The latest proposed reforms to the taxation of trust income were released by Treasury on 24 October 2012. The Policy Paper has narrowed the field of potential reform options to two, and clarifies some aspects of the Government's approach to reforming trust taxation.
In the Government's 2011 consultation paper on trust taxation, Modernising the taxation of trust income – options for reform, the Government explained that any reforms would be consistent with current principles – namely, that the taxable income of a trust should be primarily assessed to the beneficiaries, with the trustee liable on amounts not distributed (or distributable) to the beneficiaries. The Policy Paper reflects that overarching principle, and outlines two broad methods for taxing trust income.
Two proposed reform options
Two alternatives have been proposed as viable reform options:
the "Economic Benefits Model", which closely reflects the "Trustee Assessment and Deduction Model" outlined in the 2011 Consultation Paper; and
the "Proportionate Assessment Model, which closely reflects the "Proportionate within Class" model outlined in the 2011 Consultation Paper.
The "patch model" canvassed as a third alternative for reform in the 2011 Consultation Paper seems to have been shelved in favour of these two options. The Policy Paper also confirms that taxing trusts like companies will not be pursued as an alternative.
Character retention for all amounts appears to be a feature of both options in the Policy Paper. This should provide some certainty given the ATO's approach following the decision in FCT v Bamford (2010) 240 CLR 481. The ATO considers that – in the absence of special rules – beneficiaries should be assessed on a proportionate share of a blended amount of trust income.
While special rules were enacted in 2011 to ensure capital gains and franked distributions would retain their character in the hands of beneficiaries, both options in the Policy Paper endorse an extension of character retention to all amounts of trust income.
Complementing this proposed extension to character retention, streaming also features in both options. This would mean that trustees can stream particular types of income to different beneficiaries, and the tax attributes of those amounts will flow to the respective beneficiaries.
The Policy Paper touches on, but leaves open, the question of a reduced trustee tax rate. In the Government's view, the current rate is an important integrity measure. The Policy Paper also provides that reducing the trustee tax rate would have revenue implications, and could prove difficult from a regulatory perspective. Nevertheless, the Government has not entirely ruled out the idea of a cut to the rate, if associated integrity, revenue and regulatory matters can be properly addressed.
The Policy Paper proposes to extend the time for trustees to determine beneficiary entitlements from 30 June to 31 August, or even later. Although this is a welcome move in the right direction, we doubt an August deadline will be sufficient to allow many accountants to properly draw trust accounts.
Finally, the Policy Paper notes that the majority of submissions in response to the 2011 Consultation Paper supported the carving out of "bare trusts" from any reform of trust taxation, in line with prevailing practice. Further submissions are called for on how bare trusts should be defined. This suggests that the Government has accepted stakeholder views, and should provide some comfort to trustees of "bare trusts".
Option 1: Economic Benefits Model (EBM)
This model builds on the "Trustee Assessment and Deduction Model" first canvassed in the 2011 Consultation Paper.
It incorporates aspects from the "quantum" approach to taxing trusts, in contradistinction to the "proportionate" approach upheld in Bamford.
Broadly, the EBM provides that beneficiaries should be assessed on the "quantum" of distributions they receive, with the trustee being assessed on any undistributed balance. The EBM therefore moves away from current concepts of "present entitlement", and focuses instead on what beneficiaries actually receive.
While this option might prove the easiest to administer, the main concern lies in the trustee tax rate. As noted above, the Government is open to the possibility of reducing the rate. However, failing to do so while at the same time opting for the EBM method could potentially result in large amounts of undistributed tax income being assessed to the trustee at the highest marginal rate.
Option 2: Proportionate Assessment Model (PAM)
This second model builds on the "Proportionate Within Class" model outlined in the 2011 Consultation Paper.
At a technical level, it reflects the basic principles currently applied under Division 6 of the Income Tax Assessment Act 1997 - that is, that a beneficiary should be assessed on a proportionate share of the trust income. However, unlike the current approach, which assesses beneficiaries on a proportionate share of blended trust income, this model introduces a new concept, "trust profit".
"Trust profit" is the core feature of the PAM. It is designed to counter the problems arising from the Bamford decision – namely, the ability of trustees to artificially influence the "trust income" using trust deed powers. The "trust profit" concept, on the other hand, is expressed to be a net concept incorporating the trust's total "profit" over the income year, and therefore minimises the potential for manipulation.
Once the trust profit, which includes capital profits, is ascertained, the PAM calls for the determination of the different classes of trust profit, and the subsequent allocation of the trust profit to the different classes of beneficiaries. The trust's taxable income is then determined, and the beneficiaries are assessed on the trust's taxable income based on their proportionate share of the class amounts they are entitled to. The trustee is liable to assessment on the remaining amounts.
The Policy Paper states that the PAM will better reflect the amounts generally available for distribution, and will move away from reliance on the trust deed.
The Policy Paper reinforces that any reforms to trust taxation will incorporate and build on broadly accepted principles – namely, that the trust should be a “flow-through” structure, with the bulk of assessment falling on the beneficiaries, and the trustee taxable on the remainder (if any).
Nevertheless, the Policy Paper leaves open several issues, including the specific mechanics proposed for each of the options. In addition, uncertainty lingers around the question of reducing the trustee tax rate.
Submissions on the Policy Paper are due by 5 December 2012, and the Government has called for further input from all stakeholders. The proposed start date for the reform of trust taxation has been deferred one year, and is now due to commence on 1 July 2014.
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