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Allocation of income on redemption and other unit trust issues — the Federal Court decides in Colonial First State Investments

The Federal Court of Australia has handed down its decision in Colonial First State Investments Limited v Commissioner of Taxation (“Colonial First State”). The decision has been long anticipated by participants in the Australian funds management industry as it considers the tax effect of provisions in the constitution of a unit trust that seek to allocate part of the taxable income of the trust to a unitholder that redeems units in the trust.

A copy of the decision is available here.

Key points arising from the decision

Provisions relating to redemption entitlements are frequently used in the Australian funds management industry to, amongst other things, address the “last man standing” issue. This seeks to minimise the adverse tax impacts on continuing unitholders in trusts where other unitholders redeem units in the trust.

Doubt has been cast on the ability of certain trusts to allocate particular components of income (e.g. capital or other taxable gains) to particular unitholders

The Federal Court’s decision in Colonial First State emphasises the importance of the provisions in unit trust deeds that allocate income (on redemption or otherwise) being carefully and appropriately drafted. As discussed below, the drafting of the constitution of the unit trust in Colonial First State was not effective in allocating specific classes of taxable income of the trust (e.g. capital gains) to redeeming unit holders on redemption.

Concerns regarding the status of certain Australian unit trusts as “fixed trusts”

The decision also raises concerns regarding the status of Australian unit trusts as “fixed trusts” for Australian tax purposes. More specifically, the unit trust in Colonial First State was held not to constitute a fixed trust in view of its power of amendment. This would appear to support a narrow view as to what constitutes a fixed trust for tax purposes. Qualifying as a “fixed trust” is important for a unit trust for a number of reasons, such as the ability to carry forward tax losses and pass on franking credits to unit holders.

Proposed new MIT regime may resolve issues

The decision highlights some of the current limitations associated with the taxation of unit trusts under the existing rules. The Court reiterated the need for legislative clarification and reform in this regard.

It is anticipated that the proposed managed investment trust (MIT) attribution regime, if enacted as currently proposed with effect from 1 July 2011, will largely address many of the concerns raised as a result of this decision. This regime is expected to enable greater flexibility and certainty in relation to income attribution between unit holders as well as preserving the fixed trust status of MITs. The decision in Colonial First State has highlighted the importance of this regime to the Australian funds management industry. However, future developments will need to be monitored as draft legislation has not yet been released.

Summary of decision

In Colonial First State, the Court was required to consider the tax effect of certain amendments to the Constitution of a particular wholesale trust.

These amendments sought to, amongst other things, provide the responsible entity of the trust with a discretion to allocate the discounted and non-discounted capital gains to a unitholder who redeemed units in the trust as part of the amount received by the unitholder on redemption.

The Court found in favour of the Commissioner of Taxation that those provisions were not effective to allocate the capital gains of the trust to a redeeming unitholder.

This was because, amongst other things, the redeeming unitholders were not “presently entitled” to the income of the trust estate and the capital gains that were sought to be allocated to the redeeming unitholders were not included in the “income of the trust estate”. As this could not be established, whether the income allocated to a redeeming unitholder had the character of capital gains could not be considered.

The Court also found that the relevant unit trust was not a “fixed trust” for tax purposes. This was because the amendment power included in the constitution for the unit trust, in conjunction with the Corporations Act, gave the unitholders of the trust a power to amend unitholders’ entitlements to the income and capital of the trust.

Who does this affect?
Fund managers, responsible entities and unitholders who manage or invest in unit trusts, particularly those unit trusts that provide for the distribution of income on redemption.
What do you need to do?
Consider the impact of the Federal Court’s decision on the tax treatment of the trust and consider whether any changes to the constitution/trust deed are desirable, or even possible.

Author(s)

  • Cory Hillier - Senior Associate | Email
  • Kai-Chen Lamb - Senior Associate | Email
 

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