The tax laws have been changed to address a number of uncertainties and longstanding problems with the taxation of trusts, enabling the streaming of capital gains and franked distributions to beneficiaries for tax purposes, as well as introducing targeted anti-avoidance rules.
These changes were contained in Tax Laws Amendment (2011 Measures No. 5) Act 2011, which became law on 29 June 2011.
It should be noted that this is not the end of the matter – these are ‘interim changes’ pending a broader review of the taxation of trusts, including a rewrite of Division 6 of Part III of the ITAA 1936.
Which trusts are affected by the changes?
The streaming changes only affect trusts that make a capital gain or that are in receipt of a franked distribution for the 2010/11 or a later income year.
In income years in which the trust does not make a capital gain or receive a franked distribution, the streaming changes will not affect how the tax law applies to the trust.
If a trust makes capital gains or receives franked distributions but no beneficiary is made ‘specifically entitled’ to any capital gain or franked distribution, the changes should generally produce a similar result to that achieved in the past.
Practical issues in making beneficiaries specifically entitled
Broadly, in order to be specifically entitled to a capital gain or franked distribution:
Note: These amendments do not give trustees a power to stream if they do not already have this power under the trust deed.
A beneficiary’s entitlement to a capital gain must be recorded in its character in the accounts or records of the trust by no later than two months after the end of the income year.
However, a beneficiary’s specific entitlement to a franked distribution must be recorded by the end of the income year.
For the 2010/11 income year, administrative arrangements are in place which allow a trustee to make a record relating to a franked distribution until 31 August 2011 if the trustee has the same period in which to
make beneficiaries presently entitled to trust income.
That is, the Commissioner will accept that a record made in respect of a franked distribution by 31 August 2011 meets the requirements of the new law provided ITs 328 and 329 (which allow resolutions to be made by 31 August in some circumstances) would permit the trustee to make beneficiaries presently entitled to trust income within that same period.
This arrangement will apply only for the 2010/11 income year.
Further, the Commissioner intends withdrawing ITs 328 and 329 for the 2011/12 and later
It should also be noted that some court cases have thrown doubt on whether this practice works in any event.
In particular, many trust deeds will deal with income in a default manner if the trustee does not make a resolution by 30 June.
ATO staff will be instructed not to select cases for review or audit in respect of the 2010/11 income year for the sole purpose of determining whether the purported streaming of capital gains or franked distributions by a trustee is effective.
This instruction will not apply where there has been a deliberate attempt to exploit weaknesses or deficiencies in the law; in those cases the ATO will apply the law as they understand it operates.
They will also apply the law as they understand it to operate in any case that has been selected for review or audit for other reasons, and in preparing rulings or objections, and in arguing cases before the Tribunal or the courts.
Examples of beneficiaries not being ‘specifically entitled’
A beneficiary cannot be specifically entitled to an amount of a capital gain or franked distribution if there is no amount of that gain or distribution left in the trust (e.g., because the gain or distribution has been reduced to zero by expenses).
Note that new S.207-59 allows franked distributions to be pooled, allowing a beneficiary to be specifically entitled to all, or a share of all, of the franked distributions, as long as the total of all franked distributions, net of all directly relevant expenses, is positive.
Discount capital gains that are treated as income
If a trust makes a capital gain that qualifies for the 50% CGT discount and only includes that amount in its trust income (e.g., where the trust deed defines the income of the trust available for distribution to be the taxable income of the trust) then only half the gain will form part of the income of the trust.
If the trustee then resolves to make a beneficiary specifically entitled to the amount of the capital gain included in the trust’s income, then without more, that beneficiary would be specifically entitled to only half of the total capital gain.
In order for the beneficiary to be made specifically entitled to the entire capital gain, the beneficiary would need to receive (or become entitled to receive) an additional amount from the trustee (typically out of trust
capital) to ensure that their entitlement equals the amount of the capital gain.
A beneficiary cannot be made specifically entitled to franking credits.
The treatment of franking credits will be based on the beneficiary’s share (including any specific entitlement) of the relevant franked distributions.