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  FCA 64) and ruled that income meant income in its ordinary meaning. The ATO was therefore successful in both matters. The Bamfords appealed.
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  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”.
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.