Can a disclaimer retrospectively reduce a trust beneficiary’s taxation liabilities?

The beneficiaries of a trust estate executed disclaimers of income more than two years after the end of the relevant income year (2014). The Full Court of the Federal Court agreed that the disclaimers were effective to reduce the beneficiaries’ taxation liabilities in the 2014 income year, despite being executed after the year ended. The High Court disagreed, unanimously holding that the determination of the tax liability of a trust beneficiary is to be determined immediately before the end of the year of income, and no subsequent event is relevant to that determination.

Background

The trust deed for the Whitby Trust had a default distribution clause. If the trustee did not make a determination to pay, apply or set aside for the beneficiaries all or any part of the income of the trust for the 12 months to 30 June, the trustee would hold the income on trust for the beneficiaries as at 30 June. These beneficiaries were the five children of the trustee and were the respondents in the High Court.

For the 2014 income year, the trust had income but the trustee did not make a determination. Under the trust deed, the income was distributed to the respondents.

In October 2015, the Commissioner issued an amended assessment to each respondent for the 2014 income year which included as assessable income one-fifth of the income of the trust on the basis that the respondents were ‘presently entitled’ to that income within the meaning of section 97(1) of the Income Tax Assessment Act 1936 (Cth).

Section 97(1) relevantly provides that the assessable income of a beneficiary of a trust estate who is not under any legal disability and who is presently entitled to a share of the income of the trust estate includes as much of that share as is attributable to a period when the beneficiary was a resident of Australia.

In September 2016, the respondents executed disclaimers, disclaiming any right and interest in any income from the Trust.

The respondents objected to the assessments on the basis that they had validly disclaimed the income.

The matter made its way to the Full Court of the Federal Court of Australia, which held that the disclaimers were effective. The Court held that there was nothing in section 97(1) to indicate that a beneficiary’s liability is to be determined once and for all at the end of the income year by reference to the legal relationships then in existence.

The Commissioner appealed, arguing that the disclaimers did not operate to retrospectively disapply section 97(1).

Judgment

The High Court noted that the relevant aspect of section 97(1) is a beneficiary’s present legal right to demand and receive a share of the distributable income of a trust estate. The focus is on the right to receive the share, not the actual receipt of any payment.

The Court held that the taxation liability of a beneficiary of a trust is determined by ascertaining the proportion of the distributable income to which a beneficiary is entitled just prior to midnight at the end of the year of income and then applying that proportion to the net income of the trust estate. This conclusion is reinforced by the other relevant criteria in section 97(1) – that the beneficiary not be under a legal disability and be a resident. Both of those criteria are ascertained during and at the end of the income year (but not after the end of the year).

The Court rejected the respondents’ argument that events after the end of the income year could affect a beneficiary’s tax liability, on the basis that it was contrary to the text of section 97(1) and the purpose of the Division in which the section appears. The Court also noted that the respondents’ approach would cause uncertainty in the identification of beneficiaries presently entitled to a share of trust income if events years after the end of the income year, as here, could be taken into account.

The Court therefore held that “the question of ‘present entitlement’ of a beneficiary to income of a trust must be tested and examined ‘at the close of the taxation year’,[1] not some reasonable period of time after the end of the taxation year.”

Accordingly, no event subsequent to the end of the income year can affect the taxation liability of a beneficiary. As a result, the disclaimers executed by the respondents were not effective to alter the respondents’ taxation liability.

The Court unanimously allowed the appeal.

Key takeaway

The taxation liability of a beneficiary of a trust is to be determined by reference to the beneficiary’s entitlement to demand and receive a share of the net income of the trust immediately before midnight at the end of the income year.

No conduct or event arising after the end of the income year affect the beneficiary’s tax liability.

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Authored by:

Scott Couper, Partner
Craig Melrose, Associate

[1] Referring to Union-Fidelity Trustee Co of Australia Ltd v Federal Commissioner of Taxation (1969) 119 CLR 177 at 182.