Federal Commissioner of Taxation v Bamford & Ors;

The seminal decision of High Court in Bamford case has profoundly impacted few legal issues in the broad spectrum of ‘Discretionary Trust’ along with Taxation Law which is the primary consideration of this research. The initial focus will be on different aspects of taxation provisions in relation to the distribution of discretionary trust as well as streaming of income, capital gains, dividends, fund to minors etc. With respect of capital gains and dividends, significant capital gain or dividend derived by a trust will now need to be reviewed closely to ensure its tax treatment is property understood and followed. Hence, if a significant capital gain or dividend has been derived by a Trust we will need to examine closely how that receipt is to be distributed and discussed the options concerning how each amount is taxed in the hands of a beneficiary of a trust. The research examines the issue of discretionary trusts to stream income as well as minority issues. The law which maintains the operation of taxation and trust is rigmarole, contradictory as well as ambiguous to certain extent.

Discretionary Trust and streaming of income:

Discretionary trust, despite this complexity, has become commonly used device in tax planning. Discretionary trusts are the ideal structure for income streaming as the trustee’s flexibility to distribute income amongst beneficiaries is relatively unimpeded. Although there must be a reason for distribution, the Courts are reluctant to interfere in this distribution process. The Courts tend only to interfere in situations where there has been a breach of good faith. This flexibility enables a trustee of a discretionary trust to stream income and tax credits. This research explores the law underlying income streaming by discretionary trusts and evaluates the judgement of Bamford case in this aspect.[1]

The issues in Bamford case and the decision[2]:

The first and second taxpayers (Mr and Mrs Bamford) were a married couple and the directors of the third taxpayer, which was the trustee of the Bamford Trust (Trust). The Trust was a family discretionary trust and the Bamfords were discretionary beneficiaries of the Trust. The Trust's deed allowed the trustee a discretion in determining whether a receipt, profit or gain, loss or outgoing was to be treated as an income or capital account.

The court decided that –

(1) if a trust deed allows the trustee to treat a capital receipt as 'income' for the purposes of fixing the entitlements of beneficiaries to distributions, then the trustee can effectively treat it that way and 

(2) a beneficiary who becomes entitled to a share of that capital receipt as a result of the trustee treating it as 'income of the trust estate' must include their share (or proportion) of the net income of the trust estate in their assessable income. The trustee is not liable to be assessed on the amount under section 99A.

Bamford case: its implications and proposed changes on discretionary trusts and streaming of income:

The Bamford decision changed a lot of the rules applied by the Australian Tax Office when it comes to income and capital in family trusts. This will affect the operation of everyone’s family trust. In the given context it will be more appropriate. At issue in Bamford was, as herein before mentioned, the Commissioner’s contention that the term “income of the trust estate” in s97 of the ITAA 1936 referred only to income according to ordinary concepts. It has been suggested that the view of the lower courts and the majority of practitioners and commentators was that the term reflected a trust law concept.[3] This interpretation has been confirmed by the High Court. But having accounted for a capital gain in this way in accordance with the deed, the relevant amount was considered income for trust purposes. This context was reflected in assessing the "income of the trust estate" when the provisions of s.97 of the ITAA 1936 were concerned. If the capital gain had not been included from income for trust purposes, it would have been impossible to effect a distribution of that gain since the "income of the trust estate" would have been trifle. Similarly, in the given situation the making of the deed as a discretionary trust must follow the judgement of Bamford. 

The second issue considered in the Bamford Case was in relation to how income is to be apportioned between beneficiaries where there is an adjustment to taxable income. In this instance, the Tax Office had disallowed a deduction at a later date that the trust had claimed in the original tax return. As a result, the income of the trust was substantially more than the trustees had originally dealt with when they resolved how the income should be divided between the beneficiaries. The Commissioner took the position that once the trustee determines the portion of total income of the trust that a beneficiary is entitled to receive, any adjustments to that income are to be applied in proportion to the share of the net income that the beneficiaries originally received. The High Court agreed with this position. From this view point, it can be assumed that if two beneficiaries shared equally in the income of the trust and there was a subsequent amendment to that income, the change in the income would also be shared equally between the beneficiaries. 

So the following propositions emerge from the High Court's decision[4]. That is:

(a) The income of a trust estate for trust law purposes and its income for tax purposes are 2 different subject matters.

(b) In section 97(1) of the ITAA 1936 the phrase "income of the trust estate" takes its meaning from the general law of trusts and not from taxation law.

(c) Under the general law of trusts the concept of "income" is governed by rules designed to ensure that trustees fairly apportion receipts and outgoings of a period between those entitled to income and those with an interest in capital. The rules of apportionment adopted by the general law of trusts take the form of presumptions about whether particular receipts or outgoings constitute income or capital. The presumptions can be displaced by the trust deed itself.

(d) the share of the trust income to which a beneficiary is presently entitled under section 97 that percentage is then applied to the net tax income to work out the amount which is included in the assessable income of the beneficiary under section 97(1)(a) of the Income Tax Assessment Act.

The Commissioner argued that according to this approach, it may not be possible for trusts to stream different classes of income to different beneficiaries as done previously. The streaming question was not considered in Bamford, but the Tax Office extrapolated the decision to suggest that streaming was not possible (irrespective of the trust deed). So the context of Karen’s case in this regard is rather obscure.

Bamford case also demands that if the provisions of a trust deed (either because of the definition of 'income' or under a specific power granted to the trustee) permit the trustee to treat a capital receipt as 'income', then that is effective for the purposes of s.97 of the ITAA 1936. Arguably, such a characterisation does not affect the character of that receipt or outgoing for the purpose of the s.95 of the ITAA 1936 definition of 'net income'.

Few uncertainties, impact and recommendation in the light of the Bamford case: 

There are a number of issues remain uncertain from the Bamford decision. These issues include particularly the following:

(a) the effect for trust law purposes of provisions in trust deeds which equate the trust's distributable income with its tax net income where the tax net income includes notional amounts such as franking credits or deemed capital gains or where the time at which the income is recognised for tax purposes differs from the time at which it is recognised for trust accounting purposes;

(b) how a trust's distributable income is to be determined where the trust instrument employs different notions of income for different purposes;

(c) how the statutory flow-through provisions relating to discount capital gains and trusts and franking credits and trusts interact with Division 6.

While the changes will restore some of the flexibility for family discretionary trusts (in this regard Karen’s case), the new rules are very complex. If the capital gains and/or franked dividends, for example, are not successfully streamed, the tax payable and/or associated tax benefits may not apply to the potential beneficiary. So, this can affect the minority beneficiaries as stated in the Karen’s case. This can potentially result in the tax rates being higher and/or the tax benefits.

In the past, The Commissioner has made his view clear about the avoidance potential that arises from the construction of the expression “the income of the trust estate” adopted by the High Court. It is to be expected in this regard that an amendment of the trust provisions will be sought from parliament. The High Court inferred by referring to the apparent unfairness of the legislation whichever construction was adopted and acknowledging that it is more than 20 years since the late Hill J remarked of the need for legislative clarification of the scheme in Div 6[5].

Therefore, in light of the Full Federal Court’s decision in Bamford case, it is now settled law that each beneficiary will be taxed on their proportionate share of the net income of the trust to which they’re presently entitled regardless of whether the trustee formally distributed a fixed amount of trust income or a proportion of the trust income to them and regardless of whether the trust income differs from the net income of the trust. In Karen’s case the same rule will be followed.

In addition, Bamford case also decided that the terms of the trust deed can modify the ‘income of the trust estate’ to which the beneficiaries are presently entitled. This allows tax to be brought into line with distributed amounts. Both new and existing discretionary and fixed trust deeds should be reviewed according to the Bamford decision to ensure that they contain provisions permitting capital amounts to be treated as “income” to which beneficiaries are presently entitled. Trust deeds should also be reviewed to ensure that any provisions that define “income” or that affect distributable trust income will operate appropriately in view of the Bamford reasoning; as such provisions may have an effect on the assessable income for the beneficiaries. 

The easiest way to ensure that a beneficiary receives the desired amount of taxable income is for the trust deed to define trust income as being equal to the net income as defined in Section 95 of the tax legislation .Most modern trust deeds already do this, but it is still timely to review trust deeds to ascertain that they do, in fact, operate as originally intended given developments in this area in recent years. So in the given context it is highly recommended that the trustee will duly follow the provision as laid down in Section 95.

As well as the points mentioned above, the ATO indicates that, from the 2011 year, it will no longer accept streaming of different types of trust income to different beneficiaries. This has been a common strategy for many discretionary trusts, for example to stream all discount capital gains to individuals and all franked dividends to a company. In many cases inability to stream may not make a lot of difference to a family group’s overall tax position, but where this does have a significant impact, a great deal of planning may be required.[6]

In order to benefit from the outcomes of the Bamford case, trustees and their advisors need to be aware of the definitions that their trust deeds contain. So even if it is considered the given scenario that the mummy is the trustee then the trust deed if it is made should have the necessary provisions to enable them to take advantage of the Bamford principles. Consequently, the trustee in this regard, the mum, must effectively define “net income” of the trust and provide the definition of capital gains as “income of the trust estate”.

The income of minors and Tax issues:

On minority issues, the beneficiaries’ shares of the net income of the trust for tax purposes must be estimated by reference to their proportionate shares of “the income of the trust estate”. For example, the taxable benefit of a beneficiary to whom is appointed a specific amount of income, for example a child, will be greater than that specific amount if the net income exceeds “the income of the trust estate”. 

According to ATO, a minor is a person who is under 18 years of age. Therefore, special rules apply to the income of minors. Under these rules, certain types of income received by minors may be taxed at higher rates. 

The Australian Taxation Office or ATO provides a guideline to assess the tax rates. In the given scenario it is highly likely that the scheme provided by ATO will be followed. The tax rates featured by ATO in 2010-11 for minors who: 

-are Australian residents 

-are not excepted persons, and 

-have no excepted income. 

Other income 

Tax rates 

$0 - $416 

Nil 

$417 - $1,307 

Nil + 66% of the excess over $416 

Over $1,307 

45% of the total amount of income that is not excepted income 

If the minor's taxable income is less than $67,500, they will get the low income tax offset. The maximum tax offset of $1,500 applies if their taxable income is $30,000 or less. This amount is reduced by four cents for each dollar over $30,000[7].

The same provision will be applicable in the given situation provided that the trust deed has already complied with the provisions of Bamford judgement. 

Sources: 

[1] Humpty Dumpty's Rule : income streaming and trusts ,Michael Dirkis 

[2] http://www.cleardocs.com/clearlaw/trusts/trust-income-definition. 

[3] Roger Timms, Head of Tax & Superannuation at Taxpayers Australia Inc 

[4] http://law.ato.gov.au/atolaw/view.htm?DocID=LIT/ICD/S310/2009/00001 

[5] 2010 ATC ¶20-170, [17]. 

[6] http://www.agradetax.com.au/Family-Trusts-Bamford 

[7] Australian Taxation Office

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Bibliography:

Books:

1. CCH Woellner, Barkoczy, Murphy; Australian Taxation Law 2011,( 21^st Edition , 2011)

2. CCH, Barkoczy; Core Tax Legislation & Study Guide 2011, (14^th Edition 2011)

3. Stephen Barkoczy; Australian Tax Case book, (10^th Edition)

4. Nethercott; Australian Taxation Study manual and Suggested solution, (21^st Edition 2011)

5.Cynthia Coleman, Rami Hanegbi, Geoffrey Hart, Sunita Jogarajan, Richard Krever, John McLaren, Wes Obst, Kerrie Sadiq, Principles of Taxation Law 2011

 

Internet Materials:

·         Australian Taxation Office Website

·         Article on “Family Tax benefit” by National welfare rights network.

·         The kolliou Tax Report (http://www.taxreport.com.au/tag/bamford/)

·         Information from Cleardocs-(1)-(http://www.cleardocs.com/clearlaw/trusts/Bamford'scase-disscussion-paper.html)

·         Information from Cleardocs. (2)-http://www.cleardocs.com/clearlaw/trusts/trust-income-definition.html (Tina Savona - Maddocks Tax & Revenue Team)

·         Australasian Legal Information Institute -(http://www.austlii.edu.au/au/legis/cth/consol_act/itaa1936240/s98.html

·         “The Bamford case: initial reactions from the tax industry” an article by The Tax news Division (http://sites.thomsonreuters.com.au/tainsight/2010/04/12/the-bamford-case-initial-reactions-from-   the-tax-industry/)

·         “The Bamford case - the High Court decides” an Article by Mr.Rogger Timms     (head of tax and superannuation)

·         “Taxing trust income after Bamford’s case” –  an article by Mr. AH Slater QC

·         “Australia: Developments in Division 7A Loans, Bamford and Superannuation Tax Law Update“an Article by Peter P Gell