In Australia, trusts (particularly discretionary trusts) are often used to achieve tax optimal outcomes for beneficiaries. Attempts to engage in ‘income splitting’ within families are an obvious example. Some categories of income have specific tax consequences and as a result, trustees have incentives to make allocations of income to beneficiaries in ways that are considered advantageous for tax purposes. This is so with capital gains. My recent paper critically evaluates the complex regime which governs the taxation of capital gains in trusts, Subdivision 115-C of the Income Tax Assessment Act 1997 (ITAA97). This regime was enacted in 2011 as an ‘interim’ change aimed to improve the taxation of trust income, according to the explanatory memorandum. There has been no review or further reform a decade later.
In a trust setting, the notion of ‘streaming’ capital gains refers to the ability to allocate capital gains among beneficiaries in whatever ways that are considered optimal, which could be quite different to the basis for distributing other trust income. For example, a trustee may wish to allocate a trust capital gain entirely to a beneficiary who has a personal capital loss (rather than another beneficiary without a capital loss), so that the beneficiary can use the loss to reduce the taxable capital gain.
I argue that Subdivision 115-C is unnecessarily complex, and propose simpler processes that enable streaming. I also ask whether the regime meets the longstanding policy objective of ensuring a reasonable nexus between beneficiaries’ distributable and taxable income and highlight an anomaly in the regime.
Background to Subdivision 115C
Before 2011, the scheme for the taxation of trusts including capital gains was in Division 6, Part III of the Income Tax Assessment Act 1936 (ITAA36). The main purpose of Subdivision 115-C was to ensure that the streaming of capital gains to specific beneficiaries would be effective for tax purposes.
Subdivision 115-C was enacted because the Government assumed that the ‘proportionate approach,’ confirmed by the High Court in Commissioner of Taxation v Bamford (2010) (‘Bamford’) precluded streaming. In Bamford, the High Court confirmed that a beneficiary’s assessable income under income tax law (section 97 ITAA36) is determined by applying their percentage share of trust distributable income to the trust’s taxable income, this being the so-called ‘proportionate approach.’
An example
The assumed operation of Bamford and the effect of Subdivision 115-C are illustrated in the following example.
| The A Family Trust has rental income of $100,000 and a (non-discountable) capital gain of $50,000. The trustee exercises a power under the trust deed to treat capital gains as income (although capital gains are not part of trust income under general law principles, the High Court confirmed the legal efficacy of such provisions in Bamford). Therefore, distributable and taxable trust income is $150,000. |
The legal capability to stream capital gains matters to trustees if the individual tax circumstances of a beneficiary mean that allocation of the capital gain to them confers a tax advantage.
Suppose A has a personal capital loss exceeding $50,000 and for this reason, the trustee purports to allocate the capital gain wholly to A, with the rental income being allocated wholly to B.
Before 2011, because A’s share of distributable income is $50,000 (the $50,000 capital gain) or one-third ($50,000/$150,000), A’s share of trust taxable income ($150,000) must also be one-third (33.3%). In other words, $50,000. On the Government’s interpretation of the pre-2011 law, no effect can be given to the trustee’s intention to allocate 100% of the capital gain to A, because it assumed that under Bamford, the proportionate approach requires that A’s one-third allocation of trust taxable income correspond to the same proportionate shares of each component of trust taxable income, in other words, one-third of the rent and one-third of the capital gain. It was assumed A’s share of trust taxable income of $50,000 comprises rental income of $33,333 (33.3% x $100,000 rent) and a capital gain of $16,667 (33.3% x $50,000 capital gain). This is the assumption upon which the 2011 amendments proceed. The trustee’s intention to stream the $50,000 capital gain to A is frustrated.
This outcome is not inevitable at least in cases such as this where trust distributable income equals trust taxable income. In this case, it is possible to give effect to the proportionate approach that a beneficiary’s proportionate share of distributable income (one-third) matches their proportionate share of taxable income (one-third) while giving effect to streaming intentions. It could be held that A’s one-third share of trust taxable income comprises the $50,000 capital gain as intended.
But where trust taxable income differs from distributable income, it is not possible to both give effect to the proportionate approach and streaming intentions – one must trump the other.
Subdivision 115-C ITAA97 enables the streaming of capital gains through the mechanism of creating ‘specific entitlements’. A beneficiary is ‘specifically entitled’ to a capital gain when they have received or are expected to receive a net financial benefit attributable to a capital gain. Specific entitlement is similar to the notion of ‘present entitlement’ for general tax law allocation of trust income. This rule would give effect to the intention of the trustee to allocate the whole capital gain to A for tax purposes.
Here, as A is entitled to 100% of the net financial benefit attributable to the $50,000 capital gain, their specific entitlement amount is $50,000, which would also be their taxable capital gain. The effect of Subdivision 115-C is to allocate the entire taxable capital gain to A, consistent with the trustee’s streaming intentions.
Under Subdivision 115-C, if there are no specific entitlements (in other words, no streaming intention), there is a default allocation based on present entitlement to distributable income. This is based on an ‘adjusted Division 6 percentage,’ which operates in a manner that is similar to the pre-2011 proportionate approach. Otherwise, the trustee’s streaming intentions take priority over the pre-2011 proportionate approach.
The benefits and disadvantages of the 2011 reform
The major practical benefit of the regime in Subdivision 115-C is that it enables the streaming of capital gains to beneficiaries, as shown in the example above.
There is also a definite advantage compared to the pre-2011 law where capital gains are not included as part of trust distributable income. Somewhat counter-intuitively, the legislation still enables the trustee to invoke the specific entitlement mechanism to allocate capital gains among beneficiaries in a tax effective way in this situation, provided the trustee has the power to stream capital gains under the trust deed. This prevents application of the higher rates of tax under section 99A ITAA36 (the highest marginal rate of tax applied as a flat rate) where the trust’s only taxable gain is a net capital gain. Under the pre-2011 law, section 99A rates would apply as there would necessarily be no income to which a beneficiary could be presently entitled for the purpose of section 97 ITAA36 (which relies on general law notions of income).
The main disadvantage of the regime is its immense and unnecessary complexity. For example, even where there is no streaming, the regime requires a full analysis through the statutory lens of specific entitlement when there are no specific entitlements at all, with the adjusted Division 6 percentage being used to produce the same results as the pre-2011 proportionate approach.
The most problematic aspect of the regime arises in the context of partial streaming where both the specific entitlement and adjusted Division 6 percentage concepts must be utilised. There are five distinct steps to work out taxable capital gains, and the complexity arises not only because of the number of steps but also because the individual steps are very complicated.
In particular, there is an anomaly in the setting of partial streaming where capital gains are not included in trust income because the allocation that results is not at all based on the parties’ economic entitlements. This is because the capital gain not referable to specific entitlement is allocated for tax purposes based on entitlements to trust distributable income excluding streamed capital gains, but this does not take account of the fact that streaming has changed the economic entitlements of the parties.
My paper shows how streaming can be achieved in a simpler way, using fewer steps, where taxable capital gains exactly match beneficiaries’ economic entitlements whereas this is not consistently achieved under the legislation.
A review and reform is needed
The ‘interim’ reform of 2011 which enacted Subdivision 115-C ITAA97 achieves the legislative purpose of enabling streaming. But the regime is unnecessarily complex and there is at least one anomaly which creates inequity in the division of the tax burden among beneficiaries.
Subdivision 115-C ought to be reviewed with a view to addressing these deficiencies. Streaming of capital gains can be achieved through the use of simpler processes that achieve a closer match between tax liabilities and economic entitlements.
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