Taxation Trusts Income
Taxation (Trusts) 568
Taxation of Trusts: Trust Income v Net Income. An examination of operation of s 97(1) and proportionate approach and quantum approach
Introduction
It is common for the trust income (income calculated in accordance with trust deed and trust law principles) to be different from net income (assessable income less allowable deductions) of the trust estate. If net income exceed trust income, difficulties arise in determining whether the excess is assessable in the hands of the beneficiaries or the trustee.
Further difficulties arise where the difference between accounting and taxable income is due to a capital gain which the trust deed or trust law treats as an addition to the capital or corpus of the trust, but which the CGT provisions treat as assessable income. Further, where beneficiaries entitled to income are not the same as those entitled to capital, the issue then is whether income beneficiaries, capital beneficiaries or the trustee is assessable in respect of net capital gains.
These problems are addressed by defining the concepts of net income, trust law income, present entitlement and examining the operation of s 97(1) of ITAA 1936. The conclusions are drawn on the basis of various decided Case Laws, Commissioners’ rulings, Asprey Committee Report which have examined application of s 97(1), and proportionate and quantum methods to deal with the issue.
Meaning of Net Income, Trust Income and Present entitlement and operation of s 97(1)
Section 97(1) of ITAA 1936 provides that where a beneficiary of a trust estate who is not under legal disability is presently entitled to “a ‘share’ of the income of the trust estate”, the assessable income of the beneficiary shall include “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.
Before determining the tax liability of a presently entitled beneficiary under s 97(1), “net income” and “income of the trust estate (trust income)” must first be determined.
“Net income” of the trust estate is defined under s 95(1) of ITAA 1936 as the assessable income of the trust, calculated as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions. Thus, net income is a tax law concept which represents the taxable income of a trust estate.
In contrast, “income of the trust estate (trust income)” is a trust law concept which is calculated in accordance with trust law principles and the relevant terms of the trust deed (Master Tax Guide 2006, p.222). Thus, trust income is generally calculated in accordance with generally accepted accounting principles, as distinct from tax law principles. If the trust deed authorises the trustee to treat an amount as income even if it would not be income under general law, the amount is income of the trust estate for the purposes of Div 6 (ATP 2006, para.29 115).
Where the amounts of trust income and net income of a trust are equal, no problems arise in the application of s 97(1), and the amount included in the beneficiary’s assessable income will be the amount of trust income to which beneficiary is presently entitled.
However, in practice, net income may exceed trust income when under tax laws certain amounts are included in assessable income which are not income according to trust law concepts, for instance, (a) an expense for accounting purposes may not be an allowable deduction for income tax purposes (b) capital gain which a trust deed (or trust law) treats as an addition to the capital or corpus of the trust, but which the capital gains tax (CGT) provisions treat as assessable income (Master Tax Guide 2006, p.222).
On the other hand, trust income may exceed net income where deductions such as depreciation on capital items is allowed for tax purposes that does not exist or is smaller for accounting purposes (Master Tax Guide 2006, p.222).
It is a prerequisite for applying s 97(1) that a beneficiary must be “presently entitled” to a share of trust income. In Whiting case, full court held that beneficiary will be presently entitled if it can demand payment of the income from the trustee. In case of deceased estate, beneficiary will not be presently entitled to income until it is possible to ascertain the residue with certainty, that is, after provision of debts, legacies.
This is also the practice adopted by the Commissioner as set out in Taxation Ruling No IT 2622. Under s 95A(1) of ITAA 1936, a beneficiary is taken to be presently entitled when income is paid or for whose benefit income is applied. Under s 95A(2) of ITAA 1936, a person who is not otherwise presently entitled to the income of a trust but who has a vested and indefeasible interest in it is deemed to be presently entitled to the income.
When trust income and net income differ, then it is to be determined as to how much amount should be included in the beneficiary’s assessable income under s 97(1). Two approaches namely, proportionate approach and quantum approach, are used to address this issue by the courts and the Australian Tax Office.
The Proportionate Approach
Section 97(1) uses the words “presently entitled to a share of income of the trust estate” and “so much of that share of the net income of the trust estate”. Further s 96 states that except provided in this act, a trustee shall not be liable as a trustee to pay income tax upon the income of the trust estate.
It seems that according to s 97(1) and s 96, a beneficiary should be assessed on his or her share of net income and not on the amount of actual receipts even though it is unfair to the beneficiary. Legislative drafters have sought to tax presently entitled beneficiary’s on their “share” of net income of the trust estate under s 97(1) until they are legally disabled or income of the fund is accumulated.
In Zeta Force case, Sundberg J held that “. …the construction of s 97(1)(a) seems reasonably clear to me, although it may, as I have indicated, result in unfairness to beneficiaries. Had the legislature intended a beneficiary to be assessed on no more than the amount of the distributable income to which he is presently entitled, it could easily have said so.”
Under s 97(1), “share” means “percentage (proportion)”. Under proportionate approach which was adopted by Hill J in Davis case, “a share” is interpreted as a proportion or percentage of trust distribution. In Zeta Force case, Sundberg J acknowledged that “…. ‘that share’ in the phrase ‘that share of the net income of the trust estate’ in s 97(1) as meaning a ‘fraction’ or ‘proportion’ and not an amount.”
Firstly, the share of trust income to which the beneficiary is entitled is calculated as proportion or percentage of total trust income. This percentage is applied to the s 95(1) net income, to determine the amount of net income to be included in the beneficiary’s assessable income under s 97(1). For instance, if the beneficiary is entitled to 40% of trust income, the beneficiary will include 40% of the net income calculated under s 95 in beneficiary’s assessable income.
Where beneficiaries are not entitled to whole of the trust income, the balance of unallocated net income will be assessed to the trustee under s 99 or 99A of ITAA 1936. In Zeta Force case, Sundberg J has interpreted word “part” as “portion”. Therefore, under s 99 and 99A trustee will only be taxed on that “portion” of net income which has not been taxed in the hands of the beneficiary.
In Zeta Force case, Sundberg J held that “once the share of the distributable income to which the beneficiary was presently entitled had been worked out, the notion of present entitlement had served the purpose, and the beneficiary was to be taxed on that share (or proportion) of the taxable income of the trust estate….share where it appears for the second time is ‘proportion’ rather than ‘part’ or ‘portion’. When Parliament wanted to convey the latter meaning, as it did in s 99 and s 99A, it used the word ‘part’.”
Where net income exceeds trust income, presently entitled beneficiaries will be required under s 97(1) to include in their assessable income, amounts which are greater than the amounts which they either received or are entitled to receive. Where net income exceeds trust income due to capital gains, income beneficiaries who are presently entitled to the trust income are generally taxed on a proportion of the capital gain under s 97, s 98 or s 100 subject to adjustments required by subdiv.115C of ITAA 1997. This approach may not be appropriate if the gain relates to an amount that benefits a capital beneficiary. Despite the problems that arise when net income exceeds trust income, the proportionate approach is widely accepted as the correct interpretation of s 97(1) (ATP 2005, p.1096-1097).
In contrast, where trust income exceeds net income, the amount included in the assessable income of presently entitled beneficiaries will be less than the amount of trust income to which they are presently entitled. Any excess of trust income over net income will be distributed tax-free. This result is equitable because it allows the flow-through of tax concessions which beneficiaries would have received if the income had been derived through a partnership or as an individual taxpayer. However, commissioner may assess beneficiaries on distributions of trust income in excess of net income under s 99B and 99C of ITAA 1936 (ATP 2005, p.1096).
The Quantum Approach
Under the quantum view, “a share” is interpreted as the quantum or specific amount of trust income to which the beneficiary is presently entitled. In Richardson case, Merkel J has interpreted word “share” as a “quantum” when trust income is greater than net income. This dollar amount represents “that share of the net income of the trust estate” which is included in the assessable income of a presently entitled beneficiary under s 97(1).
In Zeta Force case, Sundberg J held that alternative method treats“…‘that share’ as meaning the share of the net income to which the beneficiary is presently entitled.” However, an alternative interpretation of the quantum approach was stated in Davis case, where Hill J held that a beneficiary “could be taxed on less than he or she received if the share of trust law income exceeded that part of net income as is represented by trust law income, and the maximum rate of tax under s 99A would be applicable to the balance.” Therefore according to this interpretation penalty rates will apply to the untaxed balance of net income.
Where net income exceeds trust income, the amount included in the assessable income of a beneficiary will be limited to that part of net income which equals the specific amount of the beneficiary’s present entitlement to trust income. The balance amount is taxed to the trustee under s 99A or 99. Generally 99A will apply to tax trustees on income to which no beneficiary is presently entitled at maximum marginal tax rate (penalty rates) because commissioner has very limited discretion to apply marginal rates applicable to individuals under s 99.
In Richardson case, Merkel J recommended the proportion approach where trust income exceeds net income and the quantum approach where net income exceeds trust income. This gives a different operation to the phrase “share of the net income of the trust estate” depending on whether trust income is less or greater than net income.
Merkel J attempted to justify this approach by reference to the modern rule of construction which aims to avoid absurd, extraordinary, capricious, irrational or obscure results which do not conform with legislative intent. Merkel J held that “…to give effect to the statutory purpose, different approaches to the operation of s 97(1) and in particular to the meaning of a ‘share’…need to be adopted depending on whether the trust income is less or greater than the trust’s assessable income.” This approach lacks consistency as it does not adopt one interpretation of word “share”.
Under quantum approach , where net income exceeds trust income, capital gains are taxed in hands of a trustee generally under s 99A. This is unfair as trustee is taxed at maximum marginal tax rates on the assumption that income is accumulated in the trust for tax avoidance purposes. This assumption is inappropriate because capital gains form part of the corpus of the trust under trust law and accumulated capital will generate future income flows for the benefit of income beneficiaries.
Where trust income exceeds net income, entire income will be taxed in the hands of the beneficiary under both approaches.
(www.austlii.edu.au/au.journals.SydLRev/1998/28.html)
Alternative solutions to address the problems in proportionate approach and quantum approach
In Zeta Force case, Sundberg J acknowledged that in case trust income exceeds net income, proportionate approach would satisfy the purpose of s 97(1). However, in this case, CGT event E4 will occur for beneficiaries with fixed entitlements under s 104-70 ITAA 1997. This may result in a reduction in the beneficiary’s cost base for any interest in the trust under s 104-70(6) of ITAA 1997.
However, where trust income is less than net income neither the proportionate approach nor the quantum approach produce equitable results. The proportionate approach does not achieve the statutory purpose of s 97(1) as the beneficiary will bear liability in respect of taxable income to which the beneficiary was not and will not be presently entitled (Master Tax Guide 2006, p.222).
To avoid this inequity, in Richardson case, Merkel J proposed that the quantum approach should apply. But problem will arise if trustee is required under the trust deed to accumulate part of net income as corpus of the trust. In such a case, trustee will pay tax on accumulated income at penalty rates under s 99A which is unfair as accumulated capital will generate future income flows for the benefit of income beneficiaries. Also it is inappropriate to assume that income is accumulated in the trust for tax avoidance purposes.
(www.austlii.edu.au/au.journals.SydLRev/1998/28.html)
If the trust deed authorises the trustee to treat an amount as income even if it would not be income under general law, the amount is income of the trust estate for the purposes of Div 6 (ATP 2006, para 29 115). In the article “A Matter of Trusts”, Harwood, A has recommended that trust deed should be amended so that trust income is calculated in accordance with s 95. In such a case, there would be no problems in applying s 97 as the inequity of taxing beneficiaries on income to which they have no entitlement will be removed.
(Taxation of Australia, A Matter of Trusts p.547)
If trust deed is amended to equate trust income with net income, the problems arise because trust income will be redefined whenever income tax legislation is amended, giving rise to uncertainty in relation to the taxation of trusts. Moreover it is unfair for capital beneficiaries to have accretions of capital available for distribution to income beneficiaries as it fails to recognise the different interests of income and capital beneficiaries in the trust (ATP 2005, p.1096-1097).
Instead of equating trust income with net income, it better to give power to the trustee to determine whether receipts are to be treated as capital or income.
The trust deeds of many trusts define realised gains to be trust income, thereby allowing such gains to be distributed to income beneficiaries. For income tax purposes the gains retain their character as capital gains and are regarded as income to which income beneficiaries are presently entitled and are therefore included in income assessed in the hands of beneficiaries under s 97, s 98A or s 100, subject to any adjustments required by subdiv.115C of ITAA 1997 (ATP 2006, para.29 130) . In such cases, the proportionate view can be accepted as it produces equitable results. But this will not give equitable results if income and capital beneficiaries are different.
However, in case where net income exceeds trust income due to capital gain, the Commissioner’s practice has been to assess the capital beneficiary. Practice Statement PS LA 2005/1 (GA) sets out the commissioner’s approach to the taxation of net capital gain included in the net income of a resident trust that has separate income and capital beneficiaries. This practice statement applies if :
Under capital beneficiary approach, the Commissioner will accept assessing a capital gain to a trustee on behalf of a beneficiary or treating a beneficiary as having a capital gain or gains for the purposes of s 115- 215(3) of ITAA 1997 to the extent that the beneficiary either has:
(a) by the end of the year, a vested and indefeasible interest in the trust capital representing the trust’s capital gain or, if the trust’s capital gain is a deemed amount for tax purposes, the beneficiary would have had such an interest if the gain were represented by actual trust capital; or
(b) been allocated the trust’s capital gain within 2 months after the end of the income year. All beneficiaries and trustee must agree in writing to use capital beneficiary approach. Requirements of the capital beneficiary approach would not be met if the capital beneficiaries have contingent or defeasible interests, or if their interests are mere expectancies and the trustee’s discretion has not been exercised in their favour.
The commissioner will also accept trustee approach, for convenience, where trustee will be assessed for the capital gain under s 99 or 99A and all income beneficiaries who are presently entitled to the trust income for the particular income year, capital beneficiaries and the trustee agree in writing to use it.
In case of capital beneficiary approach, a written agreement is required between beneficiaries and trustee. There is no requirement for an agreement in case of trustee approach.
Commissioner’s approach is confusing and does not resolve the controversy as to which approach is the correct interpretation of s 97(1). Also, Commissioner’s approach does not give equitable results if income and capital beneficiaries are different.
Certain “Public Unit Trusts” also called “Corporate Unit Trusts” and “Public Trading Trusts” are taxed as companies (Master Tax Guide 2006, p.246-247). There is an argument in favour of taxing discretionary trusts like companies because the two kinds of entities share certain common characteristics such as limited liability (if the trustee is a company), trusts are often used as substitutes for companies (Taxation of Discretionary Trusts, para 47-48).
(www.taxboard.gov.au/content/trusts/index.asp)
The Board of Taxation is not convinced with this argument. The Board of Taxation is of the view that, discretionary trusts have much limited access to equity finance than companies. Therefore at least for larger businesses, discretionary trusts may not provide the same advantages as companies, and are therefore unlikely to be used as substitutes for companies.
Moreover, it is inappropriate to apply the corporate taxation regime to trusts because this will import all the inequities and complexities associated with the corporate model into the taxation of trusts, for instance, wastage of franking credits, the high administrative costs and complexities associated with an imputation system and the wipe-out of tax concessions specifically allowed in legislation (Taxation of Discretionary Trusts, para 49-61).
(www.taxboard.gov.au/content/trusts/index.asp)
The Asprey Report recommends that where net income exceeds trust income, beneficiaries should be taxed on their present entitlement to trust income, but excess should be taxed to the trustee. (Asprey Report, para 15.18). To avoid inequity, the excess of net income over trust income should be taxed as income of an individual at a special tax rate which is less than penalty rates. The commissioner will retain discretion to tax trustees at penalty rates where the discrepancy between net income and trust income was brought about for tax avoidance purposes (Asprey Report, para 15.34).
(http://setis.library.usyd.edu.au/oztexts/parsons.html)
The Asprey Report recommendation is an exception to the adoption of the proportion approach where net income exceeds trust income. Therefore, in the absence of statutory reform, the Asprey Committee’s recommendations may be preferable among the alternative solutions suggested as it avoids the inequitable result of taxing the wrong beneficiaries under the proportionate approach, and removes the unjust taxation of trustees at penalty rates under the quantum approach where net income exceeds trust income.
Conclusion
In Richardson case, Merkel J’s interpretation of word “share” depends on whether net income is greater (interpreted as quantum share) or lesser (interpreted as proportionate share) than trust income lacks consistency and is confusing as it fails to give one interpretation of “share” that promotes the legislative purpose.
Approaches adopted by the Commissioner and different courts, such as, in Zeta Force case and Davis case, does not resolve the confusion and controversy as to which approach is correct interpretation of s 97(1). None of the approaches suggested by Commissioner or courts give equitable results, specially in case, where trust income includes capital gains and income and capital beneficiaries are different. However, proportionate approach is widely accepted as the correct interpretation of s 97(1).
Some alternative methods have been suggested where net income differs from trust income. These include, amending the trust instrument’s definition of income, taxing trusts like companies, or adopting the Asprey Committee’s recommendations.
The Asprey Committee’s recommendations may be preferable among the alternative solutions suggested as it avoids the inequitable result of taxing the wrong beneficiaries under the proportionate approach, and removes the unjust taxation of trustees at penalty rates under the quantum approach where net income exceeds trust income. However, legislative amendment is required to address the problems in proportionate approach and quantum approach.
References
Books
Core Tax Legislation & Study Guide, 9th edition, CCH Australia Limited, Sydney, 2006.
Australian Master Tax Guide, 38th edition, CCH Australia Limited, Sydney, 2006, Chapter 6.
Australian Tax Handbook, Australian Tax Practice, NSW, 2005, Chapter 29.
Australian Tax Handbook, Australian Tax Practice, NSW, 2006, para.29 115-29 130.
Web Sites
www.ato.gov.au
www.aph.gov.au
www.taxboard.gov.au
Practice Statements/Tax Determinations and Tax Rulings
PS LA 2005/1 (GA)
Tax Ruling IT 2622
Cases
Richardson v FCT (2001) 37 ATR 452
Zeta Force Pty Ltd v FCT 39 ATR 277
Davis v FCT (1989) 20 ATR 548
FCT v Whiting (1943) 2 AITR 421
Journal Articles/Reports
Taxation in Australia Issue (2005). A Matter of Trusts. Drafting Resolutions for the Distribution of Trust Income. Issue 39 10 May p.546-548.
Richardson v FCT (1998) SydLRev 28 available at
www.austlii.edu.au/au.journals.SydLRev/1998/28.html
Taxation of Discretionary Trusts, A Report by The Treasurer and The Minister of
Revenue and Assistant Treasurer para.45-61 available at
www.taxboard.gov.au/content/trusts/index.asp
Asprey Committee Report para.15.1-15.40 available at
http://setis.library.usyd.edu.au/oztexts/parsons.html
Lecture Notes
Lecture material on Taxation (Trusts) 568, Lecturer: Syd Jenkins.
