As I begin this post, I acknowledge wholeheartedly that this topic might surprise my collection of followers. While, yes, it is indeed a case review, it is focused on a different arm of succession law practice: trusts generally and *cough*taxation of trusts*cough*. As I witness the evolution of estate law before my eyes, I can’t help but be fascinated by decisions that provide greater clarity, and well, let’s face it, it’s a high court decision that impacts on trusts and estate law; chances are, i’m likely to read it and find something interesting in it!
So, let me tell you about Frank.
On 8 August 2018, the High Court unanimously determined that franking credits could not be distributed to beneficiaries of a trust separately, and in different proportions, to that of franked distributions.
By way of background, the Trustees of the Trust had passed resolutions to distribute franking credits to beneficiaries separately from and in different proportions to income comprising franked distributions.
The resolutions were made by the Trustees on the basis that the “Bifurcation Assumption” was valid and effective. The Bifurcation Assumption is an assumption that effectively infers that franking credits can be distributed separately from and in different proportions to the income comprising the actual franked distribution (this is referred to further below). The Trustees and Beneficiaries of the Trust ultimately lodged their respective tax returns on the basis that the Bifurcation Assumption was legally effective under Division 207 of the Income Tax Assessment Act 1997 (Cth) (‘Div 207‘).
In 2010, the Trustee of the Trust applied to the Supreme Court of Queensland for directions (under s96 of the Trusts Act) seeking that those resolutions that the Trustee passed could and did give effect to the Bifurcation Assumption. The Court ultimately granted those directions.
The Commissioner then carried out an audit and subsequently issued Amended Assessments in respect of the income tax returns. The taxpayers then filed appeals of the Amended Assessments in the Federal Court. The principal issues of those proceedings and that were raised by the Amended Assessments were the legal effectiveness of the Bifurcation Assumption and how Div 207 operated in relation to the resolutions regarding the ‘streaming’ of the franking credits to the beneficiaries.
The taxpayers argued the authority enunciated in Executor Trustees and Agency Co of South Australia Ltd v Deputy Federal Commissioner of Taxes (SA) 1993 62 CLR 545 that the directions made in the Supreme Court of Queensland conclusively determined what rights the beneficiaries had in relation to the income and that the Commissioner (and Court) was bound by those directions, even if the result (i.e. the application of the Bifurcation Assumption) was wrong at law. The Court determined that the Executor Trustees case (and therefore the directions of the Supreme Court of Qld) did not bind the Commissioner or the Court, that the Bifurcation Assumption was flawed in law and that the appeals by the taxpayers against the Commissioner should be dismissed.
The taxpayers then successfully appealed to the Full Court of the Federal Court. While Pagone J in that case accepted that Div 207 did not operate to permit the Bifurcation Assumption, the case of Executor Trustee required that although the Commissioner was not bound or may not be bound by the construction of Div 207 in the Supreme Court proceedings (and therefore the directions), the Court was bound by the part of the directions of the Supreme Court that referred to the construction of the beneficiaries interests (i.e. which was, as Applegarth J in the Supreme Court of Qld directed, vested an indefeasible interest in possession in a share of the distributable income) and the taxpayer’s appeal should be allowed. The other Judges of the Full Court agreed, and held that the directions were valid and binding.
Which brings us to this judgement following the Commissioner’s appeal of the decision of the Full Court to the High Court.
The High Court unanimously agreed that the Bifurcation Assumption was wrong at law and that there were various issues with the directions by the Supreme Court of Queensland themselves and ultimately the franking credits could not be distributed separately and in different proportions to that of franked distributions.
The High Court considered the authority of Executor Trustees in relation to the directions made by the Supreme Court of Queensland and stated that the Full Court of the Federal Court misunderstood and misapplied the authority of Executor Trustee. At paragraphs 54 to 56, the High Court said:
Executor Trustee is authority for the proposition that the general law rights of trustee and beneficiary inter se, to the extent that they are defined by a decision made in duly constituted proceedings, are defined as against the Commissioner unless the decision is set aside. In Executor Trustee, the earlier proceedings had determined rights inter se. There was no question of res judicata or of issue estoppel, and the separate declaration did not generate rights in rem against third parties. And, importantly, the earlier proceedings did not determine the application of the taxation law to those rights.
It follows that Executor Trustee is not authority for the proposition that the Commissioner, or a court under Part IVC, should determine the application of the taxing act otherwise than according to law. “When the revenue authorities come to impose a tax in relation to such rights [defined by order of the court], they must…take them as they in fact actually exist between the parties” (emphasis added). But the directions made under the equivalent of s96 of the Trusts Act do not bind the Commissioner in the application of the taxation laws.
The Full Court of the Federal Court was wrong to conclude that it was bound by Executor Trustee to hold that the directions in the State Proceedings determined conclusively, against the Commissioner, the application of Div 207 to the franked distributions.”
The High Court also noted that the proceedings in the Supreme Court of Queensland did not bind the Commissioner as the Commissioner was not a party to the proceedings and that the directions were made on the basis that the Bifurcation Assumption was correct in law (para 57-58). The High Court said that in those Supreme Court of Queensland proceedings “At its highest, the advice given could only protect the trustee from later complaint. And the answer given to the question was incorrect.” (para 58).
In the High Court’s impressive way, the Court succinctly set out the position regarding the streaming of franking credits and noted:
The Bifurcation Assumption involves the notion that franking credits are discrete items of income that may be dealt with or disposed of as if they were property under the general law. That notice is contrary to the proper understanding of Pt 3.6. Franking credits are a creature of its provisions; their existence and significance depend on those provisions.
Part 3.6 of the 1997 Act creates an imputation system which sets out the effect of receiving a “franked distirbution”. The Part creates a distinction between franked distributions and franking credits, the latter being ‘on’ or attached to the franked distribution. Under the Part, when a corporate tax entity distributes profits on which income tax has already been paid, the corporate tax entity may impute credits for that tax by “franking” the relevant distribution.
As a general rule, a member of a corporate tax entity will be taxed on the full amount of the franked distribution and the attached franking credits but will be entitled to an imputation credit, a tax offset, equal to the franking credit on the distribution included in that member’s assessable income for the tax already paid by the corporate tax entity.
That general rule is modified where the distribution is made to a trustee. In that situation, sub-div 207-B creates a system which notionally allocates the franking credits in the same proportions as the beneficiaries’ share in the franked distributions. This is the significance of the statutory reference to “notional allocation”. That reference is not, as the taxpayers’ argument would have it, an indication that a trustee may effect such an allocation of franking credits as it may choose in order to achieve an effect inconsistent with the provisions of Div 207.
The beneficiaries’ share in the franked distributions, in turn, depends on how the beneficiaries share in the income of the trust under s97 of the Income Tax Assessment Act 1936 (Cth). Subdivision 207-B ensures that the beneficiary of the trust income receives the benefit of the franked distribution to the extent that the franked distribution is received through a trust.
The system comprises four steps: first, where a franked distribution is made or flows indirectly to a trustee, the assessable income of the trust for that year includes the amount of franking credits on the distribution; second, it is necessary to identify whether any of the franked distribution flows indirection to a beneficiary of the trust; third, if any of the franked distribution flows indirection to a beneficiary of the trust, it is necessary to identify if the beneficiary has assessable income attributable to all or part of the franked distributions; and, fourth, if so, the beneficiary’s assessable income will include a franking credit amount equal to its share of the franking credit on the franked distribution.
In respect of the fourth step, s207-55 seeks to ensure that the amount of a franked distribution made to a trustee is allocated notionally amongst the beneficiaries who derive benefits from that distribution and that the allocation corresponds with the way in which those benefits were derived. Its sub-sections provide the mechanisms to achieve that objective. Section 207-55(2) provides that the amount notionally allocated, described as a share of the franked distribution, does not have to be received by the beneficiary. The table in s207-55(3) provides the method for determining the share amount – relevantly the beneficiary’s share of the trust’s net income for the relevant income year, usually calculated as a percentage of the trust’s net income.
What is clear from this stepped approach (and particularly from the fourth stage) is that the statutory notional allocation of franking credits to beneficiaries follows the proportions which have been established with respect to their notional sharing in franked distributions at the earlier stages.
So long as the trust deed confers powers on a trustee to apply classes of income of the trust estate to particular beneficiaries to the exclusion of other beneficiaries (or differentially among beneficiaries), Div 207 recognises that a trustee may stream the franked distribution (or any part of it) to one beneficiary and the other income to another beneficiary. However, Div 207 does not treat franking credits as a separate source of income capable of being dealt with, and distributed, separately from the franked distribution to which they are attached. The scheme’s objective in relation to trusts is to ensure that a beneficiary of a trust will have notionally attributed to it that proportion of the franked distributions received by the trustee that is referable to the amount of the net income distributed to the beneficiary while, at the same time, ensuring that the beneficiary obtains the benefit of the franking credits to the extent of those franked distributions. The franking credits are on, or attached to, the franked distribution. (my emphasis added)