Today marks the two year anniversary since the five judges of the High Court of Australia handed down its much publicised decision in the Bamford case. The key element of this decision was the question of what is meant by the five words "income of the trust estate" in tax provisions that determine how trustees and beneficiaries are taxed.
One year and 364 days PB (i.e. "Post Bamford") the Australian Taxation Office ("ATO") have released their own interpretation as to what the Commissioner believes the High Court of Australia really meant, in the form of Draft Taxation Ruling TR 2012/D1 (the "Draft Ruling"). The Draft Ruling discusses the meaning of the term "income of the trust estate" and provides a number of illustrative examples.
Context of the Draft Ruling
The architecture of the current tax regime for trusts is built around two core concepts:
- the income of a trust estate; and
- the net income of a trust.
The term "net income" is defined in section 95 of the Income Tax Assessment Act 1936 ("ITAA 1936") to broadly be the trust's taxable income. However "income of a trust" is not given a statutory definition. These terms assume significance because they determine the respective tax liabilities of the trust's trustee and beneficiaries.
The concept of income is of major important to trusts because:
- who is entitled to the income of a trust estate will generally determine where the tax liability for the corresponding taxable income falls; and
- if any part of the income of a trust estate is not distributed in any year of income, some part of the taxable income of the trust will not be assessed to beneficiaries, but will suffer maximum tax at the trustee level.
In broad terms, if a percentage of the trust's "income" has been distributed to a beneficiary, the beneficiary will include the same percentage of the trust's net income in their own assessable income. If any percentage of the trust's income has not been distributed to the beneficiaries, the trustee will pay tax on the same percentage of the trust's net income at the highest marginal rate (46.5%).
Because the determination and allocation of a trust's income drives the trustee's and beneficiaries' tax liabilities, the meaning of trust income has been the subject of dispute between the ATO and taxpayers. These disputes culminated in 2010 with the High Court decision in Commissioner of Taxation v Bamford (Bamford).1 In Bamford the Court held that the income of a trust was its distributable income according to trust law concepts. This definition would be influenced by any definition of income contained in the trust deed.
Following Bamford, most practitioners understand 'trust income' to be the amount defined as income in the trust deed. If the deed does not contain an income definition, the trust's income is generally considered to be its accounting income.
What does the Draft Ruling say?
Key points from the Draft Ruling:
- The ATO believes "income equalisation clauses" will not always be effective. An "income equalisation" clause is essentially a provision in the trust document that purports to define "income" of a trust estate as its net income (taxable income), seeking to eliminate any difference between the two concepts. Some deeds define income this way, others give the trustee a discretion to determine income in this manner.
- According to the ATO view, the income of a trust will be capped at the value of actual accretions to the trust during the applicable period (i.e. realised and unrealised profits/gains).
- Notional amounts such as franking credits will not be accretions to the trust2.
- Income equalisation clauses can have the effect of reclassifying certain income accretions as capital, provided that the accretion is not part of taxable income (e.g. exempt income).
Practical issues with income equalisation clauses
Given the importance of an income definition, almost all modern trust deeds contain an income definition clause. It is not uncommon for trust deeds to have an income equalisation clause. In addition, it is not uncommon for a trust deed to provide the trustee a power to reclassify amounts as either income or capital, respectively, such that the trustee can determine the amount of trust income (the latter is generally referred to as a re-characterisation clause).
Income equalisation clauses were popular in that they were seen as providing a relatively simple means for beneficiaries to be taxed on only what they receive and to avoid trustee assessment. However, the Draft Ruling highlights the ATO view that an income equalisation clause can present difficulties in practice. The Draft Ruling accepts that, PB, a trust's income can be determined by reference to a definition in the trust deed. However it has adopted what is expected to be an unpopular approach to the treatment of notional amounts and the operation of income equalisation clauses.
- It states that the trust's income in any given year is capped at actual accretions to the trust fund in that year. A consequence is that is that notional amounts cannot be accretions to the trust. In essence this will limit the trust's income to realised and arguably unrealised profits/gains.
- It adopts a complicated approach to income equalisation clauses that will require trustees to analyse each component of the trust's income in detail. Whether amounts are included in trust income will depend on their treatment for tax purposes. It will also depend on whether the amount is an accretion to the trust fund.
The following example illustrates the ATO's approach.
Example 4 from the Draft Ruling
During the year, the Adelaide Family Trust derives the following income, and has no expenses:
|Capital gain (before discount)||$200,000|
The deed of the Adelaide Family Trust contains an income equalisation clause.
The ATO says that the Trust's net income would be $330,000 ($130,000 rent + $70,000 dividend + $30,000 franking credit + $100,000 net capital gain). However its income would be $300,000, calculated in the following way:
- total accretions ($500,000 comprised of the $130,000 rent + $70,000 dividend + $200,000 actual capital gain + $100,000 exempt income);
- less accretions which have not been allocated to income ($200,000 comprised of the $100,000 discount component of the capital gain + $100,000 exempt income); and
- less any depletions to the trust fund for that year chargeable against income ($nil).
Practical issues arising from the draft ruling
The draft ruling highlights the need for trustees to give particular consideration to any income definitions/clauses in the trust document and to consider whether there have been sufficient accretions to the trust for the definition to be effective for Division 6. This process will commonly require significantly more analysis than has previously been the case, particularly where income flows through chains of trusts.
What is particularly interesting (but not altogether surprising) about the Draft Ruling is what is not said about re-characterisation clauses and, in particular, whether the re-characterisation of an income receipt to a trust capital accretion is effective for the purpose of Division 6. In our opinion such a re-characterisation, if properly exercised under a power in the deed, should be effective and does not breach the parameters set by the Draft Ruling.
How/if the Draft Ruling might impact on other area of the tax law that use the term "income" in the context of trusts remains to be seen. Some examples of other areas of the tax law the rely on the quantification of income in a trust context include:
- small business CGT concessions;
- other small business entity rules; and
- provisions relating to the taxation of financial arrangements (the connected entity test).
One would hope that the coverage of the final ruling deals with these other areas, to reduce uncertainty and to provide consistency.
It is also important to consider how the Draft Ruling will interact with other developments in trust taxation and compliance. For example, the ATO is conducting a compliance/education program to ensure trustees make appropriate trustee resolutions on or before the end of the income year. The Draft Ruling may make this task an increasingly challenging exercise for trustees, having regard to the approach taken in relation to notional amounts and income equalisation clauses.
Finally, it should be remembered that Treasury is conducting a comprehensive review of the trust taxing provisions with a significant rewrite being likely. Regardless of the outcome, trusts are likely to face continued tax challenges for the foreseeable future.
1 HCA 10.
2It is noted that some deeds may have a more sophisticated income equalisation clause that defines income in a way that excludes notional income.
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