The Full Federal Court handed down its judgement in Lewski v Commissioner of Taxation  FCAFC 145 on 18 September 2017, overturning the AAT’s decision, in : Re TVKS and FCT  AATA 1010. The Court set aside the Commissioner’s amended assessments to Mrs Lewski of $10.1m in the 2006 year and $3.1m in the 2007 year.
There were two matters of principle which form the ratio of the case.
- The first was the question of whether each trust had losses to carry forward to the relevant years from the ‘Glendale’ nursing home transaction, from the 1999 Year, when the ACE Trust had a 40% interest in the losses (as opposed to subsequent years, when it had only a 2% interest in the losses). This depended on whether relevant amounts were ‘incurred’ at 30 June 1999, on signing the contract, as opposed to 31 October 1999, when they were paid. There was an interesting legal point, in this, as there is case law to the effect that the relevant date, for derivation of income, or outgoings being ‘incurred’ is, on the settlement of the conveyance (not on executing the contract. This is the case when the land is on ‘revenue account’ (as this was, because it was buying a nursing home, which the Commissioner had ruled was on revenue account). The Court held that the relevant outgoings were incurred at contract time, contributing to the carry forward losses, to that extent. The Court’s reasoning, on this issue, with respect, appears sound.
- The second issue, on which the case turned, was the effect of the income distribution resolutions. For each trust, there was a primary resolution giving a certain amount of trust law income to Mrs Lewski, but there was an interpendant alternate resolution that applied, if the Commissioner increased the ‘assessable income’ of the trust, or decreased the ‘deductions’ allowed. In that case the the alternate resolutions were to increase the trust law income by that (or those) amounts and distribute it to the respective ‘bucket’ companies for each Trust. The idea was that this took the increased tax liability to a 30% corporate tax environment. The Full Federal Court decided that the existence of the alternate resolution (varying the amount distributed and distributing the extra to a corporate beneficiary) made the initial income entitlements of the beneficiaries, contingent, and that this meant that she could not be relevantly ‘presently entitled’, as at 30 June 2006 (because ‘presently entitled’ involves having an interest, in the Trust’s income, that is vested in interest and in possession). The contingency was, according to the Court, the Commissioner subsequently amending the Trust’s assessable income or allowable deductions. The Court’s reasoning, on this issue, with respect, is more surprising and is creating something of a flurry.
The relevant portion of the Full Court’s reasons, on this second issue, are to be found in para 121, which is as follows.
121. Assuming that each of the ‘variation of income’ resolutions was authorised by the relevant trust deed, the next question is whether the applicant was “presently entitled” within the meaning of s 97(1) of the 1936 Act to a share of the net income of the relevant trust estate (that is, 100% of the net income of the ACE Trust for the 2006 year, and 100% of the net income of the Arjod Trust above $3.5 million for the 2007 year). In concluding, at - of the Reasons, that the applicant was presently entitled, the Tribunal treated the ‘distribution of trust income’ and the ‘variation of income’ resolutions as distinct and sequential. However, we do not consider it correct to treat the resolutions in this way. In the case of the ACPS resolutions, the two resolutions were made at the same time: they were set out in a single document signed by the sole director of the company. In the case of the Drewvale resolutions [trustee of the Arjod Trust], the two resolutions were made at about the same time, at a meeting of the Board of Directors. In both cases, the resolutions were interdependent in that both resolutions dealt with the same subject matter – the distribution of the income of the trust for a particular year of income – with the latter resolution varying, in certain circumstances, the distribution made by the former resolution. In light of these matters, it is artificial to treat the two resolutions (namely, the ‘distribution of trust income’ resolution and the ‘variation of income’ resolution) as separate and sequential for the purposes of deciding whether the applicant was “presently entitled”. Rather, the two resolutions should be read together for the purposes of deciding this question. There does not appear to be any issue between the parties that, if the two resolutions are read together, the distribution to the applicant was contingent: it depended on the occurrence of an event that may or may not take place (namely, the Commissioner disallowing a deduction or including an additional amount in assessable income). It follows that, assuming that each ‘variation of income’ resolution was authorised by the relevant trust deed, the applicant was not “presently entitled” to a share of the net income of the trust estate of the ACE Trust for the 2006 year or the Arjod Trust for the 2007 year. [emphasis added]
The problem with this reasoning is, it appears, that the ‘contingent’ point was not actually argued. The Court said: “There does not appear to be any issue between the parties that, if the two resolutions are read together, the distribution to the applicant was contingent “.
- It might be different if the resolution provided for Beneficiary A to get all the trust income but, if the Commissioner increases the tax law income, Beneficiary B is to get all the trust’s income. There, it is clear that beneficiary A would lose it’s interest in the trust income.
- But, in this case, the contingency only adds an additional amount to the trust’s ‘trust law’ income and distributes the extra to the ‘bucket’ company beneficiary. In the process, Mrs Lewski is still entitled to the same actual amount. It is hard to see how that continuing entitlement was ‘contingent’.
- The Court said it would be ‘artificial’ to treat the initial and alternate resolutions as separate. But it does, also seem artificial to defeat Mrs Lewski’s unbroken entitlement to a certain amount of trust income, as ‘contingent’. She might be rejoicing now, but might not like her entitlement defeated in other circumstances.
- Also, the Court says there is a difference between a contingent interest and a defeasible interest [para 117], which it is often difficult to identify, but it then it doesn’t really say what, if anything, is the difference in tax law. Section 95A(2) of the ITAA36 says a beneficiary is is deemed to have a ‘present entitlement’ if they have a ‘vested and indefeasible’ interest in that income (even if the interest is not ‘present’ – that is not ‘vested in possession’).
The other limitation to this decision, is that their Honours don’t say how the income should be taxed (after concluding that it ought not be taxed to Mrs Lewski).
For instance, taxpayers will have to assess whether ‘default beneficiary’ clauses still work. There is a sense in which their interest is ‘contingent’ being the trustee failing to validly appoint all the trust’s income, to beneficiaries, by year end. But the clauses ought still work. This is because the relevant contingency arises on the critical 30 June date.
Trustees, of discretionary trusts will still try to manage unexpected increases in the Trust’s ‘tax law’ income, but now have take this decision into account. For instance, some trust’s define ‘trust law’ income to equal ‘tax law’ income, so as to ensure that the beneficiaries are presently entitled to everything that could be taxable (which is silly as not all taxable amounts are represented by assets that can be distributed – eg. a deemed amount after giving away the trust’s only asset). Leaving aside that kind of situation, the system might still be effective. That is because trust law income is defined as equalling the tax law income from the beginning (rather than making it hinge on the contingency of the Commissioner later amending the trust’s tax law income).
Having ‘grumbled’ about the Court’s reasoning, to some degree, it is encouraging that the Court gives some endorsement to the basic idea of a trust being able to make ‘alternate’ (contingent) distributions. This seems to come out in the following portion of para 119.
In light of these provisions, and in the absence of an express provision to the contrary, we incline to the view that it was open to the Trustee of the ACE Trust, before the expiration of an Accounting Period, to determine to distribute all or part of the Net Income of the Trust Fund on alternative bases; for example, to resolve to distribute the income to X, but provide that if certain events happen, then the income is distributed to Y. An amount cannot, of course, be distributed more than once. A distribution once made cannot be unmade, but a resolution can be made in terms which are contingent upon events so that its distribution is determined by reference to those events which have occurred.
The ripples from this decision are likely to fan out for a while.
[Related Tax Month articles on: the decision and the Commissioner’s Decision Impact Statement]