On 31 July 2024, the ATO released the following draft guidance in relation to section 99B of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936):

• Draft Taxation Determination - TD 2024/D2 Income tax: factors taken into account in applying the exceptions to section 99B of the Income Tax Assessment Act 1936 contained in paragraphs 99B(2)(a) and 99B(2)(b) (Draft TD); and
• Draft Practical Compliance Guideline - PCG 2024/D1 Section 99B of the Income Tax Assessment Act 1936 - ATO compliance approach (Draft PCG).

Comments on the Draft TD and Draft PCG are due on 28 August 2024.

It is intended that the guidance will apply with retrospective effect, once finalised.

Section 99B - Background

Aside from subsection 99B(1), the provisions of Division 6 of Part III of the ITAA 1936 only assess a beneficiary on the net income of a trust, based on their entitlement to trust income.

Subject to limited exceptions, subsection 99B(1) provides for the inclusion in the assessable income of a beneficiary of a trust, of amounts (being trust property) paid to, or applied for the benefit of, that beneficiary, where the beneficiary was an Australian tax resident at any time during the income year in which the amount was paid or applied.

The explanatory memorandum (EM) to the act which introduced section 99B explained that section 99B 'will normally apply where accumulated foreign-source income of a non-resident trust estate … is distributed to a resident beneficiary.' However, there is ongoing uncertainty regarding its application to resident trusts (which is discussed below).

The assessable income of a beneficiary under subsection 99B(1) is reduced by certain amounts, under two key exceptions, which proceed on the basis of a 'hypothetical resident taxpayer':

1. the 'corpus exception' - under paragraph 99B(2)(a), an amount that represents corpus of the trust estate, except to the extent to which it is attributable to amounts derived by the trust that, if they had been derived by an Australian resident taxpayer, would have been included in the assessable income of that Australian resident taxpayer in an income year ; and

2. the 'non-taxable exception' - under paragraph 99B(2)(b), an amount that, if it had been derived by an Australian resident taxpayer, would not have been included in the assessable income of that Australian resident taxpayer in an income year.

The harsh consequences of section 99B are compounded by the fact that the Australian beneficiary may also be assessable on an interest charge on the distribution (as a consequence of the deferral of Australian tax), calculated broadly from the income year following the income year in which the income or profits distributed were derived (or 1 July 1990, whichever is later).

Draft TD

The Draft TD provides guidance on the ATO's approach regarding the 'hypothetical resident taxpayer for the purposes of paragraphs 99B(2)(a) and (b).

In particular, it sets out the ATO's views on:

• the characteristics of the hypothetical taxpayer being limited to residency;
• the need to have regard to the circumstances that gave rise to the relevant amount in the hands of the trustee; and
• the relevance of the source of the amount paid or applied to the beneficiary.

The ATO illustrates its views on these issues through the use of a number of examples in the Draft TD.

The ATO has previously expressed its views regarding the hypothetical taxpayer test posited by paragraphs 99B(2)(a) and (b) in Taxation Determination TD 2017/24 – Income tax: where an amount included in a beneficiary's assessable income under subsection 99B(1) of the Income Tax Assessment Act 1936 (ITAA 1936) had its origins in a capital gain from non-taxable Australian property of a foreign trust, can the beneficiary offset capital losses or a carry-forward net capital loss ('capital loss offset') or access the CGT discount in relation to the amount?

In TD 2017/24 the ATO indicates that the hypothetical taxpayer posited by paragraphs 99B(2)(a) and (b) is:

1. a resident, but it cannot be assumed that this hypothetical taxpayer has other characteristics - for example, that it is an entity eligible for the CGT discount; and

2. not the trustee of the trust, but an entirely separate, fictional entity.

The Draft TD is broadly consistent with the ATO's previous guidance and the jurisprudence. It does not represent a major shift in the ATO's approach to section 99B.

Characteristics of the hypothetical taxpayer

The ATO confirms that the characteristics of the hypothetical taxpayer are limited to those expressed in the hypothesis under paragraphs 99B(2)(a) and 99B(2)(b) – namely, residence in Australia. It cannot be assumed that the hypothetical taxpayer has any other characteristics, such as being an individual, trust, or company.

Therefore no CGT discount would be available to the hypothetical taxpayer (given the CGT discount is only available to individuals, complying superannuation entities and trusts).

In this regard, the comments made in the Draft TD are substantially the same as those which the ATO has previously made in TD 2017/24 regarding the characteristics of the hypothetical taxpayer.

Characteristics of the amount

The ATO's view is that the circumstances of derivation, being the factors attributable to the transaction that generated the amount, can be considered in the hypothesis. The characteristics of the amount encompass the circumstances (and the tax attributes arising from them) that result in the trust estate receiving the amount (for example, funds or assets) which is subsequently distributed to an Australian beneficiary, thus triggering the operation of subsection 99B(1).

Example 1 in the Draft TD illustrates that when determining whether or not a capital gain arising from a CGT event A1 would be assessed in the hands of the hypothetical taxpayer, consideration is given to whether or not the asset was acquired before 20 September 1985. If it was, then the CGT provisions would operate to disregard the capital gain such that the amount attributable to the capital gain would not be included in the assessable income of the hypothetical resident taxpayer.

Example 4 in the Draft TD illustrates that where the asset disposed of is not a pre-CGT asset, then the amount (if any) by which the proceeds exceed the cost base represents a gain which would be assessable to a hypothetical resident taxpayer. To that extent, the proceeds distributed would be assessed to the beneficiary under subsection 99B(1) and the remainder would not be.

From these examples it is clear that a capital gain arising from the disposal of pre-CGT assets by a trustee should not be brought to tax by virtue of section 99B. This is useful guidance for trusts that hold pre-CGT assets.

The Draft TD also includes other examples in relation to the relevant circumstances of derivation, such as a distribution from a non-resident deceased estate (and the operation of Division 128 of the Income Tax Assessment Act 1997 (Cth) to modify the cost base and reduced cost base of the CGT asset in the hands of the legal personal representative, executor or beneficiary).

Source of the amount

In addition, the ATO expresses the view that paragraphs 99B(2)(a) and (b) require a determination of what the relevant amount received by the beneficiary represents and is attributable to. That is, the hypothetical resident taxpayer test requires determination of what the amount ultimately represents, which involves tracing through transactions to determine the ultimate source of the amount.

Example 6 of the Draft TD illustrates that where a non-resident trust:

• derives substantial income from a lending arrangement in an income year;
• uses a portion of that income in a subsequent income year to acquire a CGT asset that is later disposed of at a loss; and
• distributes the proceeds of sale to a resident beneficiary,

it is necessary to trace through the capital gains transaction to the source (being the interest income from the lending arrangement) for the purposes of determining whether the amount would be assessable to the hypothetical resident taxpayer, given the hypothetical taxpayer would not have been assessable on the proceeds from the sale of the CGT asset (as the asset was realised at a loss).

It is worth noting that the ATO does not cite any authorities for taking the position that there is an obligation to trace.

Draft PCG

The Draft PCG provides guidance on the ATO's approach to section 99B for arrangements where property of a non-resident trust (or trust property accumulated while a trust was a non-resident) is paid or applied for the benefit of a resident beneficiary. In particular, the Draft PCG provides clarity on:

• common scenarios where section 99B may need to be considered;
• record keeping where reliance is sought to be placed on an exception; and
• the ATO's compliance approach for scenarios considered to be low risk.

Common section 99B scenarios

The ATO confirms that section 99B is in play where a resident beneficiary receives trust property from a non-resident trust estate in circumstances involving distributions of funds, asset transfers, use of trust property, loans or amounts received from deceased estates.

The ATO puts taxpayers on notice that common scenarios where section 99B will need to be considered include:

• a non-resident migrating to Australia and winding up their non-resident trust after becoming a resident;
• a distribution out of accumulated profits by a non-resident trust to a beneficiary who is an Australian resident taxpayer;
• a gift of funds by a non-resident trust to a resident beneficiary;
• a loan of funds by a non-resident trust to a resident beneficiary;
• the trustee of a non-resident trust allowing a resident beneficiary to use trust property;
• a resident beneficiary receiving an amount from a non-resident deceased estate; and
• a resident beneficiary receiving a loan from a non-resident trust which is later forgiven.

These examples evidence the potential breadth of section 99B, which may not have been appreciated by some taxpayers and their advisors.

Record keeping

While recognising that it can be challenging to obtain the relevant documents/information from a non-resident trustee, the ATO highlights that the onus is on the resident beneficiary to provide sufficient evidence to substantiate the application of the 'corpus' exception or 'non-taxable' exception. If the onus cannot be met, the exception will not be available.

For the 'corpus exception', the core documents that taxpayers will be expected to provide to evidence that an amount was paid or applied from the trust's corpus include the executed trust deed (or will), minutes/resolutions and distribution statements and the trust's financial accounts (prepared in accordance with relevant accounting principles).

Further documentation required to support the 'corpus exception' or the 'non-taxable exception' will be determined by the ATO on a case by case basis. The Draft PCG provides a non-exhaustive list of potentially relevant documents/information and provides a number of examples where the sufficiency of evidence is tested. From these examples, it is evident that:

• it will not be sufficient for a resident taxpayer to provide a trustee resolution confirming payment of an amount from trust corpus in circumstances where no further documentation or information can be obtained from the trustee; and
• the financial statements for the non-resident trust must be prepared in a manner which clearly identifies the source of the payment to the resident beneficiary. This will often have its challenges.

This is consistent with the approach in Campbell v Commissioner of Taxation [2019] AATA 2043 (Campbell), that in order to establish that the 'corpus exception', the taxpayer is required to produce evidence that is consistent and reliable, and which establishes the distributions were from corpus.

In Campbell, the taxpayer's evidence was found to be inconsistent and unreliable as the evidence included two sets of contradictory financial statements (without a sufficient explanation of the relevant amounts) and only trustee resolutions/minutes for the first set of financial statements, and not the revised financial statements.

It is therefore important for taxpayers and their advisors to maintain accurate and consistent records for the purposes of relying on the 'corpus exception'. Although Campbell is an example of when records would be regarded as insufficient, the additional guidance in the form of the Draft PCG should assist taxpayers and advisors with meeting the substantiation requirements when seeking to rely on the 'corpus exemption'.

Compliance approach for low risk arrangements

The ATO confirms that two key scenarios will be considered low risk and for those arrangements which meet the low risk criteria, the ATO will not dedicate compliance resources to consider the application of section 99B other than to confirm that the required low-risk features are present. The identified low risk arrangements are:

1. Deceased estates involving a distribution by the executor of trust property from a non-resident deceased estate. The trust property must be distributed to the resident beneficiary within 24 months of the date of death and the total value of trust property received by the resident beneficiary, whether in multiple payments or one lump sum payment, must not exceed AUD2 million at the time of payment/application.

2. The provision of trust property by the non-resident trust to a resident beneficiary on commercial terms. There must be a written or verbal agreement (which can be substantiated with appropriate evidence) for the beneficiary to borrow, hire or use property on commercial terms. Importantly, the resident beneficiary must make a physical payment to the trustee equal to the interest, hire or use per the commercial terms. The rate applied for the interest, use or hire (and the broader terms of the agreement) must be consistent with market rates for the same or similar circumstances. Loans which apply the Division 7A benchmark rate and terms will be accepted for these purposes, as being on commercial terms.

Important issues not addressed

Residence of the trust

Despite the comments in the EM, the relevant case law and a literal reading of section 99B do not clearly support the position that section 99B is limited to applying to:

1. non-resident trusts that distribute foreign source income to Australian resident beneficiaries; and

2. Australian resident trusts that distribute accumulated foreign source income to Australian or non-Australian resident beneficiaries.

In Traknew Holdings Pty Ltd v FCT (1991) 21 ATR 1478, 1492, Hill J said that the application of section 99B to an Australian resident trust 'presents difficulty' but did not need to decide 'whether the extreme width of section 99B and associated sections require it to be read down having regard to the obvious legislative purpose in enacting it'. The reference to 'extreme width of section 99B' could be interpreted as suggesting that section 99B is capable of having wide application, including Australian resident trusts that distribute accumulated Australian source income to Australian resident beneficiaries.

As a result, this is an ongoing issue for the application of section 99B in relation to which guidance is required.

Unfortunately, the guidance does not confirm whether or not the ATO would seek to apply subsection 99B(1) in the case of Australian-resident trusts. However, it is noteworthy that the examples provided in both the Draft TD and Draft PCG relate solely to non-resident trusts. Further the Draft PCG is intended to provide guidance on the ATO's approach to section 99B in respect of arrangements where property of a non-resident trust (or trust property accumulated while the trust was a non-resident), may be interpretated as meaning the Draft PCG does not apply to resident trusts.

The hypothetical taxpayer test and the 'look through' approach

While the Draft TD does not address tracing through multiple layers of trusts, the case of Howard v Federal Commissioner of Taxation [2012] FCAFC 149 (Howard) confirms that paragraph 99B(2)(a) operates on a 'look-through' basis where there are interposed trusts (whether Australian or foreign resident trusts) between the ultimate recipient individual and the source of the payment.

It is curious that the Draft TD does not address this issue (or include any examples regarding this issue), given the other issues which the ATO has commented on, and the fact that the ATO does rely on other comments made in Howard in relation to the characteristics of the hypothetical taxpayer.

Broadly, in Howard, Mr Howard (an Australian resident) was the beneficiary of an offshore discretionary trust (the Esparto Trust). Mr Howard had certain amounts paid to him, or applied for his benefit, by the Esparto Trust. The amounts consisted of distributions of corpus of the Esparto Trust (a Jersey resident) that were sourced from corpus distributions from the Juris Trust (a Jersey resident) and were received by the Esparto Trust in its capacity as beneficiary of the Juris Trust. The distributions of corpus from the Juris Trust were in turn sourced from the proceeds of a share buyback received by the Juris Trust in connection with a purchase back by Esparto Ltd (a Jersey resident) of the shares held in the company by Juris Trust.

In applying paragraph 99B(2)(a), the Full Federal Court found that Mr Howard's role as a resident taxpayer is 'subsumed by the hypothesis that the Esparto Trust estate is a resident taxpayer', which in turn is 'supplanted by the Juris Trust estate’s role as a hypothetical resident taxpayer'. Accordingly, although there were two layers of trusts between Mr Howard and Esparto Ltd, the question is simply whether the amounts received by Juris Trust from Esparto Ltd would have been assessable income had it been derived by an Australian resident taxpayer. The Full Federal Court said that section 99B(a)(a) then 'conveys that result through the overlying layers of trusts back to Mr Howard'.

Given the application of the 'look-through' approach was considered in respect of the 'corpus exception' only, guidance from the ATO in relation to whether the same approach applies in respect of the 'non-taxable exception' would be welcome.

While the guidance, in particular the Draft PCG, is valuable, it is clear that taxpayers and advisors should be alive to the risk posed by subsection 99B(1) and distributions need to be managed very carefully.

Please contact us if you would like to know more about how the ATO's draft guidance.