This article discusses the elements of trust, how trusts are taxed, and how the purpose of the trust affects tax.
Trusts evolved in England in response to representations for a Court of Chancery. This court brought in a new doctrine of fairness called equity and established the concept of property being held on behalf of or trust for someone e.g., a child until they could properly take possession of it themselves.
The Court recognised that the ‘legal owner’ of an asset may have an obligation to hold and administer the asset for the benefit of another person: the ‘beneficiary’ or ‘equitable owner.’
IN THIS ARTICLE
Elements of trust
Common trust for tax purposes
The taxation of trusts
Capital gains and franked dividends
Income splitting using trusts
THE ELEMENTS OF TRUST
The important elements of a trust include the following:
- a trustee who holds the trust property
- identifiable property capable of being held in trust
- certainty of beneficiaries
- a personal obligation on the trustee to deal with the trust property for the benefit of the beneficiaries
The trustee is responsible for conducting the trust and managing its assets.
The trustee can be an individual or a legal entity such as a company.
There can be more than one trustee.
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.
The beneficiaries of a trust are the nominated persons and entities listed in the trust deed as being those who are entitled to receive the benefits under the terms of the trust document.
The first thing that must be determined when making trust resolutions is that the recipient is listed as a beneficiary in the trust deed.
If the intended recipient is not a beneficiary of the trust, the resolution will be regarded as ineffective.
COMMON TRUSTS FOR TAX PURPOSES
The class of beneficiaries to whom the income of the trust is to be paid is fixed, and the share of the income to be received by each beneficiary is fixed.
These are a common form of fixed trust. The beneficial entitlement to income of the trust is divided into units and the trust income is paid to whoever holds the units at the specified distribution date.
The trustee has the discretion to choose which beneficiaries (from a class of beneficiaries specified in the trust deed) should receive the income of the trust and/or what amount is to be paid to each beneficiary.
THE TAXATION OF TRUSTS
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.
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.
The following classes of beneficiaries are regarded as being under a ‘legal disability:
- minors (under 18)
- undischarged bankrupts
INCOME OF THE TRUST
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.
NET INCOME OF THE TRUST
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.
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 AS SUCH
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.
INCOME SPLITTING USING TRUSTS
Trusts can be used to split income between the beneficiaries except in the case of personal services income (PSI – income mainly derived as the result of the personal exertion of an individual).
The ATO considers that this arrangement is subject to challenge under Part IVA ITAA 36 – the anti-avoidance provisions.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.