Definition of "income" in a trust deed prevails - Bamford's case approach confirmed by the High Court

The High Court's recent decision in Bamford's case provides welcome clarity on the acceptable definition of "income" in trust deeds. Here's a summary. And some pointers.

They key message is:

• review the trust's deed to see what definition of income it has;
• determine if that is appropriate given the trust's objectives etc; and
• consider whether the definition needs to be changed (and can be changed).

The position for Cleardocs deeds is explained in the article. Basically, they allow the flexibility which the High Court has confirmed is valid.

Tina Savona

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What does the High Court's decision mean for a trust's deed?

The Bamford decision has provided certainty in relation to some long-debated issues regarding the taxation of trusts.

The decision is authority for the view that:

• the income of the trust is whatever the trust deed determines it to be. So trustee(s) and their advisors need to be aware of which definition (if any) the trust deed contains, and whether the trustee has the power to adopt a different definition in respect of a particular year of income; and
• if the beneficiaries of the relevant trust are made presently entitled to a 100% share of the "income" of the trust, then they will be required to include in their assessable income, 100% of their share of the taxable income of the trust.

Do deeds need to be reviewed or changed?

In light of the certainty provided by Bamford's case, some trustee(s) may wish (if the trust's deed allows) to change the definition of income used in the trust's deed. However, that may not be required even if the relevant definition is not the definition considered in Bamford's case.

So:

1. Yes deeds should be reviewed; and
2. No deeds do not necessarily need to be changed.

The review of the deed needs to consider whether or not the manner in which "income" is defined in the relevant trust deed is suitable for the particular trust given the underlying activities and assets of that trust.

The rule to go by: if in doubt, be vigilant

If you are in doubt about whether your trust deed complies with the requirements set out by the High Court in Bamford's case, seek legal advice. You should also ensure that the trust deed contains a power to adopt a different definition of income from year to year if needs be, and that the power is exercised on or before 30 June for that year.

What does a trust deed need to contain? What do the Cleardocs deeds contain?

It is important that trust deeds be reviewed, and that:

• the deed contains an appropriate definition of "income" - since 13 December 2004 Cleardocs deeds adopt a definition equivalent to taxable income ("net income" under section 95 of the Income tax Assessment Act 1936 (1936 Act);
• the deed contains a specific power for the trustee to determine whether receipts are to be treated as on capital or income account. For example, all Cleardocs deeds since Cleardocs launched in 2002 achieve this through giving the trustee a discretion to determine whether and to what extent a receipt or outgoing is on account of income or capital; and
• the deed contains a specific power for the trustee to determine whether to adopt an alternative definition of income in respect of a year of income by signing a minute to that effect (or taking some other action). Again, this feature was introduced into Cleardocs deeds in December 2004.

The Federal Court's earlier decision

In our ClearLaw article here we reported that the Full Federal Court in Bamford v Commissioner of Taxation [2009] FCAFC 66 held that for the purposes of section 97(1) of the Income Tax Assessment Act 1936 the term:

• "income" was to be defined in accordance with the relevant trust document (usually a deed) and therefore did not have a fixed and immutable meaning; and
• "share" did not refer to the actual amount that a beneficiary was presently entitled to but rather it referred to the proportion or percentage to which the beneficiary was entitled.

We also reported that on the basis of those holdings by the Court, the Court went on to hold:

• if a trust deed allows the trustee to treat a capital receipt as income for, say, the purposes of fixing the entitlements of beneficiaries to distributions, then the trustee can treat it that way effectively; and
• a beneficiary who became entitled to a share of that capital gain as a result of the trustee treating it that way was presently entitled (within the meaning of section 97), to that part of the income of the trust estate. Therefore, the beneficiary must include that share of the net income of the trust estate in its assessable income and the trustee is not liable to be assessed under section 99A.

The High Court case

On 30 March 2010, the High Court unanimously:

1. dismissed the Commissioner of Taxation (Commissioner) appeal about the meaning of "income". The High Court confirmed the findings of the Full Court that the meaning of "income" for the purposes of section 97 of the 1936 Act:
   • (a) was income according to ordinary concepts (which would exclude a capital gain); and
   • (b) could be influenced by any trustee power or discretion in the deed;
2. dismissed the Bamfords (Taxpayers) appeal about the meaning of "that share". The High Court confirmed the findings of the Full Court that the term "that share" in section 97(1) of the 1936 Act referred to a beneficiary's proportionate, or fractional, entitlement to the income of the trust estate.

The "income" argument and decision in the High Court case

Argument The Commissioner appealed in relation to the definition of "income". He argued that the meaning of "income" for the purposes of section 97 was income according to ordinary concepts (which would exclude a capital gain) and could not be influenced by any trustee power or discretion in the deed. He submitted that the capital gain was taxable in the hands of the trustee under s 99A.

Decision The High Court followed the decision of the Full Federal Court in Cajkusic & Ors v Commissioner of Taxation [2006] FCAFC 164 and found that "income" means income as defined by the trust deed.

The High Court confirmed that the term "income of the trust" as it appears in the opening words of section 97(1) derives its meaning from the general law of trusts (not from tax legislation). Accordingly, if the provisions of a trust deed (either because of the definition of "income" or under a specific power granted to the trustee) permit the trustee to treat a capital receipt or expense or outgoing as "income", then that is effective for the purposes of section 97 of the 1936 Act.

The "that share" argument and decision in the High Court case

Argument The Bamfords appealed in relation to the definition of "share". They argued that they should only be assessed on the specific amount of Trust income to which they were entitled — a fixed dollar amount of taxable income that should remain the same regardless of the denial of deductions.

Decision The High Court followed the findings of the Full Court and confirmed that the term "that share" in section 97(1) of the 1936 Act referred to a beneficiary's proportionate, or fractional, entitlement to the income of the trust estate. The Court endorsed the proportional approach of Sundberg J in Zeta Force Pty Ltd v Commissioner of Taxation — "the natural meaning to give to the word "share" where it appears for the second time [in s 97(1)] is "proportion" rather than "part" or "portion".

In simple terms this means that if a beneficiary of a trust is presently entitled to a percentage of the income of that trust, then that beneficiary must include that percentage of the trust's taxable income in that beneficiary's own assessable income.

More information from Maddocks

For more information please contact Maddocks in Melbourne (03 9288 0555) and ask for a member of the Tax & Revenue Team.

More Cleardocs information on trusts — www.cleardocs.com

Read

You can access various ClearLaw articles for more relevant information relating to discretionary, hybrid and unit trusts — including tables comparing the features, benefits, etc of each type of trust:

• Trusts
• 'Tax (Legislation and Law)'

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