08 Dec 2011

Consultation begins: Modernizing the taxation of trust income

by Simon Bowden

Trustees and beneficiaries now have an opportunity to contribute to the Government's impending rewrite and modernization of the income tax laws applying to trusts.

November 21 saw the Federal Government release its Consultation Paper, "Modernizing the taxation of trust income". The paper marks the first step towards a full rewrite and update of the provisions in the income tax law dealing with trusts that the Government plans to take effect from 1 July 2013.

The need for reform for taxation of trust income arises from longstanding failures of the trust provisions in the tax legislation to keep pace with other changes in the tax law and the increased use of trusts in commercial contexts. In particular, no amendments were made to the trust provisions to deal with the introduction of capital gains tax and the dividend imputation system more than 25 years ago, leading to uncertainty in how beneficiaries were taxed on capital gains and could access benefits such as the CGT discount and franking credits.

The uncertainty peaked after the High Court determined in Commissioner of Taxation v Bamford [2010] HCA 10 that beneficiaries were subject to tax on a proportion of the taxable income of the trust, rather than specific amounts of income. The decision provoked the Government to introduce stop-gap amendments earlier this year to facilitate streaming of capital gains and franked dividends to beneficiaries while promising a broader review of the taxation of trusts.

The main focus of the proposed amendments is the current discrepancy between trust and tax law in their treatment of trust income, such as issues of the distributable income of the trust versus its taxable income and whether certain types of trust should be disregarded for tax purposes. The discrepancies can lead to anomalous and unfair outcomes for taxpayers, as well as being open to manipulation for tax avoidance purposes.

The Consultation Paper makes clear that the Government wants to ensure that the current flow-through treatment of trusts – which aims to tax beneficiaries on their entitlements to trust amounts – operates appropriately. The Government is not interested in introducing entity taxation reforms, which would tax the trust or trustee as a company and which the Howard Government tried unsuccessfully to introduce.

The Government has also indicated that it is not interested in making legislative changes to the operation of existing trust deeds. That is, trustees will not be given powers by the tax legislation to make decisions or take actions that they do not currently have under the terms of their trusts.

Aside from these policy limitations, the Consultation Paper seeks feedback on all aspects of trust taxation, including further problems taxpayers and their representatives identify, interaction with other areas of tax law, how different types of trusts should or could be taxed, transitional issues for applying any new rules and the scope of potential reforms.

The Consultation Paper also outlines three options for reform, without expressing a clear preference for any one option or limiting the potential for other options to develop:

  • the "patch" model, which would attempt to implement changes through changes to the definitions currently used in the legislation but otherwise minimise changes to be made;
  • the "proportionate within a class" model, which would operate similarly to the existing provisions but introduce an additional step into ascertaining classes of income to be subject to specific tax treatment; and
  • the "trustee assessment and deduction" model, which would see the taxable income of the trust assessed in the hands of the beneficiaries that receive the economic benefit related to that income, ensuring that amounts retain their character as dividends, capital gains, etc in the hands of beneficiaries.

All models attempt to reduce the reliance of tax provisions on trust concepts and specific trust deeds, allowing greater flexibility in the arrangement of trust structures.

Trustees and beneficiary taxpayers should take this opportunity to review their trust deeds and identify issues with the current tax law, as well as making submissions on the changes they would like to see.

The Government expects the full consultation process to the introduction of amending legislation to take at least a year. Submissions on this first aspect of the consultation process close Friday, 10 February 2012.

Thanks to Michael Trayanovski for his help in writing this article.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.