This article was written by Andrew Clements, Kai-Chen Lamb, Sylvester Urban and Ben Wighton.
On 14 February 2018, the Board of Taxation (Board) publicly released its Review of the Tax Treatment of Bare Trusts and Similar Arrangements (Report), which was prepared in June 2017.
The key recommendation set out in the Report is for the Parliament to legislate to "look through" or essentially ignore certain bare trusts and similar arrangements for income tax purposes.
At the same time, Treasury issued a press release stating that it supported the recommendations and will seek to implement them. Treasury flagged that it will undertake a public consultation process relating to the characteristics of the arrangements that are entitled to this relief.
This is a positive development. It is hoped that the flagged reforms will finally provide legislative certainty around the Australian income tax treatment of the multitude of bare trust and other similar arrangements that are an important part of doing business today, particularly in the area of funds management and financial products and services. In particular, the flagged reforms should remove the need, as has been the case for many in the relevant industries to date, to rely on what can be regarded as "ad hoc" and, in certain cases, unclear Australian Taxation Office (ATO) administrative practices to obtain certainty around the tax treatment of such arrangements.
However, the key will be to determine what arrangements are eligible for this treatment, and what arrangements are not. The Board has suggested a key characteristics approach, which has been endorsed by Treasury. It is important that the "key characteristics" adopted are sufficiently broad to capture the multitude of nominee, custody, depositary, IDPS and other similar "bare trust" arrangements that are commonly used in the market.
Accordingly, offerors of, or participants in, arrangements that involve such relationships should review the Report to ascertain whether or not their particular arrangements are likely to qualify based on the Board's recommendations in the Report. Such offerors and participants should also consider if, and the extent to which, they would like to participate in any industry consultation that will be undertaken by Treasury regarding the key characterics of the arrangements that will be eligible for the relief.
King & Wood Mallesons intends to participate in this consultation.
Current tax treatment of bare trusts – a world of uncertainty
Very broadly speaking, "bare trusts" are generally considered to arise where a trustee holds property absolutely on behalf of a beneficiary, and the trustee has essentially no (or few) duties owed towards beneficiaries, save for the obligation to transfer property when directed.
The use of these trusts and arrangements are widespread in the market, including by offerors of financial products or financial services, fund managers, financial institutions, as well as in the context of individuals and charities.
As these arrangements fall within the existing broad definition of a "trust estate" for Australian tax purposes, they are technically subject to all of the existing Australian income tax rules and administrative obligations that apply to trusts, except where they fall within the terms of existing specified relief. This is the case despite the fact that, both legally and in practice, the roles and duties of the relevant trustee are minimal.
Treating such arrangements as separate "trusts" can give rise to many issues in practice.
For example, the main legislative provisions affecting the taxation of trusts are found in Division 6 of the Income Tax Assessment Act 1936 (Cth). In essence, Division 6 provides that beneficiaries of trusts are liable to tax on their share of the net income of the trust. This is calculated by reference to the amount of the trust's income to which a beneficiary is "presently entitled". The application of Division 6 also means that trust losses are not able to flow through to benefit beneficiaries against their other income or gains earned in an income year. This means that losses are effectively "trapped" in the trust and carried forward until they can be applied against the trust's assessable income in the future.
Similarly, the Australian tax laws generally require the trustees of trust estates to lodge an Australian income tax return each year. Accordingly, there may be a technical obligation for all trust estates – even where they are, essentially, "bare trusts" – to lodge an Australian income tax return.
There are certain areas within the tax laws that do allow "bare trusts" to be disregarded for certain purposes. For example, in the capital gains tax rules, beneficiaries of trusts that are "absolutely entitled" to trust assets as against the trustee are treated as holding the assets themselves. However, the scope of these concessions is often uncertain and they do not provide general relief from all of the relevant tax obligations.
The ATO has a long running administrative practice whereby the existence of a bare trust is disregarded and the beneficiaries are taxed on the basis that they themselves have derived that income and incurred those losses—not the trust. In other words, the practice has been to "look through" bare trusts and similar arrangements.
However, in most cases, these administrative practices are not legally binding on the ATO such that there is no legal certainty for those seeking to rely on them that they will always be respected by the ATO, or that these practices may not change. In addition, the terms of the practices are not always clear, such that there may not be certainty regarding whether a particular arrangement is eligible without seeking specific feedback from the ATO. This can pose issues in certain instances.
Introducing a "look through" approach in legislation
The Board recommended that the Government pass legislation to provide a look through approach for bare trusts and similar arrangements for income tax purposes. This should address the uncertainty that currently exists and should enshrine a practice already adopted by the Commissioner of Taxation (Commissioner) and many stakeholders.
Characteristics based approach
The Board recommended that the legislation be drafted in a way that looks to the "characteristics" of a particular trust or arrangement to determine whether it will qualify for the look through approach.
A characteristics based approach already exists elsewhere in the tax legislation (see for example, sections 106-50 and 235-820 of the Income Tax Assessment Act 1997 (Cth) which respectively deal with "absolute entitlement" for capital gains tax purposes and the taxation of "instalment trusts").
It is proposed that trusts with all of the following core characteristics should qualify for look through treatment (with certain exclusions for particular purposes, for example, withholding tax):
The trustee has no (or only minor) active duties or powers.
The beneficiaries are entitled to the benefit of all the assets and income of the trust.
Each beneficiary can demand that the trustee transfer trust assets to that beneficiary or at their direction.
The Board also recommended that ATO guidance, in the form of a Law Companion Guideline, should be issued contemporaneously, as well as the ability for the Commissioner to create legislative instruments.
Implications and next steps
These developments are pleasing in that they have the potential to provide many types of bare trusts and arrangements with some certainty around their tax treatment.
Stakeholders (for instance, custodians, depositaries and nominees, unincorporated joint ventures, and IDPS platforms) should consider participating in the consultation process to ensure that the eligibility requirements align with the features of their proposed products and structures.
It will, however, be interesting to see how, and whether, any transitional provisions will operate if the reforms are introduced.
King & Wood Mallesons will continue to provide input over the course of the proposed reform.