The recent decision of the Full Federal Court of Australia in Thomas v Commissioner of Taxation1 is a timely reminder of two points: tax results are often dictated by the rules of the non-tax world, and even unattractive cases sometimes win. We consider the decision further below.
The transaction in Thomas was relatively simple: the trustee of a discretionary trust passed resolutions which claimed to appoint the net income of the trust (including presumably dividend income) and then separately to appoint the franking credits on the dividends, but in different proportions. The logic behind the resolutions was to try to achieve two goals:
- the human beneficiary did not end up with an average tax rate exceeding 30% (so any excess net income was allocated to a corporate beneficiary, the ‘bucket company’ which by definition could never face a tax rate of more than 30%); and
- the corporate beneficiary was allocated just enough franking credits to eliminate its tax liability (and the balance was allocated to the human beneficiary who would claim a refund, given the small amount of assessable income).
The figures for the 2009 year are a good example of what the trustee’s resolutions were trying to achieve. In that year –
- the individual beneficiary included 10% of the trust’s net income in his assessable income (about A$16,600, ignoring the gross-up), but claimed to be entitled to 95% of the franking credits (over A$1m); and
- the corporate beneficiary included 90% of the trust’s net income in its assessable income (about A$157,000), but claimed to be entitled to only 5% of the franking credits (A$47,000).
At issue was the interpretation of the complex rules in Div 207-B (which had been amended to try to improve their comprehensibility and operation even before these events) are meant to prescribe what happens to a dividend and to the franking credit when franked distributions are received by a trustee. It is a plausible reading of those rules that they prescribe two outcomes:
- they inextricably tie the franking credit to the dividend income (so that the dividends can’t all go to one beneficiary and all the franking credits another); and
- they link the share of the credit to the share of the dividend (so that beneficiaries must share the franking credits in the same proportions as they share in the franked dividends).
More than a decade before these events, the Australian Tax Office ("ATO") had accepted that a trustee could separate franked dividends from other types of trust income (say, interest or rent), but the ATO’s ruling did not extend so far as to allow the separation of franking credits from the dividends which carried them.
The Full Court did not put the matter in quite this way. Instead, they said, the objective of these rules was simply to pass the benefits of the imputation system from the shareholder (the trustee) to the beneficiaries: ‘to ensure that the beneficiary of the trust income receives also the benefit of the franked distribution to the extent that the franked distribution is received through a trust …’
But there is a separate question whether any of this tax law actually matters – that is, do the tax rules always bring about these outcomes or does tax law just operate on rights and entitlements as they exist?
The case poses that question quite starkly because the taxpayer had, some years before, secured an uncontested declaration from the Queensland Supreme Court to the effect that the trustee’s resolutions were valid and effective. The ATO chose to ignore those proceedings – a stance the ATO may regret – and instead pursued the taxpayers in the usual way, issuing amended assessments claiming unpaid tax, interest and penalties.
The tax proceedings at first instance were long, obscure and complicated, made worse by the fact that the two sides couldn’t agree on fundamental matters – what could be accomplished under the terms of the Trust Deed, what had been accomplished by the trustee’s resolutions, whether the general law of trusts might be invoked, what the Supreme Court proceedings had achieved, and what that Court’s orders actually meant – even before they reached the tax question, what does all that mean for tax purposes? After 152 pages of judgment, Greenwood J concluded in favour of the ATO:
"What cannot occur if the tax offset is to be preserved and available in conformity with the tax legislation is an allocation of the … net income amongst beneficiaries on a particular basis and a distribution of the franking credits … on an entirely unrelated basis, amongst the same beneficiaries. That is what has occurred in each income year in this case … "
In other words, the trustee can try to allocate the credits as it likes (and this will create rights and obligations between the affected parties for trust law purposes) but tax law simply prescribes the tax consequences regardless.
Perhaps surprisingly, the Full Federal Court reversed this holding, taking the position that the tax law consequences would follow the trust law:
"for present purposes the relevant question is whether [the Queensland Supreme Court] orders relevantly determined conclusively the rights of the beneficiaries as against the trustee in such a way that Div 207 would operate as the taxpayers contended."
Given that the trust law rights and entitlements had been declared in the Queensland Supreme Court proceedings,
"the rights of the beneficiaries flowing as against the Commissioner … depended wholly upon the effect of the rights created as between the trustee and the beneficiary by whatever the resolutions may have achieved. The rights to be created by the trustee as against the Commissioner were a matter wholly within the control of the trustee and it was in the jurisdiction of the Supreme Court to make declarations concerning the proper construction of what the trustee had done pursuant to a domestic trust."
The ATO’s announcement that it will seek leave to appeal to the High Court must be only days away.
Finally, it is worth noting that the case interprets the rules for trusts which are not attribution managed investment trusts (AMITs). Just how an AMIT which attempted such a practice might fare under the new AMIT rules remains to be tested, but there is a specific instruction in the AMIT regime that the ‘attribution must not attribute [a component] of a particular character [to a member] because of the tax characteristics of the member…’ This is the first hurdle that would have to be overcome.