The Federal Court’s decision in Thomas v Federal Commissioner of Taxation (Thomas) confirms that a trustee cannot allocate the fictitious tax creatures we call franking credits as it chooses.
The key message of Thomas is that a franking credit is not income or an asset of a trust, even if the trust deed or trustee’s resolutions tries to make it so. As such, franking credits cannot be specifically ‘allocated’ to achieve the optimal tax position for the beneficiaries. Instead, franking credits can flow out to beneficiaries in the way the legislation directs under Division 207.
Thomas shows that even with some of the key controversies in trust taxation being settled over recent years, ‘blind spots’ remain in the operation of Division 6.
What is the case about?
Martin Thomas is a shrewd and highly successful share market trader and investor. He ran his share market activities through the Thomas Investment Trust (Trust). Year in year out, the Trust made substantial portfolio returns and received large franked dividends.
Beth Abbot, the accountant for Mr Thomas and the Trust, was very closely involved in the Trust’s activities. She prepared monthly financial reports for the Trust, advised Mr Thomas on the Trust’s distribution strategy and prepared year end Trust distribution minutes.
Over the period under review, Ms Abbot prepared resolutions which:
distributed a part of the Trust’s income to a corporate beneficiary (Martin Andrew Pty Limited (MAPL)) and another (smaller) part to Mr Thomas; and
allocated franking credits on franked distributions received by the Trust between Mr Thomas and MAPL.
There was no correlation between the amount of income distributed and the franking credits allocated to Mr Thomas and MAPL. Rather, the court heard that the ‘philosophy’ behind this distribution strategy was to ‘allocate’ only enough franking credits to MAPL to cancel out its tax liability on the income distribution and the balance to Mr Thomas. As an individual taxpayer, Mr Thomas would receive a cash refund of the franking credits that were allocated to him.
The Commissioner conducted an audit and raised significant amended assessments. Substantial penalties and interest were also applied, producing a multi-million dollar tax liability. Mr Thomas and the Trust objected against the amended assessments, which was denied. Mr Thomas and the Trust appealed to the Federal Court.
On the objection matters appealed to the Federal Court, the Commissioner was successful.
Greenwood J’s judgement, running to 140 pages and 588 paragraphs, is nothing short of epic. A large part of the judgement is dedicated to setting out the competing propositions of the Commissioner and Mr Thomas: there was such little common ground between them that Greenwood J described the competing propositions, somewhat poetically, as being like ‘ships passing in the night’. Also, legal intuition suggests that where a judgement is so long and comprehensive, it may well be because the judge expects an appeal!
The heart of Greenwood J’s decision was that the approach taken by the trustee to the ‘allocation’ of franking credits treated the franking credits like a ‘floating pool of offsets’, which could be passed through to the Trust’s beneficiaries, independently of the distribution of the Trust’s income [para 516]. His honour found that there was no basis to do this. While accepting that franking credits are a thing of ‘significant potential commercial value’ [para 463], they are not in the character of income or an asset [para 497].
Rather, the way that franking credits can be passed by a trustee to a trust beneficiary is through the rules set out at Division 207. These rules create a link between a trust income distribution, which must include part of the dividend which the franking credit is attached to, and the franking credits which are passed through to the trust to the beneficiary. Greenwood J’s judgement outlines how Division 297 would in the circumstances of this case in precise and painstaking detail.
What it means
The decision in Thomas is another reminder about the complexity of Division 6, which as a model of trust taxation, has largely remained unchanged since the original form of the legislation in 1936.
Division 6 brings two things into play. The first is trust income determined under the trust deed (‘distributable income’) and the second is trust income determined under the tax legislation (‘net income’). In some trust deeds, the two are equated (an ‘income equalisation clause’).
In Bamford, the High Court held that a beneficiary’s entitlement to a trust’s distributable income fixes a ‘proportion’ which gets applied to the trust’s net income. This ‘proportionate’ amount in turn gets attributed and taxed to the beneficiary. This, rather unimaginatively, is what is known as the ‘proportionate approach’.
Problems regularly arise in practice because distributable income will not in every case match net income. This could be for simple reasons like differences in tax and trust law recognition and/or timing. It could also be because tax law treats as assessable income certain non-cash ‘notional amounts’ like the ‘gross up’ of franking credits, Division 7A deemed dividends and capital gains produced by the market value substitution rule.
Contrary to common belief an ‘income equalisation clause’ does not necessarily solve the problem. In Draft Taxation Ruling TR 2012/D1, the Commissioner’s view is that an ‘income equalisation clause’ is ineffective in including ‘notional amounts’ within the ‘distributable income’ of a trust for Division 6 purposes (see para 15). This is because, in the Commissioner’s view, a beneficiary cannot be made presently entitled to a ‘notional amount’. It is noteworthy that the Commissioner took TR 2012/D1 off the public ruling register pending the decision in Thomas and we expect he will revisit, and most probably maintain, his position now that the decision has been handed down.
Another misconception, which has now been dispelled by Thomas, is that franking credits on franked dividends received by a trustee can be dealt with by the trustee as it wishes, in a way similar to income (in the case of a discretionary trust).
The key lesson from Thomas is that when it comes to the taxation of trusts, there are still ‘blind spots’. Notwithstanding the clarity that has been achieved over recent times (for better or worse) because of cases like Bamford, Colonial First State and Greenhatch, we still do not have all the answers when it comes to trust taxation under Division 6. Given the widespread use of trusts as a vehicle for operating trading businesses and holding investments, practitioners should proceed with caution when applying Division 6 in helping their clients meet their tax compliance obligations and tax planning objectives.