Trust Law and Trust Tax

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Contents

  • What is the Income of the Trust Estate?  
  • What is the Net Income of the Trust? 
  • The Interaction of Income of the Trust Estate and Net Income to Determine Tax Outcomes  
  • Issues with the Interaction of Income of the Trust Estate and Net Income 
  • The Ability to Define Income of the Trust Estate 
  • Limitations on the Ability to Define Income of the Trust Estate
  • The Interplay Between Income of the Trust Estate as a Trust Law Concept and the Streaming Rules
  • Disclaimers and the Different Tests Under Trust Law and the Tax Law   
  • Concessional Tax Rates for Certain Trusts where the Trustee is Assessed   
  • The Retention of the Character of Income  

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.  

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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 to Determine Tax Outcomes  

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.  
Tax payment and tax deduction planning involve strategies to minimize tax liability.

Issues with the Interaction of Income of the Trust Estate and Net Income 

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.

Tax payment and tax deduction planning involve strategies to minimize tax liability.

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. 

Tax payment and tax deduction planning involve strategies to minimize tax liability.

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. 

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.