There are some things a trust just doesn’t do. A trust is not a separate legal entity. And it does not pay income tax. The beneficiaries and / or trustees do.
Income Tax for a Trust
A trust has two different concepts of income. Net income v distributable income.
Net Income
Irrespective of who pays the tax – be it the beneficiaries per s97 or s98A or the trustee per s98 – income tax is assessed based on the trust’s net income.
s97, 98A, 98:…that share of the net income of the trust estate…
Somebody will pay tax on the net income of a trust. And that net income is determined as if the trustee – not the trust itself – was as a resident tax payer.
s95:…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….
Net income is different to the trust’s distributable trust income.
Trust Income
The trust deed governs what the trustee can actually distribute. And that distributable trust income can be different to a trust’s taxable net income.
Let’s take capital gains as an example. If the trust deed defines trust income as ordinary income excluding capital gains, then the trustee can’t distribute capital gains as income.
But net income is based on tax law and there capital gains are part of taxable (assessable income).
Here is another article that might help you: Definition of Trust Income.
Annual Tax Return
Even though a trust doesn’t pay income tax on its trust income – since the beneficiaries and/or trustee do that – a trust still has to file an annual tax return.
And this makes sense. You first need to legally assess the trust’s net income before you can start allocating it to beneficiaries and / or trustees.
What Determines Allocation
So now you got the trust’s net income in the trust’s annual tax return. Who is liable to pay tax on what income?
The answer to this question depends on three factors: residency – legal disability – and present entitlement.
Residency
An individual or company is either a resident or a non-resident for tax purposes. There is no in between. Temporary residents are Australian tax residents and working holiday makers are foreign residents, just special subcategories of the real thing.
But of course it is a lot more complicated than that. Here is a link to Tax Residency of Individuals & Companies.
Whether a beneficiary is a resident or non-resident determines who is liable to pay tax. For non-residents the trustee usually steps in. It is hard to find a non-resident overseas. So the legislator goes for the trustee in Australia.
Legal Disability
You either have a legal disability or you don’t. There is no in between. The most common forms of legal disability are minors under 18 or mentally incompetent or undischarged bankrupt or felon.
But there is actually no definition of legal disability as such. So for anything more you need to dive into case law.
Whether and what type of legal disability is the second factor that determines who pays what tax on a share of income.
Presently Entitled
Present entitlement is the third deciding factor. You find present entitlement every time there is a discussion about who is liable to pay tax on the net income.
s97:…where a beneficiary of a trust estate…is presently entitled to a share of the income…s98:…where a beneficiary …under a legal disability is presently entitled to….s98A:…beneficiary who is presently entitled to that share of income…
But when are you presently entitled? What is a present entitlement? You won’t find a definition in ITAA36 or ITAA97. So case law it is. Here are the two cases that set the precedent.
In FCT v Whiting (1943) 68 CLR 99 present entitlement means entitled to immediate payment of a share in the trust. It is a right to demand payment from the trustee or require that the trustee properly reinvest, accumulate or capitalise those funds in the trust.
In Harmer v FCT 89 ATC 5180 present entitlement is the enjoyment of a right to demand and receive payment.
Present entitlement is the third factor in working out who is liable to pay tax. But it doesn’t mean that the person presently entitled is necessarily the one who has to pay the tax. It usually does, but not always. Sometimes the trustee is liable to pay tax, even though there is a present entitlement.
And it also doesn’t mean that you only ever have to pay tax on income you are presently entitled to. If net income exceeds trust income, you as beneficiary receive a portion of the excess in your assessable income even though you are not yet presently entitled to that part of the excess. This is the proportionate approach that now applies since FCT v Bamford (2010) 240 CRL 481. See Definition of Trust Income for more details.
Liable to Pay Tax
So now let’s see who is actually liable to pay tax on what income. The first step is to see whose assessable income will include that share of net income. Once that income hits an assessable income, that is when the liability to pay tax arises.
Resident – Without Legal Disability – Presently Entitled
This is the plain vanilla scenario that you find in s97 (1) ITAA 36. No bumps in the road. The beneficiary includes their share of net income in their assessable income and pays tax at their marginal rate. The trustee pays no tax.
s97 (1): …where a beneficiary ...not under any legal disability is presently entitled to a share of the income…, the assessable income of the beneficiary shall include (i) so much of that share … as is attributable to a period when the beneficiary was a resident; and (ii) so much of that share…when …not a resident …attributable to sources in Australia.
s97 (2) and s97 (3) apply the same concept to exempt and NANE (non-assessable non-exempt) income, so use exactly the same words.
Resident – With Legal Disability – Presently Entitled
So now you hit the first bump in the road. The beneficiary has a legal disability and the trustee has to step in.
s98 (1): Where a beneficiary …under a legal disability is presently entitled to a share of the income…, the trustee …shall be assessed and liable to pay tax…as if it were income of an individual…
So the trustee includes the share of income in their assessable income. But at what rate? You use the rate that applies to that particular individual …as if it were income of an individual…
So for minors under 18 you apply the Division 6AA rates. The tax rate will depend on whether the minor is a prescribed or excepted person and whether the income is eligible or excepted assessable or trust income.
After the trustee included the share in their assessable income and paid tax on that income, the beneficiary includes that income in their assessable income and receives a credit fo the tax the trustee paid. If the trustee did their job correctly, there should be no extra tax for that portion of income to pay.
Non-resident – Presently Entitled
If a non-resident beneficiary is presently entitled to a share of net income, that share is taxable in the hands of the trustee at the non-resident rates of tax.
s98 (2A): If a beneficiary…is a non-resident at the end of the year…, subsection (3A) applies to the trustee in respect of …net income…attributable to a period when the beneficiary was a resident …and net income…attributable to period when the beneficiary was not a resident and is also attributable to sources in Australia.
s98 (3): A trustee…is to be assessed and is liable to pay tax …as if it were the income of an individual …or if the beneficiary is a company… at the rate declared by the Parliament.
The non-resident beneficiary’s assessable income also includes that share of income and receives a credit for the tax paid by the trustee .
s98A (1): Where the trustee…is assessed and is liable to pay tax…, the assessable income of the beneficiary…presently entitled…shall include…net income…attributable to …when the beneficiary was a resident, and ..not a resident…and is also attributable to sources in Australia.
s98A (2): Where the trustee is assessed and is liable to pay tax…,there shall be deducted from the income tax assessed against the beneficiary…the tax paid by the trustee…. – the Commissioner shall pay to the beneficiary an amount equal to the difference between those 2 [if trustee paid more tax than necessary].
For a non-resident it doesn’t matter whether they have a legal disability or not.
Resident – Without Legal Disability – Default Beneficiary
The default beneficiary is the beneficiary who receives any distributions that no other beneficiary is presently entitled to. This is to avoid the trustee having to pay tax on this income at the top marginal rate.
For there to be a default beneficiary(s), the trust deed must provide for one through a specified clause.
If the default beneficiary has a legal disability, then the whole exercise was for nothing, since the income goes back into the trustee’s assessable income.
Not Presently Entitled
If there are no beneficiaries who are presently entitled – be they residents or non-residents – be they with or without a legal disability – the trustee is the one to pay tax on the taxable net income at the top marginal rates or at ordinary marginal rates if the income results from a will or intestacy, a bankruptcy or the Commissioners allows it (ss 99, 99A).
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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 23 March 2020
