On 8 August, the High Court (HCA) unanimously allowed two appeals (one in part) and dismissed two appeals from the Full Court of the Federal Court of Australia in a series of tax and trust cases commonly referred to as Thomas v FCT (Thomas).
We have previously written about Thomas and the uneasy relationship between tax and trust law. Click here to read our earlier article.
The decision of the HCA in Thomas is particularly relevant to trustees of trusts and provides guidance on a number of important points, including:
- The importance of understanding what a trustee can and can’t do as part of annual tax planning. In particular, a trustee’s broad powers contained in the trust deed are not unfettered. Its powers are limited by how the tax law operates;
- How tax credits and other concessions created under the tax law (which are not recognised by trust or accounting concepts) must be treated by a trustee; and it
- Reinforces that the ATO must be involved in the resolution of disputes which consider the interpretation or application of the tax law. This will be particularly important for trustees involved in estate, family law or beneficiary disputes.
Thomas’ case is about a whether a trustee has the ability to stream income to beneficiaries in the most tax effective way possible. It is another decision which highlights the complex intersection between tax and trust law. In particular, how tax laws apply to a trustee’s powers and obligations contained in the trust deed and at law generally.
In Thomas, the HCA was asked to resolve two key questions:
- Could a trustee of a trust stream franking credits to the beneficiaries of a trust separately from, and in different proportions to, the dividends distributed to the beneficiaries?; and
- Was the ATO bound by a decision of a State Supreme Court in carrying out its duties under the tax law?
In summary, the High Court held that:
- In respect of question 1: a trustee of a trust could not stream franking credits separately from, and in different proportions to, the dividends distributed to the beneficiaries. This was the case even though the trust deed contained “streaming clauses”; and
- In respect of question 2: the ATO was not bound by a decision of a State Supreme Court in carrying out its duties under the tax law. In effect, the Trustee’s attempt to side-step the tax audit and appeals process was thwarted.
Between 2006 and 2009, the trustee of the Thomas Investment Trust (Trustee) resolved to distribute income and franking credits to two beneficiaries. One of the beneficiaries was an individual (Mr Thomas) and one of the beneficiaries was a company (Martin Andrew Pty Ltd or MAPL).
If effective, the strategy the Trustee tried to implement would have resulted in:
- No further tax being payable by MAPL on any trust distributions received from the Trustee. In effect, this meant the tax payable on any income derived by the Trustee would have been capped at the corporate tax rate; and
- Mr Thomas receiving refunds of the entire balance of franking credits not distributed to MAPL.
To achieve this result, the Trustee passed two separate resolutions in each income year:
- A “net income distribution resolution”: This resolution distributed an amount of the net income of the trust to Mr Thomas and the remaining net income to MAPL; and
- A “franking credit distribution resolution”: This resolution distributed specified amounts of franking credits (and other tax credits) to Mr Thomas and MAPL. However, these amounts were streamed separately and in different proportions to the net income of the trust.
Mr Thomas’ accountant then prepared income tax returns for the relevant years on the basis the resolutions were effective. These key aspects are contained in the table below.
|Section 95 net income||$798,826||$1,839,635||$142,651||$173,743|
|Distributions to Mr Thomas|
|Share of non PP income||$21,600||$4,615||$50||$16,600|
|Distributions to MAPL|
|Share of non PP income||$763,149||$1,822,307||$138,109||$157,143|
|Attributed foreign income||$125||$0||–||–|
|Other foreign income||$13,952||$12,713||$4,492||–|
|Foreign tax credits||$4,267||$1,821||$1,185||–|
The HCA’s decision
After considering the law relating to franking credits (contained in Division 207 of the Income Tax Assessment Act 1997 or Div 207), the HCA was clear that franking credits are a notional amount or “tax fiction” attributed to an amount of dividend received by a beneficiary. It stated:
“So long as a trust deed confers power on a trustee to apply classes of income of the trust estate to particular beneficiaries to the exclusion of other beneficiaries (or differentially among beneficiaries), Div 207 recognises that a trustee may stream the franked distribution (or any part of it) to one beneficiary and the other income to another beneficiary. However, Div 207 does not treat franking credits as a separate source of income capable of being dealt with, and distributed, separately from the franked distribution to which they are attached. The scheme’s objective in relation to trusts is to ensure that a beneficiary of a trust will have notionally attributed to it that proportion of the franked distributions received by the trustee that is referable to the amount of the net income distributed to the beneficiary while, at the same time, ensuring that the beneficiary obtains the benefit of the franking credits to the extent of those franked distributions. The franking credits are on, or attached to, the franked distribution.”
The HCA goes on to state the “bifurcation assumption” – the assumption that a trustee could because of the powers contained in the trust deed stream credits separately from the income to which they attach – was wrong.
Separately, the HCA considered whether the ATO was bound by the decision of the QSC as to how the tax law applied to Mr Thomas’ and the Trustee’s circumstances. In doing so, the HCA considered its earlier decision of Executor Trustee (1939) 62 CLR 545 (Executor Case).
The HCA concluded that the Executor Case did not prevent the ATO from carrying out its duties under the tax law because that case was confined to the determination of rights as between a trustee and beneficiary. The QSC’s orders could not bind any other person (such as the ATO) because it was not a party to that proceeding. Further, the HCA also stated in its reasons that:
- No part of the Trusts Act 1973 (Qld) empowered the QSC to decide how the tax law operated;
- The decision of the QSC was based on the incorrect premise that the bifurcation assumption was correct;
- The Full Court of the Federal Court’s interpretation of the QSC’s orders was incorrect; and
- Both the Full Court and the ATO were required to determine the tax issues according to law and not according to the orders of the QSC.
Thomas’ case has significant implications for trustee disputes. In particular, where a dispute arises as to how the tax law applies or how much tax is payable. This decision makes it clear the ATO must be involved in the resolution of such disputes because otherwise a trustee or beneficiary may be liable for additional tax if the ATO disagrees with a position which is taken between those parties.
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, Vincent Licciardi, Senior Associate and Ellis Rigby, Solicitor.
P: +61 2 9334 8921