Be Aware of the Risks: Resident Trusts with Foreign Assets or Non-Resident Beneficiaries

Tony Nunes, Senior Client Director at Kelly+Partners Tax Legal, provides his insights into international tax planning and how trusts can be of advantage. He will also present at the 5th Annual Trusts Summit on 18 February in Sydney.

International tax planning is sometimes an afterthought rather than built into a business’ global strategy. Sometimes this stems from a silo approach within organisations, but often it’s due to a lack of awareness. Using a trust as part of the international global expansion structure can be effective, but the unique attributes, benefits and limitations of trusts should be taken into account prior to any trust being incorporated into any business’ group. This article highlights two issues that are unique to groups with Australian resident trusts in their global structure.

The Non-Portfolio Dividend Concession

Subdivision 768-A of the Income Tax Assessment Act 1997 (ITAA97) allows foreign dividend income derived by Australian resident companies whether directly or indirectly via a trust (and/or partnership) to qualify as non-assessable non-exempt (NANE) income. Under Subdivision 768-A, a foreign equity distribution received by a trust will be NANE income in the hands of the corporate beneficiary company if the conditions in sections 768-5(1) and (2) are satisfied. These conditions include, for example, the requirement that the amount is all or part of the net income of the trust that would otherwise be assessable to the company [1] and that the amount can be attributed (directly or via interposed trusts/partnerships that are not corporate tax entities) to a distribution made by the foreign company in respect of an interest in that foreign company.

Another key criterion is the requirement that at the time of the distribution the corporate beneficiary satisfies the participation test in relation to the foreign company that made the distribution. Broadly, this requires that the sum of the following is at least 10% [2]:

  • Direct participation interests if rights on winding-up are disregarded; and
  • Indirect participation interests if both rights on winding-up and interests held via corporate tax entities are disregarded [3].

However, there is an important timing issue with the participation interest requirement that applies to trusts. In Taxation Determination TD 2017/22 the Commissioner notes that the participation interest requirement cannot be met unless:

  • the beneficiary is entitled to (or entitled to acquire) the requisite percentage of income or capital of the trust; and
  • that entitlement exists as at the date that the distribution is made from the relevant foreign company [4].

Thus the participation interest requirement cannot be met where a foreign company makes the relevant distribution to the interposed trust on, for example, 30 December, but the corporate beneficiary’s present entitlement to income of the trust estate does not arise until 30 June of that income year. To ensure that the participation interest requirement is met, the interposed trust must make the corporate beneficiary presently entitled to the requisite percentage of the income or corpus of the trust for the relevant income year by no later than the date of the distribution from the foreign company.

Calculating the Foreign Input Tax Offset (FITO) on offshore CGT gains

An Australian taxpayer may be entitled to a FITO for foreign income tax paid where the foreign income that was taxed offshore is included is included in its Australian assessable income. ITAA97 only includes a “net gain” in assessable income. The application of capital losses and/or the 50% general CGT discount may mean that a capital gain derived offshore is not fully included in a taxpayer’s Australian assessable income, thus limiting the amount of the FITO.

In ATO ID 2010/75 the ATO took the view that whilst an individual Australian resident may pay foreign income tax on the whole foreign capital gain, it is only partly assessable in Australia. As such, only half the foreign income tax counts towards determining the foreign income tax offset under subsection 770-10(1) ITAA97. The recent case of Burton v FCT [2019] FCAFC 141 has confirmed this approach.

In Burton’s case, the Full Federal Court only allowed 50% of the FITO for US tax paid on the sale of long term investments. This approach highlights a problem with the FITO rules. The problem arises because the rules do not recognise that both the US and Australia allows concessions on capital gains made on long-term investments (ie assets held for more than 12 months) but the methods by which this is achieved are different in each country. The US taxes the capital gain by reducing the rate of tax, whilst Australia taxes capital gains by reducing the quantum of the gain, which is then assessed at the taxpayer’s full marginal tax rate. By only allowing 50% of the FITO the effective tax rate applied to offshore capital gains is significantly higher than the tax on Australian capital gains.

However one cannot assume that all foreign capital gains would have a disallowance of a portion of the FITO and result in a higher overall tax liability compared with the realisation of investments in Australia. The concessions granted on offshore CGT gains would need to be analysed jurisdiction by jurisdiction to determine the impact on the FITO given to the Australian resident.

Thus in summary, two key reasons for utilising a trust in a group structure is the flexibility a trust provides in distributing income to a range of beneficiaries and the ability to flow through tax attributes to the beneficiaries. However, there is dark side to these benefits – the non-portfolio dividend concession must be carefully managed and there may be a significant “penalty” on the disposal of assets in jurisdictions where their treatment of capital gains causes a loss of a portion of the Australian FITO. Not being aware of this dark side to trusts could mean that the use of a trust in the group structure significantly increases the tax cost of doing business offshore.

[1] Divisions 5 and 6 of Part III ITAA36 and Division 276 ITAA97.

[2] Section 768-15 ITAA97.

[2] Corporate tax entities cannot be ‘intermediate’ entities for the purposes of section 960-185 per section 768-15(b)(ii) ITAA97.

[3] Paragraph 62 of TD 2017/22.

If you would like more information on the above information Please contact Tony Nunes at Kelly+Partners Sydney.