The Assistant Treasurer released today an options paper for the proposed reforms to the scope of the trust taxation rules and how trusts should be taxed (“Options Paper”).

The Options Paper follows on from the consultation paper that was issued last year (“Previous Consultation Paper”) regarding the proposed overhaul of the laws relating to trust taxation, and the submissions that the Government received on the Previous Consultation Paper. A summary of the Previous Consultation Paper is available here.

The Options Paper provides a valuable update on certain aspects of these proposed reforms, such as the ability to stream different categories of income and the potential exclusion of bare trusts and IDPSs from the trust tax rules. However, the Options Paper does not provide clear guidance regarding what overall method of taxation will replace the proportionate, present entitlement and income based approach to trust taxation currently in place under Division 6 of Part III of the Income Tax Assessment Act 1936 (Cwlth), and what the timing of these reforms are.

Accordingly, although the release of the Options Paper is consistent with the Government’s continuing commitment to these proposed reforms, there is little detail given in the Options Paper regarding how the reforms will actually operate.

Assuming that the timing proposed in the Previous Consultation Paper still applies, these reforms, when implemented should take effect from 1 July 2013.

Key new developments in the Options Paper

Although the Options Paper is framed as such – that is, it does not specifically provide guidance regarding how the proposed reforms to the taxation of trusts will operate, but simply sets out some options that may be available – the Options Paper does suggest certain aspects for how any new system of trust taxation will operate.

  • The Government appears open to excluding “bare trusts” and “IDPS” type arrangements from the new system for trusts taxation.
  • It appears likely, from the Options Paper, that the system of taxation that will operate for trusts under the reforms will be one of the following two models:
    • the "economic benefits model" or "EBM" (similar to the “trustee assessment and deduction” model discussed in the Previous Consultation Paper); or
    • the "proportionate assessment model" or “PAM” (similar to the “proportionate within class” model discussed in the Previous Consultation Paper).

It appears from this that the “patch” model that was canvassed in the Previous Consultation Paper (which suggested simply a fix to some of the more aberrant aspects of the existing Division 6) is not being seriously pursued as a part of these reforms.

  • Whatever model is adopted, the model is likely to provide for character retention and the ability for trusts to stream different categories of income. This is likely to be a welcome development for trustees and those who hold interests in trusts.
  • Rules may be introduced with respect to how deductions in a trust are to be applied against the different categories of taxable income generated by the trust, perhaps on a “fair and reasonable” basis consistent with case law.
  • The time for determining beneficiary entitlements may be extended from 30 June to 31 August or potentially some later date. Again, this should be welcome development for trustees.
  • The Government is unlikely to reduce the default tax rate that is applied to trustees (being currently the highest marginal tax rate) to the corporate tax rate without compelling policy reasons to do so.

The Options Paper does not provide any update or further guidance on the new proposed system of taxation for “managed investment trusts” or “MITs” that is likely to apply to many Australian managed funds. It is assumed from the Options Paper that “MITs” will not be subject to these proposed reforms and will be subject to a separate “attribution” based model for taxation.

Key aspects of the two proposed new models for trust taxation

The primary focus of the Options Paper appears to be to provide stakeholders with further guidance regarding how the two main proposed models for trust taxation will operate, and posing questions to stakeholders regarding how certain aspects of those models should operate.

“Economic benefits model”

The first of the two models, the “EBM”, appears largely similar to the “quantum” based approach to trust taxation that some suggested applied under Division 6. This model appears based on the premise that beneficiaries should be assessed based on the quantum and character of the distributions that are actually made to them, and the trustee should be taxed on the balance.

The key issues that the Government appears to be focused on with respect to the “EBM” is how amounts that are included in the taxable income of the trust but which are not recognised in the trust’s accounts are to be dealt with.

“Proportionate assessment model”

The second of the two models, the “PAM”, appears similar to the existing proportionate system of trust taxation provided for under Division 6. However, unlike Division 6 which taxed beneficiaries based on their proportionate share of the trust “income”, the “PAM” suggests that beneficiaries should be taxed based on their proportionate share of each class of trust “profit”.

Accordingly, the “PAM” appears to reflect the concerns raised by the ATO following the High Court of Australia decision in Bamford regarding the ability under Division 6 for the concept of trust “income” to be manipulated under the trust deed for the trust, by replacing that concept with a concept of trust “profit”.

Not surprisingly however, the Government’s main questions for stakeholders regarding the “PAM” relate to how trust “profit” and the various classes of trust “profit” are to be defined.

General observations

Although the release of the Options Paper is consistent with the Government’s continuing commitment to these proposed reforms, its content arguably raises more questions than it answers and the detail given regarding how the reforms will operate is limited. Further, the key methods for taxing trusts seem to be based on existing methodologies that were previously suggested under Division 6 but which were rejected by the Courts.

The Options Paper does not provide any further guidance with respect to the timing of the reforms, other than to provide that submissions in response to the Options Paper must be made no later than 5 December 2012. Accordingly, it is assumed that these reforms should still apply effective from 1 July 2013 as suggested in the Previous Consultation Paper.

It would be worthwhile for trustees and beneficiaries of trusts to review the Options Paper closely to determine what, if any, submissions they would like to make in relation to the proposals put forward in the Options Paper.