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Commissioner of Taxation v Bamford in the High Court

(Comments as at 1 April, 2010)

 

Some Thoughts on Brevity

 

“Therefore, since brevity is the soul of wit,

“And tediousness the limbs and outward flourishes,

“I will be brief.”

William Shakespeare, Hamlet

 

“Brevity is the soul of lingerie.” 

Dorothy Parker

 

Introduction

There is an apocryphal story that the judgments of Justice Kekewich were widely regarded to be fast, short and ... wrong.

In an appeal from one of his cases, Counsel commenced his submissions by saying, “Your Lordships, this is an appeal from a decision of Justice Kekewich, but there are other reasons for the appeal.”

The High Court delivered its decision in Bamford on 30 March, barely four weeks after oral arguments concluded.

The decision certainly qualifies as fast and short. It’s contained in just two hands (well ten fingers) full of pages.

Regardless of whether it’s right or wrong, it is definitive.

Both parties had appealed different elements of the Federal Court decision.

The High Court dismissed both appeals.

The decision was unanimous and only one judgment was delivered.

The Court resolved the case down to two distinct issues:

  • The meaning of the words “income of a trust estate” in the introduction to section 97(1); and

  • The meaning of the words “that share of the net income of the trust estate” in paragraph (a)(i).

 

Income of a Trust Estate

The Court rejected the Commissioner’s submission that the term meant income within the meaning of income tax law and held that it meant income within the meaning of trust law.

It also rejected the Commissioner’s submission that the meaning of the word was restricted to “ordinary income” and did not extend to “statutory income”.

How much is made of this part of the judgment remains to be seen.

However, it is helpful to consider the circumstances in which the issue arose.

In the 2002 year of income, the Trust made no ordinary income.

However, it did generate a capital gain or “statutory income”.

It was common ground that the Trustee had treated the net capital gain as income available for distribution to the beneficiaries.

This constituted “statutory income”.

However, the Commissioner argued that, because “income of the trust estate” meant “ordinary income” and there was no ordinary income, it could not be said that a beneficiary was presently entitled to the income of the trust estate.

It followed that the capital gain could not be included in the assessable income of the beneficiaries under paragraph (a)(i).

This didn’t mean that the capital gain was tax-free or exempt.

The Commissioner used this argument to assert that the capital gain should be taxed in the hands of the trustee (not the beneficiaries).

Ultimately, the Court didn’t just dismiss the appeal based on this argument, it was fairly dismissive of the manner in which the argument was put.

This part of the decision is important in that it confirms that any type of income (either ordinary or statutory) will satisfy the requirements of the introduction and therefore trigger the substantive operation of the rest of the section (including paragraph (a)(i)).

Obviously, if there was ordinary income (or both ordinary and statutory income), the operation of the section would be triggered.

However, a beneficiary must be presently entitled to that income, in order to trigger the operation of the section.

For example, if a capital gain occurred (i.e., there was “statutory income”), the gain could not be included in the assessable income of a beneficiary, unless the beneficiary was presently entitled to the gain.

Thus, it appears that, if the capital gain had not been distributed to any of the beneficiaries, all of it would form statutory and therefore assessable income in the hands of the trustee.

Therefore, the trustee would be assessable with respect to the capital gain, not the beneficiaries.

This isn’t a case about whether a Trust Deed can avoid capital gains tax, it is more a case about whether the beneficiary or the trustee pays the tax.

 

That Share of the Net Income of the Trust Estate

The Court felt that this was the more complex of the issues.

The Court defined the issue as follows:

“Shortly put, the issue of construction concerns the application of the phrase "that share" in s 97(1) in circumstances where the entitlement of beneficiaries is not to fixed proportions of the income of the trust estate but, as to some beneficiaries, to specific amounts and, as to another beneficiary, to the residue.”

This is an elegantly simple definition.

Ultimately, the Court had no hesitation in finding that the words “that share” related back to the share of the income of the trust estate to which the beneficiary was presently entitled (the “Reference Back Interpretation”).

It found that the share of the income of the trust estate dictated the share of the assessable income of the trust estate.

In the words of my previous comments, the share of the apples dictated the share of the oranges.

The Court expressed the dilemma nicely:

“On its face the section may appear to postulate the same share of two subject matters which do not correspond.”

The issue resolved down to how to determine the share.

The taxpayer emphasised the amount of the share.

The Commissioner emphasised the proportion of the share

The best way of understanding the dilemma is to consider the Court’s succinct illustration of the opposing views:

“The difference between the parties' submissions may be illustrated as follows. Upon the taxpayers' case, if there were trust income of $300,000 and net income of $180,000 and a beneficiary with an annuity of $100,000, the beneficiary's assessable income would be fixed at $100,000.

Upon the Commissioner's case, the beneficiary's assessable income would not be fixed at $100,000 but would be the same one-third proportion (i.e. $60,000).”

The taxpayer’s submission emphasised the amount of the share (i.e., $100,000, which then stayed constant).

The Commissioner’s submission emphasised the proportion of the share (i.e., $100,000/$300,000 = 1/3 x net income of $180,000 = $60,000).

The Court adopted the analysis of Sundberg J in Zeta Force Pty Ltd v Commissioner of Taxation (1998) 84 FCR 70:

“The words 'that share' in par (a)(i) refer back to the word 'share' in the expression 'a share of the income of the trust estate', and indicate that the same share is to be applied to an income amount calculated according to a different formula (taxable income as opposed to distributable income). Since the income amount may differ according to which formula is applied, the natural meaning to give to 'share' where it appears for the second time is 'proportion' rather than 'part' or 'portion'. When Parliament wanted to convey the latter meaning, as it did in ss 99 and 99A, it used the word 'part'.”

In effect, the Court agreed with the Commissioner and adopted the proportionate view.

The practical problem in the case was that the Commissioner had disallowed a deduction for a substantial amount of Trust expenditure.

The distributable income which was paid out to the beneficiaries reflected the net position after this expenditure.

However, when the disallowed deductions were added back into the assessable income of the Trust, it meant that the assessable income was much greater than the distributed income.

If the beneficiary’s share of assessable income was based on the proportionate approach, it meant that its share of the assessable income was the same proportion of a much higher amount, much of which had not been available to distribute to it (i.e., because it had been spent).

The result is that the proportionate approach means that, in situations like this (where the assessable income is higher than the distributable income), the beneficiary will have to pay tax on income that it has not received.

However, presumably, if the beneficiary did not pay tax on the excess of the proportionate amount over the fixed amount, the excess would have been subject to tax in the hands of the trustee anyway.

Again, it is ultimately a question of who pays tax and at what rate.

 

Conclusion

The Court acknowledged that both sides “accepted that whichever of the competing constructions of Div 6 were accepted examples could readily be given of apparent unfairness in the resulting administration of the legislation”.

The unfairness and anomalies did not deter the Court from being definitive in its judgment.

However, it also made it clear that the legislation needed to be reviewed.

It is submitted that the definition of the “share” is the only issue that is anomalous.

As long as a beneficiary is presently entitled to any income (whether income or capital), the issue should be what share of the assessable income of the trust should they be taxed on.

Ultimately, the beneficiary should be assessable on its share of the assessable income.

In other words, the share of oranges should dictate the tax liability with respect to the oranges.

In other words, the nexus between income and assessable income needs to be severed and another, fairer test found.

Ultimately, a beneficiary should not be taxed on assessable income it is not presently entitled to.

This does not mean that the excess assessable income should go untaxed.

It simply means that the trustee will be liable, rather than the beneficiary.

This will apply where deductions are disallowed or notional income (e.g., deemed capital gains) are generated.

In these situations, the trustee will need to ensure that it makes adequate cash flow arrangements to be able to fund its tax liability.

 

 

(Original Pre-Judgment Comments as at 12 March, 2010)

 

There is a well-know saying that “hard cases make bad law”.

Sometimes the difficulty extracts a decision from the Court that deals sensitively with the issues between the parties, but has unforeseen consequences or limited precedential value in more straightforward cases in the future.

While the High Court is yet to reach a decision on the Bamford Appeal that was heard on 2 and 3 March, 2010, there are bound to be anomalies in its decision, if the Court restricts itself to the arguments that were put by the rival Counsel.

This is an inevitable result of the adversary system, where Counsel has, in the words of Heydon J., a duty to accept or pursue every argument which may advance their client’s material interest (subject only to Counsel’s duty to the Court).

The adversary context doesn’t always permit the advance of a third or alternative way that might be contrary to the interests of the parties to the dispute.

 

Section 97(1)

The Bamford Case concerns a number of issues with respect to the interpretation of section 97(1) of the Income Tax Assessment Act 1936.

This section is fundamental to the way in which Beneficiaries of Trusts are taxed on income (and capital gains) derived by the Trustee from Trust Assets and distributed to Beneficiaries of the Trust.

The section is drafted in two parts:

  • An introduction which sets out a condition which must be satisfied before the rest of the section will apply; and

  • Three substantive paragraphs (a) to (c), which will apply if the condition in the introductory paragraph is satisfied.

There is nothing unusual in this style of drafting.

In effect, the substance of the drafting is this: “if condition A is satisfied, then B, C and D apply.”

Introduction

The introduction or condition provides as follows:

“where a beneficiary of a trust estate who is not under any legal disability is presently entitled to a share of the income of the trust estate.”

Paragraph (a)(i)

Paragraph (a)(i) effectively provides as follows:

“the assessable income of the beneficiary shall include...so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident.”

 

Present Entitlement to a Share of the Income of a Trust Estate

The introduction or condition refers to the “present entitlement” of a Beneficiary to a share of the Income of a Trust Estate.

There is some doubt about the meaning of the term “present entitlement” and it too was the subject of argument before the High Court.

However, assuming that the Beneficiary is “presently entitled” to whatever it needs to be, the first issue before the Court was the meaning of the term “a share of the income of the trust estate” in the introduction.

Once the requirements of the introduction or condition are satisfied, then the operation of paragraph (a)(i) becomes relevant.

Its role is to include some of the “net income of the trust estate” in the “assessable income” of the Beneficiary.

 

Single Beneficiary

If there was only one possible Beneficiary under the Trust Deed, the operation of the section would be relatively straightforward:

  • If the Beneficiary was presently entitled to 100% of the “net income of the trust estate”, 100% would be included in the “assessable income” of the Beneficiary; and

  • If the Beneficiary was not presently entitled to any particular “part” of the “net income of the trust estate”:

    • The Beneficiary’s part would be included in its “assessable income”; and

    • the part which it was not presently entitled to would be included in the assessable income of the Trustee itself (and would be assessable in its hands under section 99A(4C).

This means that 100% of the “net income of the trust estate” is assessable in somebody’s hands.

In other words, the ATO gets tax on all of the assessable income from somebody.

 

Multiple Beneficiaries

Unfortunately, the issue becomes more complicated where there are two or more Beneficiaries who are presently entitled to “net income of the trust estate” (I will ignore the possibility that the Trustee might be assessed on part of the “net income of the trust estate”).

If you were sitting down to draft the legislation, you would probably think that the income tax liability of each Beneficiary would be proportionate to the share of the “net income of the trust estate” that each Beneficiary was presently entitled to.

In other words, if you get part of the net income (or are entitled to get it), then you also get the tax liability for that part.

Unfortunately, we didn’t get the chance to sit down and draft the legislation.

So we have to look over the shoulders of the lawyers who did.

This is effectively what the High Court was asked to do.

You can probably guess that, if the issue had to go the whole way to the High Court, something went wrong along the way.

So what went wrong?

Ultimately, it comes down to the way they defined “that share of the net income of the trust estate” in paragraph (a)(i).

 

“Reference Forward Interpretation”

It is probably relevant to quote the paragraph in full again:

“the assessable income of the beneficiary shall include...so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident”

This quotation presents the paragraph in isolation from the introduction or condition, so it is not necessarily a reliable method of determining its meaning.

However, it will help identify the reason for the ambiguity that the High Court had to deal with.

The goal is to determine the meaning of “that share of the net income of the trust estate”.

If you consider only the words in the quotation, it is arguable that the words “that share” refer to the period during the financial year when the Beneficiary was a resident (I will refer to this interpretation as the “Reference Forward Interpretation”, because the word “that” refers forward to the words that follow it).

Thus, if the Beneficiary was only resident for 50% of the year, the term “that share” would mean 50% (i.e., the proportion of the year).

This means that the Beneficiary would only include 50% of the “net income of the trust estate” in their assessable income.

If the Beneficiary was resident for 100% of the year, “that share” would be 100%.

This interpretation might make sense if there was only one presently entitled Beneficiary.

However, it does not make sense if there are two or more presently entitled Beneficiaries.

If there were two equal “100% resident” Beneficiaries, it would arguably mean that each Beneficiary had to include 100% of the “net income of the trust estate” in their own assessable income.

In other words, the interpretation would not be helpful in determining the proportion that applied as between multiple Beneficiaries.

It would only be relevant on an individual basis to determine the proportion of the financial year.

 

“Reference Back Interpretation”

The alternative interpretation is that the term “that share” doesn’t refer forward to the period of residency.

This interpretation makes more sense when you quote both the introduction and paragraph (a)(i) together:

“where a beneficiary of a trust estate who is not under any legal disability is presently entitled to a share of the income of the trust estate, the assessable income of the beneficiary shall include...so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident”

Quoting the separate components of the section together highlights the fact that the word “share” used in paragraph (a)(i) has already been used in the introduction.

Therefore, the second alternative interpretation is that the word “share” refers back to the word “share” in the introduction (I will refer to this interpretation as the “Reference Back Interpretation”, because the word “that” refers back to the words that precede it).

So far, this probably sounds like an exercise in pedantry.

And that view could very well be right.

However, if, at this stage of the arguments, the Reference Back Interpretation sounds more attractive, then you at least have some insight into why the issue ended up in the High Court.

 

Meaning of “Share”

It’s at this very point that we have to go back and work out what the word “share” in the introduction refers to and means.

In the introduction, the word “share” forms part of the term “a share of the income of the trust estate’.

In paragraph (a)(i), the words “that share” forms part of the term “so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident”.

If you ignore the issue of residency, the words “that share” forms part of the term “so much of that share of the net income of the trust estate”.

Summary

In summary, ignoring the issue of residency:

  • in the introduction, the relevant share is a share of the “income of the trust estate”; and

  • in paragraph (a)(i), the relevant share is a share of the “net income of the trust estate”.

Applying the Amount of a Share of One Thing to a Share of Another Thing

Apart from any question about what the term “income of the trust estate” means, this interpretation means that the share of one thing (Share B) is intended to be identical to the share of a different thing (Share A).

In other words, if the share of apples is 50% (in the introduction), then the share of oranges (in paragraph (a)(i)) has to be 50% as well.

 

Meaning of "Income" and "Net Income"

This way of presenting the argument assumes that there is some difference in meaning between the terms “income of the trust estate” (apples) and “net income of the trust estate” (oranges).

It has to be acknowledged that the two terms have different meanings.

The problems are:

  • defining the different meanings; and

  • determining whether the equation of the two shares creates any anomalies.

Outside the context of the Income Tax Assessment Act, one possible meaning of the two terms is that one term means “gross income” and the other means “net income”.

 If this were the difference, then the equation of the meaning of the word “share” in both components of the section would mean that the share of gross income would determine the share of net income.

 

Income as a Composite of Income from Different Sources

This interpretation mightn’t be that inappropriate, if both gross and net income were uniform in their character.

The problem is that income of both types can be a composite of income from different sources.

Distribution of Different Classes of Income to Different Beneficiaries

It is also possible for the Trust Deed to distribute income from different sources to Beneficiaries in different proportions.

In other words, one class of income could be distributed in one proportion, while another class could be distributed in another proportion.

This alone would make it difficult to determine the appropriate “share”, if one defined share has to apply uniformly to all net income.

Different Distribution of Ordinary Income and Capital Gains

The most obvious difference in classes of income is the difference between ordinary income and capital gains.

Theoretically, the Trust Deed could limit the distribution of Income to some Beneficiaries and Capital Gains to other Beneficiaries.

The difference between gross income and net income is also relevant.

Gross Income doesn’t take into account any deductions.

Therefore, the relative share of Gross Income to Capital Gains would be different to the relative share of Net Income (excluding Capital Gains) to Capital Gains.  

This alone suggests that the equation of the two shares would not necessarily arrive at a fair result or the result intended by the Legislature.

 

Definitions of "Income" and "Net Income" of a Trust Estate

The issue is complicated by the fact that one term is defined in the Act, while the other is not.

Net Income

The term “net income of the trust estate” is defined in section 95.

In summary, it includes all assessable income less any allowable deductions.

Under section 6(1), the term “assessable income” includes both ordinary income (i.e., income according to ordinary concepts) and statutory income (including capital gains).

Income

In contrast, the term “income of the trust estate” is not defined in the Act.

Unfortunately, the absence of a definition of the term “income of the trust estate” creates uncertainty about whether it means:

  • income according to ordinary concepts (which would exclude statutory income or capital gains); or

  • both ordinary and statutory income (including capital gains).

Ultimately, you can’t work out the share of “income of the trust estate” (or “net income of the trust estate”), until you can work out what the term “income of the trust estate” means.

 

ATO's Views

The ATO adopted the view that the word "income" means ordinary income (i.e., income according to ordinary concepts) and excludes capital gains.

Therefore, in its view, the proportionate share of ordinary income (in the introduction) will determine the share of both ordinary and statutory income in paragraph (1)(a).

This view will apply whether or not the ordinary and statutory income is distributed in the same proportions.

If one Beneficiary was entitled to 100% of the ordinary income and 50% of the statutory income (including capital gains), then this interpretation means that the one Beneficiary would be assessable on 100% of both the ordinary and statutory income (even though it was only entitled to 50% of the statutory income).

This interpretation has been justified by the ATO, because it allows the Tax Legislation to prevail over the terms of the Trust Deed.

However, it is obvious that it results in an inequity between the Beneficiaries.

The outcome doesn’t necessarily benefit the ATO in terms of obtaining greater amounts of tax revenue.

In fact, it works against this possibility, by taxing Beneficiaries on Income that they haven’t received and therefore creates a tax liability that they mightn’t be able to fund.

On the other hand, presumably, the Beneficiaries who have actually received the other Income mightn’t have to pay tax on it.

 

Implications of Introduction of Capital Gains Tax

The problem is that the statutory definition of “assessable income” has expanded over time to embrace capital gains.

However, because the terms “income” and “income of the trust estate” are undefined terms, there hasn’t been any express revision of their meaning in order to embrace capital gains.

The ATO therefore seeks to limit their meanings to ordinary income as it has traditionally been understood.

This obviously creates the above anomaly that the share of ordinary income would determine the share of both ordinary and statutory income.

Threshold Issue

However, it actually creates a threshold issue about the operation of section 97(1).

If the requirements of the introduction are not met, it is arguable that paragraphs (1)(a) to (1)(c) would not apply.

Therefore, if the term “income of the trust estate” is restricted to ordinary income, it creates an anomaly with respect to a trust estate which has only derived statutory income (such as capital gains).

Presumably, the condition would not be satisfied, because there was no ordinary income.

Thus, it would be arguable that there is no basis upon which the other provisions could determine assessability or the share of assessability as between multiple Beneficiaries with respect to the statutory income.

The oral arguments before the High Court did not drill down to this level of detail.

Obviously, it is possible that the written arguments did deal with these issues.

However, they are not available to the public.

 

Definition of “Assessable Income”

It is arguable that there is some guidance to be obtained from the definition of “assessable income”.

The statutory definition of “assessable income” in section 6-1(1) states that it consists of ordinary income and statutory income.

Ordinary Income

Section 6-5(1) defines “ordinary income” as “income according to ordinary concepts”.

This is effectively what the ATO had traditionally called “income”.

Statutory Income

Section 6-10(2) defines “statutory income” as amounts that are included in your assessable income that are not ordinary income, but are included in your assessable income by provisions about assessable income.

The latter section is a deeming provision that deems some amounts to be assessable income, even though they wouldn’t have been ordinary income or assessable income according to ordinary concepts.

Significance of Use of Word "Amounts", Not "Income"

It has to be acknowledged that section 6-10(2) studiously avoids any use of the word “income”, except as part of a larger phrase such as “ordinary income” or “assessable income”.

It refers to “amounts”, not “income”, which are defined as “statutory income”.

In other words, it doesn’t deem the “amounts” to be “income”.

Instead, it leapfrogs the concept of “income” and deem the “amounts” to be “assessable income”.

This raises a question mark as to whether we are entitled to assume that the word “income” itself might now include both “ordinary income” and “statutory income”.

In other words, if the term “assessable income” now incorporates both “ordinary income” and “statutory income”, are we also entitled to assume that the word “income” incorporates both “ordinary income” and “statutory income”?

In other words, when the word “income” appears by itself, does it now mean “income according to ordinary concepts” or does it incorporate both “ordinary income” and “statutory income”?

 

Extended Meaning of Word "Income"

Despite the reluctance of section 6-10(2) to use the term “income”, it is arguable that, at least in this context, the composite term “income of the trust estate” incorporates both “ordinary income” and “statutory income”.

This would mean that paragraphs (a) to (c) would be triggered by a present entitlement to either “ordinary income” or “statutory income”.

Similarly, it would reduce the anomalies that result from applying the defined “share” to a radically different concept in paragraph (a).

To a certain extent, this result means that the terms of the Trust Deed might prevail.

However, on another view, it is simply the statutory concepts of “ordinary income” and “statutory income” that are prevailing.

In other words, the operation of section 97(1) would be triggered by the payment of “ordinary income” or “statutory income” within their statutory meaning, regardless of how the income or gain was characterised by the Trust Deed or the Trustee at the time of distribution.

This interpretation creates some level of harmony between the statute and the Trust Deed.

 

Notional Income

The High Court was also troubled by the treatment of “notional income”.

This term refers to amounts that are deemed to be included in assessable income in circumstances where there might not actually be funds available to distribute to the Beneficiaries.

Examples include:

  • assessable income that arises because the ATO has declined to allow a deduction for expenditure that has been made (in other words, the money has been spent, but it is clawed back into assessable income); and

  • capital gains that are deemed to arise, because of the operation of the market value substitution rules (in other words, there is deemed to have been a capital gain, even though the trustee has not actually received the amount of the gain).

It is likely that it will be held that no Beneficiary would be “presently entitled” to notional income.

As a result, notional income would be assessable in the hands of the Trustee, rather than any of the Beneficiaries.

There was some discussion with respect to how the Trustee would fund the tax liability.

However, ultimately, it was assumed that:

  • the Trustee would be entitled to recoup the tax out of the trust estate; and

  • In the absence of sufficient funds, the Trustee would be personally liable.

 

Conclusion

These views do not necessarily represent the arguments or views of either Counsel or the Judges of the High Court.

However, it is submitted that, if the High Court is prepared to go beyond the arguments of Counsel on behalf of their individual clients, there is scope for a sensible interpretation of the Legislation that is fair as between Beneficiaries and the ATO.

 

Copyright: Ian Gray Solicitor

 

 

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