Trust me... I’m the Tax Office
Tax Telegraph, August Issue
On 28 March 2012, the ATO issued Draft Taxation Ruling TR 2012/D1 which sets out the Commissioner of Taxation's (Commissioner) view on what constitutes "income of the trust estate" in the context of Division 6 of Part III (Division 6) of the Income Tax Assessment Act 1936 (ITAA 1936) and related provisions. When trustees are determining distributions, they must ensure that the apportionment of the "income of the trust estate" between beneficiaries determines the proportionate share of the net income of the trust to which beneficiaries are ultimately assessed on, as calculated under section 95(1) of ITAA 1936. This is in line with the High Court's decision in the Bamford case and will be subject to scrutiny by the ATO, along with trustee resolutions which determine these shares of income.
Once the ruling is finalised, it will apply retrospectively (with some limited exceptions), and accordingly, may apply to the determination of trust income for the current year.
The fundamental characteristics of a trust estate
The current taxation law for trusts is based around two key concepts:
- The income of a trust estate
- The net income of the trust.
Broadly, the 'net income' of the trust is defined in section 95 of the ITAA 1936 to be the trust's taxable income. However, there is no statutory reference to the 'income of the trust estate', and accordingly, it is determined by reference to the trust deed and legal precedent.
The Tax Act applies such that, if a percentage of the 'income of the trust estate' is distributed to a beneficiary, the same percentage of the trust's net income should be included in the beneficiary's income tax return as assessable income (referred to as 'the proportionate approach').
Trust net income may be different to trust income depending on how the trust deed is written. Some trust deeds equate trust income with net income where as other trust deeds will determine income of the trust estate to be according to ordinary accounting concepts or trust law concepts. In these circumstances differences in the definition of income may result in beneficiaries being taxed on amounts quite different to the actual cash distribution received.
Where no beneficiary is presently entitled to trust income (or a proportion thereof), the trustee will be taxed at the top marginal tax rate on any trust net income for which no beneficiary is presently entitled.
As the determination and apportionment of a trust's income is what drives the beneficiary's and trustee's tax liability, the meaning of 'income of the trust estate' has been the subject of dispute between taxpayers and the ATO. Following the Bamford case, most tax professionals understand the 'income of the trust estate' to be the amount defined in the relevant trust deed. Where the deed does not define income, it will generally be income according to ordinary concepts, which is accounting income.
The Draft Ruling
The draft ruling states that there is no set or static meaning of the expression 'income of the trust estate' and its meaning will depend principally on the terms of each trust deed and the general law of trusts. The income must be:
- Measured in respect of distinct years of income
- A product 'of the trust estate'
- An amount in respect of which a beneficiary can be made presently entitled.
Broadly, the draft ruling proclaims that, notwithstanding how a particular trust deed may define income, the 'income of the trust estate' for Division 6 purposes must be represented by a net accretion to the trust estate for the relevant purposes. In effect, there is a statutory cap on what the income of the trust estate may be for a particular year. Interestingly, there was no mention of a statutory cap in the Bamford decision.
This draft ruling specifically states that the income of the trust estate for an income year cannot be more than the sum of:
- The accretions to the trust estate (whether accretions of property, including cash, or value) for that year
- Less any accretions to the trust estate for that year which have not been allocated, pursuant to the general law of trusts (as that may be affected by the particular trust instrument), to income [and therefore cannot be distributed as income]
- Less any depletions to the trust estate (whether depletions of property, including cash, or value) for that year which, pursuant to the general law of trusts (as that may be affected by the particular trust instrument), have been allocated as being chargeable against income.
According to the ruling, where a trust deed equates the income for trust purposes with the net income, there are limits on the extent to which notional income amounts included in net income can be included in the income of the trust estate. Notional income includes a notional amount of assessable income included in the trust's net income such as franking credits attached to franked dividends, capital proceeds for a capital gains tax (CGT) event as a result of the market value substitution rule in section 116-30 of the Income Tax Assessment Act 1997 and Division 7A deemed dividends.
To illustrate this issue consider the following:
|Taxable income of trust||Accounting income|
|Franked dividends||$70||Franked dividends||$70|
|Franking credits||$30||Net rental loss||($90)|
|Net rental loss||($90)||Accounting loss||($20)|
Having regard to the Commissioner's ruling where the trust deed defines the 'income' of the trust to be net income, it cannot be $10. Therefore even if the resolution was expressed as 'Beneficiary 'A' is entitled to 100% of the income' the income (including franking credits) cannot be distributed to the beneficiary.
The majority of modern trust deeds contain an income definition clause, with many deeds having an income equalisation clause or the power to reclassify amounts as income or capital, ultimately giving the trustee the power to determine the income of the trust estate.
Income equalisation clauses provide simplicity by ensuring that beneficiaries are taxed on what they receive and guaranteeing the trustee is not taxed at top marginal rates.
However, the draft ruling states that a trust deed which equates trust income with net income can only include notional income amounts to the extent that they are matched by notional expenses. Therefore even where a trust deed defines income of the trust to mean net income (being taxable income), there may still be a discrepancy between the income of the trust estate to which beneficiaries are presently entitled and the taxable income on which the beneficiaries are ultimately assessed.
This ruling emphasises the importance for trustees to review any income clauses or definitions in the trust deed and to consider if there will be any substantial notional income or expenses in the trust.
As Treasury is currently undertaking a comprehensive review of the trust taxing provisions with a Division 6 policy paper expected to be released in September 2012, it is clear that trusts are likely to face continued scrutiny from the ATO for many years to come.
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