Trusts are an integral part of real estate investment and development. Unit trusts and property syndicates are a common means of bringing money together to acquire and develop real estate assets. Many investments in these unit trusts and syndicates are effected through trusts - often family discretionary trusts.
There has been uncertainty in relation to the determination of the tax liabilities of beneficiaries and trustees. The recent High Court decision of Bamford v. FCT [2010] HCA 10 has provided clarification of two key issues, being the meaning of:
The Commissioner had issued Practice Statement PS LA 2009/7 in relation to the first issue, indicating that notwithstanding the decision in the full Federal Court, he would apply his views regarding how beneficiaries and trustees are taxed. The High Court decision corrects this position.
The taxation of trusts is governed within Division 6 of Part III of the Income Tax Assessment Act 1936. Section 97 provides that where a beneficiary of a trust is presently entitled to a share of the income of the trust estate, the beneficiary’s assessable income includes so much of that share of the net income of the trust estate. While the ‘net income of the trust estate’ is defined as the taxable income of the trust, the italicised terms are not defined, but are critical to the operation of Division 6.
Unless beneficiaries are presently entitled to the entire income of the trust estate, the trustee is assessed under section 99A at the highest marginal rate plus the Medicare Levy. If trust income is interpreted as distributable or accounting income, this can give rise to taxation of the trustee where the trust deed provides that the beneficiaries are presently entitled to an amount which is less. Further, if income does not include capital gains and the trust only derives capital gains, there may be no income to which beneficiaries are presently entitled and the trustee is taxed.
Bamford v. FCT [2010] HCA 10
(Bamford case)
A clause in the trust deed gave the trustee discretion to determine whether any receipt, profit or gain or payment, loss or outgoing or any sum of money or investment was or was not to be treated as income or on capital account. The Bamford Trust had made a capital gain from the sale of an investment property during the year. The Commissioner assessed the trustee on the basis that the income of the trust estate did not include the capital gain.
The Commissioner argued that ‘income’ referred only to income according to ordinary concepts which does not include a capital gain. The trust deed cannot change this character and, therefore, no beneficiary could be presently entitled to the capital gain. The taxpayer argued that income could be income as determined under the terms of the trust deed.
The Court regarded the expression as a reference to the body of trust law which determines the trust’s distributable income, including the exercise of any relevant discretion by the trustee:
‘The very juxtaposition with s97(1) of the defined expression ‘net income of the trust estate’ and the undefined expression ‘the income of the trust estate’ suggests that the latter has a content found in the general law of trusts, upon which Div 6 then operates.’
Therefore, if the trustee, in pursuance of a power that enabled it to do so, determined that a capital gain was part of the income so that the beneficiaries were entitled to it, there was no reason why this result should not follow for tax purposes.
The trustee treated the gain on the investment property as part of trust income and so the Bamford’s were presently entitled to that gain. As a result, they were entitled to all of the income of the trust estate and so, no assessment could be levied on the trustee in respect of income to which no beneficiary was presently entitled.
The ATO assessment adopted the proportionate approach to the meaning of ‘share’ i.e. the proportion of the income of the trust estate to which each beneficiary is presently entitled.
The Bamfords relied on the quantum approach i.e. the specific dollar share of the trust income to which the beneficiary is presently entitled, arguing that a beneficiary could not be taxed on more income than they could actually demand from the trustee. As such, any net income not included in any beneficiary’s assessable income would be assessed to the trustee.
The Court held that the proportionate view was in accordance with the meaning of the legislation.
The Bamford case is authority for the proposition that the income of the trust estate is determined by a combination of the terms of the trust deed, any exercise of relevant trustee discretions and, in the absence of provisions in the trust deed or trustee discretions, the trust law about the meaning of income. The trust deed governs what is income for the purposes of fixing the proportion to which beneficiaries are presently entitled.
The proportion is then applied to the net income to determine the tax liability of the beneficiaries.
It follows that a trust deed can define income in accordance with the provisions of the Income Tax Assessment Acts, such that profit and loss accounts of the trust can be prepared on the basis of net income to ensure there are no differences between income of the trust estate and net income.
Trust deeds should be reviewed in light of the Bamford case decision to ensure that:
As a result of the proportionate approach, a distribution that attempts to allocate specific amounts of net income to particular beneficiaries and the remainder to a residual beneficiary will be ineffective. Each beneficiary will be assessed on a proportion of the net income of the trust, based on their proportionate share of the trust income, regardless of whether they received only a specific amount of the income of the trust.
It is expected that the focus of the ATO’s audit activity will turn to monitoring compliance with the terms of the trust deed. In anticipation, taxpayers should:
