Reform of taxation of trusts

The Assistant Treasurer has released a consultation paper that explores the current issues impeding the effective operation of Div 6 of Pt III of the ITAA 1926 as well as those hampering the effective taxation of trusts more broadly. The paper also outlines a number of options for reform, ranging from minor changes to the current operation of Div 6 to the introduction of a new model for the taxation of trust income.

Back on 16 December 2010, the Assistant Treasurer announced that the Government would conduct a public consultation process as the first step towards updating the trust income tax provisions in Div 6 and rewriting them into the ITAA 1997. The paper is part of that consultation process.

The Government considers that, where used appropriately, trusts are a legitimate structure through which Australians should be able to conduct their personal and business affairs. The Government says that any options for reform would be developed within the broad policy framework currently applying to the taxation of trust income. That is, the taxable income of a trust will continue to be assessed primarily to beneficiaries, with trustees being assessed to the extent that amounts of taxable income are not otherwise assessable to beneficiaries.

Principles of Government policy framework

The Government says five principles outline its policy framework concerning trusts:

1. Tax liabilities in respect of the income and gains of a trust should “follow the money” in that they should attach to the entities that receive the economic benefits from the trust.

2. The provisions governing the taxation of trust income should be conceptually robust, so as to minimise both anomalous results and opportunities to manipulate tax liabilities.

3. The provisions governing the taxation of trust income should provide certainty and minimise compliance costs and complexity.

4. It should be clear whether amounts obtained by trustees retain their character and source when they flow-through, or are assessed, to beneficiaries.

5. Trust losses should generally be trapped in trusts subject to limited special rules for their use.

The Government said it has determined that the key issues impeding the effective taxation of trusts that require immediate reform include:

• the interaction between the distributable income and taxable income of a trust;
• the method by which the taxable income of a trust is allocated to either the beneficiaries or trustee of the trust;
• whether the amounts received by a beneficiary retain their character and source (and when “streaming” of those amounts is effective for tax purposes); and
• the scope of Div 6 and other taxing provisions applying to trusts.

The paper discusses issues such as:

• problems with the operation of Div 6 eg anomalous outcomes (through differences in a trust’s distributable and taxable income), present entitlement issues, “nil” assessments, application of s 99B;
• interaction between Div 6 and other parts of the tax law eg CGT provisions, franked distribution rules, consolidation provisions, withholding tax rules, Div 7A, managed investment trust regime, the trustee beneficiary reporting rules;
• fixed trusts;
• the trust loss rules;
• the family trust rules; and
• key features of trust regimes in other countries eg USA, Canada, UK, NZ, Ireland, South Africa.

Possible options for reform

The paper looks at three models for reforming the taxation of trust income:

• the “patch” model - would involve retaining the existing structure of Div 6, but defining the term “income of the trust estate” for tax purposes. The response to the 4 March 2011 Treasury discussion paper indicated that the preferred approach to defining that term as part of a “patch” model was to use tax concepts. Treasury says that defining “income of the trust estate” using tax concepts would require adjustments to be made to the concept of taxable income to better reflect the actual amount available for distribution to the beneficiaries of the trust (ie to account for both notional income and expense amounts);
• the “proportionate within class” model - rather than being assessed on a proportionate share of the taxable income of the trust, a beneficiary would be assessed on a proportionate share of so much of the taxable income of each class. If there is only one class of income, the paper says the the “proportionate within class” model would operate in the same way as the current model. The different classes of income could be determined in two ways: (i) the classes could be determined with reference to the trust’s deed; (ii) the classes could be set out for tax purposes within the tax law and would not depend on how the amounts are treated in the trust deed. The steps in the “proportionate within class” model would be:
  • determine the trust’s distributable income;
  • determine the different classes of income that the trustee will maintain;
  • allocate the trust’s distributable income to these different classes of income;
  • calculate the taxable income of the trust;
  • allocate the trust’s taxable income to the classes maintained by the trustee; and
  • determine the share of the relevant beneficiaries to each class of taxable income based on their proportionate entitlement to that class of trust’s distributable income; and
• the “trustee assessment and deduction” (TAD) model - this is where the taxable income of a trust would be assessed in the hands of those beneficiaries that receive the economic benefits related to that taxable income. Assessable amounts that are not distributed by a certain time (or taxable income with no underlying economic benefits capable of distribution) would be taxed in the hands of the trustee. The TAD model would provide a deduction to the trustee for distributions of taxable income to the beneficiaries of the trust. If the trustee distributes all of the taxable income, no tax would be payable by the trustee. The paper notes that the definition of a distribution (and whether it is deductible) is therefore critical. Broadly, a “distribution” to a beneficiary might include: (i) an actual payment of cash or property to a beneficiary (in their capacity as a beneficiary); and (ii) an application of cash or property for the benefit of, or at the direction of a beneficiary (in their capacity as a beneficiary). A distribution would be deductible for an income year if it was made by a specific date after the end of the income year. The size of the deduction would reflect the taxable income related to the amount distributed (including, for example, a gross-up for attached franking credits).

“Fixed trust” paper still to come

Mr Shorten said the Government was aware that the current restrictive definition of “fixed trust” was an issue for trusts other than managed investment trusts and considered that a review of different options for a more workable approach was warranted. He said Treasury would release a separate discussion paper on the appropriateness of the current definition of “fixed trust” for public consultation early next year. “This will allow the Government to consider the problems with the current definition and announce its response around the middle of the year”, Mr Shorten said.

Timeframe for reform

Treasury says the process to modernise the taxation of trust income is likely to involve the following steps (timeframes and dates are indicative):

• Release of initial consultation paper – November 2011.
• Consultation forums (before and after close of public submissions) – January to March 2012.
• Release of policy design paper – May 2012.
• Consultation roundtables (before and after close of public submissions) – May to June 2012.
• Release of exposure draft legislation – July 2012.
• Consultation roundtables (before and after close of public submissions) – July to August 2012.
• Possible second round of exposure draft legislation – Sept to October 2012.
• Introduction of legislation – November 2012.

These indicative timeframes assume a target start date of 1 July 2013. Actual timeframes will depend on the scope of the review and on broader Government priorities.

IPA response

The IPA welcomes the release of the paper, which begins the process of modernising antiquated trust rules which have created unnecessary complexity and uncertainty. Updating of the taxation of trust has always been a top priority amongst tax professionals and is long overdue.

The Institute has been advocating for reform in this area of tax law for many years. Recent Court decisions have highlighted the need to address compliance difficulties faced by the 600,000 trusts in Australia, many of which are used by small to medium businesses.

The Government has indicated that the review is not a crack down on use of trust. It considers that, where used appropriately, trusts are a legitimate structure through which taxpayers should be able to conduct their personal and business affairs. Let’s hope that the broad policy framework currently applying to the taxation of trust income remains intact through the review process.

As the consultation option paper is the important first step in the reform process, the IPA are inviting all members to provide input into our submission.