In one sense, the High Court judgment in FCT v Carter [2022] HCA 10 (Carter) will come as welcome relief for tax advisors. That is, after dealing with the Australian Taxation Office’s (ATO) view of the ‘lore’ in the form of practical compliance guidelines, Carter turns minds back to the ‘law.’ Unfortunately, the law in Carter can result in unpleasant tax outcomes for certain trust beneficiaries.

Carter considered whether a (valid) disclaimer by a beneficiary of present entitlement to income of a trust was effective for purposes of section 97 of the Income Tax Assessment Act 1936. The High Court said ‘no.’ That is, despite the disclaimer an amount is still assessable under section 97.

This article focuses on the section 97 aspects of Carter. For the trust trainspotters, there is interesting analysis in the judgment of Gageler, Gordon, Steward, and Gleeson JJ about the relevance of assent to the concept of present entitlement and by Edelman J about the differences between a gift at common law and a declaration of trust. The former involves a transfer of rights while the latter involves a creation of equitable rights and obligations, may be unilateral, and not come to the attention of the beneficiary.

The legislative scheme

In Division 6, under section 97 the basic income tax treatment of the net income of a trust is to assess the beneficiaries on a share of the net income of the trust (“tax income”) based on their present entitlement to a share of the income of the trust (“trust law income”).

A criterion on which section 97 works is that a beneficiary "is presently entitled to a share of the income of the trust estate" (High Court’s emphasis).

A beneficiary is presently entitled to a share of the income of a trust estate "if, but only if: (a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and (b) the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment".

The issue in Carter, to quote the High Court:

… is one of timing. Specifically, is a beneficiary's present entitlement under s 97(1) – the present legal right to demand and receive payment of a share of the income of a trust estate – to be determined immediately prior to the end of a year of income by reference to the legal relationships then in existence, or can events after the end of the year of income, which may affect or alter those legal relationships, be considered?

The facts in brief and judicial history

The Whitby Trust was established in 2005. Mr Caratti and one of his children were joint guardians.

For the income year ended 30 June 2014, the trustee of the Whitby Trust did not resolve to distribute or accumulate income. As the trustee failed to appoint or accumulate the income, under the default clause in the Whitby Trust deed, the income of the trust for the 2014 year was held on trust for each of the primary beneficiaries, being the five children of Mr Caratti, in equal shares as tenants in common. (Three are of the children were the respondents in Carter).

On 27 October 2015, the Commissioner issued an amended assessment to the respondents for the 2014 income year which included as assessable income one fifth of the income of the Whitby Trust on the basis that the respondents were "presently entitled" to that income within the meaning of section 97.

On 3 and 4 November 2015, the respondents executed deeds of disclaimer in respect of their default distributions. Those disclaimers were ineffective. On 30 September 2016, the respondents executed further disclaimers (the Third Disclaimers).

The respondents objected to the 2014 assessments, contending, among other grounds, that each had by the Third Disclaimers disclaimed the distribution.

The Administrative Appeals Tribunal (AAT) held that the Third Disclaimers were ineffective because they were made after the respondents, with knowledge, had failed to disclaim and had accepted the entitlements to income.

The respondents appealed to the Full Federal Court on the AAT's finding that the Third Disclaimers were ineffective. By notice of contention, the Commissioner contended that the Third Disclaimers, even if effective at general law, did not retrospectively disapply section 97.

The Full Federal Court held that the Third Disclaimers were effective and dismissed the Commissioner's notice of contention. The Commissioner appealed to the High Court on the sole ground that the Full Federal Court erred in finding that the Third Disclaimers operated retrospectively to disapply section 97 in respect of the 2014 income year.

What did the High Court say?

The High Court - Gageler, Gordon, Steward, and Gleeson JJ, Edelman J agreeing – said that a disclaimer is not effective for purposes of section 97. Key points in the judgment were:

The appeal turned on the proper construction of section 97 Division 6.
The phrase "is presently entitled to a share of the income of the trust” in section 97 is expressed in the present tense. It is directed to the position existing immediately before the end of the income year.
The fact that section 97 is directed to identifying the legal right of the beneficiary immediately prior to the end of the year of income is important. In relation to each trust , once the beneficiaries with those rights are identified, it permits section 97 to operate and, consistently with the stated purpose of Division 6, provides for those beneficiaries to be assessed on a share of the net income of the trust based on their present entitlement to a share of the income of the trust .
The respondents’ contention that the phrase "is presently entitled" should be construed to mean "really is" presently entitled for that income year, such that, for "a reasonable period" after the end of the income year, later events could subsequently disentitle a beneficiary who was presently entitled immediately before the end of the income year, was rejected.
The question of the "present entitlement" of a beneficiary to income of a trust must be tested and examined "at the close of the taxation year", not some reasonable period after the end of the taxation year.

What does Carter mean?

The ATO says in ATO ID 2010/85 that a beneficiary having disclaimed income was not presently entitled for purposes of section 97. It is likely that the ATO will withdraw or amend ATO ID 2010/85. Taxpayers who relied on ATO ID 2010/85 have administrative protection against penalties and interest but not against tax if the ATO amends an assessment relying on Carter.

Taxpayers establishing discretionary trusts should consider whether it is still appropriate to include provisions that create a default distribution to individual beneficiaries in the event of the trustee failing to exercise its discretion (as is the case in many trust deeds). Not only does this expose the entitlement created to the commercial and relationship risks of the primary beneficiaries but based on Carter results in unavoidable taxation liability if the default distribution clause is triggered.

The High Court recognised, just as it had in the decision in FCT v Bamford (2010) 240 CLR 481, that the construction adopted by the Court may result in unfair outcomes from the resulting administration of the legislation. However, the High Court noted that these unfair outcomes arise because the legislation “and [section 97] in particular, is drafted to tax a beneficiary by reference to present entitlement, not receipt.“ This may be cold comfort to beneficiaries who find themselves subject to a tax liability arising on a default distribution but who must pursue the underlying entitlement (if there is one) at great expense. A new level of complexity in family law settlements may be just one such instance where advisors need to take an even greater level of care.

As we approach year-end, trustees, and advisors, need to be aware that once the trustee appoints income, presently entitled beneficiaries “just prior to midnight” on 30 June are assessed on their share of the net income of the trust under section 97. As Carter illustrates, default beneficiaries are in the same position as beneficiaries where the trustee appoints income.

A disclaimer after 30 June – including on 1 July – even if effective for trust law purposes will not absolve the beneficiary from the tax liability under section 97 on the share of the net income. The beneficiary would then be in the position of having to repay the distribution but still having to pay the tax.

As part of year-end tax planning, where there is an intention that a beneficiary (including default) will be presently entitled to income on 30 June, the beneficiary should be given notice of that intention before it is conferred or the default clause applies. After midnight on 30 June is too late.

Sladen Legal’s tax team regularly advises on Division 6 and section 97. If you have any questions about what Carter may mean for you and your arrangements, please contact:

Neil Brydges
Principal Lawyer | Accredited Specialist in Tax Law
M +61 407 821 157 | T +61 3 9611 0176
E: nbrydges@sladen.com.au

Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327 | T +61 3 9611 0105
E: dsmedley@sladen.com.au

Edward Hennebry
Senior Associate
T +61 3 9611 0113 | M +61 405 847 261
E: ehennebry@sladen.com.au