Accounting Treatment of Unrealised Capital Gains by TurksLegal

Accounting Treatment of Unrealised Capital Gains A PAPER BY PAUL ANDERSON AUGUST 2009

Accounting Treatment of Unrealised Capital Gains

Summary A recent Supreme Court decision raises a question of interest to accountants, namely the appropriate treatment for accounting purposes of unrealised capital gains on investments owned by a Trust.

Who Does This Impact? Accountants, Trustees and other persons actively involved in the administration of Trusts.

What Action Should Be Taken? Interested parties should review the terms of the relevant Trust Deed and the accounting treatment adopted.

Contents:

TURKSLEGAL

Facts

Income v Capital

Trusteeâ&#x20AC;&#x2122;s Determination

Release

Conclusion

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Accounting Treatment of Unrealised Capital Gains by Paul Anderson

The recent Supreme Court decision of Wood v Inglis raises questions of interest to accountants. In particular, it deals with the appropriate treatment for accounting purposes of unrealised capital gains on investments owned by a Trust.

Facts Dr William Inglis died on 11 October 2007 survived by four adult children from his first marriage, his second wife, Helen, and an adult son from his second marriage. On 22 September 1982 he had established a discretionary Family Trust called ‘The Inglis Research Trust’, of which he, his wife and children were the potential beneficiaries. The Trustee was Inglis Research Pty Limited. Dr Inglis held 8 out of 10 shares in the company and was also a director with his wife and one of his children. In practice, income was distributed each year to Dr Inglis and/or his wife, Helen, and credited to their beneficiary loan accounts, on which they drew for living expenses. The Trust funds were mainly invested in shares which, by the time of Dr Inglis’ death, were worth over $2 million. Between 1982 and 1998, the Trust accounts were prepared by Ernst & Young on the basis that the share portfolio was valued at the lower of cost and net realisable value. Following a change of accountants in 1998 to a Mr Tierney, the accounts were prepared on the basis that the share portfolio was revalued each year to market value and the net movement in the value of investments was treated as income. As a result, at the time of his death, Dr Inglis’ loan account stood at $1,357,588. Mr Tierney adopted this approach in the mistaken belief that this had always been the approach on which Ernst & Young had prepared the accounts. The change in the approach was to have significant and dramatic consequences. By his Will dated 7 December 2005, Dr Inglis left the residue of his estate, which included his Trust loan account, to Helen. In a Memorandum of Wishes in respect of the Trust, he expressed the wish that the net assets of the Trust be distributed equally among his five children. Following the death of Dr Inglis, his four children by his first marriage formed the view that Mr Tierney’s accounting treatment was mistaken and inappropriate and should be reversed. A new set of accounts was prepared on the basis that investments were shown at lower of cost or realisable value and Dr Inglis’ loan account was reconciled to a new figure of $61,900, i.e. a reduction of approximately $1.2 million. Legal proceedings were instituted effectively between Helen and the children of the first marriage. The practical impact of the dispute was that the sum of $1.2 million was either an asset of the residuary estate to which Helen alone was entitled or an asset of the Trust to be shared among the children.

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Accounting Treatment of Unrealised Capital Gains by Paul Anderson

Income v Capital Could the Trustee lawfully treat movements in the value of investments as income as distinct from capital? The defendants argued that such movements were ‘unrealised capital gains’ and not income. Clause 6(f ) of the Trust Deed empowered the Trustee to determine whether any property or money constituted capital or income and the Trustee’s decision in this respect shall be binding….

Justice Brereton accepted that income tax decisions were not irrelevant but were also not decisive. Two independent expert accountants were called but gave conﬂicting opinions. However, they both agreed that market value accounting methodology was ‘permissible’ if ‘imprudent’. Nothing in the Trust Deed precluded the Trustee from adopting such methodology. This conclusion was only reinforced by clause 6(f ) which was clearly designed to avoid disputes as to whether receipts, proﬁts and distributions were capital or income by empowering the Trustee to make a determination.

Trustee’s Determination The next step was whether the Trustee had in fact determined to treat movements in the market value of investments as income. Mr Tierney had mistakenly adopted the new accounting policy while under a misapprehension as to the approach adopted by his predecessor. However, he did not suggest that this was at the request of Dr Inglis and the Judge found that there was no express resolution of the Trustee or express direction by Dr Inglis to Mr Tierney to change the methodology from historical cost to market value accounting. Clause 10 of the Trust Deed required the Trustee to prepare a Balance Sheet and a Profit and Loss Statement at the end of each year. Mr Tierney had duly prepared such financial statements for each of the 1999 to 2006 financial years. The financial statements had been forwarded to Dr Inglis for signature and they were returned without comment. Dr Inglis also signed a Company Minute approving and adopting the accounts of the company, including a right of indemnity from the Trust. Dr Inglis took an active interest in the affairs of the Trust. Comments made in his lifetime to at least one of his children suggested that he was aware of the approximate balance of this loan account and that the loan account would form part of his Estate. In his Honour’s view, these comments demonstrated knowledge and approval of an amount in the loan account that could only stand if market value methodology had been adopted. It was true that the Trust’s income tax returns and Dr Inglis’ personal income tax returns reflected a different approach. These were prepared on the basis that unrealised capital gains were not taxable. However, it was not uncommon to have different treatments of income for a trust itself and its income tax returns.

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Accounting Treatment of Unrealised Capital Gains by Paul Anderson

Year in and year out after 1999 the Trustee (by Dr Inglis) accepted accounts prepared by his accountant on the basis that treated increases in the value of investments as income (and distributed them ultimately to Dr Inglis’ beneﬁciary loan account).

To the judge’s mind ‘it was of great signiﬁcance’ that Dr Inglis made his last Will on the footing that a substantial loan account of the Trust would form an asset of his Estate. That was a result that could only be consistent with adoption of market value methodology in the accounts. The power under clause 6(f ) was sufﬁciently exercised when the Trustee accepted the annual accounts on the basis that unrealised capital gains were income each year. There was no requirement for that decision to be made by instrument in writing.

Release The four adult children had arranged for the accounts to be rewritten on the basis that unrealised capital gains were not recognised as income. On two separate occasions, Helen signed a Minute at the request of the children authorising the preparation of the accounts on this basis. However, when asked to sign a formal Deed of Release and Indemnity Helen declined and required an ‘independent audit’. What was the effect of the two signed Minutes? His Honour held that Helen had only signed the Minutes in her capacity as a director of the Trustee company. To change the loan account balance, the Trust would need a formal Deed by Helen in her capacity as Executor of the Will and Helen had declined to sign such a Deed. This had all occurred within two months of the ‘catastrophic loss’ of her husband at a time when she had never received the beneﬁt of independent legal advice. In short, the signed Minutes had no impact on the ultimate outcome of the case.

Conclusion The most interesting aspect of the decision is probably the Judge’s view that clause 6(f ) of the Trust Deed permitted the Trustee to determine whether an item was income or capital. Common sense would suggest that there is a limit to how far such a clause will run. For example, could a Trustee determine that an item was capital in the face of a unanimous consensus among accountants that it was income? Accounts for Trust and income tax purposes can and frequently do adopt differing approaches. However, there is little doubt that the Commissioner of Taxation will object if an income tax return is prepared on the basis of a Trustee’s determination that an item is capital rather than income or vice versa when the Commissioner’s view is to the contrary.

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Accounting Treatment of Unrealised Capital Gains by Paul Anderson

For more information, please contact:

Paul Anderson Partner T: 02 8257 5742 paul.anderson@turkslegal.com.au

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