Beware the foreign asset in an Australian discretionary trust: The ATO’s final Determinations emphasise the need for review and legislative change.

The Commissioner has finalised his Taxation Determinations TD 2022/12 and 2022/13 regarding the taxation of capital gains made by foreign beneficiaries of Australian resident discretionary trusts on the sale of non-taxable Australian property.  These determinations follow the current law as confirmed in Greensill and N&M Martin, and again reinforce the need for review of the taxation of trusts which, particularly following the hasty patchwork of Division 6E, is overly complicated and does not appear to reflect the intention of the legislature or the existing taxation structures.

Last week the Commissioner of Taxation released Taxation Determinations 2022/12 and 2022/13, which followed the decisions in Greensill and N&M Martin [2021] FCAFC 99 and concluded:

• the source concept from Division 6 Part III ITAA36 does not apply to determine whether a non-resident beneficiary (or trustee) is taxed on a capital gain from a resident trust, or on taxable Australian property held by a non-resident trust under Subdivision 115-C ITAA97; and
• a capital gain by a non-resident beneficiary of a resident discretionary trust on non-taxable Australian property is not disregarded under Subdivision 855-A ITAA97.

We summarised the basic implications of the decisions in Greensill and N&M Martin following the refusal of special leave by the High Court of Australia in February 2022 in our Alert here.

Compliance activity and risk

Taxation Determinations TD 2022/12 and TD 2022/13 will apply retrospectively.  In the Commissioner’s usual course, he has indicated that he will not devote compliance resources to identify arrangements prior to the 2019 financial year solely on the basis of these determinations, but if the issue arises in the course of other compliance activities the Commissioner will apply the law accordingly. 

There is, of course, always a risk that such a matter will arise as part of other compliance activity.  However, there is an increased risk of adjustments in response to the decisions in Greensill and N&M Martin and the two tax determinations because of the Commissioner’s focus on the taxation of trusts, and particularly those trusts with international dealings.  The Commissioner’s attention on this area is evident from his Taxpayer Alerts TA 2021/2 regarding foreign income disguised as a gift or loan (see our discussion of the TA here) and TA 2022/1 regarding distributions to children over 18, as well as the draft TR 2022/D1 and PCG 2022/D1 regarding the application of section 100A ITAA36 (see our discussion regarding 100A here).  It is, perhaps, fortuitous that these determinations issued within a week of the hearing of the appeal in Guardian before the Full Court of the Federal Court of Australia.

It is important that non-resident beneficiaries are aware of the risk of amended assessments following the release of the determinations.  The Commissioner’s compliance activity and any adjustments are unlikely to be limited by the legislated amendment period because the focus area of the compliance activity (from the 2020 financial year to date) will be within the amendment period, and for prior years non-resident beneficiaries may not have lodged Australian income tax returns resulting in an effective unlimited amendment period.

Implications and need for change

In submissions before the Full Federal Court and the High Court of Australia, senior counsel for the taxpayers in Greensill and N&M Martin identified that the application of the law as the Commissioner contented (and was found) did not appear to achieve the purpose of the legislature, and it disrupted the basic capital gains tax structure and reflected a change post the 2011 insertion of Division 6E (see the High Court transcript here).

Two strange practical consequences of the law include:

• Capital gains without an Australian source are taxed differently for discretionary trusts compared with fixed trusts; and
• Capital gains without an Australian source will be taxed differently from ordinary income without an Australian source.

From experience, it is very difficult to explain this to advisers for inbound investors.  Division 855 was introduced to encourage foreign investment.  The level of confusion and inconsistency achieves the exact opposite.

In his Compendium to the two tax determinations, the Commissioner has since responded to several arguments regarding the consistency of the determinations with the purpose of the legislation and policy objectives by reference to the decision of the Full Federal Court in Greensill and N&M Martin.  Critically, although the Full Federal Court acknowledged that the introduction of Division 6E removed the taxation of capital gains from Division 6, the Court only observed that the ‘thesis that Parliament never intended that a foreign beneficiary be bought to tax on non-Australian gains’ did not result in a different construction of Division 115-C (at [77]).  This is a matter of statutory interpretation.  The Court did not comment on the purpose of the legislation and whether that purpose was met.

At present, the law on the taxation of trusts with respect to residency implications and capital gains is nonsensical.  This is not to comment on the decision in Greensill and N&M Martin, but the legislation as enacted and what surely must be unanticipated results.  Not only may the interplay of Division 6, Subdivision 855-A, Subdivision 115-C and (the hastily inserted) Division 6E lead to perverse results per the circumstances in Greensill and N&M Martin, but the operation of those provisions as considered in Greensill and N&M Martin may have more far reaching implications for the taxation of trusts and the application of section 99B ITAA36 (for example) and the resident beneficiaries’ receipts from foreign trusts (see TD 2017/23 and TD 2017/24).

At the very least, over a decade after the introduction of Division 6E it is clearly well-past time for a review of these taxation provisions and the overarching policy on the taxation of trusts. 

We will discuss taxation of trusts, both foreign and resident trusts with foreign and resident beneficiaries, the decisions in Greensill and N&M Martin and particularly the interpretation of section 99B ITAA36 in a further article.