Fam­i­ly trusts after Bamford

On 30 March this year, the High Court dis­missed the appeal by the Com­mis­sion­er of Tax­a­tion against the deci­sion of the Full Fed­er­al Court in the Bam­ford case. This is a land­mark deci­sion for trust law in Australia.

This was the first time that the High Court had been approached to con­sid­er two impor­tant con­cepts in trust law — the mean­ing of ​“share” in the Bam­fords’ appeal and the def­i­n­i­tion of ​“net income” in the ATO’s appeal.

The case involved con­sid­er­a­tion of key aspects of Sec­tion 97 of the Income Tax Assess­ment Act 1936 (ITAA36). In the major­i­ty of instances this pro­vi­sion deter­mines the extent to which ben­e­fi­cia­ries are assess­able on trust distributions.

The Bam­ford Trust

Mr & Mrs Bam­ford were a mar­ried cou­ple and the direc­tors of the trustee com­pa­ny of the Bam­ford Trust. The trust was a fam­i­ly dis­cre­tionary trust and the Bam­fords were dis­cre­tionary ben­e­fi­cia­ries of the trust. The trust deed allowed the trustee a dis­cre­tion in deter­min­ing whether any receipt ​“is or is not to be treat­ed as being on income or cap­i­tal account”.

The Com­mis­sion­er denied deduc­tions claimed by the trust in the 2000 income year. This denial result­ed in the tax­able income of the trust exceed­ing its ordi­nary income. As a result the Com­mis­sion­er sought to assess Mr and Mrs Bam­ford on their pro­por­tion of the increased tax­able income.

With the deduc­tions being dis­al­lowed, the trust did not have suf­fi­cient car­ried for­ward loss­es to apply against cap­i­tal gains in the 2002 income year. This meant the trust had a net cap­i­tal gain which the Com­mis­sion­er sought to assess against the trustee at the high­est mar­gin­al rate.

The issues before the court

The Bam­fords argued that in respect of the 2000 tax return and the mean­ing of ​“share”, they ought only to be assessed on the spe­cif­ic amount of trust income to which they were enti­tled, that is a fixed amount of tax­able income that would remain the same regard­less of the denial of the deduc­tions (the quan­tum approach). Con­se­quent­ly, accord­ing to the Bam­fords, any remain­ing amount should be taxed in the trustee’s hands.

The Com­mis­sion­er of Tax­a­tion took the oppo­site view, argu­ing that the addi­tion­al trust tax­able income should be taxed in the hands of the Bam­fords in pro­por­tion to the actu­al amounts they received (the pro­por­tion­ate approach).

In respect of the 2002 income year, the Bam­fords argued that the trustee’s res­o­lu­tion that cap­i­tal gains be dis­trib­uted to Mr and Mrs Bam­ford as income was effec­tive, so that all rel­e­vant cap­i­tal gains had, in fact, been dis­trib­uted to Mr & Mrs Bam­ford as income and should be assessed in their hands (at a less­er mar­gin­al tax rate), rather than in the hands of the trustee. This was pur­suant to a pow­er in the trust deed.

The Commissioner’s coun­ter­ar­gu­ment regard­ing the 2002 income year was that the mean­ing of income for the pur­pos­es of Sec­tion 97 ITAA36 was income accord­ing to ordi­nary con­cepts, so that all rel­e­vant cap­i­tal gains should be taxed in the hands of the trustee. The Com­mis­sion­er fur­ther argued that the mean­ing of income could not be influ­enced by any trustee pow­er or dis­cre­tion con­tained in the trust deed.

The path to the High Court

The mat­ter was first heard by the Admin­is­tra­tive Appeals Tri­bunal. The AAT ruled that the pro­por­tion­ate approach should be fol­lowed in respect of the year 2000 tax return and the mean­ing of share in sec­tion 97 of the ITAA 36.

IIn rela­tion to the 2002 return and the mean­ing of income in sec­tion 97, the AAT fol­lowed the 1982 Full Court deci­sion of Totledge (Com­mis­sion­er of Tax­a­tion of Com­mon­wealth of Aus­tralia V Totledge Pty Lim­it­ed [1982] FCA 64) and ruled that income meant income in its ordi­nary mean­ing. The ATO was there­fore suc­cess­ful in both mat­ters. The Bam­fords appealed.

Full Court

In the Full Court deci­sion, Emmett J, Stone J and Per­ram J all arrived at the same con­clu­sion in rela­tion to the mean­ing of share and ruled in favour of the Com­mis­sion­er, but stat­ed that the pro­por­tion­ate approach should be used. How­ev­er, in rela­tion to the mean­ing of income they allowed the Bam­fords’ appeal, albeit for slight­ly dif­fer­ent reasons.

Emmett J felt that there was an under­ly­ing assump­tion in Divi­sion 6 of the Act which incor­po­rat­ed trust prin­ci­ples in the def­i­n­i­tion of income for the pur­pos­es of sec­tion 97. On the oth­er hand, Stone J and Per­ram J chose to fol­low the 2006 deci­sion in Cajku­sic (Cajku­sic V Com­mis­sion­er of Tax­a­tion [2006] FCAFC 164) in rul­ing that trust law prin­ci­ples should apply to the def­i­n­i­tion of income for the pur­pos­es of sec­tion 97.

This left the Com­mis­sion­er with a dif­fi­cult choice. On one hand he had a Full Court deci­sion in Totledge rul­ing that ​“income” meant ordi­nary income. On the oth­er hand he was faced with the mat­ter of Cajku­sic and now Bam­ford which ruled on the mean­ing of income accord­ing to trust law principles.

The Com­mis­sion­er appealed to the High Court on the issue of the mean­ing of ​“income”. The Bam­fords sub­se­quent­ly appealed on the issue of the mean­ing of ​“share”.

The decision

In the High Court both mat­ters were heard togeth­er. Most lawyers and accoun­tants would have been sur­prised at how quick­ly the judg­ment was hand­ed down.

The High Court reject­ed both appeals. The Court reject­ed the argu­ments used by the Com­mis­sion­er and held that the terms of the trust deed should pre­vail in deter­min­ing how the ben­e­fi­cia­ries should be assessed to tax.

The Com­mis­sion­er did have a vic­to­ry in that the High Court found against the Bam­fords on the argu­ment put for­ward that they should only be assessed on the quan­tum of trust income that was dis­trib­uted to them and instead imposed the pro­por­tion­ate approach.

Impli­ca­tions of the decision

In light of the Bam­ford deci­sion it is imper­a­tive that all trust deeds be reviewed to ensure that they con­tain an appro­pri­ate def­i­n­i­tion of income and that they con­tain a pow­er for the trustee to deter­mine whether receipts are to be treat­ed as cap­i­tal or income. In the absence of such a deter­mi­na­tion, the income of the trust is deemed to be equal to the net income pur­suant to Sec­tion 95 of ITAA36. In addi­tion, any unit dis­tri­b­u­tion income should refer to the spe­cif­ic income clause in the trust deed.

If on review the trust deed either con­tains an inad­e­quate def­i­n­i­tion of income or is insuf­fi­cient­ly flex­i­ble, the trustee should con­sid­er arrang­ing to have the trust deed amend­ed. Amend­ments need to be care­ful­ly draft­ed to ensure that a reset­tle­ment of the trust does not occur.

In the future

Although the Com­mis­sion­er has yet to out­line the com­pli­ance approach­es the ATO will take as a result of the Bam­ford deci­sion, it is like­ly that there will be a push from the Com­mis­sion­er for leg­isla­tive reform in this area.

There is a pos­si­bil­i­ty that the ATO will with­draw its prac­tice state­ment PS LA ²⁰⁰⁵⁄₁ (GA). This state­ment allows a depar­ture from the pro­por­tion­ate approach in tax­ing the recip­i­ent of the cap­i­tal gain, even though they do not receive any oth­er income.