Bamford's Case: Time to Revisit the Trust Deed

Advising trustees of trusts in relation to the annual distribution of trust income (and the associated tax liability) is never a straight forward exercise.  The correct position at law and the technical guidance available for taxation purposes has often been a battle-ground of interpretation between the Australian Taxation Office (“ATO”) and the humble tax advisor.

The ATO stringently enforces the argument that, regardless what the trust deed says, the only true income of the trust is income “according to ordinary concepts”, and from this the Trustee will make the trust distribution.  On the other side, tax advisors have long since held the ground that we look to the trust deed and what the deed identifies as income of the trust, and from there the Trustee will make the trust distribution.

Trust income defined
The starting point is section 95 of the Income Tax Assessment Act 1936 (“ITAA 1936”), which defines the concept of “net income” of a trust estate as assessable income, less allowable deductions, of the trust estate in respect of a year of income.  Thus, net income is similar to the concept of taxable income.

Then there is the concept of “present entitlement”, where section 97 of ITAA 1936 provides that a beneficiary of a trust estate, who is not under any legal disability, is presently entitled to a share of the income of the trust estate the assessable income of the beneficiary includes that share of the net income of the trust estate.

Simply due to the terminology used in these two sections, there is often considerable uncertainty in relation to the calculation and taxation of trust income.  Section 95 refers to “net income” of the trust estate or taxable income (ie. total assessable income less allowable deductions), whereas section 97 makes reference to the “income of the trust estate” which indicates that income should be calculated in accordance with the specific trust deed concerned and general trust law principles (ie. not tax law principles).

The decision in Bamford’s Case
The Full Federal Court (“the Court”) declared emphatically the “proportionate approach” as the appropriate way to deal with trust distributions, even where beneficiaries are allocated specific dollar amounts.  The proportionate approach states that regardless of the formulation of the “net income” that applies, whatever share of that income is enjoyed by a beneficiary as a present entitlement, the beneficiary will have included in its assessable income that same proportionate share of the net income of the trust.

The Court also confirmed that “income of the trust estate” (from section 97) is determined by the contents of the relevant trust deed.  On that basis it can be concluded that:

·    If the trust deed is silent - then “income of the trust estate” is determined according to ordinary concepts;

·    If the trust deed adopts income determined according to Australian Accounting Standards - then that is the prevailing income concept; or

·    If section 95 concepts are adopted - then the calculations used to determine “net income” prevail.

Furthermore, if the trustee is entitled to treat a capital gain as income according to the terms of the trust deed, it will be part of the “income of the trust estate” for the purpose of determining the proportion of the net income of the trust assessable to the beneficiaries individually.

This clearly highlights the importance of having a relevant and up to date definition of income in every trust deed, regardless of when the trust deed was executed.

How are trust distributions effected by the definition of “net income” adopted?

We provide the following example to illustrate the effect a different definition of “net income” in the trust deed will have on the trust distributions of a trust.

In this example, we see the basis on which the Trustee of the Bamford Trust intended to distribute the “net income” for the 2000 tax year.

By using the word “next” in Column A to describe each succeeding distribution, it would appear that the Trustee of the Bamford Trust contemplated that the quantum approach would apply – which differs to the proportionate approach adopted by the Commissioner.

In Column B, we can see the actual income for the 2000 tax year was $187,530 and the trust distributions of income made were in accordance with the trust deed (in Column A), making distributions up to Mr & Mrs Bamford.

After the Commissioner disallowed a superannuation contribution and interest deductions amounting to $191,702, the net income of the Bamford Trust was increased to $379,232.  In Column C, we see the adjusted net income of $379,232 was allocated on a proportionate approach to the presently entitled beneficiaries from Column A.

In Column D, we can see that if no determination had been made by the Trustee of the Bamford Trust to define “net income”, and section 95 had instead applied to the calculation of the net income, the trust distribution of the adjusted net income of $379,232 would have been allocated as seen above.

The effect of adopting a section 95 definition of “net income” and using a balance method of distribution (for the last beneficiary) is to isolate any adjustment to the net income of the trust in the hands of the balance beneficiary.  The “fixed” distributions, for example to the children, remain unaffected.

Where to now?
Following the announcement of the Bamford decision, there are some important practical consequences for taxpayers.  Firstly, for trusts with correctly drafted deeds, the risk that capital gains will be assessed at penal rates by the trustee (if the trust does not derive other income in the year) is removed.  Instead, the capital gain will be taxed in the hands of the beneficiaries.

Secondly, following the Full Federal Court’s support of the proportionate approach, even in circumstances where a beneficiary is only allocated a defined dollar sum, it clearly follows that if trust deeds are not appropriately drafted, beneficiaries may be taxed on more than the actual distribution amount they receive.

It is now timely to consider the review of trust deeds, to ensure the trust deed effectively defines “net income” of the trust and provides the ability to redefine capital gains as “income of the trust estate”.

We recommend that if you have a trust structure and have not reviewed the trust deed in the last two to three years, it would be prudent to contact your knp representative and we can arrange to review the details of the trust deed and any recent distribution minutes to ensure the most appropriate definitions and terms are being used.

Email your knp representative, knp@knp.com.au or call to make an appointment on +61 3 9824 8111.