The decision below and the QSC decision
In a complex matter, the Full Federal Court has unanimously allowed the taxpayers’ appeals against the August 2015 decision of Greenwood J in Thomas v FCT [2015] FCA 968. Greenwood J had held that a discretionary trust could not distribute franking credits to an individual beneficiary differently from the manner in which the net income of the trust was resolved to be distributed. In doing so, the Court ruled that franking credits were not net income of the trust and could not be “streamed” independently from the net income of the trust.
At the same time, the Court ruled that it was not bound by orders previously obtained by the trustee by way of declaration from the Supreme Court of Queensland (Applegarth J) [2010] QSC 417 that franking credits could be allocated differentially from the net income of the trust.
The Full Federal Court case – introduction and facts
In this case the lead judgement was given by Pagone J (with whom Dowsett & Perram JJ agreed). The Court ordered that the taxpayer’s appeal be allowed from the decision of the Federal Court at first instance and that the matter be remitted back to the Commissioner for re-assessment.
By way of introduction, Pagone J states as follows.
- The principal issue in these appeals is whether the taxpayers are entitled to franking credits in the relevant income tax years. Other issues concerning penalty assessments also arise if the taxpayers are unsuccessful on the principal issue.
- The appellants are Thomas Nominees Pty Ltd (“Thomas Nominees”), Mr Martin Andrew Thomas (“Mr Thomas”) and Martin Andrew Pty Ltd (“MAPL”). Thomas Nominees was the trustee of the Thomas Investment Trust (“the trust”) which was established by a trust deed dated 1 February 1979 that was amended on various dates including, relevantly, on 1 October 1992. Mr Thomas and MAPL were beneficiaries of the trust in each of the income tax years ending 30 June 2006, 2007, 2008 and 2009. Mr Thomas and his mother were the directors and equal shareholders of Thomas Nominees, and Mr Thomas was the sole director and shareholder of MAPL.
- The trustee carried on an exchange traded option trading business during the relevant tax years which involved dealing in exchange traded options in shares. The options were exercisable at specified dates by one or other of the parties as provided in the option document. In each of the relevant income years the trustee received dividends which had been franked in accordance with Div 207 of Part 3–6 of the Income Tax Assessment Act 1997 (Cth) (“the 1997 Act”). The trustee derived other income during the relevant tax years, and incurred expenses in deriving that income, but the issues in these proceedings concern the entitlements to the franked credits connected with the dividends. In each of the years in question the appellants contended that, and the Commissioner contested that, the franked credits were to be taken into account in reducing the assessable income of the beneficiaries rather than that of the trustee. The Commissioner did not contend that the beneficiaries could not have become entitled to claim the benefit of the franked credits as beneficiaries of a discretionary trust or that the beneficiaries could have been made entitled to receive the benefits as they claimed, but that they had not become entitled to the benefits they claimed pursuant to the terms of Div 207 in the circumstances which occurred.
- The terms of Div 207 of the 1997 Act, and its relationship to Div 6 of the Income Tax Assessment Act 1936 (Cth) (“the 1936 Act”), is complicated, but its overall intent is relatively clear. The provisions are designed in part to ensure that a beneficiary of a discretionary trust obtains the benefit of franking credits to the extent that the franked distributions are reflected in the beneficiary’s entitlements to the net income of the trust. The Commissioner’s submissions in the appeals, and the Commissioner’s relevant earlier published rulings, support that view. The legislative mechanism through which that object is achieved, however, is necessarily complicated because of the need for a mechanism to match (a) frankable distributions received by trustees to (b) trust income distributed to beneficiaries. A beneficiary of a discretionary trust will typically receive part of the net amount of trust income that may have included franked distributions received by a trustee of the trust estate but which will not be sufficiently traceable to, or matchable with, any franked distribution received by the trustee. An objective of Div 207 is to provide a mechanism by which the beneficiary will have attributed that proportion of the franked distributions received by the trustee that is referrable to the amount of the net income distributed to the beneficiary.
- The general rule in relation to franked distributions by a corporate tax entity to a member of that entity is that the member will be entitled to a tax offset equal to the franking credit on the distribution included in that member’s assessable income. Subdivision 207-B, however, modifies that general rule in cases where the franked distribution is made to a partnership or to the trustee of a trust. An objective of the subdivision is to ensure that the beneficiary of the trust income receives also the benefit of the franked distribution to the extent that the franked distribution is received through a trust.
The resolutions to distribute the dividends and franking off-sets in different proportions
The matter involved the distribution of some $3 million of net income of the trust and some $9 million of franking credits in the 2006 to 2009 income years in circumstances where the individual beneficiary received some 90% of the franking credits.
Pagone J set out the thinking of the bookkeeper who prepared the resolutions distributing the trust’s income and the franking credits in different proportions, between the individual and corporate beneficiary.
- Ms Abbott also prepared the tax returns and the financial accounts.
- Ms Abbott’s method in preparing the Monthly Position Statements for Mr Thomas and the trustee was this.
- She would identify the profit, based on the monthly (year-to-date) P & L Statement.
- She would then make adjustments so as to calculate the s 95 net income assuming no other transactions to year end for the sake of the exercise. The adjustments involved adding back non-deductible expenses and adding the franking credits related to the dividend distributions to the trustee of the trust – the required gross-up. Non-taxable capital gains were excluded and removed from the calculation resulting in the total taxable income at that date upon the hypothesis of no further transactions to year end: T, p 72, lns 3-4.
- The next step was to notionally allocate the s 95 net income between MAPL and Mr Thomas to ensure that Mr Thomas did not receive an amount that would cause him to be paying more than 30c in the dollar as an average tax rate.
- After having notionally allocated the s 95 net income, Ms Abbott would notionally allocate the franking credit offsets (benefits) between the two beneficiaries based on an amount sufficient to meet (and no more) MAPL’s income tax liability based on the notional s 95 net income distribution with the balance allocated to Mr Thomas. Thus, the “only intention” in allocating a particular amount of offsetting franking credit benefits was to meet the tax otherwise payable by MAPL and no more. The remaining franking credits would then be allocated to Mr Thomas and applied against his tax payable. The assumption was that he would then be entitled to a refund of the surplus or unused franking credit benefits beyond offsetting the tax payable by him.
- Ms Abbott accepted that these steps reflected her philosophyin preparing the documents throughout the relevant tax years: T, p 73, ln 8.
In essence, her approach was to give the individual beneficiary sufficient of the trust’s income, so that his assessable income would be enough to pay 30% income tax, on average (ignoring franking credits). She would then distribute the balance of the trust’s income to the corporate beneficiary (with it’s assessable income being based on the trust amount). She would then allocate sufficient franking credits to the corporate beneficiary, so that it didn’t have any tax to pay and the balance of the franking credits to the individual beneficiary, reducing his tax, even to zero and even giving him substantial refunds from the franking off-sets (which are redundable).
The book keeper distributed the income and then the franking credits in separate resolutions (consistent with her idea that the income and the franking credits could be ‘de-coupled’ and distributed independent of each other. These were the resolutions.
| 2006 | 2007 | 2008 | ||
| Section 95 Net Income | $798,826 | $1,839,635 | $142,651 | $173,743 |
| Distributions to Martin Thomas: Share of non PP income Franking credits TFN withheld |
$21,600 $2,416,217 $17,502 |
$4,615 $4,765,353 – |
$50 $1,030,839 – |
$16,600 $1,050,925 – |
| Distributions to MAPL Share of non PP income Franking credits Attributed foreign income Other foreign income Foreign tax credits |
$763,149 $228,900 $125 $13,952 $4,267 |
$1,822,307 $548,488 $0 $12,713 $1,821 |
$138,109 $42,780 – $4,492 $1,185 |
$157,143 $46,900 – – – |
The difference between this decision and the one at first instance
The difference between this decision and the one at first instance was that the Full Federal Court held that it was bound by the Queensland Supreme Court decision, holding that the effect of the resolutions was to treat ‘franking credit off-sets’ as separate property, effectively distributed as set out in the 2nd resolution (despite being distributed in quite different proportions). Pagone J put it his way in his FFC judgement.
- His Honour’s dismissal of the application for rectification is significant because his Honour’s orders did not operate to alter the resolutions made by the trustee. His Honour’s declaration may, however, nonetheless bind the Commissioner (as the Commissioner correctly conceded) to the extent that his Honour’s orders conclusively determined the rights of the beneficiaries and the trustee. In Executor Trustee and Agency Co of South Australia v Deputy Federal Commissioner of Taxes (South Australia) [1939] HCA 35; (1939) 62 CLR 545Latham CJ said at 562-3:
The Commissioner of Taxation who takes moneys from a taxpayer as a contribution to the revenue cannot be described as a privy in estate to the taxpayer where rights have been determined in a proceeding to which the commissioner was not a party. But when, in duly constituted proceedings before a competent court, the rights of a cestui que trust against a trustee and the corresponding duty of the trustee towards thecestui que trust have been defined, there is no means whereby those rights can be otherwise defined, because each party is conclusively bound by the order of the court. If the right in question is a right of the cestui que trust to receive money, such as income, from the trustee, the order necessarily and in the nature of the case finally determines, so far as it goes, the nature and extent of the right of the cestui que trust. When the revenue authorities come to impose a tax in relation to such rights, they must, in my opinion, take them as they in fact actually exist between the parties. Thus, although the commissioner cannot be said to be “bound” by the order of the Supreme Court as res judicaia or in any other way, he has no option but to assess the trustee or the cestuis que trust upon the basis of their duties and rights as declared by the order.
Dixon J (with whom Evatt J agreed) said at 569-570:
Even if these two orders had not been made and the construction of the will were altogether open, I should not place upon it the interpretation for which the appellant contends. The orders, however, fix the rights of the beneficiaries in relation to the income of the land upon which the tax is levied, and, in my opinion, they control the situation.
There is no question of res judicata or issue-estoppel. But the rights in question being measured by the nature and extent of the interests which are taken in the land as at 30th June 1938, we must look at all operative instruments which define those interests. The orders define the interests of the six beneficiaries. It is true that they do not purport to give new interests and that in law they operate only as declarations determining, as between trustee and beneficiary, the interests otherwise existing, that is, arising under the will. But it is none the less true that the beneficiaries can, after the making of the orders, have no interest in the land inconsistent with the orders.
McTiernan J at 572 said:
It was said that, as the commissioner was not a party to the proceedings, the orders were not binding in this appeal. It is true that none of the questions decided in those proceedings is binding on the commissioner as if it were a res judicata. But the will and the orders made by the Supreme Court determine the interests which according to the law of South Australia the annuitants have in the income from the land. I agree that the interests were liable to taxation upon the basis that they were correctly declared by the orders.
It is respectfully correct to say, as was observed by Greenwood J at [425]-[445], that the Commissioner is not bound by the construction of Div 207 adopted by Applegarth J, but for present purposes the relevant question is whether his Honour’s orders relevantly determined conclusively the rights of the beneficiaries as against the trustee in such a way that Div 207 would operate as the taxpayers contended.
- The issue before Applegarth J was whether the trustee had distributed to the beneficiaries franking credits upon the footing that the franking credits were trust property able to be distributed separately pursuant to the terms of the trust. At [40] his Honour identified the issue as put to him in the proceedings as follows:
The issue in this matter is whether the franking credits which formed part of the trust property in each relevant year were distributed to the beneficiaries in accordance with the resolutions that recorded them being applied, being resolutions that dealt specifically with the franking credits. The issue is whether the resolution that was intended to distribute franking credits was effective to pass them to the beneficiary recorded in the resolution that dealt with franking credits, or whether, as the ATO apparently suggests, franking credits were allocated in accordance with the other resolution. The ATO’s suggestion is at odds with the terms of the resolutions which were executed contemporaneously, and does not accord with the clear intent of the trustee. That said, I apprehend that the essential issue in respect of which the trustee seeks direction pursuant to s 96 of the Trusts Act 1873 (Cth) is whether the Deed permits a differential allocation of franking credits so as to achieve the outcome intended by the trustee’s resolutions. If it does not, the trustee seeks rectification of the resolutions.
(Emphasis added.)
At [50] Applegarth J concluded that the resolutions purported to allocate the franking credits differentially according to the terms of the trust.
The Final Result
It was on this basis that the Full Federal Court allowed the taxpayer’s appeal and referred the matter back to the Full Federal Court for reassessment in accordance with its reasons.
(Thomas & Anor v FCT [2017] FCAFC 57, Full Federal Court, Dowsett, Perram and Pagone JJ, 12 April 2017.)
[FJM; FFC; LTN 70, 13/4/17]