on that beneficiary's specific tax profile, on a "quantum" basis, ie they are taxed on the amount of the capital gain/dividend streamed to them. If a beneficiary is not "specifically entitled" to a capital gain or a dividend, it will be taxed on a proportionate basis to the beneficiaries based on their share of the income of the trust.
Treasury has also introduced an anti-avoidance provision aimed at preventing the manipulation of tax outcomes by making "exempt entities" entitled to amounts of the trust income that will lead to a disproportionate amount of the trust's tax income being apportioned to them, thereby avoiding tax. On this issue, we believe that Treasury has overplayed its hand as the types of arrangements that concern has been expressed over involves a level of mischief that would ordinarily be caught by Part IVA.
Capital Gains
The proposed section 115-228 provides that a beneficiary will be specifically entitled to a capital gain to the extent that, in accordance with the terms of the trust:
- the beneficiary has a vested and indefeasible interest in trust property representing the capital gain; and
- the vested and indefeasible interest is recorded in the accounts of the trust.
The section goes on to state that something is done in accordance with the terms of a trust if it is in accordance with the exercise of a power conferred by the terms of the trust or because of the operation of legislation, the common law or rules of equity (which we interpret as meaning some form of "constructive" trust over the trust property). The EM confirms that there is no need for a "present entitlement" to the amount of the capital gain but it must be more than a merely "notional" allocation of the income. The usual distribution powers of a trust deed should enable this to be satisfied.
Dividends
In contrast, the proposed section 207-58 provides that a beneficiary will be specifically entitled to a dividend to the extent that, in accordance with the terms of the trust:
- the dividend has been specifically allocated, in its character as a franked distribution, to the beneficiary; and
- that specific allocation is recorded in the accounts of the trust.
The EM states that whilst the accounting requirement is not intended to prescribe any particular approach, the accounts must stand as objective evidence reflecting the allocation of dividends and other amounts of income of a particular type and directly relevant expenses.
What this means for trust deeds
It's critical to understand that the trust deed is the key to an effective streaming outcome.
The trust deed must enable the trustee to determine the character of any amount as income or capital, to calculate net income and to classify that income according to its type (as a capital gain, income, foreign income, interest income, etc).
For a capital gain, the trustee must be able to create a vested and indefeasible interest in the gain in favour of a specified beneficiary.
If the deed allows the trustee to recognise, record and distribute different categories of income and capital to a particular beneficiary, the streaming outcome can be achieved. The new rules require this to be done on a "gain by gain" basis.
A similar approach will apply to dividends. The section does not specifically refer to the creation of a "vested and indefeasible interest" in trust property representing the dividend .
However, the ability to "allocate" the dividend must relate back to a specific power in a trust deed.
Naturally, before amending a trust deed, it will be necessary to establish that there is an appropriate amendment clause in the deed, that this permits the proposed amendment and that the amendment does not result in a resettlement of the trust.
While the legislation is still in draft and there is a further round of consultation to come, we believe that you should be advising clients that their deeds should be reviewed and, if necessary, amended to ensure the trustee has the power to:
- determine what is income for trust purposes;
- recognise, record and distribute different classes of income, including capital gains; and
- make a beneficiary specifically entitled to a capital gain or dividend.