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IVY LING[*]
The decision in Richardson v FCT[1] (hereinafter Richardson) on 25 November 1997 is a new development in the interpretation of section 97(1) o f the Income Tax Assessment Act 1936 (ITAA)[2] because a new “differential” approach to interpreting section 97(1) was formulated by Merkel J in the Federal Court of Australia.[3] Is Richardson the long awaited answer to the difficulties in relation to the operation of section 97(1) which arise where trust law income differs from net income as first identified by the Asprey Committee in 1975?[4]
Firstly, the relevant law on the operation of section 97(1) will be examined. This includes defining the concepts of net income, trust law income and present entitlement. The proportionate and quantum approaches to interpreting section 97(1) will also be examined. Secondly, the facts and the decision in Richardson’s case will be outlined. Thirdly, Merkel J’s interpretation of section 97(1) will be closely examined and problems will be identified in Merkel J’s interpretation of section 97(1). Merkel J’s approach will also be examined in light of the recent decision by Sundberg J in Zeta Force Pty Ltd v FCT.[5] Fourthly, alternative solutions will be suggested to address the difficulties that arise from the poor drafting in section 97(1). Finally, a conclusion will be drawn as to the significance and implications of Richardson for the future interpretation of section 97(1). The question of whether Merkel has resolved the confusion in the operation of section 97(1) will also be discussed.
Section 97(1) provides that: 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 –(a) the assessable income of the beneficiary shall include –
(i) 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” [Emphasis added.]
Before determining the tax liability of a presently entitled beneficiary under section 97(1), “net income” and “income of the trust estate” (trust income) must first be determined.
“Net income” of the trust estate is defined under section 95(1) as the assessable income of the trust, calculated as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions. Thus, net income is a tax law concept which represents the taxable income of a trust estate.
In contrast, “income of the trust estate” (trust income) is a trust law concept which is calculated in accordance with trust law principles and the terms of the trust instrument. Thus, trust income is generally calculated in accordance with generally accepted accounting principles, as distinct from tax law principles.[6] Where the amounts of trust income and net income of a trust are equal or the same, no problems will arise in the application of section 97(1), and the amount included in the beneficiary’s assessable income will be the amount of trust income to which the beneficiary is presently entitled.[7]
However, in practice, net income may exceed trust income when the ITAA specifically includes amounts in assessable income which are not income according to trust law concepts (for instance, net capital gains,[8] bonus share dividends,[9] the imputation credit attached to franked dividends,[10] and balancing charges on the disposal of depreciable property).[11]
On the other hand, trust income may exceed net income where deductions such as accelerated depreciation[12] and investment allowances13 are allowed for tax purposes but not trust law purposes.[14]
It is a prerequisite for applying section 97(1) that a beneficiary must be “presently entitled” to a share of trust income. As held by Kitto J in Taylor v FCT,[15] “present entitlement” refers to an interest in possession in an amount of income that is legally available for distribution, so that the beneficiary has a right to obtain payment of it or would have, but for a legal disability. Kitto J’s test qualifies the test in FCT v Whiting[16] where it was held that “presently entitled” referred to a right to income presently existing such that a beneficiary may demand payment of the income from the trustee. Beneficiaries may be assessable on trust income even where the beneficiary was unaware of any interest in the trust,[17] where income was applied for the beneficiary’s benefit,[18] where the beneficiary’s share of trust income cannot be precisely calculated at the time of present entitlement,[19] and where no payment has actually been received from the trustee.[20]
When trust income and net income differ, the perplexing question of what amount should be included in the beneficiary’s assessable income under section 97(1) will arise because of the uncertainty involved in interpreting the words “presently entitled to a share of the income of the trust estate” and “so much of that share of the net income of the trust estate”. In an attempt to address this problem, two possible approaches to interpreting section 97(1) have been expressed – the proportionate approach and the quantum approach.
(i) The Proportionate Approach
Under the proportionate approach which was adopted by Hill J in Davis & Anor v FCT,[21] “a share” is interpreted as a proportion or percentage of the trust distribution. Firstly, the share of trust income to which the beneficiary is presently entitled is calculated as a proportion or percentage of total trust income. This percentage is applied to the section 95(1) net income, to determine the amount of net income to be included in the beneficiary’s assessable income under section 97(1). As illustrated in Tables 2A and 2B, (see Appendix) if the beneficiary is entitled to one tenth (10 per cent) of trust income, the beneficiary will include 10 per cent of the net income in the beneficiary’s assessable income, irrespective of whether net income exceeds trust income (Table 2A) or is less than trust income (Table 2B).
Provided that there are beneficiaries who are presently entitled to the whole amount of trust income, net income will be allocated among these beneficiaries proportionately, and the trustee will not be assessed under sections 99 or 99A regardless of the amount of net income. Where beneficiaries are not entitled to the whole of trust income, the balance of unallocated net income will be assessed to the trustee under sections 99 or 99A.
Where net income exceeds trust income, presently entitled beneficiaries will be required under section 97(1) to include in their assessable income, amounts which are greater than the amounts which they either received or are entitled to receive,[22] (as illustrated in Table 2A). Where net income exceeds trust income due to capital gains, income beneficiaries who are presently entitled to trust income will be taxed on a proportion of the net capital gain included in net income to which they have no entitlement.[23] This inequitable result is inconsistent with legislative intention to tax the beneficiary who is presently entitled to the capital gains.[24]
In contrast, where trust income exceeds net income, the amount included in the assessable income of presently entitled beneficiaries will be less than the amount of trust income to which they are presently entitled. Any excess of trust income over net income will be distributed tax-free (as illustrated in Table 2B). This result is equitable because it allows the flow-through of tax concessions which beneficiaries would have received if the income had been derived through a partnership or as an individual taxpayer.[25]
It is noted that whilst the Commissioner may assess beneficiaries on distributions of trust income in excess of net income by literally applying sections 99B[26] the Commissioner does not do so in practice.[28] Despite the problems that arise when net income exceeds trust income, the proportionate approach is widely accepted as the correct interpretation of section 97(1).[29]
(ii) The Quantum Approach
Under the quantum view, “a share” is interpreted as the quantum or specific amount of trust income to which the beneficiary is presently entitled. This figure or dollar amount represents “that share of the net income of the trust estate” which is included in the assessable income of a presently entitled beneficiary under section 97(1).
Unlike the proportionate approach, where net income exceeds trust income, the amount included in the assessable income of a beneficiary will be limited to that part of net income which equals the specific amount of the beneficiary’s present entitlement to trust income. Beneficiaries are not taxed on the balance of net income since this amount is taxed to the trustee under sections 99A or 99 (as seen in Table 2A). Generally, section 99A will apply to tax trustees on income to which no beneficiary is presently entitled at maximum marginal rates (currently at 47 per cent) because the Commissioner has very limited discretion to apply marginal rates applicable to individuals under section 99.[30]
Although the quantum approach avoids the taxation of capital gains in the hands of income beneficiaries where net income exceeds trust income, it may be difficult to justify the taxation of the balance of net income at penalty rates because this wrongly assumes that income is accumulated in trusts merely for tax avoidance purposes. In practice however, there are many valid reasons why businesses prefer to operate through trusts.[31] Furthermore, the imposition of penalty rates on capital gains validly accumulated in a trust is inappropriate because these amounts traditionally form part of the corpus of the trust under trust law and accumulated capital will generate future income flows for the benefit of income beneficiaries.
Where trust income exceeds net income, the same result as under the proportionate approach is achieved, if beneficiaries are entitled to the whole of trust income (as seen in Table 2B). The difference between the two approaches becomes evident when part of trust income is distributed to the beneficiaries (as seen in Table 2C).
It is acknowledged that an alternative interpretation of the quantum approach was stated in Davis, where Hill J held that a beneficiary “could be taxed on less than he [or she] received if the share of trust law income exceeded that part of net income as is represented by trust law income, and the maximum rate of tax under section 99A would be applicable to the balance.”[32] This curious interpretation of the quantum approach implies that penalty rates will apply to the untaxed balance of net income, which contradicts the quantum interpretation of “a share” as defined above. In this paper, the former interpretation of the quantum approach will be adopted.
The taxpayer (Richardson) was the chairman of the board of directors of IR Pty Ltd, which was involved in managing building projects. IR Pty Ltd was the trustee (the Trustee) of the Richardson Family Trust (the Trust) of which the taxpayer was an income beneficiary. In 1981, in the course of a project, the Trustee purchased two additional blocks of land, Lots 20 and 14, which were retained by the Trustee after the project’s completion. In 1984, Lot 14 was exchanged for Lot 18. Lots 18 and 20 were later sold for a profit ($863 935), which was transferred by the Trustee into the “capital profits reserve” of the Trust.
On 24 June 1988, the trustee resolved to distribute all but $47 000 of the “net income of the trust” to Richardson. The $47 000 was distributed to another Family Trust (the Second Trust). In its 1988 income tax return, the Trustee recorded a taxable income of $65 330 which was recorded as being distributed to the Second Trust and Richardson.[33]
The Commissioner issued assessments to the two beneficiaries on the basis of the income as returned by the Trust ($65 330). This assessment was amended by adding $707 122 to represent the profit on sale. Consequently, the Commissioner included $707 622[34] in Richardson’s assessable income on the basis that the profit was part of taxable income of the trust because it arose as an incident or in the ordinary course of the Trust’s business. Alternatively, the Commissioner contended that the properties were bought for purposes of resale at a profit.
Richardson objected to the amended assessment. After the objection was disallowed by the Commissioner, Richardson appealed to the Administrative Appeals Tribunal (the AAT), contending that the taxable income of the trust did not include the profit as the properties were acquired for long-term rental purposes without the intention of resale at a profit.
The AAT held that the acquisition of the properties arose as an ordinary incident of the Trust’s business. Therefore, the profit was assessable as income according to ordinary concepts. The AAT also decided that as the taxable income of the trust equaled trust income, no difficulties arose in the operation of s97(1). Richardson then appealed to the Federal Court and two issues were raised. The first issue was whether the AAT erred in law in finding that the acquisition and therefore the profit was an ordinary incident to the Trust’s business. The second issue related to the interpretation of section 97(1) in circumstances where net income differs from trust income.
On the first issue, Merkel J held that the AAT correctly concluded that the profit was assessable as an ordinary incident of the trust’s business under the principles in Westfield Ltd v FCT[35] and FCT v Myer Emporium Ltd.[36] Richardson’s contention that the Trustee did not have a profit-making purpose was rejected because the AAT’s conclusion was based on a finding of fact that the sale of properties was incidental to the Trust’s ordinary business activities.
Merkel J then considered the application of section 97(1). Since the AAT concluded that the profit on sale was income, the profit was assessable as ordinary income under tax law.[37] In contrast, the Trustee treated the profit as a capital profit for trust purposes. Thus, Merkel J concluded that “all the material before the AAT pointed to a significant discrepancy between the trust income and the assessable income.”[38] This raises the difficult issues involved in the operation of section 97(1) where net income differs from trust income. Thus, the AAT had erred in finding that trust income equaled net income as it had not given real and genuine consideration to the issue before it, and there was no evidence to support the AAT’s conclusion. Hence, Merkel J remitted the matter to the AAT, to determine the net income and trust income of the trust in accordance with law. According to Merkel J, since it was inevitable that the trust income and net income of the trust would differ, his views on the operation of section 97(1) were set out in obiter.
Firstly, Merkel J held that the purpose of section 97(1) is “to ensure that the beneficiary presently entitled to trust income bears a commensurate ‘share’ of the tax liability in respect of the taxable income.”[39] The appropriateness of the proportionate and quantum approaches were determined by reference to this statutory purpose.
Where net income for tax purposes is less than trust income, the proportionate approach satisfies the purpose of section 97(1).[40]
However, where trust income is less than net income, the proportionate approach does not achieve the statutory purpose as the beneficiary will bear liability in respect of taxable income to which the beneficiary was not and will not be presently entitled, as discussed above.[41] To avoid this inequity, Merkel J proposed that the quantum approach should apply in this situation.[42]
Merkel J recognised that to adopt the proportionate approach where trust income exceeds net income and the quantum approach where net income exceeds trust income gives a different operation to the phrase “share of the net income of the trust estate” depending on whether trust income is less or greater than net income. However, Merkel J attempted to justify this approach by reference to the “modern rule of construction” or purposive interpretation which aims to avoid absurd, extraordinary, capricious, irrational or obscure results which do not conform with legislative intent.[43] After citing section 15AA of the Acts Interpretation Act 1901 (Cth) and cases which support purposive interpretation, Merkel J concluded that:
... to give effect to the statutory purpose, different approaches to the operation of s97(1) and in particular to the meaning of a “share” ... need to be adopted depending on whether the trust income is less or greater than the trust’s assessable income.[44] [emphasis added]
Merkel J distinguished Richardson’s case from Hill J in Davis, by arguing that:
in Davis, no submission was made or argument put to Hill J against the conclusion at which his Honour arrived. That is not so in the present case. Further, the approach to construction which I have adopted was not put to or considered by his Honour.[45]
Section 15AA of the Acts Interpretation Act 1901 (Cth) provides that in interpreting a provision, “a construction that would promote the purpose or object underlying the Act ... shall be preferred to a construction that would not promote that purpose or object.” The operation of the purposive approach to statutory interpretation is explained in the following cases.[46]
The requirement of s15AA(1) that one construction be preferred to another can have meaning only where two constructions are otherwise open, and s15AA is not a warrant for redrafting legislation nearer to an assumed desire of the legislature.[47]
If the choice was between two competing interpretations, ... the advantage may lie with that which produces the fairer and more convenient operation so long as it conforms with legislative intention. If ... one interpretation has a powerful advantage in ordinary meaning and grammatical sense, it will only be displaced if its operation is perceived to be unintended. [48]
[I]f the literal meaning of a provision is to be modified by reference to the purposes of the Act, the modification must be precisely identifiable as that which is necessary to effectuate those purposes and it must be consistent with the wording otherwise adopted by the drafts[person].[49] [emphasis added]
Thus, section 15AA and purposive interpretation requires courts to choose “one construction” (which promotes the legislative purpose) over another. It does not authorise courts to adopt two different meanings to the same word, depending on the circumstances. Even though courts can give effect to the statutory purpose by reading down a provision[50] or “by addition to, omission from, or clarification of, the particular provision”,[51] it is unlikely that the draftsperson intended the word “share” in section 97(1) to mean both a proportionate share as well as a quantum share.
Merkel J, when faced with two competing interpretations of section 97(1), chose to adopt both approaches. On this basis, Merkel J’s interpretation of section 97(1) is inconsistent with purposive interpretation and is open to criticism. Recently in Zeta Force, Merkel J’s differential approach was considered by Sundberg J,[52] who declined to follow Merkel J’s approach for the following reasons. Firstly, Sundberg J rejected Merkel J’s starting point that the purpose of section 97 is to ensure that the tax assessed on trust income is borne by the beneficiaries in shares commensurate with their entitlements[53] because the purposive approach to construction does not authorise such a conclusion. Although McHugh J in Saraswati v R[54] held that the literal construction of a provision can be departed from where to adopt it would defeat the object or purpose of the enactment, Sundberg J doubted that McHugh J “had in mind giving a phrase a different meaning according to the facts of the particular case.”[55] Thus, Sundberg J submitted that “the line which divides enlightened construction from reconstruction was passed in Richardson.”[56]
Secondly, Sundberg J submitted that the purpose of section 97 as adopted by Merkel J is a matter to be decided rather than assumed,[57] which implies that the basis for Merkel J’s differential approach was wrong from the start. According to Sundberg J, the construction of section 97(1) indicates that “[t]he contrast between the expressions ‘share of the income of the trust estate’ and ‘that share of the net income of the trust estate’ shows that the drafts[person] has sought to relate the concept of present entitlement to distributable [trust] income, and not to taxable [net] income”.[58] Once the share of the distributable income is worked out, the beneficiary is to be taxed on that share (or proportion) of the taxable income of the trust. This construction of section 97(1)(a) seems reasonably clear even though it may result in unfairness to beneficiaries. Had the legislature intended a beneficiary to be assessed on no more than the amount of present entitlement to distributable income, it could have easily said so.[59] Furthermore, to assimilate the two expressions is to disregard an intentional contrast by the legislature.[60] Therefore, the language used by the legislature does not support the “purpose” behind section 97(1) which was adopted by Merkel J.
Another problem with Merkel J’s interpretation arises from the taxation of trustees at section 99A penalty rates where net income exceeds trust income, which as argued above, is inappropriate.[61] This problem will not be solved by distributing all net income, as suggested by Merkel J[62] because the trustee’s discretion to distribute all net income is subject to the trust deed. For instance, trustees may be required under the trust deed to accumulate part of net income as corpus of the trust. Furthermore, trustees distribute trust income, as distinct from net income. Therefore, Merkel J’s solution appears to equate trust income with net income, which gives rise to the problems of uncertainty and inequity as outlined below.[63]
Therefore, neither the proportionate approach nor the quantum approach produces equitable results where net income exceeds trust income, as acknowledged by Hill J in Davis.[64] Merkel J’s interpretation only adds to the confusion and uncertainty in interpreting section 97(1) and does not solve this perplexing problem.
According to the Commissioner, where net income exceeds distributable income (trust income), the beneficiary will be assessable on the income distributed, and the trustee will be assessable on the balance of undistributed income under sections 99 or 99A, thus adopting the quantum approach. However, the Commissioner states that where beneficiaries are presently entitled to a proportionate share of trust income and in the absence of tax avoidance implications, the income may be assessed to beneficiaries in the proportion to which they are presently entitled, thus adopting the proportionate approach.[65] The Commissioner’s approach is confusing and does resolve the controversy as to which approach is the correct interpretation of section 97(1).
It is clear however that the weight of authority supports the proportionate method.[66] Recently, the Full Federal Court in FCT v Prestige Motors[67] accepted the proportionate approach as “the usual position”. Furthermore, the certainty of a single rule in interpreting section 97 is preferred to a rule which is subject to exceptions in the interest of fairness, as recognised by the Asprey Committee.[68]
(i) Amend the Trust Instrument Definition of Income
If trust deeds are amended so that trust income is calculated in accordance with section 95 net income, Moshinsky argues that there would be no problems in applying section 97 as the inequity of taxing beneficiaries on income to which they have no entitlement will be removed.[69] The same result is attained by amending trust deeds so that an income beneficiary will be entitled to net income.
Problems arise when trust income is equated with net income because trust income will be redefined whenever income tax legislation is amended, giving rise to uncertainty in relation to the taxation of trusts. Moreover, it is unfair for capital beneficiaries to have accretions of capital available for distribution to income beneficiaries as it fails to recognise the different interests of income and capital beneficiaries in trust property. Difficulties also arise in relation to notional statutory concepts such as the imputation credit attached to franked dividends which is included in taxable income under section 160AQT but is never included in trust income. In this situation, it will be inequitable to tax presently entitled beneficiaries on trust income defined according to net income because these credits are never actually received by beneficiaries.
(ii) Applying the Corporate Taxation Model to Trusts
It is inappropriate to apply the corporate taxation regime to trusts because this will import all the inequities and complexities associated with the corporate model into the taxation of trusts, for instance the wastage of franking credits which gives rise to vertical inequity, the high administrative costs and complexities associated with an imputation system and the wipe-out of tax concessions specifically allowed in legislation.[70] Thus, taxing trusts like companies may not be an equitable solution to the problems in section 97(1). This is supported by the Asprey Report and the Law Council of Australia.[71]
Delany argues that trustees should be taxed on net income and refundable tax credits should be allowed to beneficiaries on taxes paid by trustees.[72] However, given that tax credits are not refundable for shareholders, it would be contrary to government policy to allow refundable credits for beneficiaries. Moreover, this proposal will increase administrative costs and will not avoid the wipe-out of tax concessions.
(iii) The Asprey Committee’s Recommendations
The Asprey Report recommends that where net income exceeds trust income, beneficiaries should be taxed on their present entitlement to trust income, but the excess should be taxed to the trustee.[73] To avoid inequity, the excess of net income over trust income should be taxed as income of an individual at a special tax rate which is less than penalty rates.[74] The Commissioner will retain discretion to tax trustees at penalty rates where the discrepancy between net income and trust income was brought about for tax avoidance purposes.[75]
Although this recommendation introduces an exception to the adoption of the proportionate approach where net income exceeds trust income, the Asprey Committee does not purport to justify its recommendation by interpreting “a share” as meaning a quantum share as done by Merkel J and avoids the taxation of accumulated income at penalty rates. Therefore, in the absence of statutory reform, the Asprey Committee’s recommendations may be preferable among the alternative solutions suggested as it avoids the inequitable result of taxing the wrong beneficiaries under the proportionate approach, and removes the unjust taxation of trustees at penalty rates under the quantum approach where net income exceeds trust income.
Merkel J’s interpretation of the word “share” which depends on whether net income is greater (interpreted as a quantum share) or lesser (interpreted as a proportionate share) than trust income is unjustifiable because it lacks consistency. Purposive interpretation does not allow a court to adopt two inconsistent interpretations of the same provision. On the contrary, a court is required to choose one interpretation that promotes the legislative purpose, which Merkel J failed to do. Furthermore, the language used by the legislature does not support the “purpose” behind section 97(1) adopted by Merkel J.
Merkel J’s decision in Richardson adds to the long list of perplexing and nonuniform interpretations of section 97(1) by the courts, the AAT and the Board of Review[76] and does not resolve the confusion and uncertainty as to which approach to interpreting section 97(1) is correct. Instead, Richardson has magnified the confusion by introducing a new (arguably unjustifiable) approach to interpreting section 97(1).[77] However, criticisms of Merkel J’s approach submitted by Sundberg J in Zeta Force are persuasive and constitute cogent reasons against adopting Merkel J’s differential approach in future cases which involve the interpretation of section 97(1).
Nonetheless, Richardson is a significant and interesting development in the interpretation of section 97(1) which may prove to be the catalyst for long overdue legislative reform of section 97(1). Merkel J’s decision illustrates how the problem inherent in interpreting section 97(1) is not susceptible to a judicial solution because attempts to clarify its operation has only resulted in greater confusion. After many attempts by the courts and tribunals to address this issue, it must finally be conceded that problems in the application of section 97(1) can only be remedied by Parliament, and not by courts. Recently in Zeta Force, Sundberg J reiterated the need for legislative reform to address this problematic aspect of Division 6.[78]
Some alternative methods for addressing the anomalous results caused by section 97(1) where net income differs from trust income were suggested. This included amending the trust instrument’s definition of income, taxing trusts like companies, or adopting the Asprey Committee’s recommendations. After identifying the deficiencies in each method, it was concluded that the best remedy next to legislative reform is to adopt the Asprey Committee’s recommendations. Even though the Commissioner accepts that legislative amendment is required to remedy the defects in section 97, this project was not given high priority.[79] It is hoped that the pending redrafts of section 97(1) through the Tax Law Improvement Project will clarify the operation of section 97(1) and remove the inequities that currently operate in the taxation of trusts regime.[80]
1. How the Commissioner arrived at Richardson’s amended assessment
(on 15 December 1994)
1988 Income Tax Return : The Trust
Taxable income as returned 65,330
Add : Net profit on sale of properties 707,122
Amended taxable income 772,452
Less : Distribution to Second Richardson Trust 47,000
Amended assessment to Richardson 725,452
1988 Income Tax Return : Richardson
As amended 725,452
As assessed 17,830 –
Amended assessment 707,622
As a result of the amended assessment, Richardson was assessed on $725,452 in total, which
was all but $47,000 of the net income of the trust for the year of income.
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