Tax Insight: Thomas' Case: The uneasy relationship between tax and trust law

The somewhat strained and counterintuitive relationship between tax law and trust law has again been highlighted with the Full Federal Court’s controversial decision earlier this year in Thomas v Commissioner of Taxation [2017] FCFCA 57 (Thomas’ Case).  In Thomas’ Case, the Full Federal Court held that:

• The Commissioner of Taxation (Commissioner) was compelled to follow the Queensland Supreme Court’s orders regarding the interpretation and effect of the trustee’s resolutions; and
• A trustee could distribute (“stream”) dividend income to certain beneficiaries in different proportions to the franking credits attached to those dividends.

Despite the effect of the dividend imputation system, and in particular, Division 207 of the Income Tax Assessment Act 1997, the combined effect of the Full Federal Court’s decision and the Supreme Court’s orders was to establish – in the midst of an ATO audit – that the trustee could separate the franking credits from the dividends so as to distribute the trust’s income in the most tax advantageous manner. Thomas’ Case, therefore demonstrates the inherent tension between trust and tax law.

The High Court granted the Commissioner special leave to appeal on 20 October 2017.

The facts

The Thomas Investment Trust (the Trust) resolved to distribute income and franking credits to two beneficiaries (Mr Thomas and a corporate beneficiary) in differing proportions.

After being notified of the commencement of an audit by the ATO, the trustee of the Trust (Trustee) applied to the Queensland Supreme Court for a declaration as to the proper construction of the resolutions, and whether they were in accordance with the trust deed.

The Commissioner chose not to intervene in the proceedings, but instead issued a letter to the Supreme Court stating that it was unclear if franking credits could “form part of the income of a trust estate… because franking credits are merely a tax concept”.

The Trustee was empowered under the trust deed to apply “income of the Trust Property” as it saw fit.  The trust deed allowed the Trustee to separately record different categories of income, including, “dividends which… any other separately identifiable taxation consequence or benefit is attached or arises“.  The trustee was also empowered to deal with trust income separately by resolution.

In the 2006 to 2009 income years, the Trust’s assessable income included franked dividends and income from other sources. In each income year, the Trustee resolved to distribute, by way of:

1. A “net income distribution resolution”, a specified amount of the net income of the trust to Mr Thomas and the remaining net income to the corporate beneficiary; and
2. A “franking credit distribution resolution”, specified amounts of franking credits to each of Mr Thomas and the corporate beneficiary, in differing proportions to the net income distribution resolution”, with Mr Thomas being entitled to a larger proportion of the available franking credits.

This distribution strategy resulted in the corporate beneficiary having a nil tax liability and Mr Thomas receiving cash refunds of the franking credits allocated to him.

The Supreme Court held that the Trustee resolutions were valid and in accordance with the terms of the trust deed, with Applegarth J concluding that “the resolutions under consideration purported to allocate the franking credits differentially. I am unable to see why the trustee was not empowered to do so… I conclude that the resolutions were effective to distribute the franking credits according to the intent of the trustee, as reflected in the dual resolutions”.

Federal Court at first instance

In the Federal Court appeal, Greenwood J, held:

1. The orders made by the Supreme Court were not binding on either the Commissioner or the Federal Court;
2. The “franking credit distribution resolutions” did not clearly demonstrate Trustee’s consideration of, and intentions as to, the distribution of franked dividends;
3. There was no relevant nexus between the distribution of the franked dividends and the allocation of the franking credits as was required by section 207-55 of the Income Tax Assessment Act 1997, such that the approach adopted by the Trustee represented an “impermissable un-linking” that was inconsistent with the legislation; and
4. The distributions to the beneficiaries were determined by the “net income distribution resolutions”.

His Honour further held that the Supreme Court’s orders did not represent “a determination of matters” between the Trustee and the beneficiaries, but rather represented “declarations going beyond the inter se domestic relationship”, and that the Commissioner could not be deprived of the opportunity to make submissions on the issues by operation of the Supreme Court orders.

Full Federal Court

On appeal, the Full Federal Court unanimously reversed the Federal Court’s decision, finding that:

the Supreme Court orders “nonetheless bind the Commissioner…. to the extent that [the orders] conclusively determined the rights of the beneficiaries and trustee”;

1. The intention of the “franking credit distribution resolutions” was that the benefit of the franking credits should be enjoyed by the specified beneficiaries and was capable of being secured by properly framed resolutions;
2. One interpretation of the resolutions was that the “net income distribution resolutions” determined the distribution of the net income of the trust for the relevant income year, and that the “franking credit resolutions” were ineffective as they purported to treat franking credits as separate items of income or property that did not automatically flow to the beneficiaries under Div 207 according to the distribution of net income;
3. Although the interpretation of the resolutions as set out in the Supreme Court orders was surprising and “difficult to embrace”, the orders conclusively determined each beneficiary’s share of the Trust’s net income for the 2006 to 2008 income years and was binding on the Commissioner and the Federal Court. The resolutions for the 2009 income year (although not covered by the Supreme Court orders) should (albeit reluctantly) be interpreted by the Federal Court in the same way; and
4. The Supreme Court orders even if procedurally irregular, remained valid and binding until set aside.

The Full Federal Court’s decision meant that the franking credits could be distributed in different proportions to the dividend income to which they related, in the manner set out in the “franking credit resolutions”.

What’s next?

The Commissioner has tended to perceive the obtaining of Supreme Court orders in respect of trust law as an aggressive tax litigation tactic used to “sidestep” tax disputes in the Federal jurisdiction.

The High Court’s decision in this case will be important, not just in resolving the question of whether franking credits can be split from dividend income, depending on the terms of the trust deed, but also whether the misalignment between trust law and tax law in this context can also be resolved, or at the very least, clarified. However, until the High Court decides this case, the question of whether, and when, the Commissioner is bound by Supreme Court orders in relation to the interpretation of trust law concepts remains uncertain.

Please contact a member of our National Taxation Group to discuss how these issues may affect you.

This article was written by Nima Sedaghat, Partner, Renuka Somers, Special Counsel and Travis McCarthy, Solicitor.