On Wednesday 8 August 2018, the High Court of Australia unanimously allowed one appeal, partly allowed a second appeal and dismissed two appeals from the Full Federal Court decision in Federal Commissioner of Taxation v Thomas [2018] HCA 31 (Thomas).

The taxpayer sought to use a trust structure to allocate or “stream” income separately from credits available on franked distributions, collecting more than $9 million in franking credits in the process.

The key conclusions relevant to taxpayers and practitioners are as follows:

  • it is decided: franking credits are creatures of tax law only and are not income or an asset of a trust
  • as such, franking credits cannot be separately allocated disproportionately to the income to which they attach (such as dividends) to achieve an optimal tax position for beneficiaries and
  • directions given by State Supreme Courts are effective to issue binding determinations of the rights and facts as they occur between the parties, but cannot determine the operation of federal tax laws to bind the Commissioner.

What is the case about?

In the interests of brevity, those interested in the background of the taxpayer’s colourful scheme can read more in our previous article on the Federal Court decision.

In short, over a number of years, the trustee prepared resolutions which:

  • distributed a part of the trust’s income comprising the franked distributions to a corporate beneficiary and to another (notably smaller) part to the taxpayer and
  • sought to distribute or “stream” the corresponding franking credits in different proportions to the income.

The assumption that such a manoeuvre was permissible at law was referred to throughout the 7-year litigation as the “Bifurcation Assumption”

The final adjudicator: the High Court of Australia

Surprisingly, the legal basis of the Bifurcation Assumption was no longer an issue to be determined by the High Court of Australia, having been conceded by the Taxpayers in the course of the appeal.

The issues determined by the High Court are outlined below:

Is the Court bound by Executor Trustee1

The principal question in the High Court appeal was whether the Full Federal Court was correct in considering itself bound by the decision in Executor Trustee. Specifically, whether it could be concluded that the directions obtained by the trustee from the Supreme Court of Queensland to conclusively determine the rights of the parties (Directions) were binding on the Court – even though the Directions contained an error of law plainly acknowledged by both sides to the appeal.

Ultimately, the Court found that the Full Federal Court was wrong to conclude that it was bound by the Directions, given the following:

  • Executor Trustee is authority for the proposition that the general law rights of trustee and beneficiary, as determined by a competent court as to the facts and rights as between the parties, are binding until set aside
  • however, it is not authority for the proposition that the Commissioner is bound as to the actual application of the taxation laws to the determined facts and rights and
  • moreover, on the basis of not being a party to the proceedings in which the Directions were made, the Commissioner was not bound (because, as aforementioned, the Directions determine only the rights as between the parties).

The Court also found that, in any event, a question about how the taxation acts operate is not suitable for determination under section 96 of the Trusts Act, which at most could only direct the trustee to protect it from later complaint.

Can the resolutions be constructed in a different way so as to give effect to the franking credit fork?

The alternative submission of the Taxpayers, if the High Court did not accept that that it was bound by Executor Trustee, was that the substitute construction of the resolutions posited by the Full Federal Court should be upheld.

On this view, the franked distributions were “notionally allocated” to match the purported, and separate, distribution of the franking credits. This argument was quickly dismissed by the High Court, which found that this argument was flawed as it was contrary to the terms of the resolutions and the intention of the trustee, as well as to the proper construction of the legislation.

The Taxpayers also attempted to establish alternate arguments around estoppel by convention, rectification of the resolutions and denial of procedural fairness. The Court made some interesting observations on these grounds but did not indulge the Taxpayers.