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
Trust income is what the trust deed defines as income. It is the income the trustee can distribute to beneficiaries. But trust income is not the only definition of income relevant to a trust.
There is also net income. Net income is the trust’s taxable income, consisting of ordinary income and statutory income.
And then you also have accounting income, ie. the income you show in the trust’s financial statements.
These three definitions of income don’t necessarily match. And that is where the problem starts.
Trust Income
A trust is not a separate legal entity. It is a relationship between a trustee and its beneficiaries, governed by a 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.
Net Income
Net income is the trust’s taxable income, ie assessable income less deductions. It is the income somebody will pay tax on – a beneficiary under s97 or s98A or the trustee under s98.
s95 ITAA 1936, “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…”
Assessable income includes ordinary and statutory income. This is important.
* Exempt or non-assessable non-exempt (NANE) income doesn’t fall under assessable income.
Ordinary Income
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. Franking credits or capital gains are not. This is also important.
Statutory Income
Statutory income is listed in s6-10 (2) ITAA97.
(2) Amounts that are not ordinary income, but are included in your assessable income …, are called statutory income.
Capital gains and franking credits are statutory income.
Accounting Income
Trust income and net income are the only income definitions that matter. How does accounting income come into the mix?
Tax doesn’t worry about accounting income. Tax lives in its own little world. Net income is whatever your assessable income less deductions is. So tax will never pull accounting income into the mix.
But your trust deed might. If your trust deed says that trust income equals accounting income, then you got accounting income in the mix.
Then you can only distribute as trust income whatever profit you show in your trust’s financial statements applying generally accepted accounting principles.
So your trust income might have to equal accounting income.
Trust Income v Net Income
So you have trust income and net income.
The big problem starts when trust income is not the same as net income. When the trustee distributes x amount but the trust tax return shows y amount.
Then you have income that somebody gets but didn’t pay tax on. Or you have income that somebody pays tax on but didn’t get. In the first case, the ATO will kick up a storm. In the second case, the relevant beneficiary will.
You can’t change net income. Taxable net income is set by tax law. It is assessable income less deductions.
The only thing you can change is the definition of trust income in your trust deed. Trust income is whatever your deed says it is. So if you want to avoid any gap, you get your deed to define trust income accordingly.
Definition of Income in your Trust Deed
Trustees can’t just distribute any amount they fancy. They can only distribute trust income – aka distributable trust income – as defined in the trust deed. If the trust deed says that something is not income, then that amount is not distributable as income. End of story.
The trust deed can determine distributable trust income in five ways. It can:
a) define trust income with a s95 clause and no variations
b) define trust income with a s95 clause plus variations
c) define trust income without a s95 clause
d) empower the trustee to define trust income. Or
e) be silent on the issue.
a) s95 clause and no variations
Most modern trust deeds define trust income through a so-called s95 clause if they don’t give the trustee the power to define trust income. 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) s95 clause with variations
Some trust deeds – often older ones – define income with reference to s95 but add a variation
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 w or x,” or “also includes y and z”.
So whenever you have w, x, y or z, trust income will be different from s95 net income
c) No s95 Clause but a different definition
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, trust income doesn’t include these.
So you will have a difference whenever the trust derives capital gains or franked dividends.
d) Empower trustee to define income
Most modern trust deeds empower the trustee to define income. In that case, 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 in a state of delirium defines trust income differently from net income, you have a potential difference.
e) 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 a difference again.
How to deal with a Difference?
Whenever trust income does not equal net income, you have a difference you need to deal with.
You either have income distributed to somebody who doesn’t pay tax on this income (scenario # 1 – Trust Income > Net Income). Unhappy ATO.
Or you have somebody paying tax on income they don’t get (scenario # 2 – Trust Income < Net Income). Unhappy beneficiary or trustee.
Scenario # 1 – Trust Income > Net Income
When trust income exceeds net income, the beneficiary is only assessed on their proportionate share of net income.
And that makes sense. Taxable income is taxable income. Just because the trust deed authorises the trustee to distribute more doesn’t mean that there is more to tax.
The big question is: What happens to that excess, ie the amount of trust income that isn’t taxable? Who pays tax on that?
The answer is: Nobody – yet. The ATO assesses that income neither to a beneficiary nor to the trustee – not in the year derived and not when distributed to the beneficiary.
So what happens to it instead?
Nothing if it is a discretionary trust. There is no cost base. So CGT Event E4 shoots into the void. Or to be more precise: Discretionary trusts don’t trigger a CGT event E4. So for a discretionary trust that non-assessable income is forever non-assessable. It is NANE.
But for a unit trust, you can trigger a CGT event E4. You reduce the cost base by the non-assessable amount, assuming you have a CGT event E4. As was the case in Layala Enterprises Pty Ltd (in lieu) v FC of T 98 ATC 4858
Scenario # 2 – Trust Income < Net Income
When trust income is less than net income, the excess is assessable. You pay tax on net income. Your taxable income doesn’t go down just because your trust deed defines income to be less.*
*If it was so, all trust deeds would define trust income in a way that trust income would forever be nil.
The big question is: Who is liable to pay the tax on this excess? Remember, nobody got that excess. So who pays tax on it? Would you happily pay tax on income you never got? Of course, you wouldn’t.
So this scenario hit the Administrative Appeals Tribunal (‘AAT’) and the courts like a firestorm.
There are two schools of thought trying to solve this issue.
Quantum View
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.
Since 2010 the quantum view no longer prevails but had to give way to the proportionate view. However, the quantum view is not dead. It still applies in two cases. Streaming and when trust income is nil.
Streaming
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 is Zero
If the trust income is nil and so there is nothing to distribute, then there is no proportionate share of distributions. There must be trust income before a beneficiary can be assessed on any net income.
Hence, 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).
Proportionate Approach
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 but all to the beneficiaries.
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.
Summary
So to avoid all this drama make sure your trust deed defines trust income with reference to s95 ITAA 1936 or gives the trustee the power to define trust income.
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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 16 August 2023
