Question

What is meant by the term ‘net income’ in Div 6 ITAA 1936? How does it affect the taxation of income derived by a trust?

Answer 1

The rules concerning taxation of trust income are contained in Division 6 of the Income Tax Assessment Act 1936 (the ITAA 1936).  Most of the key sections in Division 6, for example sections 95 and 97, have been in the Act since its commencement and have not been subject to material amendment.

This has created a number of interpretational problems when considering the impact of subsequent tax reform such as capital gains tax and franking of dividends. Division 6 has not been amended to deal with the impact of provisions enacting these reforms, and it appears that Division 6 was not considered when the relevant provisions were written.

As a result, issues arise concerning whether capital gains, dividend gross up amounts and other statutory income amounts are included in income for the purposes of Division 6, and if not how the net income of the trust as defined in section 95 (which clearly includes these amounts) is distributed amongst trust beneficiaries.

Given the number of trusts, the lack of certainty in the area and the apparent demise of entity tax these issues have never been more relevant, nor has there ever been a greater need for clarification and reform.

The issues covered below include:

• the meaning of income in section 97;
• dealing with accounting and tax differences;
• present entitlement and associated practical issues, including reliance on default beneficiaries and timing of year end distributions;
• quantum versus proportionate views;
• the ATO approach;
• the impact of section 50 in relation to the allocation of expenses;
• streaming of capital gains and dividends;
• dealing with capital gains where there is no income;
• various other practical issues and planning opportunities; and
• a general overview of other trust issues including private company loan rules, trust and company losses and the 45 day rule.

Without a present entitlement to some income, it is impossible to flow the tax liability on the net income of the trust to the beneficiaries.

If there is no such present entitlement, the trustee will be liable for tax on the net income.

As a starting point, one might well expect that an undefined term takes its ordinary meaning. While perhaps it need not necessarily follow, it might therefore be argued that the meaning of the term income can be determined by applying GAAP as modified or clarified by the substantial body of case law on the meaning of income for tax purposes.

A word of warning here.  Accountants commonly prepare special purpose accounts which do not necessarily comply with accounting standards or GAAP, so it does not follow that the (net) income figure in your annual accounts necessarily represents income for GAAP.

A number of people have argued that if you define the term income in the trust deed, then that definition determines its meaning.

The better view is that it is not possible to alter the meaning of a word in an Act by way of a definition in a contract or a deed. Having said that, it is our understanding that the Australian Taxation Office (ATO) has historically accepted this argument, so it can be expected that a good number of people have relied upon it.

Net income is defined in subsection 95(1) of the ITAA 1936 to mean (in summary) the total assessable income of the trust estate calculated as if the trustee were a resident taxpayer in respect of that income, less all allowable deductions.

Clearly there will be circumstances where there are differences between the net income of the trust which is based on assessable income less allowable deductions, and income for GAAP less amounts expensed against that income for accounting purposes.  Obvious differences arise as a result of capital gains, imputation gross ups and other deemed statutory income amounts that would not be included in ordinary income (for example imputed CFC and FIF income, deemed dividends and transfer pricing adjustments).  Alternatively certain income is tax exempt, for example under sections 23AH and 23AJ of the ITAA 1936, but would be included in GAAP income.  Further, there may be differences in the timing of income recognition or related deductions.