Bamford’s case the ongoing wash-up: the ATO's view on the meaning of "income of the trust estate" – Draft Taxation Ruling TR 2012/D1

As part of the ongoing wash-up from Bamford’s case, the Australian Taxation Office (ATO) has released a draft ruling setting out its preliminary view on the meaning of the phrase "income of the trust estate" for the purposes of Division 6 of Part III of the Income Tax Assessment Act 1936 (Cth) (ITAA36).

The practical implication of the ATO’s view is that trust deeds that define "income" of the trust to mean "taxable income" may still give rise to a mismatch between:

• the "income of the trust estate" — to which the beneficiary/ies are entitled; and

• the "taxable income" of the trust — on which the tax the beneficiary/ies must pay is assessed.

This may:

• affect the application of the proportionate approach to taxing beneficiaries under section 97(1) on their share of the "income of the trust estate"; and
• in certain situations, result in trustees being left with tax payable at the highest marginal rate on some, or all, of the taxable income of the trust.

The draft ruling is contained in Draft Taxation Ruling TR 2012/D1 released on 28 March 2012.

What are the implications for Cleardocs deeds?

If you are concerned about the implications of Bamford’s case for trusts with a Cleardocs deed, then you can read an article here.

What is the relevance of the phrase "income of the trust estate"?

The phrase "income of a trust estate" is important as it determines who — the trustee or the beneficiary/ies — is liable to pay tax on the taxable income of a trust estate under Division 6 of Part III of the ITAA36.

The law provides that:

• if a beneficiary of a trust who is not under a legal disability is presently entitled to a share of the "income of the trust estate", then that beneficiary is required to pay income tax on the taxable income of the trust estate[1];

• the beneficiary must pay the tax in the same proportionate share of the "income of the trust estate" as they are presently entitled to[2]; and

• if no beneficiary is presently entitled to the "income of the trust estate", then the trustee will be liable to pay income tax on the taxable income of the trust estate.[3]

In 2010, the High Court in Bamford's case considered various issues, including the meaning of the phrase "income of the trust estate" for these purposes.

What was the outcome and significance of Bamford's case?

In Bamford's case, the High Court held that, for the purposes of the relevant section[4] the "income of the trust estate" is to be determined according to trust law (as opposed to tax law concepts). The key impact of this point is that when calculating what constitutes the "income of a trust estate" for these purposes the clauses in the trust deed determine the outcome. Because of this, the phrase "taxable income" of a trust estate does not necessarily equal the "income of the trust estate" — whether it does, or not, depends on the relevant clauses in the deed.

Bamford's case highlighted the importance of the definition of "income" in the trust deed. In particular, it highlighted the problems with the potential mismatch between the definitions of:

• the "income of the trust estate" — to which the beneficiary/ies are entitled; and
• the "taxable income" of the trust — on which the tax the beneficiary/ies must pay is assessed.

In five earlier ClearLaw articles, Maddocks has reported extensively on the developments in Bamford's case and its implications. You can read an overview of the case, with links to articles on each of the key developments, and the implications for trusts with a Cleardocs deed, here.

What is the ATO's view of the phrase "income of the trust estate" as expressed in the TR 2012/D1?

Consistent with Bamford's case, the ATO[5] accepts that the expression "income of the trust estate" for the purposes of Division 6 of Part III of the ITAA36 has no set or static meaning and will depend primarily on the terms of the trust deed and general trust law.

However, given the context of Division 6, the ATO considers that for an amount to constitute "income of a trust estate", the amount must:

1. be measured in respect of distinct years of income;
2. be a product "of the trust estate"; and
3. be an amount to which a beneficiary is, or can be made, presently entitled.

According to the ATO, this means that:

• an amount that formed part of a trust estate at the start of a particular income year cannot be "income of the trust estate" for the purposes of section 97(1) for that income year. This is so even if the trust deed provides trustee with an absolute discretion to determine what is "income"; and
• "income of the trust estate" for the purposes of section 97(1) is not the gross income of the trust estate, but the distributable income of the trust estate. That is, income that is available for distribution to beneficiaries or accumulation by the trustee.

The draft ruling is contained in Draft Taxation Ruling TR 2012/D1 released on 28 March 2012. You can read the draft ruling by clicking here.

Generally, Maddocks concurs with the ATO’s views expressed in TR 2012/D1.

What is the effect of the ATO's view?

The effect of the ATO’s view, outlined above, is that, according to the ATO, "income of the trust estate" for a particular income year is capped. That is, in the ATO's view, the "income of the trust estate" for a particular income year cannot be more than the aggregate accretions to the trust estate for that income year — less the following amounts:

• any amounts derived by the trust estate in that income year which do not "constitute income" (see next heading) under general trust law — and therefore cannot be distributed as income; and
• any outgoings or expenditure incurred in that income year which is referable or chargeable against income under general trust law.

What amounts do not "constitute income" in the ATO’s view?

The ATO considers that as the following amounts do not "constitute income" under general trust law, they cannot form part of the "income of the trust estate" for the purposes of section 97(1):

1. any franking credit amounts included in the trust's net income under subsection 207-35(1) of the Income Tax Assessment Act 1997 (Cth) (ITAA97);
2. any net capital gain derived as a result of the market value substitution rule in section 116-30 of the ITAA97 (dealing with capital proceeds) or section 112-20 of the ITAA97 (dealing with cost base);
3. any deemed dividend amounts paid to the trustee under subsection 109D(1) of the ITAA36;
4. any amount of attributable income under an attribution or accruals regime such as Part X (about controlled foreign companies) or Division 6AAA of Part III (about non-resident transferor trusts) of the ITAA36; and
5. any amount that is included in the net income of the trust under section 97(1) ITAA36 that:
   • represents a share of the net income of another trust; but
   • does not represent a distribution of income of that other trust.

What is the practical implication of the ATO's view?

The practical implication of the ATO’s view is that trust deeds that define "income" of the trust to mean "taxable income" may still give rise to a mismatch between:

• the "income of the trust estate" — to which the beneficiary/ies are entitled; and

• the "taxable income" of the trust — on which the tax the beneficiary/ies must pay is assessed.

This is because notional amounts which constitute taxable income cannot, according to the ATO, be included as "income of the trust estate" — examples of those notional amounts are: franking credits, deemed capital gains as a result of the market substitution rules, and certain deemed dividends.

This may:

• affect the application of the proportionate approach to taxing beneficiaries under section 97(1) on their share of the "income of the trust estate"; and
• in certain situations, result in trustees being left with tax payable at the highest marginal rate on some, or all, of the taxable income of the trust.

Does the draft ruling change anything to do with the new law on streaming?

The new streaming provisions recently introduced will continue to apply. They are not affected by the ATO's views as set out in the Draft Ruling. You can read more about the streaming provisions in an earlier ClearLaw article here.

How will Maddocks and Cleardocs combine to update you about any changes in the ATO’s view?

The draft ruling sets out the ATO's preliminary views of:

• how it will interpret the phrase "income of a trust estate" in Division 6 of Part III of the ITAA36; and
• how it will apply sections 97(1), 99 and 99A of the ITAA36.

However, the ATO’s view may change.

Through ClearLaw, Maddocks will notify you if there are any changes to the ATO's views or if TR 2012/D1 is finalised.

More information from Maddocks

For more information, contact Maddocks on (03) 9288 0555 and ask to speak to a member of the Tax and Revenue Team.

More Information from Cleardocs

For more information:

• about the Cleardocs:
  • Discretionary Trust, see here. You can order a trust online from that page;
  • Unit Trusts (fixed or non-fixed), see here. You can order a trust online from that page;
  • Hybrid Trust, see here. You can order a trust online from that page;
• see a Guide by Maddocks dealing with:
  • a comparison table of key benefits and things to be wary of in each type of trust, here; and
  • a comparison table of the key features of each type of trust here.

[1] Section 97(1) of the ITAA36

[2] Section 97(1) of the ITAA36 and Bamford

[3] Sections 99 and 99A of the ITAA36

[4] Section 97(1) of the ITAA36

[5] See TR 2012/D1.