HG Alert: Changes to the taxation of family discretionary trusts - 8 Mar 2011

The interaction between trust law and tax law has long been a source of ongoing confusion for those who use family discretionary trusts to protect their assets. The Assistant Treasurer, Bill Shorten, has proposed new legislation to clarify the way discretionary trusts are taxed. If the rules are changed, the many hundreds of thousands of Australians who use family discretionary trusts may need to update their trust deeds to reflect the new rules.

Below, Special Counsel Damian O'Connor outlines the changes proposed and the process from here.

Why are changes being proposed?

The proposed legislation, to be enacted by the Federal Government, was announced on 4 March 2011, and will apply from the current income year 2010-2011. It focuses on two issues:

  1. Who pays the tax where the taxable income of the trust is different from the income of the trust that is available for distribution under the trust deed. For a variety of reasons, including differences between accounting and tax rules, a beneficiary may be taxed on a greater proportion of the trust income than they actually get.
  2. Whether it is possible for different beneficiaries to receive different types of income (such as discount capital gains), or whether they will be taxed as if they receive an 'undissected share' of all the taxable income of the trust.

In recent times, the law relating to the taxation of trusts and beneficiaries has been plagued by uncertainty. In Bamford v Commissioner of Taxation (March 2010), the High Court of Australia questioned established practices used by taxpayers and their advisers in dealing with trusts, without providing the pathway forward that many had hoped for.

The decision in Bamford determined that the correct approach to use in determining how beneficiaries are taxed is the 'proportionate approach'. The following example illustrates how the proportionate approach presently works:

If John is entitled to the trust's income of $10 and Steve is entitled to the trust's capital gain of $100, it may be that, depending on the terms of the trust deed, John will be taxed on all the trust's taxable income of $110, including the capital gain of $100. This may be the case even though John is not entitled to the capital gains under the trust deed, and this outcome arises because the trust's taxable income is different from the income that is available for distribution under the trust deed.

Treasury discussion paper

The Treasury has released a discussion paper that contains the Board of Taxation's advice on how to deal with the issues that have given rise to this uncertainty in the way trusts are taxed, such as those outlined in the example above. The discussion paper considers the various ways clarity might be achieved, and whatever decision the Government makes on the new legislation, it is likely to have important consequences for the way in which family trusts operate.

The next steps

While the Government's proposal addresses only two aspects of the problematic area of taxation of trusts, taxpayers and their advisers can at least look forward to gaining some certainty around these two aspects. The final details of the legislation will, of course, be critical.

Any changes that are made to trust deeds must be carefully considered to ensure they achieve the desired result, while not triggering any adverse outcomes (such as trust resettlements).

The Federal Government has called for comments and feedback on the proposals contained in the discussion paper by close of business on Friday 18 March 2011.

For more information on the proposed changes, please contact HopgoodGanim's Taxation and Revenue practice, who are also available to help channel your comments on the proposals so that you can make your voice heard on this critical area of tax reform.