Taxation of trusts

Where capital gains and franked distributions have been derived in the current year, trustees will need to consider whether they wish to 'stream' these amounts to particular beneficiaries at year end by making them 'specifically entitled' to the capital gain and / or franked distribution.

For 'streaming' to be effective, Trust Deeds should be reviewed to ensure that capital gains may be distributed as either trust income or capital, and that they permit ‘specific entitlement’ of capital gains and franked distributions.

Trustee distribution resolutions will also need to be carefully drafted to ensure that they comply with the streaming rules.

Where a trust has distributed income during the year ended 30 June 2011 to a private company beneficiary, the entitlement to which remains unpaid, i.e. an unpaid present entitlement (UPE), a number of important deadlines are fast approaching.

Taxpayers have until the lodgement day of the trust's 2011 tax return - which for many trusts will be 15 May 2012 - to decide whether to ‘invest’ the UPE on terms that comply with the ATO's administrative guidance. If not invested by this date, the UPE will be considered a loan for Division 7A purposes. In order to avoid it being treated as a deemed dividend, taxpayers then have until just prior to the private company's lodgement day for the 2011-12 income year - which for many will be 15 May 2013 - to either pay out the UPE or place it on complying Division 7A loan terms.

Where UPEs have been put under investment agreements - in respect of either 2010 or 2011 trust distributions - it is important to remember that the first liability to pay interest under these investment agreements will arise at 30 June 2012. Interest must be accrued for the relevant period in the accounts at 30 June 2012 and paid to the private company beneficiary by the lodgement date of the trust's 2012 tax return (which for many will be 15 May 2013).

On 28 March 2012 the ATO released a Draft Taxation Ruling (TR 2012/D1) setting out the Commissioner's preliminary views as to the meaning of the 'income of the trust estate' for taxation purposes. When finalised, the draft ruling will effectively apply from 1 July 2010, although the final form it takes may depend on the outcome of the current Trust Reform process.

The draft ruling introduces a number of key concepts, including:

• The 'income of the trust estate' (often referred to as distributable income) for taxation purposes cannot be more than the sum of the net accretions to the trust estate for that year (to the extent that they are treated as income by the relevant Trust Deed). This effectively places a 'statutory cap' on what the 'income of the trust estate' may be for taxation purposes.
• Notwithstanding how a particular Trust Deed may define income, the 'income of a trust estate' for an income year cannot exceed this cap. Where the 'income of the trust estate' in accordance with the Trust Deed is greater than the 'statutory cap', the 'income of the trust estate' for taxation purposes is limited to the 'statutory cap'.
• Amounts which do not represent a net accretion in cash or value to the trust fund for an income year cannot be taken into account in calculating the 'income of the trust estate' for taxation purposes. This includes notional income and expense amounts (such as franking credits), and payments sourced from capital of the trust or from prior year income.

Although the draft ruling raises a number of issues and questions which have not been addressed by the ATO to date, it does give rise to a number of practical matters which should be considered prior to finalising 2012 trustee distribution resolutions.

• Going forward trustees will effectively have to calculate a trust's distributable income in two ways - in accordance with the Trust Deed and the draft ruling - and compare any differences to ensure that no unexpected tax outcomes result. This will be particularly important where the 'statutory cap' is $nil (see example below).

Note that the draft ruling's interpretation of 'income of the trust estate' does not in itself alter the amount of distributable income which is determined in accordance with the particular Trust Deed and which is distributed to beneficiaries. Instead it impacts the amount of distributable income taken into account for the purposes of calculating each beneficiaries' 'share' of the income of the trust estate - with this share (or percentage) then applied to the trust's taxable income in order to determine each beneficiaries final tax position in respect of the trust distribution.

• Although the primary focus of the draft ruling is on the effectiveness of income equalisation clauses (which make the trust's distributable income equal to its taxable income), the general principle that a trust's distributable income for tax purposes cannot be more than the sum of the net accretions to the trust estate for that year appears to apply to all trusts.
• When preparing trust distribution resolutions consider making beneficiaries presently entitled to a fixed percentage (%) of the trust's distributable income as opposed to a fixed amount. Although the 'statutory cap' may operate to reduce the trust's distributable income for tax purposes, as the beneficiaries are presently entitled to a fixed percentage of the trust's distributable income they continue to be taxed on the same proportion of the trust's taxable income. The draft ruling may have limited impact in this situation.
• Where trustees are looking to make beneficiaries specifically entitled to capital gains and franked distributions it will be advisable to do an 'initial' streaming calculation prior to the finalisation of any distribution resolutions to understand how beneficiaries will be taxed as the allocations between capital gains, franked distributions and other income may vary due to the application of the 'statutory cap'.

One of the major commercial implications of the draft ruling will be that it may no longer be possible for trustees to utilise income equalisation clauses to 'create' distributable income through the inclusion of 'notional income' amounts such as franking credits. This will have a particular impact on those trusts with negatively geared share portfolios.

Consider the following example where an income equalisation clause is in place.

Without Draft Ruling (per Trust Deed)		With Draft Ruling (Statutory cap)
Dividend	$70,000	Dividend	$70,000
Franking credits	$30,000	Franking credits	-
Interest	($80,000)	Interest	($80,000)
Total	$20,000	Total	$0

In accordance with the Trust Deed, the trust has $20,000 of distributable income. However, applying the draft ruling means that franking credits will be excluded from the calculation of the trust's distributable income thereby resulting in a 'statutory cap' of $nil. This means that for tax purposes the trust will be taken not to have made any distributions in the current year and that the trustee will therefore be assessed and liable to pay tax on the trust's taxable income at top marginal tax rates.

In this situation, trustees may want to consider whether it is possible under the particular Trust Deed to recharacterise certain items of trust income or expenses (as the case may be) in order to ensure that the 'statutory cap' is a positive amount.