Australia’s foreign trust rules

 

Australia is often referred to as an appealing jurisdiction for the world’s wealthy individuals and families. One reason for this might be the perception (or maybe misconception) that there is no inheritance tax (IHT).

That said, although tax may not apply at the time of death, there is a claw-back of tax when the inheritor sells the asset as they also inherit the deceased’s tax cost base. Therefore, practically, it aligns the timing of the tax liability with the sale receipts but does not force the unnecessary disposition of wealth in order to pay taxes.

Australian tax-resident individuals or beneficiaries can also access a 50 per cent discount on capital gains from assets held for at least 12 months, which effectively reduces the top marginal tax rate for residents (including the healthcare levy) from 47 per cent to 23.5 per cent. This discount is not available to companies or (generally) foreign tax residents.

It appears that Australia’s ‘patchwork’ tax system has a way of catching up with taxpayers but provides favourable concessions here and there, especially for providers of capital, and contains some practical measures too. Australia’s foreign trust rules, however, are a lot less desirable.

Australia’s foreign trust rules

Australia has a worldwide taxation system on all income and gains of Australian tax residents, including a foreign accruals regime.

Broadly, Australia’s foreign trust rules were designed to prevent Australian tax residents from accumulating foreign-sourced income in a foreign trust and then returning the amounts back to Australia as tax-free capital.

However, the rules contained in s.99B (and assisted by s.99C) of the Income Tax Assessment Act 1936 (the 1936 Act) reach much further than that. In fact, amounts derived by foreign residents from foreign sources at a time where there was no connection to Australia can be subject to taxes.

Example

A foreign trust was established 15 years ago by a previous generation (say, mum and dad in generation one) that holds all the family’s wealth. A family member (say, daughter from generation two) decides to migrate to Australia. Any future payments or loans from the foreign trust to the daughter in Australia would be taxable to her at a rate of up to 47 per cent in her Australian tax return, without the benefit of the capital gains tax (CGT) discount and with a non-deductible ‘throw-back’ interest charge. The Australian Taxation Office (ATO), in its interpretative decision ATO ID 2011/93, makes this view very clear.

It is clear from the language of s.99B of the 1936 Act and, by inference, from s.102AAM(5), that there is no apportionment of the amount included in assessable income by reference to the residency status of the beneficiary at the time the income was derived by the trust. Rather, the only explicit condition concerning residency is that the beneficiary be a resident at some time during the year of income in which the trust property is paid to them or applied for their benefit.

Despite having been introduced more than 45 years ago, there is little guidance or interpretation on the rules in s.99B of the 1936 Act, with many issues yet to be settled (including their potential application to resident trusts).

So, what do foreign trustees, executors and their Australian beneficiaries need to know so that they do not fall foul of these traps?

What is a foreign trust?

Broadly, a foreign trust is a trust estate that is not a resident trust estate. A resident trust estate is one where:

• any trustee was an Australian tax resident at any time during the year of income (ending 30 June); or
• the ‘central management and control’ of the trust estate was in Australia at any time during the year of income.

A common mistake is that an Australian resident might be inadvertently appointed as a trustee (say one of several trustees) and this unfortunately brings the foreign trust into the Australian tax net. The same applies if an Australian resident is appointed as the executor of a foreign deceased person’s estate or testamentary trust.

Regard could sometimes be had to a double taxation agreement (DTA), which might modify the residency position, say, if the ‘place of effective management’ is in the overseas jurisdiction. This is not always a simple solution, however.

Further, foreign trusts are not always treated as ‘trusts’ for Australian tax law. Australia’s trust laws originate from English and Welsh common law, so some civil-law trusts may instead be treated as companies for Australian tax purposes. In general, where legal ownership of assets vests in one entity, with an obligation to hold the assets for the benefit of another entity, then it is likely to be a trust for Australian tax purposes. Therefore, the tax residency status of the trust (i.e., trustee) is usually the starting point for any analysis, in addition to a careful reading of the trust deed.

Timing is everything

Section 99B(1) applies where ‘an amount’ of trust property is ‘paid to’ or ‘applied for’ the benefit of a beneficiary of the trust estate, where the beneficiary was an Australian tax resident at ‘any time’ during a year of income but including the amount in the beneficiary’s assessable income.

Therefore, provided the beneficiary is not an Australian tax resident at any time in the year that they receive any amounts from the foreign trust (received directly or dealt with on their behalf), then s.99B should not apply.

This is easier said than done where the beneficiary has already entered Australia without any pre-planning. As a general statement, Australian tax residency is ‘easy to make and hard to break’.

Although a detailed discussion of Australia’s tax-residency rules is beyond the scope of this article, it should be noted that the first test is a common-law test of whether the person actually ‘resides’ in Australia (a factual enquiry) and, if leaving Australia, whether they maintain a continuity of association with Australia as their home. There is currently no ‘bright line’ test and so uncertainty arises. The current 183-day test merely expands on the common-law test (i.e., it doesn’t act as a safe harbour).^[1]

Relief could be available if the beneficiary was a holder of a temporary visa (and did not have an Australian spouse) in the relevant tax year, which, in general, would treat the beneficiary as a non-resident for Australian tax purposes.

Additionally, relief may also be available under a DTA if the beneficiary is a foreign resident for the purposes of the DTA and the ‘other income’ article allocates sole taxing rights to the state of residency.

What are the exits?

Once caught by s.99B(1), s.99B(2) then contains a number of ‘exits’ to reduce the assessable amount but with drawbacks, of course. The main reductions are considered below.

The corpus reduction

Amounts paid from the foreign trust, which represent ‘corpus’ (that is, the amounts initially applied to establish the trust or further contributions or gifts to the trust), are not assessable to an Australian beneficiary. Foreign trust laws and the trust deed may also affect what is trust corpus and how it can be paid to the beneficiaries.

However, amounts that would have been assessable if they had been derived by a ‘hypothetical resident taxpayer’ (see below) are excluded from being considered tax-free corpus for these purposes. That is, the income and gains of the foreign trust that have been accumulated and added to corpus will not be tax-free when paid to an Australian beneficiary.

Further, the sparse case law on s.99B seems to require ‘tracing’ or ‘cascading’ of amounts that originate from multiple layers of trusts. Therefore, if one trust realises a return on a share buy-back, which would be corpus for trust-law purposes but deemed to be an assessable dividend for Australian tax purposes, then a subsequent distribution of that amount to a later trust would not make it corpus for the purposes of s.99B.

Generally, the practical challenge will be evidencing that the amount has been sourced from trust corpus. The burden of proof for Australian tax purposes is on the taxpayer and, in the absence of appropriate accounting and trust records to discharge that burden (on the balance of probabilities), the Australian beneficiary may be unable to avail themselves of the corpus reduction.

The otherwise not assessable reduction

A further reduction applies where the amounts derived would not have been assessable to a ‘hypothetical resident taxpayer’. This approach seems to retain all the characteristics of the income or gain being derived (income/asset attributes) but ignores all the characteristics of a taxpayer (taxpayer attributes).

This leads to an anomalous outcome under s.99B, as a pre-CGT gain on one asset could be non-assessable (as it was acquired by the trustee prior to the introduction of the CGT rules on 20 September 1985; the acquisition date being an asset attribute) but the CGT discount could be denied on another gain for the same taxpayer (as accessing the discount is a taxpayer attribute).

Further questions arise as the assessable ‘amount’ referred to in s.99B(1) is a ‘gross’ concept, whereas capital gains are a ‘net’ concept. This is a function of s.99B having been written prior to the introduction of CGT in Australia and having never been updated since.

It also means that a capital gain by a foreign trust, which would generally be non-assessable (provided it is not from Australian real estate or an interest in a ‘land-rich’ entity), becomes fully assessable without the benefit of the CGT discount (or application of capital losses) when paid to an Australian beneficiary. This means that gains on the same asset class from a foreign trust are taxed at twice the tax rate in the hands of an Australian beneficiary than if they had been derived by the same beneficiary from an Australian trust. This disparate outcome is confirmed by the ATO in its 2017 tax determination TD 2017/24.

The otherwise taxable reduction

The final sets of reductions relate to where the trust amount is assessable to an Australian resident under the ‘ordinary’ trust taxing rules or under the ‘attribution’ rules.

Quite broadly, where a beneficiary has a ‘present entitlement’ to trust income, the beneficiary is assessable at their marginal tax rate. Where there is no ‘present entitlement’, the trust is assessable, generally at a flat 47 per cent rate without the CGT discount. This is usually why trusts are treated as flow-through entities for Australian tax purposes. Of course, the foreign income of a foreign trustee escapes both these provisions and s.99B fills the gap as a ‘catch-all’ provision.

Additionally, where an Australian resident has dealt with a foreign trust on a non-arm’s length basis, then that person may become an ‘attributable taxpayer’ and assessable on part of the foreign trust income on an attribution basis. Section 99B avoids double taxation in this case by allowing the attribution rules to apply in priority (these rules allow for the CGT discount).

Interesting questions arise where the ‘amounts’ under the above taxing provisions might be less than the ‘amount’ calculated under s.99B. It is possible that the excess is assessable under s.99B’s catch-all scope.

Expanding the web

Section 99C expands the web of what is caught within s.99B(1). The general rule in s.99C(1) aims to ensure that the application of the trust benefits for the beneficiary are not affected by the passage of time, swapping benefits or a series of transactions resulting in indirect benefits being provided to the beneficiary.

Section 99C(2) then deems certain amounts to be caught by s.99B. Trust payments, loans (interest and non-interest bearing), loan repayments and the enjoyment of trust property (among other things) are deemed to be ‘applied for the benefit of a beneficiary’. This is unusual (even disharmonious) as it deems the beneficiary to receive an assessable trust distribution even where they are acting in their capacity as a creditor or a debtor and not as a beneficiary.

It also treats the loan principal (the debt amount) as being assessable rather than merely any difference with, say, an arm’s-length interest rate. There is also no valuation guidance in relation to non-cash benefits, which could be open to interpretation.

Finally, the rules also appear to allow a tracing of amounts so that a genuine gift from a foreign relative to an Australian beneficiary that is sourced from a foreign trust might still be caught. The reductions in s.99C(2) discussed above are still available; however, the unusual outcomes that can arise make their application conceptually difficult.

Special cases

Foreign pension funds and returning executives

Australia has favourable rules relating to superannuation (retirement) funds. In some cases, concessional tax treatment is extended to lump-sum payments from foreign superannuation funds. Generally, this means withdrawing lump-sum amounts tax-free from the foreign pension fund within six months of establishing Australian tax residency.

However, most foreign pension funds may not qualify as a ‘foreign superannuation fund’. Based on case law, this is generally due to the foreign fund providing release of funds for more than simply retirement (at a prescribed age), death or invalidity (e.g., home ownership, medical expenses) and, therefore, concessional tax treatment is not available to them.

Such lump-sum withdrawals are therefore dealt with under s.99B instead (without concessions).

Deceased estates and testamentary trusts

Unusually, Australia’s deceased estate tax rules look at the residency status of the executor or the trustee/s and not the residency of the deceased. Therefore, where the executor is not an Australian tax resident, s.99B can apply.

In a general sense, the assets of the deceased form part of the corpus of the foreign estate/trust based on their market value on the date of death. Therefore, they should form part of the corpus reduction under s.99B(2), although this is not as clear where the deceased was an Australian tax resident. In any case, the earnings on those assets or of a testamentary trust that are paid to an Australian beneficiary would be assessable under s.99B.

Pre-migration trusts

If established appropriately, an inbound migrant could establish an offshore trust to hold their global wealth prior to becoming an Australian tax resident. This might manage Australia’s attribution rules but any payments to or on behalf of the Australian beneficiaries (included under the extended meaning in s.99C) would be assessable under s.99B.

The sting in the tail

In addition to s.99B taxing a trust amount at up to 47 per cent, an interest charge is also applied where the trust amounts were sourced in a jurisdiction that was not deemed to be comparably taxed to Australia^[2] or the amount was concessionally taxed in those listed comparable jurisdictions (e.g., capital gains in New Zealand).

That means that most trust payments from all other jurisdictions will attract an interest charge at the base rate published by the Reserve Bank of Australia on a 90-day yield bank accepted bill.

In general, the interest charge applies from the first income year after the amount was derived by the trustee up to the end of the year in which it is included in the Australian beneficiary’s tax return. This could be years.

This is in addition to the normal interest and penalty charges where the ATO may issue an amended assessment. An amount caught under s.99B will most likely come to the ATO’s attention from data matching with the Australian Transaction Reports and Analysis Centre.

Is there any credit relief?

A foreign income tax offset may be allowed where the trustee has paid tax on behalf of the Australian beneficiary. This is not always the case as mismatches can arise. For example, the foreign tax may be levied on a different amount, on a different taxpayer or on a different basis (e.g., IHT).

In addition, if the trust is located in a low-tax jurisdiction, there may be little relief from the Australian ‘top-up’ burden.

Is there a cure?

Generally, there is little that can be done once s.99B takes effect. The section is self-executing and does not rely on any tax avoidance purpose or mischief. As such, it can apply to ordinary family and commercial arrangements.

As is often the case, prevention is better than a cure. This means that prior to any relocation to Australia, high-net-worth families should plan their global tax affairs, accept that their worldwide income, assets and structures will come within the Australian tax net and, therefore, overlap across two (or more) jurisdictions.

Assets held personally will usually obtain a step-up in the tax cost base of their assets to market value at the time of becoming an Australian tax resident.

It may also be possible for offshore structures to obtain a market value uplift in their assets if they are ‘imported’ to Australia. However, this is not always as straightforward, so it may be simpler to wind them up instead (subject to exit taxes in the foreign jurisdiction).

Conclusion

Beneficiaries living in or migrating to Australia should be cautious of Australia’s punitive foreign trust rules. Although they were intended to disincentivise the alienation of income offshore, their application in a modern, globally mobile world can have unintended adverse consequences. Ordinary transactions, including the repatriation of foreign employment earnings, pre-migration wealth, foreign gifts and inheritances to Australian beneficiaries, can be caught with limited remedies.