Family Trust

What is a Trust Beneficiary?

A beneficiary in the context of a trust is an individual, company or another trust that has been designated to receive benefits from the trust’s assets or income. These benefits are determined by the specific terms set out in the trust deed, which is the legal document that establishes the trust and outlines how it will be managed and by whom.

The benefits received can be in various forms, such as cash distributions, property, or other assets, and can be distributed at specified times, under certain conditions, or at the discretion of the trustee.

Primary Beneficiaries

These are individuals explicitly named in the trust deed, often at the core of the trust’s establishment. Commonly, these include spouses or de facto partners who are the initial focus of the trust’s benefits. The trust deed directly specifies these beneficiaries, making their entitlements clear from the outset.

General Beneficiaries

This group extends beyond those explicitly named, including individuals related to the primary beneficiaries by blood or marriage. It typically includes children, grandchildren, and potentially more distant relatives such as parents and grandparents. The inclusion of general beneficiaries allows the trust’s benefits to potentially extend to a broader family network, although their entitlements are still subject to the trustee’s discretion. General Beneficiaries are usually included in most modern trust deeds.

Income or Capital Beneficiaries

Trust deeds may differentiate beneficiaries based on the type of benefit they receive. Specifically, between income and capital. Income beneficiaries are entitled to the earnings generated by the trust’s assets, such as interest or rental income, but do not have rights to the underlying capital assets. This distinction allows for precise control over the trust’s distributions.

In contrast, capital beneficiaries have rights to the trust’s principal or capital assets but may not receive the generated income. This description can be critical for long term asset management and estate planning, ensuring that the trust’s capital growth benefits the intended parties.

Default Beneficiaries

These beneficiaries serve as a contingency mechanism within the trust structure. Should the trustee not distribute the trust’s income or capital within a given fiscal year, default beneficiaries are entitled to these undistributed benefits.

Utilising default beneficiaries is a strategic measure to prevent the trust from incurring the highest marginal tax rate on undistributed income, as it ensures that all income is attributed to beneficiaries rather than accumulating within the trust.

Trust Beneficiary Rights

Right to Information About the Trust

Beneficiaries are entitled to know about the trust’s existence, its terms, and how it’s being managed. This includes being informed about the trust’s assets and the decisions made by trustees. Beneficiaries can request financial statements or accounts from the trustees. These documents show how the trust’s assets are being managed, including any income generated or expenses incurred.

Right to Enforce the Trust

If beneficiaries believe the trust is not being managed in accordance with its terms or their best interests, they have the right to take legal action. This ensures trustees cannot misuse the trust’s assets or act against the beneficiaries’ interests.

Limitations on Beneficiary Rights

While beneficiaries have significant rights, there are limitations. For example, a trustee has discretion in distributing assets for discretionary trusts, and beneficiaries might not challenge these decisions if the trustee acts within the trust’s terms and their discretion.

What is a Trustee?

A trustee refers to one or more individuals or a company assigned the legal responsibility to hold and manage a trust’s assets. This role involves administering the trust strictly in accordance with the trust deed, which is the document that officially sets out the terms and conditions of the trust’s operation.

The trust deed grants the trustee legal ownership of the trust’s assets with the explicit purpose of managing these for the advantage of the beneficiaries. The trustee’s actions are governed by both the trust agreement and trust law, emphasising the importance of integrity, diligence, and fairness in the execution of their duties.It is also common for the deed to empower the trustee to distribute the trust’s assets or income to the beneficiaries.

The trustee cannot be the only beneficiary of a trust in which he/she acts as the trustee. This is because a trust is a relationship whereby a person (the trustee) holds legal ownership of certain assets for the benefit of another person(s) (the beneficiary). If the trustee was the sole beneficiary of the trust, both the legal ownership of the trust assets and the right to benefit from those assets would reside in the one person, i.e. the trustee. There would therefore be no trust in existence.

Trustee Duties

Acting in Good Faith

A trustee should manage the trust’s affairs with honesty and integrity. This means that all actions taken by the trustee should be done with transparency and without any intent to mislead or deceive the beneficiaries or other involved parties.

Exercise Reasonable Care

Exercising Reasonable care demands that a trustee manages the trust with a level of care and diligence that would be reasonably expected from someone in their position. This involves making prudent decisions regarding the trust’s assets, such as investments, distributions, and other financial matters. The expectation is that a trustee will make informed decisions that are in the best interest of the trust and its beneficiaries.

Maintain Accurate Records

Maintaining Accurate Records is essential for a trustee to demonstrate transparency and accountability. This involves keeping detailed records of all transactions, distributions, and decisions made in relation to the trust’s assets.

Avoid Conflicts of Interest

This requires a trustee to manage the trust in a way that their personal interests do not interfere with their duties. A trustee must avoid situations where their personal gain could conflict with the interests of the trust or its beneficiaries. This duty is crucial for maintaining the integrity of the trust and ensuring that decisions are made solely in the interest of the beneficiaries.

Fulfilling the Trust Terms

Fulfilling the trust’s terms mean adhering strictly to the conditions and stipulations outlined in the trust deed. Trustees must ensure that the trust is administered exactly as intended by the settlor, respecting the wishes of the settlor regarding asset distributions, beneficiary benefits, and other key aspects of the trust’s operation.

Not Benefit from Their Position

A trustee must not derive any personal benefit from their role in administering the trust, except as explicitly allowed by the trust’s terms or by law. This ensures that the trustee’s actions are motivated by the best interests of the beneficiaries rather than personal gain.

Individual vs Corporate Trustee

An individual trustee(s) refers to one or more individuals granted legal title to the trust’s assets to manage for the benefit of the trust’s beneficiaries.

Advantages & Disadvantages of an Individual Trustee

The advantages of appointing an individual trustee in managing a trust stem primarily from the simplicity associated with this option. Unlike corporate trustees, which require the formation and maintenance of a separate legal entity, individual trustees eliminate the need for additional steps and the associated costs.

A significant risk associated with individual trustees is the potential for incapacity. Should a sole trustee become unable to manage the trust due to health issues or other incapacitating conditions, it complicates the trust’s management. Without clear legal provisions for automatic removal or replacement, confusion may arise among beneficiaries about who will assume control, potentially necessitating the appointment of a new trustee, which could be a complex process.

In cases of bankruptcy, an individual trustee‘s personal financial troubles can spill over into the trust‘s management. Distinguishing between personal assets and those held in trust becomes challenging. This blurring of lines can lead to the trustee‘s creditors targeting the trust‘s assets, undermining the trust‘s purpose and the beneficiaries‘ interests.

The death of a sole individual trustee introduces significant administrative hurdles. Initially, all trust assets default to vesting with the Public Trustee, creating a vacuum in management until a successor is appointed. The process of appointing a new trustee involves executing a new trust deed and transferring all assets to the successor, a procedure that can be both complex and time consuming.

Advantages & Disadvantages of a Corporate Trustee

A corporate trustee is a company that acts as a trustee, as opposed to one or more individuals acting as trustee.

A trustee company should normally operate solely as a trustee and not conduct business or investment activity in its own right. Although trust assets are held on behalf of the beneficiaries, a trustee has the formal legal title to trust assets. Theoretically, assets held on behalf of beneficiaries should not be available to litigants of a trustee company conducting its own business. However, to avoid confusion and potential legal claims, it is best practice to use a trustee company solely as a trustee. It is possible to use a trustee company as a beneficiary of a trust (providing the company is not the sole beneficiary) however accurate records would need to be kept to distinguish between the company’s activities vs the trust’s activities. In reality, best practice is not to use a company trustee as a beneficiary.

Perpetual Succession

A key benefit of a corporate trustee is its ability to ensure perpetual succession. This means that the management of the trust can continue uninterrupted even if a director passes away or leaves the company. The process for addressing such changes involves simply appointing new directors without the need to transfer asset titles. This continuity is invaluable for beneficiaries relying on trust distributions, minimising delays in the management of their financial interests.

Limited Liability Protection

A corporate trustee provides an additional layer of financial protection through limited liability. Since the company is recognised as a separate legal entity, it bears the responsibility for any financial obligations or debts, rather than the directors personally. This arrangement shields the directors’ personal finances from the trust’s liabilities, offering peace of mind and financial security.

In situations where a director faces bankruptcy, the assets within the trust remain secure and unaffected. The clear legal distinction between the trust’s assets and the personal assets of the director ensures that trust funds are insulated from individual financial issues, maintaining the integrity and purpose of the trust.

Flexibility in Trust Management

Corporate trustees offer a level of flexibility unmatched by individual trustees. Changes in the company’s directors or shareholding structure do not impact the legal status of the trust, allowing for adaptive trust management over time without legal complications.

The structure of a corporate trustee allows for seamless transitions in leadership if a director becomes incapacitated or unable to fulfil their role. Shareholders have the authority to appoint new directors, ensuring the trust’s management continues without disruption.

In cases where a sole director is also the sole shareholder, their personal representative can appoint a new director, maintaining the continuity and stability of trust administration.

Extra Cost

The main disadvantage of appointing a corporate trustee involves the initial company registration set up cost. Companies are also required to pay an annual ASIC levy.

What is a Trust Deed?

A trust deed is a foundational legal document that outlines the structure and operating rules of a trust. It dictates how the trust is set up and managed and ensures that all activities within the trust adhere to established terms and legal requirements.

The trust deed begins by defining the duration of the trust and its primary goals. This sets the stage for all activities and decisions within the trust, aligning them with the specified objectives.

Then the trust deed also highlights the powers bestowed upon the trustee and the responsibilities they must uphold. It outlines the scope of what the trustee is allowed to do in the management of the trust’s assets, ensuring they act within the boundaries set forth by the deed.

Additionally, the deed specifies which types of assets the trust is permitted to acquire and maintain. This clause ensures that the asset portfolio aligns with the overall strategic goals of the trust.

Lastly, the document identifies the trust’s beneficiaries and clearly states their entitlements regarding the income and capital derived from the trust’s assets. This part is crucial as it details the distribution mechanism and timings for the trust’s outputs to its beneficiaries.

Trust Deed Legal Requirements

• Drafting Requirements: The trust deed must be drafted by a legally competent individual to ensure it meets the stringent standards required for such a document.
• Signatures and Dates: It requires the signatures and dates from all trustees, validating their agreement and acknowledgement of their roles and responsibilities.
• Execution According to Law: Proper execution according to the specific laws of the relevant state or territory is mandatory to ensure the trust deed’s legality and enforceability.
• Ongoing Review: Reviews and updates of the trust deed are required to accommodate changes in law or in the operational circumstances of the trust.

Role of the Trust Deed in Supporting Trust Objectives

The trust deed is an essential document that lays the foundation for managing a trust and ensures that the reasons for establishing the trust are legally supported and clearly defined.

Following are the ways in which trust deed specifically supports various objectives for setting up a trust:

Separation of Ownership and Control

One of the primary reasons for establishing a trust is to separate the ownership of assets from their control. This is particularly important in situations where the beneficiary is underage or has a disability that might impair decision making capabilities.

The trust deed legally designates a trustee to manage the assets on behalf of the beneficiary. It clearly defines the trustee’s powers and responsibilities, ensuring that the assets are managed prudently and in the best interest of the beneficiary, regardless of their ability to make decisions themselves.

Enhancing Flexibility in Tax Planning

Trusts are often used as tools for tax planning, offering flexibility in how taxes are handled in relation to the assets and their distribution. The trust deed specifies the types of transactions permissible within the trust, along with the distribution rules that can be designed to optimise tax advantages.

For instance, the allocation of income or capital gains can be structured in a way that minimises the tax burden on the beneficiaries, in accordance with the trust’s objectives and legal tax planning strategies.

Asset Protection

Protecting assets from potential claims against the beneficiary is another crucial function of the trust. Through the trust deed, assets are placed under the control of the trustee, legally separating them from the personal property of the beneficiaries.

This separation helps shield the trust’s assets from creditors, legal judgements, or other financial claims directed at the beneficiaries. The trust deed outlines these protective measures, ensuring that the assets remain secure and are used solely for the purposes intended by the trust.

Important Terms in a Trust Deed

Appointor

An appointer in a trust deed holds an important role, primarily responsible for overseeing the trustees’ management without being involved in the everyday operations of the trust. Often called a protector or guardian in certain trust deeds, the appointer has the authority to appoint new trustees or remove existing ones. This level of control becomes particularly significant if a trustee decides to resign or passes away, ensuring continuity and proper management of the trust.

The selection of an appointer is a significant decision as this individual or group wields substantial influence over the trust’s administration by managing the composition of trustees. Trusts can also have multiple appointers, which allows for shared responsibility and oversight, potentially providing a broader perspective or balance in decision making regarding trustee appointments and removals.

This setup helps maintain the integrity and purpose of the trust, aligning it closely with the trust’s intended goals.

Settlor

The settlor initiates a trust by transferring an initial property or asset into it, an action referred to as the settlement. Typically, this initial contribution is made for a nominal amount. Once the settlement is complete, the settlor generally has no further involvement in the trust’s operations.

It is advisable for the settlor to be an external third party who does not have any other role in the trust, such as a trustee or beneficiary, to avoid potential conflicts of interest and tax implications. Often, professionals like accountants or lawyers are chosen to act as settlors due to their expertise and impartiality.

Vesting Date

A trust is not designed to last forever. In many regions, including most states and territories in Australia, the law limits the duration of a trust to a maximum of 80 years. However, the specific term of a trust can be shorter, depending on the stipulations in the trust deed.

Trusts can also be structured to commence or conclude based on specific events, which should be clearly detailed in the trust deed to ensure clarity and legal compliance over the duration of the trust.

The vesting date of a trust deed signifies the point at which the trust is scheduled to terminate. This date is important as it marks the end of the trust’s operation and the final distribution of its assets. Generally, there is flexibility to extend the vesting date if necessary, under two conditions:

• Extension Before the Vesting Date: Any changes to prolong the lifespan of the trust must be made before the vesting date arrives.
• Compliance with Maximum Duration: Even with an extension, the total duration of the trust must not exceed 80 years.

Once the vesting date has passed, it is no longer possible to alter it.

The main provisions dealing with the taxation of trusts and trust income are contained in Division 6 of the Income Tax Assessment Act 1936 (ITAA 36).

The trust itself is not a taxpayer and does not pay tax. Tax on the taxable income of the trust is payable by the trustee and/or the beneficiaries.

To determine what tax is payable and by whom, Division 6 ITAA 36 requires:

• that the beneficiaries of the trust are identified and it is determined which beneficiaries are presently entitled; resident of Australia and not under a legal disability; and
• that the income of the trust; and the net income of the trust be calculated.

Present entitlement

Generally, a beneficiary will be regarded as presently entitled when the beneficiary can demand immediate payment from the trustee. A beneficiary does not have to have received monies to be regarded as presently entitled to them.

Legal disability

The following classes of beneficiaries are regarded as being under a ‘legal disability:

• minors (under 18)
• undischarged bankrupts
• felons

Trusts can be used to split income between the beneficiaries except in the case of personal services income.

Trust income

The income of the trust is generally determined by the trust deed.

If the trust deed does not specify when a receipt is to be treated as income of a period, and the trustee does not have any special power to characterise receipts, then the question of whether the whole or part of a receipt constitutes income of the trust will fall to be determined per the general presumptions of trust law.

See the Complexities with Trust Law & Tax Law Interaction section below in this article for more detail to complex issues which can arise. 

Trust taxable income

Trust taxable income is the total assessable income of the trust estate determined as if the trust were a resident taxpayer less all allowable deductions.

Special rules govern the use and carry forward of revenue losses.

A trust is entitled to a 50% discount on the disposal of assets held for more than 12 months.

Who pays the tax?

Where there are resident beneficiaries who are presently entitled to all of the income of the trust and are not under a legal disability, no tax is paid by the trustee. The beneficiaries’ assessable income will include their share of the net income of the trust on which they pay the tax.

Where the trust does not have any income there will not be any beneficiaries presently entitled to the income of the trust. Therefore, if the trust has taxable income, no share of the trust’s taxable income will be included in its assessable income. Instead, it will be assessed to the trustee, usually at the highest marginal tax rate.

It should be noted that despite the above, beneficiaries are assessed on any capital gains or franked dividends to which they are made specifically entitled. Capital gains and franked distributions to which a beneficiary has been made specifically entitled are excluded from the income of the trust and the net income of the trust to apply Division 6 ITAA 36.

Trust Capital gains and franked dividends

Where permitted by the trust deed, the capital gains and franked distributions (including any attached franking credits) of a trust can be effectively streamed for tax purposes to specific beneficiaries by making them “specifically entitled” to those amounts via trust resolutions – discussed below. Other types of income cannot be streamed.

The taxation of streamed capital gains and franked distributions is effectively taken out of Division 6 ITAA 36 and taxed under Subdivisions 115-C and 207-B of the ITAA 1997 respectively.

Subdiv 115-C provides that capital gains are assessed to those beneficiaries that are made specifically entitled to them on a quantum basis. This is regardless of whether they form part of the income or capital of the trust estate.

Any capital gains and franked distributions that are not streamed to specific beneficiaries are assessed under Division 6 ITAA 36. Generally, this means they are proportionally assessed to the beneficiaries who are presently entitled to the income of the trust or the trustee to the extent that the net income of the trust has not been distributed.

Creating specific entitlements

For capital gains and/or franked dividends to be streamed, specific beneficiaries must be made specifically entitled to them. This means the following elements must be satisfied:

• the beneficiary must receive or reasonably expect to receive an amount; and
• the amount must be equal to the beneficiary’s share of the net financial benefit; and
• the amount must be referrable to the capital gain or franked distribution in the trust; and
• the entitlement to the amount must be recorded in its character in the accounts of the trust.

The terms of the trust deed are critical in determining if the specific entitlement requirement can be met.

NET FINANCIAL BENEFIT REFERABLE TO A CAPITAL GAIN

NET FINANCIAL BENEFIT REFERABLE TO A FRANKED DISTRIBUTION

When determining a beneficiary’s share of the net financial benefit referable to a capital gain, the net financial benefit referable to the capital gain will usually be the trust proceeds from the transaction that gave rise to the CGT event reduced by trust capital losses applied against the capital gain only to the extent that tax capital losses were applied in the same way.

When determining a beneficiary’s share of the net financial benefit referable to a franked distribution, the (gross) financial benefit is reduced by directly relevant expenses. These can include any annual borrowing expenses (such as interest) incurred in respect of the underlying shares (allocated rate against any franked and unfranked dividends from those shares) or relevant management fees incurred.

Entitlement must be recorded

The amount of the net financial benefit that the beneficiary has received or can reasonably be expected to receive must be recorded in its character as referable to the capital gain or franked distribution in the accounts or records of the trust. A record merely for tax purposes is not sufficient.

The amount does not have to be expressed as a dollar amount. It may be expressed as a share of the trust gain or franked dividend or an amount by reference to a formula.

For example, the following will suffice: 10% of the capital gain on the sale of x asset

According to the terms of the trust deed (or clause x of the trust deed), Beneficiary A is entitled to all (or x%) of the franked distributions of the trust.

Where a beneficiary is entitled to unspecified amounts, this will not be sufficient to create a specific entitlement.

For example, the following will not suffice:

• $1,000 of trust income
• all of the trust income
• the balance of the trust income
• x% of the trust income

The reason such distributions are not sufficient to give rise to a specific entitlement is that the entitlements have not been recorded in their character regarding the capital gain or franked distribution. It does not matter that the entitlement includes capital gain or franked distribution.

Requirements for valid trustee distribution resolutions

A trustee of a trust must prepare and document a resolution to distribute the income of a trust on or before the year of the relevant financial year.

If it cannot be evidenced that the resolution was made before 30 June of the relevant financial year, the following issues will arise:

• no beneficiary will be taken to be presently entitled to a share of income of the trust estate as at 30 June and therefore the trustee will be assessed on the taxable income at the top marginal rate; or
• where the trust deed includes a default beneficiary clause, the default beneficiary will be treated as presently entitled to a share of the income of the trust estate, even though a distribution may be made to another beneficiary.

Points to be noted include the following:

• It is necessary to have a copy of the trust deed. A resolution must be consistent with the terms of the trust. Therefore it is necessary to ensure that a copy of the trust deed (including amendments) is available.
• It is necessary to determine who are the beneficiaries.
• It is also necessary to identify the specific clause(s) in the trust deed which defines the income of the trust and to determine whether the trust deed specifies how it is to be distributed amongst the beneficiaries.
• The resolution should then document the application of such distribution under the terms of the trust deed.

Resolutions have to be made by the end of the income year

As mentioned, all trustees who make beneficiaries presently entitled to trust income by way of a resolution must do so by the end of an income year (30 June). If the trust deed requires the resolution to be made on a date before 30 June, then the resolution must be made by this earlier date.

The trustee’s resolution may be documented in the form of a file note, exchange of emails or a draft minute that is finalised after 30 June if such documentation is executed before 30 June.

Records created after 30 June may be accepted as evidence of the making of the resolution by that date
The Australian Taxation Office (ATO) has stated in a factsheet that if a resolution is validly made by 30 June, it will accept records created after 30 June as evidence of the making of a resolution by that date.

There is no standard format for a resolution
The important thing is that the resolution must establish, in one or more beneficiaries, a present entitlement to the trust income by 30 June.

The wording of the resolution must be unambiguous
The resolution does not need to specify an actual dollar amount for the resolution to be effective in making a beneficiary presently entitled unless the trust deed specifically requires it.

A resolution is effective if it prescribes a clear methodology for calculating the entitlement – for example, the entitlement can be expressed as a specified percentage of the income, whatever that turns out to be.

A resolution should be in writing
Whether the resolution must be recorded in writing will depend on the terms of the trust deed. However, a written record will provide better evidence of the resolution and avoid a later dispute (for example, with the ATO or with relevant beneficiaries) as to whether any resolution was made by 30 June.

A written record will be essential if it is desired to effectively stream capital gains or franked distributions for tax purposes – this is because a beneficiary can only be made specifically entitled to franked dividends or capital gains if this entitlement is recorded in writing.

What is a Bucket Company?

A bucket company is a company established as a beneficiary to a trust. The term bucket signifies its position beneath the trust, serving as a conduit for funneling funds into the trust and to the bucket company to minimise tax.

Typically, a bucket company comprises three key components:

• Presence of a trust holding surplus income available for distribution.
• The company beneficiary must be designated as a beneficiary according to the terms outlined in the trust deed.
• Evaluation of whether the bucket company is integrated into a family group structure, considering potential implications related to family trust distributions tax.

There are two primary methods for extracting money from a bucket company:

• Dividends to Shareholders
• Loans from the bucket company. However, these loans must normally comply with Division 7A requirements.

Bucket Company Advantages

For those with a Family Trust generating profits, employing a bucket company strategy can be advantageous. This approach allows for a cap in tax on distributed trust profits to either 30% or 25%, which is considerably lower than individual marginal tax rates, which may reach up to 47%. Company tax rates applicable to bucket companies are 25% for a Base Rate Entity and 30% for other companies.

Consider a scenario where a trust earns profits from its business activities or investments.

Option 1: These profits could be evenly distributed between Individuals 1 and 2, who may face marginal tax rates ranging from 32.5% to 45%.

Option 2: Alternatively, profits could be distributed to Individuals 1 and 2 up to the 32.5% tax bracket, with the remainder allocated to the bucket company. This allows for the benefit of the company’s capped tax rate of either 25% or 30%. Depending on individual circumstances, option 2 could result in significant tax savings for the current financial year.

The funds retained after tax in a bucket company can then be utilised for various purposes, including investment in shares, property, or providing loans to other entities at predetermined interest rates.

A bucket company approach may be suitable for business owners in the following scenarios:

• substantial fluctuations in income from one fiscal year to another.
• nearing retirement or planning to divest the business and anticipating reduced business income in the future.

Funds can be extracted through dividend payments to shareholders. As dividends are taxed at the company rate, shareholders receive franking credits equivalent to the tax already paid by the company.Depending on individual tax rates, this can result in potential tax savings. Retired individuals with lower incomes may strategically receive dividends over time to potentially qualify for tax refunds on franking credits, or at least pay less tax due to lower marginal tax rates than they may have previously had.

Bucket Company Disadvantages

Using a bucket company is not suitable for individuals subject to the Personal Services Income (PSI) rules, as income is attributed to the individual, not to the bucket company.

Funds transferred to a bucket company need to be invested wisely. While the company may invest in various assets such as properties and shares, holding appreciating assets within the company may not be optimal. This is because a company doesn’t benefit from the 50% Capital Gains Discount available to individuals and trusts.

To minimise risk, bucket companies should focus on passive investments rather than actively running businesses, which could jeopardise accumulated assets within the bucket company.

For a bucket company to receive income from a trust, the trust should physically transfer the funds into the company’s bank account before filing its tax return. This requires having the necessary funds available without negatively impacting cash flow. Alternatively, if direct transfer isn’t feasible, establishing a Division 7A loan between the distributing trust and the bucket company becomes necessary.

A trustee of a trust can make a family trust election (FTE) in respect of that trust. The FTE provides the trust with a number of benefits (explained more fully below) including:

• less stringent testing in order for losses of the family trust to be utilised as a deduction.
• concessional treatment in respect of the application of the holding period rule that enables the beneficiaries of the family trust to utilise franking credits on dividends distributed to them.
• concessions regarding the satisfaction of the continuity of ownership test for a company in which the family trust holds shares.
• expanded eligibility for the family trust to access the small business re-structure rollover.

Conversely, if a FTE is made, there is a risk of family trust distributions tax for distributions made to persons or entities outside the ‘family group’.

It is certainly the case that a family trust election will not be appropriate for every trust and a case-by-case assessment of suitability is recommended.

The family trust election requires a living individual to be nominated as the ‘test individual’, also known as a ‘specified individual’ or ‘primary individual’. The election must be made in writing and in an approved form. The ambit of the family group is defined by reference to the test individual. The test individual must be living at the time of election, but the subsequent death of that individual will not upset the standing of the election.

The trust is permitted to distribute income or capital of the trust to persons within the family group (see heading below regarding definition of family group). However, it is first necessary to determine that the trust is eligible to make a family trust election by having satisfied the family control test.

Applying an FTE retrospectively
A family trust election can be instituted retrospectively. However, this retrospective commencement time is only possible where at all times from that earlier income year:

• the trust satisfied the family control test; and
• only the test individual or members of the family group have been made presently entitled to capital or income from the trust or received distributions of capital or income.

Reasons for making a family trust election

The trust has losses or bad debts, and the trust loss rules would prevent the trust from carrying the losses forward or claiming the bad debt. Making a family trust election in relation to a trust makes it an “excepted trust”. The rules regarding the denial of tax losses and bad debts under the trust loss provisions do not apply to excepted trusts. The income injection test, which is part of the trust loss rules, will still apply to a family trust.

If a non fixed trust holds equities on which frank distributions are received, the beneficiaries will be entitled to claim a tax offset for the imputation credits attached to the dividends, if they are franked. In the absence of the family trust election, the recipient of the dividend would not be able to satisfy the holding period rule. There is an exception if the beneficiary of the trust is an individual and has franking credit entitlements in an income year of $5,000 or less.

If a company has losses, which is owned by a non-fixed trust, the company cannot satisfy the continuity of ownership test unless the trust is a family trust. To satisfy the continuity of ownership test, the same persons must beneficially own more than 50% of exactly the same shares in the company from the beginning of the loss year until the end of the year in which the losses are recouped.

Where at least 50% of the shares in a company are held by a non-fixed trust, it is not possible for the company to satisfy the continuity of ownership test because 50% or more of the shares do not have a beneficial owner. (The trustee is the legal and not the beneficial owner).

Nevertheless, if the trustee makes a family trust election from at least the beginning of the loss year, the shares are taken to be beneficially owned by the family trust from that time which means the company can satisfy the continuity of ownership test.

If a transferor non-fixed trust or transferee non-fixed trust wishes to gain the benefit of the rollover on assets under the small business restructure rollover (Subdivision 328-G ITAA 1997), it is necessary that they are family trusts and the same family groups are the “ultimate economic owners” of the assets.

If there is another trust where it is desired to bring that second trust within the family group, a method of doing this is to make a family trust election for the second trust and nominate the same test individual as for the trust that has already made a family trust election.

Eligibility – the family control test

A family trust election is only available for a trust if the family control test is passed. The test requires that the trust is ‘controlled’ by a controlling group consisting of some or all of the following persons:

• The test individual and / or any members of the family group; or
• Any of the above persons and an expert adviser to the family; or
• The trustee of one or more family trusts. This is provided that the test individual is the same person in respect of both trusts and the family group has greater than a 50% stake in the income or capital of the trust.

Broadly, the group will be taken to control the trust if either of the following powers exists:

• The group has power to obtain the benefit (including indirectly, if relevant) of the income or capital of the trust; or
• The group has power to control (including indirectly, if relevant) the distribution of income or capital of the trust; or
• The trustee generally acts in accordance with the directions or wishes of the group; or
• The group has power to remove or appoint the trustee; or
• The group has greater than a 50% stake in the income or capital of the trust; or
• Persons in the group are the only persons who can benefit from the income and capital of the trust.

Note that some of these above control tests will not be satisfied where the relevant power is being exercised by an expert adviser described in point 2 above.

The ‘family group’ consists of the following:

Individuals that can be included in the family group:

• The test individual, their child, parent, grandparent, brother, sister, nephew, niece. Note that a ‘child’ includes an adopted child, stepchild, ex-nuptial child, child of a spouse, or child within the meaning of the Family Law Act.
• The spouse of any of these above-listed persons. This includes an ex-spouse and an individual with whom the individual is in a relationship and lives with on a genuine domestic basis.
• The lineal descendants of a nephew, niece or child of the test individual or the test individual’s spouse. Note that lineal descendants is defined to include adopted children, step-children or ex-nuptial child.
• An individual who was a spouse of the test individual or the spouse of a family member before a relationship breakdown in a marriage or relationship.
• An individual who was member of the family group immediately before the death of the test individual or another family member and who becomes the spouse of a person who is not a member of the family group.
• An individual who was a child of the spouse of the test individual or group family member before a breakdown of the marriage or relationship.

Entities that can be included in the family group:

• The family trust itself.
• An alternative trust with the same test individual specified in its family trust election.
• A company, trust or partnership which has made a valid interposed entity election to be a part of the family group.
• A company, trust or partnership whereby members of the family group (and / or their relevant family trusts) have fixed entitlements to all of the income and capital of that entity.
• Certain interests in small enterprises, certain funds and certain tax-exempt bodies.

Note that the above-listed persons do not cease being part of the family group merely because of the death of the test individual or another family member.

Effect of death on a family trust and a family group

Death of a family member

Section 272-95(2) states: “A person does not cease to be a family member merely because of the death of any other family member”.

The important word in this provision is “merely”. This appears to mean “solely”. That is, if there is another reason, in addition to the death of someone in the family that makes an individual no longer in the family, 272-95(2) has no application and the person concerned will no longer be a member of the family. They may still be a member of the family group.

As a simple example, assume the test individual dies. This means the (former) spouse of the test individual is no longer the spouse of the test individual and, without more, the spouse would cease to be a member of the family and the family group. However, due to the operation of 272-95(2), the spouse remains a member of the family and the family group.

New relationship following death

As stated above, an individual will not cease to be a member of the family group if they were the spouse of a deceased member, and the living former spouse becomes the spouse of another person who is not a member of the primary individual’s family. However, that person is very likely to cease being a member of the family.

For example, assume that Mark is married to Jennifer. Jennifer is a sibling of the test individual of a family trust. This makes both Jennifer and Mark members of the family. Jennifer dies. This means that Mark is no longer the spouse of a sibling of the test individual. If nothing more occurred, Mark would remain in the family due to the operation of 272-95(2).

However, Mark meets Jane and they marry. Jane is not a member of the test individual’s family. Due to this, Mark will cease to be a member of the family because the death of Jennifer is not “merely” what is causing Mark not to be a member of the family. Mark is now the spouse of a person outside the family, and this means that there is another reason, other than the death of Jennifer, that takes him outside the family.

In this instance, 272-90(2A)(b) will have operation to include Mark (not Jane) in the family group of the test individual. However, Mark (nor Jane) will be in the family of the test individual. This means that distributions can be made to Mark by the family trust without incurring FTDT. Distributions to Jane would attract FTDT. If the family control test is being considered for an entity, Mark’s influence over that entity would not be taken into consideration because he is not a member of the test individual’s family.

If Mark and Jennifer had children, these children would be either nephews or nieces of the test individual and the children would remain members of the family.

Step-children

Assume Gary, a nephew of the test individual is married to Rita. This is a second marriage for Rita, and she has child from her first marriage. The child’s name is Charles. All three individuals are members of the test individual’s family because Gary is a nephew of the test individual and Rita is a spouse of Gary. Further, Charles is in the family because he is a step-child of Gary.

Gary dies. If nothing more happens, Rita and Charles will remain members of the test individual’s family because a person does not cease to be a family member merely because of the death of any other family member.

However, Rita meets Usain, and they start living together as a couple. This makes Rita the spouse of Usain. Accordingly, Rita ceases to be a member of the test individuals’ family because the death of Gary is not the only reason Rita is no longer a member of the family. However, Rita remains a member of the family group due to the operation of 272-90(2A)(b).

Charles ceases to be both a member of the family and the family group. He is no longer the step-child of Gary and Charles’ mother’s relationship to Usain means that he cannot rely on the “mere death” inclusion to keep him in the family. Further, there is no provision in section 272-90 that will include him in the family group.

Variation of the test individual

The ATO will not permit a test individual to be changed to another test individual if the first test individual has died.

However, if the conditions are satisfied, a test individual can be varied to another test individual. These provisions are available whether or not the test individual has died. The conditions that must be met are:

• The new test individual must have been a member of the family since the original family trust election commenced; and
• Any distributions since the original election was made have been to the new test individual or anyone included in the new test individual’s family group; and
• There must not have been any previous change of the test individual; and
• The variation of test individual must happen in the period between the start of the income year specified in the original election and ending 5 years after that time.

Revoking or Varying a Family Trust election

Revoking
The family trust election may not be revoked other than in limited circumstances. Specifically, revocation is permitted where within 4 years after the income year specified in the original family trust election:

• The trust which has the election in place is a fixed trust; or
• Concessions available under the election have not been utilised by the trust. For example, tax losses must not have not been recouped by the trust or another entity where those losses could not have been recouped without an election in place. Similarly, bad debt deductions or franking credits must not have been claimed if the claim was only available because an election was in place.

Once revoked, the trust is not permitted to have a further family trust election instituted.

Varying
The test individual may be varied on only one occasion within 4 years after the income year specified in the original family trust election. This is provided that:

• The new test individual was a member of the original test individual’s family group when the election commenced; and
• Since the election commenced, no person outside of the new test individual’s family group has been made presently entitled to capital or income of the trust or received distributions of capital or income.

The test individual may also be varied pursuant to family court orders where there is a marriage breakdown.

Interposed entity election

It is possible for a company, trust or partnership to make an interposed entity election to also be included in a family group. This election must be made in writing and in an approved form.

An interposed entity election is not necessarily required where members of the test individual’s family have fixed entitlements to all of capital and income of the entity. In such circumstances, the entity will automatically be a member of the family group.

For an entity to be eligible to make an interposed entity election, the interposed entity must itself pass a modified version of the family control test at the end of the income year of the proposed commencement of the election. To pass the modified test, the controlling group must beneficially hold (including indirectly, if relevant) fixed entitlements to greater than 50% of the capital or income in that interposed entity.

The interposed entity election may be elected to commence in an income year later than the income year in which a family trust election commenced and also retrospectively. However, retrospective commencement is only possible where at all times from that earlier income year:

• the company, trust or partnership satisfied the family control test; and
• only the test individual or members of the family group have been made presently entitled to capital or income from the trust or received distributions of capital or income.

The interposed entity election may only be revoked in limited circumstances. For example, where the entity is a member of the family group i.e. where only members of the family group hold fixed entitlements to 100% of the capital and income of the trust. The interposed entity election will automatically be revoked where the underlying family trust revokes its family trust election.

Note that an interposed entity election can be made in respect of two or more family trusts where the test individual in each of these family trusts is identical. This enables different family trusts to distribute to the same interposed entity without any family trust distributions tax consequence.

A trust is not itself a legal entity but more accurately describes a relationship between persons over property. The relevant relationship can be summarised as follows: the trustee of the trust holds trust property for the benefit of beneficiaries of the trust and in so doing must follow the terms of a trust deed. An issue can arise where the terms of a trust are amended to change fundamental aspects of the trust relationship.

This includes amendments which alter, for example, the property held on trust or the persons who are beneficiaries under the trust. The impact of such a change is a potential trust resettlement under trust law which results in the original trust terminating and a new trust being established. This only occurs where the amendments to the substance of the trust are sufficiently significant – such that it can be said that the trust terminated and assets of the trust were settled on terms of a different trust.

From a taxation perspective, a trust resettlement has various potential tax consequences. This includes capital gains tax by the happening of CGT events E1 (where a trust is created over a CGT asset by declaration or settlement) and / or CGT event E2 (where assets are transferred to an existing trust). Note that where two or more CGT events result from a single incident, the most appropriate CGT event will apply. That is, there is no double-taxation because of the applicability of two or more CGT events. Other tax consequences of resettlement include the trust being unable to utilise previous accumulated losses.

The somewhat difficult question worth exploring is therefore, what amendments to the trust will cause it exceed the threshold for resettlement? Put another way, what has to occur for a trust to change so fundamentally that it is deemed to have terminated and a new trust established?

According to judicial development in this area, a resettlement will generally not happen unless one of the following occur:

There is less than ‘some’ continuity in membership of the trust
There is less than ‘some’ continuity in the property of the trust

Additionally, any amendments must be made validly and with the support and authority of a power of amendment contained within the trust. It is important therefore to firstly consider if the trust deed allows for the proposed amendments and secondly to ensure the procedures and requirements for amendment as set out in the deed are actually complied with. Any action which purports to amend the operation of the trust without the backing of the trust deed may trigger a CGT response.

The Australian Tax Office largely holds the view that a resettlement according to trust law is the trigger point for CGT event E1 and / or E2. However, note the ATO (in Taxation Determination 2012/21) does clarify that it is possible that capital gains tax could apply to trust amendments that fall short of a trust law resettlement. This includes instances where there are changes to trust assets that result in those relevant assets being made subject to a separate character of rights and obligations.

Such amendment would give rise to the conclusion that the asset has been settled on terms of a different trust (even where the original trust itself is not resettled for trust law purposes). An example could include the following amendment to a trust deed: ‘the terms of this deed are amended such that the property at 123 XYZ Street is to be held on a separate trust for the benefit of beneficiary A’. In this scenario the trust property is being made subordinate to the governance of an alternative trust and this would invoke the application of CGT event E1 and / or E2.

The ATO have provided useful determinations and private rulings attempting to answer the question of when a trust resettlement will occur as a result of amendments to trusts. We have attempted to summarise some of material below. Please note that while the ATO resources can be a useful reference, following the material is not always a foolproof way to ensure compliance with taxation law.

Taxation determination 2012/21

Example 1

XYZ Discretionary Family Trust was settled to benefit members of the XYZ family. The trust deed permitted the trustee to appoint income to any beneficiary including Mr XYZ, Mrs XYZ and their children and grandchildren and a private company used to run the family business. The family sells the company to a third-party outside of the family and the trust deed is therefore amended to exclude the company from the list of beneficiaries. The trustee also resolves to add beneficiaries to the existing list. This includes spouses of children and trusts and companies in which the family has a controlling interest. As this amendment is a valid exercise of an amendment power contained within the deed, there is no resettlement.

Example 2

The XYZ Trust is a unit trust. Per the terms of the trust deed, the trustee has power to invest in only a limited class of assets. The trustee is permitted to amend the scope of the power of investment within the deed with the consent of all unitholders. Therefore, the unitholders meet and amend the deed to change the range of assets which can be invested in. As this amendment is a valid exercise of an amendment power contained within the deed, there is no resettlement.

Example 3

XYZ Discretionary Family Trust was settled to benefit members of the XYZ family. The trust deed does not contain a definition of income or a provision permitting the trustee of the trust to stream income. The trustee, pursuant to an unfettered power to amend the deed, inserts clauses defining income of the trust, authorising the trustee to separately identify and label various sources of income and authorising the streaming of income. As these amendments are a valid exercise of an amendment power contained within the deed, there is no resettlement.

Example 4

XYZ Discretionary Family Trust was settled to benefit members of the XYZ family. The trustee has wide powers to declare that a particular asset of the trust is to be held exclusively for one or more of the trust beneficiaries to the exclusion of other beneficiaries of the trust. In exercise of this power, the trustee declares that one of several assets forming part of the corpus of the trust is to be held exclusively ‘in trust’ for one of the beneficiaries. In this instance, the trust obligations attaching to that asset have changed in a manner consistent with the conclusion that the assets have commenced to be held on the terms of a separate trust. The original trust does not terminate, but CGT event E1 will occur for the trust in relation to that asset.

Taxation determination 2019/14 (CGT on trust splitting arrangements)

Example 1: XYZ Discretionary Family Trust was settled to benefit members of the XYZ family. The trustee is XYZ Pty Ltd and the deed gives the trustee discretion to appoint income to any beneficiary. One child of Mr XYZ’s first marriage and one child of his second marriage are director of the trustee company and appointors under the trust. To prevent conflict between the children of the first marriage and the children of the second marriage, the deed is amended by the trustee pursuant to a power of amendment and a trust split arrangement is implemented. In this instance, a new trust is created causing CGT event E1 to occur.

Private rulings

Ruling 1052074891633

The terms of the trust deed allowed the trustee to alter, revoke or vary the provisions of the Trust Deed. The trustee proposed to amend the deed to remove certain beneficiaries (who had never received income or capital distributions). There was held to be no CGT event in this instance.

Ruling 1051963323592

The terms of the trust deed allowed the trustee to make changes to the trust including by excluding beneficiaries. The Trustee proposed to amend the deed to remove specified beneficiaries and update the definition of income. There was held to be no CGT event in this instance.

Ruling 1051937315142

The trustee had a broad power of amendment under the deed to vary the deed. The trustee proposed to exercise their power to add a beneficiary to the trust and appoint a new appointor. There was held to be no CGT event in this instance.

Ruling 1051913201627

The trustee is a corporation with two director shareholders. The trustee has power under the deed to amend the proposed clause under the trust deed and trustee company constitution. The director shareholders proposed to amend the constitution of the corporate trustee to alter shareholding and directorship. There was held to be no CGT event in this instance.

Ruling 1051908342813

The trustee had a broad power of amendment under the trust deed to vary the deed. The trustee proposed to replace a parent with a children as a specified beneficiary and to remove and replace the identify of persons within a class of general beneficiaries. The proposed variation was a valid exercise of power of the trustee. Therefore, there was held to be no CGT event in this instance.

Transfer duty considerations

It should be borne in mind that the question of resettlement is also relevant for transfer duty purposes. The relevant state duties legislation, case law and rulings should be consulted to determine what amendments to the trust will triggers an event resulting in a transfer duty liability.

The interplay between trust law and the tax system in respect of trusts can be a conceptually challenging topic to navigate.

The most major complexities flow from the principle that a trust is taxed such the beneficiaries or trustee of trust are assessed on their share of the net income (taxable income) of the trust which is first determined by calculating their share of the income of the trust estate. The nature of the income of the trust estate is based on trust law principles (not tax law principles) yet has the potential to have a significant impact on taxation outcomes for the relevant trust.

You can see this principle articulated in section 97(1) of the Income Tax Assessment Act of 1936 which reads:

‘…where a beneficiary of a trust estate who is not under any legal disability is presently entitled to a share of the income of the trust estate: the assessable income of the beneficiary shall include: (i) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and (ii) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia…’

What is the Income of the Trust Estate?

Firstly, note that income of the trust estate is also often referred to as distributable income. These terms are synonymous.

The income of the trust estate is not a defined term in the tax legislation. However, the evolved meaning of that term according to trust law is: income according to trust concepts. That is, the definition of income (and expenses and capital) that follows the trust law. The trust law in turn broadly follows ordinary and accepted accounting principles. Therefore, income of the trust is broadly equivalent to the calculation of profit (pre tax) for accounting purposes according to accepting accounting principles.

However, one of the complexities under trust law is the ability of the trust deed and, the trustee (if permitted under the trust deed) to define income of the trust estate and to re classify certain receipts (income) and outgoings (expenses) as capital or income at discretion. This concept will be discussed further on, along an address on some of the limitations the power to re classify and define income of the trust estate.

What is the Net Income of the Trust?

The net income is essentially the taxable income of the trust calculated on the assumption the trust were a resident taxpayer (even though, technically speaking, a trust is not a standalone legal entity the tax law treats it as such).

This is set out in section 95(1) of the ITAA 1936 which provides as follows:

‘…net income, in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions…’ 

As you can see, the net income of the trust is calculated differently from the income of the trust estate.

There are many transactions that will be treated differently under the two above concepts. The differences ultimately depend on the definition of income of the trust estate. However, assume the income of the trust estate is not defined as therefore follows trust law (based on accepted accounting principles), common examples of receipts and outgoings treated differently include:

• where an outgoing of the trust is not deductible for tax purposes (e.g. entertainment expenditure) but an expense for accounting purposes.
• where the rate of deductible depreciation recognised on an asset under tax law differs from the rate of depreciation recognised for accounting purposes.
• where employee entitlement provisions are is not deductible for tax purposes but may be expensed for accounting purposes.
• where receipts are tax exempt or discounted for tax purposes (e.g. CGT discount, small business CGT concessions) but not exempt / discountable for accounting purposes.

As you can see, the reason for the different treatments be because of (i) inherent recognition criteria; or (ii) as a result of different timing rules applied to recognise an outgoing or receipt.

So, what are the implications of the differences between income of the trust estate and net income?

The Interaction of Income of the Trust Estate and Net Income

As outlined in Division 6 of the ITAA 1936, the process necessary to determine tax outcomes broadly involves the following steps:

• the income of the trust estate needs to be calculated according to the relevant definition of income of the trust estate and any re classification of receipts and outgoings made by the trustee in the annual resolution.
• the beneficiaries which are made presently entitled to trust income (e.g. by resolution of the trust at 30 June) need to be identified.
• The percentage share of each beneficiary to income of the trust estate needs to be calculated.
• The net income of the trust needs to be calculated according to the formula in section 95(1) of the ITAA 1936 which involves adding up assessable income less allowable deductions.
• That determined percentage share is then applied against the net income of the trust.

There are many issues presented by the distinction between the income of the trust estate and the net income of the trust and the overlaying applicable trust law principles. These are addressed by sub heading below.

The tax risk of the trustee being assessed where there is no income of the trust estate

There is a peculiar and potentially adverse outcome that can result where there is income of the trust estate (that is, nil income). In this instance, the entirety of the net income will necessarily be assessed to the trustee of the trust. This outcome is regularly disastrous as the tax rate imposed on the trustee of the trust is the highest tax rate.

The reason this outcome occurs is that the taxation of trusts relies on there being some income of the trust estate which is relevant to determining the share entitlement of beneficiaries to net income of the trust. If there is nil income of the trust estate then mathematically it is not possible to calculate a share of entitlement which can then be applied against net income.

As an example, assume the trustee of the trust gifts trust property of the trust. That transaction is the only receipt or outgoing for the entire income year. The change of ownership over the CGT asset (the property) will trigger CGT event A1. There is no capital proceeds received for the sale of the property. Therefore, no amount can be included in the income of the trust estate in respect of the transaction. This is because for amount to be included in the income of the trust estate there must be a net accretion to the trust (i.e. an increase in value to the trust) at least according to the prevailing ATO view. This concept is addressed further on. For taxation purposes the market value substitution rule will apply to facilitate the calculation of a capital gain in respect of the transaction. In this instance, because there is no income of the trust estate over which a beneficiary share can be calculated, the trustee of the trust must be assessed on the entire net income (which may be significant).

The potential for an outcome where there is no income of the trust estate needs to be carefully managed.

It is possible that the way the trust deed defines income of the trust estate or the way the trustee is empowered under the deed or to characterise certain receipts or outgoings as income of capital may all impact the amount calculated. If the amount calculated is not at least $1, there is a significant tax risk if the net income of the trust is positive.

That is, the trust deed may define income of the trust estate in such a way that causes undesirable outcomes. Alternatively, the trustee of the trust may be afforded powers that affect the calculation of income of the trust estate and may inadvertently exercise those powers in such a way that causes undesirable outcomes.

The risk of the shifting tax burdens in an undesired manner

Another risk with the potential fluidity to the calculation of income of the trust estate is the risk that beneficiaries are assessed are taxed on amounts that do not match what they receive. The outcomes have potential to become more wild the greater the disparity between net income and the income of the trust estate.

For example, assume there are two beneficiaries of a trust. The net income of the trust is calculated as $50,000 and the income of the trust estate is calculated as $200,000. The trustee of the trust resolves to distribute $40,000 to the first beneficiary and $10,000 to the second beneficiary. Therefore, the first beneficiary has a share entitlement of the income of the trust estate of 80% and the second beneficiary has a share entitlement of 20%. For taxation purposes, the percentage of 80% and 20% is applied against the net income. Therefore, the first beneficiary is taxed on $160,000 ($200,000 x 80%) despite only being made presently entitled to $40,000 and the second beneficiary is taxed on $40,000 ($200,000 x 20%) despite only being made presently entitled to $10,000. Here, there is a clearly a greater tax burden experienced by beneficiary A as the difference between economic outcomes and taxation outcomes is $120,000 (i.e. $160,000 – $40,000). This is compared with beneficiary B where the difference between economic outcomes and taxation outcomes is $30,000 (i.e. $40,000 – $10,000). This example demonstrates the real risk that tax outcomes may not match desired economic outcomes for beneficiaries.

What we can see is that the definition of income of the trust estate dictates the way the burden of tax falls. If the income of the trust estate was, for example, defined more broadly to include a particular capital gain of $150,000 that occurred during the income year, the income of the trust estate would align with net income of the trust. Therefore, assuming the trust resolution was updated to distribute the income of the trust estate 80%/20% between the beneficiaries, the first share would be taxed on $160,000 and receive $160,000. The second beneficiary would be taxed on $40,000 and receive $40,000.

Obviously, the result of defining the income of the trust estate has an impact on the amount the trust must distribute to the beneficiaries. There may, of course, be an option to retain the amount that beneficiaries have been made presently entitled to. However, the concepts of present entitlement and unpaid present entitlements are not addressed in this article.

Some taxpayers may seek to take advantage of differences between net income and income of the trust estate as an alternative form of income splitting. The difference between the concepts enables the trustee to distribute income of the trust estate to a beneficiary who has favourable tax attributes (e.g. a taxpayer with deductible tax losses or who is on a low marginal rate). That tax favoured beneficiary will be taxed on an amount which exceeds the distribution amount to which they have been made presently entitled. The alleged benefit of this approach is that the tax favoured beneficiary will be assessed on a greater amount than they are actually physically entitled to and this maximises overall tax outcomes. This approach does not necessarily carry the same risks as other income splitting techniques, provided the beneficiary entitled to the income receives the benefit of the distribution. This is because other techniques often rely on a beneficiary being made presently entitled to an amount but not actually receiving the benefit of that entitlement. These techniques are currently subject to a high level of criticism by the ATO which threatens to apply section 100A of the ITAA 1936 or Part IVA of the ITAA 1936 to such arrangements. However, it should be noted that the ATO is aware (refer to PS LA 2010/1) of arrangements which are designed to take advantage of the differences between net income and income of the trust estate. The ATO retains the power to cancel any tax benefit obtained (and impose penalties) where there is a scheme, and the various criteria of Part IVA are satisfied. There are also a number of specific anti avoidance and integrity provisions that may apply to address income splitting behaviours.

The Ability to Define Income of the Trust Estate

If there is no definition of income of the trust estate in a trust deed, trust law principles must be applied to calculate it. That is, the trustee is not permitted to characterise receipts or outgoings as revenue or capital (in contradiction to trust law principles) in calculating the income of the trust estate. Remember that trust law principles are based on accepted accounting principles.

However, as flagged throughout this article, the trust deed may specifically define income of the trust estate. There are broad powers afforded for tampering with the definition and the ability to characterise receipts and outgoings as revenue or capital for trust law purposes (subject to certain limitations addressed below). This was confirmed in the Bamford case where the High Court held that a trust instrument could characterise capital receipts as income and therefore enables these receipts to be included in the income of the trust estate.

To provide some examples of the ways income of the trust estate can be defined, refer to the below as extracted from the CPA Australia Trustee Resolution Guide:

• Income being the net income of the trust calculated under section 95(1) of the ITAA 1936.
• Income being ordinary income as defined under trust law
• Income being ordinary income as defined under trust law but including some receipts such as capital gains.
• Income as determined at the discretion of the trustee.
• Income as determined at the discretion of the trustee but which is treated as ordinary income for trust law purposes if the trustee does not exercise such a discretion.
• Income as determined at the discretion of the trustee but which is treated as being the net income of the trust under section 95(1) of the ITAA 1936 if the trustee does not exercise such discretion.

There are many other possible variations and each may have implications on determining tax outcomes for the trustee of the trust and / or beneficiaries.

As addressed above, there are a number of risks and considerations when it comes to defining income of the trust estate and characterising receipts and outgoings.

Limitations on the Ability to Define Income of the Trust Estate

The ATO in Draft Taxation Ruling 2012/D1 holds the view that should be a number of limitations on the ability for income of the trust estate to be re defined.

The ruling essentially provides that notional tax amounts may not form part of the income of the trust. There must actually be a net accretion (an increase to the property or an increase in value to the trust).

For example, a franking credit included in trust net income is a tax notion. The franking credit does not provide a genuine increase of value to the trust (other than tax value, of course). The franking credit is merely include in assessable income as a function of the imputation system which is a notional system under the tax law which is designed to enable a taxpayer to have corporate level tax refunded to a shareholder. Further examples of notional items include:

• so much of a share of the net income of one trust (the first trust) that is included under section 97 in the calculation of the net income of another trust, but which does not represent a distribution of income of the first trust;
• so much of a net capital gain that is attributable to an increase of what would have otherwise been a relevant amount of capital proceeds for a CGT event as a result of the market value substitution rule in section 116-30 of the ITAA 1997;
• so much of a net capital gain that is attributable to a reduction of what would have otherwise been a relevant cost base or reduced cost base of a CGT asset as a result of the market value substitution rule in section 112-20 of the ITAA 1997;
• an amount taken to be a dividend paid to the trustee of the trust pursuant to subsection 109D(1), and
• an amount of attributable income under an attribution/accruals regime such as Part X (about controlled foreign companies) or Division 6AAA of Part III (about non resident transferor trusts).

The limitation to defining income of the trust estate can be problematic when it comes to income equalisation clauses in a trust deed. These clauses purport to equalise income of the trust estate with net income of the trust. To the extent notional amounts exist, the income of the trust will start to vary from net income as the notional amounts may not be included in the calculation of income of the trust estate.

However, note that an amount of notional income is able to satisfy notional expenses chargeable against trust income. That is, notional deductions can reduce notional assessable income. It is only to the extent that the total notional income amounts for an income year exceed notional expense amounts of the trust estate for that year, they cannot form part of the income of the trust estate for that income year.

The Interplay Between Income of the Trust Estate as a Trust Law Concept and the Streaming Rules

The streaming of capital gains and franked dividends (those two alone) to beneficiaries (without those capital gains and franked dividends having to be shared by beneficiaries in accordance with the percentage entitlement to income of the trust estate) is permitted under the tax law. Refer to Division 6E of the ITAA 1936 (generally) and subdivision 115-C and subdivision 207-B of the ITAA 1997.

However, in order for a streaming to be effective, along with the relevant power to stream being contained in the trust deed, the relevant beneficiary must receive an amount, or be entitled to receive an amount equal to the net financial benefit referrable to a capital gain or franked dividend. Crucially, the entitlement must be recorded in character in this way. If a franked dividend or capital gain is not recorded as such in the trust, any intention to stream will be hindered.

Remember that each capital gain (and franked dividend) may be separately streamed. Therefore, the resolution may be required to refer to the specific capital gain (or franked distribution) being streamed.

Note the risk that the ability to stream may be hindered where a loss or outgoing is applied against a relevant gross capital gain (for trust purposes) or franked distribution such that the net financial benefit is inadvertently reduced to nil. For example, where a gross gain of $100,000 is offset by a $100,000 capital loss. In this instance, there is a nil net financial benefit in respect of that particular capital gain which means it may not be streamed. There may be some discretion afforded to the trustee to determine how losses and outgoings are characterised and applied against capital gains and franked distribution in order to mitigate the risk of a nil net financial benefit outcome.

Note also the risk that a tax notional capital gain cannot be streamed (i.e. where there is no actual capital proceeds where a CGT event happens to a CGT asset and therefore the capital gain is calculated for tax purposes under the market value substitution rules).

Note also that the decision to stream will alter the calculation of the percentage share of each beneficiary to the income of the trust estate. This is because the streamed capital gain or franked distribution is removed from the process of calculating each beneficiary’s percentage share of the income of the trust estate. Any capital gain or franked distribution not streamed will still be counted in determining each beneficiary’s percentage share of the income of the trust estate.

The message here is that the way the trust is defines income of the trust estate and the powers afforded to the trustee to re characterise amounts (and the way those powers are annually exercised) should be closely considered to mitigate the risk of unwanted tax outcomes.

Disclaimers and the Different Tests Under Trust Law and the Tax Law

Importantly, there are different tests under trust law and tax law for what constitutes an effective disclaimer. Arguably, following the determinations of the High Court in the Carter case, the requirements for an effective disclaimer for tax purposes has become more onerous than the requirements for an effective disclaimer for trust law purposes.  The implication of this being that it is now entirely possible for a beneficiary to disclaim their interest for trust law purposes (and therefore forfeit the right to call of the trustee to make immediate payment) but for that disclaimer to not be effective for tax purposes. In this situation, the beneficiary would remain liable to tax on the distribution despite the fact they are no longer entitled to the amount they were made presently entitled to.

Concessional Tax Rates for Certain Trusts Where the Trustee is Assessed

Note that concessional tax rates are available in respect of a trust estate resulting from a will or intestacy (a deceased estate) or in certain other exceptional circumstances to prevent the trustee from being assessed at the highest marginal rate on income which has not been allocated to beneficiaries (via present entitlement). In this instance, there will often be less concern with the trustee being assessed on income of the trust estate as the highest tax rate does not apply.

The Retention of the Character of Income

In relation to trusts, it is important to remember that trusts are a transparent (flow through) entity. This means that income of the trust (e.g. rental income, dividend income etc.) retains its character when it flows into the hands of the relevant beneficiary who is being assessed. The beneficiary will be entitled to a share of the different types of income that comprise net income in accordance with their share of the income of the trust estate. The retention of the character principle is concept worth considering when it comes to the drafting of a trust deed and in the exercise of discretion in annual distribution resolution as it may not otherwise be possible to allocate certain beneficiaries a certain form (character) of income.