Unrealised capital gains can constitute trust income – recent case: Clark v Inglis

The NSW Court of Appeal's recent decision in Clark v Inglis[1] 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

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How does the Court’s decision affect my trust accounting?

If you are a trustee:

• be aware that even if you don't make an express determination about the accounting method that you apply to the trust's accounts, the Commissioner may imply or infer that a determination has been made. The Commissioner will do that on the basis of how the trustee prepared the trust's accounts. So if a trustee accepts that the accounts of a trust are prepared a certain way, then doing so will constitute a determination that those methods are approved; and
• make sure you treat gains (and any tax returns lodged) in ways allowed under generally accepted accounting standards. If you are unsure what those standards are, then seek advice.

What happened in the case?

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 accounting treatment in question

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.

What did the Trust's deed say about the tax treatment of income?

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".[2]

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

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:

• the yearly Trust distributions to Dr Inglis were increased;
• this in turn increased the loan owed by the Trust to Dr Inglis; and
• this in turn reduced the Trust assets otherwise available.

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 initial decision – which the Court of Appeal upheld

The primary judge:

• indicated that income tax case law authorities were relevant but not decisive; and
• held that the Trust's deed allowed the Trustee to determine the income tax treatment of unrealised capital gains — on this point, he relied on two independent accountants and the Trust's accountant acting as expert witnesses (though they expressed reservations about the appropriateness of the activity); and
• found that — even without reference to the Trust's deed — the Trustee was entitled to treat movements in market value as income for the purposes of the Trust's accounts.

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.

Profit” v “Income”

Counsel for the children:

• argued that the corporate trustee adopted a concept of profit in making distributions from the Trust;
• argued that the concept of profit is wider than income;
• argued that the notion of profit should not be imposed on the terms of the deed when it speaks of "income"; and
• asked the Court to reverse the accounting treatment by the Company, in turn reversing the loan account to Dr Inglis.

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:

• revenue — which arises in the course of ordinary activities; and
• gains — which represent other items that meet the definition of income, and may or may not arise in the course of ordinary activities of an entity.

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

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:

• deeds should contain 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 1936 Act);
• deeds should contain a specific power for the trustee to determine whether receipts are to be treated as capital or income. 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
• deeds should contain 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). This was restated in our summary after the Bamford decision earlier this year. All Cleardocs trust deeds contain this power.

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 business and tax issues — www.cleardocs.com

Read

You can access various ClearLaw articles for more relevant information relating to taxation issues:

• Trusts
• Tax (Legislation and Law)

Order Cleardocs trust packages

• Discretionary (Family) Trust
• Unit Trust - fixed
• Unit Trust - non-fixed
• Hybrid Trust
• Service Agreement
• Bare Trust for SMSF borrowing - related party
• Bare Trust for SMSF borrowing - bank

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[1] [2010] NSWCA 144

[2] Section 97(1) of Division 6 of Part III of the Income Tax Assessment Act 1936 (1936 Act)