Trusts

The provisions governing trusts, including in whose hands trust income is assessed and the amount assessed, are complex. A good starting point is always the trust deed. This is because the deed governs the operation of the trust.

Trust deeds

Taxpayers should review trust deeds to determine how trust income is defined, eg whether capital gains are included or whether trust income is equated with taxable income. This may have an impact on the trustee’s tax planning.

It is also critical to check who are the trust beneficiaries and ensure that all distributions of income are valid under the deed.

Family trust election

Trustees should consider whether a family trust election (FTE) is required to ensure any losses or bad debts incurred by the company will be deductible and to ensure that franking credits will be available to beneficiaries. Similar considerations can apply for companies owned by trusts.

If an FTE has been made, trusts should avoid distributing outside the family group to avoid the family trust distribution tax. The tax is 46.5% (ie the top personal marginal tax rate plus Medicare levy) on the amount or value of income or capital to which a non-family member is presently entitled or that is distributed to a non-family member.

Trusts and Division 7A

An amount of trust income to which a private company is or has been presently entitled, but that has not been distributed to the company, may be regarded as a loan made by the company to the trust, for the purposes of the deemed dividend provisions of Div 7A.

The Commissioner has indicated that he will apply Div 7A where there is an unpaid present entitlement (UPE) from a trust to an associated private company. The approach that the Commissioner will adopt in UPE cases is outlined in Taxation Ruling TR 2010/3, and guidance as to how that Ruling will be applied is contained in Practice Statement Law Administration PS LA 2010/4.

In broad terms, a trust distribution to a beneficiary who is a private company that remains unpaid may be regarded by the ATO as a deemed dividend in the hands of the trustee. Such deemed dividends could be avoided if the UPE (that arises on or after 1 July 2011) is paid out, or if a complying loan agreement is entered into, by the due date for lodgment of the private company's tax return.

Note that the ATO has also issued a supplementary guide, which taxpayers should read in conjunction with the Ruling and PS LA 2010/4. This guide is available on the ATO’s website at www.ato.gov.au/businesses/content.aspx?doc=/content/00283451.htm.

Income of a trust estate

The existence or absence of a beneficiary’s present entitlement to “income of the trust estate” is used in Div 6 to determine the liability of the beneficiary or the trustee, in a particular income year, to tax on the “net income of the trust estate”. Although the term “net income of the trust estate” is defined in s 95, the term “income of the trust estate” is not defined in ITAA 1936 and there remains some uncertainty as to its meaning. Note that the Government has committed to redrafting the trust income tax laws, partly to better align the concept of “income of the trust estate” with “net income of the trust estate”.

In FCT v Bamford (2010) 75 ATR 1, the trust deed permitted the trustee to determine that a capital gain should be treated as income of the trust estate. For the 2001–2002 income year, the trustee made such a determination and distributed equal shares of a capital gain to Mr and Mrs Bamford. The Commissioner argued that the capital gain, by its nature, was not “income of the trust estate”. The High Court held that the term “income of the trust estate” took its meaning from “the general law of trusts, but adapted to the operation of the 1936 Act upon distinct years of income”. The High Court noted that “income”, under the general law of trusts, can include a capital gain. Therefore, in Bamford, the “income of the trust estate” included a capital gain treated by the trustee as distributable income in accordance with the terms of the trust deed. In contrast, capital gains were found not to be part of the income of a trust estate in Colonial First State Investments Ltd v FCT (2011) 192 FCR 298. The basis for this decision was that there was no provision in the Constitution of the trust that permitted the trustee to treat capital gains as income of the trust estate.

The ATO now accepts that a provision of a trust instrument, or a trustee acting in accordance with a trust instrument, may treat the whole or part of a receipt as income of a period and it will thereby constitute “income of the trust estate” for the purposes of s 97: see the ATO’s Decision Impact Statement on the Bamford case and Practice Statement Law Administration PS LA 2010/1. However, the ATO considers that the Bamford case has not resolved “the effect of a recharacterisation clause that requires or permits a trustee to treat as capital what is otherwise received as income”.

Tax returns for the 2009–2010 income year and previous income years that were prepared on the basis of an interpretation of the law that was reasonably open prior to the Bamford litigation will not be disturbed unless there has been a deliberate attempt to exploit Div 6 or there is a dispute for some other reason: see Practice Statement Law Administration PS LA 2010/1.

The ATO has set out its preliminary views on the meaning of “income of the trust estate” as used in Div 6 in Draft Taxation Ruling TR 2012/D1. The Draft says there is no set or static meaning of the expression “income of the trust estate” as used in Div 6 and the meaning in the case of a particular trust will depend principally on the terms of that trust and the general law of trusts. Following Bamford, the ATO said it considers that “it is clear that the determination of the income of a trust is grounded in trust law and generally involves a focus on the receipts and outgoings for an income year”. Further, the ATO said the statutory context in which the expression is used may also influence its meaning. Note that the ATO has indicated that the Draft would not be finalised while the Government is looking to reform the law in the area. (See Pending changes relating to trust income below.)

Taxpayers should avoid retaining income in a trust because it may be taxed in the hands of the trustee at the top marginal tax rate of 46.5%.

Pending changes relating to trust income

Following the High Court's decision in Bamford, the Government announced that it would update and rewrite Australia’s trust taxation laws. The Government considers that, where used appropriately, trusts are a legitimate structure through which Australians should be able to conduct their personal and business affairs.

The Government says that any options for reform would be developed within the broad policy framework currently applying to the taxation of trust income. That is, the taxable income of a trust will continue to be assessed primarily to beneficiaries, with trustees being assessed to the extent that amounts of taxable income are not otherwise assessable to beneficiaries.

On 24 October 2012, the Government released a policy options paper for reforms to the taxation of trusts. The options paper considers two possible models for taxing trust income that were outlined in the initial consultation paper released in November 2011:

• an economic benefits model (EBM) – referred to as the "trustee assessment and deduction model" in the consultation paper, the EBM uses tax concepts to determine how different amounts should be dealt with for tax purposes. Broadly, the EBM would assess beneficiaries on taxable amounts distributed or allocated to them, with the trustee assessed on any remaining taxable income; and

• a proportionate assessment model (PAM) – referred to as the "proportionate within class" model in the consultation paper, the PAM uses general concepts of profit to determine tax outcomes. Broadly, the PAM assesses beneficiaries on a proportionate share of the trust's taxable income equal to their proportionate share of the "trust profit" of the relevant class. As currently occurs, present entitlement would be used as the basis for attributing the trust profit or class amounts to beneficiaries.

A third model canvassed in the consultation paper – the "patch" model – seems to have been ruled out. The Government has also ruled out taxing trusts like companies.

The new measures are expected to be introduced with effect from 1 July 2014. (Draft legislation has not yet been released at the time of writing.)

Tax file number (TFN) withholding rules for closely-held trusts

The TFN withholding arrangements have been extended to closely-held trusts (except where specifically excluded). However, withholding does not apply if the beneficiaries of closely-held trusts quote their TFN to the trustees of such trusts: s 202DO of ITAA 1936.

The amount to be withheld is equal to the top marginal rate plus Medicare levy (ie 46.5%). There are also reporting and payment requirements for trustees of trusts who are subject to the rules. The purpose of the measure is to encourage beneficiaries to quote their TFN to the trustees of such trusts, which will in turn enable the ATO to use the TFN information to match amounts reported by trustees and amounts reported in beneficiaries’ tax returns.

Small business entities

Under the small business entity regime, a taxpayer does not need to elect to enter into the regime. Instead, it will be apparent from a small business entity’s tax return whether it has used the tax concessions.

Concessions available

The tax concessions available to small business entities (subject to any additional criteria set out in the particular concessions themselves) include:

• capital allowance concessions – an immediate deduction for depreciating assets costing less than $6,500, and one general small business depreciation pool from the 2012–2013 year;

• an instant tax write-off for the first $5,000 of the cost of eligible motor vehicles purchased in the 2012–2013 or later income years;

• simpler trading stock rules – being allowed to ignore the difference between the opening and closing value of trading stock (up to $5,000);

• small business CGT concessions – the 15-year exemption, 50% reduction, retirement exemption and rollover concession;

• the prepaid expenses rules;

• the use of the GDP-adjusted notional tax method for working out PAYG instalments;

• the FBT car parking exemption;

• GST concessions – the choice to account for GST on a cash basis, apportion GST input tax credits annually and pay GST by instalments; andthe two-year period of review.

Definition of a small business entity

An entity is classified as a small business entity for an income year if:

• it carries on a business in the current year; and

• it had an aggregated turnover for the previous year of less than $2 million, or is likely to have an aggregated turnover for the current year that is less than $2 million.

The aggregated turnover is the annual turnover of the entity’s business plus the annual turnover of any businesses that the entity is connected to or affiliated with.

An “affiliate” is an individual or company that acts, or could reasonably be expected to act, in accordance with the directions or wishes of the taxpayer or in concert with the taxpayer in relation to the affairs of the business of the individual or company: s 328-130(1).

An entity is connected with another entity if: (a) one of the entities “controls” the other entity; or (b) if the two entities are “controlled” by the same third entity, in which case all three entities will be connected: s 328-125(1).

• NOTE: A person who is a partner in a partnership in an income year is not, in their capacity as a partner, a small business entity for the income year: s 328-110(6).

• NOTE: The Government has released draft legislation proposing to amend the connected entity test so that it is based on ownership of interests rather than beneficial ownership of interests. If enacted, the small business concessions would apply to structures involving trusts, life insurance companies and superannuation funds in the same way as they apply to structures involving other types of entities. These changes are proposed to apply to CGT events happening after 7:30pm (AEST) on 10 May 2011. The proposed amendments have not yet been introduced into Parliament.