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Amendments to Discretionary Family Trusts / Unit Trusts

Advising Trustees of trusts in relation to the annual distribution of trust income (and the associated tax liability) is never a straight forward exercise. Over the past ten years, it has been a battle-ground of interpretation between the Australian Taxation Office (ATO) and, us, the humble tax advisor.

After almost four and a half years of litigation, as a result of the High Court’s decision in Commissioner of Taxation v Bamford; Bamford v Commissioner of Taxation [2010] HCA 10, it appears that two major interpretive questions have been answered.

1. Trust income or tax income?
   

   Regardless of what the trust deed says, the ATO has argued that the only true income of a trust is income "according to ordinary concepts", otherwise referred to as tax income. Tax income would not include a capital gain. It is from this income that the Trustee will make the trust distribution.

   Tax advisors do not agree with that argument. We look to the trust deed to determine how the deed defines what is or is not income of the trust. If the trust deed gives the Trustees power to classify capital gains as income, then our position has always been that the Trustee can distribute the capital gain, as income.

2. Proportionate / quantum approach?
   

   The second contention concerns what happens after a trust distribution has been made, but that distribution is less than what should have been distributed? Do the additional monies go to the beneficiaries in the same proportion as they had received the previous distribution, or should the additional monies be taxed in the Trustee's hands? The ATO’s stance was the first (known as the proportional approach), tax advisors believed the second (known as the quantum approach)!

Questions answered

These two questions have now been answered by the High Court in the Bamford case. The High Court has confirmed that "income of the trust estate" is to be determined by reference to the relevant trust deed. On that basis:

• If the trust deed is silent - then "income of the trust estate" is determined according to ordinary concepts (and would therefore exclude a capital gain) pursuant to section 95 of ITAA 1936;
• If the trust deed provides the Trustee with power to treat a capital gain as income, and the Trustee exercises that power, the capital gain will be part of the "income of the trust estate";
• The result of both of the above achieves the object of Division 6 of ITAA 1936 being to secure payment of tax upon the whole of the net income of a trust estate, by either the beneficiaries or the Trustee;
• a beneficiary who becomes entitled to a share of a capital gain as a result of the Trustee treating it as 'income of the trust estate' must include their share (or proportion) of the net income of the trust estate in their assessable income. The Trustee will not be liable to be assessed on that amount under section 99A of the ITAA.

So why is this decision important?

Irrespective of when your trust deed was established, we need to:

1. review certain definitions including 'income', 'net income' and 'trust income'. The definition of 'income' and various associated clauses are essential in providing the Trustees with the power to include capital gains as income for the purposes of section 97(1) of the ITAA 1936 to treat a capital gain as income for the purposes of making a distribution (and therefor to be able to take advantage of the Bamford decision). For trusts with correctly drafted deeds, the risk that capital gains will be assessed at penal rates in the hands of the Trustee is removed. Instead, the capital gain will be taxed in the hands of the beneficiaries;
2. update the powers of the Trustee to comply with the most recent requirement of the major banks in Australia. We have identified a total of 14 amendments that may be necessary;
3. insert amendments that will allow us to try to reduce the possibility of a breach of Division 7A of the ITAA and in particular section 109D(3) of Division 7A of Part III (Division 7A) of the Income Tax Assessment Act 1936, a matter specifically addressed in Taxation Ruling TR2010/3.