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On 28 March 2012, the Commissioner issued Draft Taxation Ruling TR 2012/D1 (the Draft Ruling) which sets out the Commissioner's views, in draft, in respect of the meaning of 'income of the trust estate' as used in Division 6 of Part III of the Income Tax Assessment Act 1936 (the 1936 Act).
This article sets out:
The Commissioner has called for submissions on the Draft Ruling and the closing date for these is 11 May 2012.
The term 'income of the trust estate' is used in sections 97 and 98 of the 1936 Act and is a precondition to the operation of these provisions.
Referring to section 97 of the 1936 Act, part of it provides as follows:
97(1)Subject to Division 6D, where a beneficiary of a trust estate who is not under any legal disability is presently entitled to a share of the income of the trust estate:
Section 98 of the 1936 Act deals with beneficiaries under a legal disability.
Put simply, a beneficiary presently entitled to receive a distribution of trust income will include in their assessable income the same share of the trust's net (or tax) income as the share of trust income they receive. This recognises that 'income of the trust estate' and 'net income' of the trust are two (2) different concepts. While 'net income' is defined in the 1936 Act, 'income of the trust estate' is not. The meaning of these words has been considered by numerous court cases, including the recent High Court decision in Bamford.1
In Bamford, the High Court affirmed that the phrase 'income of the trust estate' refers to "distributable income, that is to say, income ascertained by the trustee according to appropriate accounting principles and the trust instrument". In Bamford, the trustee sought to characterise a capital profit as income of the trust pursuant to clause 7(n) of the trust deed of the Bamford Trust which empowered the Trustee to determine whether any receipt "is or is not to be treated as being on income or capital account".
The Commissioner's contention in Bamford was that the income of the trust should be determined according to ordinary concepts. The capital profit was therefore not income according to ordinary concepts and it therefore would not be 'income of the trust estate' for the purposes of Division 6 of Part III of the 1936 Act. It followed that as there was no other income, there would be no 'income of the trust estate' at all and therefore the capital gain made in the 2002 income year would be left to be assessed to the trustee of the Bamford Trust pursuant to section 99A of the 1936 Act.
As stated above, the High Court did not accept the Commissioner's contention and decided the case in favour of the taxpayer (being that "income of the trust estate" is to be ascertained by the trustee according to appropriate accounting principles and the trust instrument). The net income comprising the net capital gain was therefore assessed to the beneficiary presently entitled to the capital profit (which had been re-characterised as income by the trustee in accordance with the trust deed) and not to the trustee of the Bamford Trust.
The Australian Taxation Office (the ATO) issued a decision impact statement in respect of the Bamforddecision on 2 June 2010 (the DIS). In the DIS, the Commissioner sought consultation with stakeholders regarding the meaning of "income of the trust estate" and other issues with a view to determining whether resolution of these issues required the making of public rulings. He also withdrew a number of rulings2 which, among other things, supported the streaming of different types of trust income (such as capital gains and franked dividends). These rulings, one of which dated back to 1967, were relied on by taxpayers in preparing and managing the affairs of a trust estate. The withdrawal of the rulings caused much disruption and was widely criticised at the time leading to a Government response.
That response came on 16 December 2010 when the Assistant Treasurer announced that it would conduct consultations with stakeholders as a first step towards updating the trust income tax provisions in Division 6 of Part III of the 1936 Act (the Media Release).3 The areas to be examined were as follows:
Further to the Media Release, and in March 2011, Treasury released a discussion paper which set out various options to better align the concepts of trust income (or distributable income) with taxable (or net) income. In summary, these options included defining distributable income:
Following that consultation period, the Assistant Treasurer released for public comment exposure draft legislation containing proposed amendments to enable the streaming of capital gains and franked dividends. The issue of better aligning income of the trust estate with net income was not to be dealt with as part of these proposed amendments. Instead, the issue would be addressed in a broader review and proposed rewrite of Division 6 of Part III of the 1936 Act. To ensure there could be no manipulation of the issue, to be included in a then future bill would be specific anti-avoidance rules to:
…target the use of low tax entities, especially exempt entities, to reduce the tax payable on the taxable income of the trust.4
On 21 November 2011, the Assistant Treasurer released a consultation paper titled Modernising the taxation of trust income - options for reform (Consultation Paper - November 2011) (the November 2011 Consultation Paper) the purpose of which was to explore options for the updating, re-writing and reforming of Division 6 of Part III of the 1936 Act.5 As part of that review, the interaction between distributable income (or income of the trust estate) and taxable income (or net income) is to be examined and reform options produced.
It appears that the Draft Ruling was prepared in response to requests made by members of the Trust Subgroup of the National Tax Liaison Group in their meeting of 21 October 2011. The minutes to that meeting reveal that possible topics for public rulings included:
…whether notional amounts (that is, recognised for tax purposes but which do not represent any accretion of value to the trust estate) can be income of a trust estate if the trust deed equates the trust's income with its section 95 net income.
Accordingly, given future legislative changes to Division 6 of Part III of the 1936 Act are being contemplated by Treasury by virtue of the November 2011 Consultation Paper, it would appear that the Draft Ruling's application may be limited to the period up to the date any future legislative changes take effect including for the period prior to the issue date of the ruling. To this extent, the ruling is intended to have retrospective effect.6
The starting point for the Draft Ruling is the observation that the term 'income of the trust estate' is not defined in 1936 Act. While the case law states that the term is to be defined by reference to appropriate accounting principles and the terms of the trust instrument, the Commissioner states there is a 'statutory context' which exists and which sets the parameters in which the meaning of the term must be interpreted.
That statutory context requires that the income be:
The Commissioner goes on to state that, from this, the meaning of 'income of the trust estate' cannot exceed the amount determined by the following formula (the Income Formula):7
Notional amounts which are defined to include franking credits, deemed net capital gains and amounts included by operation of the accruals and attribution provisions are not included in the definition (unless they are fully offset by notional expenses). This approach effectively imposes a maximum cap on the income of a trust estate and will apply notwithstanding any contrary term of the trust instrument which may produce a higher amount of income than the above formula.
The Draft Ruling also covers the use of income equalisation clauses which we examine further below.
As was stated in Bamford (affirming Zeta Force Pty Ltd v Commissioner of Taxation (1998) 84 FCR 70), the meaning of the term 'income of the trust estate' is the distributable income ascertained according to appropriate accounting principles and the trust instrument. Rather than adopt the specific formulation adopted in Bamford, the Draft Ruling focuses on income determined under trust law. We note that this can be potentially quite different to distributable income determined under appropriate accounting principles and the trust instrument. The Commissioner notes that the trust law encompasses the general law, statutory law, trust accounting principles, the trust deed and the actions of the trustee in administering the trust in accordance with the trust deed.
The Commissioner analyses each of these sources of the trust law. In summary:
The Commissioner states that the meaning of the 'income of the trust estate' depends not only on the trust law but also on the statutory context of Division 6 of Part III of the 1936 Act. The Commissioner states that the following propositions arise from the statutory context:
Income equalisation clauses are clauses in some trust deeds which equate the income of the trust estate with the trust's net (or taxable) income. The effect of this is to bring within 'income of the trust estate' amounts which may be treated as income for taxation purposes (such as net capital gains) and exclude other amounts which are excluded from net income (such as exempt income). There is also a corresponding and similar effect for expenses.
The Commissioner states that these clauses are valid to the extent that they do not include 'notional amounts' which are not reduced by corresponding 'notional expenses'. That is, unless the net income is represented by the net accretions of the trust, the notional amount making up the difference will not be included as income of the trust estate.
We examine Example 1 in the Draft Ruling which demonstrates the effect of some of these propositions in a typical scenario.
Example 1 involves a family trust which receives the following income and incurs the following expense in the income year:
The trust had no other income or expenses in that year. On the face of it, the trust had a loss of $5,000. Under the trust deed, 'income' was defined to mean such an amount as determined by the trustee. Therefore, pursuant to the trust deed, the trustee resolved to treat an amount of $5,001 as income. This amount represented income from a prior year which had been accumulated or capitalised.
The net income of the trust was $25,000, determined as follows:
The Commissioner concludes that, despite the determination made by the trustee, there is no income of the trust estate to which any beneficiary could be made presently entitled and therefore, the trustee will be assessed and liable to pay tax in respect of the trust's net income of $25,000. We consider the Commissioner's approach below.
Where a trust deed includes an income equalisation clause or, as in Example 1, the trustee has a power to re-characterise receipts or other amounts as income, the Commissioner asserts that notional amounts not reduced by notional expenses are not included in the income of the trust. This is illustrated in Example 1 as the franking credit was disregarded in determining the income of the trust estate. If it had been included (say by the trustee making a determination to that effect), the trust would have been taken to have had income of the trust estate of $25,000. If a beneficiary had been presently entitled to that amount, the trustee would not have been liable to pay tax.
The Commissioner regards notional amounts, such as franking credits, the deemed amount of a capital gain or attribution amounts under Part X of the 1936 Act, as not capable of being an accretion to the trust estate and not capable of being income of the trust estate.
Under the Commissioner's view, income of the trust estate cannot exceed a maximum amount which equals the total accretions to the trust estate reduced by certain amounts. Applying the Income Formula produces a negative amount ($70,000 less $75,000) which means that it is not possible for there to be any income of the trust estate in the current year. This therefore aligns the income of the trust estate with the trust's asset position (including cash) for that year. Something that does not represent a net accretion to the trust estate cannot, on this view, form part of the income of the trust estate.
The result of this in Example 1 was that the franking credit and the amount of accumulated or capitalised income of a prior year that been determined by the trustee to be income of the current year were disregarded with the consequence being that there was no income of the trustee was assessable on the net income of the trust. The mismatch between income of the trust estate and net (or tax) income prevented the net (or tax) income from being taxed in the hands of the beneficiaries.
Example 1 also illustrates the effect of this proposition. In Example 1, as there is no trust income derived in an income year (that is, there is a loss), the trustee resolved pursuant to a power specifically conferred by a term of the trust to treat part of the trust fund, representing income from a prior year which had been accumulated or capitalised, as income (thereby removing the loss and creating a small amount of income overall). This was done to ensure that there was at least some trust income and presumably to avoid the trustee being subject to tax under section 99A. This is a situation which commonly occurs in practice.
The Commissioner rejects this approach because the above proposition would not allow the trustee to treat income of the trust fund (from prior years) as income of the current year. This interpretation is likely to be disputed by many tax advisors.
We see the Commissioner's approach to the income of the trust estate represented by the Income Formula and his approach to income equalisation clauses may cause additional complexities for some trusts particularly those:
Since Bamford, the Commissioner has taken a number of positions which limit the ability of trust deeds, or the trustee acting under a power conferred by the trust deed to determine what is income.
In Bamford itself, the Commissioner argued that capital gains could not be included in income of the trust estate in spite of anything in the trust deed to the contrary. This would have had the effect that in cases where only capital gains were derived by the trust in a year of income, the tax would be borne by the trustee at significantly higher rates of tax than if the capital gain was taxed in the hands of a company or an entity entitled to a CGT discount. The Commissioner argued that this was so even where the gain was distributed to beneficiaries. Acceptance of this view would, in effect, have arbitrarily abolished the CGT discount in a number of circumstances which commonly arise. Fortunately the court ruled against the Commissioner in this case.
Following his defeat in Bamford, the Commissioner has now in the Draft Ruling taken a number of positions designed to limit the ability of trustees to determine the income of the trust estate, regardless of the powers conferred on them by the trust deed. The effect of the views taken by the Commissioner will, unsurprisingly, result in many more cases where income and gains must be taxed at higher rates in the hands of the trustee rather than at lower rates in the hands of beneficiaries. The Commissioner's view will also prevent franking credits being passed through to beneficiaries in some cases.
Notwithstanding that the interpretations put forward in the Draft Ruling are both new and at odds with previously expressed views by the ATO, they will have a retrospective application. It would be fairer to taxpayers to leave contentious interpretations which produce arbitrary outcomes to be dealt with by Treasury's review and, if some or all are to be adopted, that this be done by prospective legislation.
Some of the views expressed by the Commissioner in the Draft Ruling are questionable in that they involve elaborate and unnecessary extensions of the existing case law. These views have only recently been proffered by the Commissioner. They produce arbitrary and often deleterious outcomes for taxpayers. We think that in the interests of proper tax administration the Commissioner should act on the basis of propositions clearly supported by the case law and other propositions might be left to be considered by Treasury's review following consideration of public comments on the November 2011 Consultation Paper.
1 We also note the decision in Colonial First State Investments Limited v Commissioner of Taxation  FCA 16 and Cajkusic & Ors v Commissioner of Taxation  FCA FC 164.
2 Taxation Ruling TR95/29, Taxation Ruling IT331 and Practice Statement (General Administration) PSLA 2005/1.
3 Media Release of 16 December 2010, No 025 - Assistant Treasurer and Minister for Financial Services & Superannuation.
4 Media Release of 13 April 2011, No 052 - Assistant Treasurer and Minister for Financial Services & Superannuation.
5 Media Release of 21 November 2011, No 155 - Assistant Treasurer and Minister for Financial Services & Superannuation.
6 Refer to paragraph 59 of the Draft Ruling.
7 Refer to paragraph 13 of the Draft Ruling.
8 Refer to Forrest v Commissioner of Taxation  FCAFC 6
9 Refer to paragraph 89 of the Draft Ruling.
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