Australian Discretionary Trusts & Non-Resident Taxpayers
A decision by the Australian Federal Court has called into question the ongoing use of discretionary trusts because of the tax costs they create, however that has significant impacts for non-residents.
Discretionary trusts are widely understood as instruments that provide asset protection, flexibility, and succession planning, however, a decision by the Australian Tax Office challenges a long-held view that discretionary trusts provide a mechanism that enables individuals to receive income (or a distribution) that doesn’t change the character, source, or timing for tax purposes.
The existing policy as been understood to not tax foreign beneficiaries of Australian-resident trusts for capital gains on GST assets, as they were not seen as taxable property, however, this has been challenged by an ATO ruling against what is standard and accepted practice.
The ruling had potentially serious consequences and as COVID-19 has forced many taxpayers to remain within Australian borders or offshore because of its border closures, there are some potentially serious issues lying in wait.
The Case before the Court
The case before the Federal Court hinged on shares in a resident company being sold by the trust and that the discretionary trust had resolved to distribute capital gains to beneficiaries.
As the beneficiary was a UK-resident for tax purposes, the shares were presumed to be non-taxable Australian property and be non-taxable in Australia. However, from the ATO’s perspective, that was only true had he owned/sold them directly, rather than through a trust.
The ATO assessed the transactions through four provisions and claimed that tax was payable on a deemed amount:
- Div 6E which removes capital gains from the ‘net income’ of a trust estate
- Div 115-C which deals with the capital gains made by trustees
- Div 855 which exempts non-residents from CGT unless the CGT event is happening to ‘taxable Australian property,’ and
- The portion of Div 6 dealing with the collection of tax owed by non-residents from resident trustees.
The trustee disputed the assessments as the beneficiary was non-resident, that there were two CGT events, and that the assets were not taxable Australian property. The argument was that as a foreign resident for tax purposes, the beneficiary could disregard the capital gain the sale of shares because Because the shares are not classified as taxable Australian property.The ATO viewed the trust as being resident and that the capital gain has been made by the trust, therefore was taxable. Had the trust been a ‘fixed’ trust, this may not have been true because the gain is related to a CGT asset belonging to the trust, not to an individual beneficiary.
The Federal Court upheld the ATO’s position in its ruling and the case is now awaiting the outcomes of an appeal by the taxpayer.
Why this case is so problematic
The core issue is that the provisions that had been applied to the case were drafted in haste to solve a problem in how the ATO viewed streaming franking credits and capital gains and that the Government of the time had acted to legislate a ‘standard’ practice.
The consequence of the hastily drafted provisions is that they create conflict because of how they work – or rather, don’t properly work — and that the assumption that the use of a trust by a non-resident beneficiary would negate the tax payable.
When a standard or accepted practice is challenged this way, it’s a can of worms for taxpayers.
It could be argued that the Federal Court’s decision is contradictory to the policy that tax outcomes for a discretionary trust – or so-called flow-through’ entity – should consider the tax outcome if the income was derived from the trust directly. The decision also calls into question the clarity of the policy directive of Division 855, which is that foreign residents should only be required to pay tax in Australia for capital gains made on disposing Australian taxable property.
The decision, however, holds the same line in other determinations and until the results of the appeal are known, taxpayers with Australian investments need to consider the structures of their investments.
The impact of COVID-19
Australia’s tax residency rules are inherently complicated in more ‘normal’ times, as there are a series of tests that determine whether or not a taxpayer is resident for tax purposes.
The coronavirus pandemic and the closure of our borders has made a complicated situation even more so as many taxpayers may find that they are considered Australian residents for tax purposes, if they have been forced to stay because of border closures. Alternatively, taxpayers caught offshore because they were unable to return to Australia may also need to consider their position from a tax perspective.
Review your discretionary trust arrangements
If you are the beneficiary of a discretionary trust and typically non-resident for tax purposes in Australia, we do recommend talking to an international tax specialist to review your Australian investment structures and identify any potential tax consequences.
Contact our team on 02 9957 4033 or email us with your initial enquiry.
Last updated December 2020. This factsheet is provided for information purposes only and is correct at the time of publishing. It should not be used in place of advice from your accountant. Please contact us on 02 9957 4033 to discuss your specific circumstances.