Key points and times

  • The new rules allowing streaming of capital gains and franked dividends has been introduced into the Parliament and the government wants it passed and effective this year.
  • To stream you will need to actually make resolutions by 30 June and 31 August.
  • To stream franked dividends, you will need to record in the accounts or records of the trust ('records' includes distribution minutes) that a beneficiary is 'specifically entitled' to an amount of a franked dividend on or before 30 June.
  • To stream capital gains, you will need to record in the accounts of records of the trust that a beneficiary is specifically entitled to an amount of a capital gain by 31 August.
  • The priority issue is to check your trust deed to ensure that it enables the trustee to classify amounts of income by their source and make distributions of that classified income: this will be critical if a beneficiary is to be 'specifically entitled' to a capital gain or franked dividend, upon which the streaming amendments depend. It may or may not require amendment, and there are alternative strategies.

The Hall & Wilcox Tax team have sent you three updates in the last four weeks about the proposed amendments that are intended to ensure that, post-Bamford, capital gains and franked dividends can be effectively 'streamed' through trusts.

The Bill introducing the streaming amendments (Tax Laws Amendment (2011 Measures No 5) Bill 2011) was introduced into the Federal Parliament by Assistant Treasurer Bill Shorten yesterday together with an Explanatory Memorandum (EM).

This update outlines the things that, in our opinion, you should be considering and may require action to be taken within the next 27 days if you intend to effectively 'stream' capital gains and franked dividends through a trust under the streaming amendments, assuming that they are passed in the form they have been introduced.

Background

The general background to these reforms and the consultation process that took place (and our involvement in this process) was outlined in our previous updates, which you can access by clicking on the links below.

Two key points to note about the context to the streaming amendments are:

  • The Government calls these amendments 'interim changes' – a broader review and update of the taxation of trusts will take place over the course of the year and this will lead to a broader 're-write' (and, we expect, re-modelling) of Division 6.
  • They are very deliberately limited to streaming 'real' capital gains and franked dividends only: these amendments will not apply to stream notional capital gains (eg a gain arising from the application of the market value substitution rule), unfranked dividends, foreign income/foreign tax offsets, interest or any other type of income.

So, expect more change in 2012 and beyond.

How the streaming amendments will work

By-and-large, the 'model' that Treasury started with in developing these amendments – and which will be the basis of your trust tax calculation/reconciliation for the 2011 year – has not varied. The detail around it has.

The streaming amendments will broadly work in this way:

  • Through a legislative process set out in the new Division 5B, effectively streamed capital gains and franked dividends will be backed out of Division 6 and taxed to the beneficiary on a quantum basis (that is, on the actual amount streamed) under Subdiv 115-C (capital gains) and Subdiv 207-B (franked dividends).
  • Any capital gains or franked dividends that are not effectively streamed will continue to be taxed to the beneficiaries under Division 6 on a proportionate basis, as is currently the case.
  • To effectively stream a capital gain and/or a franked dividend, the trustee must make a beneficiary 'specifically entitled' to the amount of the capital gain or franked distribution and the requirements to do so are now prescribed in the legislation.
  • The trustee must be able to make a beneficiary 'specifically entitled' to a capital gain and/or a franked dividend under the terms of the trust and the specific entitlement must be reflected in the trust's accounts or records. These enabling terms must be in the trust deed or available to the trustee by the operation of legislation or common law or equitable rules. The streaming amendments do not give the trustee a power to stream capital gains or franked dividends where they do not already have the power to do so.

The key to achieving an effective taxation outcome in respect of a 'streamed' capital gain and/or franked dividend under the streaming amendments is to ensure that the trustee has created a 'specific entitlement' in favour of a beneficiary in the way the legislation will require. This is the critical issue to focus on between now and 30 June.

When a beneficiary is 'specifically entitled' to a capital gain or a franked dividend under the streaming amendments

Key changes

The definition of 'specifically entitled' has evolved, and we think improved, considerably from the earlier drafts of the streaming amendments.

Firstly, the definition of 'specifically entitled' is broadly the same (with some modifications to reflect the obvious differences between the two) for both capital gains and franked dividends: this is an improvement from the earlier draft bill, where the same term was defined differently for each item.

Secondly, the ability to stream is based on the beneficiary being entitled to a 'financial benefit' in respect of the capital gain or franked dividend. This is a significant difference from the definition in the earlier draft bill, which required an 'allocation' (which we submitted to Treasury could only happen in an entirely notional sense) and the creation of a 'vested and indefeasible interest in trust property representing the gain' (which troubled us because it depended on an undefined and uncertain concept). We consider the current approach an improvement. It is also, in our view, an indicator of the future direction of Division 6: that is, a model that looks to the underlying 'cash' or financial benefits enjoyed by the beneficiaries of the trust to determine the amount on which they will be taxed.

Under the streaming amendments, the specific entitlement is calculated by applying this statutory formula:

Capital Gain x Share of net financial benefit

_______________________

Net financial benefit

It is within the elements of this formula that the complexity lurks!

Capital gain is a capital gain made by the trust in the relevant income year.

Net financial benefit is the 'financial benefit' that is referrable to the capital gain (after losses have been applied) or the franked dividend (after directly relevant expenses have been applied).

The term 'financial benefit' is already defined in the legislation at section 974-600 in very broad terms: it means anything of 'economic value' and most obviously cash or a cash equivalent (like a bank account).

The use of the term 'directly relevant expenses' in reference to franked dividend remains a concern to us as it is unclear what nexus will be required between the expenses and the earning of a franked dividend before it is considered 'directly relevant' – the EM offers an explanation at paragraph 2.53 but it is unclear: for example, it refers to the 'management fee' incurred in respect of managing a share portfolio for the purpose of deriving dividend income as being 'allocated against dividend income as relevant' without any explanation of how this allocation could be reasonably done.

Share of the net financial benefit means that part of the 'financial benefit' that is referrable to the capital gain that, under the terms of the trust:

  • the beneficiary has received or can be reasonably expected to receive;
  • that is referrable to the capital gain (after applying losses) and/or the franked dividend (after applying directly relevant expenses);
  • is recorded, in its character as referable to the capital gain or franked dividend, in the accounts or records of the trust no later than:
    • two months after year end in the case of a capital gain;
    • the end of the income year in the case of franked dividends.  

Each of these elements requires closer consideration.

The 'beneficiary has received or can be reasonably expected to receive'

The EM explains that an amount will be 'received' when it has been 'credited or distributed to them (including under a reinvestment agreement), or paid or applied on their behalf or for their benefit". This does not require a 'tracing' of funds back to the actual proceeds received from the CGT event or receipt of the dividend. It is sufficient if the beneficiary gets the equivalent amount. This means that the requirement can be met even if the actual proceeds from the CGT event of dividend have been re-invested or otherwise applied. This is welcome and we made the point in our submission that this would have imposed an impossible requirement to link cash to a particular gain.

Alternatively, according to the EM, a beneficiary will 'reasonably be expected to receive' an amount if they have a present entitlement to the amount, a vested and indefeasible interest in trust property representing the amount or the amount has been 'set aside' for the beneficiaries exclusive benefit.

The important thing to note here is that this requirement can only be satisfied if the trustee exercises power to give the beneficiary an interest in the relevant funds that is, legally, as good as it being paid to the beneficiary: the EM makes it clear that a 'notional allocation' in the trust's tax records (the tax return or tax reconciliation) will not be sufficient (paragraph 2.46).

Moreover, specific provisions have been drafted into the streaming amendments so as to make it clear that 'notional' or zero amounts which by definition cannot be 'received' – which includes franking credits (see paragraphs 2.60 and 2.61) – cannot be streamed. Nor can capital gains which arise as a result of the operation of the market value substitution rule: in such a case, it is limited to the amount (if any) that would have been treated as a capital gain for tax purposes if the rule did not apply.

Consider the example at paragraph 2.56:

Example 2.4

The Baguley Trust derives net rental income of $100,000 and a franked distribution of $70,000 (with $30,000 attached franking credits) from shares in TAS Pty Ltd. The trustee had interest expenses of $100,000 on a loan taken out to purchase the shares in TAS Pty Ltd. As a result, there are no net franked dividends.

The trust's income is $70,000 and the taxable income is $100,000.

The Baguley Trust has two beneficiaries, Justin and Kerry. Under the terms of the trust, Justin is entitled to net franked dividends and Kerry is entitled to all other income.

Justin has no entitlement to income as the trust has no net dividend income. He is also not specifically entitled to anything as there is no net franked dividend to which he can be specifically entitled.

By contrast, Kerry is entitled to all of the trust's income ($70,000).

As Kerry is entitled to all of the income of the trust and as no-one was specifically entitled to any of the franked distribution, Kerry's share of the franked distribution equals all of the distribution (section 207-55). It follows that she receives all of the franking credits (section 207-57).

Is referrable to the capital gain (after applying losses) or the franked dividend (after applying directly relevant expenses):

This requires an equivalence between the amount of the capital gain or the franked dividend (both net of capital losses/directly relevant expenses) and the amount in respect of which a beneficiary is sought to be made 'specifically entitled'.

The EM makes an interesting point about a 'financial benefit' not needing to accrue at the time of the CGT event for it to be 'referable' to the relevant gain, but that it can look to the 'financial benefit' provided to the beneficiary over the time the relevant asset has been held by the trust, including distributions that have been made from unrealised gains arising on an asset revaluation. Consider the example at paragraph 2.55:

Example 2.3

The Zhang Trust buys an investment property in 2001 for $100,000. The trustee of the trust has the power to revalue the property according to generally accepted accounting principles and treat any increase in its value as income of the trust.

Each year for the following 10 income years, the trustee revalues the asset upwards by $20,000 and treats this amount as income of the trust. For each of the first five years, the trustee distributed $20,000 from the revaluation to John, who is no longer a beneficiary of the trust. For each of the remaining five years, the trustee distributed $20,000 from the revaluation to Kevin (who is still a beneficiary of the trust).

In the 2011-12 income year, the trustee sells the property for $400,000. The trustee makes an accounting gain of $100,000 ($400,000 less the revalued amount of $300,000) and a (tax) capital gain of $300,000 ($400,000 capital proceeds minus the cost base of $100,000). The trustee distributes the $100,000 accounting gain to William.

Assuming there are no losses or expenses, the net financial benefit referable to the gain (over the life of the asset) is $300,000. After applying the CGT discount, the taxable capital gain is $150,000.

Kevin received a $100,000 share of the net financial benefit referable to the gain (in five payments of $20,000) and therefore is specifically entitled to one third of the $300,000 capital gain.

William also received a $100,000 share of the net financial benefit referable to the gain (one payment of $100,000) and is also specifically entitled to one third of the $300,000 capital gain.

There is one third of the capital gain to which no beneficiary is specifically entitled. (John cannot be specifically entitled to any of the capital gain because he is no longer a beneficiary.)

Is recorded, in its character as referrable to the capital gain, in the accounts or records of the trust no later than two months after the end of the income year in the case of capital gains and no later than the end of the income year in the case of franked dividends

From a practical perspective, this is the most important requirement and we are pleased that the EM is clearer on this point compared to its earlier releases.

The timing rules here are critical. For capital gains, you have two months from year end to make the relevant recordings but for franked dividends, they must be made by 30 June. For many trusts, this will give rise to practical issues, as the trustee may not have received all information relating to the distributions received during the income year.

The EM states that 'accounts or records' would include the trust deed, trustee resolutions or distribution statements (including schedules or notes to these), but will not include trust records (eg a return, tax work paper or tax reconciliation) without anything more.

Moreover, the EM provides some guidance as to the approach that can be taken to record a distribution in the accounts or records of the trust 'in its character as referrable to the capital gain'. The EM confirms that, if done properly, there is scope to effectively 'record' a specific entitlement by reference to a 'formula' or as a 'share' (the total of which is to be determined later). However, on our reconciliation of the relevant parts of the EM, the thing to which the formula or share is to be applied must be the capital gain or franked dividend and cannot be the trust income, even if it includes a capital gain or franked distribution.

We have extracted the relevant passages from the EM to illustrate this.

First, the EM states (paragraph 2.43):

The entitlement can be expressed as a share of the trust gain or distribution. More generally, the entitlement can be expressed using a known formula even though the result of that formula is calculated later. For example, a trustee could resolve to distribute to a beneficiary:

  • $50 referrable to a franked distribution;
  • half of the 'trust gain' realised on the sale of an asset;
  • the amount of a franked distribution remaining after calculating directly relevant expenses and distributing $10 to another beneficiary;
  • thirty percent of a 'net dividends account' that includes all franked and unfranked distributions, less directly relevant expenses charged against the account (so long as their entitlement to net franked distributions can be determined; and
  • the amount of (tax) capital gain included in the calculation of the trust's taxable income remaining after the application of the capital gains tax (CGT) discount. (In such a case the beneficiary would generally be specifically entitled to only half of the gain, and that entitlement is take to be made up equally of the taxable and discount parts of the gain.)

Second, the EM states (at paragraph 2.64):

The following resolutions or trust entitlements would satisfy the requirement of being 'recorded in its character as referrable':

  • Under a trust deed, a beneficiary is entitled to all of the capital gains of a trust.
  • The trustee resolves to distribute all of the dividends of the trust to a beneficiary.
  • Under a trust deed that includes capital gains as income (either by default or because the trustee exercises a power to re-characterise an amount as income), a beneficiary is entitled to all of the profits made or derived from an asset.
  • Under a trust deed that does not include capital gains as income, the trustee resolves to advance capital representing profits from the sale of a property equally to the beneficiaries.  

Third, the EM states (at paragraph 2.65):

Where a beneficiary is entitled to unspecified amounts (or shares) — such as 'the balance' of trust income, 'all of the trust income', 'half of the trust income' or '$100 of trust income' — this is not sufficient to create a specific entitlement. This is because the entitlements have not been recorded in their character as referable to a capital gain or franked distribution.

  • This is true even if the beneficiary's entitlement contains amounts referable to capital gains or franked distributions.
  • Further, it is true even if the beneficiary's entire entitlement is referable to capital gains and/or franked distributions.

30 June 2011 considerations

We see three key matters that will require your consideration and possible action in the next 27 days to 30 June 2011 if you wish to achieve an effective outcome under the streaming amendments:

The Trust Deed

It is critical to remember that the streaming amendments can only come into play if your trust deed (and it will be the trust deed – the circumstances in which you can rely on legislation, the common law or equity will be the exception rather than the rule) allows the trustee a power to do these things:

  • Allows income to be classified and accounted for separately according to its source (in particular, capital gains and franked dividends) from the perspective of the trustee.
  • Then, allows for distributions of that income to be made to the beneficiaries once it has been classified and accounted for.

In our view, if you cannot achieve this classification by source in the hands of the trustee under the trust deed, the default position is that the income forms a single 'blended' amount for trust purposes (separate to what it is for tax purposes). Moreover, some trust deeds, in particular older ones, may place a requirement on the trustee to 'pool' the income of the trust into a single, indistinguishable amount. In either case, we cannot see how upon distribution to a beneficiary the income can be regarded as referable to a capital gain or franked dividend. This may call for a variation to the trust deed if there is no risk of a resettlement.

  • Related to the previous point, the power to classify and separately account for trust income must be supported by a power to allocate capital losses and 'relevant expenses' in a corresponding way or the requirement of the provisions cannot be satisfied.
  • Advance or distribute trust capital (in some deeds called 'corpus') – indeed, in the case of capital gains, it may be a cleaner approach to distribute an amount that under the terms of the trust deed will be (because there is no income equalisation clause), or by the application of a power of reclassification can be, treated as trust capital under a provision allowing an advance of trust capital to the beneficiary.
  • "Pay, apply or set aside" an amount in favour of a beneficiary – most trusts will have this, the important thing to ensure is that the power provided gives the beneficiary full proprietary rights in respect of the amount.

Minutes/records of the trustee's decisions

In preparing the trustee's minutes for the 2011 income year, if you are seeking to rely on the streaming amendments, do so on the basis that the minute is a 'record' for the purposes of the legislation and so must fulfil a legislative purpose: to substantiate the trustee's compliance with the requirements of the legislation.

As such, we recommend that:

  • the minute narrate the relevant sections of the trust deed that are being relied upon to 'stream' the income for trust purposes;
  • that the relevant amount being so streamed is 'referable' to an amount of either a capital gain or a franked dividend (for instance, by narrating the amount of the capital gain and the circumstances in which it arose); and
  • importantly, that the minute also discuss how the beneficiary will 'receive' the amount streamed to them (for example, by it being paid, by the creation of a present entitlement) or how and why it is reasonable to expect that he amount will be received by them – for example, for it having been set aside for the benefit of the beneficiary under the relevant power and the income or any other benefits arising from that amount so set aside being held for the benefit of the beneficiary (and not the trust).

Also, remember the relevant timing points for the preparation of distribution minutes: 30 August (two months from year end) for capital gains and 30 June for franked dividends. For the 2011 year, for practitioner's to do this effectively they will at the very least require a record of franked dividends earned by the trust over the course of the year.

We have prepared a sample distribution minutes based on the Hall & Wilcox standard trust deed. Click here to view sample.

Accounts and other records

The comments regarding distribution minutes apply equally to accounts and other tax records (returns, work papers and reconciliations): they should be treated as a form of statutory substantiation from here on.