Streaming trust income allows the tax-effective allocation of income. In other words, streaming saves tax. It is one of the reasons why discretionary trusts are so popular in Australia.
Streaming Trust Income
Streaming trust income became possible through the introduction of Division 6E ITAA36 together with Subdivision 215-C and 207-B ITAA97. This trio came in as a response to the Bamford case.
These new rules allow a discretionary trust to isolate and stream capital gains and franked distributions together with any franking credits.
Streaming of trust income doesn’t change the total of s95 income itself. Beneficiaries or trustees still receive the same total amount of Div 6 income. Streaming just changes who gets what type of income.
Income Definitions
The trust has trust income and net income. Yes, there is also accounting income and God knows what other definition of income, but for us as tax agents only these two income definitions matter. Trust Income v Net Income.
Distributable Trust Income
Trust income is what the trustee can actually distribute. So it is the distributable trust income. The trust deed sets out how to determine this distributable trust income. Trust law concepts and general accounting principles also come in, But in principle, the trust deed determines how to calculate distributable trust income.
Taxable Net Income
Net income is the income in the trust’s tax return. So it is the trust’s taxable income. Think assessable income less deductions. It is the income somebody will pay tax on. s95 ITAA36 sets out how to determine taxable net income. Net income includes ordinary income and capital gains.
Streaming
Streaming is all about who gets what portion of the income. Who gets what portion of distributable trust income and what portion of taxable net income?
Ideally, you want both incomes to be the same. And modern trust deeds usually include a clause to allow the trustee to make them the same.
But if they are not the same, then – thanks to Bamford – you distribute net income to the same proportion as trust income.
The big question are capital gains and franking credits. Neither of these counts as ordinary income.
Trust
It all starts with the trust. You first determine the trust’s distributable and net income. Let’s assume that the trust deed includes a clause that says distributable trust income is equal to the trust’s taxable net income. So now you determine the trust’s net income.
You start with s95 ITAA36. It tells you to determine assessable income as if the trust was a resident taxpayer.
s95 ITAA36: …total assessable income…calculated…as if the trustee were a taxpayer …and were a resident, less all allowable deductions…
So net income includes net capital gains*. This is important.
*A trust can claim the 50% CGT discount in Division 115 as well as the small business CGT concessions in Division 152 ITAA97 if it meets the relevant conditions.
Net income also includes franked distributions. Wherever the franked distribution goes, the attached franking credits go as well.
s207-35 ITAA97: If…a franked distribution…; the accessible income of the…trust …includes the…franking credit on the distribution.
A trust receives a refundable tax offset for the attached franking credits, assuming that the discretionary trust has made a family trust election and satisfies the 45 days holding period.
So this is how a trust determines its net income. But the trust doesn’t pay tax on this income. The beneficiaries or trustees do.
Beneficiaries
So now we get to what streaming is about. The big question is which beneficiary will include what portion of the trust’s net income in their assessable income.
Before Division 6E ITAA36 there was no streaming of capital gains and franked distributions to specific beneficiaries. So whatever portion of trust income you received, that was your portion of capital gains and franked distributions.
The High Court in FCT v Bamford (2010) 240 CLR 481 as well as the Full Federal Court in FCT v Greenhatch [2012] FCAFD 84 confirmed the proportionate approach. (FCT = Federal Commissioner of Taxation)
Under the proportionate approach each beneficiary includes their share of net income in their assessable income. And the allocation of trust income determines that share.
The proportionate approach isn’t always great for beneficiaries. And so the legislator relented and introduced Subdivision 115-C and 207-B ITAA97 as well as Division 6E ITAA36.
A trustee can now stream net capital gains and franked distributions to specific beneficiaries if certain conditions apply.
Subdivision 115-C ITAA97 allows the streaming of capital gains, Subdivision 207-B ITAA97 franked distributions. Both share a very important concept: Specifically entitled.
Specifically Entitled
This concept of specific entitlement sits at the core of any streaming. Both s115-228 and s207-58 ITAA97 lead with that:
s115-28 and s207-58 ITAA97: (1) A beneficiary … is specifically entitled to…
There is no explicit definition of specific entitlement though. s95 ITAA36 just says, “specifically entitled has the same meaning as in the Income Tax Assessment Act 1997”. So not particularly helpful.
But there is something close to a definition.
s115-28: (1) A beneficiary … is specifically entitled to … where …the beneficiary has received, or can be reasonably expected to receive;
If nobody has a specific entitlement, there is no streaming.
Conditions
Not every trustee can stream income. And not every intention to stream ends up being a streaming of income.
The trust needs to tick five boxes in order for a streaming of capital gains or franked distributions to actually come through.
# 1 Is there a capital gain / franked distribution?
There must be a net capital gain or franked distribution. If there isn’t, then there is nothing to stream.
# 2 Does trust income include the income you want to stream?
The trust income must include the capital gain or franked distribution you want to stream. If it doesn’t, then there is nothing to stream.
If the trust deed defines trust income as ordinary income excluding statutory income, then you can’t stream capital gains since not included in trust income.
# 3 Does the trust deed empower the trustee to stream?
The trust deed must allow the trustee to stream capital gains and/or franked distributions. Without power to stream the trustee can’t stream.
The trust deed can give the trustee express or implied power to stream.
A trustee has express power to stream if the trust deed empowers the trustee to separately account for distinct classes of income or capital, and beneficiaries’ entitlements then relate to those classes.
An implied streaming power would be if the trust deed for example empowers the trustee to distribute income or capital at their absolute discretion. And there is nothing further in the trust deed, or trust law in the relevant jurisdiction, that limits that power.
# 4 Did the trustee make a beneficiary specifically entitled?
The trustee must make a beneficiary specifically entitled. Without specific entitlement there is nothing to stream.
# 5 Did the trustee record the specific entitlement on time?
If the trustee didn’t record the specific entitlement within the set time frame, then there is no streaming.
Streaming
So when a trust meets all five conditions, it can stream. And this streaming happens in two steps. Subdivision 115-C and 207-B move capital gains and franked distributions into the beneficiary’s assessable income. And Division 6E then takes these amounts out of net income. Otherwise there would be a double-up.
Net Capital Gain – Subdivision 115-C ITAA97
Subdivision 115-C starts with a clear mission statement.
s115-210: This Subdivision applies if a trust… has a net capital gain…that is taken into account in working out the …net income (as defined in section 95…)…
s115-215: The purpose…is to ensure that…net income attributable to…capital gains are treated as a beneficiary’s capital gains when assessing the beneficiary, so: …the beneficiary can apply capital losses against gains; and …the appropriate discount percentage …
A beneficiary is specifically entitled to a capital gain to the extent that, in accordance with the terms of the trust, they have or can reasonably expect to receive the capital gain. And that interest is recorded in the accounts of the trust.
s115-28: (1) A beneficiary … is specifically entitled to …a capital gain … where …an amount …that, in accordance with the terms of the trust (a) the beneficiary has received, or can be reasonably expected to receive; and (b) is …the capital gain (after …any losses…); and (c) is recorded,…, in the accounts or records of the trust no later than 2 months after the end of the income year.
(2) To avoid doubt, …something is done in accordance with the terms of the trust if it is done in accordance with (a) the exercise of a power conferred by the terms of the trust; or (b) the terms of the trust deed (if any), …legislation, the common law or the rules of equity.
Franked Distribution – Subdivision 207-B ITAA97
Subdivision 207-B follows the same concept for franked distributions. The words are almost identical to Subdivision 115-C. The main difference is a shorter time frame to record the specific entitlement – no later than the end of the income year rather than 2 months after the end of the income year.
s207-58: …and (c) is recorded,…, in the accounts or records of the trust no later than the end of the income year.
To distribute franking credits to beneficiaries, the trustee of a discretionary tust must have made a family trust election per Subdivision 272 of Schedule 2F ITAA36.
All Capital Gains and Franked Distributions
Subdivisions 115-C and 207-B don’t just deal with streamed income, meaning the capital gains and franked distributions somebody is specifically entitled to. But also with the capital gains and franked distributions that only have a present entitlement attached.
s115-227: …a beneficiary or the trustee …has.. a share of a capital gain that is the sum of (a) …the capital gain…specifically entitled to and (b)…the capital gain to which no beneficiary…is specifically entitled, and to which the trustee is not specifically entitled – that amount multiplied by the entity’s adjusted Division 6 percentage…
s207-55 (4): the amount is the sum of…(a)…specifically entitled…and…(b) amount of the franked distributions to which no beneficiary is specifically entitled – that amount multiplied by…the…adjusted Division 6 percentage…
So Subdivision 115-C and 207-B deal with all capital gains and all franked distributions – be it specific entitlement or only a present entitlement.
The specific entitlements get allocated to the relevant beneficiary at quantum (so the full amount). And the present entitlements get allocated on a proportionate basis using the adjusted Division 6 percentage.
Division 6E
So now you look at the rest of the trust’s net income. But that s95 income currently still includes capital gains and/or franked distributions. Subdiv 115-C and 207-B ITAA97 moved the amounts into assessable income but they didn’t take them out of s95 net income. Right now we are doubling up.
And so Division 6E ITAA36 saves the day by taking capital gains and franked distributions plus franking credits out of s95 net income. Division 6E is actually reasonably short. It just has three sections: 102 UW, 102 UX and 102 UY. That is all.
s102 UW
Section 102UW just sets out when Div 6E will apply. Not much action here yet.
s102UW: This Division applies if: (a) the net income…exceeds nil; and (b) any of the following are taken into account in working out the net income..: ((i) a capital gain (…after applying steps 1 to 4 of the method statement … ); (ii) a franked distribution …; (iii) a franking credit.
s102 UX
Section 102 UX doesn’t do much either. It basically just says that when you work out the assessable income for a beneficiary or trustee, take the adjusted Division 6E amounts.
s102 UX (2): Assume that the income…were equal to the Division 6E income…(3) Assume that the net income…were equal to the Division 6E net income…(4) Assume that the amount of a present entitlement …were equal to…Division 6E present entitlement.
s102 UY
So then finally s102 UY in Division 6 E comes in and actually does the work. It adjusts the income of the trust to exclude the income already allocated and then allocates the rest on a proportionate basis using the adjusted Div 6 percentage.
There is Division 6E income, Division 6E net income and Division 6E present entitlement. You get to these by starting with trust income, net income and a beneficiary’s present entitlement and then taking out any capital gains, franked distributions and franking credits.
s102UY: (2) The Division 6E income… is the income … worked out on the assumption that…the things mentioned in paragraph 102UW(b) were disregarded. The Division 6E income … cannot be less than nil.
(3) The Division 6E net income..is the net income …worked out on the assumption that the things mentioned in paragraph 102UW(b) were disregarded. The Division 6E net income …cannot be less than nil.
(4) A beneficiary …has… a Division 6E present entitlement to the income …that is equal to the amount of the beneficiary’s present entitlement to the income…, decreased by: (a) …the beneficiary’s share of the capital gain …; and (b) …the beneficiary’s share of the franked distribution…
Adjusted Division 6 Percentages
The adjusted Division 6 percentage plays a huge role in all this. It is the percentage used to allocate any presently entitled amounts on a proportionate basis. It is calculated by taking a beneficiary’s present entitlement less their specific entitlements and dividing it by net income less any specific entitlements.
The adjusted Div 6 percentage is defined in s95 ITAA36.
s95: adjusted Division 6 percentage…means the entity’s Division 6 percentage of the income of the trust estate calculated on the assumption that the amount of a capital gain or franked distribution to which any beneficiary or the trustee of the trust estate is specifically entitled were disregarded in working out the income of the trust estate.
Consultation Paper
The Federal Government released a Consultation Paper in November 2011 with the aim to reform the taxation of trusts. There was a lot more to follow. But so far nothing has.
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