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Constructive trusts should be ignored for tax purposes, according to A Tax System Redesigned (“Ralph Review”),[1] within the principle that:
trusts that arise by operation of law rather than by choice of the settlor should be excluded from the entity tax regime.[2]
But not all trusts arising by law are believed to be ineligible for entity treatment. One of the ‘policy intentions’ behind the recommendation is to determine which trusts are and are not suitable.[3] It is said that trusts, which arise by operation of law, cannot be expected to meet the requirements of the entity tax regime if:
the parties involved do not know, and reasonably could not know, from the outset that a trust was created (a constructive trust).[4]
And, correspondingly,
where the parties involved know, or reasonably could have known, from the outset that a trust was created[5]
then the fact that the trust arises by operation of law does not disqualify it from entity measures.
Policy for defining this reach of entity taxation depends on what the parties know about the existence of trusts arising by operation of law, or can be expected to know. This test of knowledge has its problems: to ask whether ‘from the outset’ the parties could know of the device is a kind of equitable solecism; a constructive trust is not ‘created’ at ‘the outset’- if this means the earliest time to which most constructive trusts relate[6] - rather, an order of an equity court is given retrospective effect to the time when the wrongful or trust-engendering facts occurred. A fiction of equitable property is thus employed. Property rights are conferred to undo wrongs. Existence of such a constructive trust is literally unknowable until after it has become effective.[7] Constructive trustees are treated as though they always held the subject property for the party invoking the trust, though every indication is that until the court decreed the trust they meant to hold the property for themselves. In short, the constructive trust creates property interests which are treated as having commenced at the time of the events to which the trust responds.
So what constitutes knowledge of a constructive trust ‘from the outset’? Knowledge can only be foresight. ‘Parties involved’ must be attributed with a predictive ability about whether an equity court will intervene. One should call the trust ‘known’ when it is likely to be imposed. This is not just a quality of pre-disposing facts, it also involves an assessment of the judicial system.
Is it sensible to raise a tax based on the predictability with which equitable discretions are exercised? Factors satirised as ‘the length of the Chancellor’s foot’ should surely not be a determinant of liability to entity taxation.
Trusts arising by another act of law are clearly knowable. Consider the statutory trust: no equitable discretions stand in the way of the positive terms of an enactment. In Registrar, Accidents Compensation Tribunal v FCT[8] the High Court interpreted the provisions of the Accidents Compensation Act 1985 (Vic) and found that Division 6 of the Income Tax Assessment Act 1936 (Cth) applied to investments made by the Registrar. No rule of law or equity prevented the imposition of ordinary trust obligations on a person who is otherwise a servant of the Crown; the matter depended on the terms of the legislation whereby the trust or trust-like relation arose.
Resulting and constructive trusts are said to be distinguishable by equity in a manner ‘similar’ to the difference the Ralph Review sees between parties who could or could not know of the trusts’ existence. A different measure of predictability in judicial intervention is needed. Whereas a constructive trust is a discretionary process, the outcome of which may be difficult to foresee at the time of the facts to which it responds, resulting trusts are occasioned by stricter rules. The Ralph Review gives two illustrations. The first is that
[a] resulting trust can arise when a trust is expressly created but express interests of beneficiaries do not include all the potential interests in the trust estate.[9]
This is economically stated to say the least. Failed dispositions to express trusts may take the following two forms:[10]either an intended disposition to an express trust may fail to vest property in the trustor or property vested in a trust may not be exhausted when all the trust purposes have been carried out. The first form arises when the transfer to the trust miscarries or when the trustee lacks capacity. Or secondly, property vested in a trust may not be exhausted when all the trust purposes have been carried out. The second form may occur, for example, when the last beneficiary dies and the trust property still remains or when a hospital is built but funds remain in the development trust. Either the trust itself or the disposition to it fails.
The second illustration given by the Ralph Review states that
[a] resulting trust may also arise when title to property is transferred and the person making the transfer does not intend to dispose of the beneficial interest.[11]
The elliptical wording of this illustration will no doubt cause difficulty and confusion as an important fact about resulting trusts is concealed. Resulting trusts are equitable inferences which supply the absence of intention. There is no category of expressly intended resulting trusts. Resulting trusts operate as presumptions of what a relevant intention would be if it were known.[12] The device is used to fill ambiguities or gaps occurring when things of value are exchanged. For example, property may be incompletely transferred or property may be transferred to someone who does not exist. An intended gift may be made by persons who die without making their intentions clear. Presumptions of resulting trust apply in these cases, making assumptions to supply the missing evidence of what transferors intended. In Lord Upjohn’s words in 1970, presumptions of resulting trust were invented
because they represented the common sense of the matter and what the parties, had they thought about it, would have intended.[13]
In this way, when property is transferred gratuitously to a stranger, equity ungenerously presumes that the transferor did not intend the stranger to take a beneficial interest. By operation of law, then, the transferor is ascribed with an intention to withhold a beneficial title to what is transferred. This is implied by rule of law, not evidenced as a fact.
To say that the resulting trust is or could be known to the parties involved ‘from the outset’ ascribes a nonsensical intention to those who occasion its existence. Property must be formally transferred to others in the knowledge that they are dead. Wilfully ineffective gifts of property must gratuitously be made. Intentionally failed dispositions to express trusts are even more absurd. One must foresee that a trust will fail to exhaust trust property, often, generations in advance. Death and the vale of years must be miraculously overcome, or persons setting out to vest property on trusts must foresee the ineffectiveness of their acts. Such cynical gift-denying purposes surely belong to very few.
Resulting trusts arise in the same way as constructive trusts – by operation of law – and their existence ‘at the outset’ is unknowable in the same way.[14] Pre-disposing facts of resulting trusts relate to the absence of intention, whilst the pre-disposing facts of constructive trusts involve the commission of frauds and equitable wrongs. No difference exists in terms of what can be known of their jural existence before a court of equity intervenes.
It must be said that, for classificatory purposes, a variety of opinions have been expressed on what element is uppermost in the resulting trust’s constitution. Some equity scholars have preferred to see the resulting trust as dependent on an implied intention to create a trust,[15] while others prefer a trust arising by operation of law,[16] and still others as a bit of both.[17] Whichever is to be regarded as primary, the salient fact is that resulting trusts originate from the court’s decree rather than the parties’ declaration. Transferors of property can scarcely intend not to have an intention.
From the reasons that the Ralph Review gives that constructive trusts should be excluded from entity taxation, it follows that the resulting trust should also be excluded. One can enlarge this conclusion: all trusts which arise by operation of law should be excluded from entity taxation, excepting the exiguous class of statutory trusts.
It is, of course, a welcome step that constructive trusts are to be regarded as transparent for revenue purposes. This device fits most uncomfortably within the old trust-taxing provisions.[18] Constructive trusts are more like damages than entities; they are ‘a formula through which the conscience of equity finds expression.’[19] Indeed, the term ‘constructive trust’ is an oxymoron of sorts, as the term ‘trust’ plays little part in the relation. In fact, most constructive trustees are actively distrusted by their beneficiaries.
None of the revenue statutes in Australia, the United States, Canada, New Zealand and the United Kingdom now make any reference to the constructive trust. The Ralph Review proposes an Australian first. The matter has been left until now in the province of judge-made law. In the United States, a seminal 1961 decision of the Supreme Court determined the fiscal irrelevancy of constructive trusts.[20] Canada has followed a similar path – albeit for many years with a different equitable theory of the constructive trust.[21] No case law authority in the United Kingdom or New Zealand as yet exists.[22]
James v United States decided that the ‘control’ over ‘readily recognisable economic value’ possessed by constructive trustees is the equivalent to their derivation of income.[23] Prior to a constructive trust being found, a person later held to be a constructive trustee is properly taxed in full measure on these advantages. When a constructive trust is decreed, its subject property and all income derived thereon pass to the beneficiary from the time of the trustee’s wrong. Retrospective liability on the beneficiary is thus imposed.[24]
Positions of United States’s law and the recommendations of the Ralph committee begin to differ at this point. After the constructive trustee pays over the trust property and its income to the trust beneficiary, the Ralph Review states that “balancing adjustments” should be made.[25] Beneficiaries of constructive trusts are made liable to pay the trust’s tax liability from the time it was first incurred. This is a tax liability referable to the income of constructive trust property before the remedy was decreed. Look at the Ralph Review’s example:[26]
Robert is an employee of XYZ Ltd and owes a fiduciary duty to the company. In breach of that duty, Robert makes a gain of $100 on 1 July 2000. The gain is income under ordinary concepts. He invests the money at 10%. He incurs transaction costs of $1 per year on that investment. On 1 July 2002 a court finds that Robert was in breach of fiduciary duty and that a constructive trust existed from 1 July 2000. Robert repays to XYZ Ltd $120 (being the original gain plus interest) on 1 July 2002. In the 2000-1 income year $100 (the gain derived as a result of the breach of duty) is included in Robert’s assessable income. In each of the 2000-1 and 2001-2 income years $10 (the interest earned on investing the $100) is included in Robert’s assessable income. Robert is entitled to a deduction of $1 for the costs of earning that income. In the 2002-3 income year $120 is included in the assessable income of XYZ Ltd. That amount represents the original gain plus interest paid to XYZ Ltd by Robert. XYZ Ltd is entitled to $2 of deductions representing the costs of Robert of earning that income. In the 2002-3 income year $2 is included in Robert’s assessable income, representing the deductions previously allowed to Robert for costs in earning the repaid income. Robert is entitled to a deduction of $120 in the year representing the repaid income that was included in his assessable income.
We will concentrate on Robert’s reimbursement of tax paid. Deductions for expenses incurred in making wrongful earnings will not be considered here.[27] By way of refund, Robert is only given ‘a deduction’ for tax paid on the income which he was later found to hold for the beneficiary. This may recognise the fact that the statutory time-period for the re-opening of the tax assessments of constructive trustees will often have passed and there is no other means of reimbursement available under the proposed legislation.[28]
Allowing deductions for tax wrongly paid is rarely appropriate for the reimbursement of persons later found to be constructive trustees. In analytic terms, the category of ‘deduction’ seems to be misused. In the cashflow/tax value approach outlined in the Ralph Review, an “essential element” of expenditure is that “it is consumed in the course of deriving gains”.[29] Paying tax in error does not lead to gains. Nor is the loss incurred in the year of recognition. In practical terms, there will often be an unfairness to the hapless constructive trustee, the loser of the case. The value of tax paid by constructive trustees is reimbursed by providing them with tax deductions which they may not have the income to absorb in the deduction year, or if they are in a lower tax bracket. Not all constructive trustees should be considered rogues. Even those that are should not be robbed by an impartial tax system. The following example will illustrate this point:
An investor sells a retail shop preliminary to her retirement and a substantial amount of capital gains tax is paid. In a later year, a 50 per cent interest in the value of the shop prior to its realisation is impressed with a constructive trust in favour of the investor’s former partner. The partner is then entitled to a corresponding share in the gross sale proceeds of the shop and is personally liable for tax thereon. The investor, now in retirement, is given a tax deduction equal to the tax she wrongly paid on what turned out to be her former partner’s share. The deduction by this time is of little use to her. In value it is many times her annual income.
Should the new Australian regime for taxing constructive trusts provide appropriate maintenance of the value of refunds allowed for taxes paid before the existence of the devices is decreed? Shortly before the decision in James v United States,[30] s 1341 was inserted in the US Internal Revenue Code. This provision mitigates the effect of the payment of tax on sums refunded by persons who believed they had a ‘claim of right’ at the time when the tax was paid. Therefore, only constructive trustees not of the fraudulent variety could benefit. Embezzlers, thieves and other rogues have no ‘claim of right’ to the proceeds of their wrongs.
Section 1341 Computation of tax where taxpayer restores substantial amount
held under claim of right
(a) General rule – If –
(1) an item was included in gross income for a taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;
(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and
(3) the amount of such deduction exceeds $3000,
then the tax imposed by this chapter for the taxable year shall be the lesser of the following:
(1) the tax for the taxable year computed with such deduction; or
(2) an amount equal to-
(a) the tax for the taxable year computed without such deduction, minus
(b) the decrease in tax under this chapter . . . for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).
Constructive trustees who pay tax on amounts to which they are found not to be entitled are given a choice: either they can have a deduction for the amount of the overpaid tax in the year when restitution is made or they can opt for a tax credit equal to the amount of extra tax that they paid in the year that the income was received. The latter option will be of use to the investor in our example. Credit for tax paid under a ‘claim of right’ better restores to the tax-paying constructive trustees the value of their sometimes honest mistakes. Perhaps consideration should be given to introducing an equivalent of s 1341 in Australia.
[*] Associate Professor, Faculty of Law, Monash University.
[1] Australia, Review of Business Taxation, A Tax System Redesigned: More Certain, Equitable and Durable, July 1999, recommendation 16.15 (“Ralph Review”).
[2] Ibid at 550.
[3] Ibid at 550-551.
[4] Ibid at 550.
[5] Ibid.
[6] Mushinski v Dodds [1985] HCA 78; (1985) 160 CLR 583 at 614 per Deane J, citing A Scott, The Law of Trusts, Volume 5, Brown Little (3rd ed, 1967) at [462.4]; see H Ford and W Lee, Principles of the Law of Trusts, Law Book Co (3rd ed, 1996) at [22080].
[7] See M Cope, Constructive Trusts, Law Book Co (1992) pp 15-17.
[8] (1993) 178 CLR 145 at 161-168 per Mason CJ, Deane, Toohey and Gaudron JJ.
[9] Ralph Review, note 1 supra at 551.
[10] See J Glover, “Re-assessing the resulting trust: modern and medieval themes” [1999] MonashULawRw 5; (1999) 25 Mon L R 110 at 113.
[11] Ralph Review, note 1 supra at 551.
[12] Reaffirmed in Westdeutsche Bank Girozentrale v Islington London Borough Council [1996] UKHL 12; [1996] AC 669 at 709 per Lord Browne-Wilkinson; contra, P Birks, “Restitution and resulting trusts” in S Goldstein (ed), Equity and Contemporary Developments (1992) 371; P Birks, ‘Trusts raised to reverse unjust enrichment: the Westdeusche case” [1996] RLR 94-96; R Chambers, Resulting Trusts, Oxford University Press (1997) p 2.
[13] Pettitt v Pettitt [1969] UKHL 5; [1970] AC 777 at 816 [emphasis added]; see also Calverley v Green [1956] HCA 28; (1984) 95 CLR 353; Napier v Public Trustee (WA) (1981) 55 ALJR 1.
[14] See R Chambers, note 12 supra, p 3.
[15] JP Costigan, “The classification of trusts as express, resulting and constructive” (1914) 27 Harv L R 437; R Meager, W Gummow, Jacobs Law of Trusts in Australia, Butterworths (6th ed, 1997) at [1201]; J Riddall, The Law of Trusts, Butterworths (4th ed, 1992) p 191; K Gray, The Elements of Land Law, Butterworths (2nd ed, 1993) p 373; L Sheridan, Keeton’s and Sheridan’s Law of Trusts, Barry Rose Law Publishers (12th ed, 1993) pp 189-190; A Oakley, Parker and Mellows: The Modern Law of Trusts, Sweet and Maxwell (6th ed, 1994) pp 27,189; W Swadling, “A new role for resulting trusts?” (1996) 16 Leg St 110.
[16] F Maitland, Equity, Cambridge University Press (2nd ed, 1936) pp 77-80; W Mowbray, Lewin on Trusts, Sweet and Maxwell (16th ed, 1964) p 115; A Scott and W Fratcher, The Law of Trusts, Brown Little (4th ed, 1989) at [404.1]; Ford, note 6 supra at [21000].
[17] D Waters, The Law of Trusts in Canada, Carswell (2nd ed, 1984) p 301; J Martin, Hanbury and Martin’s Modern Equity, Sweet and Maxwell (14th ed, 1993) p 70.
[18] Contra, MacFarlane v FCT [1986] FCA 266; (1986) 13 FCR 356 and Zobory v FCT [1995] FCA 1226; (1995) 129 ALR 484 – oddities noted by J Glover in “Taxing the constructive trustee” in A Oakley (ed), Trends in Contemporary Trusts Law (1996) 315 at 316; and in Ford, note 6 supra at [22000].
[19] Beatty v Guggenheim Exploration Co 225 NY 380 (1919) at 386 per Cardozo J.
[20] James v United States [1961] USSC 84; 366 US 213 (1961), reversing CIR v Wilcox [1946] USSC 39; 327 US 404 (1946); see discussion of Wilcox in JA Moore and RC Solien, “Homeless income” (1953) 8 Tax Law Review 425 at 429.
[21] See R v Poynton (1972) 72 DTC 6329 (Ont CA) and the ‘institutional’ constructive trust, explained in Revenue Canada Interpretive Bulletin IT 256R (27 August 1979).
[22] See SW Bowman, “Constructive trusts – Whether recognised for tax purposes” (1987) 35 Canadian Tax Journal 1464 at 1466 and Glover, note 18 supra at 316-317.
[23] [1961] USSC 84; 366 US 213 (1961) at 216, 218 per Warren CJ (for the majority); one is otherwise faced with “the incongruity of having the gains of the honest labourer taxed and the gains of the dishonest labourer immune”.
[24] This corresponds with Australia, Treasury, A Platform for Consultation: Building on a Strong Foundation, February 1999 at 485-486.
[25] Ralph Review, note 1 supra at 550.
[26] Note 24 supra at 486, see Example 22.2: “Treatment of constructive trust under this option”.
[27] Discussed in J Glover, “Taxing the proceeds of corruption” in B Rider (ed), Corruption: The Enemy Within (1997) 197 at 207ff: should criminal taxpayers be allowed to deduct the expenses of illegal activities (e.g. a bank robber’s cost of ropes to bind bank staff and bullets used)?
[28] The majority in James v United States [1961] USSC 84; 366 US 213 (1961) at 220 only gave the constructive trustee a deduction for earlier tax paid in the year that he made restitution: see RT Manicke, “A tax deduction for restitutionary payments? Solving the dilemma of the thwarted embezzler” [1992] U Ill LR 593.
[29] Ralph Review, note 1 supra at 157.
[30] [1961] USSC 84; 366 US 213 (1961).
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