The NSW Court of Appeal's recent decision in Clark v Inglis highlights that when determining what is trust income, the definition of "income" in the trust deed is only part of the story. The other part of the story is the accounting method the trustee adopts. The Court held that unrealised gains on a trust’s portfolio of shares can form part of the trust’s distributable income — even if the gains are not assessable income for capital gains tax purposes. This is a further development on the decision in Bamford’s case.
So the key message is: be clear about the definition of income in your trust deed, and understand the implications of your chosen accounting method.
As discussed in our previous ClearLaw article here, all Cleardocs trust deeds adopt a definition of income which complies with the High Court's recent findings in Bamford.Veronica Doody and Emily Millane
If you are a trustee:
The Inglis Research Trust (Trust) was a discretionary trust, established with a corporate trustee (Company). The sole director of the Company was the deceased (Dr Inglis). The class of potential beneficiaries included Dr Inglis, his wife and his children.
From 1999-2006 the accounts were prepared on the basis of revaluing the share portfolio of the Trust and taking the net movement to the profit account as income, or as a loss, depending on how the shares performed in the previous year.
The income referable to an increase in the value of investments of the Trust was notionally distributed to the beneficiaries, including Dr Inglis. These amounts were in turn lent by Dr Inglis to the Trust, creating a beneficiary loan entitlement.
The trustee of the Trust chose to treat certain unrealised capital gains as distributable income. Although the unrealised gains may not conventionally be considered income in an accounting sense, they constituted an enforceable entitlement of the beneficiaries as against the Trust under the terms of the Trust deed. Accordingly, the Court found that by treating the capital receipts as income over a period of time, the Company had determined to recharacterise those receipts. Therefore, there was no need for an express determination by the Company to treat the receipts in this way.
The Trust's deed did not define "income". However, it did give the Trustee power to determine whether a receipt was in the nature of income or capital. The same clause in the deed also provided that characterisating a receipt or profit as income of the Trust fund had to be done in accordance with the "relevant income tax legislation".
Our recent ClearLaw article on the ATO's response to the Bamford decision here gives an overview of the relevant tax legislation and discusses the acceptable characterisation of receipts.
The dispute arose after Dr Inglis died and left his estate to his second wife. His children — aiming to protect their interests in the assets of the Trust — sought to reverse the accounting treatment and the resulting beneficiary loan account entitlement.
Over the years, by treating the unrealised gains as income the trustee had disadvantaged the children because:
But under Dr Inglis' will, his children were to benefit from the Trust assets. Therefore, they argued that the Company's accounting treatment should be reversed, then the loan owed to Dr Inglis would be reversed and the Trust assets increased.
The primary judge:
It was significant that the corporate trustee, through Dr Inglis, had accepted and adopted the accounts, and therefore validly determined to treat the increase in market value of the share portfolio as income. Treating the increase as income was supported by the fact that Dr Inglis' will showed a substantial loan account which would form an asset of his estate. The court held that Dr Inglis, in his two capacities as director and testator, understood and intended that the Trust adopted accounts and become indebted to him.
Counsel for the children:
The Court decided that even though the notion of profit is different from income, it is still possible to treat unrealised increases in the value of investments as income.
The Court accepted that the definition of income encompasses both:
This Court confirmed the Bamford position that what is "income" for the purposes of Division 6 of the 1936 Act is a question principally for the trust deed.
We reiterate our previous comments that:
For more information please contact Maddocks in Melbourne (03 9288 0555) and ask for a member of the Tax & Revenue Team.
You can access various ClearLaw articles for more relevant information relating to taxation issues:
Order Cleardocs trust packages
  NSWCA 144
 Section 97(1) of Division 6 of Part III of the Income Tax Assessment Act 1936 (1936 Act)
Leigh is a partner in the Maddocks Tax & Revenue team.
Leigh regularly provides advice on:
His advice covers both direct and indirect tax considerations.
Leigh advises Australian and multinational companies, high net worth individuals, accountants and financial advisers on all areas of taxation law.
The legal information and commentary on this site is general only. Documents ordered through Cleardocs affect the user's legal rights and liabilities. To assess their suitability for the user, legal accounting and financial advice must be obtained.
For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of their team.