It is becoming increasingly common for Australian residents to have an interest in – or receive -distributions from a trust established overseas. It is also a situation that raises a wide range of complex tax issues and traps for the unwary, but which can be managed with careful planning.
Australians with family links to the UK will often have an interest in a trust established in a nearby low tax jurisdiction such as Jersey. There has also been a noticeable increase in instances of New Zealand citizens, who have a very low barrier of entry when it comes to living and working in Australia, having to deal with interests in trusts established in NZ where there can be important differences in the types of assets held (e.g. the family home may be held in a trust, something that would be very uncommon in Australia).
Distributions of income and capital gains received from foreign trusts
Australian tax residents are taxed on their worldwide income which would include distributions of income and capital gains received from a foreign trust. Where the individual also pays tax on the income, including withholding tax, in the foreign country, then a foreign tax offset will be allowed as a credit against the Australian tax payable.
Tax implications for “temporary residents”
Under the special concessions for individuals living in Australia under a temporary entry visa, i.e. those without Australian citizenship or permanent resident status, foreign-sourced investment income and capital gains will generally be exempt from Australian tax. It is important to note that NZ citizens, unlike those from other countries, will effectively be treated as temporary residents indefinitely unless they become Australian citizens.
When foreign-sourced income, other than a capital gain, is distributed to a temporary resident by a discretionary trust (irrespective of the residency status of the trust), the income will be exempt from Australian tax. This raises the question of how to treat foreign-sourced capital gains made by a non-resident trust and distributed to a temporary resident.
The ATO guidance is not entirely clear, and there is a risk of foreign capital gains being taxed to the individual under Section 99B of the tax legislation, with no ability to offset them against capital losses and no access to the CGT discount. If the foreign capital gains have been capitalised in the foreign trust and are later paid to a temporary resident as a capital distribution, however, it may be possible to avoid paying Australian tax on the distribution.
What else is taxed under Section 99B?
This is a wide-ranging section that operates to tax Australian residents on amounts received from foreign trusts, with several specific exceptions, most notably amounts from the trust corpus that would not normally be subject to tax in Australia.
Assume for example that Xavier’s grandparents in the UK set up an investment trust in Jersey for his benefit with a starting balance of £100,000, and he is able to withdraw the total balance of trust funds (£250,000) when he turns 25. Xavier is an Australian citizen living in Australia, and he is therefore not a temporary resident.
The trust corpus in this case is the original deposit of £100,000, which is tax-free, while the remaining £150,000 representing accumulated trust income must be converted into AUD at the current exchange rate and declared as assessable income in Xavier’s Australian tax return for the year in which the funds were paid to him.
In the Jersey trust example the income would not have paid foreign tax as it would have been specifically set up in a way that ensures the income was not taxed in the UK, so ultimately this represents a tax deferral, with Xavier paying Australian tax at his usual marginal rate on all of the trust’s accumulated income when he receives the payment.
In other situations, however, it is possible that tax may have been paid by the trustee in the trust’s country of residence, and because that tax was not paid by the Australian resident beneficiary, the beneficiary would not be entitled to a foreign tax credit in Australia.
It is common, for example, for a NZ trust to accumulate its income and have tax paid by the trustee because the trustee’s tax rate may be lower than the marginal tax rate of individual beneficiaries. This situation is unlikely to occur with an Australian trust.
As noted above, while Kiwis will generally have temporary resident status and be exempt from Australian tax on income distributions from foreign trust, the exemption does not extend to foreign-sourced capital gains made by a foreign trust and distributed to an Australian resident beneficiary (except perhaps where they are a temporary resident).
The Australian tax treatment of receipts from foreign trusts can be extremely complex, can lead to unexpected tax consequences for Australian residents if they are unaware of the rules and can even result in a degree of double taxation. The spectre of Section 99B looms large in situations such as this and has become an increasing area of focus for the ATO.
Combined with the increasingly extensive information sharing arrangements between tax authorities around the world and AUSTRAC transaction reporting requirements, this frequently triggers enquiries or even amended tax assessments where the ATO believes that amounts received from offshore may represent unreported income.
This article was first published in the 2023-24 Summer Issue of Financial Times.