This article was written by Kai-Chen Lamb, Greg Protektor and Amanda Kazacos.
The Australian Taxation Office has finalised two Tax Determinations (TD 2017/23 and TD 2017/24) ("Determinations") regarding the treatment of capital gains that flow through foreign trusts. The Determinations confirm the ATO's view that, unlike for Australian trusts, capital gains do not retain their character as they flow through a foreign trust, such that Australian resident beneficiaries are taxed on distributed capital gains as ordinary income and do not obtain the benefit of the discount capital gains concession.
The finalisation of the Determinations in this form is surprising, given that this view appears to be contrary to the established view of many in the market who have utilised foreign trust structures in a funds management or cross-border investment context. The ATO recognises in the Determinations that there are alternative views, but it is not clear why the ATO has decided to form this view in preference for the other views, particularly given that there is no established case law on this point.
Impact for fund managers and investors
Whatever the reasons behind the ATO coming to the view reached in the Determinations, the finalisation of the Determinations should be taken into account and are important for fund managers seeking to offer product into the Australian market, and for Australian investors structuring their investments in assets offshore. In particular:
- Australian resident investors who invest in offshore assets through foreign trust structures should consider what the impact of the Determinations is on these structures, and whether there are any changes that can or should be made to optimise any existing foreign trust structures that are in place.
- Fund managers that have a range of offshore product that they are seeking to offer to the Australian market should be mindful of the ATO's views in determining which structures to offer to Australian investors. In particular, the ATO's views in the Determinations cast doubt on what may previously have been regarded as one of the advantages of a foreign trust structures vis-à-vis, say, a corporate structure.
- The Determinations are consistent with an emerging suspicion by the ATO around the use of foreign trusts by Australian residents. In particular, the interpretation adopted by the ATO in these Determinations is likely to have the effect of disincentivizing the use of foreign trust structures by Australian residents, even where there may be other commercial reasons why such structures would be preferred.
ATO view of taxation of beneficiaries of foreign trusts – technical explanation
The ATO in Tax Determination TD 2017/23 confirms that a trustee of a foreign trust should disregard a capital gain or loss where the CGT asset is not "taxable Australian property" (TAP). Tax Determination TD 2017/23 considers the priority and application of two provisions within the legislation, Division 855 of the Income Tax Assessment Act 1997 (ITAA 1997) and section 95 of the Income Tax Assessment Act 1936 (ITAA 1936).
By way of overview, Division 6 of the ITAA 1936 governs the income tax treatment of the net income of the trust estate. Specifically, the definition of "net income" in section 95(1) broadly requires calculation of the total assessable income of the trust estate calculated as if the trustee were a taxpayer in respect of that income and was a resident. Division 855 of the ITAA 1997 contains rules which allows non-residents (including foreign trustees) to disregard capital gains in relation to assets that are not TAP, effectively to increase foreign investment in Australia. Division 6E of the ITAA 1936 removes capital gains from the calculation of net income of the trust estate for the purpose of determining the amount assessable in the hands of the beneficiary (or trustee) and the portion of any net capital gain of a trust assessable in the hands of a beneficiary is calculated under Subdivision 115-C of the ITAA 1997.
The Commissioner determined in TD 2017/23 that section 855-10 must override subsection 95(1), so that any capital gains or capital losses made by a foreign trust are to be ignored by the trustee in calculating the net income of the trust. As capital gains are not included in the net income of the trust, the beneficiaries of the trust cannot be treated as having capital gains under Subdivision 115-C and can only account for a return from non-TAP as ordinary income under section 99B of the ITAA 1936. Tax Determination TD 2017/24 provides that any non-TAP distributions to Australian beneficiaries of foreign trusts must be assessed as ordinary income under section 99B of the ITAA 1936, they cannot be utilised by the beneficiary to offset capital losses or carry-forward net capital losses and additionally, cannot be reduced in quantum by applying the CGT discount.
Broader implications - changing our understanding of the law
The impact of the Determinations has the effect of changing the view of certain tax law principles, including:
- Narrowing the effect of the residency assumption in section 95 of the ITAA 1936 Act, by providing that Division 855 effectively overrides this.
- Expanding the ambit of section 99B, that was previously considered to only apply as a fall back provision in certain limited circumstances.
- Creates inconsistency with the concept that trusts are "flow-through vehicles" by taxing Australian beneficiaries on revenue account in relation to a capital gain derived by the foreign trust.
- Creates a differential as between the investment by an Australian beneficiary in a foreign trust as compared to an Australian trust, where previously it may have been thought that the domicile of the trust (as opposed to say, the residency of the beneficiaries and the source of the relevant income) should not impact on the overall tax treatment.