Foreign trusts should carefully consider if distributing capital gains to Australian resident beneficiaries remains a tax effective option. Foreign residents (including foreign trusts) do not pay capital gains tax (CGT) on some types of capital gains – for example, on the sale of shares. However, this may disadvantage an Australian resident who receives a distribution from such a trust, as that beneficiary cannot access the general 50% CGT discount and cannot offset the amount against their capital losses. The capital gain is instead taxed as ordinary income. This is now the published view of the Australian Taxation Office (ATO) in Taxation Determination TD 2017/23.
On 13 December 2017, the ATO finalised Taxation Determination TD 2017/23 (TD 2017/13), previously released in draft in November 2016, regarding the treatment of capital gains made by foreign trusts.
To summarise, the Commissioner of Taxation (Commissioner) has taken the view that:
- if a foreign trust makes a capital gain regarding an asset that is not ‘taxable Australian property’
- an amount relating to that capital gain is distributed to an Australian resident beneficiary; then
- the amount does not retain its character as a capital gain in the beneficiary’s hands. Rather the beneficiary is assessed on that gain as ordinary income under section 99B of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).
The Commissioner’s view… and how he got there
Calculate the foreign trust’s net income as per usual
Subsection 95(1) of the ITAA 1936 requires the trustee of a trust to calculate the net income of the trust for an income year as if it were a tax resident of Australia. It is referred to as the ‘residency assumption’ and applies even to foreign trusts (for a trust which is not a unit trust, this broadly means a trust where the trustee is not an Australian resident for tax purposes, and the central management and control of the trust is outside Australia).
Disregard capital gains which don’t relate to ‘taxable Australian property’
Section 855-10 of the Income Tax Assessment Act 1997 (ITAA 1997) however provides that a trustee of a foreign trust may disregard a capital gain (or capital loss) if it relates to a CGT asset which is not ‘taxable Australian property’. ‘Taxable Australian property’ broadly means real property in Australia or a 10% interest or more in an entity (such as shares in a company or units in a unit trust) where more than 50% of the value of the entity’s assets relate to real property in Australia.
Resolve the conflict by applying the more specific tax law
These two provisions appear to contradict, so the question arises as to which one should operate in priority. The Commissioner has taken the view that the more specific provision (i.e. section 855-10 of the ITAA 1997) should apply. Therefore the trustee of a foreign trust should disregard any capital gains relating to CGT assets that are not ‘taxable Australian property’ when calculating its net income under subsection 95(1) of the ITAA 1936.
What are the consequences of the Commissioner’s view?
There are significant consequences.
As the capital gain is not included in calculating the trust’s net income under subsection 95(1) of the ITAA 1936, if an amount relating to that capital gain is distributed to Australian resident beneficiaries:
- those beneficiaries will not be treated as having made the capital gain
- instead the beneficiaries receive that distribution as ordinary income and are assessed under section 99B of the ITAA 1936
- the beneficiaries cannot apply the general 50% CGT discount or use capital losses to offset the amount of the gain.
The example below shows how the Commissioner could apply these provisions:
The Kiwi Trust was established in New Zealand. The trust is a foreign trust for CGT purposes, as the trustee company is incorporated in New Zealand and the trust is centrally managed and controlled there. The trustee can appoint income and capital of the trust to a range of beneficiaries, some of whom are resident in Australia.
The trustee invests in shares in Australian companies that are not ‘taxable Australian property’. The trustee sells some of those shares.
As the trust is a foreign trust for CGT purposes and the shares are not ‘taxable Australian property’, no capital gains or losses from the sale will be reflected in the net income of the trust under subsection 95(1) of the ITAA 1936. Accordingly, Subdivision 115-C of the ITAA 1997 will not treat the trust’s beneficiaries (or the trustee) as having capital gains in respect of the sale.
The trustee distributes an amount attributable to the gain to a beneficiary resident in Australia. Section 99B of the ITAA 1936 may then apply to include an amount in the beneficiary’s assessable income.
Key take-away: Reconsider income received from foreign trusts
This is an unexpected interpretation from the Commissioner, given that trusts are generally considered to be ‘flow-through’ vehicles for tax purposes. Australian residents who invest offshore using foreign trust structures should consider the impact of TD 2017/13. If a foreign trust makes a capital gain, it will need to be considered whether distributing those capital gains to Australian resident beneficiaries remains tax effective or whether changes to the existing foreign trust structure are required.