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Explanatory Memo (Client Alert in more detail)
 March 2004

Trust Distributions and Capital Gains

The Tax Office has issued a Practice Statement concerning the tax issues arising when there are distributions of trust income and capital gains to separate beneficiaries.

Based on a technical application of the law, a beneficiary entitled to a share of trust ‘income’ pays tax on that share of the trust’s net (taxable) income. As a capital gain is not ‘income’, beneficiaries entitled to income may be taxed on capital gains distributed to other beneficiaries, although they have no entitlement to the cash.

The Practice Statement outlines administrative practices that the ATO will follow in certain circumstances to address this anomaly. These are discussed further below.

Background

The rules concerning taxation of trust income are contained in Division 6 of the Income Tax Assessment Act 1936 (ITAA 1936). Most of the key sections in Division 6, for example sections 95 and 97, have been in the Act since its commencement and have not been subject to material amendment.

This has created a number of interpretative problems when considering the impact of subsequent tax reform such as capital gains tax and franking of dividends. Division 6 has not been amended to deal with the impact of provisions enacting these reforms, and it appears that Division 6 was not considered when the relevant provisions were written.

The starting point of our analysis is section 97 of the ITAA 1936. In essence, it provides that where a beneficiary not under a legal disability is presently entitled to a share of the income of a trust estate, the assessable income of the beneficiary shall include that share of the net income of the trust estate.

Income takes its ordinary meaning, based on case law and generally accepted accounting principles.

Net income is defined in subsection 95(1) of the ITAA 1936 to mean (in summary) the total assessable income of the trust estate calculated as if the trustee were a resident taxpayer, less all allowable deductions. Clearly, capital gains are not ‘income’ but they are included in assessable income and therefore ‘net income’.

The proportionate approach has been widely accepted in recent cases, including, for example, Zeta Force Pty Ltd v. FC of T [1998] ATC 4681 (Zeta Force). Under the proportionate approach, beneficiaries presently entitled to trust ‘income’ will be assessed on that share of ‘net income’ (including capital gains that they may not be entitled to). The Tax Office recognises this outcome as inappropriate in its Practice Statement.

A trustee may wish to stream a capital gain to a particular beneficiary for a variety of reasons, including an entitlement to the general 50% CGT exemption, the existence of capital losses or for commercial or family reasons.

The tax liability in relation to a capital gain must follow the ordinary income distributed, and it is not technically possible to distribute all of the income to one beneficiary and a capital gain to another. If that is attempted, the analysis of section 97 indicates that the tax liability on the capital gain will accrue to the beneficiary who gets the ordinary income entitlement.

ATO Practice Statement Law Administration PS LA 2004/3

The Tax Office has now issued Practice Statement PS LA 2004/3 for the guidance of ATO officers in relation to the tax treatment of trust beneficiaries where trust income and capital gains are distributed to separate beneficiaries. While the Practice Statement focuses on trusts that have separate and distinct income beneficiaries and capital beneficiaries, the document acknowledges that the different entitlements to income or capital may be subject only to the exercise of trustee’s discretion. On that basis, and based on discussions with the contact officer of the Practice Statement, it appears that the Tax Office accepts the application of the Practice Statement to discretionary trusts as well.

We note that the Practice Statement also focuses on ‘extra capital gains’ that arise under division 115 of the Income Tax Assessment Act 1997, concerning discount capital gains. The extra capital gain arises where a beneficiary gets a distribution of a discount capital gain from a trust. The extra capital gain grosses the capital gain up to its pre-discount amount so that a beneficiary can apply any capital losses and then apply the 50% discount, if available. Although the Practice Statement focuses on ‘extra capital gains’ the examples used show that the ATO intends to address the distribution of capital gains generally (regardless of any discount).

The PS accepts the application of the proportionate approach in relation to the distribution of trust income and acknowledges the inequitable outcomes that can result (as discussed above) where income is distributed to one beneficiary and capital gains are distributed to another. To deal with this situation, the Practice Statement outlines a capital beneficiary approach and a trustee approach, as discussed below.

Capital Beneficiary Approach

Under the capital beneficiary approach, the Tax Office will accept that a capital beneficiary includes the relevant capital gain in its assessable income, notwithstanding the outcome that would otherwise arise under the law in following the proportionate approach.

The Tax Office will accept this approach where, broadly:

         the beneficiary has a vested and indefeasible interest in the capital gain of the trust;

         the trustee has conferred a present entitlement to the capital gain for the relevant beneficiary by the end of the year of income or within a further two months of year end.

Trustee Approach

As an alternative to the capital beneficiary approach, the Tax Office will accept an assessment of the capital gain, or part of the gain, to the trustee.

This approach will only be accepted if there is no tax avoided as compared to at least (either) the proportionate approach or the capital beneficiary approach.

Written Agreements

The Practice Statement states that these concessional administrative approaches can only be followed if the capital beneficiaries and the trustee agree in writing to follow that approach. Any written agreement in this regard is to be made within two months of the end of the income year and retained for at least five years after the end of the income year.

The Tax Office notes that if a beneficiary does not prepare their income tax return in accordance with the agreement, the agreement will be ignored in assessing all other beneficiaries.

Examples

The Practice Statement contains a number of examples, together with a flow chart to illustrate the Tax Office’s proposed administrative approach. The examples given relate to fixed trusts that have separate income and capital beneficiaries. Notwithstanding, similar principles should apply in relation to discretionary trusts where the trustee’s discretion is exercised to make distributions of income and capital to separate beneficiaries.

What if ‘Income’ is Defined to Equal ‘Net Income’?

Many modern trust deeds define income to be income as defined in section 95 of the ITAA 1936, therefore including capital gains in income, at least for the purposes of working out beneficiary entitlements.

There seems to be a common view held by practitioners that where the trust deed defines income in this manner the capital gain component can be streamed to a particular beneficiary for tax purposes also. So, for example, a capital gain may be distributed to one beneficiary, and all other income (as defined) is distributed to another beneficiary.

With respect, when strictly applying the proportionate approach, there is considerable doubt. This is as a result of the distinction made between income for section 97 purposes, and income as defined in the trust deed in ANZ Ltd v. FCT [1998] ATC 4850, the comments of Finkelstein J in Richardson v. FCT [1997] ATC 5098 and also the weight of authority supporting the proportionate view as summarized in Zeta Force.

Based on these cases, it would seem that regardless of the definition in the trust deed, income for section 97 purposes will not include capital gains when the proportionate approach is followed.

Fortunately, the Practice Statement provides some potential relief from the proportionate approach as outlined above.

It should be noted that the Tax Office states in paragraph 2 of the Practice Statement that it does not deal with cases where a trust deed defines ‘income’ to be ‘net income’, as discussed above. Based on subsequent discussions, it appears that while the Tax Office lacks an established view in that case, it is likely to still apply a more practical approach on the basis outlined in the PS. Consider seeking confirmation from the ATO in appropriate cases.

Family Trust Elections of Non-Fixed Trusts

If a trustee fails to make a family trust election, a beneficiary of a non-fixed trust will be deemed not to be a qualified person even if the trustee has held the shares at risk for at least 45 days. The interest of a beneficiary of a non-fixed trust is determined by their entitlement to the relevant dividend income. As the beneficiary’s interest is not fixed (i.e. an indefeasible vested interest in the corpus of the trust), a family trust election is required. Without a family trust election, the beneficiary’s risk in interest of the underlying holdings of the trust and consequently will not be taken to have held their interest at risk for the 45 days in order to be deemed a qualified person.

For further information, please review ATO Interpretative Decision 2003/1105 –– Franking of dividends: holding period and related payments –– qualified person – no family trust election, which can be found at the following address:

<http://law.ato.gov.au/atolaw/view.htm?find=%22id%202003%2F1105%22&docid=AID/AID20031105/00001>

Where a trustee fails to make a family trust election, a beneficiary who holds an interest in the corpus of the trust will only be entitled to the tax offsets attached to dividends flowing through the trust if the beneficiary’s interest is an indefeasible vested interest in the corpus. Without a family trust election or a clause in the trust deed prohibiting the creation of other interest that may diminish the beneficiary’s interest, the beneficiary can not be said to enjoy an indefeasible vested interest and be entitled to the tax offsets.

For further information, please review ATO Interpretative Decision 2003/1106 –– Franking of dividends: holding period and related payments ––trustee of a trust –– interest in corpus, at the following address:

<http://law.ato.gov.au/atolaw/view.htm?find=%22id%202003%2F1106%22&docid=AID/AID20031106/00001>

A beneficiary is taken to hold an interest in the shares held by the trustee. In order for a beneficiary of a non-fixed trust to be a qualified person, the trustee of the trust must also be a qualified person. In order for a trustee to be a qualified person, it must hold the shares at risk for at least 45 days. There are no exceptions to this rule.

For further information, please review the ATO Interpretative Decision 2003/1108 –– Franking of dividends: holding period and related payments –– qualified person –– family trust election at the following address:

<http://law.ato.gov.au/atolaw/view.htm?find=%22id%202003%2F1108%22&docid=AID/AID20031108/00001>

No Required Holding Period for the Small Shareholder Exemption

An individual may still be qualified to receive tax offsets on franked dividends under the Small Shareholder Exemption even if their shares have not been held at risk for 45 days. The exemption treats an individual taxpayer as a qualified person in relation to all dividends paid on shares held.

To be eligible for the exemption, the following two requirements must be satisfied:

§         the individual’s franking credit total for the relevant year must not exceed $5,000; and

§         the individual must not have made, or be required to make, a related payment, such as purchasing an option, in respect of their shares.

The exemption applies regardless of when the individual acquired the shares or whether or not the shares were held at risk.

For further information, please refer to ATO Interpretative Decision 2003/1107 –– Holding period and related payments: small shareholder exemption, at the following address:

<http://law.ato.gov.au/atolaw/view.htm?find=%22id%202003%2F1107%22&docid=AID/AID20031107/00001>

Commissioner’s Discretion on Logbook Requirements for Car Fringe Benefits

Please refer to ATO Interpretative Decision 2003/1099 –– Car fringe benefits: logbook requirements –– exercise of the Commissioner’s discretion, which can be accessed via the following link:

<http://law.ato.gov.au/atolaw/view.htm?find=%22id%202003%2F1099%22&docid=AID/AID20031099/00001>

CGT Rollovers on Asset Transfers to a Company

Please refer to ATO Interpretative Decision 2004/94 — Capital gains tax: Subdivision 122 - A rollover: no consideration received:

<http://law.ato.gov.au/atolaw/view.htm?find=%22ato%20id%202004%2F94%22&docid=AID/AID200494/00001>

ATO Interpretative Decision 2004/95 — Capital Gains Tax: Subdivision 122 - A rollover: shares transferred from current shareholders:

<http://law.ato.gov.au/atolaw/view.htm?locid=‘AID/AID200495>

ATO Targets Property Schemes

For further information on this matter please refer to the following media release:

<www.ato.gov.au/corporate/content.asp?doc=/content/mr2004001.htm>