April 2010

Trusts, income & tax implications

The High Court decision in Commissioner of Taxation v Bamford clarifies and confirms two important aspects of the complicated interaction between tax law and trust law. While Bamford’s Case directly concerned a very traditional style of family discretionary trust the legal analysis and implications of the decision also apply to unit trusts, hybrid style of trusts, private fixed trusts and also managed investment trusts.

Bamford’s Case involved the interpretation of section 97 of the Income Tax Assessment Act 1936, which provides as follows:

"…….. where a beneficiary of a trust estate who is not under a legal disability is presently entitled to a share of the income of the trust estate:

(a) the assessable income of the beneficiary shall include:

(i) so much of that share of the net income of the trust estate……"

"Income" is different to "net income". "Net income" is defined in the tax laws to mean net income as calculated for tax purposes. "Income" is not defined. To apply section 97 it is necessary to know what the "income" of the trust is and what a beneficiary’s "share" of that income is. Put simply, these were the two issues before the High Court:

  • What does "income of the trust estate" mean?

  • What does "that share" mean?

What does "income" of the trust estate mean?

The first issue concerned the 2002 income year. In that year the Bamford Trust (the Trust) incurred a net loss but derived a net capital gain of $29,227 from a one-off land sale. For tax purposes, the net income of the Trust was $16,100.

Who is to be taxed on the $16,100 ? Is it the beneficiaries, Mr and Mrs Bamford, equally and at their personal marginal tax rates ? Or is it the trustee of the Trust who, if section 97 did not apply, would be taxed under section 99A at a flat rate of tax equal to the top marginal tax rate.

The Commissioner argued that "income of the trust estate" means income under ordinarily understood concepts which does not include capital gain amounts. Since there is no "income of the trust estate" there can be no beneficiary with any share of "income" and, argued the Commissioner, the trustee of the Trust should be subject to tax on the $16,100 net income under section 99A.

Mr and Mrs Bamford argued that the trustee of the Trust had a power to characterise the capital gain amount as income and that the trustee in fact exercised that power. This meant that there was "income of the trust estate" to which Mr and Mrs Bamford could be presently entitled and that they should each include $8,050 in their personal assessable income.

The High Court found in favour of the Bamfords and dismissed the Commissioner’s appeal on this first issue. The Court decided that "income" of a trust should be determined having regard to principles of trust law. This includes the common law of trusts, statutory law dealing with trusts and importantly, the trust deed that governs the trust. There is some suggestion also that accounting principles can also be used as well as trust law to calculate the "income of the trust estate".

Once again a Court has reinforced the position that the terms of the trust deed are critical to the effective administration of a trust for both trust law and tax law purposes.

The trust deed establishing the Bamford Trust had no definition of "income" and the trustee had to rely on the power to characterise the capital gain as an amount of "income" in order to achieve the result that the Bamfords’ intended. This issue would likely not have arisen for the Bamfords if the trust deed had a flexible and practical clause defining "income" as well as the trustee’s power to characterise receipts and outgoings as being on either income account or capital account.

What does "that share" mean?

In the 2000 year there was a discrepancy between "income" and "net income" of the Trust due to the Commissioner denying certain expenses that had been claimed as tax deductions. For the 2000 year, this resulted in the "net income" of the trust exceeding the "income" of the trust by $191,701. The trustee of the Trust had created in the Church of Scientology a present entitlement to the "balance" of the trust "income" after the allocation to nominated beneficiaries of specific dollar amounts allocated in a specific order.

The Bamford’s argued that, because of the way that the trustee had specifically crafted the beneficiaries present entitlements to trust "income", all of the $191,701 should be brought to tax in the hands of the "balance beneficiary" being the Church of Scientology (a tax exempt entity). The Commissioner disagreed saying that each beneficiary was required to include their proportionate share of the $191,701 in their assessable income for tax purposes.

The High Court agreed with the Commissioner confirming the long standing practice of adopting the "proportionate" view. The "proportionate" view is simply that, what ever proportion of the "income" of the trust a beneficiary is entitled to, that beneficiary must include in their assessable income for tax purposes the same proportion (ie "that share") of the trust’s net income.

For example, the "income" of a trust is $90 and the trustee, by minute, creates in Beneficiary 1 a present entitlement to "1/3 of the trust income", in Beneficiary 2 a present entitlement to "$30" and in Beneficiary 3 a present entitlement to the "balance of the trust income". Each of the Beneficiaries have a present entitlement to a share of 1/3 (ie $30) of the trust "income" albeit that the present entitlement is created by the trustee using different language in their trustee minutes. If the "net income" of the trust proves to be say $120, the proportionate view will apply to cause each of the Beneficiaries to include 1/3 of the "net income" (ie $40) in their assessable income. The excess of $30 "net income" over trust "income" is not all taxed to Beneficiary 3 being the "balance beneficiary".

Under the "proportionate" view the same mathematical approach is adopted where the "net income" of the trust is less than the "income" of the trust.

It is expected that many trust deeds will need to be reviewed and amended to assist trustees in dealing with the first issue but it is not expected that the trust deeds will need to be amended to proscribe the adoption of the "proportionate view" because this is now clearly the position at common law.

Author - Andrew Frankland