Introduction

The streaming of certain types of capital gains to investors is common practice amongst managed funds: it allows fund managers to pass on the benefit of discounted gains to long term investors. The recent Federal Court decision in Colonial First State Investments Ltd v FCT [2011] FCA 16 has cast doubt over this practice.

The case concerned Colonial First State Investments Ltd (Colonial), the responsible entity and trustee of Colonial First State Firstchoice Investments Property Securities Fund No1 (the Retail Fund) which held units in the Commonwealth Property Fund 6 (the Wholesale Fund). Colonial was also the trustee of the Wholesale Fund.

The dispute arose after Colonial proposed amendments to the Constitution of the Wholesale Fund to allow it to:

  • Stream short-term capital gains to investors that exited their investment within a year (with the result that those investors would receive no discount on those gains).
  • Stream long-term capital gains to all other investors (with the result that those investors could benefit from discounted gains).

 Colonial sought a private ruling from the Commissioner confirming that the proposed streaming of the capital gains would be effective.

The Commissioner ruled that Colonial was not able to stream capital gains and also found that the Wholesale Fund was not a "fixed trust" for tax purposes (with the result that tax losses and franking credits would be of little if any value).

On 18 January 2011, the Federal Court dismissed Colonial's appeal against all but one of the positions taken by the Commissioner in the private ruling. Stone J held that the amended Constitution did not allow Colonial to stream short-term and long-term capital gains because the Constitution did not allow Colonial to re-characterise capital as income and vice versa. Stone J also agreed with the Commissioner's classification of the Wholesale Fund as not qualifying as a "fixed trust".

Background

On 9 September 2009, the Commissioner issued a private ruling in which he answered "No" to all questions asked by Colonial. Colonial then lodged a Notice of Objection which was disallowed by the Commissioner on 12 October 2009. Colonial then appealed to the Federal Court where Stone J upheld all but one of the Commissioner's answers.

The request for the private ruling was made in the context of Colonial's proposal to amend the Constitution of the Wholesale Fund. This was influenced by what Colonial perceived as unfairness in the tax treatment of payments made to investors investing for the long-term as opposed to the short term.

To remedy this, Colonial proposed to amend the Constitution of the Wholesale Fund to allow it to stream short-term capital gains to those investors that redeemed their units within a short period of time. The proposed amendments can be summarised as follows:

  •  The amount payable to an investor on redemption of a unit (the Redemption Amount) is the amount derived by dividing the net Trust value by the sum of the number of units on issue.
  • The Responsible Entity is, in its absolute discretion, at liberty to appropriate the Redemption Amount from such of the following accounts of the Trust as the Responsible Entity may elect:
    • The account representing the corpus of the Trust (Corpus Account), but not exceeding the issue price paid by the holder of the unit being redeemed.
    • The account to which are credited the Trust's short term capital gains (Short-Term Capital Gain Account).
    • The account to which are credited the Trust's long term capital gains (Long-Term Capital Gain Account).
    • The Corpus Account for any balance remaining.
  • Consequential amendments were proposed to define short-term and long-term gains. Short-term gains were those that would have arisen in respect of assets that were acquired and disposed of within 12 months. All other gains were long-term gains.

Issues in contention

In the ruling application, Colonial posed a number of questions asking whether the ITAA 1936 and the ITAA 1997 would operate in a specific way in relation to the facts postulated. The Commissioner answered "No" to all questions.

The questions were premised on the assumption that the Retail Fund redeemed units in the Wholesale Fund and was entitled to receive a Redemption Amount which was greater than the amount initially paid on subscription for a unit (Subscription Amount). The difference between the Redemption Amount and the Subscription Amount was referred to as the "Gain part" (Gain Part).

The issues considered by the Federal Court were as follows:

  •  Is the Retail Fund a beneficiary of the Wholesale Fund?
  • Is the Retail Fund presently entitled to a share of the net income of the Wholesale Fund? Is the Gain Part income of the trust estate of the Wholesale Fund?
  • Is the Gain Part the proportion of the net income to which the Retail Fund was entitled?
  • Are the remaining investors taxed on that part of the income that has not been effectively distributed to the redeeming unit holders during the year?
  • Will the Retail Fund generate a capital gain under CGT Event C2 on redemption of a unit?
  • Is the Wholesale Fund a "fixed trust" within the meaning in s 272-5 in Sch 2F of the ITAA 1936?

Decision

 Is the Retail Fund a beneficiary of the Wholesale Fund?

The Commissioner had ruled that because the units in the Wholesale Fund were held by Citicorp (as custodian for Colonial) and not directly by Colonial, the Retail Fund (of which Colonial was the trustee) was not a Beneficiary of the Wholesale Fund.

Stone J quickly dismissed the Commissioner's reasoning as wrong, stating that it was not necessary that a Beneficiary of a unit trust have legal title to the units. Her Honour adopted a "substance over form" approach, deciding that the fact that Citicorp had "title" to the units was of limited relevance to determining who was a beneficiary.

Is the Retail Fund presently entitled to a share of the net income of the Wholesale Fund?

After finding that the Commissioner was wrong on the "beneficiary" issue, the Court went on to consider the meaning of "presently entitled" in s 97 of the ITAA 1936.

Section 97 provides that a beneficiary will be assessed on its "share" of the "net income" of the trust estate where that beneficiary is "presently entitled" to the "income" of that trust estate. In other words, to be assessed, a beneficiary needs to meet 2 criteria, namely:

  •  It needs to be "presently entitled."
  • Its present entitlement must be to the "income" of the trust.

If it meets those requirements, it will be assessed on its share of the "net income" (as distinct from "income") of the trust.

Colonial had asked the Commissioner to consider whether the Gain Part (being the excess of the Redemption amount over the Subscription Amount) would be included in the assessable income of the Retail Fund as a result of it being a beneficiary of the Wholesale Fund. Central to this question was whether the Retail Fund was "presently entitled" to a share of the "income" of the Wholesale Fund, which was required in order for the Retail Fund to be taxable on that income (ie the Gain Part). Colonial was of the view that the Retail Fund (which was the hypothetical exiting investor) was presently entitled with the result that it would be taxed on the Gain Part.

Stone J considered the meaning of "presently entitled" in s 97 and agreed with the Commissioner's decision that the Retail Fund was not presently entitled. Stone J, citing Harmer v FCT (1991) 22 ATR 726 with approval, held that a beneficiary is "presently entitled" if and only if:

"(a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and (b) the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment."

Stone J examined clause 12 of the Wholesale Fund's Constitution which dealt with the redemption of units and the calculation of the Redemption Amount. Clause 12 provided that the entitlement to receive the Redemption Amount must be "satisfied within a reasonable time after the request for redemption is received" and provided the Responsible Entity (ie Colonial) with the discretion to allocate that Redemption Amount to the various accounts.

However, the allocation of the Redemption Amount to the various accounts under clause 12 was to be made "at the end of the financial year during which the entitlement to that Redemption Amount arises".

The Commissioner had decided (in the ruling) that the entitlement to receive the Redemption Amount arose before the Responsible Entity was able to allocate the Gain Part and, as present entitlement must exist at the time the income is received, it was impossible to satisfy the "presently entitled" requirement in the postulated fact scenario.

Stone J disagreed with the Commissioner's view that present entitlement must exist at the time the income is received. Instead, Stone J decided that the present entitlement only had to exist within the relevant tax year. However, Stone J agreed that the test in Harmer could not be met as Colonial would not allocate the Gain Part to the relevant accounts (ie decide whether to pay it from short-term or long-term capital gains) until after the end of the income year and, therefore, there was no present entitlement within the income year. On this basis, Stone J concluded that the requirement of present entitlement in s 97 was not met.

Presumably, the "present entitlement" test would have been satisfied if Colonial had drafted the amendment to the Constitution such that the allocation of the Redemption Amount occurred at the time the units were redeemed (or at some other time during the income year) instead of at the end of the income year.

The "present entitlement" question was central to Colonial's plan of ensuring that there was "fairness" in the taxation of exiting and remaining investors. The Court's decision meant that the amounts paid to exiting investors would not be taxed in their hands as trust income because the exiting investor (ie the Retail Fund) was not "presently entitled" to the Gain Part (and only beneficiaries who were presently entitled could be taxed).

This aspect of the case raises a concern as s 97 imposes no timing requirement on present entitlement.

In fact, most trustees do not declare (and therefore do not distribute) income until after the end of the income year when all expenses have been met and the trustee has determined the income available for distribution. As Stone J found that a beneficiary needs to be "presently entitled" to income during the year, it follows that trustees need to declare an amount and specify whether that amount was capital or income before the end of the year in order for beneficiaries to be assessed (the alternative being that the trustee would be taxed at the top marginal tax rate).

Interestingly, Stone J's decision is based on the fact that there can be no present entitlement because the sources of the Redemption Amount could not be identified until after the end of the year.

It is unclear whether this aspect of the decision is limited by the fact that the Commissioner (and Stone J) did not accept that amounts would be allocated during the year (because the Constitution said otherwise) or whether this has wider reaching consequences for all other trusts. It raises questions as to whether the Commissioner's practice of allowing trustees to allocate income within 2 months of the end of the income year will continue to apply.

 Is the Gain Part "income" of the trust estate of the Wholesale Fund?

The Commissioner submitted that even if Colonial was presently entitled to the Redemption Amount, this did not mean that the Gain Part formed part of the "income" of the Wholesale Fund for the purposes of s 97.

This aspect of the case is arguably the most complex as it deals with the distinction between "income" and "net income".

Section 97 distinguishes between "income" and "net income" of the trust estate. In order for a beneficiary to be assessed, that beneficiary has to be presently entitled to a share of the "income" and will then be assessed on that same share of the "net income". The distinction can, in simple terms, be explained as follows:

  •  "Income" refers to income under accounting principles and trust law concepts and
  • "Net income" refers to taxable income which includes a net capital gain, franking credits and other amounts that are assessable by virtue of the income tax legislation.

Because "income" refers to income under accounting principles and trust law concepts, it does not include capital gains. The exception to that is where the trust deed gives the trustee an express power to re-characterise capital to income and vice versa. If the trust deed contains such a power, then capital receipts (once re-characterised by the trustee) are "income".

The Commissioner had argued that the amended Constitution did not have a clause that allowed the trustee to re-characterise capital into income (and the Gain Part was a capital receipt and therefore not "income"). Colonial argued that clause 32 did in fact permit a re-characterisation of income to capital (and vice versa) such that the Gain Part was re-characterised to income and formed part of the s 97 "income" of the trust estate.

After examining clause 32, Stone J agreed with the Commissioner that the clause did not permit the Trustee to re-characterise income to capital and vice versa. While the clause did permit Colonial to decide which part of the Redemption Amount would be allocated to one or more accounts, it did not provide Colonial with the power to determine that capital was income and vice versa.

Stone J distinguished clause 32 of the Constitution with the trust deeds in FCT v Bamford (2010) 75 ATR 1 and Cajkusic v FCT (2006) 62 ATR 1091 which gave the trustee an express power to allocate receipts between income and capital. Stone J decided that the present circumstances were different to Bamford and Cajkusic because, when properly construed, the Constitution of the Wholesale Fund did not have a provision equivalent to that in Bamford and Cajkusic and did not permit the Trustee to re-characterise. On this basis, Stone J held that the Gain Part did not form part of the "income" of the trust estate for the purposes of s 97.

As a result, even if the exiting investor was "presently entitled", the Gain Part would not be taxed in the hands of the exiting investor upon the redemption of a unit, because the Gain Part was not "income".

This aspect of the decision emphasises the need for careful drafting as Stone J's decision was based solely on the proper interpretation of clause 32.

Importantly, Stone J made it clear that it is possible for trustees to re-characterise receipts. What is required is that the trust deed gives the trustee that power. Here, Colonial had failed because its re-characterisation clause was faulty. Unfortunately, the Court was not asked or required to consider whether amounts, once re-characterised by a trustee, could then be streamed to different beneficiaries.

 Is the Gain Part the proportion/share of the net income to which the Retail Fund was entitled?

The next issue for determination was the meaning of "share" or "proportion". This was relevant because under s 97(1), a beneficiary that is presently entitled is required to include in their assessable income their "share" of the "net income" of the trust.

The Commissioner had submitted that even if a redeeming investor was "presently entitled", it did not mean it would be assessed on the Gain Part because the Gain Part was not a "share" or "proportion" of the net income. Stone J agreed and held that under s 97(1), it is a "share" of the net income of the Wholesale Fund that would be included in the assessable income of the Retail Fund and that included not the Gain Part, but so much of the Gain Part as corresponded with a net capital gain.

Stone J decided that a redeeming investor could not simply include the amount received on the redemption of their own unit in their assessable income. Rather, they are assessed on their share (or proportion) of the total amount of the "net income" (being the income calculated for tax purposes) of the trust.

For example, if the trust generated a net capital gain of $1,000 in an income year and the beneficiary was entitled to 5 per cent of the net income of the trust, the beneficiary would include in its income 5 per cent (being it's "share") of $1,000 and not the amount received for the redemption of that holder's unit (which would most likely be a different amount).

Are the remaining investors taxed on that part of the income that has not been distributed to the redeeming unit holders during the year?

Colonial had submitted that the remaining investors would be taxed on only that part of the income that had not been distributed to redeeming investors. The Commissioner disagreed.

Stone J agreed with the Commissioner. This was due to Stone J's earlier finding that the Gain Part was not "income" such that it could not simply be deducted from what remained at the end of the income year. Therefore, it was not possible to equate the net income at the end of the income year with that amount that had not been distributed during the income year (the "retained part" in the words of Stone J).

While not expressly stated in the decision, the implication is that the remaining investors would be assessed on their share of the "net income" (which would include the Gain Part) of the trust estate.

 Will the Retail Fund generate a capital gain under CGT Event C2 on redemption of a unit?

The Court then proceeded to deal with CGT as Colonial had asked the Commissioner whether the redemption of a unit would give rise to CGT Event C2.

Colonial had argued that no capital gain was made by the Retail Fund upon the occurrence of CGT Event C2 on redemption of a unit for either of the following reasons:

  • The capital proceeds for redemption of a unit were only the amount debited to the Corpus Account (i.e. the Subscription Amount) and not the entire Redemption Amount.
  • If the capital proceeds were the entire Redemption Amount – the anti-overlap provision in s 118-20 of the ITAA 97 would operate to reduce the capital gain to zero because the Gain Part was assessable as income of the Retail Fund.

Stone J held that the redemption of the unit gave rise to CGT Event C2 and that the entirety of the Redemption Amount constituted the capital proceeds for CGT Event C2.

Stone J held that the Gain Part would not be taken into the calculation of the net income of the Retail Fund for the reasons expressed earlier in her judgment: namely, the Retail Fund was not "presently entitled" to “income” of the Wholesale Fund, and even if it was it would include in its income a share of the "net income" and not the Gain Part (the Gain Part is an "amount" and not a "proportion" or "share"). Therefore, Stone J held that in the absence of the Retail Fund being assessed on any share of the net income of the Wholesale Fund, the anti-overlap provision in s 118-20 of the ITAA 97 could not operate to reduce the capital gain on occurrence of CGT Event C2 by such an amount.

Is the Wholesale Fund a "fixed trust" within the meaning in s 272-5 in Sch 2F of the ITAA 1936?

The final question was whether the Wholesale Fund was a "fixed trust" for the purposes of the trust loss provisions.

The classification of a trust is relevant for tax purposes as it determines the tests that apply in determining whether the trust can carry forward tax losses and distribute franking credits to beneficiaries. Practically, it is difficult for a trust that is not a fixed trust to satisfy the tests and access those tax benefits.

Stone J analysed the statutory requirement for a "fixed trust" and concluded that what is required is that a beneficiary has an interest that is "vested and indefeasible".

The Commissioner argued that because clause 43 of the Constitution permitted the Responsible Entity to modify or delete the Constitution, it meant that a beneficiary's interest was not "indefeasible" as it could always be defeated by an amendment.

Stone J ruled that the Wholesale Fund was not a fixed trust not because the Constitution could be amended, but rather because s 601GC(1)(a) of the Corporations Act 2001 caused the Wholesale Fund to fail the "defeasibility" test. This section gave the members of a registered MIT the ability to modify, repeal or replace the constitution. This, Stone J decided, meant that the investors could vote to terminate their right to a share of income or capital meaning that their interest was defeasible.

This aspect of Stone J's decision creates significant concern as it prevents any MIT (and its beneficiaries) from accessing a range of tax benefits merely because the Corporations Act provides investors with the power to vary the constitution by special resolution.

Result of the decision

In summary, the Court decided that Colonial's proposed way of ensuring fairness in the taxation of exiting and remaining investors had failed. The proposal failed because:

  1. Exiting investors would be paid the Gain Part from an account that contained capital gains generated by the trust. A capital gain was not "income" of the trust unless the trustee had re-characterised it to "income". The Trustee was unable to do so because clause 32 was poorly drafted and did not give it the power to re-characterise.
  2. The Gain Part was not "income" and therefore an exiting investor could not be "presently entitled".
  3. Even if the Gain Part was "income", there would be no "present entitlement" because present entitlement had to arise during the income year and clause 12 made it clear that the determination as to where the Redemption Amount would be paid from was to be made after the end of the income year.
  4. The Gain Part distributed to exiting investors during the income year would form part of the "net income" of the trust and would be assessable to the remaining investors (who were ‘presently entitled’ at or before year end under the Constitution) in their respective proportions.
  5. The full Redemption Amount received by the exiting investors constituted "capital proceeds" for CGT purposes.

Implications

The decision emphasises the importance of careful drafting of trust deeds.

The decision does not deal with the question of whether a trustee can stream certain types of receipts to different classes of beneficiaries.

The decision raises concerns regarding the status of unit trusts as "fixed trusts" for tax purposes. This is of potential concern for all registered funds as it appears to support an overly narrow and legalistic interpretation of the provisions without any regard for policy. There may be a need for further judicial authority or a legislative change to clarify whether s 601GC of the Corporations Act in fact results in all trusts failing the "fixed trust" test.

Had the arrangements proposed by Colonial been put into effect, the exiting investors would have generated a C2 capital gain, being the difference between the Redemption Amount and the Subscription Amount (ie they would have generated a capital gain equal to the difference between what they received on redemption and what they initially paid to acquire their units). At the same time, all remaining investors would have been assessed on their shares of the "net income" of the trust and that "net income" would have included the Gain Part of all redemptions. In other words, the remaining investors would have been assessed on the Gain Part despite the fact that the Gain Part would have been distributed to the exiting investors (and would be subject to tax in their hands as a capital gain).

Double taxation issue

Therefore, the practical outcome of Stone J's decision is that unit trust arrangements may be subject to double taxation where amounts paid to exiting investors are not appropriately structured. If a trustee purports to distribute a capital gain, it will need to ensure that it has a functioning re-characterisation clause to make these gains "income" that a beneficiary can be "presently entitled" to. Otherwise, there may be double tax, namely, a capital gain taxed in the hands of the exiting investor and an equivalent amount of trust income taxed in the hands of the remaining investors (who are assessed on their share of the gain purported to be distributed to the exiting investor).

Proposed MIT changes

It is expected that the changes to the MIT tax regime proposed to apply from 1 July 2011 will address some of these issues. Under the proposed changes, unit holders in MITs should be assessed based on the amount of income that is actually distributed to them such that there will be no need to consider questions of "proportion" or "share". However, it appears that uncertainty will remain on the ability to stream income as Treasury has indicated that this will not be dealt with in the proposed legislation.