The definition of trust income determines who gets what income and who pays the tax on this income. So it is important to get this right.
Definition of Trust Income
A trust is not a separate legal entity. It is a relationship between trustee and beneficiaries. And this relationship is governed by the trust deed. The trustee can only do as the trust deed allows them to do.
And so if the deed defines income in a certain way, then that is the income the trustee can distribute. Only that and nothing else. This is why the definition of trust income plays such an important role.
There are different definitions of income affecting a trust. They are different but some might overlap. Some you want to overlap.
All assessable income is either ordinary income or statutory income unless it is exempt income or non-assessable non-exempt (NANE).
Income according to ordinary concepts – ordinary income – is listed in s6-5 (1) ITAA97.
6-5 (1): Your assessable income includes income according to ordinary concepts, which is called ordinary income.
But this doesn’t tell you what ordinary income actually is. Neither ITAA 97 nor ITAA 36 tell you what ordinary income is.
Ordinary income is what everyone would consider to be income. Dividends are ordinary income., but not franking credits. This is important and you will soon see why.
Statutory income is listed in s6-10 (2) ITAA97.
(2) Amounts that are not ordinary income, but are included in your assessable income by provisions about assessable income, are called statutory income.
Capital gains and franking credits are statutory income. Franking credits are statutory income for the purposes of the gross-up provisions of the ITAA 1997.
In the trust’s financial statements you find total profit determined by applying generally accepted accounting principles.
This accounting income is whatever it is. Whether it is this amount or that doesn’t really matter as such in ‘tax land’. Tax lives in its own little world.
However, if the trust deed stipulates to determine distributable trust income in accordance with generally accepted accounting principles, then of course accounting income is relevant for that reason. Because s97 requires to determine trust income as well as net income.
Net income is defined in s95 ITAA36. It is the income that is included in assessable income – be it by the beneficiaries or trustee. It is the income somebody will pay tax on – a beneficiary under s97 or s98A or the trustee under s98.
When you look at section 95, it is actually just a list of definitions. And the definition of net income sounds like this,
net income…means the total assessable income of the trust estate calculated…as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions…
So net income per s95 is the trust’s taxable net income. And it includes capital gains. This is important.
But it is not enough to determine net income to calculate the tax consequences. You also need to calculate trust income to see whether there is a difference between the two. Because any difference might impact tax.
Trust income is what the trustee can actually distribute. Trustees can’t just distribute any amount they fancy. They can only distribute trust income – distributable trust income – as defined in the trust deed.
If the trust deed says that something is not income, then it is not income. And so can’t be distributed as trust income.
The trust deed can determine distributable trust income in four ways. It can define trust income – a) with or b) without a s95 clause. It can c) empower the trustee to define trust income. Or it can d) do neither and be silent on the issue.
a) s95 clause
Most modern trust deeds define trust income through a so-called s95 clause. A s95 clause basically just says that whatever your net income per s95 for tax purposes is, that is the income you can distribute. Not more and not less.
(Distributable) Trust income = (Taxable) Net Income
A s95 clause might look like this,
“Income of the trust is the same as net income as defined under section 95 of the Income Tax Assessment Act 1936 (as amended).”
With a s95 clause trust income always equals net income. And that is good. That’s what you want.
b) Without a s95 Clause
Some trust deeds – often older ones – define income but don’t include a s95 clause.
The trust deed might have something close to a s95 clause saying, “Trust income is equal to net income as calculated under section 95 of the ITAA36 but excludes x or y.” So some part of net income is not included in trust income.
Or the deed might say, “Trust income is income according to ordinary concepts plus x or y.”
Income according to ordinary concepts doesn’t include statutory income. So unless the trust deed specifically adds capital gains and franking credits – x and y – trust income doesn’t include these.
Whenever trust income doesn’t include all statutory income, you have an issue whenever the trust derives capital gains or franked dividends.
c) Empower trustee to define income
If the trust deed empowers the trustee to define income, you are on the right track. Assuming the trustee thinks straight, they will define trust income as net income, so basically follow a s95 clause.
But if the trustee doesn’t think straight and in a state of delirium defines trust income different to net income, you have an issue.
d) Does Neither
If the trust deed is silent on the issue, trust income is determined under ordinary concepts, which as you know does not include statutory income. And then you have an issue again.
So whenever trust income does not equal net income, you have an issue.
And the issue is that you either have income distributed to somebody who doesn’t pay tax on this income (net income < trust income).
Or you have net income that can’t be distributed. So somebody paid tax on income they didn’t get (net income > trust income).
Net Income < Trust Income
When distributable trust income exceeds net income, the beneficiary is only assessed on their proportionate share of net income.
The ATO doesn’t treat the excess as being assessable to the beneficiary, either in the year derived or when distributed to the beneficiary, or as assessable to the trustee.
However, this non-assessable amount distributed to the beneficiary will reduce the cost base of any fixed trust interests held by the beneficiary where CGT event E4 applies. As was the case in Layala Enterprises Pty Ltd (in lieu) v FC of T 98 ATC 4858
Discretionary trusts on the other hand don’t trigger a CGT event E4 since its beneficiaries don’t have any interest in the trust. There is no cost base that would be reduced.
Net Income > Trust Income
When net income exceeds trust income, the excess is assessable because Division 6 assesses net income and not trust income.
But who is liable to pay the tax on this excess?
The quantum view says that a beneficiary can only be assessed on amounts they are presently entitled to receive. And so the trustee should be assessed under s99 or 99A on the excess, since beneficiaries are not presently entitled to an amount that is not distributable trust income.
Let’s say net income is $10,000 and trust income is $8,000 distributed to four equal beneficiaries. The quantum view would see each beneficiary include $2,000 in their assessable income and the trustee paying tax on the remaining $2,000.
The proportionate view – and this is the view that now dominates since FCT v Bamford (2010) 240 CLR 481 – stipulates that beneficiaries are assessed on their share of the net income.
And that share is determined by the proportion of trust income that the beneficiaries are presently entitled to receive. If the beneficiaries are presently entitled to all of the distributable trust income, then no net income is assessed to the trustee.
So in the example the trustee now pays no tax and each beneficiary includes $2,500 in their assessable incomes, even though they only received $2,000.
This proportionate approach now dominates thanks to FCT v Bamford (2010) 240 CLR 481. In this case the High Court refers to s97 (1) which reads like this,
s97 (1) …where a beneficiary … is presently entitled to a share of the income of the trust estate, … the assessable income of the beneficiary shall include…that share of the net income of the trust estate as is attributable …
The High Court argued that the reference at the very start to “income of the trust estate” is referring to the distributable trust income. And that it is this distributable trust income that determines “that share” used to determine the beneficiaries’ share of net income. Hence confirming the proportionate approach.
So when net income exceeds trust income, beneficiaries end up paying tax on amounts they have not received since the proportionate approach now applies.
However, the quantum view is not dead. For the streaming of income under section 6E the income to stream is determined at actual amounts (quantum) and not on a proportionate basis.
Trust Income = Zero
But what happens if trust income is zero? If there is nothing to distribute, then there is no proportionate share of distributions.
So there must be trust income before a beneficiary can be assessed on any net income. If there is no distributable trust income, but there is taxable net income, the taxable net income is assessed to the trustee under either s99 or 99A (as applicable).
Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 18 January 2019