Australia: High Court clarifies question on trust streaming of franking credits

Last Updated: 10 September 2018
Article by Toby Blyth and Carlos Gouveia

In brief - Commissioner is bound by a court's finding of legal fact, but not to taxation consequences that flow from that fact

In Commissioner of Taxation v Thomas [2018] HCA 31, the High Court recently confirmed an important issue in respect of the streaming of distributions with associated franking credits via a trust.

Streaming occurs when a trustee allocates a certain type of income to one beneficiary and another type of income to another.

The types of income that are streamed to particular beneficiaries can have a particularly beneficial taxation result in the hands of certain beneficiaries. For example, if a beneficiary has a capital loss from another source, and receives capital gains streamed via the trust, that beneficiary will be able to use those capital losses to offset them against the capital gains, whereas a beneficiary without capital losses could pay more tax.

The nature of the franking credit regime currently is that in certain cases it refunds money to taxpayers who otherwise have no taxable income and owe no tax (the Opposition has announced plans to modify this).

Given this, there is a strong incentive to stream franking credits via trusts in a tax effective manner.

Where the trust deed permits streaming, and a trustee distributes the capital gain or franked distribution to a "specifically entitled" beneficiary, the notional allocation system in Subdivision 207-B of the Income Tax Assessment Act 1997 generally operates smoothly.

Franking credits cannot be separated from distribution

In Commissioner of Taxation v Thomas, the High Court dealt with a more interesting variation of franking credit streaming and held that franking credits are not an independent source of income that can be distributed or streamed by a trustee. They must travel with the franked distribution itself.

The trustee sought to distribute franking credits as discrete items of income (ie, separate from the distribution), instead of streaming franked distributions.

The High Court observed (at [12]) that Subdivision 207-B 'creates a system which "notionally allocates" the franking credits in the same proportion as the beneficiaries' share in the franked distributions...'

The High Court held that Division 207 does not treat franking credits as a source of income capable of being dealt with, and distributed, separately from the franked distribution to which they are attached. The High Court expressly labelled this argument as "wrong".

The two resolutions made by the trustee (one dealing with distribution of income and the other dealing with distribution franking credits from that income) could not operate together.

The income distribution resolution was effective and carried with the income stream the franking credit. The franking credit resolution had no effect.

Trustee cannot seek to pre-empt via state court ruling on powers of trustee

Trustees in all states of Australia have a right to approach the Supreme Court to seek a declaration as to affairs or legal consequences. A ruling will excuse the trustee from any liability if the trustee acts in accordance with the ruling.

In this case the trustee had pre-emptively sought to deal with this issue via the ruling mechanism following notification from the Commissioner of intention to conduct an audit.

The trustee approached the Queensland Supreme Court seeking ruling to the effect that the trustee was entitled to distribute franking credits. Crucially, the Commissioner was not a party.

The Queensland Supreme Court held that franking credits were a discrete source of income that could be streamed and made a declaration accordingly.

The Commissioner did not agree with the result and commenced proceedings in the Federal Court. The first instance judge agreed with the Commissioner. The taxpayer then appealed to the Full Federal Court which agreed with the taxpayer.

The High Court disagreed with the Full Federal Court.

Ruling of legal fact is not a ruling on taxation consequences of that fact

The taxpayer argued that previous High Court authority meant that a ruling by a state court bound the Commissioner in a tax sense.

The High Court held that such an argument was incorrect.

It held that the taxpayer had drawn the incorrect conclusion from the previous case, which case was correct as far as it went.

The High Court clarified that once a court has made a finding as to a legal fact, the Commissioner is bound by that fact, but not as to the taxation consequences that flow from that fact.

For example, if a court found that a beneficiary became entitled absolutely to a particular asset by a matter of fact or operation of law, then the Commissioner should apply, for example, capital gains tax consequences to that finding.

However, this case was different because the declaration sought by the taxpayer in the Queensland court was a declaration as to the taxation consequences of a particular set of facts.

Such a decision, especially when the Commissioner was not a party to the proceedings, could not bind the Commissioner to apply the tax law in a way inconsistent with the tax law.

Toby Blyth Carlos Gouveia
Regulatory and financial services
Colin Biggers & Paisley

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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