High Court rules on trust income

In an eagerly awaited decision, the High Court has unanimously handed down its judgment in the Bamford case confirming that it is correct to apply the “proportionate view” where the net income of a trust for tax purposes exceeds its accounting income. In a related issue, the Court also upheld a decision that a capital gain made by a trust, but distributed as trust income, should be treated as income of the trust for tax purposes.

The decision is important in determining the extent to which beneficiaries of trusts are assessable to trust distributions.

Mr and Mrs Bamford were beneficiaries of a trust (the B Trust) and also the directors of the trustee company. In the 2000 income year, the B Trust made a contribution to an offshore superannuation fund on behalf of Mr and Mrs B using borrowed funds. In determining the net income of the B Trust for that year, the trustee claimed a deduction for the contribution and the interest on the loan ($191,701 in total).

The net income was then distributed to various beneficiaries, including Mr and Mrs Bamford, each of them receiving specific monetary amounts.

In 2005, the Commissioner applied the anti-avoidance provisions of the tax law to disallow the deductions for the superannuation contribution and the interest. As a consequence, the B Trust’s taxable income for the 2000 income year exceeded its accounting income.

The Commissioner then issued amended assessments to Mr and Mrs Bamford, contending they were liable to tax on a proportionate share of the amount by which the taxable income exceeded the trust income (ie. the “proportionate view”). The High Court has now upheld this view.

The trust deed in the Bamford case gave the trustee the discretion to determine whether a particular receipt should be treated as income or capital. The trustee relied on this power to pass a resolution to distribute the first $60,000 of net income, “including [the] capital gain”, to Mr and Mrs Bamford in equal shares.

The Commissioner, however, contended that the capital gain did not constitute income of the B Trust and, since under tax law, there was no beneficiary presently entitled to the amount in question, assessed the trustee at the special rate allowed under the tax law.

The Full Federal Court has earlier found for the Commissioner on the first issue, but disagreed with the Commissioner on the other issue, finding that the capital gain formed part of the net income of the B Trust. Both parties appealed to the High Court which dismissed both appeals.

The High Court’s decision

The High Court unanimously dismissed the appeals by the Commissioner and Mr and Mrs Bamford.

The Court said that the words “income of the trust estate” in the tax law (s 97(1) of the Income Tax Assessment Act 1936) refer to distributable income, that is, income ascertained by the trustee according to appropriate accounting principles and the trust deed. Having identified the share of the distributable income to which the beneficiary is presently entitled, the Court said s 97(1) requires “that share of the net income of the trust estate” to be ascertained, ie. that share of the taxable income (and not the distributable income).

In the 2000 income year, the net income of the B Trust included the amount of $191,701 which had been wrongly claimed as a deduction. Thus, the Court said the assessable income of Mr and Mrs Bamford included a share of that amount equivalent to the share they each received of the distributable income.

Capital gain

On the capital gain issue, in the High Court’s view, the word “income” is to be interpreted as income of the trust estate as understood in trust law. Accordingly, it said the net capital gain became income of the B Trust once the trustee exercised its discretion to treat the capital gain as income of the trust.

The wash-up

The drafting of trust deeds should always be done with great care. The High Court’s decision, while it confirms what many considered to be the case, also highlights the importance of the terms of trust deeds (eg. does the deed adequately define “income”?) and of minutes recording the distribution of income. The definition of “income of the trust estate” in the trust deed is critical.

Those SMEs with trusts, or who are considering setting up a trust, should be aware of the Court’s decision and obtain professional advice.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.

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