The High Court’s recent judgment in Federal Commissioner of Taxation v Carter (2022) HCA 10 is among the most significant this year – and it has some stiff competition.
To boil down the decision, the High Court held that a beneficiary who has an entitlement to trust income just before midnight on 30 June of an income year is taxable on that entitlement, regardless of whether they later disclaim that entitlement. As a result:
- if a valid disclaimer is made by a beneficiary by 11.59pm on 30 June, it should be effective in displacing any existing entitlement to trust income for that year.
- if the disclaimer is made from 12.00am on 1 July or later, the beneficiary may have disclaimed their entitlement to trust income – meaning they will no longer be able to demand and receive payment of that entitlement – but they will still be taxed on that income. A lose-lose situation.
The Commissioner has now issued a Decision Impact Statement (DIS) in relation to the decision. It provides a useful summary of the decisions of the High Court, Full Federal Court and Administrative Appeals Tribunal. As the High Court found in the Commissioner’s favour, it does not offer much of substance beyond what we see in the High Court’s judgment.
More telling is the accompanying media release, in which the Commissioner cautions beneficiaries to take this into account before making such a disclaimer. It indicates the Commissioner is serious about applying this decision in future compliance action.
A summary of this decision and our practical advice to advisors and taxpayers are set out below.
In this case, a handful of beneficiaries were presently entitled to an amount of trust income for the 2014 income year.
They were not immediately aware of this fact, as their entitlement arose due to the dangerous combination of the trustee’s failure to confer a valid present entitlement to the trust income by 30 June 2014, and the beneficiaries being named in the deed as default beneficiaries (as the children of the individual who established and controlled the trust).
As soon as the beneficiaries became aware of their entitlements to the trust income, they sought to disclaim the entitlements. After some back and forth, the Full Federal Court confirmed that the disclaimers were indeed effective in disclaiming the beneficiaries’ entitlements to the trust income and, per the Full Federal Court’s decision in the Ramsden case, the disclaimers operated retrospectively as if the entitlements never arose.
The Commissioner did not seek to challenge the validity of the disclaimers in the High Court. Rather, the Commissioner asserted that even if the beneficiaries had effectively disclaimed their entitlements to the relevant income for trust law purposes, the beneficiaries were still taxable on those entitlements under section 97 of the Income Tax Assessment Act 1936 (Cth) (1936 Act).
The High Court agreed, stating:
- section 97 of the 1936 Act operates to assess a beneficiary based on their present entitlement to trust income. It is concerned with the beneficiary’s right to receive income, not their actual receipt of the income.
- section 97 is expressed in the present tense and requires a point in time determination. It requires us to identify the legal rights existing just before the end of the income year (being midnight on 30 June) and determine which entities are taxable on the trust income in accordance with those rights.
- while a disclaimer made sometime after 30 June may be effective in disclaiming a beneficiary’s entitlement to income for trust law purposes, the beneficiary cannot retrospectively expunge or alter the rights that existed just before midnight on 30 June of the relevant income year.
This decision may be technically correct on a plain language reading of section 97, but it produces an exceptionally harsh practical outcome for beneficiaries who are lumped with an income tax liability as a result of a decision made without their knowledge and for which they may not ever see any tangible benefit.
We often see this where the Commissioner challenges the effectiveness of a trustee’s distribution resolution, potentially years after the fact, with some unsuspecting default beneficiary being left to carry the bag for the tax liability. In some cases, the trust may not have sufficient funds to pay out the entitlement, because the funds have been paid or applied for the benefit of some other entity, or the trust fund is otherwise depleted.
This is another example of the Commissioner taking an approach of: push a strict interpretation of the language of Division 6 of the 1936 Act (which is quickly becoming the most unworkable part of the taxation law) and hang the practical consequences.
The practical reality is that the Commissioner’s previous position on disclaimers produced no unfairness or uncertainty and was not, so far as we are aware, being exploited in any significant manner. The position established in the Ramsden case – that a valid disclaimer operates retrospectively as if the entitlement never arose – produced a fair outcome for all and was in the best interests of good tax administration. The Commissioner was happy to accept this position for many years, as set out in ATO ID 2010/85 (now withdrawn, some time after the Commissioner decided to push this new position on disclaimers and section 97).
This decision also raises uncertainty about what happens where a default beneficiary becomes entitled to a trust amount well after 30 June as a result of a decision to disallow or adjust a trust distribution. This may include where the Commissioner asserts that the apparent legal rights to income do not square with the parties’ actual intentions and are therefore a sham, in line with the Raftland case. Our question there is: do those apparent legal rights to income existing as at midnight on 30 June establish the basis for the taxation of the relevant trust income for that year, or does the concept of sham continue to operate retrospectively in respect of entitlements to trust income notwithstanding the Carter decision?
This case provides another reason why the Government must make some tangible policy decisions to drag Division 6 into the modern world. The Commissioner’s recent administrative guidance released on section 100A and Div 7A have come about as a result of persistent Government inaction. Until we have legislative change, everyone – including the Commissioner – is stuck working with legislation that is well and truly outdated.
The law is becoming increasingly unfriendly to those who operate through trusts. Until the uncertainty is resolved, taxpayers should seriously consider avoiding the use of trusts and escaping them where possible!
Our key messages for advisors and taxpayers are:
- read the deed: be aware of who the default beneficiaries are and ensure they are fully aware – now, not later – of the circumstances in which they may be entitled to trust income and the implications of such an entitlement.
- don’t leave it to the last minute: try to have decisions as to the nomination of entitlements to income, or the accumulation of such income, be made and recorded well in advance of 30 June. This should hopefully avoid the matter falling through the cracks, resulting in the default distribution clauses kicking in. Provided you take our next piece of advice to heart, it may even allow beneficiaries some time to consider their position and decide whether they wish to disclaim that entitlement while they are still able.
- provide prompt notice to beneficiaries of their entitlements: over time a trust’s financial position may change dramatically and for the worse, particularly in times of volatile financial markets. If beneficiaries only become aware of their entitlement some time after the fact and have not previously returned that income, the trust may no longer have the financial resources to pay out the entitlement and the beneficiary may have to fund the tax bill out of their own pocket. Prompt notice allows for prompt action by all parties involved.
- think before disclaiming: if you discover sometime after 30 June that your client is entitled to an amount of trust income, take a breath before advising them to disclaim that entitlement. They are taxable on the income and there may be no unscrambling that egg. To disclaim the entitlement would just mean that they cannot seek payment of their entitlement from the trust. With that in mind, the most appropriate course may be for the beneficiary to immediately call on payment of the entitlement, or so much as is necessary to pay the associated tax liability.
- consider who should be the default beneficiary/ies and get informed consent: often the default beneficiaries of a trust are the same individuals establishing it, so it is easy enough to advise them of any risks. Other times they may ask – with the best of intentions – that their children or other relatives be named as default beneficiaries. In such a case, the children should take advice as to the associated risks and provide their informed consent to being named as such. For some particularly risk averse clients it may be beneficial to name a corporate entity as the default beneficiary (which comes with its own complications, including Division 7A!) or to have no entity with a default entitlement to trust income (meaning the trustee is assessed on undistributed income).
- consider your exposure: if you or your client no longer controls or is no longer associated with a trust, they should seriously consider immediately disclaiming any interest in the income of that trust from the date of the disclaimer in perpetuity. For example, consider family disputes. An individual trustee, or the directing mind and will of a corporate trustee, could place financial pressure on an individual by resolving to make them presently entitled to income of the trust – but then:
- refuse to make payment of the entitlement when asked;
- take steps to artificially reduce or eliminate the entitlement; or
- claim an inability to pay on the basis the trust doesn’t have assets it can liquidate to satisfy the full entitlement or even to pay the associated tax liability.
In these circumstances, the beneficiary may have options for asserting that they had no genuine present entitlement to that income as at 30 June (subject to our comments above regarding the uncertainty around sham distributions), but it’s not an easy thing to unwind.
The taxation of trusts is becoming increasingly complex with recent developments in the Carter and Greensill cases, and in relation to section 100A and Division 7A, to name a few. We recommend that you seek proper advice before entering into new arrangements, or as soon as you consider you may have a trust or tax law issue. Problems don’t get better with age.