The Australian Taxation Office (ATO) published the final version of the Practical Compliance Guidelines (PCG) 2016/16, which provides guidance in relation to what will be considered by the Commissioner when exercising his discretion to treat an interest in the income or capital of a trust as being a fixed entitlement, and by extension whether a trust is a fixed trust for most tax law purposes.
PCG 2016/16 has application for the meaning of fixed entitlements and fixed trusts as outlined in Schedule 2F of the Income Tax Assessment Act 1936 (ITAA 36). However, despite submissions to the contrary, the final PCG does not address the meaning of those terms for the purpose of the 'non-arm's length income' rules (the ATO position is still that Taxation Ruling TR 2006/7 applies) nor former subsection 160APHL(14) of the ITAA 36 (the holding period rule for streaming franking credits).
PCG 2016/16 provides assistance as to when:
- the Commissioner will exercise his discretion to treat a trust as a fixed trust; and
- circumstances where a safe harbour applies to treat a trust as a fixed trust,
as if the Commissioner had exercised his discretion.
The concept of fixed entitlements and the ATO view
A trust is a fixed trust if persons have fixed entitlements to all of the income and capital of the trust. A beneficiary will be considered to have fixed entitlements to income or capital of a trust, if their interest is vested and indefeasible.
In regard to what constitutes a vested interest, PCG 2016/16 states that:
“…an interest is ‘vested’ if it is vested in interest or vested in possession. An interest is vested in possession when it gives its holder a right of present enjoyment, whereas an interest is vested in interest if it gives its holder a present right to future enjoyment”.
PCG 2016/16 confirms that the mere object of a discretionary trust does not have a vested interest in, and therefore does not have a fixed entitlement to, either the income or capital of the trust. This is consistent with the understanding that the entitlement to income or capital by a beneficiary of a discretionary trust does not arise under a trust instrument, but pursuant to an exercise of the power of the trustee of that trust.
PCG 2016/16 also includes the Commissioner’s view on the concept of ‘indefeasible interests’ as being an interest that “can be defeated by the actions of one or more persons or by the occurrence of one or more subsequent events.”
PCG 2016/16 lists the following trustee powers as powers which cause a beneficiary’s interest to be defeasible:
- power to amend the trust deed;
- power to issue or redeem units;
- power to issue units of different classes or to reclassify units;
- power to classify receipts as being on income or capital account where the units that have been issued do not all have equal rights to receive the income and capital of the trust;
- power to appoint a beneficiary’s interest in the income or capital of the trust to another beneficiary;
- power to settle or appoint any part of the corpus of the trust to a new trust with different beneficiaries; and
- power to enforce the forfeiture or cancellation of partly paid units due to the non-payment of a call for payment except where such partly paid units would be void ab initio.
Satisfaction of the ‘savings rule’ in subsection 272-5(2)
Under subsection 272-5(2) of Schedule 2F of the ITAA 36, there is a ‘savings rule’ provision, which states that the mere fact that a trustee has a power to redeem units in a unit trust, or issue further units, does not mean that unit holders’ interests in the income or capital of the unit trust are defeasible, provided that legal requirements are satisfied.
PCG 2016/16 lists a series of situations where the savings rule has application. Overall, the rule applies where further units are issued or existing units are redeemed for a price based on a market value of the assets and liabilities of the relevant trust.
PCG 2016/16 also outlines a safe harbour. If the safe harbour applies, the trustee of a trust is allowed to manage the trust’s tax affairs as if the Commissioner had exercised the discretion to treat the beneficiaries as having fixed entitlements to the income and capital of the trust.
Attachment B to PCG 2016/16 outlines the conditions that must be satisfied in order to qualify for access to the safe harbour. Those conditions differ depending upon how the relevant trust is categorised. Attachment B outlines six categories of trusts:
- listed trusts;
- registered managed investment schemes that are trusts;
- certain widely held trusts that satisfy licensing requirements;
- unregistered managed investment schemes that satisfy licensing requirements;
- specific singles interest holder trusts; and
- other trusts.
Whilst PCG 2016 addresses a range of different trust structures as outlined above, most SME and private business taxpayers will be interested in the sixth safe harbour provided in Attachment B. To satisfy the conditions applicable to this category of “other trusts”:
- the trust must have a trust instrument;
- all beneficial interests in the income and capital of the trust are vested;
- all beneficial interests have the same rights to receive the income and capital of the trust;
- all beneficial interests in the income and capital of the trust can be expressed as a percentage of the total income and capital of the trust;
- the trust is not a discretionary trust or a trust with default income or capital beneficiaries;
- a trustee or manager has never exercised a power capable of defeating a beneficiary's interest to defeat a beneficiary's interest in the income or capital of the trust, and
- an arrangement has not been entered into which would result in section 272-35 of Schedule 2F of the ITAA 36 having application, in the trafficking of the tax benefit of a tax loss, bad debt deduction or debt/equity swap deduction, or in fraud or evasion.
Importantly, PCG 2016/16 states that a safe harbour only applies for the period during which the safe harbour conditions are satisfied. The requirement to have a fixed entitlement before, during and immediately after an exchange of units under a scrip-for-scrip roll-over under Subdivision 124-M of the Income Tax Assessment Act 1997 is provided as an example of a situation where a taxpayer requires certainty at a future time (the immediately after requirement) and therefore could not use the safe harbour approach. It may be necessary in such circumstances to request a private ruling form the Commissioner to confirm that the safe harbour may apply.
Commissioner’s discretion to treat an interest as a fixed entitlement
PCG 2016/16 asserts that where the beneficiaries’ interests in the trust are not fixed entitlements, and the trust does not satisfy the requirements for a ‘safe harbour’, the trustee may request that the Commissioner exercise his discretion to treat beneficiaries’ interest sas being vested and indefeasible.
PCG 2016/16 contains a list of factors which are favourable to the exercise of the discretion. The list includes circumstances where all beneficiaries have equal rights to receive the income and capital of the trust, and unanimous approval by all beneficiaries is required to amend a trust instrument.
The list of factors adverse to the exercise of the Commissioner’s discretion include:
- a trustee or manager exercises a power to defeat beneficiaries’ interests in the income or capital of the trust;
- there are significantly different beneficiaries of the trust in an income year for which an entity seeks to have a fixed entitlement than the beneficiaries of the trust in the income year(s) in which the trust made a tax loss or incurred a bad debt deduction or debt/equity swap deduction;
- an arrangement has been entered which would result in section 272-35 having application, in the trafficking of the tax benefit of a tax loss, bad debt deduction or debt/equity swap deduction, or in fraud or evasion.
The application of PCG 2016/16 is complex and professional assistance is essential to ensure that the taxpayer’s circumstances can benefit from the savings rule and / or safe harbour, or whether the Commissioner’s discretion should be requested.
For further information or advice, please contact: