Trusts. Basics. Back to Basics. Seminar. An NTAA. Topics covered

Transcription

1 Trusts Basics 2016 An NTAA Back to Basics Seminar Topics covered A Hands-on Guide to Setting Up and Operating a Trust Accounting for Trusts Common journal entries used to prepare the financials Step-by-step Guide to Preparing the 2016 Trust Tax Return STEP 1: Dealing with all major income and expense items STEP 2: Completing the Distribution Statement Avoid making costly mistakes An Essential Guide to Distributions from a Beneficiary s Perspective! And...all this is wrapped up with a comprehensive CASE STUDY, which brings together and highlights the various tax issues associated with trusts! Presented by Rebecca Morgan & Ben Kilkenny on behalf of the National Tax & Accountants Association Ltd.

2 Trusts Basics 2016 Statement of purpose and intention IMPORTANT INFORMATION This seminar paper ( paper ) has been produced for the purpose of continuing professional education seminars provided by the National Tax and Accountants Association Ltd ( NTAA ) to its members. Those members are professional accountants, tax agents and tax advisers to whom the NTAA provides continuing education in relation to matters of taxation and accounting. The information contained in this paper together with anything said at any time during the seminars which are conducted by reference to it, including during periods of informal discussions, ( seminar information ) is intended to be educational and used as a guide only. The seminar information is not intended to constitute advice. A person should not act on the basis of the seminar information as it has been generalised for educational purposes. In particular, the seminar information does not consider all of the matters that might be relevant to a particular client in particular circumstances. As the seminar information may apply differently to different people in different circumstances, the seminar information should not be used as a substitute for expert advice. Seminar information is not financial product advice. The NTAA and those who present the seminar information do not hold an Australian Financial Services Licence nor are they otherwise authorised to provide financial product advice pursuant to the Corporations Act Whenever you see this symbol in the seminar notes it identifies an example of a matter which may require the intervention of a person who is licensed or authorised, in order to give financial product advice. This has been done to highlight areas of particular concern. Note that it should not be assumed that, because there is no warning symbol, no licence or authorisation is required. A person who is not licensed or authorised should not give financial product advice. An unlicensed or unauthorised person can however provide factual information. ASIC regulatory guides 36 and 244 explain the difference between financial product advice and factual information (it is also noted that a limited exemption applies to registered tax agents or BAS agents (within the meaning of the Tax Agent Services Act 2009). That exemption is set out at S.766B(5)(c) of the Corporations Act 2001). Private Binding Rulings Any Private Binding Ruling ( PBR ) referred to in these seminar notes (as published on the ATO s register) cannot be relied upon as precedent or used for determining how the ATO will apply the law in other cases. This is because a PBR is only binding on the ATO in relation to the specific taxpayer to whom the ruling was issued, some of the material facts have been removed in preparing the edited version for publication on the ATO s website, and the PBR has not been updated by the ATO to reflect, for example, changes in legislation and any changes in the ATO s view on how the law applies. Disclaimer The NTAA, its directors, employees, contractors, consultants, presenters, related entities, authors and anyone else involved in the production of the seminar information expressly disclaim any and all liability to any person, whether a purchaser or not, for the consequences of anything done or omitted to be done by any such person relying on any part or the whole of the seminar information, including the appearance or omission of a warning symbol. The seminar information may be subject to change as taxation, superannuation and related laws and practices alter frequently and without warning. National Tax & Accountants Association Ltd: 2016

3 Trusts Basics 2016 All persons and other entities appearing in any Examples or Case Studies in these notes are fictitious. Any resemblance to real persons or entities, living, dead or otherwise, is purely coincidental. Exemptions and concessions The seminar information has not taken into account the various Legislation, Practice Statements, Revenue Rulings and General Guidelines issued by State and Territory revenue authorities. This may have an effect on the application of the exemptions and concessions referred to in the paper. The application of exemptions and concessions are further subject to all relevant conditions and requirements being met. Copyright Copyright 2016 National Tax & Accountants' Association Ltd. All rights reserved. Except as permitted by the Copyright Act 1968, no part of this information may be reproduced or published in any form or by any means, electronic or mechanical, including photocopying, recording, or by information storage or retrieval system, without prior written permission from NTAA. Reproduction in unaltered form for your personal, non-commercial use is permitted. Other than for any use permitted under the Copyright Act 1968, all other rights are reserved. Law The law is stated as at 29 July Acknowledgments The preparation of these notes has involved a tremendous amount of work and commitment by Rebecca Morgan, Taxation Manager and Ben Kilkenny, Taxation Specialist. A special thank you should also go to the following people: Kristyn House, Marketing Manager, for her assistance with project managing the seminar. Sara Barnett, Seminar Co-ordinators, for her assistance in collating and formatting these notes. Kristyn House and Brett Pollard for filming and editing the online version of this seminar. Presented by: Rebecca Morgan, Taxation Manager & Ben Kilkenny, Taxation Specialist On behalf of the National Tax & Accountants Association Ltd Palmerston Crescent South Melbourne Vic 3205 Telephone : (03) Facsimile : (03) National Tax & Accountants Association Ltd: 2016

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5 Trusts Basics 2016 BASICS TO SETTING UP A TRUST... 1 Introduction What is necessary to set up a trust? Key roles in a trust Key clauses in an effective trust deed Types of trusts Discretionary trust Unit trust Hybrid trust Bare trust Class trust Testamentary trust or Will trust Child maintenance trust Service trust Superannuation fund Special disability trust Other trusts Advantages and disadvantages of popular trust structures Tax administration issues with trusts Who applies for a trust tax file number? Who is required to lodge a trust tax return? When is a trust an Australian resident for tax purposes? Common GST issues with setting up a trust Who registers for GST the trust or trustee? Whose name and ABN goes on tax invoices? What are the GST registration issues for a partnership of discretionary trusts? National Tax & Accountants Association Ltd: August 2016 i

6 Trusts Basics 2016 TAXING TRUST INCOME The concept of trust income Trust income in accordance with the trust deed Trust income may be reduced under statutory cap Distributing trust income to beneficiaries Who pays tax on the net (taxable) income? Where a beneficiary is made entitled to trust income Where no beneficiary is entitled to trust income Taxing trust income that does not include capital gains and/or franked dividends The proportionate approach and later amendments The taxation of capital gains The taxation of a capital gain which has been streamed to a trust beneficiary The taxation of a capital gain which has not been streamed to trust beneficiaries The taxation of franked dividends The taxation of a franked dividend which has been streamed to a trust beneficiary The taxation of a franked dividend which has not been 'streamed' to a trust beneficiary The taxation of other trust income The taxation of other income where trust income includes capital gains and/or franked dividends Dealing with revenue losses ACCOUNTING FOR TRUSTS Accounting for a trust where income is determined under ordinary concepts What does ordinary concepts mean? Accounting for a trust where income is determined under an equalisation clause Accounting for capital gains and franked dividends Dealing with entertainment expenses and Division ii National Tax & Accountants Association Ltd: August 2016

7 Trusts Basics 2016 OTHER IMPORTANT TRUST ISSUES Trust exposure to Division 7A Unpaid present entitlement between a trust and a bucket company Subdivision EA and bucket company UPEs Trust losses and family trust elections How to navigate the trust loss provisions Accessing revenue losses using FTEs The small business entity regime Personal Services Income ( PSI ) Working out if the PSI rules apply What if the PSI rules do not apply? What if the PSI rules do apply? Reporting net PSI where the PSI rules apply PREPARING THE 2016 TRUST TAX RETURN Introduction Using financial accounts to prepare a trust tax return Process for completing the trust tax return Key items that need to be considered in the financials Major income items When is income derived for tax purposes? What is included in assessable income? Major expense items Completing Item 5 Business expenses Checklist of common business deductions Reconciling accounting profit to taxable income Income reconciliation adjustments (Label A) Expense reconciliation adjustments (Label B) Worksheet for tax reconciliation on the T Return Checklist of common reconciliation adjustments National Tax & Accountants Association Ltd: August 2016 iii

8 Trusts Basics Net Small Business Income Other tax return labels COMPLETING THE DISTRIBUTION STATEMENT Completing the Statement of Distribution Primary production versus non-primary production activities Statement of Distribution A guide to the key labels A BENEFICIARY S PERSPECTIVE Distributions to resident individuals Recording a net capital gain distributed by a trust Dealing with tax-free distributions from a unit trust Correctly reporting PSI attributed from a trust Distributions to minors Determining when a minor needs to lodge a tax return Exclusions and exceptions to Division 6AA Distributions to resident companies Recording trust distributions on the C Return Distributions to non-residents Overview of the rules CASE STUDY Case study K9 Discretionary Trust Background information The income distribution resolution process Client meeting (15 June 2016) Client meeting (29 June 2016) The financial accounts of the trust Review of the financial accounts Reconcile trust income and net income iv National Tax & Accountants Association Ltd: August 2016

9 Trusts Basics Who pays tax on the net (taxable) income? Who pays tax on the net capital gain? Pays tax on the net franked dividend and the franking credit? Who pays tax on the other trust income? Summary of who pays tax on net (taxable) income Completing the relevant tax returns Completing the trust tax return Recording each beneficiary s share of the trust s net income in their 2016 tax return GLOSSARY OF COMMON TRUST TERMINOLOGY... I Notes... VI National Tax & Accountants Association Ltd: August 2016 v

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11 Basics to setting up a trust BASICS TO SETTING UP A TRUST National Tax & Accountants Association Ltd: August

12 Basics to setting up a trust Notes 2 National Tax & Accountants Association Ltd: August 2016

13 Basics to setting up a trust Basics to setting up a trust Introduction Trusts have been popular for many years and are a common structure in Australia for either holding investments or running a business. Trusts may also be used, or may arise, in other situations, such as when a person dies and a deceased estate is brought into existence. Trusts are often viewed as the favoured entity (compared to other entities) to carry on a taxpayer s business or as an investment structure for a number of reasons, including: Flexibility Distributions of income and/or capital can often be made to numerous beneficiaries in varying quantities. Asset protection The assets of a trust are generally protected if a beneficiary is sued. However, this asset protection advantage may now be considered to have been reduced in light of the decisions in ASIC in the matter of Richstar Enterprises Pty Ltd vs Carey (No.6) [2006] FCA 814 ( Richstar ), and also Kennon v Spry; Spry v Kennon [2008] HCA 56 ( Spry ). Taxation advantages Distributions to beneficiaries of income and/or capital may be made in a tax effective manner. For discretionary trusts, this advantage arises from the trustee s ability to allocate income to different beneficiaries in order to achieve a tax effective outcome. The aim of these seminar notes is to provide practical guidance on completing a trust income tax return (including the very important income distribution statement with all its labels) and to determine the tax consequences for beneficiaries in receipt of such distributions. The focus of these seminar notes will be mainly on discretionary trusts, which are generally considered to provide the best combination of the advantages referred to above. The following segment of the notes considers the basics to setting up a trust under the following headings: 1. What is necessary to setting up a trust? (Refer to page 4); 2. Types of trusts (Refer to page 13); 3. Advantages and disadvantages of popular trust structures (Refer to page 19); 4. Tax administration issues with trusts (Refer to page 20); and 5. Common GST issues with setting up a trust (Refer to page 22). Note that all section references in these seminar notes are to the Income Tax Assessment Act 1936 ( ITAA 1936 ) unless stated otherwise. National Tax & Accountants Association Ltd: August

14 Basics to setting up a trust 1. What is necessary to set up a trust? A trust is a relationship where a person ( the trustee ) is under an obligation to hold property ( the trust property or the trust fund ) for the benefit of other persons ( the beneficiaries ). A trust is not technically a separate legal entity even though it may be treated as such for income tax and GST purposes. The trustee is the legal owner of the trust property and the beneficiaries hold the beneficial interest in the trust property. In the case of a discretionary trust, no single beneficiary holds a beneficial interest in any of the trust property. The following diagram illustrates what is required to establish a trust, including the key players in such an arrangement. (Trust assets, e.g., Investment Property) Mr. A Mrs. A Child 1 (Settlor) (Settled Sum) (Trustee) (Trust Deed) Child 2 (Beneficiaries) (Appointor) The key elements of a trust generally consist of the settlor, a settled sum (e.g., $10), a trustee, trust property/assets, beneficiaries, an appointor (that has the role to appoint and remove the trustee) and a personal obligation attached to the property (i.e., the obligation imposed on the trustee to deal with the trust property for the benefit of the beneficiaries). 1.1 Key roles in a trust The Settlor The settlor is the person who creates the trust by settling a sum of money or item of property on the trustee for the beneficiaries. TAX TIP Settled sum amount The settled sum is the initial money or property settled on the trustee by the settlor to create the trust. The settled sum should be minimal (e.g., $10) so that the stamp duty payable will be minimal in those states where stamp duty is paid at concessional rates where there is unidentified or nominal trust property on the establishment of the trust. 4 National Tax & Accountants Association Ltd: August 2016

15 Basics to setting up a trust The following example illustrates a typical settlor clause found in a modern trust deed. EXAMPLE 1 Extract from a discretionary trust deed The Settlor covenants to pay to the Trustee the Settled Sum and the Trustee declares that it will hold that sum and the Trust Fund described in this deed upon the trusts and with the powers and subject to the conditions set out in this deed. Note: All extracts from trust deeds in these notes are the copyright of NTAA Corporate and cannot be reproduced or used in any way. The above extract is adapted from Clause 3.1 of an NTAA Corporate Discretionary Trust Deed, and refers to the trust property being the original settled sum as well as other assets constituting the Trust Fund. Note that words commencing with capital letters are often defined terms in the deed. It is not necessary for a trust to have been created by a settlor. Although discretionary trusts are usually created by settlement, trusts such as unit trusts are often created by the unitholders subscribing for units in the trust under a deed of trust, rather than by settlement. A trustee can also establish a trust by merely declaring that from a particular date the trustee will hold certain property (which they may already own) on trust for the benefit of the beneficiaries. TAX TIP Settlor should not be a beneficiary If a trust is being created by way of settlement (e.g., a discretionary trust) then the settlor should be someone who is not related to any of the beneficiaries due to the application of S.102 (dealing with revocable trusts). Section 102 will apply where the settlor has power to revoke the trust or where income is distributed to a child of the settlor who is under 18. When S.102 applies, the trustee (and not the beneficiaries) will pay tax on the net income of the trust at the settlor s marginal tax rate. To avoid the possible application of S.102, the trust should be irrevocable and the settlor should not be a parent of any of the beneficiaries. Ordinarily this means the settlor should be unrelated to the family for whom the trust is being established. The NTAA does not recommend the use of the professional advisor as the settlor. Best practice is for the settlor to be a close friend who will not benefit under the trust. In many trust deeds the settlor (and any related entities) is specifically excluded from being a beneficiary. Once a trust has been settled, the settlor usually has no further role or part in the operation of the trust unless the trust deed specifically gives the settlor powers, which would be rare and not advisable, such as the power to revoke the trust The Trustee The trustee is the legal owner of the trust property, although not the beneficial owner. Being the legal owner, all of the transactions of the trust are carried out, and the assets are owned, in the name of the trustee. The trustee should sign all documents for, and on behalf of, the trust (i.e., in its capacity as trustee for the trust). The trustee s overriding duty is to follow the terms of the trust deed. The trustee also has a duty to act in the best interests of the beneficiaries. There are many other duties imposed on the trustee by law. In addition to a trustee s duties, the trustee is usually provided with broad discretionary powers in the trust deed. These duties can include the power to buy and sell assets, to distribute income and capital on a discretionary basis to a range of potential beneficiaries, to borrow money, to insure trust property, and to employ agents. National Tax & Accountants Association Ltd: August

16 Basics to setting up a trust Matters to consider in selecting a trustee 1. Who should be the trustee? 2. If a corporate trustee is being used, who should be the directors and shareholders of that company? 3. Trustee s right of indemnity 4. Personal liability of directors of corporate trustees A trustee can be personally liable for the debts and transactions they undertake on behalf of the trust. Therefore, if the trustee is sued, their liability may not be limited to the trust s assets (although they may be able to seek indemnity or reimbursement from the trust s assets). For this reason, it is best practice to have a company as trustee rather than an individual. This is particularly the case for a trust carrying on a business and otherwise interacting with other third parties. It may be less of an issue for an investment trust receiving passive income (e.g., dividends and interest). Another advantage of having a company as trustee is that a company does not have a finite life. This will reduce the need to change the legal ownership of assets if, for example, an individual trustee dies. This is particularly relevant in light of the Richstar decision. For example, if a discretionary beneficiary is also in a position of control (e.g., a director of a corporate trustee), assets of the trust may potentially be available to creditors of that beneficiary/director in the event of the beneficiary s/director s bankruptcy. This is also true where the beneficiary is in a position of control by virtue of being an appointor. Even though a trustee may be personally liable for debts of the trust, the trustee has a right to be indemnified out of the assets of the trust. This right of indemnity provides the trustee with a level of personal protection from losses incurred as follows: the trustee may pay for expenses incurred in administering the trust directly out of the trust fund; and the trustee may be reimbursed from the trust fund for expenses incurred (by the trustee) in administering the trust fund. Despite having this right of indemnity, it is still best practice to have a company as the trustee, as an individual trustee may in some circumstances lose that right of indemnity. Even where a company is acting as trustee of a trust, the directors of the company may be made personally liable for the liabilities of the trust under S.197 of the Corporations Act Where there has been no breach of trust or acting outside the trustee s scope of duties, a director of a corporate trustee will generally not be personally liable for debts of the trust where an indemnity clause exists in the trust deed. A director may also be personally liable under S.588G of the Corporations Act 2001 if the company incurs debts while it is insolvent. A director of a trustee company has a positive duty to prevent the trustee company from incurring debts while it is insolvent. Further, directors and officers of trustee companies can be held personally liable for taxation offences of that trustee company (e.g., refer to S.8Y of the Taxation Administration Act 1953). 6 National Tax & Accountants Association Ltd: August 2016

17 Basics to setting up a trust TAX TIP Corporate trustee still generally recommended Even though there are circumstances in which a director of a trustee company may be personally liable, a corporate trustee still offers greater protection than individuals acting as trustees. Therefore it is recommended that a company should be the trustee The Appointor The appointor is the person named in the trust deed who has the power to remove and appoint the trustee. The appointor can be a beneficiary provided this is not prohibited under the terms of the deed. The appointor may also have other powers. For example, their consent may be required before the trustee can wind up the trust early (i.e., before the vesting day). It will depend on the terms of the deed as to whether the appointor has a role beyond removing and appointing the trustee. While the trustee controls the assets of the trust and the distributions of income, the real power and control of the trust lies with the appointor as they have the power to remove and appoint the trustee. Thus extreme care must be taken in drafting the deed as to who should be the appointor. If there is no appointor named in the trust deed, and the trust deed does not otherwise give this power to another party (e.g., the trustee), then reference should be made to the Trustee Act of the relevant state or territory. Generally, the court has jurisdiction to appoint a new trustee where no-one is willing (or able) to act. TAX TIP Appointor has most powerful role The terms of the trust deed should be read to precisely ascertain the role of the appointor before choosing which person (or persons) should be named as appointors, whether before or after the trust is established. Succession issues should also be considered when naming an appointor (i.e., who will take over in the role in the event of the existing appointor s death). Many unit trusts do not have an appointor, instead giving the power to remove or appoint the trustee to the unitholders Who should be the beneficiaries of a trust? A person to whom the trustee has discretion to appoint income or capital is referred to as an object or beneficiary of the trust, and these two terms are often used interchangeably. In the case of a discretionary trust it is common to have a very wide range of objects including companies and other trusts. However, they must be described with sufficient certainty so that it can be determined, at any point in time, whether or not a particular individual or entity is or is not a member of the range of objects. Where this is not the case, a trust may not come into existence. It is for this reason that a trust deed, when defining the objects or beneficiaries, often only includes companies in which a beneficiary has a share, or only trusts under which a beneficiary can benefit. In other words, such companies or trusts must be clearly identifiable. The trustee itself can be an object (or beneficiary) provided the trust deed allows it. Many trust deeds prohibit the trustee from being appointed a beneficiary, so it is important to check the trust deed before attempting to make distributions to such trustees. The trustee cannot be the only beneficiary or else the legal and beneficial ownership will merge and the trust will cease to exist, or never come into existence. There are often several categories of beneficiaries within trusts, and the following are common classes of beneficiaries included in many discretionary trust deeds. National Tax & Accountants Association Ltd: August

18 Basics to setting up a trust (a) Primary beneficiaries These are usually the persons named in the trust deed who are eligible to receive a distribution on the vesting of the trust. In a discretionary trust they are often the husband and wife and their lineal descendants (i.e., sons, daughters, grandchildren, great-grandchildren, etc.). (b) General beneficiaries These are the beneficiaries, usually named in the trust deed by way of their relationship to the primary beneficiaries, who are eligible to receive a distribution of income or capital. General beneficiaries usually include the primary beneficiaries and other named people (e.g., relatives), as well as related companies and trusts, and charities. Note that a trust deed may not have two different categories of beneficiaries as described above. Many trust deeds just have one type of beneficiary. In standard unit trusts, the only types of beneficiaries will be the unit holders. The class of beneficiaries of a discretionary trust usually aims to be as wide as possible (while still ensuring beneficiaries remain identifiable) to provide maximum flexibility. (c) Default beneficiaries Default beneficiaries are those beneficiaries who, under the terms of the trust deed, receive an automatic distribution of income (or capital, if the trust is vesting, for example) where the trustee has not distributed all of the income (or capital) of the trust. Commonly, the default beneficiaries are the primary beneficiaries (e.g., the husband, wife and their children). Default beneficiary clauses are commonly included in trust deeds to ensure the trustee of the trust is not taxed on the net income of the trust (i.e., which would usually be subject to tax at the highest marginal rate). (d) Bucket companies Often a distribution will be made to a bucket company (which, as discussed above, needs to firstly be identifiable as a primary or, more commonly, general beneficiary) which attracts a tax rate of 30%. 1.2 Key clauses in an effective trust deed The operation of a trust is governed by the terms of the trust deed. In order to achieve the many advantages (and often to avoid the disadvantages) that a trust offers, it is important that the trustee is empowered by the terms of the trust deed to undertake the actions and transactions it wishes or may wish in the future to undertake, and that the discretionary powers given to the trustee in the trust deed are as wide as possible. In addition, some clauses are crucial to ensure that the trust is tax effective. The main purpose of such clauses is to ensure that the trust and its beneficiaries do not pay more tax than is required, and in particular to minimise the risk that the trustee is assessed on the net income of the trust at a tax rate of 49% under S.99A (i.e., where there is no beneficiary presently entitled to trust income, as discussed later). Set out below are some important clauses and issues that should be addressed in the trust deed. (a) Definition of trust income A trust deed should contain a clear definition of trust income for the purpose of the trust, and preferably provide the trustee with an unfettered discretion to classify any receipt or amount as income or capital of the trust. When working out which beneficiaries of the trust will pay tax on the net income (i.e., taxable income) of the trust, the income of the trust estate must first be known. As per S.97, beneficiaries that are presently entitled to a share of the income of the trust estate will be assessed on that same share of the net income of the trust. This calculation is what is known as the proportionate approach, and will be discussed later in these seminar notes. 8 National Tax & Accountants Association Ltd: August 2016

19 Basics to setting up a trust In the High Court decision in FCT v Bamford [2010] HCA 10 ( Bamford ), it was confirmed that the trust deed plays an important role in determining the income of the trust estate. In particular, the income of a trust estate is to be determined with regard to the trust s deed and to trust accounting principles. As a result, no practitioner should attempt to distribute the income of a trust without making specific reference to the particular trust s deed where they will need to identify and interpret the impact of the relevant income definition clause. In most modern trust deeds, as a general observation, the relevant income definition clauses will generally seek to provide the trustee with some flexibility or discretion to determine what amounts are included in the trust income. See below for a typical example. EXAMPLE 2 Extract from a discretionary trust deed The trustee may determine the income for each Income Period and has the absolute discretion to determine whether the income of the trust Fund shall include the whole or part of any receipt, profit or gain which would not be credited to the income of the Trust Fund for accounting or taxation purposes. Note: All extracts from trust deeds in these notes are the copyright of NTAA Corporate and cannot be reproduced or used in any way. The above extract is adapted from Clause 5.1 of an NTAA Corporate Discretionary Trust Deed. Where such a clause is present in the relevant trust deed, the NTAA would generally advise that the trustee exercise this power such that trust income (and expenses allocated to this income), are determined under ordinary concepts and where relevant, with a modification to also include any real gross capital gains in trust income (as opposed to notional capital gains such as those arising under the market value substitution rule). The inclusion of the gross capital gains (not normally considered part of income under ordinary concepts) is suggested so as to assist with the streaming of such capital gains. Note that the streaming of capital gains will be discussed further in the chapter entitled Taxing Trust Income. TAX WARNING What if trust income is defined to equal tax income in the trust deed? Trust income may be defined to equal the net (taxable) income of the trust calculated under S.95 (e.g., under what is often referred to as an income equalisation clause). This clause may be hardwired so that the trustee has no flexibility or discretion to alter this definition of income of the trust, or may operate as a default clause where the trustee fails to exercise their discretion. In the NTLG Trust minutes dated 18 September 2012, although the ATO noted that there was continuing debate and concern as to the effectiveness of an income equalisation clause, it reconfirmed that it would attempt to give effect to such clauses as far as possible. Despite this, such clauses need to be handled with care, specifically when practitioners want to stream capital gains (particularly discounted capital gains) or where notional income amounts (such as franking credits) have been included as trust income. This may breach the statutory cap, and therefore, according to the ATO, could vary the intended result of a trustee s distribution that relies upon an income equalisation clause. The statutory cap will be discussed in further detail in the chapter entitled Taxing Trust Income. Note: if the trustee fails to determine the income in accordance with the primary income definition clause, many modern trust deeds will also provide a default definition of trust income. National Tax & Accountants Association Ltd: August

20 Basics to setting up a trust (b) Income streaming clause It has historically been accepted that income of the trust retains its character when distributed to beneficiaries. Refer to Charles v FCT [1954] HCA 16. As such, many trusts include clauses enabling the trustee to stream income (i.e., direct specific classes of income, for example interest income, to particular beneficiaries). Unfortunately, Bamford has also brought to light concern as to whether streaming clauses are effective for tax purposes. In particular, while properly-worded streaming clauses may be effective to direct specific classes of trust income to beneficiaries, the desired tax outcome may not always be achieved. Following the Bamford decision, the Government introduced amendments in Tax Laws Amendment (2011 Measures No. 5) Act 2011 that enable the tax-effective streaming of capital gains and franked dividends which took effect from the 2011 income year. The ability to stream capital gains and franked dividends will still need to be permitted by the trust s deed. As a result, practitioners will need to confirm the existence of an appropriate streaming clause within the deed. TAX TIP Implied streaming clause Note that the streaming power need not be separately and explicitly set out in the trust deed, rather it can be implied where the deed confers on the trustee a power to distribute income or capital at the trustee s discretion, and/or otherwise allows them to identify and distribute separate classes of income or capital and there is nothing further in the deed or trust law that fetters that power. (c) Default distribution clause Trust income to which no beneficiary is presently entitled is generally taxed in the hands of the trustee at the top marginal rate of tax plus the Medicare levy (i.e., currently 49% in total) under S.99A. To avoid this possibility, many discretionary trust deeds include a default distribution clause. A typical approach in many trust deeds is to have a clause that determines in the event a trustee fails to determine the income of the trust in accordance with the income definition clause (or within the time specified), that the income is automatically distributed to particular named beneficiaries. Usually, this is achieved via a default distribution, in equal proportions to the primary beneficiaries (or a specifically named beneficiary). See below, for a typical example of such a clause. EXAMPLE 3 Extract from a discretionary trust deed The trustee will hold so much of the income of each Income Period as is not before 11:30pm on the last day of the Income Period the subject of a valid and effective Distribution upon trust for those Primary Beneficiaries who are 18 years of age or more and who are living at 11:30pm on the last day of that Income Period in equal shares as tenants in common. Note: All extracts from trust deeds in these notes are the copyright of NTAA Corporate and cannot be reproduced or used in any way. The above extract is adapted from Clause 5.4 of an NTAA Corporate Discretionary Trust Deed. 10 National Tax & Accountants Association Ltd: August 2016

21 Basics to setting up a trust Trust Deed Checklist The following table provides a quick reference to key elements and commonly used clauses: Clauses Date and party details Discussion The date the trust deed is established/executed is critically important as is the party details i.e., the name and address of the: Settlor Appointor Trustee Beneficiaries Recitals Definitions The recitals are the formalities of the deed and it is useful to be familiar with their contents. Where a trust deed defines a term that it uses, it is that meaning that takes precedence over that term s ordinary meaning. Some important definitions to look for include: Income Capital Beneficiaries Declaration of trust Perpetuity period/vesting Date The trust deed will contain a declaration of trust formally recognising the establishment of the trust. A trust generally has a limited life. This is 80 years and has been codified in respective State or Territory legislation. An exception to this is South Australia where there is no perpetuity period. Income streaming clause Appointor Settlor (where applicable) Settled sum (where applicable) Trustee Modern trust deeds will commonly include a clause that expressly empowers the trustee to selectively direct specific classes of income to particular beneficiaries. As discussed above, the role of the appointor is very important and the appointor should be clearly identified. The settlor must be identified and should have no further role in the trust, either as a beneficiary, appointor, trustee or otherwise. The settled sum is usually a nominal sum (e.g., $10) in order to minimise any potential stamp duty issues on establishment of the trust. The trustee, as legal owner of the trust property, plays a critical role in the trust and should be given wide ranging discretionary powers. National Tax & Accountants Association Ltd: August

22 Basics to setting up a trust Clauses Beneficiaries - primary and general beneficiaries Discussion The classes of primary, general and default beneficiaries should be clearly defined even if they cannot be identified specifically, or have not yet come into existence. For example, the general beneficiary clause may include wording to the effect that a spouse of a primary beneficiary is to be classified as a general beneficiary. This will allow a future spouse of a primary beneficiary to be a general beneficiary even though that person was not in existence (as a spouse) at the time the trust was established. Similarly, after naming a primary beneficiary, the primary beneficiary clause will often include the term and the lineal descendants of that primary beneficiary. This will allow future children and grandchildren of the primary beneficiary (who are not yet born or in existence at the time the trust is established) to become primary beneficiaries upon their birth. Compensating adjustment clause Power to offset losses against capital clause Control stripping clause It is useful to be familiar with these clauses but this is usually addressed at a higher level. Power to vary deed and bring forward vesting day Succession clause Dispute resolution A procedure for resolving disputes, and the relevant State or Territory law under which any disputes will be determined, should be specified. This is usually the place where the trust is settled or established and is typically where the trustee and beneficiaries are situated. Additional powers for the trustee including the following: Ability to accumulate income Ability to invest Ability to borrow Ability to make a family trust election Ability to make an interposed entity election Ability to receive further capital (including gifts) The trust deed should be broadly worded giving the trustee a large range of discretionary powers to undertake all conceivable activities. 12 National Tax & Accountants Association Ltd: August 2016

23 Basics to setting up a trust 2. Types of trusts The number of different types of trusts available to choose from can be somewhat overwhelming. For this reason, this segment of the notes looks at some of the more common types of trusts that may exist. 2.1 Discretionary trust Characteristics Discretionary trusts are the most common form of trust. An ordinary discretionary trust differs from other types of trusts in that the beneficiaries do not have a fixed entitlement to the trust funds. Instead, the trust deed of the trust generally defines the potential beneficiaries of the trust very broadly, and the trustee is then given complete discretion to determine which of these persons are to receive the capital and/or income of the trust (each year) and how much each person will receive. The following is an illustrative example of a discretionary trust. Trustee Discretionary Trust in which the trust property (e.g., a business and/or investments) is held Beneficiaries TAX TIP Family Trusts Discretionary trusts are often referred to as family trusts because they are usually established for the investment of property (or carrying on of a business) to benefit a particular family group. However, references in these seminar notes to a family trust are generally references to a family trust as defined for tax purposes in the trust loss provisions of Schedule 2F to the ITAA A trust needs to specifically elect to be a family trust for these purposes. Family trusts are discussed later in these seminar notes Why is a discretionary trust used? The reasons for using discretionary trusts include the following: asset protection purposes, especially where a corporate trustee is used; the trustee has flexibility regarding the distribution of income and capital to different beneficiaries; less regulation than a company, especially where the trustee is not a company; and the trust deed can be tailored to meet the needs of principals and beneficiaries. National Tax & Accountants Association Ltd: August

24 Basics to setting up a trust 2.2 Unit trust Characteristics A unit trust is a trust in which the trust property is divided into a number of defined shares called units, with a beneficiary s interest in the trust property generally being relative to their holding of units. Beneficiaries generally subscribe for their units in similar way as shareholders subscribe for shares in a company. In an ordinary unit trust, a beneficiary (or unitholder) is entitled to the income and capital of the trust in proportion to the number of units held. Like a company, it is possible for a unit trust to have different types of units with different rights attached. The following is an illustrative example of a unit trust. Trustee Unit Trust in which the trust property (e.g., a business and/or investments) is held Unitholder A Unitholder B TAX TIP Fixed unit trust Unitholders of a unit trust may assume they have a fixed interest in the income and capital of the trust (i.e., fixed proportions of income and capital). However, references in these notes to a fixed trust are generally references to a fixed trust as defined in the trust loss provisions of Schedule 2F to the ITAA The trust loss rules are discussed later in these seminar notes Why are unit trusts used? Unit trusts are generally used as a vehicle for carrying on a business and/or holding investments, as the parties involved are issued with units which (like shares): define the party s interest in the assets and income of the trust; can be easily transferred; and can be re-acquired by the trustee. Other reasons as to why unit trusts are used include the following: less regulation is involved when compared to a company; the trust deed can be tailored to meet the needs of the principals and beneficiaries; and a unit trust is easier to wind up than a company, especially where the trustee is not a company. 14 National Tax & Accountants Association Ltd: August 2016

25 Basics to setting up a trust 2.3 Hybrid trust Characteristics A hybrid trust, as the name suggests, has both discretionary and fixed characteristics. The term hybrid trust is a generic term for a trust, which has elements similar to both discretionary, and unit trusts, and there are many different forms of hybrid trusts. One common form of hybrid trust endeavours to combine the best elements of a unit trust with the best elements of a discretionary trust in the one entity, and has both unitholders and discretionary beneficiaries. In this form of hybrid trust the trustee has the discretion to distribute income to the discretionary beneficiaries, and the unitholders then have a right to receive income and capital that has not been distributed to a discretionary beneficiary. The following is an illustrative example of a hybrid trust. Trustee Hybrid Trust in which trust property (e.g., a business and/or investments) is held Discretionary beneficiaries Unitholders EXAMPLE 4 Hybrid Trust Jesse and Walter have decided to set up a car wash business together. Jesse is married and Walter is married with two children. Jesse and Walter are unrelated. Jesse and Walter each own one unit in the hybrid trust and their immediate family members are discretionary beneficiaries under the deed. The trust deed is drafted to allow discretionary income and capital distributions to these discretionary beneficiaries, with Jesse and Walter being entitled (in accordance with their unit holding) to any undistributed income/capital Why are hybrid trusts used? As noted previously, a hybrid trust is a cross between a discretionary and unit trust. Therefore, a hybrid trust can be appealing as it includes the benefits of both and, therefore, may be viewed as useful for carrying on a business and/or holding investments depending on the particular circumstances of the entities involved Tax considerations with hybrid trusts The ATO has stated that the tax benefits often promoted in relation to hybrid trusts (such as the unitholders being able to claim a deduction for any interest incurred on borrowings to acquire the units) may not be available. Refer to TD 2009/17 and TA 2008/3. There are many versions of hybrid trusts, and not all of them have been targeted by the ATO. In addition, there may be legitimate non-tax reasons to use a hybrid trust structure, such as those set out for Class Trusts (which are discussed shortly). National Tax & Accountants Association Ltd: August

26 Basics to setting up a trust 2.4 Bare trust Characteristics A bare trust arises where the trustee simply holds property for and on behalf of a specific beneficiary. With a bare trust, the trustee has no discretion and no active duties other than to transfer the property to one or more beneficiaries when required. The trustee is merely the nominee of the beneficiaries (i.e., the trustee must act according to the instructions of the beneficiaries). The following is an illustrative example of a bare trust. Trustee (as legal owner) Bare Trust in which trust property (e.g., an investment asset) is held Beneficiaries (as beneficial owner(s)) Why is a bare trust used? Generally, the main reasons for using a bare trust include the following: Privacy the beneficiary may not wish to disclose their identity when dealing with the asset. Age of beneficiary the beneficiary may be a minor and unable to be the legal owner of the asset. Convenience creation of a bare trust is simple without complicated administrative issues to deal with, and the trustee is not faced with the burden of exercising any kind of discretion Tax considerations with bare trusts For CGT purposes, any disposal of the asset(s) of the trust by a bare trustee will be treated as a disposal by the beneficiary (rather than by the trustee) refer to S of the ITAA 1997 and TR 2004/D25. For GST purposes, where the bare trustee acquires a property that is held for a beneficiary that is carrying on an enterprise, there will be GST implications for the beneficiary rather than the trustee upon the acquisition, sale or lease of the property refer to GSTR 2008/3. Furthermore, beneficiaries of a bare trust will be entitled to any income generated from the trust s assets (e.g., rental income earned from an investment property). 16 National Tax & Accountants Association Ltd: August 2016

27 Basics to setting up a trust 2.5 Class trust A class trust is a kind of hybrid trust. It is similar to a discretionary trust except that the trust deed provides that the income and capital must be distributed between certain classes of beneficiaries in the proportions set out in the trust deed. Each class is usually a discrete family group. The following is an illustrative example of a class trust. Trustee Class Trust in which trust property (e.g., a business and/or investments) is held Beneficiary class A Beneficiary class B In some class trusts, each class may own separate units in the trust, with those units giving each class of discretionary beneficiaries a fixed proportion of the income and/or capital of the trust. Each class of discretionary beneficiaries would be related to a particular unitholder (with the discretionary beneficiaries in each class being essentially the same as those found in most discretionary trusts). After the income has been distributed to the classes in the set proportions, it can then be distributed on a discretionary basis among the beneficiaries in each class. 2.6 Testamentary trust or Will trust As the name suggests, a testamentary (or will) trust is a trust, which can only take effect upon the death of the person who makes the will (i.e., commonly known as the testator ). They are popular in estate planning because income distributed to minors from a testamentary trust is not taxed at penal rates (potentially 47%, plus the 2% Medicare levy if applicable) under Division 6AA of the ITAA A deceased estate is also a form of trust, but is not strictly a testamentary trust. The deceased estate will come to an end once the terms of the will have been satisfied and the deceased s assets have been distributed (i.e., upon administration of the deceased estate refer to IT 2622). Subject to the terms of the deceased s will, a testamentary trust may be operated similar to a discretionary trust. The testamentary trust is created on the death of the person, and can generally last for many years (at least up to 80 years). 2.7 Child maintenance trust This is a trust established upon a breakdown of a relationship (e.g., following a divorce), and where a party to the relationship has been ordered to pay child maintenance. Similar to a testamentary trust, income distributed to minor beneficiaries from a child maintenance trust is not taxed at the penal rates of tax under Division 6AA of the ITAA Child maintenance trusts are generally popular as the maintenance provider can effectively use pre-tax income to meet their child maintenance obligations. National Tax & Accountants Association Ltd: August

28 Basics to setting up a trust 2.8 Service trust This is a generic name applied to any type of trust (e.g., discretionary, unit or hybrid) which is being used to provide services to a professional practice or other business entity. It is usually controlled by the owners of the professional practice or business entity. Once in widespread use, popularity of service trusts have significantly declined since the introduction of TR 2006/2, which sets out the ATO s view that fees paid to service trusts must be more commercially realistic than what has previously been common practice. Refer also to the ATO document Your service entity arrangements. 2.9 Superannuation fund A superannuation fund is a special purpose trust designed to provide retirement and/or death benefits for its members and their dependants. Provided the trust deed and the operation of the superannuation fund comply with the Superannuation Industry (Supervision) Act 1993 ( SIS Act ) and the SIS Regulations, the trustee operating the Fund, the members, and any contributing employers, may obtain tax concessions Special disability trust Special Disability Trusts (or SDTs ) are specific types of trusts which (since 20 September 2006) have been established to comply with certain provisions in the Social Security Act 1991 and/or the Veterans Entitlement Act SDTs attract social security means testing concessions for the principal beneficiary (who must be assessed as severely disabled under the legislation) and any eligible contributors. An SDT can be a testamentary trust established through a will. The purpose of such a trust (apart from receiving the means testing concessions) is to assist immediate family members and carers who have the financial means to do so, to make private financial provision for the current and future care and accommodation needs of a family member with a severe disability. Due to the purpose and nature of these trusts, the government is often seeking to expand the tax concessions that can apply to SDTs, including: Ensuring that any unexpended income of the SDT is not taxed at the highest marginal rate. The CGT main residence exemption, which generally allows individuals to disregard capital gains made upon the disposal of a dwelling used as their main residence, has been extended to include a residence that is owned by the trustee of an SDT and is used by the principal beneficiary as their main residence. Introducing a CGT exemption that applies for all CGT assets transferred into an SDT for no consideration Other trusts The above list is certainly not exhaustive. There are other forms of trusts such as public trusts, estate proceeds trusts, pedigree trusts and constructive trusts as well as variations of the trusts already mentioned. As these are specialised structures, they are beyond the scope of this trust basics seminar. 18 National Tax & Accountants Association Ltd: August 2016

29 Basics to setting up a trust 3. Advantages and disadvantages of popular trust structures In order to decide which type of trust is most suitable in a particular set of circumstances, a taxpayer should first compare the advantages and disadvantages of different types of trusts. Below is a summary table comparing two of the most popular trust vehicles, being discretionary trusts and unit trusts. Note that many of the concepts listed below will be discussed later in these seminar notes. Comparing the two main types of trusts summary table Discretionary Trust Interest in trust No Yes Unit Trust Who controls the trust Trustee/Appointor Trustee/Unitholders Vesting date Generally must vest within 80 years Limited liability Yes, if trustee is company 50% CGT discount Yes Yes Small business CGT concessions Yes Yes Interest deductibility for investment in trust No Discretionary distributions Yes No Generally must vest within 80 years Yes, if trustee is company Yes CGT events E4 and K6 Not applicable Can apply Division 149 Generally no application Can apply Beneficiaries easily transfer their interest No Yes Beneficiaries have some right over income they receive No Yes Asset protection Arguable see Richstar Some Restriction on number of beneficiaries In practical terms, no Restricted to unitholders Flexibility High Low Complexity Medium Medium Good for independent parties No Yes Good for one family Yes Depends A beneficiary who provides an interest-free loan to a discretionary trust will not be entitled to a deduction under S.8-1 of the ITAA 1997 if they have borrowed money in their own name in order to fund the loan to the discretionary trust. This is because, in line with the ATO ruling IT 2385, at best, a beneficiary of a discretionary trust has a right to be considered as a potential beneficiary. This is not enough to create a sufficient nexus between the beneficiary s interest expense and the (potential) derivation of a share of the trust income. A unitholder that borrows to fund their subscription for units in a standard unit trust (i.e., not a hybrid trust) will generally be able to claim a deduction for interest incurred under S.8-1 of the ITAA 1997 if they have a reasonable expectation they will derive income from the units purchased. A deduction for interest will not be allowable where the units are acquired solely for the purpose of capital profit from their resale. Refer to ATO ruling IT National Tax & Accountants Association Ltd: August

30 Basics to setting up a trust 4. Tax administration issues with trusts Once the formalities of setting up a trust have been dealt with, the focus should turn to addressing key tax administration issues. 4.1 Who applies for a trust tax file number? Generally, it is the trustee of the trust that applies for a tax file number ( TFN ), which is issued to the trust (not the trustee). The application for a TFN can be made online via the Australian Business Register website at or by completing either of the following paper forms: Tax file number application for companies, partnerships, trusts and other organisations (NAT 3799); or ABN registration for companies, partnerships, trusts and other organisations (NAT 2939). Executors of deceased estates should refer to the ATO factsheet TFN application for a deceased estate. In addition to the TFN application, the Australian Taxation Office ( ATO ) may require documents to be submitted with the application to prove the trustee s identity before issuing a TFN to the trust. One method of proving the identity of the trustee(s) is for their own TFN to be provided in the trust s application. For trusts with corporate trustees, the ACN/ARBN of the company(s) will also need to be provided. Where individual trustee(s) of a trust have not provided their own TFN in the application, they may need to provide their full name, residential address and date of birth, along with other proof of identity documents. In the case of company trustee(s) not providing their TFN, they may be required to provide their date of incorporation, a certified copy of the company registration, and extracts from the trust deed showing all of the following: Trust name. Trustee s name. Commencement date. Signatures. Seal. It should be noted that although not compulsory to have a TFN, applying for a TFN will allow the trust to: Lodge a tax return. Enquire about its tax affairs. Where it has savings accounts on which it receives interest payments, or investments that earn income, such as shares in companies that pay dividends, voluntarily supplying its TFN to the paying entity will ensure no tax is withheld from such payments. 4.2 Who is required to lodge a trust tax return? The Commissioner of Taxation makes an announcement at the end of each income year notifying entities which are required to lodge an income tax return to do so within a specified period. The obligation to lodge a trust tax return in respect of each income year with the ATO generally falls on the trustee irrespective of the amount of income derived. However, if no trustee is an Australian resident and the trust carries on business or derives income from property in Australia, then a public officer for the trust must generally be appointed within 90 days. This is for the purposes of ensuring someone is responsible for the various taxation responsibilities of the trust (e.g., lodgment of trust tax return). Refer to S.252A. 20 National Tax & Accountants Association Ltd: August 2016

31 Basics to setting up a trust The basic information required to be disclosed in a trust tax return is similar to that required in returns for other entities, but for some notable differences. For instance, the trustee is also required to complete a Statement of Distribution section giving additional information, such as: which beneficiaries are entitled to income of the trust; and details of any income that is accumulated rather than distributed to beneficiaries (i.e., income to which no beneficiary is presently entitled). In each case additional information is required to show how a number of different key amounts have been allocated among the various beneficiaries and/or trustee. These items typically include franking credits, net capital gains, foreign income and foreign income tax offset. The preparation of the trust tax return is discussed in further detail later on in these notes. 4.3 When is a trust an Australian resident for tax purposes? Where a part (or all) of a trust s net income has not been included in beneficiaries income (i.e., by way of the trust distributing income to them), a trust s residency status will be important in determining what income the trustee of the trust will be liable to pay tax on. Generally speaking, where there is a share of trust income to which there is no beneficiary presently entitled, a trust that is not a resident estate will only be subject to Australian income tax on income that is sourced in Australia and/or capital gains on assets that are classified as Taxable Australian Property. Other exemptions may also apply for some classes of Australian-sourced income received by non-resident trusts, such as interest, unfranked dividends and royalties (all of which are generally subject to withholding tax when received by non-residents). Franked dividends will also not be taxed in the hands of the trustee of a non-resident trust, as the tax paid by the resident Australian company is seen as a final tax for Australian tax purposes. Section 95(2) provides that a trust will be a resident trust estate in relation to a year of income if, at any time during the year of income: (a) (b) a trustee of the trust estate was a resident; or the central management and control of the trust estate was in Australia. TAX TIP Residency status of a trust A trust is either a resident trust or a non-resident trust for the whole of the income year. A trust cannot be a resident trust for part of the year and a non-resident trust for the remainder of the year. If a trust is a resident trust within the above requirements, it is also a resident trust for CGT purposes. This is, however, modified for a unit trust which will only be treated a resident trust for CGT purposes under S of the ITAA 1997 if it meets one of the requirements in the second column and one of the requirements in the third column from the table below: One of these requirements is satisfied: And also one of these: 1 Any property of the trust is situated in Australia. The central management and control of the trust is in Australia. 2 The trust caries on a business in Australia. Australian residents held more than 50% of the beneficial interests in the income or property of the trust. National Tax & Accountants Association Ltd: August

32 Basics to setting up a trust 5. Common GST issues with setting up a trust A trust may make supplies and acquisitions in respect of investment and/or trading activities that it may carry on, which may give rise to Goods and Services Tax ( GST ) implications. This segment of the notes will discuss the following GST issues with setting up a trust: Who registers for GST (i.e., the trust or trustee)? Whose name and ABN goes on tax invoices? What are the GST registration issues for a partnership of discretionary trusts? 5.1 Who registers for GST the trust or trustee? For GST purposes, it is the entity that carries on the enterprise that is required to be registered (i.e., where its turnover is above the threshold) or who chooses to register for GST. Refer to S.23-5 and S of A New Tax System (Goods and Services Tax) Act 1999 (the GST Act ). As a trust is treated an entity for GST purposes, it is the trust that registers for GST purposes and obtains an Australian Business Number ( ABN ). Given that a trust is not a legal entity, it is accepted that the trustee of a trust is taken to be an entity consisting of the person (which extends to a company) who is the trustee at any given time. Accordingly, it is the trustee of the trust that should complete and lodge Business Activity Statements ( BAS ) for the enterprise carried on by the trust. TAX WARNING Entity for GST purposes is the trust, not the trustee The GST legislation does not create two separate entities, the trust and the trustee, but rather the relevant entity is the trust, with the trustee standing as that entity when a legal person is required. However, it would be necessary to distinguish between the entity that is the trustee acting in that capacity and that entity acting in its own right, as they are treated as separate entities for GST purposes. 5.2 Whose name and ABN goes on tax invoices? As noted previously, although a trust is an entity for GST purposes, it is not a legal entity so where the trust registers for GST it is the trustee that will be named on the Australian Business Register ( ABR ) and will be issued with an ABN in its capacity as trustee. In practical terms, most trusts will be identified on the ABR as the trustee for the trust (e.g., The trustee for the Smith Family Trust ). Section of the GST Act requires a tax invoice to contain enough information to clearly ascertain the identity and ABN of the supplier. When the trustee issues a tax invoice, that tax invoice generally must show the trustee s ABN. That is, the ABN issued to the trustee in its capacity as trustee of the trust. Where the trustee acts as trustee for more than one trust, or has an ABN in its own capacity, it must be careful it quotes the correct ABN. The Commissioner takes the view in GSTR 2013/1 (at paragraph 23) the identity of the trust must be clearly ascertainable from the document. Information sufficient to identify the trust includes (but is not limited to) a registered business name under which the trust's enterprise is carried on. The identity of the trust may also be clearly ascertainable if the trustee's name is included on the tax invoice. In addition, the ABN issued to the trust must also be clearly ascertainable from the document. 22 National Tax & Accountants Association Ltd: August 2016

33 Basics to setting up a trust 5.3 What are the GST registration issues for a partnership of discretionary trusts? Partnership of discretionary trusts A partnership of discretionary trusts is a commonly used structure for unrelated parties carrying on a business. A partnership of discretionary trusts is simply a partnership in which each partner is a trustee of a discretionary trust. That is, rather than individuals being a partner in the partnership, each individual s discretionary trust is the partner. This structure has the usual advantages afforded to a discretionary trust, but also caters for unrelated parties to go into business together. There are, of course, certain disadvantages with this structure. In some circumstances the partnership of discretionary trusts may wish to have a nominee appointed to act as manager on behalf of the trustees. Nominees are often appointed to make things simpler for the operation of the partnership s business, with the partnership being represented as a single entity. For example, contracts may be entered into with the nominee manager (e.g., J&S Electrical Service Pty Ltd) rather than with the partnership of trusts (e.g., ABC Pty Ltd as trustee for The Jones Family Trust and XYZ Pty Ltd as trustee for the Smith Family Trust). The nominee (i.e., the corporate manager) is usually shown as having legal title to the property of the partnership. The management agreement often provides that it is the partners in the partnership that beneficially own the property. As the corporate manager is only acting as nominee or agent, it does not limit the liability of the partnership or the partners where transactions entered into by the corporate manager are as agent for the partnership GST registration issues As in the case of a trust, a partnership is also an entity for GST purposes, and therefore it is the partnership that registers for GST and obtains an ABN. The partnership may make supplies and acquisitions itself or, if it has an agent acting for it, through the agent. If there is no agent, the partnership will obtain the ABN and, if necessary (i.e., where its turnover is above the registration threshold) or if it chooses to do so, register for GST. However, if there is an agent (e.g., a corporate manager for a partnership of discretionary trusts), the question will arise as to who should account for GST and how it should be done. Generally: The partnership will need to register for GST (i.e., broadly, if its turnover is at least $75,000 a year or if it voluntarily opts in) and should lodge all BAS statements for the business. The agent will need an ABN if the partnership wishes to issue and receive tax invoices through the agent. That is, for GST purposes, an agent making a supply on behalf of a GSTregistered supplier can issue a tax invoice (provided it complies with S of the GST Act). Refer to GSTR 2000/37 and GSTR 2013/1. The tax invoice will need to clearly ascertain both the agent s name and ABN. If the agent does not register for GST (in most cases it would not be required to do so), there may be confusion with purchasers who, upon inquiry of the Australian Business Register, would conclude they cannot claim an input tax credit. If the agent does register for GST, purchasers should have no reason to question the validity of tax invoices and their ability to claim input tax credits, but the agent will have the added obligation of lodging BAS statements (but these are likely to be nil statements). In any event, the agent will need to register for GST if it has its own enterprise, if it is paid by the partnership for its services as agent or if the partnership and agent use Division 153-B of the GST Act in accounting for GST (provided in all cases that it meets the turnover threshold or chooses to voluntarily register), and will lodge BAS statements taking any relevant supplies or acquisitions into account accordingly. National Tax & Accountants Association Ltd: August

34 Basics to setting up a trust Notes 24 National Tax & Accountants Association Ltd: August 2016

35 Taxing Trust Income TAXING TRUST INCOME National Tax & Accountants Association Ltd: August

36 Taxing Trust Income Notes 26 National Tax & Accountants Association Ltd: August 2016

37 Taxing Trust Income Taxing trust income Under the proportionate approach, the beneficiaries of a trust are broadly taxed on their share of the net (taxable) income of a trust, based on their share of any trust income to which they have been made presently entitled (or specifically entitled in the case of streamed capital gains or franked dividends). EXAMPLE 1 The taxation of trust income The ABC Discretionary Trust has trust income (comprising business income) of $2,000 and net (taxable) income of $3,000. On 30 June, the trustee resolved to distribute 60% of the trust income to Mary (Mary is presently entitled to 60% of the trust income) and 40% of the trust income to John (John is presently entitled to 40% of the trust income). Consequently, Mary has a 60% share of the trust income and, as such, she is taxable on 60% of the trust s net (taxable) income (i.e., being $3,000 x 60% = $1,800). Similarly, John has a 40% share of the trust income and, as such, he is taxable on 40% of the trust s net (taxable) income (i.e., being $3,000 x 40% = $1,200). However, the above example belies the complexity of the taxation of trust income. In order to more fully understand how trust income is taxed, there are numerous concepts and terms that must first be understood, including the following: The meaning of trust income This is important because it is this income to which beneficiaries are made presently (or specifically) entitled in accordance with the trust deed which forms the basis upon which the net (taxable) income of the trust is taxed. The meaning of that share of the net (taxable) income Recent case law has confirmed that a beneficiary s share of the net (taxable) income of a trust (e.g., as referred to in S.97) is based on their proportionate share of the trust income. The proportionate approach is discussed in the ATO s TD 2012/22, and is also discussed below. The concept of present entitlement The process of creating a present entitlement varies from deed to deed, however, a present entitlement generally arises where the trustee pays, applies or sets aside trust income to, or for the benefit of, any beneficiary (e.g., where the trustee resolves to distribute an amount of trust income to a beneficiary). The concept of specific entitlement This broadly refers to the process by which a capital gain and/or a franked dividend can be streamed to a beneficiary. Trust income (and trust capital) to which a beneficiary has been made specifically entitled must also be taken into account in determining the taxation of trust income, as set out below. The meaning of net (taxable) income This is the taxable income of the trust (refer S.95). These concepts and terms will be considered in more detail under the following broad headings: 1. The concept of trust income (Refer to page 28); 2. Who pays tax on the net (taxable) income? (Refer to page 36); 3. Taxing trust income that does not include capital gains and/or franked dividends (Refer to page 38); 4. The taxation of capital gains (Refer to page 41); 5. The taxation of franked dividends (Refer to page 48); and 6. The taxation of other trust income (Refer to page 57). Note that all references are to the Income Tax Assessment Act 1936 ( ITAA 1936 ) unless otherwise stated. National Tax & Accountants Association Ltd: August

38 Taxing Trust Income 1. The concept of trust income Trust income, or income of the trust estate (these terms are interchangeable), is a pivotal concept because a beneficiary s liability to tax is calculated by reference to their share of the income of the trust estate. For example, among other things, S.97(1) provides that: where 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 shall include: (i) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and (ii) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia TAX WARNING Trust income versus net (taxable) income Trust income is different to the net (taxable) income of the trust. In some cases, although different concepts, they may be equal to the same amount (such as where an equalisation clause applies refer below), however, they will often be different amounts. Such differences can arise where, for example, trust income includes an entertainment expense which is not deductible for tax purposes (in this case the net (taxable) income of the trust will exceed the trust income), or where trust income (pursuant to the trust deed) includes a gross capital gain which was reduced under the CGT general discount for the purposes of determining net (taxable) income (in this case trust income will exceed the net (taxable) income of the trust). Assuming one s objective is to determine how the income of a trust (or, more precisely, the net (taxable) income of a trust) is taxed and to whom, the starting point is to confirm how the trustee of the trust calculated its distributable trust income under the trust deed. The variations of how income may be calculated under the trust deed (i.e., often referred to as the income definition in the trust deed) are potentially endless, however, some common income definitions are set out below. Reference should also be made to resolutions prepared to distribute trust income as it may confirm the method by which the trustee calculated trust income. 1.1 Trust income in accordance with the trust deed Income of the trust for trust law purposes is calculated with reference to the trust deed and the general law of trusts. When administering a trust, the trustee will, in accordance with the trust deed, characterise any receipt, profit or gain as income or capital. This is how a trustee accounts for trust property. As noted above, the income definition used to calculate trust income varies from trust deed to trust deed, however, the following are some common examples: (a) Income equals net (taxable) income This type of income definition clause specifies that the income under the trust deed is equal to income for tax purposes, being net (taxable) income calculated under S.95 (that is, income is determined under an income equalisation clause ). The inclusion of an income equalisation clause purports to remove any difference between trust income (to which beneficiaries are made presently entitled or specifically entitled) and net (taxable) income (upon which beneficiaries are assessed for tax purposes). 28 National Tax & Accountants Association Ltd: August 2016

39 Taxing Trust Income (b) Income determined under ordinary concepts The trust deed may contain an income definition clause which states that income available for distribution is to be determined according to ordinary concepts (trust income would also be determined in this way where the trust deed contains no income definition). This means that, prima facie, when calculating the income of the trust, the trustee has no regard for the tax treatment of any particular item. For example, income according to ordinary concepts does not include a deduction for capital works under Division 43 of the ITAA 1997 (this is a deduction for tax purposes only), and nor would it take into account a franking credit as trust income. In some cases the trustee may have discretion to modify this outcome. In addition, a capital gain would not automatically be included as income under ordinary concepts. Deed permitting, however, the trustee may be able to include a gross capital gain in trust income (support for a trustee s ability to do so can be found in the High Court s decision in FCT v Bamford [2010] HCA 10 ( Bamford )). Alternatively, the trust deed may permit no modification by the trustee. 1.2 Trust income may be reduced under statutory cap According to draft ruling, TR 2012/D1, in addition to considering how trust income is calculated under the deed, it is also necessary to consider the ATO s view regarding the calculation of trust income for the purposes of determining the taxation of a trust s net (taxable) income under the ITAA. In particular, this involves consideration of whether trust income (determined under the deed) must be reduced pursuant to a statutory cap for tax purposes. This is particularly relevant where an income equalisation clause has the effect of including an imputation credit in trust income. TAX WARNING The ATO concept of a statutory cap One of the more significant features of the ATO s view regarding trust income for tax purposes is that the ATO do not accept that notional income amounts, being artificial tax constructs, such as franking credits, can be included in trust income (and, as such, also argue these amounts are not capable of being distributed to beneficiaries) regardless of whether or not these amounts are included in trust income calculated under the trust deed. The purpose of the statutory cap is broadly to exclude notional income amounts from trust income to the extent that the trust income is being used to determine a beneficiary s share of net (taxable) income. The ATO has released TR 2012/D1 in relation to this issue (at the time of writing this was still in draft form pending a more comprehensive review of trust taxation). Fortunately, the potential application of the statutory cap is limited and, in many cases, the trustee will be able to determine trust income in such a way as to avoid the statutory cap. In practical terms, in most cases, not including imputation credits in trust income will ensure the statutory cap will not be breached. It is only in cases where trust income exceeds the statutory cap that trust income will be capped for tax (i.e., S.97) purposes, notwithstanding what it is for trust deed purposes. Specifically, many trustees will calculate trust income under ordinary concepts (with or without certain modifications, such as in relation to capital gains - refer below) where the trust deed contains the relevant powers and discretions to allow the trustee to do so. The effect of this is that notional income amounts, such as franking credits, are excluded under this approach which means that the statutory cap will have no application. With the exception of the following example, the taxation of trust income contained in these seminar notes is discussed below without reference being made to the statutory cap because, in the common examples provided, it is not relevant. National Tax & Accountants Association Ltd: August

40 Taxing Trust Income EXAMPLE 2 Statutory cap results in unintended tax outcomes The trust deed of the Britt Discretionary Trust ( DT ) defines income for trust purposes to equal net (taxable) income (i.e., an income equalisation clause applies). For the income year, trust income and net (taxable) income was $100,000, comprised of $70,000 franked dividends and attached franking credits of $30,000. The trustee of DT distributed the $100,000 trust income per the trust deed as follows: (a) The first $20,000: Sam (an Australian resident individual); and (b) The remainder: Karen (an Australian resident individual). These distributions were made by the trustee intending that, because trust income was equal to net (taxable) income, the beneficiaries would be assessed on the net (taxable) income on a dollar for dollar basis (i.e., Sam on $20,000 and Karen on the $80,000 balance): Beneficiary Share of (deed) trust income Percentage share Share of net (taxable) income Sam $20,000 20% $20,000 Karen $80,000 80% $80,000 Total (check) $100, % $ 100,000 This is each beneficiary s share of trust income (being trust income determined under the trust deed). The beneficiaries are assessed using the proportionate approach because the franked dividends were not streamed to the beneficiaries. These concepts are discussed below. Unfortunately, as a result of the statutory cap, this outcome will not eventuate. Specifically, based on the formula provided in TR 2012/D1, the statutory cap (which represents the net accretions to the trust) is only $70,000 (calculated as $100,000 trust income under the deed, less the $30,000 franking credit which constitutes notional income). This means that, notwithstanding that trust income is determined to be $100,000 under the trust deed, for tax purposes (S.97), trust income is capped at $70,000 (i.e., at a basic level, this reduction is required because, in the ATO s view, only $70,000 of the $100,000 is capable of being distributed to beneficiaries). The implication of the statutory cap applying is that the incidence of tax will fall otherwise than as the trustee intended (basically because the beneficiaries are assessed on their share of $70,000, not $100,000), as illustrated in the following table: Beneficiary Share of trust income for tax purposes Percentage share Share of net (taxable) income Sam $20, % $28,600 Karen $50, % $71,400 Total (check) $70, % $ 100,000 As explained above, trust income for tax purposes is reduced to $70,000 under the statutory cap. It is evident from the above that the imposition of the statutory cap has resulted in the beneficiaries of the trust not being taxed on the trust distribution in the manner intended. For example, Sam was expected to be assessed on a $20,000 trust distribution but, instead, is required to include $28,600 in his assessable income. 30 National Tax & Accountants Association Ltd: August 2016

41 Taxing Trust Income TAX WARNING The validity of the statutory cap At this stage, it is important to be aware that TR 2012/D1, like all draft rulings, contains the ATO s preliminary view regarding this issue. Since its release, several questions have been raised regarding different aspects of the draft ruling and, as the ATO s views are yet to be directly tested in the Courts, the draft ruling should not be taken to represent settled law. Pending the decision in Thomas v Commissioner of Taxation [2015] FCA 968, the draft ruling had been withdrawn from the public rulings program. However, on 31 August 2015, the Federal Court handed down its decision confirming that franking credits cannot be separately streamed, and do not form part of trust income. At the time of writing, however, the draft ruling has still not been finalised. Therefore, uncertainty in this area remains and, in light of this, when dealing with the taxation of a trust s net (taxable) income it is recommended that, should a client adopt a position that does not accord with the draft ruling, the client must be informed of the potential risk associated with that position in the event the ATO conduct an audit. 1.3 Distributing trust income to beneficiaries A trust is not a separate legal entity and, subject to a number of specific exceptions (e.g., where the trust is a corporate unit trust), is not itself a tax paying entity. Rather, if the trustee distributes the trust income to one or more beneficiaries of the trust, they are taxed on the net (taxable) income of the trust (or the trustee is assessed on their behalf) in the year that the net income is derived (in the manner set out below). Alternatively, to the extent the trust income remains undistributed, the trustee is taxed on the net (taxable) income of the trust. The decision of the trustee to distribute trust income (or accumulate the trust income, as the case may be) is made with reference to trust income determined under the trust deed. Where applicable, however, in distributing the trust income, consideration should be given to any impact the statutory cap may have on trust income for tax purposes. In order to avoid a trustee assessment (and/or to avoid a default beneficiary being assessed) it is important that the trustee effectively distributes the trust income to trust beneficiaries in each income year. In this regard, the trustee would generally wish to distribute the income in a tax effective way and in doing so, the trustee may have regard to the following: the respective financial positions and marginal tax rates of the various beneficiaries; and the character of the trust income derived by the trustee that is being passed on to the beneficiaries (i.e., following recent amendments, the law now prescribes specific rules which allow for capital gains and franked dividends to be streamed to trust beneficiaries). TAX TIP What is a trust distribution? A reference in these notes to a trust distribution is a reference to the process by which the trustee appoints income to a beneficiary (i.e., makes them presently entitled to trust income, or specifically entitled to a franked dividend or capital gain refer below). A beneficiary will generally be presently entitled to the income of a trust if they have a right to demand the trustee pay that amount to them (subject to any legal disability that may preclude them from demanding immediate payment, such as being under the age of 18). Most discretionary trust deeds refer to the trustee having a discretion to pay, apply or set aside income for the benefit of any beneficiary. Potentially, this could include the trustee exercising discretion to pay an expense of behalf of the beneficiary. Alternatively, the trustee may, as part of an annual income distribution resolution, set aside an amount for a beneficiary (generally giving rise to what is referred to as an unpaid present entitlement ), which does not involve a cash distribution. National Tax & Accountants Association Ltd: August

42 Taxing Trust Income Income distribution resolutions The actions that a trustee must take regarding the determination and distribution of trust income must comply, first and foremost, with the requirements of the relevant trust deed. In addition, for tax law purposes, the trustee of a trust is effectively required to formally distribute the trust income no later than 30 June in each income year to avoid a trustee assessment or the trigger of a default beneficiary assessment (although, the resolution may be made earlier where required or permitted by the trust deed). In addition, any desire to stream any capital gains included in trust income or net franked dividends will be ineffective if done after 30 June. Refer also to the ATO fact sheet Resolutions checklist. TAX WARNING No administrative relief from 30 June deadline Up until the 2011 income year, the ATO provided administrative relief from the 30 June deadline by allowing trustees up to 31 August following the income year to prepare the income distribution resolution (and still avoid a S.99A assessment to the trustee). For example, under the ATO s administrative approach, a trustee had until 31 August 2011 to distribute income for the year ended 30 June This approach was set out in IT 328 and IT 329 (both now withdrawn). It is important to be aware that the ATO s administrative relief was withdrawn with effect from the 2012 income year. The manner in which an income distribution is made will also be determined by the relevant trust deed. There is no standard format for a trustee income resolution, however, what is generally required is that any resolution should establish, in at least one beneficiary, a present entitlement to the trust income by 30 June. For example, many trust deeds provide that the trustee can make the distribution by way of a resolution, and may evidence the distribution by way of minutes of proceedings. Depending on the trust deed, the trustee may actually be able to distribute the income by making an oral resolution by 30 June and preparing a minute to evidence this at a later time. TAX WARNING Streaming franked dividends and timing issues It is not recommended that trustees rely on oral resolutions, regardless of whether this is permitted under the trust deed. Written evidence, such as a written resolution, should exist to support any income distributions resolutions of the trustee. This is because, if a dispute were to arise (e.g., with the ATO) in relation to whether or not the trustee had resolved to distribute income, in the absence of a written resolution or other written evidence the trustee may have difficulty in proving their position. Furthermore, in order to stream either a franked dividend or a capital gain, one requirement that must be satisfied is that the beneficiary s specific entitlement must be recorded in the accounts or records of the trust by 30 June, meaning that it is essential that a written record is kept. If the income distribution resolution is used to satisfy this requirement, as is often the case, it must be in writing by 30 June. Technically, a written record for a capital payment that is made to effectively stream a capital gain does not need to be recorded until 31 August, however in most instances, where the gross capital gain has been included in the income of the trust estate, the required income resolution will still need to be made by 30 June. The following table illustrates how the timing and documentation rules that applies in relation to making a resolution differ depending on the type of income being distributed. For example, as discussed above, streamed franked dividends and capital gains must generally be distributed in writing by 30 June, whereas a verbal distribution on 30 June of other trust income is usually effective (subject to the relevant trust deed). Notwithstanding these differences, to avoid any complexities, it is recommended best practice for trustees to distribute trust income under a written resolution prepared, dated and signed by 30 June (or earlier, if the trust deed so requires). 32 National Tax & Accountants Association Ltd: August 2016

43 Taxing Trust Income Income Item Date resolution required Must resolution be in writing? Verbal resolution acceptable? 1. Streamed franked dividends 2. Streamed capital gains (included in trust income) 3. Streamed capital gains (included in trust capital) 4. Other trust income (including unstreamed franked dividends and capital gains) 30 June Yes No 30 June Yes No 31 August Yes No 30 June No Yes The trust deed should be consulted to determine whether there are any specific requirements regarding, for example, when trust income must be distributed or whether a verbal resolution is permitted, etc. A single individual trustee or single director of a trustee company makes a written resolution by recording, signing and dating it. If there are multiple directors of a trustee company they can meet, sign and date the written resolution or, alternatively, they are able to use a circulating resolution under which the written resolution takes effect when the last director signs (this must be signed by all directors entitled to vote and recorded in the minute book of the company). Refer to S.248A and S.248B of the Corporations Act If there are multiple individual trustees, they can meet, sign and date the written resolution, or alternatively, use a similar process to a circulating resolution as discussed above, under which the written resolution takes effect when the last trustee signs. A verbal resolution is a decision of the trustees/directors made in accordance with a power contained in the trust deed and can include where a resolution is made verbally at a meeting, a phone hook-up or a conference call. In the case of a single trustee/director, a verbal resolution is referring to the trustee/director turning their minds to the trust distributions. Where a verbal resolution is purported to have been made (and allowed by the relevant trust deed), the ATO requires that a written record (e.g., a note, diary entry, or draft minute) should still be maintained to provide better evidence and avoid later disputes as to whether the resolution was made by 30 June. As the capital gain is included in trust income, it must be distributed by 30 June in order to avoid a trustee being assessed at the top marginal rate (or the triggering of a default beneficiary clause). This is the case notwithstanding the reference to 31 August (or 2 months after year end) in S This position is not entirely free from doubt - some argue that a trustee can effectively stream a capital gain using a verbal resolution on 30 June as long as they ensured that a written minute was prepared to document the verbal resolution by 31 August, however, this view is not confirmed by the ATO. To avoid any unnecessary confusion, the NTAA would recommend that a written resolution streaming the capital gain be prepared, signed and dated by 30 June. Where a capital gain is included in trust capital and streamed through a capital distribution, nothing needs to be in writing to implement this until 31 August. Whilst a written resolution is not required under the legislation, the need to evidence the distribution by 30 June would suggest it is best practice to ensure this is done. In addition to this, many trust deeds specifically required resolutions or minutes to be completed in writing by this date anyway. As noted above, distributing other trust income via a verbal resolution is possible (subject to the trust deed), however the ATO will generally require that, at a minimum, it be supported by contemporaneous documentation and then formally documented in a minute (or minute resolution) to create a formal record of the verbal resolution. Again, the NTAA s view is that it would be better practice to ensure written resolutions are prepared as evidence of when the distribution of trust income was made. National Tax & Accountants Association Ltd: August

44 Taxing Trust Income Determining the relevant trust income As discussed above, reference should always be made to how the relevant trust deed determines the applicable trust income. Some deeds may provide a hard-wired definition of trust income or they may provide a general or limited discretion to the trustee. As a result, there is no standard trustee resolution that covers all of the different options relating to the definition of trust income you may come across. Having said that, it is generally prudent (or it may even be required by the trust deed) to clarify how the trustee (in accordance with the relevant trust deed) has determined the income of the trust for the purpose of the annual resolution. Should a trustee wish to align trust income with that of ordinary concepts (where this is permitted under the trust deed), such a determination could be worded, and made on or before 30 June of the relevant income tax year as follows: EXAMPLE 3 Extract from discretionary trust resolution Determination of Income: RESOLVED THAT, in exercise of the power under clause XX of the Trust Deed and every other power enabling it, the Trustee determines that the income of the Trust for the year ending 30 June 20XX comprises all those amounts being income for the purposes of the accounting records of the Trust ( Accounting Records ), less the expenses and outgoings of the Trust for the year ending 30 June 20XX attributable to those amounts for the purposes of the Accounting Records, in each case whether recorded in the Accounting Records by or after 30 June 20XX. In addition, a trustee may wish to align trust income with that of ordinary concepts (where they are permitted under their relevant trust deed) as well as include any gross capital gains. Such a determination could be worded as follows (depending on the relevant deed): EXAMPLE 4 Extract from discretionary trust resolution Determination of Income: RESOLVED THAT, in exercise of the power under clause XX of the Trust Deed and every other power enabling it, the Trustee determines that the income of the Trust for the year ending 30 June 20XX comprises: (a) All those amounts being income for the purposes of the accounting records of the Trust ( Accounting Records ), less the expenses and outgoings of the Trust for the year ending 30 June 20XX attributed to those amounts for the purposes of the Accounting Records, in each case whether recorded in the Accounting Records by or after 30 June 20XX, other than amounts included under paragraph (b) below; and (b) The amount of each capital gain (as defined under subsection 995-1(1) of the Income Tax Assessment Act 1997) made in the year ended 30 June 20XX remaining after the recoupment for the purposes of the Accounting Records of any unrecouped current-year or prior-year capital losses. Note: The above two extracts are the copyright of the NTAA and provided for demonstration purposes only. A resolutions wording will need to be drafted to comply with the provisions of the relevant trust deed. 34 National Tax & Accountants Association Ltd: August 2016

45 Taxing Trust Income Distributing the relevant trust income Because of the 30 June deadline noted above, at the time the trustee prepares the income resolution, the exact amount of trust income will likely be unknown. There are a number of ways to deal with this issue, including distributing trust income in one of the following ways: (a) Percentage based income distributions By using percentages (e.g., trust income distributed 20% to Sam, 30% to Alex and 50% to ABC Pty Ltd), it does not matter what the trust income is because each beneficiary is entitled to a fixed proportion. There is no amount of income to which no beneficiary is presently entitled (even in the event of a later amendment) so a trustee assessment will not arise. Whilst the percentage method is conceptually simple, it does not always make for effective tax outcomes, particularly where trust income does not equal net (taxable) income. For example, if the trustee wanted to distribute the first $20,000 of trust income to Sam, they would need to convert the $20,000 to a percentage of the total trust income. If the trust income was $100,000, the trustee could allocate 20% to Sam. However, if the trust s net (taxable) income ended up being $130,000, Sam is proportionately entitled to 20% and therefore he would be assessed on $26,000 (i.e., 20% of $130,000). In other words, Sam would need to include $26,000 in his assessable income, despite only being presently entitled to $20,000 of trust income. (b) Fixed income distributions This is where the trustee makes fixed dollar distributions so that a beneficiary s share of trust income is capped (e.g., the trustee may allocate the first $20,000 of trust income to Sam, the next $30,000 to Alex, etc.). Notably, whilst this provides clarity as to the amount of trust income distributed, this does not mean the beneficiary s share of net (taxable) income is also capped (as highlighted above and also below in relation to the proportionate approach). Fixed income distributions can also be problematic if the entire trust income has not been quantified by the time the resolution is prepared or, even if it has been quantified, if the ATO later amend trust income upwards. In both cases, there may be an amount of trust income to which no beneficiary is presently entitled (resulting in a trustee assessment, potentially at the top marginal rate under S.99A or an unwanted assessment to the default beneficiary). In order to protect against this outcome it is common for a trustee to also identify a balance beneficiary. (c) Balance beneficiaries Trustees often identify one or more beneficiaries to whom the balance of income is distributed, should the trust income end up exceeding the total of the fixed dollar amounts already appointed. For example, the trustee may appoint the first $20,000 of trust income to Sam, the next $30,000 to Alex and the balance (if any) to ABC Pty Ltd (i.e., ABC Pty Ltd is the balance beneficiary ). This way, no matter how large the trust income, the beneficiaries will be collectively entitled to all of it (with the balance beneficiary receiving trust income in excess of the appointments of fixed dollar income). This is also referred to as a mop-up clause. National Tax & Accountants Association Ltd: August

46 Taxing Trust Income TAX WARNING Distributing $416 to minors It is a common tax practice for trustees to distribute (in the form of a fixed income distribution) the first $416 of trust income to each of the minor beneficiaries in order to obtain (the now somewhat limited) benefit of utilising the lower tax-free threshold generally available to most taxpayers under the age of 18 years as at 30 June of the relevant income tax year. Unfortunately, the application of the proportionate approach means that where dollar figures are utilised in such a manner, the distributions so specified will not always result in the minor beneficiary (or the trustee on their behalf under S.98) including the same dollar amount of net (taxable) income in their assessable income. For example, if John Junior s entitlement (as a minor) to $416 equates to 2.5% of the total trust income, then John Junior will also have a 2.5% share of the trust s net (taxable) income. Therefore, if the net (taxable) income of the trust was $20,000, John Junior s share of that amount will be $500 (i.e., 2.5% x $20,000). This means that some tax will be payable as the relevant trust income distribution will result in taxable income over and above the minor s annual tax-free threshold of $ Who pays tax on the net (taxable) income? The trustee of a discretionary trust is required to lodge an annual trust tax return which requires disclosure of (among other things) the trust s trust income (calculated under the trust deed and in accordance with general trust law principles refer above) and net (taxable) income. The trust tax return also requires that a distribution statement be completed which provides details of the beneficiaries to whom the trust income was distributed (if any) and also outlines each beneficiary s share of the trust s net (taxable) income, including details of what the amount is comprised of (e.g., capital gains, franked dividends, foreign source income, other income etc.). In most cases the beneficiary is required to include the distribution in their own tax return and pay tax on the distribution (e.g., this is the case with a resident adult individual or a resident company beneficiary), in other cases, the trustee is required to pay tax on the beneficiaries behalf (e.g., this is the case with a minor beneficiary and a non-resident beneficiary). 2.1 Where a beneficiary is made entitled to trust income Regardless of the type of beneficiary to whom trust income has been distributed, and whether they are a resident or a non-resident, their share of the net (taxable) income will be determined by applying the rules set out in the following provisions: For capital gains including streamed capital gains (i.e., a capital gain to which the beneficiary was made specifically entitled ) Subdivision 115-C of the ITAA For franked dividends including streamed franked dividends (i.e., a franked dividend to which the beneficiary was made specifically entitled ) Subdivision 207-B of the ITAA For other income (e.g., business or rental income) Division 6 of the ITAA 1936 (including S.97). Be aware that the rules in relation to determining a beneficiary s share of the net (taxable) income of a trust have recently changed, and are discussed below. Prior to considering this aspect of the analysis, the following table broadly considers the common circumstances in which a trust beneficiary will be assessed in their own right, or where the trustee will be assessed on the beneficiary s behalf, where the beneficiary is made presently entitled to trust income (or specifically entitled to a capital gain or franked dividend). 36 National Tax & Accountants Association Ltd: August 2016

47 Taxing Trust Income Type of beneficiary Adult individual Minor Company Trustee Resident beneficiary Assessed on share of net income at marginal rates under S.97 and Subdivisions 115-C and/or 207-B of the ITAA Under a legal disability therefore trustee is assessed on share of net income under S.98(1). A penalty rate of tax may apply. Company assessed on share of net income at the applicable company tax rate under S.97 and Subdivisions 115-C and/or 207-B of the ITAA Taxation of net income is made with reference to the circumstances of that other trust. Non-resident beneficiary Trustee assessed at non-resident adult rates on share of net income sourced in Australia under S.98(2A) and (3). Trustee assessed on share of net income sourced in Australia under S.98(1). A penalty rate of tax may apply Trustee assessed on share of net income sourced in Australia under S.98(2A) and (3) at the applicable company tax rate. Trustee assessed on share of net income sourced in Australia at the top marginal rate for an individual under S.98(4). The beneficiary is assumed to be a non-resident for the whole of the income year. The beneficiary s share of net income must also be included in their assessable income, however, they are entitled to a refundable credit for any tax paid or payable by the trustee. Refer S.98A. Consider whether the distribution is wholly or partly subject to withholding tax (i.e., unfranked dividends, interest and royalties). Where the distribution is subject to WHT then the beneficiary does not pay tax on this amount as WHT is a final tax. Refer to S.128A(3), 128D and Subdivision 12-F of the Taxation Administration Act To the extent a dividend is franked, however, there is no WHT and no requirement for trustee or beneficiary to pay tax on this amount. Refer S.128B(3)(ga). If the beneficiary is a beneficiary in more than one trust or derives income from any other source they must also include their share of net income from this trust in their assessable income but a credit is available for tax paid by the trustee refer to S.100(1) and S.100(2). Tax will be at the penalty rates applying to minors unless the income is excepted trust income under S.102AG or the beneficiary is an excepted person under S.102AC. Section 98(4) applies where a beneficiary is acting in the capacity of trustee of another trust and the trustee, or if multiple trustees then at least one, is a non-resident at the end of the income year. Section 98(4) does not apply to a chain of trusts if the relevant share of net income is attributable to an amount which was earlier taxed under S.98(4). However, an amount previously taxed under S.98(4) may also be taxed to an ultimate individual or company beneficiary. In this case, a credit is allowed under S.98B. Neither S.99 nor s.99a would apply to an amount taxed under S.98(4). Refer to S.99E. Also consider whether trustee might be assessed under S.98(4) on Australian sourced income because one trustee is a non-resident at the end of the income year. Also refer comments in above. National Tax & Accountants Association Ltd: August

48 Taxing Trust Income 2.2 Where no beneficiary is entitled to trust income If there is trust income to which no beneficiary has been made presently entitled, the trustee is generally assessed on the corresponding share of the net (taxable) income of the trust at the top marginal rate pursuant to S.99A (unless the Commissioner considers it reasonable to tax the trustee at marginal rates under S.99, such as in the case of a deceased estate). The concept of income to which no beneficiary is presently entitled would generally not arise in relation to a unit trust because the trust deed would normally provide that the holder of a unit will be presently entitled to a proportion of trust income based on the proportion of total units they hold (although the trustee of a unit trust may still have the power to accumulate income in some circumstances, for example, with the approval of unit holders). EXAMPLE 5 Trustee s liability in relation to undistributed income For the income year ending 30 June 2016, the DEF Discretionary Trust ( DEF ) had trust income and net (taxable) income of $75,000. The trustee of DEF made various resolutions by 30 June 2016, in accordance with the trust deed, to distribute a total of only $55,000 to various beneficiaries of the trust. As a result, the trustee is assessed under S.99A on $20,000 of net (taxable) income at 49% (assuming that the trust deed did not contain a default beneficiary clause ). It will not always be the case that the trustee will be assessed under S.99A on income to which no beneficiary is presently (or specifically) entitled. Many modern trust deeds contain what is referred to as a default beneficiary clause. The effect of this clause is to make nominated beneficiaries entitled to any trust income the trustee has not allocated by 30 June. 3. Taxing trust income that does not include capital gains and/or franked dividends The process of determining the tax consequences of a trust distribution (which has changed following various amendments to the law which took effect from the 2011 income year) varies depending on what type of income is distributed, and in the case of franked dividends and capital gains, whether or not these amounts have been streamed to the beneficiaries. In circumstances where trust income consists of income other than capital gains or franked dividends, such as trading income, rent and interest or unfranked dividends, the beneficiary s liability to tax is determined under Division 6 of the ITAA 1936 using the proportionate approach. For example, in the case of a resident beneficiary who is not under a legal disability, such as a resident adult individual beneficiary, S.97 provides that where the beneficiary is presently entitled to a share of the income of the trust estate, the assessable income of the beneficiary shall include so much of that share of the net income of the trust estate. After much debate over the course of several decades, the High Court in Bamford v FCT [2010] HCA 10 has definitively stated that the meaning of that share of the net income as it appears in S.97 basically means a proportion or a percentage (as opposed to a fixed dollar amount, which was basically the competing view). This is referred to as the proportionate approach. 38 National Tax & Accountants Association Ltd: August 2016

49 Taxing Trust Income EXAMPLE 6 Applying the proportionate approach The Grieg Discretionary Trust ( DT ) has trust income of $80,000 for the 2016 income year, which is comprised of $70,000 trading income and $10,000 interest income. The net (taxable) income is $85,000 ($80,000 trust income plus $5,000 non-deductible entertainment expenses), comprising $75,000 trading income and $10,000 interest income. The trustee of DT resolves on 30 June 2016 to distribute the trust income as follows: The first $20,000 of trust income: Scott (resident adult); and The remainder: Andrew (resident adult). Under the proportionate approach, the following formula is applied to determine the amounts included in the assessable income of each beneficiary: (Present entitlement to trust income / Trust income) x Net (taxable) income In this example, the formula is applied as follows: Beneficiary Present entitlement to trust income Percentage of trust income Share of net (taxable) income Scott $20,000 25% $21,250 Andrew $60,000 75% $63,750 Total $80, % $85,000 Scott is required to include $21,250 in his assessable income and Andrew is required to include $63,750 in his assessable income under S.97. Each beneficiary receives a (proportionate) blended amount of the trading income and the interest income. TAX WARNING Streaming other income may be problematic The law provides legislative backing for the streaming of capital gains and franked dividends only (and only in certain circumstances). The position in relation to streaming other income (e.g., interest, unfranked dividends) remains uncertain. By way of background, prior to the 2011 income year, it was accepted practice that basically any class of income was able to be streamed (provided the trust deed allowed). Taxpayers largely relied on (now withdrawn) TR 92/13 to do so. However, following the recent amendments to the taxation of trust income (and the recent decision in Bamford), there are two primary areas of concern regarding this issue: (a) whether Division 6 supports the streaming of other income (the ATO think not, however, whether or not this view is correct at law remains to be seen); and (b) the interaction between the existing non-resident withholding provisions is unclear. This issue is significant because, if other income cannot be effectively streamed, trustees can no longer minimise tax paid on distributions of trust income by (for example) streaming foreign income generally or Australian sourced interest income to non-resident beneficiaries. It is hoped the issue of streaming other income will be resolved as part of the broader Division 6 review, however, in the meantime, caution is advised. National Tax & Accountants Association Ltd: August

50 Taxing Trust Income 3.1 The proportionate approach and later amendments In addition to stating that the proportionate approach is used to work out the amount of the net (taxable) income that a beneficiary includes in their assessable income (as noted above), TD 2012/22 also provides numerous examples of the practical effect of applying this approach. Interestingly, various examples in the determination consider the impact of an upward amendment (usually as a result of an ATO audit) to the trust s net (taxable) income and the proportionate approach. Where there is an increase in the trust s net (taxable) income it is necessary to determine who is taxed on that increase and it is in these circumstances that the application of the proportionate approach can become more complicated. EXAMPLE 7 ATO amendment increases net (taxable) income The trust deed of the ABC Discretionary Trust ( DT ) determines income under ordinary concepts. For the 2016 income year, trust income and net (taxable) income is $100,000 and is comprised of business income. The trustee of DT distributes the trust income as: Sally (resident adult individual): the first $30,000; Susie (resident adult individual): the next $30,000; and Sonia (resident adult individual): the balance (if any). Applying the proportionate approach, the $100,000 net (taxable) income of the trust is assessed to the beneficiaries as follows: Beneficiary Present entitlement to trust income Percentage of trust income Share of net (taxable) income Sally $30,000 30% $30,000 Susie $30,000 30% $30,000 Sonia $40,000 40% $40,000 Total $100, % $100,000 However, it is subsequently determined that an incorrect tax deduction has been claimed for entertainment expenses which results in the net (taxable) income increasing to $110,000. Note that trust income does not alter because the trust income was determined under ordinary concepts and, therefore, the entertainment expenses were properly charged against the income of the trust. Who is assessed on the additional $10,000 of net (taxable) income? Under the proportionate approach, each beneficiary applies their respective shares of the trust income, being 30%, 30% and 40% to the additional net (taxable) income of $10,000 which results in each of them being assessed on an additional amount, as follows: Beneficiary Present entitlement to trust income Percentage of trust income Share of additional $10,000 income Sally $30,000 30% $3,000 Susie $30,000 30% $3,000 Sonia $40,000 40% $4,000 Total $100, % $10, National Tax & Accountants Association Ltd: August 2016

51 Taxing Trust Income Would the outcome differ if the trust deed contained an equalisation clause? Yes. In this case, the trust income would also increase to $110,000 (i.e., on the basis that trust income is defined to be equal to net (taxable) income determined under S.95). Therefore, because Sally and Susie were distributed fixed (maximum) amounts, Sonia (as the balance beneficiary ) is presently entitled to the additional $10,000 of trust income. Accordingly, each beneficiary will be assessed on the following amounts in total: Beneficiary Present entitlement adjusted trust income Percentage of trust income Share of amended net income Sally $30, % $30,000 Susie $30, % $30,000 Sonia $50, % $50,000 Total $110, % $110,000 Sally and Susie have already been assessed on $30,000 (refer above), therefore, they are not assessed on any part of the $10,000 increase in net (taxable) income. However, Sonia (being the balance beneficiary ) picked up the additional trust income and, therefore, applying the proportionate approach, she is assessed on the additional $10,000 (calculated as $50,000 less the $40,000 she has already been assessed on refer above). The above example is adapted from Examples 9 and 10 of TD 2012/ /22 for further examples of the application of the proportionate approach. 4. The taxation of capital gains Refer to TD The taxation of trust income in circumstances where the trust income includes a capital gain (and/or a franked dividend refer below) becomes more complex. Capital gains are dealt with exclusively under Subdivision 115-C of the ITAA 1997, and the way in which they are taxed depends on whether or not, and the extent to which, these amounts have been streamed to the beneficiaries of the trust. A trustee might choose to stream a capital gain (or franked dividend) to reduce the tax ultimately payable on these amounts by streaming them to those beneficiaries who can utilise them to the greatest advantage (e.g., capital gains may be streamed to a beneficiary with capital losses or a discount capital gain may even be streamed away from a corporate beneficiary which will not be able to utilise the discount). 4.1 The taxation of a capital gain which has been streamed to a trust beneficiary A capital gain (or part thereof) may potentially be streamed to a beneficiary. However, prior to considering how a streamed capital gain is taxed, it is first necessary to briefly consider when a capital gain is taken to be streamed When has a capital gain been streamed to a beneficiary? In order for a trustee to stream a capital gain (or a franked dividend) it is necessary for the beneficiary to be made specifically entitled to the capital gain. The concept of specific entitlement is a relatively new concept, introduced as part of the Government s interim changes to the taxation of trust income (which took effect from the 2011 income year). National Tax & Accountants Association Ltd: August

52 Taxing Trust Income Note that, whilst the recent amendments provide a mechanism for trustees to be able to stream capital gains (and franked dividends) to beneficiaries, this mechanism is only effective where the deed permits streaming in the first instance (through a specific streaming power or otherwise). As a starting point, under S , the extent to which a capital gain is taken to be streamed is determined with reference to whether: (a) there is a beneficiary, or beneficiaries, that have received, or are reasonably expected to receive, an amount equal to the net financial benefit referable to the capital gain; and (b) that entitlement was recorded in its character in the accounts or records of the trust no later than 2 months after the end of the year (generally 31 August). (a) Specific entitlement of a capital gain included in trust income To the extent the gross capital gain was included in trust income, a common way a beneficiary is made specifically entitled is where the trustee has resolved to make one or more beneficiaries presently entitled to trust income representing the gross capital gain. In order to be effective, however, the following requirements must be satisfied: 1. The trustee must have resolved to make the beneficiary presently entitled to trust income representing the capital gain by year-end (i.e., by 30 June), or earlier if required or permitted under the trust deed. The entitlement must be in writing, technically by 31 August (two months after year-end) but, for the reasons outlined above, it is recommended that the entitlement be in writing by 30 June). If not, the following issues arise: the trustee may be assessed on the amount under S.99A (or a default beneficiary) on the basis that, as at 30 June the capital gain represented an amount of trust income to which no beneficiary was presently or specifically entitled refer above; and the recorded in the accounts or records of the trust requirement will not be satisfied. Therefore, be wary if a capital gain included in trust income is purportedly streamed to a beneficiary pursuant to an income distribution resolution prepared any time after 30 June of the relevant income year (even if it is prepared by 31 August following that income year). 2. The income distribution resolution must be worded in such a way to create the specific entitlement. If the wording is not prescriptive enough, only a present entitlement may arise (the implication being that the capital gain will not have been effectively streamed in which case it will be taxed on a proportionate basis to any beneficiaries made presently entitled to other trust income). Refer below. This is a common way specific entitlement can arise, but it is not the only way. Refer to TD 2012/11. TAX TIP Wording of the income distribution resolution is important As noted above, the wording of the income resolution is significant. In this regard, the legislation does not prescribe how a specific entitlement to a capital gain must be worded in the trustee resolution, however, an acceptable example is: $50 referable to the gross capital gain included in the calculation of trust income. It is important to note that the capital gain may not be effectively streamed if the resolution uses generic references such as all of the trust income or $100 of trust income. (b) Specific entitlement of a capital gain via a capital distribution Alternatively, if only the net (taxable) capital gain is included in trust income (e.g., where an income equalisation clause applies), or where no part of the capital gain is included in trust income, one or more of the beneficiaries will be specifically entitled to the capital gain or part thereof (i.e., the part of the capital gain not included in trust income under an income equalisation clause ) where the trustee has distributed the capital gain via a capital distribution (i.e., as opposed to an income distribution as discussed immediately above). 42 National Tax & Accountants Association Ltd: August 2016

53 Taxing Trust Income In the case of a capital distribution made for the purpose of streaming a capital gain, to be effective the capital distribution resolution must be made and documented (i.e., put in writing) by 31 August (being two months after year-end). Notably, the S.99A issues referred to above do not arise in respect of capital distributions. Further, note that S of the ITAA 1997 allows a resident trustee to choose to be specifically entitled to a capital gain in certain circumstances. TAX WARNING The meaning of net financial benefit The concept of net financial benefit is important when streaming a capital gain because the extent to which a gross capital gain has been streamed is actually measured with reference to the extent to which the relevant beneficiary (or beneficiaries) are specifically entitled to the net financial benefit of the capital gain. The net financial benefit of a capital gain is a reference to the actual financial benefit referable to the capital gain that, in most cases, will be the gross capital gain. Therefore, in order to effectively stream 100% of a capital gain, in most cases, the relevant beneficiary (or beneficiaries) must be specifically entitled to 100% of the gross capital gain. Many trustees inadvertently fail to fully stream a capital gain as intended where only the net capital gain is included in trust income, as discussed further below. Furthermore, a capital gain cannot be streamed where there is no net financial benefit. For example, a beneficiary cannot be made specifically entitled to a capital gain arising under the market value substitution rule where no capital proceeds have been received, because the net financial benefit is limited to what the capital gain would have been had the rule not applied. Refer to S (3) of the ITAA A method statement for the taxation of a streamed capital gain As noted, capital gains distributed to beneficiaries of a discretionary trust are basically dealt with exclusively under Subdivision 115-C whether streamed or not. The following methodology can be applied to determine the tax treatment of a capital gain, which has been wholly streamed to one or more trust beneficiaries. This will be the case where a beneficiary (or beneficiaries) are specifically entitled to 100% of the net financial benefit of the capital gain (which usually means they must be specifically entitled to the gross capital gain), whether via an income distribution, a capital distribution, or a combination of both. However, that is not to say that a capital gain cannot be partly streamed (in fact, a partial streaming may occur inadvertently refer below in relation to the use of an income equalisation clause). In these circumstances, the taxation of the capital gain is basically determined using a combination of the methods, which applies to a wholly streamed capital gain and a capital gain that has not been streamed. Both methods are discussed below (with examples provided). In applying the method statement, it is important to note that, as a general principle, it must be applied to each beneficiary in respect of each capital gain received through a trust (basically because under S it is the beneficiary s entitlement to each capital gain that is relevant). However, capital gains can be dealt with in a single class without consequence (e.g., where none of the individual capital gains are discountable or, alternatively, if they are all discountable). Note that all references in the following table are to ITAA 1997, unless otherwise stated. National Tax & Accountants Association Ltd: August

54 Taxing Trust Income Step: Method statement: The taxation of a streamed capital gain 1 Determine the amount of the gross capital gain streamed to the beneficiary Where the capital gain was wholly streamed to one or more trust beneficiaries, each beneficiary s share of the capital gain (i.e., the amount to which they are specifically entitled ) is identified with reference to the beneficiary s share of the net financial benefit of the capital gain. The share of capital gain is equal to: Where: Capital gain x Share of net financial benefit Net financial benefit Capital gain = the gross capital gain (not reduced by CGT concessions, such as the CGT 50% general discount, or capital losses) and regardless of the amount of the capital gain included in trust income. Net financial benefit = generally (but not always) the gross capital gain. Capital losses that are applied at trust level will reduce the net financial benefit of a capital gain (but only if capital losses are applied consistently for tax purposes). Share of net financial benefit = this is generally the amount of the net financial benefit (usually the gross capital gain) to which the beneficiary is presently entitled (provided timing and documentation requirements etc. are satisfied for the beneficiary to be specifically entitled ). However, if all, or some, of the capital gain was not included in trust income, it includes the amount distributed via capital distribution (if any). Refer to S and below. 2 Calculate the beneficiary s attributable capital gain. The beneficiary s share of the capital gain is converted into a tax amount, called the attributable capital gain, under S (1), using the following formula: Where: Net capital gain x Share of capital gain Capital gain Net capital gain = the taxable amount of the capital gain after applying capital losses and after applying applicable CGT discounts. Capital gain = the capital gain (without capital losses and CGT discounts, and regardless of the capital gain amount included in trust income). Share of the capital gain = the beneficiary s share of the gross capital gain as determined at Step 1, above. This formula is essentially applying the beneficiary s share of the capital gain to the net capital gain (i.e., after applying capital losses and CGT concessions). If a beneficiary has a 25% share of the capital gain, they will pick-up 25% of the net capital gain. Therefore, if the entire capital gain is streamed to one beneficiary (i.e., that beneficiary is made specifically entitled to the entire capital gain), the beneficiary will pick-up the entire net capital gain. The trustee is able to choose the order in which they apply capital losses and this may reduce the taxable portion of a capital gain to nil. Be wary if capital losses were taken into account when making a beneficiary specifically entitled (i.e., they were applied at trust level) because, to be effective for this purpose, the capital losses must be consistently applied for tax purposes. 44 National Tax & Accountants Association Ltd: August 2016

55 Taxing Trust Income Step: Method statement: The taxation of a streamed capital gain 3 Apply the applicable gross-up rules. The beneficiary is required to gross-up the attributable capital gain calculated at Step 2 above under the rules contained in S (3), as follows: (a) Where neither the 50% general discount nor the 50% active asset reduction was applied, the beneficiary s attributable capital gain remains as is. (b) Where one of the 50% general discount or the 50% active asset reduction was applied, the beneficiary s attributable capital gain is doubled. (c) Where both the 50% general discount and the 50% active asset reduction were applied, the beneficiary s attributable capital gain is multiplied by four. 4 Calculate the beneficiary s net (taxable) gain. The beneficiary s grossed-up capital gain is then dealt with in accordance with the method statement in S to determine the beneficiary s own net capital gain for the income year (i.e., by applying the beneficiary s capital losses and any relevant CGT concessions), which is then included in their assessable income. The following example illustrates how the method statement above applies in practice where the capital gain is included in trust income (i.e., the gross capital gain is included in trust income) and the gross capital gain is wholly streamed to one or more trust beneficiaries via an income distribution resolution (which satisfies the timing and documentation requirements and is appropriately worded such that the beneficiary is specifically entitled, as discussed above). EXAMPLE 8 Entire capital gain is streamed to beneficiaries The ABC Discretionary Trust had trust income and net (taxable) income as follows: Income items Trust income Net (taxable) income Net rental income $100,000 $100,000 Discount capital gain $100,000 $50,000 $200,000 $150,000 The trustee included the gross capital gain in trust income, as permitted under the trust deed. The trustee distributed the trust income as follows: (a) Capital gain: 50% to Alice (specific entitlement). (b) Capital gain: 50% to Eve (specific entitlement). (c) Other income: In equal proportions to Eve and John. Based on the method statement above, the capital gain assessed to Alice is as follows: Step 1: Share of the capital gain The net financial benefit referable to the capital gain in this case is $100,000 (i.e., in this case it is equal to the gross capital gain). Alice s share of the gross capital gain is $50,000, calculated as follows: $100,000 (capital gain) x $50,000 (share of net financial benefit) $100,000 (net financial benefit) National Tax & Accountants Association Ltd: August

56 Taxing Trust Income Step 2: Alice s attributable capital gain The net capital gain is $50,000 (being $100,000 less the CGT 50% discount). Alice s share of the net gain, or her attributable capital gain, is $25,000, calculated as follows: $50,000 (net capital gain) x $50,000 (share of capital gain) $100,000 (of capital gain) Step 3: Apply the gross-up rules Under S , Alice is taken to have a grossedup capital gain of $50,000 (being double the $25,000 attributable capital gain). Step 4: Calculate the net (taxable) gain Alice applies the method statement in S (e.g., by applying any personal capital losses she has and the CGT general discount claimed by the trustee) to determine her own net capital gain for the income year. Because Eve is also specifically entitled to 50% of the gross capital gain, her share of the gross capital gain and her attributable capital gain are both calculated in the same way (i.e., $50,000 and $25,000 respectively). Under S Eve is taken to have a grossed-up capital gain of $50,000, to which she applies the method statement in S The other income (rental income) is taxed equally to Eve and John under the proportionate approach, as explained under other income below. 4.2 The taxation of a capital gain which has not been streamed to trust beneficiaries To the extent a capital gain has not been streamed it is taxed under Subdivision 115-C on a proportionate basis to the beneficiaries of the trust who are presently entitled to other trust income (or the trustee, as appropriate). Specifically, rather than assessing trust beneficiaries based on their proportionate share of trust income, beneficiaries are assessed based on their adjusted Division 6 percentage. A beneficiary s adjusted Division 6 percentage is the beneficiary s percentage share of, or present entitlement to, trust income calculated after excluding capital gains and franked dividends to which any beneficiary (or the trustee) is specifically entitled. Such amounts need only be excluded if they are actually included in trust income for trust purposes in the first place. After ascertaining the beneficiary s share of the gross capital gain based on their adjusted Division 6 percentage, the beneficiary s attributable capital gain is worked out in the way set out above (refer to streamed capital gains), which is then grossed-up under the gross-up rules. EXAMPLE 9 No part of the capital gain is streamed The XYZ Discretionary Trust ( DT ) had trust income for tax purposes and net (taxable) income as follows: Income items Trust income Net (taxable) income Net rental income $100,000 $100,000 Discount capital gain $100,000 $50,000 $200,000 $150,000 The trustee included the gross capital gain in trust income, as permitted under the trust deed. 46 National Tax & Accountants Association Ltd: August 2016

57 Taxing Trust Income The trustee of DT distributed the trust income as follows: (a) The first $50,000: Avery (b) The remainder: Sarah In this case, because the capital gain has not been streamed, the beneficiaries are assessed on the capital gain on a proportionate basis, based on their adjusted Division 6 percentage. Therefore DT s $50,000 discount capital gain is assessed as follows: Beneficiary Avery Sarah Adjusted Div 6 percentage $ 50,000 $200,000 $150,000 $200,000 = 25% = 75% Share of capital gain Attributable capital gain Grossed-up capital gain $25,000 $12,500 $25,000 $75,000 $37,500 $75,000 Total 100% $100,000 $50,000 $100,000 Because there has been no streaming, no adjustment is required to convert the Division 6 percentage into the adjusted Division 6 percentage (i.e., they are the same). Because no part of the capital gain has been streamed, these percentages also represent each beneficiary s share of the capital gain, which is used to determine each beneficiary s attributable capital gain. Refer above. Pursuant to the gross-up rules in S , each beneficiary is required to double the attributable capital gain (i.e., because only the CGT 50% general discount applied to the capital gain made by DT). Each beneficiary then applies the method statement in S (e.g., by applying any personal capital losses first and then the CGT general discount claimed by the trustee). It is evident from the analysis above that, where no part of the capital gain is streamed, beneficiaries are assessed on the net capital gain based on their proportionate share of the trust income (i.e., as adjusted for any streamed amounts, where applicable). The taxation of the net rental income is discussed below in these notes, however, for completeness, note that the rental income is also taxed on a proportionate basis (albeit under different provisions and based on a slightly different formula) Streaming a capital gain with an income equalisation clause Some trust deeds will only allow the trustee to include the net capital gain as part of trust income. This commonly occurs where the income definition clause is hard-wired so that income equals net (taxable) income (i.e., an income equalisation clause applies). Where an income equalisation clause applies and the trust has derived a capital gain which is eligible for either or both of the CGT 50% general discount or the 50% active asset reduction, the gross capital gain and the net capital gain will not be the same amount. The issue for the trustee in these circumstances is that only the net capital gain forms part of trust income and, as such, only that part of the capital gain can be streamed under an income distribution resolution. For example, if a $100,000 capital gain is reduced to $50,000 under the CGT 50% general discount, only the $50,000 net capital gain is included in trust income where an income equalisation clause applies. Based on these figures, this means the trustee can effectively only stream half of the capital gain to particular beneficiaries as part of its income resolution (i.e., $ 50,000), the remainder will be assessed to those beneficiaries who are presently entitled to the other income of the trust under the proportionate approach (based on each beneficiary s adjusted Division 6 percentage ). Alternatively, in absence of other income, the trustee will be assessed on this portion of the capital gain under S.99A (at the top marginal rate). National Tax & Accountants Association Ltd: August

58 Taxing Trust Income TAX TIP Effectively stream net capital gain via capital distribution The trustee is able to avoid this issue by making a capital distribution of the tax-free (or discounted part) of the capital gain (this amount is allocated to trust capital as a result of the income equalisation clause and therefore cannot be distributed via an income distribution). In this regard, there is no requirement for this distribution to be to the same beneficiary (or beneficiaries) to whom the capital gain was streamed as part of the income resolution, although a variation in percentages between the income and capital distributions will impact on the proportion of the overall taxable gain for each beneficiary. Rather, what is necessary is that the beneficiaries are made specifically entitled to 100% of the net financial benefit referable to the capital gain (i.e., usually the gross capital gain and whether by income or capital distribution). 5. The taxation of franked dividends Franked dividends are generally dealt with under Subdivision 207-B of the ITAA 1997, whether or not they have been streamed to one or more beneficiaries of the trust. Subdivision 207-B of the ITAA 1997 operates in a similar way to Subdivision 115-C of the ITAA 1997 (refer above in relation to capital gains), although it does contain its own nuances, which are important to consider separately (including the tax treatment of the attached franking credit). When dealing with franking credits, reference should also be made to the section of the notes dealing with family trust elections contained in the Other important trust issues chapter. Furthermore, if trust income determined under the trust deed includes a franking credit, reference should be made to TR 2012/D1, which deals with the application of the statutory cap (discussed earlier in these notes). 5.1 The taxation of a franked dividend which has been streamed to a trust beneficiary Prior to considering how a streamed franked dividend is taxed, it is first necessary to briefly consider when a franked dividend is considered to be streamed. TAX TIP Issues with streaming a franked dividend By way of an overview, note that it is effectively the net franked dividend (i.e., franked dividend less directly relevant expenses) that can be streamed to trust beneficiaries under Subdivision 207-B of the ITAA Furthermore, franking credits cannot be streamed separately to an underlying dividend; in fact, a beneficiary is not able to be made specifically entitled to a franking credit (although franking credits are generally not included in trust income in any case). Refer to the recent case of Thomas v Commissioner of Taxation [2015] FCA 968. Unfranked dividends also cannot be streamed effectively for tax purposes. If the relevant expenses exceed the franked dividend excluding franking credits (i.e., the franked dividend is negatively geared ), the attached franking credits are not capable of being streamed. However, the benefit of franking credits can still generally be passed out to beneficiaries, as discussed below. 48 National Tax & Accountants Association Ltd: August 2016

59 Taxing Trust Income Streaming a franked dividend to a trust beneficiary As with a capital gain, in order for a trustee to stream a franked dividend it is necessary for the beneficiary to be made specifically entitled to the franked dividend. Under S , the extent to which a franked dividend is streamed is determined with reference to whether: (a) a beneficiary (or beneficiaries), have received, or are reasonably expected to receive, an amount equal to the net financial benefit referable to the franked dividend; and (b) that entitlement was recorded in its character in the accounts or records of the trust no later than year-end (i.e., generally 30 June). A common way a beneficiary is made specifically entitled to a franked dividend is where the trustee has resolved to make one or more beneficiaries presently entitled to the trust income representing the net franked dividend. However, in order to be effective for streaming purposes, the trustee must have resolved to make the beneficiary presently entitled to the franked dividend by year-end (or earlier if required or permitted under the trust deed) and this entitlement must be put in writing by year-end. If not, the trustee may be assessed on the amount under S.99A and the recorded in the accounts or records of the trust requirement (referred to above) will not be satisfied. Furthermore, the resolution must be worded in such a way to create the specific entitlement, if the wording is not prescriptive enough then only a present entitlement may arise (which means the franked dividend has not been effectively streamed ). In this regard, the legislation does not prescribe how a specific entitlement to a capital gain or a franked dividend must be worded in the trustee resolution; however, an acceptable example is: $50 referable to the net franked dividend. Note that this is a common way, but not the only way, the specific entitlement can arise. It is important to note that generic references when streaming are problematic; terms such as all of the trust income, half of the trust income or $100 of trust income will not make a beneficiary specifically entitled to a franked dividend. (a) No streaming permitted where there is no net financial benefit The concept of net financial benefit is important when streaming a franked dividend because the extent to which a franked dividend has been streamed is measured with reference to the extent to which the relevant beneficiary (or beneficiaries) are specifically entitled to the net financial benefit of the franked dividend. Refer to S and the method statement below. The net financial benefit of a franked dividend is the actual financial benefit referable to the franked dividend after the application by the trustee of expenses that are directly relevant to the franked dividend. This will generally (but not always) be equal to the net franked dividend. TAX WARNING Streaming and negatively geared shares It is not possible to stream a franked dividend where there is no net financial benefit. This will be the case where the gross franked dividend has been reduced to nil by directly relevant expenses. Naturally, this may be problematic when dealing with negatively geared shares (where interest expenses will often reduce net franked dividends to nil). Fortunately, the practical effect of the new rules is that, although the dividends cannot be streamed, the franking credits can still generally be passed out to beneficiaries and remain refundable provided the trust has at least $1 of trust income and $1 of net (taxable) income. Specifically, the beneficiaries who are presently entitled to a share of trust income (which would include the folded in negative gearing loss) will be entitled to the franking credits based on the proportionate approach (i.e., the franking credits are dealt with in the same way as any other amounts that have not been streamed). National Tax & Accountants Association Ltd: August

60 Taxing Trust Income (b) Pooling of franked dividends Whilst Subdivision 207-B provides a statutory basis for streaming franked dividends, what is less clear is that there are two specific methods for doing this. Under Method 1 the trustee streams each franked dividend separately and under Method 2 the trustee pools all the franked dividends received and streams all or part of the pooled amount. Prima facie, the legislation (specifically S ) looks at each franked dividend individually when determining a beneficiary s share of the net financial benefit referable to that franked dividend. However, S provides that if: (a) a trust receives two or more franked dividends in an income year; and (b) all of the franked dividends received, to the extent they are distributed, are distributed in a single class; then, for the purposes of Subdivision 207-B and Division 6E, the trustee can treat all the franked dividends received by the trust as one single franked dividend (i.e., the franked dividends are effectively pooled ). It is then this single pooled amount that is relevant for S EXAMPLE 10 Pooling franked dividends (Method 2) The Onzlo Trust derived franked dividends and incurred expenses in deriving some of those franked dividends, as follows: Company Dividend Expenses Franking credit ABC $700 $200 $300 DEF $1,400 $1,500 $600 XYZ $2,100 $1,000 $900 Can the franked dividends be pooled? $4,200 $2,700 $1,800 Yes. Where the franked dividends are distributed in a single class, the trust is treated as having received one single franked dividend. As the total franked dividends of $4,200 exceed the total directly relevant expenses of $2,700, there is a net financial benefit of $1,500 (i.e., $4,200 - $2,700) to which beneficiaries can be made specifically entitled. This effectively allows the trustee to stream the franked dividends notwithstanding there is no net financial benefit referable to the DEF dividends The taxation of a streamed franked dividend The following methodology can be applied to determine the correct tax treatment of franked dividends which have been wholly streamed to trust beneficiaries. The method statement is applied to each beneficiary in respect of each franked dividend (or bundle of franked dividends) received through the trust. However, if the trustee has distributed all the franked dividends received within a single class of income (in order to facilitate streaming as noted above), the following methodology will apply to the class of shares as a whole. Note that all references in the method statement are to the ITAA 1997, unless otherwise stated. 50 National Tax & Accountants Association Ltd: August 2016

61 Taxing Trust Income Step: Method statement: The taxation of streamed franked dividends 1 Determine the amount of the franked dividend streamed to the beneficiary. Where the franked dividend was wholly streamed, each beneficiary s share of the streamed franked dividend (i.e., the amount to which they are specifically entitled ) is identified with reference to their share of the net financial benefit. The share of franked dividend equals: Where: Franked dividend x Share of net financial benefit Net financial benefit Franked dividend = the gross franked dividend with franking credits not included and expenses directly related to the franked dividend not deducted. Net financial benefit = the financial benefit referable to the franked dividend (after any directly relevant expenses). Share of net financial benefit = this is generally the amount of the net franked dividend to which the beneficiary is presently entitled (provided timing and documentation requirements etc. are satisfied for the beneficiary to also be specifically entitled ). Refer to S and S and below. 2 Calculate the beneficiary s attributable franked dividend. The beneficiary s share of the franked dividend is converted into a tax amount, called the attributable franked dividend, under S , using the formula: Where: Net franked dividend x Share of franked dividend Franked dividend Net franked dividend = the gross cash dividend reducing it by directly relevant deductions, such as a directly relevant interest expense. Franked dividend = means the gross cash franked dividend, without taking into account franking credits or related expenses. Share of franked dividend = the beneficiary s share of the franked dividend as determined at Step 1, above. This formula applies the beneficiary s share of the franked dividend to the net franked dividend. If there are no directly related expenses, the attributable franked dividend will be the same as their share of the gross franked dividend at Step 1. If there is no net franked dividend amount, there is no attributable franked dividend, (in this case, refer below regarding negatively geared shares in relation to dealing with the attached franking credits). National Tax & Accountants Association Ltd: August

62 Taxing Trust Income Step: Method statement: The taxation of streamed franked dividends 3 Calculate the beneficiary s share of the attached franking credits. Where a beneficiary has an attributable franked dividend, they will also be entitled to a share of the attached franking credit under S , as follows: Where: Franking credit x Share of franked dividend Franked dividend Franking credit = the franking credit attached to the dividend in question (or dividends as appropriate). Franked dividend = means the gross cash franked dividend, without taking into account franking credits or related expenses. Share of the franked dividend = the beneficiary s share of the gross franked dividend as determined at Step 1, above. This formula bases the beneficiary s entitlement to franking credits on their share of the franked dividends. If the beneficiary had a 75% share of the (gross) franked dividends, they would be entitled to a 75% share of the franking credits. If there is no net franked dividend amount, there is no attributable franked dividend under Step 2 above and streaming will not be possible. However, the benefit of imputation credits may still potentially be passed out to beneficiaries. Refer below. 4 Calculate the beneficiary s assessable income amount. The beneficiary will include the following amounts in their assessable income: 1. Their attributable franked dividends calculated under Step 2; and 2. Their share of the franking credits calculated under Step 3. The beneficiary is entitled to a tax offset equal to their share of the franking credit. Excess credits are generally refundable (except for corporate beneficiaries). Refer S , S and S National Tax & Accountants Association Ltd: August 2016

63 Taxing Trust Income EXAMPLE 11 Entire franked dividend streamed to one beneficiary The Wilson Discretionary Trust ( DT ) has trust income and net (taxable) income as follows: Income items Trust income Net (taxable) income Business income $90,000 $90,000 Franked dividend $21,000 $21,000 Franking credit - $9,000 Interest expenses ($10,000) ($10,000) $101,000 $110,000 To avoid the application of the statutory cap (refer to TR 2012/D1 and above), the trustee did not include the franking credit in trust income (as permitted under the trust deed). The interest expenses are directly related to the dividend. The trustee of DT distributed the trust income as follows: (a) Net franked dividend: 100% to James (specific entitlement). (b) Other income: In equal proportions to Sophia and James. Based on the method statement above, the franked dividend is assessed as follows: Step 1: Share of franked dividend The net financial benefit referable to the franked dividend is $11,000, being $21,000 cash dividend less $10,000 directly related interest expenses. James share of the franked dividend is $21,000: $21,000 (franked dividend) x $11,000 (share of net financial benefit) $11,000 (net financial benefit) Step 2: Attributable franked dividend The taxable net franked dividend is $11,000 (being $21,000 less $10,000 deductible interest expenses). James share of the net franked dividend, or his attributable franked dividend, is $11,000, calculated as: $11,000 (net franked dividend) x $21,000 (share of franked dividend) $21,000 (franked dividend) Conceptually, as the entire (gross) franked dividend was streamed to James, he picks-up 100% of the net franked dividend. Step 3: Share of the franking credit Under S , based on James share of the franked dividend, his share of the franking credit is $9,000, calculated as: $9,000 (franking credit) x $21,000 (share of franked dividend) $21,000 (franked dividend) Step 4: Assessable income amount James must include in his assessable income both the $11,000 attributable franked dividend and the $9,000 franking credit. However, James is also entitled to claim a $9,000 tax offset equal to his share of the franking credit and this is potentially refundable. Refer to S , S and S The other income (rental income) is taxed equally to Sophia and James using the proportionate approach, as explained under the taxation of other income below. National Tax & Accountants Association Ltd: August

64 Taxing Trust Income 5.2 The taxation of a franked dividend which has not been streamed to trust beneficiaries A franked dividend that has not been streamed is taxed under Subdivision 207-B on a proportionate basis to the beneficiaries of the trust who are presently entitled to other trust income. Beneficiaries are assessed based on their adjusted Division 6 percentage. After ascertaining the beneficiary s share of the gross franked dividend based on their adjusted Division 6 percentage, the beneficiary s attributable franked dividend and share of the franking credit is worked out in the way set out above (refer streamed franked dividends). EXAMPLE 12 No part of the franked dividend is streamed The Muller Discretionary Trust ( DT ) has trust income and net (taxable) income as follows: Income items Trust income Net (taxable) income Rental income $79,000 $79,000 Franked dividend $21,000 $21,000 Franking credit - $9,000 Interest expenses ($10,000) ($10,000) Non-discount capital gain $100,000 $100,000 $190,000 $199,000 To avoid the application of the statutory cap (refer to TR 2012/D1 and above), the trustee of DT did not include the franking credit in trust income (as permitted under the trust deed). The trustee has included the non-discount capital gain in trust income as permitted under the deed. The trustee of DT distributed the trust income as follows: (a) Capital gain: (b) Other income: 100% to Ted (specific entitlement). The first $30,000: Ted; and The remainder: Toby (i.e., $60,000). Because the franked dividend has not been streamed, the beneficiaries are assessed on a proportionate basis, based on their adjusted Division 6 percentage. The trust s franked dividend (and attached franking credit) is taxed as follows: Beneficiary Ted Adjusted Div 6 percentage $30,000 $90,000 = 33% Share of franked dividend Attributable franked dividend Share of franking credit $7,000 $3,667 $3,000 Toby $60,000 $90,000 = 67% $14,000 $7,333 $6,000 Total (check) 100% $21,000 $ 11,000 $9, National Tax & Accountants Association Ltd: August 2016

65 Taxing Trust Income The adjusted trust income is $190,000 less $100,000 streamed capital gain = $90,000. Also note that the $100,000 capital gain streamed to Ted is excluded from his adjusted Division 6 percentage (and is dealt with separately refer below). These percentages are rounded. Further, note that, because no part of the franked dividend has been streamed, these percentages also represent each beneficiary s share of the franked dividend, which is used to determine each beneficiary s attributable franked dividend and share of the franking credit. Toby and Ted include their attributable franked dividend and share of the franking credit in assessable income and each is entitled to a tax offset. Refer to S , S and S It is evident from the above that, where no part of the franked dividend is streamed, each beneficiary is assessed on the net franked dividend (and the attached franking credit) based on their (adjusted) proportionate share of the trust income. An entitlement to a franking credit offset arises on the same basis. For completeness, note that the rental income is also taxed on a proportionate basis (albeit under different provisions, as discussed below in relation to other income ). The (gross) capital gain is wholly streamed to Ted and, as such, he will be assessed on the net capital gain (after applying personal capital losses, if any), as discussed earlier in the notes Dealing with negatively geared shares Franked dividends cannot be streamed to specific beneficiaries where there is no net financial benefit (i.e., where the gross cash dividend is less than the directly related expenses). This can often result where the underlying shares are negatively geared. However, this does not mean the attached franking credits are lost; rather, those beneficiaries that are presently entitled to other trust income will basically benefit from the franking credits in proportion to their income entitlement (i.e., based on their adjusted Division 6 percentage ). In the event the trust has no other trust income at all (there is no trust income to distribute), the beneficiaries will not be able to access the franking credits. Instead, the trustee will be assessed on any net (taxable) income (and is entitled to a credit but any excess franking credit is lost). Alternatively, if there is distributable trust income but no net (taxable) income, the franking credits are also lost. Refer to S , S , S and S EXAMPLE 13 Franking credits and negatively geared shares The Jameson Discretionary Trust ( DT ) had trust income and net (taxable) income as follows: Trust income Net (taxable) income Business income $300,000 $300,000 Franked dividend $14,000 $14,000 Franking credit - $6,000 Less: Dividend expense ($20,000) ($20,000) $294,000 $300,000 Note, because there is no net financial benefit referable to the franked dividends, there is no amount that can be streamed. The trustee of DT distributed the trust income as follows: (a) The first $50,000: Max (b) The next $200,000: Maria (c) The reminder: Sally (i.e., $44,000) National Tax & Accountants Association Ltd: August

66 Taxing Trust Income In determining how the franked dividend (and franking credit) is taxed, note the following: 1. Even though the shares are negatively geared, each beneficiary still has a share of the gross franked dividend based on their adjusted Division 6 percentage. 2. There is no attributable franked dividend because there is no net dividend. Therefore, no beneficiary includes any part of the dividend in their assessable income under Subdivision 207-B, but rather is assessed under S.97 as part of the trust distribution. 3. The beneficiaries are still entitled to a share of the franking credits based on their adjusted Division 6 percentage. The franking credit must be included in the beneficiary s assessable income under Subdivision 207-B, and a (refundable) tax offset is available. Beneficiary Max Maria Sally Adjusted Div 6 percentage $ 50,000 $294,000 $200,000 $294,000 $ 44,000 $294,000 = 17% = 68% = 15% Share of franked dividend Attributable franked dividend Share of franking credit $ 2,381 $ 0 $ 1,020 $ 9,524 $ 0 $ 4,082 $ 2,095 $ 0 $ 898 Total (check) 100% $ 14,000 $ 0 $ 6,000 The other income of the trust is assessed under Division 6, subject to the modifications provided for in Division 6E of the ITAA 1936, as set out below Franking credits and family trust elections Where a trust holds shares and is receiving franked dividends, there are special rules (discussed below) that affect the ability of the trustee or a beneficiary to qualify in accessing franking credits. (a) Applying the 45 day holding rule to a discretionary (or non-fixed) trust For a trust beneficiary to claim a tax offset for franking credits passing through a trust, both the beneficiary and the trustee must be a qualified person. TAX TIP Pre 1 July 1997 shares The holding period rule generally applies in relation to shares or interest in shares, which were acquired by a taxpayer on or after 1 July Special rules apply to beneficiaries of trusts (excluding widely held public share trading trusts) that acquired shares or an interest in shares after 3pm legal time in the ACT on 31 December The beneficiary of a trust will not be a qualified person unless the trustee is also a qualified person. As such, the trustee must have held the shares for at least 45 days at risk throughout the primary qualification period. The primary qualification period commences on the day after the day on which the beneficiary acquired interests in the shares and ends on the 45th day after the day on which the share goes ex-dividend (note: a share, or interest therein, becomes exdividend on the day after the last day on which the shareholder is entitled to receive dividends on the shares). 56 National Tax & Accountants Association Ltd: August 2016

67 Taxing Trust Income However, a beneficiary of a discretionary trust, not being a family trust (see below), will not be able to satisfy the holding period test even though the trustee may have held the shares for 45 continuous days. The reason for this is that a beneficiary will only be a qualified person where they have a fixed interest in the trust. Therefore, a beneficiary of the non-family trust, cannot generally satisfy the holding period rule, and therefore cannot be a qualified person (but see the exception for a family trust and the small shareholder exemption). Refer also to ATO IDs 2002/603 and 2002/604. (b) Using family trust elections to access franking credits To satisfy the holding period rule, a family trust election ( FTE ) can be made by the trust in which the shares or interests in shares are held. Assuming the trustee held the shares at risk for 45 continuous days, the beneficiary will satisfy the holding period test. If the trust from which the beneficiary received the franked dividends is a family trust, the fact they do not have a fixed interest in the trust no longer prevents them from satisfying the holding period rule. FTEs are discussed in more detail later in these seminar materials (albeit in the context of claiming tax losses). (c) The small shareholder exemption for trust beneficiaries If a discretionary trust has not made an FTE, and distributes franked dividends to a beneficiary, the beneficiary can still be a qualified person if they qualify for the small shareholder exemption. Under the small shareholder exemption a beneficiary will be a qualified person in relation to all dividends paid during the year on shares that the taxpayer held (or held an interest in) if: the taxpayer is an individual; and the total franking credits received by the taxpayer from all sources is not above $5,000. It is important to note that franking credits received as a beneficiary in a trust count towards the $5,000 threshold (including a trust that has made an FTE). Refer to ATO ID 2004/ The taxation of other trust income Where trust income consists of other income, including business income, rent and interest but not capital gains or franked dividends, the beneficiary s liability to tax is determined under Division 6 using the proportionate approach, as was discussed earlier in the notes. However, a different methodology may apply where the trust derived capital gains and/or franked dividends, in addition to the other income, as set out below. 6.1 The taxation of other income where trust income includes capital gains and/or franked dividends Where a trust has a franked dividend and/or capital gain, in addition to the other income, the other income may not be assessed under only Division 6. Instead, Division 6E may apply to modify the way beneficiaries are assessed under Division 6 to avoid double counting. Division 6E basically excludes capital gains and/or franked dividends (streamed and unstreamed) that have already been assessed under Subdivision 115-C and 207-B of the ITAA 1997 respectively. National Tax & Accountants Association Ltd: August

68 Taxing Trust Income The following method statement can be used to determine if, and how, Division 6E affects the taxation of the other income of a trust for Division 6 purposes: Step: Method statement: The taxation of trust other income under Div. 6E 1 Identify whether Division 6E applies. Pursuant to S.102UW, Division 6E will only apply where: (a) The net (taxable) income of the trust exceeds nil; and (b) Any of the following things are taken into account when working out the net (taxable) income of the trust: a capital gain to the extent that an amount remains after applying capital losses and applicable discounts; a franked dividend to the extent an amount remains after deducting directly relevant expenses; and/or a franking credit. If Division 6E applies, S.102UX effectively restates the components of the formula used to determine the amounts of other income which are assessable to the beneficiary by excluding all capital gains and franked dividends. Refer S.102UY. If Division 6E does not apply, other income is still assessed on a proportionate basis, but under Division 6 (without reference to Division 6E). Refer above. 2 Apply the formula in Division 6E to determine taxation of other income. Determine the amount of other income included in the beneficiary s assessable income as follows: Where: Division 6E present entitlement to trust income Division 6E trust income x Division 6E net (taxable) income Division 6E present entitlement to trust income = the dollar amount of trust income the beneficiary is presently entitled to, excluding any part of that entitlement that relates to a capital gain, franked dividend or franking credit included in the income of the trust. Division 6E trust income = the amount determined to be income of the trust by the trustee, excluding any amount that relates to a capital gain, franked dividend or franking credit included in the income of the trust; and Division 6E net (taxable) income = the taxable income of the trust, excluding any amount that relates to a capital gain, franked dividend or franking credit included in the income of the trust. Division 6E trust income and net (taxable) income cannot be less than nil. 58 National Tax & Accountants Association Ltd: August 2016

69 Taxing Trust Income EXAMPLE 14 The taxation of other trust income The Gabby Discretionary Trust ( DT ) had trust income and net (taxable) income as follows: Income items Trust income Net (taxable) income Business income $ 120,500 $ 124,000 Discount capital gain $ 30,000 $ 15,000 Net franked dividend $ 6,500 $ 6,500 Franking credit - $ 4,500 $ 157,000 $ 150,000 The trustee of DT included the gross capital gain in trust income as permitted under the trust deed. This is calculated as $120,500 business income plus $3,500 non-deductible entertainment expenses. The trustee of DT distributed the trust income as follows: (a) Net franked dividend: 100% to Alf (specific entitlement). (b) Capital gain: 100% to Carmen (specific entitlement). (c) Other income: The first $ 20,000 to: Alf, and the remainder to: Sonia (i.e., $ 100,500). The other income of the trust (comprising business income) is taxed to the beneficiaries pursuant to Division 6E. The components of the formula in Division 6E are as follows: 1. Division 6E present entitlement to trust income for each beneficiary is as follows: (a) Alf: $ 20,000 (his specific entitlement to the franked dividend is excluded); (b) Carmen: Nil (her specific entitlement to the capital gain is excluded); and (c) Sonia: $ 100,500 (no adjustment required). 2. Division 6E trust income $ 120,500 (i.e., $ 157,000 less $ 30,000 gross capital gain included in trust income, less $ 6,500 net franked dividend). 3. Division 6E net (taxable) income $ 124,000 (i.e., $ 150,000 less $ 15,000 discount capital gain, less $ 6,500 net franked dividend, less $ 4,500 franking credit). In this example, the formula in Division 6E is applied as follows: Beneficiary Div. 6E present entitlement Percentage of Div. 6E trust income Share of Div. 6E net (taxable) income Alf $ 20, % $ 20,584 Sonia $ 100, % $ 103,416 Total (check) $ 120, % $ 124,000 Note that the Division 6E trust income amount is $120,500 as calculated above. The total of the Division 6E present entitlement amounts is equal to Division 6E trust income. Therefore, Alf is required to include $20,584 in his assessable income and Sonia is required to include $103,416 in her assessable income. Furthermore, because the capital gain was streamed to Carmen, she will be assessed on the $15,000 taxable capital gain (assuming she has no capital losses in her own name). Likewise, because the franked dividend was streamed to Alf, he will also include the net franked dividend of $6,500 in his assessable income, along with the $4,500 franking credits. National Tax & Accountants Association Ltd: August

70 Taxing Trust Income 6.2 Dealing with revenue losses Where a trust makes an overall loss for an income year, the loss is retained in the trust and no distribution is made. If, however, a trust makes a loss from a particular activity (e.g., a net rental loss) but has net (taxable) income overall, the loss reduces the trust s overall net income. Under the new rules, trust revenue losses (such as a business loss) are first recouped against income other than capital gains and franked dividends, however, once the other income has been absorbed, the remaining tax losses are proportionally recouped against capital gains and franked dividends (not franking credits), regardless of whether or not they have been streamed. This is achieved via a rateable reduction to reduce the taxable amount of the capital gain to ensure beneficiaries (and/or the trustee) are not assessed on more than the total taxable income of the trust (the net (taxable) income, which takes revenue losses into account). Refer to S of the ITAA 1997 (for capital gains) and S of the ITAA 1997 (for franked dividends). Specifically, in relation to capital gains, S (2) provides for a rateable reduction where the net (taxable) income of the trust (excluding franking credits) is less than the sum of the net capital gain and the total net franked dividends (net of direct expenses) included in the assessable income. Therefore, for example, a rateable reduction would apply where: a trust s only income is from capital gains and franked dividends and the trust also has general management expenses; or a trust has net capital gains and/or franked dividends and the other sources of income are in a loss position. EXAMPLE 15 Net capital gain exceeds taxable income The Britt Discretionary Trust ( the trust ) derived the following amounts of income and incurred the following losses: Non-discount capital gain: $ 30,000 Less: Rental loss ($ 10,000) $ 20,000 The net (taxable) income is $20,000 is exceeded by the net capital gain of $30,000. Therefore, S (2) is satisfied and the net capital gain will be subject to the rateable reduction. Specifically, before calculating the attributable capital gain, the net capital gain of $30,000 is first reduced by multiplying it by 2/3rds (i.e., being $20,000 / $30,000 or the ((net (taxable) income) / net capital gain). This reduces the net capital gain to $20,000, which is also the net (taxable) income of the trust. Therefore, if, for example, a beneficiary had a 100% share of the capital gain, the attributable capital gain will be $20,000 (100% x $20,000). A similar analysis applies in relation to franked dividends. Refer to S Furthermore, note that when dealing with trust losses, reference should be made to the trust loss provisions, which are discussed further in the chapter entitled Other important trust issues. 60 National Tax & Accountants Association Ltd: August 2016

71 Accounting for Trusts ACCOUNTING FOR TRUSTS National Tax & Accountants Association Ltd: August

72 Accounting for Trusts Notes 62 National Tax & Accountants Association Ltd: August 2016

73 Accounting for Trusts Accounting for trusts The two most common questions that arise in the context of accounting for trusts are: 1. Is a trust required to prepare financial accounts if the trust is a non-reporting entity (a trust not required to comply with Australian Accounting Standards)? 2. If so, is it recommended that the accounting profit of the trust reflect trust income as determined under the trust deed? In short, the answer to both these questions is yes. It is necessary that a trust prepare financial accounts (in fact, in some cases, the deed may require that records be maintained to account for receipts, profits and gains from trust property). Furthermore, it is generally recommended (though not mandatory) that the accounting profit in those accounts reflect trust income as determined under the trust deed. In this regard, the flexible nature of a discretionary trust (both in terms of the variety of ways in which trust income is defined and the way in which it is distributed) makes it imperative that financial accounts be prepared to document and account for the transactions of the trust. If the accounts are prepared on the same basis as trust income, in addition to facilitating the preparation of the trust tax return for the income year, the financial accounts will provide invaluable corroborative evidence in relation to: the way trust income has been calculated under the trust deed (e.g., trust income is often determined under ordinary concepts with or without modification, or may be determined pursuant to an equalisation clause, and there are many other examples); details of the beneficiaries to whom the trustee distributed trust income, and the amount of the relevant entitlement; and details of streamed capital gains and franked dividends. In some cases the effect of the income definition in the trust deed (and often the exercise of any discretion evidenced by the income distribution resolution) is that trust income will be equal to the income (less expenses), for the purposes of the accounting records (with or without further modification). In these cases, the way in which the financial accounts are prepared will take on particular importance. TAX TIP Consistency between trust income and the accounts Best practice dictates that there is consistency between the income definition in the trust deed (as confirmed in the income distribution resolution) and the financial accounts. This puts the trustee in the best possible position in the event a dispute arises (e.g., between the trustee and a beneficiary in relation to their entitlements to trust income, or between the trustee and the ATO, regarding the taxation of trust income). However, it should be noted that this remains a vexed issue, particularly because the ATO has yet to provide its view. Given the importance of the trust accounts, the purpose of this section of the notes is to provide suggested journal entries relevant to the preparation of a trust s financial accounts. This section focuses on accounting for a trust that (pursuant to the trust deed) determines trust income under ordinary concepts (with modification as relevant to include a gross capital gain). Suggested entries are also provided for a trust that utilises an income equalisation clause. 1. Accounting for a trust where income is determined under ordinary concepts (refer to page 64), and 2. Accounting for a trust where income is determined under an equalisation clause (refer to page 68) National Tax & Accountants Association Ltd: August

74 Accounting for Trusts 1. Accounting for a trust where income is determined under ordinary concepts This section provides some suggested journal entries that can be used to ensure the accounting profit in the financial accounts reflects trust income, in circumstances where the trust income is determined (as permitted by the trust deed) under ordinary concepts, (modified to allow the trustee to include gross capital gains in trust income where relevant). In this regard, the trust deed may specifically provide that trust income be determined on this basis, more commonly, however, the trustee may exercise a discretion provided for under the trust deed to determine income under ordinary concepts (as modified for the inclusion of gross capital gains). Alternatively, where the trust deed contains no income definition, trust income will be determined under ordinary concepts (although, in this instance, without modification to include capital gains). As discussed earlier in the notes, it is becoming increasingly common for trustees to determine trust income under ordinary concepts (with a modification to include gross capital gains), mainly because, by doing so, the trustee is able to avoid the following two issues: (a) The potential application of the statutory cap The broad effect of the statutory cap is to reduce trust income determined under the trust deed in most circumstances where a notional income amount has been included in trust income. This will commonly occur where an income equalisation clause applies to include the attached franking credit (i.e., a notional income amount of a franked dividend) in trust income. A trustee can avoid the application of the statutory cap by calculating trust income under ordinary concepts (where permissible under the deed) because this has the effect of excluding all notional amounts, including franking credits. Refer to TR 2012/D1 and below. (b) Streaming issues The ability to effectively stream a capital gain can be compromised where the trust includes only the net capital gain in trust income (e.g., which would occur where an income equalisation clause applies) and also where trust income includes no part of the capital gain. These issues were discussed in some detail above, however, for present purposes, be aware that modifying the definition of trust income determined under ordinary concepts to include gross capital gain allows the trustee to effectively (and more simply) stream the capital gain (i.e., through an income resolution). TAX WARNING Ensure trust income is effectively distributed It is not mandatory that the accounting profit of a trust reflect trust income, although it is recommended. Where the accounts are prepared on this basis, the accounts provide a clear record of the way in which trust income was calculated and to whom it was distributed. However, it is important to note that, of itself, the preparation of financial accounts does not serve as a proxy for determining the way in which trust income is calculated, nor the way in which it has been distributed (this is generally determined with reference to the trust deed and the income distribution resolution respectively). This is particularly so given that the accounts will, in most cases, be prepared after 30 June (i.e., after the trust income should have been determined and distributed). For example, if the trustee has not properly distributed trust income by 30 June (e.g., under a resolution by 30 June, or earlier as required or permitted under the deed), the trustee (or a default beneficiary ) will be assessed on the net (taxable) income of the trust, even if the accounts of the trust later record trust income as having been distributed. 64 National Tax & Accountants Association Ltd: August 2016

75 Accounting for Trusts 1.1 What does ordinary concepts mean? Where trust income is determined under ordinary concepts, notional income (e.g., a franking credit) and expense amounts are excluded (as are capital gains, unless the trustee is permitted under the trust deed to modify this outcome to include capital gains, and chooses to do so). Note that, where a difference arises between trust income and net (taxable) income (e.g., resulting from the treatment of franking credits), these are dealt with in the tax reconciliation process. Some common income and expense items requiring consideration are listed below, along with a summary of how each is treated in terms of calculating trust income under ordinary concepts. TAX WARNING Accounting treatment provided as a guide only The accounting entries outlined below are only applicable for a non-reporting entity. The entries have been provided to illustrate one way a trustee may account for trust income determined under ordinary concepts (as modified for capital gains), they do not purport to represent the only acceptable way in which this can be done. Furthermore, the accounting entries are intended to provide general guidance only. Franked dividend A franking credit is excluded from trust income where it is determined under ordinary concepts. The franking credit is dealt with in the tax reconciliation process. Capital gain A capital gain is not included in trust income where it is determined under ordinary concepts. However, where the trustee is able to modify that outcome (deed permitting) and does so, trust income can be modified to include a gross capital gain. Note that the inclusion of the gross, rather than the net, capital gain is done to facilitate streaming. Entertainment expenses Where trust income is determined under ordinary concepts, entertainment expenses are generally taken into account to reduce trust income (even though the expenses may not be deductible for tax purposes). The non-deductible portion is dealt with in the tax reconciliation process. Note this would apply to most non-deductible expenses such as fines and penalties as well. Capital works Division 43 claim A Division 43 amount is a notional deduction, which is excluded from the calculation of trust income determined under ordinary concepts. A Division 43 deduction is dealt with as part of the tax reconciliation process. Depreciation Depreciation which has been properly allocated against income for trust purposes and which represents the decline in the value of trust assets, is generally taken into account when calculating trust income. One concern is that any depreciation, which is over and above the actual depletion of trust assets, would be excluded from any calculation of trust income determined under ordinary concepts. Unrealised gains and losses (on investment assets or trading stock) Unrealised gains or losses do not form part of trust income determined under ordinary concepts. The following case study provides suggested accounting entries where the trust income is being determined according to income under ordinary concepts for franked dividends, capital gains, entertainment expenses and Division 43 deductions. It provides a suggested example of how to record these items of income and expenses so that they are correctly and consistently represented in the financial accounts. National Tax & Accountants Association Ltd: August

76 Accounting for Trusts CASE STUDY Accounting for trust income under ordinary concepts The trustee of the Brooks Discretionary Trust ( DT ) has complete discretion as to the determination of trust income. The trustee ascertains that, among other types of income, trust income for the 2016 income year will include a franked dividend and a capital gain. On 29 June 2016, the trustee exercises their discretion to determine trust income under ordinary concepts, with a modification to allow for the inclusion of gross capital gains in trust income. The trustee then prepares and signs a resolution which confirms the way in which income has been determined, as well as providing for the distribution of the trust income as follows: Franked dividends and capital gains: Sonia (these amounts were streamed to her) Other income: Dale Some time after year-end the trustee sets about preparing DT s financial accounts for the 2016 income year. The trustee is aware that it is best practice to prepare the accounts to reflect trust income, as determined under the deed, and chooses to proceed on that basis. However, with that objective in mind, the trustee is unsure about the treatment of certain income and expense items. Specifically, the trustee is unsure whether the following items should be reflected in trust income (and recorded in the accounts as such), and how the amount should be accounted for. (a) Entertainment expenses The trustee has determined that trust income includes net business income of $80,000, which is comprised of sales income less business expenses. This amount is included in trust income (and, therefore, in the accounting profit). However, the $80,000 net business income does not yet take into account a $12,000 (meal) entertainment expense incurred by the trust. The trustee has not recorded this amount because of uncertainty regarding the extent to which it reduces trust income. DT values meal entertainment using the 50/50 method and only half the expense is deductible. The trustee consults his accountant who confirms that, regardless of the deductibility of the entertainment expense for tax purposes, the expense reduces trust income as determined under ordinary concepts. Therefore, the following entry is posted to ensure the full $12,000 entertainment expense is also reflected in the accounting profit: DR: Deductible entertainment expense $6,000 xx xx 2016 DR: Non-deductible entertainment expense $6,000 CR: Cash at bank $12,000 To record the payment of entertainment expenses. For the purpose of this case study, DT s entitlement to claim GST input tax credits has been ignored. The non-deductible portion of the entertainment expense is posted to a non-deductible entertainment expense account so it can be identified and added-back to net (taxable) income. Refer below. 66 National Tax & Accountants Association Ltd: August 2016

77 Accounting for Trusts (b) Capital works deduction under Division 43 The trust is entitled to claim a $5,000 capital works deduction under Division 43 of the ITAA The trustee is advised that a Division 43 claim is a notional deduction that is excluded from trust income (and trust capital) where trust income is calculated under ordinary concepts. As such, it should not be reflected in the accounting profit. It is, however, taken into account when calculating net (taxable) income. Refer below. (c) Capital gain The trust made a $50,000 discount capital gain from the sale of shares (i.e., after applying the CGT 50% discount, the net capital gain in relation to the capital gain is $25,000). Pursuant to the trust deed, the trustee modified its income to include the gross capital gain and, as such, the gross capital gain is included in trust income and also included in the accounting profit per the financial accounts. The following journal can be used to record the allocation of the $50,000 gross capital gain to trust income (assuming a capital gain on a CGT asset without a cost base): DR: Cash at bank $50,000 xx xx 2016 CR: Trust Income Capital gains $50,000 To record receipt of the gross capital gain and allocation to trust income. It is important to note that the $25,000 net capital gain is taken into account when determining how much of the capital gain Sonia is required to include in her assessable income for tax purposes (but the net capital gain is not reported in the financial accounts). (d) Franked dividends The trust derived a $21,000 franked dividend (with attached franking credits of $9,000). A franking credit constitutes a notional income amount. The franking credits are not included in trust income where determined under ordinary concepts and nor should it be included in accounting profit (or in any other part of the accounts). The following entry can be used to record the receipt of the $21,000 franked dividend: DR: Cash at bank $21,000 xx xx 2016 CR: Trust Income Franked dividends $21,000 To record receipt of the franked dividend and allocation to trust income. After recording the above entries, DT s trust income and accounting profit are calculated as: Income and expense items Trust income/ Accounting profit Net business income $68,000 Franked dividend $21,000 Franking credit $ Nil Gross discount capital gain $50,000 $139,000 This is calculated as $80,000 net business income less $12,000 entertainment expense. National Tax & Accountants Association Ltd: August

78 Accounting for Trusts The trustee posts the following entry to ensure the accounts also reflect the distribution of the $139,000 trust income to the trust beneficiaries (as per the resolution above): 30 June 2016 DR: P& L Appropriation $139,000 CR: UPE 2016 Capital gains Sonia (beneficiary) $50,000 CR: UPE 2016 Franked dividends Sonia (beneficiary) $21,000 CR: UPE 2016 Other income Dale (beneficiary) $68,000 To record the (unpaid) distribution of trust income per the trustee resolution. This is a sub-account of the beneficiary s general UPE account (on the balance sheet). How are the beneficiaries of DT taxed? For completeness, note that Sonia and Dale are assessed on the net (taxable) income of the trust broadly based on their share of trust income (which ties to the accounts). Because the capital gain was wholly streamed to Sonia, she is assessed on the $25,000 net capital gain (assuming she has no capital losses). Refer Subdivision 115-C. Because the franked dividend was wholly streamed to Sonia, she is assessed on the $21,000 franked dividend plus the $9,000 franking credit (a total of $30,000); she is also entitled to a $9,000 franking tax offset. Refer to Subdivision 207-B ITAA Because Dale has a 100% share of other income (as modified under Division 6E), he is required to include $69,000 in his assessable income. The other income amount is comprised only of business income and is calculated as $68,000 business income (included in trust income), as adjusted to add-back the $6,000 non-deductible entertainment expense and deduct the $5,000 Division 43 claim. 2. Accounting for a trust where income is determined under an equalisation clause In many cases a trustee will seek to avoid determining trust income under an income equalisation clause where trust income includes capital gains and/or franked dividends. There are a number of reasons for this, including that, where an equalisation clause applies, the inclusion of the net capital gain in trust income (rather than the gross capital gain) may result in inadvertent errors when attempting to stream the capital gain to beneficiaries. Furthermore, the inclusion of franking credits in trust income is generally avoided where possible to avoid dealing with the statutory cap. There will be cases, however, where a trustee is unable to avoid the application of an income equalisation clause to determine trust income, such as where the clause is hard-wired. In these cases, if the trustee wishes to prepare the accounts to reflect trust income (as is recommended), it is necessary that all income and expense items must also be considered and recorded in trust income (and the financial accounts) on a tax basis (i.e., trust income is taken to be equal to net (taxable) income). 68 National Tax & Accountants Association Ltd: August 2016

79 Accounting for Trusts TAX WARNING Accounting entries are intended as a guide only As above, the accounting treatment outlined below applies to a non-reporting entity and is provided as a guide only. Furthermore, where the financial accounts of a non-reporting entity are prepared on a tax basis, a statement to this effect should be included in the notes to the accounts. This is a mandatory requirement of the Accounting Professional and Ethical Standard ( APES ) 315, and applies to all public practitioners (i.e., CPA, CAANZ and IPA). 2.1 Accounting for capital gains and franked dividends If financial accounts are being prepared on a basis that is consistent with trust income and trust income includes a capital gain, it may be necessary to ensure that only the net capital gain, rather than the gross capital gain, is included in trust income and reflected in accounting profit (assuming these are different). Similarly, where trust income includes a franked dividend, the franking credit must also be included. This is because, where an income equalisation clause applies, trust income is calculated on a tax basis (i.e., it is taken to be equal to net (taxable) income). The following suggested accounting entries may assist in recording a capital gain or franked dividend on a tax basis. (a) Capital gain Net capital gain included in trust income By way of example, the following journal entry records the allocation of a $10,000 capital gain (which is subject to the CGT 50% discount) to trust income and to capital (i.e., the discount portion of the capital gain is allocated to capital, and the taxable portion is allocated to income). xx xx 2016 DR: Cash at bank $10,000 CR: Trust Income Capital gains $5,000 CR: Discount Reserve $5,000 To record receipt of the gross capital gain: the net capital gain being allocated to income and the discount portion being allocated to a capital reserve. This example assumes the capital gain has been made on a CGT asset without a cost base. The Discount Reserve is a sub-account of the Capital Profits Reserve that records the discount portion of a post-cgt capital gain (it is a balance sheet account). As alluded to above, where there is a difference between a gross capital gain and a net capital gain (e.g. where the CGT 50% discount applies), it is not possible to fully stream the dividend using only an income distribution resolution. This is because it will only be possible to stream that portion of the net financial benefit referable to the capital gain, which was allocated to trust income. To solve this problem, the trustee may make a capital distribution of the discount part of the capital gain allocated to trust capital. By way of example, if the capital gain in the example above is wholly streamed to, say, Beneficiary A, a suggested accounting entry for recording this in the financial accounts (after both an income and capital distribution have been undertaken by the requisite dates), as follows: National Tax & Accountants Association Ltd: August

80 Accounting for Trusts DR: P&L Appropriation $5, June 2016 DR: Discount Reserve $5,000 CR: UPE 2016 Capital gains Beneficiary A $10,000 To record Beneficiary A s specific entitlement to gross capital gain (as a UPE). This specific entitlement arises upon the making of both an income and capital distribution. The Discount Reserve is a sub-account of the Capital Profits Reserve, which records the discount portion of a post-cgt capital gain (it is a balance sheet account). This is a sub-account of Beneficiary A s general UPE account (on the balance sheet). (b) Franked dividend Franking credit included in trust income It is important to note that, where a franking credit is included in trust income (whether as a result of an equalisation clause or otherwise), unless this notional income amount is supported by a notional deduction, according to the ATO, the trust income will be reduced by the amount of the franking credit for tax purposes under S.97 under the statutory cap. Refer to TR 2012/D1. TAX WARNING Equalisation clauses and the statutory cap Despite the ATO s view of what is considered to be trust income, it is still recommended that trust accounts be prepared in accordance with the trust deed s definition of trust income. However, be aware that this may cause anomalous results, such as where financial accounts do not match trust income according to the ATO s view. The following journal entries provide a suggestion regarding recording the receipt of a franked dividend where an income equalisation clause applies. In this example, the franked dividend received by the trust is $7,000 (with an attached $3,000 franking credit) and the franked dividend is subsequently wholly streamed to Beneficiary A. DR: Cash at bank $7,000 xx xx 2016 DR: UPE Clearing Account $3,000 CR: Trust Income Franked dividends $10,000 To record receipt of the franked dividend and allocation to trust income. DR: P&L Appropriation $10, June 2016 CR: UPE 2016 Franked dividends Ben. A $10,000 To record Beneficiary A s specific entitlement to the franked dividend (as a UPE). 30 June 2016 DR: UPE Franked dividends Ben. A $3,000 CR: UPE Clearing Account $3,000 To clear UPE Clearing a/c against Beneficiary A s UPE Franked dividend. This is a balance sheet account used to record franking credits (to which Beneficiary A subsequently became entitled). This is a sub-account of Beneficiary A s general UPE account (on the balance sheet). 70 National Tax & Accountants Association Ltd: August 2016

81 Accounting for Trusts 2.2 Dealing with entertainment expenses and Division 43 Leaving aside capital gains and franked dividends, all other income and expense items must also be considered and recorded in trust income (and the financial accounts) on a tax basis. Therefore, adjustments to trust income may be required in respect of expenses that are nondeductible for tax purposes (such as entertainment), or an amount that is deductible for tax purpose but which represents a notional expense, such as a Division 43 claim. In this regard, the following accounting entry can be used to record the payment of partly deductible entertainment expenses. In this example, the total entertainment expense is $10,000 and only $5,000 is deductible for tax purposes. To the extent the entertainment expense is deductible, the expense is allocated against trust income (and is included in the financial accounts as such) and, to the extent the expense is not deductible, it is allocated to trust capital (and is recorded in the financial accounts as such). xx xx 2016 DR: Deductible entertainment expenses (P&L item) $5,000 DR: Capital Reserve $5,000 CR: Cash at bank $10,000 To record the payment of entertainment expenses: the deductible portion reducing trust income and the non-deductible portion being allocated to trust capital. For the purpose of this discussion, the trust s entitlement to GST input tax credits has been ignored. It has been suggested by our external accountants that an alternative to DR: Capital Reserve is DR: UPE Entertainment Beneficiary. The following accounting entry can be used to record a capital works deduction under Division 43 of the ITAA Assume that the Division 43 deduction amount is $2,500. DR: Building write-off expense (P&L item) $2,500 xx xx 2016 CR: Accumulated building write-off reserve $2,500 To record the trust s Division 43 capital works deduction amount. National Tax & Accountants Association Ltd: August

82 Accounting for Trusts Notes 72 National Tax & Accountants Association Ltd: August 2016

83 Other important trust issues OTHER IMPORTANT TRUST ISSUES National Tax & Accountants Association Ltd: August

84 Other important trust issues Notes 74 National Tax & Accountants Association Ltd: August 2016

85 Other important trust issues Other important trust issues In addition to the calculation and taxation of trust income, there are numerous other important issues that often impact on the taxation of a trust, some of which are addressed below. One of the more controversial developments relating to trusts is the ATO s change of interpretation regarding certain unpaid distributions to associated corporate beneficiaries (referred to as bucket companies ). In some cases, the resulting unpaid present entitlement ( UPE ) may be treated as a deemed dividend back to the trust under Division 7A. In the past, a UPE between at trust and a bucket company (a bucket company UPE ) was treated by the ATO simply as a UPE and not a loan and, therefore, it did not attract Division 7A (leaving aside possible issues that could arise in relation to Subdivision EA of Division 7A). Consequently, bucket company UPEs were commonplace, and tax effective, because they allowed the distribution to be capped at the corporate rate whilst allowing the distributing trust to continue to enjoy the use of the funds indefinitely and without cost. TAX WARNING ATO change their view on bucket company UPEs The ATO has changed its view in relation to this issue, contending that a bucket company UPE will eventually become a loan for Division 7A purposes, unless the trustee undertakes certain action with a prescribed timeframe (the options are basically limited to paying out the distribution or paying compensation). The implications of the ATO s change of interpretation are set out further below. Refer also to TR 2010/3 and PS LA 2010/4. Another area that requires attention is the complex trust loss provisions when dealing with a loss trust. This section of the notes provide an overview of these measures to assist in identifying pertinent issues and then considers each of the relevant tests in some detail, and the circumstances in which they are applicable. One of the more common issues that arise in relation to the trust loss measures is whether a profitable discretionary trust is able to distribute profits to a discretionary trust with available revenue losses and what issues are involved (including application of the income injection test). In these circumstances, it is often necessary to consider utilising family trust elections ( FTEs ) and/or interposed entity elections ( IEEs ). Consideration may also need to be given to the application of the Small Business Entity ( SBE ) regime. There are various concessions available to SBEs, including concessions relating to prepaid expenses, depreciation claims and capital gains derived in respect of business assets. Furthermore, another important issue that may need to be considered when dealing with a trust client is the application of the personal services income ( PSI ) rules. The issues identified above are discussed in this section under the headings set out below. 1. Trust exposure to Division 7A (Refer to page 76); 2. Trust losses and family trust elections (Refer to page 80); 3. The small business entity regime (Refer to page 91); and 4. Personal Services Income ( PSI ) (Refer to page 93). Please note that all references are to the Income Tax Assessment Act 1936 ( ITAA 1936 ) unless otherwise stated. National Tax & Accountants Association Ltd: August

86 Other important trust issues 1. Trust exposure to Division 7A Tax practitioners have had to accept and adapt to the ATO s backflip relating to their position in relation to the application of Division 7A for trusts distributing to private company beneficiaries (referred to as bucket companies ). Division 7A broadly aims to prevent shareholders of a private company (or their associates) accessing company profits tax-free by way of payments, loans or debts forgiven by a company in favour of a shareholder (or associate) by treating such transactions as a dividend of the recipient. TAX WARNING Division 7A can apply to a trust It is important to be aware that Division 7A also applies to trusts. This is sometimes overlooked due to a common misconception that Division 7A only applies to companies. Specifically, there are two broad risk areas in this regard: (a) Unpaid present entitlements owing from a trust to a private company beneficiary in the same family group (referred to as bucket company UPEs ); and (b) Subdivision EA (of Division 7A). 1.1 Unpaid present entitlement between a trust and a bucket company A trustee does not necessarily make an immediate physical distribution of cash to a beneficiary to whom trust income has been distributed. Depending on the trust deed, the trustee may be able to distribute the income by simply making a resolution to merely set-aside that income for the benefit of a beneficiary by 30 June in that income year. Once the trustee has resolved to distribute income to one or more beneficiaries (whether by written resolution, or otherwise as prescribed by the trust deed), then that beneficiary is presently entitled to that income. This means that, until such time as that income is paid to, or on behalf of, that beneficiary, that entitlement is accounted for as an unpaid present entitlement ( UPE ). In the past, the existence of bucket company UPE of itself caused no adverse tax consequences because the ATO held the view that such a UPE was not a loan for Division 7A purposes (with the exception of where the UPE was actually converted into an ordinary loan). However, the ATO has since changed its view regarding this matter. Specifically, in TR 2010/3, the ATO is now of the view that in certain situations (discussed below) a bucket company UPE constitutes the provision of financial accommodation by the company to the trust, which satisfies the (extended) definition of a loan for Division 7A purposes. Refer also to ATO factsheet: Division 7A unpaid present entitlement. TAX TIP Quarantined pre-16 December 2009 bucket company UPEs The ATO will not be seeking to apply Division 7A to bucket company UPEs that arose before 16 December 2009 and, therefore, there is generally no need for trusts to pay out these UPEs to avoid the application of Division 7A. To ensure that any pre-16 December 2009 UPEs continue to remain outside the scope of Division 7A, tax practitioners should ensure clients have quarantined these UPEs in the accounts of both the trust and the company. Although pre-16 December 2009 UPEs are generally quarantined from the new rules, as long as these UPEs remain in existence, Subdivision EA (of Division 7A) can still apply if the trust makes a payment, loan or forgives a debt in favour of a shareholder (or their associate) of the company. Refer to paragraph 13 of PS LA 2010/4. 76 National Tax & Accountants Association Ltd: August 2016

87 Other important trust issues The ATO s view is significant because, if the UPE is treated as a loan and the trustee and the company fail to enter into a complying loan agreement under S.109N within the relevant time frame, the trust will be required to include a deemed dividend in its assessable income equal to the amount of the loan (subject to the company s distributable surplus). Fortunately, there is action the trustee can take to avoid the UPE being treated as a loan or, in the event the UPE is treated as a loan, to avoid triggering Division 7A. The action that can be taken in this regard is discussed below in the context of a distribution of trust income by a trustee to a bucket company pursuant to an income distribution resolution made on 30 June TAX WARNING UPEs converted into an ordinary loan It is important to be aware that the options available to a trustee to avoid having a bucket company UPE being treated as a loan for Division 7A purposes, or to avoid triggering Division 7A (in the event the UPE has converted into a loan) are only available where the UPE has not already been converted into an ordinary loan. For example, a UPE would be converted into an ordinary loan where a bucket company UPE is paid out and the funds are lent back to the trust (i.e., where the UPE is converted into, or replaced by, an ordinary loan), and likewise where the parties agree to convert the UPE to a loan without a physical flow of cash (e.g., under a set-off arrangement). Where a UPE is recorded in the accounts of the trust and/or the bucket company as a loan (rather than a UPE), this may indicate that the UPE has already been converted into an ordinary loan (i.e., it warrants further investigation). Refer to paragraph 21 of PS LA 2010/ When will the UPE be a loan for Division 7A? Under the (extended) definition of a loan in S.109D(3)(b) (which refers to the provision of financial accommodation ), a bucket company UPE arising on 30 June 2016 will be taken to be a loan for Division 7A purposes made by the company to the trust in the 2017 income year unless either of the following actions are taken: 1. The trustee pays out the UPE by the lodgment day of the trust s tax return for the year in which the UPE arose (e.g., by 15 May 2017 for UPEs created on 30 June 2016). 2. The trustee put the UPE funds on sub-trust for the sole benefit of the bucket company by the lodgment day of the main trust s tax return for the year in which the UPE arose (e.g., by 15 May 2017 for UPEs created on 30 June 2016). PS LA 2010/4 sets out three options which will satisfy the ATO that UPE funds are held on sub-trust for the sole benefit of a bucket company. The most common options are the 7 year or 10 year interest only loan (referred to as Option 1 and Option 2 respectively), under which the main trust is obliged to pay annual interest at a specified rate to the sub-trust, to which the bucket company is presently entitled. In addition, the UPE principal must also be returned at the end of the 7 (or 10) year period. Note that lodgment day is defined in S.109D(6) as the due date for lodgment of the return, or date the return was actually lodged if that date is earlier. However, even if the UPE is considered to be a loan (i.e., because the trustee has not paid out the UPE or put it on sub-trust), this will not automatically trigger Division 7A. Specifically, the trustee still has time to take certain action to prevent the loan from triggering Division 7A (i.e., the trustee is able to either pay out the loan or enter into a complying Division 7A loan agreement, provided this is done within the timeframe specified in Division 7A). National Tax & Accountants Association Ltd: August

88 Other important trust issues How can the trustee avoid triggering Division 7A? As noted above, where a bucket company UPE arising on 30 June 2016 is not paid out and the funds are not held on sub-trust for the company s sole benefit by the lodgment day of the trust s 2016 tax return, the UPE will be taken to be a loan for Division 7A purposes made by the bucket company to the trust in the 2017 income year. However, it is important to note that this will not, of itself, cause Division 7A to be triggered. In this regard, a deemed dividend will only arise if, by the lodgment day of the company s 2017 tax return (i.e., being the income year in which the loan is made), the trustee fails to: fully repay the Division 7A loan; or enter into a Division 7A loan agreement that complies with S.109N. Therefore, if no Division 7A complying loan agreement is entered into and the loan is not repaid in full by the requisite date, being the lodgment day of the company s 2017 return (generally May 2017), Division 7A will apply and the trust will be required to include a deemed dividend in its assessable income, equal to the outstanding loan amount (subject to the company s distributable surplus). TAX WARNING Failure to make minimum yearly repayments Division 7A may also be triggered in a year in which the requisite minimum yearly repayment is not made. Refer to S.109E. For example, if a loan arises in the 2017 income year, the Division 7A loan agreement must be entered into by the lodgment day of company s 2017 tax return to avoid Division 7A applying. However, a deemed dividend (to the extent of the minimum yearly repayment) will still arise if the trust fails to make the first minimum yearly repayment by 30 June Summary of crucial dates The following diagram provides an overview of the crucial dates identified above in respect of a bucket company UPE arising on 30 June 2016: 30 June 2016 Private company becomes presently entitled to an amount of trust income from an associated trust (i.e., the bucket company UPE arises). 15 May 2017 If the UPE is not paid out to the bucket company or put on sub-trust for the sole benefit of the bucket company by this date, the UPE becomes a loan. 15 May 2018 The trustee must pay out the loan or put it under a S.109N complying loan agreement by this date. If not, a deemed dividend will arise under Division 7A equal to the outstanding loan amount (subject to the company s distributable surplus). Date may be different depending on the lodgment day of the main trust s 2016 tax return. Date may be different depending on the lodgment day of the company s 2017 tax return. 78 National Tax & Accountants Association Ltd: August 2016

89 Other important trust issues TAX WARNING Problems with bucket company UPEs The practical implication of the ATO s new approach to dealing with a UPE of a bucket company is that trustees are forced to rethink all trust distributions made to bucket companies. For example, the new rules create significant cash flow implications for the trustee, firstly in relation to compensating the bucket company for the use of funds representing the UPE, and secondly in relation to the repayment of the UPE principal. Furthermore, issues may arise as to how to utilise the funds in the company given a company is not an ideal investment vehicle (e.g., ineligibility for the CGT 50% discount). 1.2 Subdivision EA and bucket company UPEs Subdivision EA basically applies where a bucket company UPE is created and, whilst it remains unpaid, the trust makes a payment or loan, or forgives a debt, in favour of a shareholder (or their associate) of the company. Refer to S.109XA and S.109XB. This anti-avoidance provision seeks to include the value of the payment, loan or debt forgiveness in the assessable income of the shareholder (or associates) as a deemed dividend, to the extent of the distributable surplus of the bucket company. To avoid this, the relevant shareholder (or associate) of the bucket company should seek to either repay any loans or payments to the trust or enter into a Division 7A loan agreement with the trust to avoid any assessable dividends. In the absence of Subdivision EA, the trust (and ultimately the beneficiary) would enjoy the use of the funds representing the bucket company UPE interest-free compared with, for example, the costs associated with borrowing directly from the company under a Division 7A loan agreement. Further, tax payable on the distribution would be capped at the applicable corporate rate. It is evident from the above that the precursor for Subdivision EA applying is that a bucket company UPE exists. Under the new rules, where UPE funds are held on sub-trust (in accordance with TR 2010/3), it is important to note that the UPE remains (i.e., the UPE does not become a Division 7A loan) and, therefore, Subdivision EA can still potentially apply. Refer to paragraph 106 of PS LA 2010/4. In contrast, however, where a bucket company UPE becomes a loan, the company s entitlement to the UPE funds no longer exists (it has been replaced with the loan to the trust). Therefore, because no UPE remains, Subdivision EA cannot apply. Refer to paragraph 182 of TR 2010/3 and paragraph 103 of PS LA 2010/4. EXAMPLE 1 Subdivision EA applies to UPE funds on sub-trust On 30 June 2016, the Simmons Family Trust makes an associated bucket company, ABC Pty Ltd ( ABC ), presently entitled to $120,000 of trust income (where trust income is defined to equal net (taxable) income). The entitlement remains unpaid and the UPE is put on subtrust for the sole benefit of ABC by 15 May Therefore, the UPE continues to exist. During the 2017 income year, the trust also advanced $50,000 to Shaun to buy a car for his own use. Shaun is a shareholder of ABC and a beneficiary of the trust. In this case, as the UPE still exists, Subdivision EA can potentially apply to the loan from the trust to Shaun. As a result, the Simmons Family Trust must pay interest to ABC under the sub-trust agreement for use of the UPE funds of $120,000 and, in addition, Shaun is potentially assessable on the $50,000 deemed dividend, subject to ABC s distributable surplus (i.e., unless he either repays the loan or enters into a Division 7A complying loan agreement under S.109N by the lodgment day of the trust s 2017 tax return). Another common example of where Subdivision EA may apply to bucket company UPE is where a loan is made to a bucket company shareholder (or associate) when a pre-16 December 2009 UPE is still in existence (refer to paragraph 28 of TR 2010/3 and paragraph 13 of PS LA 2010/4). National Tax & Accountants Association Ltd: August

90 Other important trust issues 2. Trust losses and family trust elections Schedule 2F to the ITAA 1936 contains special rules for trusts which restrict the use of prior year and current year losses, and the deductibility of debt deductions in relation to bad debts. The broad purpose of these trust loss rules is to ensure that trusts are not able to access the benefit of revenue tax losses and/or debt deductions unless the trust is able to satisfy certain tests. These tests largely seek to determine whether there has been a change in ownership or control of the trust, and/or whether income has been inappropriately injected into the trust. This broad purpose is achieved by ensuring that the following consequences generally arise where certain prescribed tests cannot be satisfied: 1. the trust is not permitted to claim a deduction for prior year losses and debt deductions (i.e., the carry forward losses are permanently lost); and 2. in relation to current year losses, the trust s net income or loss must be calculated in such a way as to deny the benefit of any loss accruing prior to a change in ownership or control. TAX TIP The trust loss rules do not apply to capital losses It is important to note that the trust loss rules apply to revenue losses only. That is, the rules have no application to capital losses. Unfortunately, the trust loss rules are complex and, as a result, are often incorrectly applied which can lead to unexpected tax liabilities. The purpose of this section is to provide a broad overview of how the rules apply to assist in identifying any issues that may require further research (note that relevant provisions are provided to assist in this regard). 2.1 How to navigate the trust loss provisions The following table contains a step-by-step overview to navigating the trust loss provisions. Legislative references are contained within Schedule 2F to the ITAA Step A guide to navigating the trust loss provisions Ref Consider whether the loss trust is an excepted trust that is not subject to the trust loss rules. Excepted trusts that are not subject to the trust loss rules include complying superannuation funds and deceased estates (but not a testamentary trust) up until the end of the income year in which the 5 th anniversary of death occurs. Consider whether the loss trust has already made a family trust election. A trust that has elected to be a family trust is only subject to a modified income injection test ; the remaining trust loss rules generally have no application. Under the modified income injection test, provided the trust has not received an injection of income from an outsider (i.e., broadly, an entity outside the family group ), the loss is available to the trust. If the loss trust is not an excepted trust or a family trust, classify the trust as one of the following types of trust. This classification will ultimately determine which of the trust loss tests are applicable (as noted below). (a) Fixed trust This classification generally applies where beneficiaries have fixed entitlements to all of the income and capital of the trust. A fixed entitlement exists if a beneficiary has a vested and indefeasible interest in a share of the income or capital of the trust. The trust must be a fixed trust at all times from the loss year to the income year. S S S S S National Tax & Accountants Association Ltd: August 2016

91 Other important trust issues Step A guide to navigating the trust loss provisions Ref. 3 cont (b) Non-fixed trust where some of the entitlements in a trust are defeasible, the trust will be a non-fixed trust (e.g., discretionary and hybrid trusts are generally classified as non-fixed trusts). Many purported fixed trusts are in fact non-fixed trusts. One common reason for such a misclassification is that, in order to qualify as a fixed trust, it is generally accepted that the deed of the unit trust must provide that units can only be redeemed or issued for their market or net asset value (based on Australian accounting principles). Note: widely held trusts have not been addressed in these seminar notes. Broadly, a trust is widely held if more than 20 individuals have fixed entitlements to at least 75% of the income and capital of the trust. Determine which trust loss tests apply. For most small business taxpayers, there are four trust loss tests that can apply, which are broadly as follows: The 50% stake test This test requires that the same individuals have fixed entitlements to more than 50% of the income and capital of the trust. The pattern of distributions test This test requires that more than 50% of certain trust distributions are distributed to the same individuals. The control test To satisfy this test, a group must not begin to control the trust during the test period. The income injection test This test broadly prevents a tax benefit being obtained under a scheme involving an outsider injecting income into a trust with tax losses or other deductions. The applicable trust loss tests vary depending on how the trust is classified above, as outlined in the following table (note that excepted trusts have been included in the following table for the purpose of comparison). 4 The trust loss tests Income injection test Fixed trusts? Does the trust loss test apply to: Non-fixed trusts? Family trusts? Excepted trusts? Yes Yes Yes No Div. 269 (Subdiv. C, D & E) Division % stake test Yes Maybe No No Pattern of distribution test No Yes No No Control test No Yes No No This includes excepted trusts other than family trusts. A modified version of the income injection test applies to family trusts to ensure that the test is not breached where, broadly, income is injected from members within the family group. Refer below. An alternative test is also available in certain cases where non-fixed trusts directly or indirectly hold fixed entitlements in the fixed trust. In relation to a non-fixed trust, the 50% stake test would apply to a non-fixed unit trust, and potentially also to a hybrid trust. However, this test would not apply to a discretionary trust. This test only applies in respect of prior year losses and debt deductions. National Tax & Accountants Association Ltd: August

92 Other important trust issues Step A guide to navigating the trust loss provisions Ref. 5 6 If the loss trust is unable to satisfy the applicable trust loss tests (as outlined above), the trust could consider making a Family Trust Election ( FTE ) in order to access the trust loss or debt deduction. As indicated above, by making an FTE, the trust is classified as a family trust. In terms of accessing revenue losses and debt deductions, the main benefit of making an FTE is that the trust is generally only required to satisfy a modified income injection test (rather than up to 4 tests in the absence of an FTE). The modified income injection test is discussed in more detail below. However, it is important to be aware that, whilst making an FTE can be beneficial for a trust, there are certain restrictions placed on family trusts (e.g., a family trust cannot make distributions of trust income outside the family group without attracting a liability for family trust distribution tax ). Many trusts which only intend to distribute trust income within the family group simply choose to make an FTE from the outset rather than consider whether or not the trust satisfies the applicable trust loss tests in the event a loss or debt deduction is to be recouped (as outlined above). This practice allows the trust to simplify their affairs by reducing the applicable trust loss tests. In particular, this approach is often adopted by discretionary trusts because, in addition to simplification for trust losses, it can also provide access to franking credits received by the trustee of the trust where the credits would otherwise be lost. This issue is discussed above in relation to distributing franking credits from a discretionary trust. If the loss trust is not able to make an FTE to access the revenue loss and/or debt deduction, or chooses not to do so, and is not otherwise able to satisfy the applicable trust loss tests, the following consequences may arise: (a) If the 50% stake test or the control test is failed (where they are applicable, as set out above), the practical effect of the provisions means that any debt deductions and revenue losses incurred in an income year prior to failing the 50% stake test or control test are lost for good. However, special rules ensure that any losses/debt deductions incurred in the year the test was failed generally continue to be deductible provided they were incurred after the test was failed and provided the relevant tests are satisfied going forward (i.e., basically provided there is no additional change in the ownership or control of the trust which would cause either the 50% stake test or control test (as applicable) to be failed). (b) If the pattern of distributions test (i.e., which is relevant to non-fixed trusts) is failed in a particular income year, the trust will not be able to deduct any revenue losses and/or debt deductions incurred in a prior income year. These losses/debt deductions are lost for good. (c) If the income injection test is failed, the income injected into the trust is included in the net income of the trust (without any offsetting deduction being permitted). In this regard, any related deductions are lost for good but any unrelated deductions continue to be potentially available to the trust (i.e., provided the relevant tests are satisfied). S S Div. 266 Div. 267 Div. 268 Div National Tax & Accountants Association Ltd: August 2016

93 Other important trust issues The 50% stake test A fixed trust cannot deduct a revenue tax loss (or a debt deduction) unless it satisfies either the 50% stake test or the alternative 50% stake test. The 50% stake test requires that, at all times during the test period (as defined below): (a) the same individuals beneficially hold between them, directly or indirectly, fixed entitlements to more than 50% of the income of the trust; and (b) the same individuals (who may differ from the individuals with the income entitlements) beneficially hold between them, directly or indirectly, fixed entitlements to more than 50% of the capital of the trust. Note that for prior year revenue losses, the test period is the income year in which the loss was incurred, the income year in which the deduction is claimed and all intervening years and, for current year revenue losses, the test period is the entire current income year. Refer generally to S to S , S and S As noted above, in the case of a non-fixed trust, the 50% stake test will only apply where individuals have a fixed entitlement to 50% or more of the income or capital of the trust at any time during the test period. As such, the 50% stake test will not apply to an ordinary discretionary trust, although it could apply to a hybrid trust. TAX WARNING Discretionary trust unit holders are problematic Where units in a unit trust (or shares in a unit holder company) are held by a non-fixed trust such as a discretionary trust, there is no interest that is capable of being traced through to an individual and therefore the discretionary trust s ownership percentage does not contribute towards satisfying the 50% stake test. In these circumstances, consider whether the fixed trust is able to satisfy the alternative 50% stake test. Refer to S Effectively the discretionary trust unit holders need to pass the trust loss rules. Also consider whether the discretionary trust unit holder is able to make a family trust election, as discussed below The control test In order to deduct tax losses and debt deductions, all non-fixed trusts are required to pass the control test, which requires that control of the trust remains with the same group throughout the test period (as defined above in relation to the 50% stake test). That is, the test is passed if another group does not, during the test period, begin to control the trust directly or indirectly. Refer to S , S and Subdivision 269-E. Pursuant to S , a group, being a person, a person and one or more associates, or two or more associates of a person, will control a non-fixed trust if the group: has the power to obtain beneficial enjoyment (directly or indirectly) of income or capital; is able (directly or indirectly) to control the application of the income or capital; is capable under a scheme of gaining such beneficial enjoyment or control; is in a position where the trustee is accustomed, under an obligation or reasonably expected to act in accordance with the directions, instructions or wishes of the group; is able to remove or appoint the trustee; or acquires more than a 50% stake in the income or capital of the trust. National Tax & Accountants Association Ltd: August

94 Other important trust issues The pattern of distributions test The pattern of distributions test only applies to non-fixed trusts, and only in relation to claiming a deduction for prior year losses or debt deductions. The test applies in relation to debts that were incurred (or arose) in an earlier income year, regardless of whether they were written-off in the current or prior income year. Refer to S and S Furthermore, the pattern of distributions test only applies to non-fixed trusts that have distributed income or capital (or both) in: 1. the income year in which the deduction is to be claimed, or within 2 months of year end; and 2. at least one of the 6 earlier income years. TAX TIP Test does not apply if no distribution is made The pattern of distributions test is designed to examine whether there has been a change in those who actually benefit under the trust. Therefore, if the trust did not make a distribution of income or capital in any one of the six earlier income years, or if it does not distribute any income or capital in the income year in which the prior year loss or debt deduction is to be claimed (or within two months after the end of that income year), the trust is not required to meet the pattern of distributions test. To satisfy the pattern of distributions test for an income year, before the end of 2 months after the end of the income year, the trust must have distributed: (a) more than 50% of all test year distributions of income directly or indirectly to the same individuals for their own benefit; and (b) more than 50% of all test year distributions of capital directly or indirectly to the same individuals for their own benefit. The test applies independently to both income and capital and, therefore, the individuals that satisfy the test in relation to income distributions need not be the same individuals that satisfy the test in relation to capital distributions. The test year distributions of income are equal to the total of all distributions of income made by the trust in certain periods and likewise for distribution of capital (refer to S (1) and (2)) The income injection test The income injection test is an anti-avoidance provision contained in S which aims to prevent a tax benefit being obtained under a scheme involving an outsider injecting scheme assessable income into a trust with tax losses or other deductions so that no tax, or less tax, is payable on the income. Fixed trusts and non-fixed trusts must satisfy the income injection test before a deduction (including any current year deduction, prior year tax loss or debt deduction) can be claimed by the trust in an income year. Excepted trusts are not required to satisfy the test and a modified watered-down version of the test applies to family trusts. A trust (not being an excepted trust) will generally fail the income injection test if the trust has a tax loss or other allowable deduction for the income year (i.e., in the absence of the income injection test) and, under a scheme the following happen (in any order): (a) The trust derives scheme assessable income usually, the income injected into the trust; (b) An outsider provides a benefit (directly or indirectly) to the trustee, a beneficiary or to an associate of either this is usually the scheme assessable income; (c) The trustee, a beneficiary or an associate thereof either directly or indirectly provides a return benefit to the outsider or their associate (refer to the Tax Warning below); and 84 National Tax & Accountants Association Ltd: August 2016

95 Other important trust issues (d) It is reasonable to conclude that: the trust derived the scheme assessable income; or the outsider provided the benefit; or the trustee, beneficiary or associate provided the return benefit; wholly or partly, but not merely incidentally, because the deduction would be allowable. The test cannot be overcome by simply appointing the outsider as a trustee or by giving the outsider a fixed entitlement to income or capital so they are not an outsider. Refer S (2). If the income injection test is failed, the general implications are that the scheme assessable income is included in assessable income (with no offsetting deductions being permitted) and any deductions related to the scheme assessable income cannot be claimed. Refer S TAX WARNING Loss trust provides a benefit to outsider It may not always be obvious whether the loss trust has, or has not, provided a return benefit to the outsider or their associate (refer to paragraph (c) above). A common illustration of where a benefit is provided to the outsider is where a distribution is made from Discretionary Trust A to loss Discretionary Trust B (where the trusts are outsiders to each other refer below) which remains unpaid (the distribution is recorded as an unpaid present entitlement by both trusts). In this case the return benefit exists because Trust B did not call for immediate payment of the distribution (and no compensation was paid). Refer to the ATO document Trust loss provisions. (a) Who is an outsider to a trust? Determining an outsider to a trust varies depending on whether or not the trust is a family trust (being a trust that has made an FTE). An outsider to a trust that is not a family trust is a person other than the trustee or a person with a fixed entitlement to a share of the trust s income or capital (e.g., a unit holder). Refer S (2). TAX WARNING Family trusts can still be caught by trust loss rules One of the main reasons a trust may elect to make an FTE is that only one trust loss test applies to family trusts, being a modified income injection test. The modified income injection test is generally easier to satisfy (compared with the income injection test that applies to other trusts) as the test only applies to income from a more narrowly defined definition of an outsider. The application of how this test is modified for family trusts is discussed below. Importantly, a trust will not fail the income injection test if it simply makes a tax loss from trading in one income year and a taxable profit from the same activities in the following income year which it offsets with the prior year losses. However, one of the most common scenarios where the operation of the income injection test may become problematic is where a trust with a taxable profit seeks to distribute the income to a related trust that has incurred losses (which, in the absence of this test, are deductible). EXAMPLE 2 Distributing from a profit trust to a loss trust Profit Trust and Loss Trust are discretionary trusts. The same family control, and are beneficiaries of, both Profit Trust and Loss Trust. Further, Profit Trust is a beneficiary of Loss Trust, and vice versa. Profit Trust has a history of profitable operations. Loss Trust does not, it has both current year and prior year losses. National Tax & Accountants Association Ltd: August

96 Other important trust issues Neither Profit Trust nor Loss Trust have made an FTE (i.e., they are not family trusts). Therefore, as noted above, for the purposes of the trust loss measures, Profit Trust is an outsider to Loss Trust and Loss Trust is an outsider to Profit Trust. The trustee of Profit Trust is considering distributing trust income to Loss Trust for the 2016 income year to absorb some of Loss Trust s revenue losses in order to reduce the overall tax payable by the group. However, it is not intended that the distribution will be paid across to Loss Trust. It will be recorded as a UPE in the books of both trusts (and no compensation will be paid in respect of the UPE). The proposed distribution can be illustrated as follows: Distribution of trust income Profit Trust UPE asset / liability Loss Trust Does Loss Trust pass the income injection test? The above transactions will fall foul of the income injection test as a result of the following: 1. In the absence of these rules a deduction is available to Loss Trust (i.e., the tax loss). 2. Loss Trust has derived scheme assessable income, being the trust distribution from Profit Trust to Loss Trust. 3. Profit Trust, an outsider, has provided a benefit to the trust, being the trust distribution from Profit Trust to Loss Trust. 4. Loss Trust has provided a return benefit to Profit Trust (the outsider) by not calling for immediate payment of the unpaid present entitlement. 5. In these circumstances it is likely the Commissioner will argue that it is reasonable to conclude that the assessable income has been derived by Loss Trust, and the benefits provided, wholly or partly, but not just incidentally, because Loss Trust has prior year losses available for deduction and, therefore, the income injection test is failed. Because the income injection test is failed, the trust distribution would be fully assessable to Loss Trust and a deduction in respect of the tax loss disallowed. Refer to S Could the income injection test be satisfied using Family Trust Elections ( FTEs )? Yes. A trust that has made a Family Trust Election is classified as a family trust and is only required to satisfy a modified version of the income injection test. In the above circumstances, it is possible for Profit Trust and Loss Trust to use FTEs (alone or in combination with an interposed entity election) in order to access the loss. FTEs and IEE are discussed in further detail below. 2.2 Accessing revenue losses using FTEs If revenue tax losses and/or debt deductions are not available to a trust (including fixed trusts and non-fixed trusts) because the trust fails one or more of the trust loss tests that are applicable to the trust (e.g., for a fixed trust, the 50% stake test and the income injection test apply), the trust should consider making a family trust election ( FTE ). In terms of accessing trust losses, the broad effect of making an FTE is that the relevant trust loss tests will no longer apply. In fact, the only test that applies to a family trust is a modified watered-down version of the income injection test. Consequently, as a result of making an FTE, previously unavailable losses and/or debt deductions may become available. 86 National Tax & Accountants Association Ltd: August 2016

97 Other important trust issues Family trust elections ( FTE ) As noted above, an FTE is a general election for a trust to become a family trust. There are many reasons why a trust may consider making an FTE. For example: Reasons to make an FTE Deductibility of tax losses and debt deductions incurred by a trust (as noted above) Deductibility of tax losses and debt deductions of a fixed (unit) trust owned by a discretionary trust Satisfying the company loss rules Access to franking credits received by a trust Exclusion from the trustee beneficiary reporting rules Explanation A trust that is a family trust is only required to pass a modified income injection test rather than up to four tests, in order to claim revenue tax losses and debt deductions. Broadly, this test is only failed if outsiders inject income into the trust. Where a discretionary trust owns units in a unit trust that has tax losses or debt deductions, the discretionary trust making an FTE will assist the unit trust to pass the 50% stake test (unless the alternative test, contained in S , applies and is met). A discretionary trust which owns shares in a company that has tax losses or debt deductions can assist the company to pass the continuity of ownership (same owners) test by making an FTE (the trust will be taken to hold an interest as an individual). Where a discretionary trust receives franked dividends on shares it acquired after 3pm on 31 December 1997, making an FTE will enable beneficiaries to claim any franking credits distributed to them. Family trusts are not required to comply with the trustee beneficiary reporting rules that apply to certain closely held trusts (including discretionary trusts). TAX WARNING Beware the implication of making an FTE Unfortunately, the downside of making an FTE (or an interposed entity election ( IEE ) refer below) is that it effectively limits the range of beneficiaries that the family trust can distribute to by imposing an additional tax at 49% (inclusive of effect of the Medicare levy and temporary budget repair levy for the 2015 to 2017 income years), called family trust distribution tax, on distributions made to any beneficiary of the trust who is not part of the family group. (a) Making a family trust election An FTE can be made at any time, although a trust can make only one FTE. Once made, an FTE election applies from the start of the specified income year and to all future years (subject to the family control test ) and can only be varied or revoked in limited circumstances. Refer to S (10). An FTE (and an IEE) can be made retrospectively for trust loss purposes (i.e., the election can specify a prior income year), provided the specified year is not before the 2005 year. However, where an FTE (or IEE) is to apply retrospectively, the trust must pass the family control test in all those earlier years and must have only made distributions of income or capital in those earlier years to the primary individual or members of their family group. National Tax & Accountants Association Ltd: August

98 Other important trust issues TAX WARNING Passing the family control test A trust cannot make an FTE unless it passes the family control test. To pass the test, control (as defined) of the trust must be held by one of a number of specified groups (such as one or more members of the primary individual s family or the primary individual and one or more members of the primary individual s family). Refer to S If the FTE is to apply from the start of the year, then the trust must generally pass the test throughout the entire year. However, subject to an exception for retrospective FTEs, once a trust has passed the test for the specified income year, it is not required to pass it in each subsequent year to continue being a family trust. Refer to S (4) and S (10). Where the election is to apply retrospectively, the family control test must be passed at all times from the start of the specified income year, and in each of the income years up to the year in which the election is made. Refer to S (4A). Consideration should be given as to the date from which the FTE (or IEE as discussed below) is required to be effective. For example, if an FTE is being made by a loss trust to enable it to access a tax loss, the FTE should generally be made for the income year in which the loss was incurred to ensure the trust is a family trust (an excepted trust ), for those provisions at all times during the test period (from the beginning of the loss year to the end of the income year). (b) The primary individual When a trust makes an FTE, it must nominate a (i.e., one) primary individual (also referred to as the test or specified individual) whose family group will be taken into account in relation to the FTE. The identity of this person is relevant for determining whether a liability for family trust distribution tax ( FTDT ) arises (for distributions made outside the family group ), and whether the trust has passed the income injection test (i.e., for the purposes of claiming losses or debt deductions). Care should be taken in selecting an appropriate primary individual because this will limit the persons to which the trust can make distributions. Furthermore, once nominated, this person remains the primary individual for as long as the trust exists (even if the person dies) unless an exception applies (the exceptions are limited). Refer to S (5A), (5B) and (5C) Interposed entity elections ( IEE ) An IEE is entity specific (as opposed to an FTE which is a general election). That is, an IEE is made by an entity (e.g., a trust or company) with respect to a specific family trust. For example, if ABC Trust makes an IEE, it must do so in respect of a family trust, say, the DEF Family Trust. Practically, the reasons ABC Trust may seek to make such an IEE are that: 1. The ABC Trust will no longer be considered to be an outsider of the DEF Family Trust for the purposes of the modified income injection test this test is discussed below. 2. The ABC Trust becomes part of the family group of the primary individual specified in FTE made by DEF Family Trust. This is important because, as noted above, where a family trust distributes income or capital outside the family group, FTDT will be payable at 49% on those distributions. Refer to Division An important implication/limitation to be aware of in these circumstances is that ABC Trust will be subject to FTDT at 49% on future distributions it makes outside that family group. An IEE must specify a day in the income year from which the election will take effect, although this need not be the same year specified in the FTE. As with FTEs, an IEE can specify an earlier income year, provided it is not earlier than the 2005 year. Refer to S (6B). It is important to note that an entity cannot make an IEE unless it passes the family control test. Furthermore, an entity can make multiple IEEs, but only if each family trust has the same primary individual. Once made, an IEE is generally irrevocable, except in limited circumstances. Refer to S (4) and (7) and S National Tax & Accountants Association Ltd: August 2016

99 Other important trust issues The meaning of family and family group The concept of family (as per S ) and family group (as per S ) is relevant for both FTDT purposes and for the trust loss provisions (i.e., the income injection test). Specifically: (a) For FTDT purposes if a family trust or an interposed entity makes a distribution of income or capital outside the primary individual s family group, a liability for FTDT will arise. For these purposes, all family members of the primary individual are part of their family group. (b) For trust loss purposes if a family trust receives a distribution from an outsider, which is generally a person who is not a member of the primary individual s family group, the trust will fail the modified income injection test which applies for the purposes of claiming tax losses. (a) Who is included in the family group? Family group is defined in S to include (of note) the following: Members of the primary individual s family, as defined in S (discussed below). A former spouse or a former step-child. A widow/widower who has remarried. The family trust itself. Family trusts with the same primary individual specified in their FTE. An entity (i.e., a company, partnership or trust) that has made an IEE. A company, partnership or trust in which the primary individual, or family members of the primary individual, or a family trust in which the primary individual is the primary individual, or any combination of these persons have fixed entitlements, directly or indirectly, to all of the income and capital of the company, partnership or trust. Refer to S (5). EXAMPLE 3 Wholly owned entity included in family group The Johnno Family Trust has made an FTE specifying John as the primary individual. On 30 June 2016, the trustee resolved to distribute $10,000 income to J Pty Ltd, the sole shareholder of which is John. As all the entitlements to the income and capital of the company are held by the primary individual (John), J Pty Ltd is part of John s family group. (b) Who are the family members of the primary individual? The definition of family is defined in S The diagram below identifies the persons included in a primary individual s family (extracted from the ATO factsheet Family trusts - concessions ): National Tax & Accountants Association Ltd: August

100 Other important trust issues Applying the modified income injection test A common reason that a trust may choose to make an FTE is so that the trust is classified as a family trust, which means that, in terms of accessing tax losses (depending on when the loss was incurred and the date from which the FTE applies), there will be only one test that applies, being the modified income injection test. As noted, the income injection test, as it applies to non-family trusts (i.e., to trusts which have not made an FTE), will broadly apply if the loss trust received scheme assessable income from an outsider and it is reasonable to conclude that the loss trust received the income because of the available losses. For those purposes, an outsider is defined to mean any person other than the trustee, or a person with a fixed entitlement to a share of the trust s income or capital. When applying the income injection test to a family trust, the definition of outsider is modified (hence the term modified income injection test ). In this regard, if the trust has made an FTE (i.e., it is a family trust), under S (1) an outsider is any person other than the following: The trustee. A person with a fixed entitlement to a share of the income or capital of the trust. The primary individual and their family (as defined in S refer above). An entity that has made an IEE (to be included in the primary individual s family group) which was in force when the scheme began. A family trust with the same primary individual. An entity (fixed trust, company or partnership) in which the above persons and entities have fixed entitlements, directly or indirectly, to all of the income and capital of the entity. TAX WARNING Family and family group are separately defined It is important to note that a person is not a member of the primary individual s family simply because they are a member of their family group. Specifically, the meaning of family group underpins the imposition of FTDT whilst the meaning of family is central to the operation of the modified income injection test (i.e., an outsider can include a person who is not a member of the primary individual s family ). Therefore, a person who is a member of a primary individual s family group, but not a member of their family (as defined), such as a widow or widower who has remarried, a former spouse or a former step-child (refer above), will be an outsider to a loss trust for the purposes of satisfying the modified income injection test. The use of FTEs and IEEs is particularly effective (and common) in circumstances where a profit trust wishes to make a distribution to a loss trust to make use of its tax losses. This can be achieved, without contravening the trust loss provisions, with the use of FTEs (and IEEs). EXAMPLE 4 Distributing from a profit trust to a loss trust The ABC (discretionary) Family Trust (the Profit Trust ) has a history of profitable operations. A number of years ago Simon established the DEF (discretionary) Family Trust (the Loss Trust ), which has current year revenue losses. Simon, his wife and his children are beneficiaries of the Profit Trust and the Loss Trust. Furthermore, the Profit Trust is a potential beneficiary of the Loss Trust, and vice versa. The Profit Trust and the Loss Trust have each previously made an FTE selecting Simon as the primary individual. 90 National Tax & Accountants Association Ltd: August 2016

101 Other important trust issues On 30 June 2016, the trustee of Profit Trust resolved to distribute $50,000 of trust income to Loss Trust (where trust income equals net taxable income). The distribution was not physically paid and was recorded as an unpaid present entitlement ( UPE ) in the books of both trusts. No compensation was received in respect of the UPE. Loss Trust has sufficient carry forward tax losses to offset the $50,000 trust distribution such that no tax would be payable on the distribution. However, Simon is concerned that the trust loss rules will prevent the tax loss being used in this manner. The distribution can be illustrated as follows: Profit Trust! Distribution of trust income " UPE asset / liability Loss Trust # Flow of transactions:! Profit Trust distributes $50,000 trust income to Loss Trust. " The $50,000 distribution remains unpaid and is recorded as a UPE in the books of both trusts. # Loss Trust applies available tax losses so that no tax is paid on the $50,000 distribution. Does Loss Trust pass the modified income injection test? For the purposes of the trust loss provisions, the Profit Trust and the Loss Trust are family trusts which means that the trusts are excepted trusts and, as such, the only applicable test in this case is the modified income injection test. In the circumstances outlined above, the modified income injection test does not apply to prevent Loss Trust applying its available tax losses because Loss Trust did not receive scheme assessable income from an outsider. This is because the Profit Trust and the Loss Trust have each made an FTE selecting Simon as the primary individual which means the Profit Trust is not an outsider to the Loss Trust. Refer to S (1) and above. Furthermore, note that the same outcome could have been achieved had Loss Trust made an FTE with Simon as the test individual and then Profit Trust, instead of making an FTE, made an IEE to be included in Simon s (i.e., the primary individual s) family group. 3. The small business entity regime Small businesses (including those operated through a trust) that satisfy the current annual turnover threshold level of less than $2 million may be able to access a range of tax concessions including: A 28.5% tax rate for SBE companies in the 2016 income year. Access to the Small Business Income Tax Offset ( SBITO ) for individual SBE sole traders, individual partners of an SBE partnership or individual beneficiaries of an SBE trust. Simplified trading stock rules. Simplified depreciation rules, currently including a temporary $20,000 immediate write-off. Immediate deductions for prepaid expenses. Access to the Small Business Capital Gains Tax (CGT) concessions. Certain GST concessions such as GST cash accounting. National Tax & Accountants Association Ltd: August

102 Other important trust issues Generally speaking, an entity (including a trust) qualifies for the small business entity ( SBE ) concessions if the business is an SBE for the income year in question (although some of the concessions have additional conditions which must be satisfied). 3.1 When is a taxpayer a small business entity? Pursuant to S (1) of the ITAA 1997, a taxpayer that is an individual, partnership, company or trust will be a small business entity for an income year (referred to as the current income year ) in which both of the following requirements are met: (a) The taxpayer is carrying on a business in the current income year The expression carrying on a business is not defined and, as such, takes on its common law meaning, as discussed in TR 97/11. Note that a taxpayer is taken to be carrying on a business in an income year in which a business they previously carried on is being wound up, if the taxpayer was an SBE in the income year they ceased business. Refer S (5) ITAA (b) The taxpayer has an aggregated turnover of less than $2 million A taxpayer satisfies the aggregated turnover test where one of the following three methods of qualifying is satisfied: The taxpayer carried on a business in the income year before the current income year (the prior income year) and the taxpayer s aggregated turnover for the prior income year was less than $2 million. The taxpayer s aggregated turnover for the current income year is likely to be (i.e., is estimated to be) less than $2 million. However, this method of qualifying cannot be used where the taxpayer carried on a business in the two prior income years and the taxpayer s aggregated turnover for the two prior income years was $2 million or more. The taxpayer s aggregated turnover for the current income year is actually less than $2 million (note: an entity that satisfies the aggregated turnover test based solely on its actual current year turnover has reduced access to some of the SBE concessions refer to note under S (4) of the ITAA A taxpayer s aggregated turnover is equal to the annual turnover of the taxpayer, together with the annual turnover of any connected entities and affiliates. The annual turnover of an entity is the GST-exclusive amount of all ordinary income derived by the entity in the ordinary course of its business, excluding such income derived from dealings with connected entities and affiliates (in order to avoid double counting). Ordinary income is income according to ordinary concepts such as gross sales of trading stock and interest from business bank accounts, but not proceeds from the sale of business assets. Refer to S If the taxpayer started or ceased a business part way through an income year, the annual turnover for that year must be calculated using a reasonable estimate of what it would have been if the taxpayer had carried on the business for the entire year. Refer to S (5). TAX TIP Proposed changes to the $2 million turnover threshold As part of the 2016/17 Federal Budget announcements, the government proposed that the $2 million turnover threshold for most of the current SBE concessions be increased to $10 million from the 2017 income year. Note, however, access to the SBE CGT concessions will still remain subject to the $2 million threshold, while access to the Small Business Income Tax Offset ( SBITO ) is proposed to be subject to a $5 million turnover threshold from National Tax & Accountants Association Ltd: August 2016

103 Other important trust issues 4. Personal Services Income ( PSI ) Where a trust derives Personal Services Income ( PSI ), the calculation of its taxable income may be affected by the operation of special rules relating to PSI ( the PSI rules ). Broadly speaking, PSI is income that is mainly a reward for an individual s personal efforts or skills and may be earned by the individual directly (e.g., as a sole trader) or through a company, partnership or trust (referred to as a Personal Services Entity or PSE ). The word mainly in the definition of PSI is not defined. However, the ordinary use of the word means more than half, therefore income received by a trust will be PSI if more than 50% of the income received is a reward for the personal efforts, skills, knowledge or expertise of the individual who performed the services. (a) What is not PSI? Income earned by a trust will not be PSI where the income is mainly (or wholly) derived from: the sale or supply of goods (e.g., income from the sale of furniture); the use of an asset (e.g., for the supply and use of an excavator); granting a right to use property (e.g., from the grant of a licence); or a business structure. (b) What are the consequences of the PSI rules applying? Where the PSI rules apply to a trust, the following broad consequences can arise: 1. The trust will be denied certain deductions against the PSI. 2. The trust (i.e., the PSE) must treat the PSI (less allowable deductions) as belonging to the individual who did the work. That is, the net PSI cannot be distributed to entities or individuals other than the individual who performed the work. Effectively, where net PSI received by a trust is treated as belonging to (i.e., attributed to) an individual, the income is excluded from the taxable income of the trust via the tax reconciliation in order to avoid double taxation. 3. The trust will be required to complete certain additional labels on their income tax return. 4. The trust may have additional PAYG withholding obligations. Prior to 2013, trusts impacted by the PSI rules were also required to complete a separate Personal services income schedule. This is no longer required, however in the 2016 income tax year, more detailed information must be disclosed at Item 30 of the trust return (discussed later in these notes). 4.1 Working out if the PSI rules apply Where some or all of the income earned by a trust is PSI, the next step is to work out whether the PSI rules apply to this income. Broadly speaking, the PSI rules will not apply in an income year where the trust is taken to be conducting a Personal Services Business ( PSB ). A trust is generally taken to be conducting a PSB in respect of an income year where at least one of the following requirements is met: (a) The results test is met If the trust does not pass this test, it must apply an additional rule (referred to as the 80% rule ) to work out if 80% or more of its income comes from one client. National Tax & Accountants Association Ltd: August

104 Other important trust issues (b) (c) Less than 80% of the trust s PSI is derived from one source and the trust satisfies at least one of the following tests: The unrelated clients test. The employment test. The business premises test. The trust has received a PSB determination ( PSBD ) from the ATO this will generally be the case where at least 80% of the trust s PSI is from one client. However, a trust may also apply for a PSBD if it is not sure whether it will pass one of the above PSB tests, or if unusual circumstances prevent the trust from passing any of the tests The results test Basically a trust will pass the results test (contained in S of the ITAA 1997) if the following requirements are met in respect of at least 75% of the trust s PSI: (a) the income is for producing a result i.e., the trust will only receive payment when the work has been completed; (b) the trust is required to supply the plant, equipment or tools of trade required to do the work note that this test is passed if no plant, equipment or tools of trade are required to perform the work; and (c) the trust is liable for the cost of rectifying any defects in the work. A contract or agreement to produce a result is usually flexible about how the task is done. For example, the trust is usually free to engage people and hire plant, and payment is usually made on a negotiated price rather than an hourly rate. If a trust passes the results test, the PSI rules will not apply to any of the PSI The 80/20 rule If a trust does not pass the results test, the next step is to apply what is commonly known as the 80/20 rule. Under the 80/20 rule, a trust must work out whether 80% or more of its PSI comes from one client (including their associates) in an income year. (a) Where one client provides 80% or more of the trust s PSI the PSI rules will apply to the trust, unless it applied to the ATO for a PSBD in order to work out whether the PSI rules apply. If a trust does not apply for a determination, the PSI rules will automatically apply. TAX TIP PSBDs where unsure or unusual circumstances exist A trust may also apply for a PSBD from the ATO if it is unsure or had unusual circumstances that prevented it from passing one of the PSB tests (i.e., the results test, the unrelated clients test, the employment test or the business premises test). (b) Where each client provides less than 80% of the trust s PSI the trust can seek to apply the unrelated clients test, the employment test or the business premises test to work out if the PSI rules apply. 1. The unrelated clients test Broadly speaking, a trust will pass the unrelated clients test (and, therefore, will not be subject to the PSI rules) in an income year if it receives PSI from two or more unrelated clients, as a direct result of making offers or invitations (such as by advertising) to the public. Refer to S The employment test Generally, a trust will pass the employment test (and, therefore, will not be subject to the PSI rules) in an income year if the trust has employees, partners or other contractors to perform at least 20% (by market value) of the principal work, or has apprentices for at least half the income year. Refer to S National Tax & Accountants Association Ltd: August 2016

105 Other important trust issues 3. The business premises test Broadly speaking, a trust will pass the business premises test under S (and, therefore, will not be subject to the PSI rules) in an income year if, at all times during the year, the trust maintained and used business premises: owned or leased by the trust; used for personal services work more than 50% of the time; used exclusively by the trust; that are physically separate from the private residence of any associates of the trust; and that is physically separate from the business addresses of clients and their associates. 4.2 What if the PSI rules do not apply? As noted earlier, the PSI rules do not apply to a trust which has passed one of the four PSB tests (discussed above), or which holds a PSBD received from the ATO. As a result of passing these tests, there will be no changes to the deductions the trust can claim and the PSI is not be formally attributed under the PSI regime to the individual who performed the work (i.e., the principal individual). This does not mean, however, that the trust can then be used as an income-splitting vehicle with respect to the derived PSI (see the tax warning below). TAX WARNING Using a trust to split income The application of the general anti-avoidance provision of Part IVA of the ITAA 1936 to arrangements involving the use of an entity (e.g., a trust) to effectively avoid or reduce tax by alienating (splitting) PSI continues to be an issue for the ATO. The ATO s views on when Part IVA applies to such arrangements are contained in several rulings, including IT 2121, IT 2330, IT 2503, and IT 2639, which were based on a series of court decisions handed down in the 1980 s, including Tupicoff v FCT 84 ATC 4851 ( Tupicoff ) and FCT v Gulland; Watson v FCT; Pincus v FCT 85 ATC The rulings suggest that Part IVA may apply in these cases on the basis that the income of the entity is PSI, particularly where payments to the principal individual performing the work are not commensurate with their services. As a result, clients who derive PSI through a trust should be aware that even if the PSI rules are passed (i.e., the results test or one of the 80/20 tests), the structure should still not be used to split income via distributions to other entities and family members. Refer to ATO fact sheet General anti-avoidance rules for a PSB Does the use of trusts increase the risk of Part IVA applying? Where a trust is used to derive PSI, the likelihood is that it will be a discretionary trust. In that case, a concern arises given the potential of a discretionary trust to stream income to a broader range of beneficiaries (compared to a company which can generally only pay dividends to its shareholders) to achieve an optimal result for the taxpayer. In particular, the Commissioner considers the use of trusts to split PSI in a tax effective manner between beneficiaries who make no contribution to the derivation of the income (e.g., where distributions equal to a tax-free threshold amount, are made to children of the principal) fall into this category of more blatant arrangements to which Part IVA may apply. The following example is adapted from the facts in Case W58 89 ATC 524 in which the AAT held that Part IVA applied to an arrangement involving income splitting by a discretionary trust. National Tax & Accountants Association Ltd: August

106 Other important trust issues EXAMPLE 5 Part IVA applies to income splitting by trust Daryl, a computer consultant, contracts his services to X Co Pty Ltd ( X Co ) under a consultancy agreement entered into by his family company, as requested by X Co. Daryl is the sole shareholder of the family company. At the same time, acting on the advice of his accountant, Daryl established a discretionary trust, the trustee of which was the family company. Apart from amounts retained to pay any debts or expenses and a small salary paid to Daryl, the balance of the fees received from X Co are distributed to Daryl s family in a tax-effective manner, having regard to tax thresholds. Would Part IVA apply to this arrangement? Yes. The dominant purpose of this arrangement was to obtain a tax benefit. There is no commercial justification for going that step further and establishing the trust to derive Daryl s PSI. Neither is it explicable as a normal family arrangement. As such, in the absence of the trust, it could reasonably be expected that the company would have paid Daryl all the income distributed to his family members. Furthermore, the fact that Daryl is not remunerated adequately for his services and the manner in which the trust splits the income with family members are indicative of a tax avoidance purpose. Traditionally, where a trust was not deriving PSI, there was generally no suggestion from the ATO that Part IVA would apply, despite the fact the distributions are often strategically made based on tax considerations. TAX TIP Change in ATO position on Part IVA and professional income On 30 June 2015, the ATO revised its guidelines (originally published in September 2014), Assessing the risk: allocation of profits within professional firms (the guidelines ), which assess the risk of the general anti-avoidance rules in Part IVA of the ITAA 1936 applying to the allocation of profits from a professional firm carried on through a partnership, trust or company, where the income of the firm is not PSI. The ATO considers the guidelines will apply to relevant arrangements within professional firms including, but not limited to, providing services in the accounting, architectural, engineering, financial services, legal and medical professions. The purpose of the guidelines is to provide an explanation of how the ATO will assess the tax compliance risks associated with the allocation of profits from a business structure of a professional firm carried on through a partnership, trust or company. In particular, the guidelines will apply where: an individual professional practitioner ( IPP ) provides professional services (such as accounting or legal services) to clients of the firm, or is actively involved in the management of the firm and the IPP and/or associated entities have a legal or beneficial interest in the firm; the firm operates by way of a legally effective partnership, trust or company; and the income of the firm is not PSI. The ATO is concerned that, despite the existence of a genuine business structure, Part IVA may have application to schemes designed to ensure the IPP is not directly rewarded for their services provided to the business, or receives a reward that is substantially less than the value of those services. Where the IPP has arranged for the distribution of business profits or income to their spouse or other associated entities without regard to the value of services provided by the IPP to the business, the ATO may consider cancelling any relevant tax benefit under Part IVA. 96 National Tax & Accountants Association Ltd: August 2016

107 Other important trust issues 4.3 What if the PSI rules do apply? As noted earlier, where the PSI rules apply, the trust (i.e., the PSE) will not be able to claim certain deductions, and the net PSI may be attributed to the individual ( the principal individual ) who performed the work. Additional reporting and withholding obligations may also apply Deductions when the PSI rules apply One of the consequences of the PSI rules applying to a PSE (i.e., the trust) is that there are certain deductions the PSE cannot generally claim against the PSI, such as the following: (a) rent, mortgage interest, rates and land tax in relation to the residence of the principal individual (or their associate) used as a home office; (b) payments to associates for support work (i.e., non-principal work). Principal work is basically the work required to be done under the contract and which generates the PSI; (c) superannuation contributions on behalf of associates solely doing non-principal work; and (d) car expenses for more than one privately used motor vehicle. As well as the specific deductions listed above which are affected, there is also a general deduction rule that only allows a PSE trust to claim the same deductions that the principal individual who generated the PSI could have claimed in the same situation. For a PSE trust to be entitled to a deduction under the general deduction rule, the expense must be an allowable deduction under tax law, and relate to gaining or producing the principal individual s PSI Attribution of income (and losses) to the relevant individual The other main consequence of the PSI rules applying to a trust is that it must attribute (i.e., treat) the PSI generated as belonging to each principal individual who performed the services. This means that a PSE (e.g., a trust) cannot retain the profits from the PSI, and that each principal individual who performed the work must include a PSI profit in their tax return at Item 9 of the 2016 individual tax return. There is a series of steps a PSE must take in order to attribute PSI to an individual. Broadly, the following steps should be taken where the PSI was generated by only one individual: 1. Identify the amount of PSI received in an income year (exclude non-psi income). 2. Deduct any salary or wages promptly paid by the PSE to the individual who performed the services. 3. If the PSE derives both PSI and non-psi, deduct any entity maintenance deductions from the taxpayer s non-psi first, and then deduct any remaining amount from the PSI. 4. Subtract any other allowable deductions from the PSI received. If the result is a positive amount, then there is net PSI. This amount is treated as belonging to the principal individual who performed the services, who must include it in their tax return. Where there is a net PSI loss (i.e., a negative amount remains), this amount is transferred to the individual who may be able to claim it against their other income (i.e., it cannot be used by the PSE). The tax reporting requirements in relation to a net PSI loss are discussed in detail below. Note that the attribution process differs slightly where several individuals generate the PSI. For further details, refer to the ATO s publication Personal services income. National Tax & Accountants Association Ltd: August

108 Other important trust issues EXAMPLE 6 Attributing PSI of an individual Sandi is an architect who operates through a trust (Sandi s Architectural Services Trust), with a corporate trustee. Sandi completes two contracts on behalf of the trust, which generates $40,000. The trust also earned $2,000 in interest income during the year. The $40,000 is PSI and the trust has also worked out that the PSI rules apply. The trust promptly paid $30,000 to Sandi as salary or wages, and incurred $25,000 in allowable deductions (of which $5,000 were entity maintenance deductions). The amount attributed to Sandi is calculated as follows: PSI received by the trust $40,000 Less: salary or wages promptly paid to Sandi ($30,000) Less: entity maintenance deductions ($ 3,000) Less: allowable deductions (assume all PSI related) ($20,000) Net PSI loss ($13,000) This is the entity maintenance deduction amount left after applying them against the non-psi first (i.e., $5,000 - $2,000 = $3,000) Sandi must record the $13,000 net PSI loss (and offset it against her other income, or carry it forward where there is no other income) and the $30,000 salary or wages in her tax return. Additional PAYG withholding obligations for PSE (e.g., trust) When the PSI rules apply to a PSE, the trust will have additional PAYG obligations for the amount attributed to each principal individual who performed the services. The additional PAYG withholding obligations ensure that PAYG withholding has been reported and paid to the ATO in relation to the attributed income; and each principal individual who performed the services claims a PAYG withholding credit on their individual tax return. Broadly speaking, a PSE trust that has additional PAYG withholding obligations must: Register for PAYG withholding (if it is not already registered); Work out the amount of PAYG withholding for the attributed income; Report and pay the additional PAYG withholding amounts through its activity statement; Give each principal individual who performed the services an annual PAYG payment summary; and Send the ATO an annual report showing the additional PAYG withholding. These additional PAYG withholding obligations will continue for the attributed income until the PSE trust s circumstances change and the PSI rules no longer apply. 4.4 Reporting net PSI where the PSI rules apply A trust deriving PSI (whether as a PSB or a PSE) will first have reported its gross PSI and associated expenses just like any other business income at Item 5 Business income and expenses of the 2016 trust tax return. If the trust is a PSE (in that the PSI rules apply as none of the relevant tests discussed above can be passed) then it may have to report the following amounts at the Reconciliation items: any expenses that are made non-deductible due to the operation of the Part 2-42 of the ITAA 1997 (refer to expense reconciliation adjustments ); and any PSI that is attributed to an individual under Part 2-42 (refer to Income reconciliation items ). This is because S treats any attributed PSI as non-assessable non-exempt income of the trust. 98 National Tax & Accountants Association Ltd: August 2016

109 Other important trust issues Note that there is no longer any need to complete a separate PSI schedule as the revised Item 30 in the 2016 trust income tax return obtains all the relevant information from a trust so as to confirm if it has self-assessed to be a PSB. In response to the first question at Item 30, Does your income include an individual s personal services income (PSI)? Print X in the Yes box at Label N if the income of the trust includes an individual s PSI (otherwise, print X in the No box). If No was answered at Label N, you do not need to answer any more questions. If Yes was answered at Label N, the remaining labels at Item 30 need to be completed. If YES, the trust should complete Label A and include the total amount of income derived during the year that was PSI of one or more individuals that have been included at the Item 5 Business income and expenses income labels. Exclude any exempt or non-assessable nonexempt components of the PSI (e.g., GST). Write at Label B the total amount of expenses against this PSI included at the Item 5 Business income and expenses expense labels. Item 30 then proceeds to ask the trust how the relevant PSI tests apply to its particular circumstances. If one of these tests can be satisfied, the PSI regime will not apply to the relevant PSI. Despite this, however, the ATO may still apply the general income tax anti-avoidance provision of Part IVA to reverse any attempts of income splitting via trust distributions. If the results test is satisfied in respect of any individual s PSI derived by the trust, print X in the Yes box at Label C; otherwise, print X in the No box at Label C. If the trust holds a PSBD in respect of any individual s PSI, print X in the Yes box at Label D; otherwise, print X in the No box at Label D. Labels E1, E2 and E3 require information in relation to any PSI for which the trust did not satisfy the results test or hold a PSBD, and where each source of the particular PSI yielded less than 80% of the total specific PSI. Note that if 80% or more of the specific PSI in the income year comes from one client (and their associates), then the trust cannot self-assess whether it meets the unrelated clients test, employment test or business premises test and should not complete Labels E1, E2 or E3. National Tax & Accountants Association Ltd: August

110 Other important trust issues Notes 100 National Tax & Accountants Association Ltd: August 2016

111 Preparing the 2016 Trust Tax Return PREPARING THE 2016 TRUST TAX RETURN National Tax & Accountants Association Ltd: August

112 Preparing the 2016 Trust Tax Return Notes 102 National Tax & Accountants Association Ltd: August 2016

113 Preparing the 2016 Trust Tax Return Preparing the 2016 trust tax return Introduction As previously noted, while a trust is not a separate legal entity, it is treated as an entity for tax purposes and is required to lodge a trust tax return (the T Return). The trust return records all relevant income and expenses of the trust and provides the platform on which the tax reconciliation can be completed. All business entities are required to complete a tax reconciliation to convert accounting concepts of income and expenses that are generally recorded in the financials to net (taxable) income concepts to determine what is available for distribution for income tax purposes. Once this is done, the Distribution Statement can then be prepared to advise of which beneficiaries are presently or specifically entitled to the relevant trust income and more importantly what percentage (and amount) of the taxable income they will need to include in their own income tax returns. Where the trust makes an overall loss for the income year, the loss remains in the trust to be offset against any future assessable income of the trust. While there are a number of different forms of trusts, most of them are required to complete the same trust return. The following chapter of the notes aims to give an in depth summary of the process of reconciling accounting net profit to taxable income. 1. Using financial accounts to prepare a trust tax return (Refer to page 104); 2. Major income items (Refer to page 107); 3. Major expense items (Refer to page 121); 4. Reconciling accounting profit to taxable income (Refer to page 136); 5. Net small business income (Refer to page 139); and 6. Other tax return labels (Refer to page 139). National Tax & Accountants Association Ltd: August

114 Preparing the 2016 Trust Tax Return 1. Using financial accounts to prepare a trust tax return When developing your skills in relation to the preparation of a trust return, much of your effort will be directed at identifying where the income tax rules differ from the accounting treatment of various items of income or expenses so that the appropriate reconciliations can be made. Most of the information needed to complete a trust tax return is found in the client s accounting records and financial statements specifically, the Profit & Loss Statement ( the P&L ) and the Balance Sheet. 1. The Balance Sheet is one of the primary financial statements as it shows the assets, liabilities and owner s equity (or, in the case of a trust, the Trust Funds) at a particular point in time generally 30 June of a given year. 2. The Profit & Loss is also a primary financial statement as it shows the net income or loss of a business (i.e., revenue items less expense items) for a particular period of time generally from 1 July of a given year until 30 June of the following year. The financial statements reflect the accounting treatment of each transaction and must, therefore, be analysed to identify any tax adjustments before completing the tax return. Most businesses use computer software (e.g., QuickBooks, MYOB, etc.) to keep up-to-date accounting and financial records. These can produce a number of reports, including the above-mentioned financial statements, which form the basis from which we prepare a trust income tax return. Some clients may not prepare financial statements. Therefore, the information required for preparation of the client s tax return must be obtained from other source records (e.g., bank statements). The principles discussed below apply equally to these clients. TAX WARNING Relying on client s financials Practitioners should not assume the financial statements produced by a client using such software are correct. For example, the client may have misclassified entertainment expenditure as a marketing cost in the P&L. However, this amount may not be deductible from a tax perspective and needs to be identified and taken into account when calculating the taxable income of the client. Tax practitioners need to both ensure the financial statements have been prepared on a competent basis (i.e., the system or framework for classifying and preparing the financial statements is sound) as well as reviewing tax sensitive line items. Taxable income is the basis upon which Australian income tax is payable. In the trust context this is technically referred to as net income. However, taxable income is often different to accounting profit. As a result, certain accounting items (both income and expense) may need to be adjusted for tax purposes. This process of making tax adjustments involves completing a tax reconciliation to convert the information taken from the Balance Sheet and P&L such that it complies with the taxation law requirements. The discussion contained in these notes on preparing the trust tax return will be on the basis that the trust s financial statements are prepared on an accounting basis i.e., an equalisation clause does not apply to equate trust (i.e., accounting) income to net income. Obviously where accounts have been prepared to incorporate net (taxable) income concepts, less reconciliation should be required. The question of whether a trust is required to prepare financial accounts and, if so, the basis upon which they should be prepared is discussed in the Accounting for trusts section of these notes. 104 National Tax & Accountants Association Ltd: August 2016

115 Preparing the 2016 Trust Tax Return 1.1 Process for completing the trust tax return Every trustee that is an Australian resident must furnish a return using the prescribed trust form (i.e., NAT 0660). Likewise, each non-resident trustee must lodge a return using the same form, if the trust has derived Australian source income (including capital gains) other than dividend, interest or royalty income from which withholding tax has been deducted in accordance with Division 12, Schedule 1 of Taxation Administration Act 1953 ( TAA 1953 ). The following flowchart summarises the process for completing a trust tax return from the trust s financial statements and/or accounting records: Prepare the financial statements (P&L and Balance Sheet) Prepare supporting work papers to reconcile and record any tax differences Prepare tax reconciliation (if applicable) Prepare the tax return (including the statement of distribution) 1.2 Key items that need to be considered in the financials It is suggested that the Balance Sheet items be reviewed first, and then a review of the P&L be undertaken. This approach is suggested on the basis that all P&L transactions have a balance sheet effect, but not all Balance Sheet transactions have a P&L effect. Consequently, it is possible to identify tax adjustments more efficiently by first reviewing the Balance Sheet, including movements in Balance Sheet items!" EXAMPLE 1 Reviewing movements in the Balance sheet When reviewing the Balance Sheet, the review should include not only looking at the balance of the item in the Balance Sheet at the relevant date but also the movement in the account during the income year (i.e., last year s Balance Sheet balance compared to this year s balance). For example, a review of the Balance Sheet may disclose the following for a non-sbe taxpayer. 30 June June 2016 Depreciating assets cost $ 25,000 $ 30,000 Less: Accumulated depreciation ($ 15,200) ($ 14,900) $ 9,800 $ 15,100 It is important to not only review the closing balances as at 30 June 2016, but also to identify the reason for the movement in the Depreciating assets at cost account balance from $25,000 (as at 30 June 2015) to $30,000 (as at 30 June 2016) and the Accumulated depreciation account balance from $15,200 to $14,900 respectively. Clearly there has been at least one acquisition, but there may also have been some disposal of assets. National Tax & Accountants Association Ltd: August

116 Preparing the 2016 Trust Tax Return The NTAA suggest the following order as a general guide when reviewing a Balance Sheet: Current assets (e.g., bank account, debtors, trading stock). Non-current assets (e.g., land and buildings, plant and equipment, loans, intellectual property). Current liabilities (e.g., bank overdraft, trade creditors, accruals, deferred income). Non-current liabilities (e.g., bank loans, hire purchases, unpaid entitlements to beneficiaries, other creditors). Corpus (or Trust Funds ) of a discretionary trust (e.g., settled sum, capital profits reserve, asset revaluation reserve, trust losses). Corpus (or Trust Funds ) and reserves of a unit trust (e.g., subscribed capital, capital profits reserve, asset revaluation reserve, trust losses). Similarly, a review of the Profit & Loss statement should include the following: Gross income (e.g., income from the sale of trading stock, income from services provided, management fees). Investment income (e.g., interest, dividends, royalty). Distributions from other entities (e.g., distributions from partnerships or other trusts). Profit or loss from the disposal of fixed assets (e.g., plant and equipment, investment assets). Cost of goods sold (i.e., opening stock plus purchases less closing stock). Interest expenses. Legal fees. Remuneration expenses (e.g., salary or wages, annual or long service leave, superannuation contributions). Repairs and maintenance expenditure. Entertainment expenditure. General expenses (e.g., accounting fees, amortisation, depreciation, bad debts written-off, commission expenses) Checklist to identify key transactions In reviewing the financial statements of a trust it needs to be determined whether a transaction that is recorded on an accounting basis needs to be adjusted to determine the net income (or loss) of that trust for tax purposes. Furthermore, there may be transactions that are assessable or deductible for tax purposes that may not have been included in the financial statements. Adjustments to accounting profit (or loss) can be classified into four categories depending on the tax treatment of a transaction. The following process assists in determining whether or not an adjustment may be required. 1. Is there income recorded for accounting purposes, but is not assessable income for tax purposes? This could occur if: A specific provision applies in income tax law to exclude the amount from being assessable income (e.g., certain government grants or PSI that is derived by a PSE that has been attributed to an individual). A tax concession applies (e.g., the 50% general CGT discount). There are timing differences in the accounting and tax treatment of an income amount (e.g., the sale of a depreciating asset that was depreciated at a higher rate for accounting purposes than for tax. This has the effect of resulting in a lower adjustable value and, therefore, a higher profit on sale for accounting purposes, compared with a higher adjustable value and, therefore, a lower profit on sale for tax purposes). 106 National Tax & Accountants Association Ltd: August 2016

117 Preparing the 2016 Trust Tax Return 2. Is there assessable income for tax purposes, but is not included in the accounting profit (or loss)? This could happen if: A specific provision in the income tax law treats the amount as income (e.g., franking credits attached to franked dividends derived by certain Australian residents). There are timing differences in the accounting and tax treatment of an income amount (e.g., where a depreciating asset is sold and that asset was depreciated at a lower rate for accounting purposes than for tax). 3. Is there an expense claimed for accounting purposes, but is not deductible (either in whole or in part) for tax purposes? This could occur where: A specific provision of the income tax law denies all or part of a deduction (e.g., entertainment that was not provided as a fringe benefit, penalties and fines and annual leave and long service that has been accrued but not paid). There are timing differences in the accounting and tax treatment of an expense item (e.g., borrowing costs that are expensed for accounting purposes are generally claimed over a maximum of five years under S of the ITAA 1997 instead of being claimed in full in the year the expense occurred for tax purposes). 4. Is there an expense that is deductible for tax purposes, but is not included in the accounting profit (or loss)? This could occur where: The amount is wholly or partly deductible under a specific provision of the income tax law; (e.g., certain capital improvements to land under Division 43, the interest component of hire purchase repayments under Division 240, certain blackhole expenditure under S ). There are timing differences in the accounting and tax treatment of the expense item (e.g., prepayments). 2. Major income items Section 95(1) of the ITAA 1936 provides that net income is defined: in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trust were a taxpayer in respect of that income and were a resident, less all allowable deductions [Emphasis added] The concept of net income is critical to preparing a trust return, as it forms the basis of determining a beneficiary s tax liability on any trust distributions. Specifically, S.97 of the ITAA 1936 provides: where 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: (a) the assessable income of the beneficiary shall include: (i) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident [Emphasis added] The assessable income of an Australian resident includes ordinary income (e.g., sales income, professional fees, rent) derived from all sources, in and out of Australia, unless it is exempt or non-assessable pursuant to a provision in the income tax law. Assessable income also includes statutory income i.e., income that is specifically included in assessable income by a provision of the income tax law (e.g., dividends, net capital gains). Refer to S.6-5, S.6-10 and S National Tax & Accountants Association Ltd: August

118 Preparing the 2016 Trust Tax Return EXAMPLE 2 Ordinary and statutory income Amphibian Pty Ltd as trustee for the Amphibian Trust sells snorkels and scuba gear in retail outlets throughout Australia. Income from the sales is ordinary income for tax purposes, and is recorded at Item 5, Label H Other business income (non-primary production) on the trust s income tax return. The trust also derived a net capital gain of $200,000 from the sale of a building. For tax purposes the net capital gain is statutory income and will be recorded at Item 21, Label A Net capital gain on the trust s tax return. Where an amount is both ordinary and statutory income, S.6-25(2) provides that the specific statutory provision prevails, unless a contrary intention appears. Assessable income (and therefore, taxable income) is calculated on an annual basis referred to as an income year generally ending on 30 June. In order to be included in assessable income for a particular income year, income (ordinary and statutory) must have been derived by the taxpayer during that year. Special rules may affect when certain types of income are taken to be derived for tax purposes. EXAMPLE 3 Recognition of a capital gain from the sale of an asset Aquarius Pty Ltd as trustee for the Aquarius Trust has a 30 June year-end. On 1 June 2016, the corporate trustee entered a contract to sell some of its land. Settlement of the contract did not take place until 1 September 2016, at which time the corporate trustee relinquished possession of the land to the purchaser and received payment for the balance of the purchase price (i.e., less the deposit already paid). Even though the payment for the land was received in the 2017 income year, any capital gain (for income tax purposes) is taken to be derived in the 2016 income year when the sale of land contract was entered into (i.e., contract date not settlement date is relevant here). Refer to S of the ITAA Furthermore, as mentioned previously, differences may arise between what is assessable income for tax purposes and accounting income (as shown in the taxpayer s P&L). As a result, a reconciliation is required to convert a taxpayer s profit for accounting purposes into its net income. TAX TIP Accounts prepared on a tax basis Where financial accounts are prepared on a tax basis (i.e., in accordance with income tax law rather than treating income and expense items under their ordinary meaning or under generally accepted accounting principles) a tax reconciliation is not usually required. Therefore, the tax return of a trust may be completed relatively quickly. It should be noted that financial accounts are generally prepared on a tax basis where the trustee has adopted an equalisation clause in the trust deed (i.e., equating trust income to net income). 108 National Tax & Accountants Association Ltd: August 2016

119 Preparing the 2016 Trust Tax Return 2.1 When is income derived for tax purposes? For tax purposes, income is brought to account (i.e., derived) using one of the following methods: the cash (or receipts) basis; or the accruals (or earnings) basis. In contrast, a deduction is generally allowed when it is incurred, even if it has not yet been paid and is not dependent on how the taxpayer recognises its income. Refer to S.8-1(1) The cash (or receipts) method Under the cash basis, income is derived in the income year it is actually or constructively received. Basically, income is constructively received when it is applied or dealt with on the taxpayer s behalf, or at the taxpayer s direction. Refer to S.6-5(4) and S.6-10(3). Individual taxpayers with salary income generally use this method, although it may also be appropriate for small professional practices (e.g., accounting firms). Reference should be made to TR 98/1. EXAMPLE 4 Cash basis taxpayers Building Design Pty Ltd as trustee for the Building Design Trust operates a consulting business and brings its income to account on a cash basis. The trust does not normally extend credit to its clients but recently allowed a major client extra time to pay consulting fees of $10,000. As the trust uses the cash basis consistent with TR 98/1, it will not be assessable on this amount until the income year in which the fees are received. A modified cash accounting method was available to business taxpayers who entered the former Simplified Tax System ( STS ) before 1 July Under this method, ordinary income was generally taken to be derived when received and expenses were generally deductible when paid (i.e., not incurred). However, on 1 July 2007, the STS was replaced with new streamlined provisions relating to SBEs. Where a taxpayer was in the STS prior to 1 July 2005 (and continued to be an STS taxpayer until the end of the 2007 income year), used the STS accounting method in both the 2006 and 2007 income years and is an SBE for the 2008 and subsequent income years, the taxpayer may continue to use this method for as long as they remain an SBE and do not stop using this income recognition methodology The accruals (or earnings) method Under the accruals method, income is derived when there is a right to receive it. This is usually when a debt becomes due and payable (i.e., the point of derivation occurs when a recoverable debt' is created). The accruals basis is generally appropriate for taxpayers in business. EXAMPLE 5 Accruals basis taxpayers AAA Grade Electrical Supplies Pty Ltd as trustee for the AAA Grade Electrical Trust is a wholesale business that sells electrical supplies to trade professionals. In June 2016, a customer, Monty, ordered $10,000 worth of supplies. On 10 June 2016, the trust issued Monty an invoice for the supplies delivered. The invoice was issued under the usual 30 days payment terms. By 30 June 2016, the invoiced amount was still outstanding. As the trust recognises its income on an accruals basis, it must include the invoiced amount of $10,000 in its assessable income for the 2016 income year not the 2017 income year in which they will actually receive payment. The income was derived by the trust on issuing the invoice, which created a legally recoverable debt. National Tax & Accountants Association Ltd: August

120 Preparing the 2016 Trust Tax Return For more information on which method of accounting is more appropriate refer to TR 98/1 which provides guidelines on when to use the cash or accruals method. 2.2 What is included in assessable income? The following discussion considers what is included in assessable income at most of the common items in the 2016 trust tax return. It is assumed that the taxpayer is a resident trust that is not an SBE and that the financial accounts of the trust are prepared on an accounting basis Completing Item 5 Business income Australian sourced business income directly derived by the trust is shown at Item 5 and is generally obtained from the financial accounts of the trust. This is basically the accounting income of the trust. Differences between business income (and business expenses) for accounting and for tax purposes are dealt with in the tax return at Item 5 - Reconciliation items. This item primarily contains three business income columns consisting of Primary production ( PP ) income (column 1), Non-primary production ( NPP ) income (column 2) and Totals (sum of columns 1 and 2). This is required, as the ATO need to be able to identify whether or not taxpayers would be entitled to the benefits of the averaging provisions where they derive PP income. Any averaging calculations applicable do not need to be calculated as part of the preparation of the trust income tax return as it will be calculated by the ATO after lodgment. (i) Labels C and D Gross payments where an ABN was not quoted A trust carrying on an enterprise is generally required to quote its ABN when supplying goods or services to another entity. If the ABN is not quoted, the payer must withhold 49% from the payment and remit the amount withheld to the ATO, unless an exception applies. Refer to TR 2002/9 for more details about the requirements to withhold where no ABN is quoted. If the trust has had tax withheld from amounts received because it did not quote an ABN, the gross amount of income (i.e., after adding back the tax withheld) from which tax was withheld for not quoting an ABN is shown at Labels C and/or D (depending if the income is PP or NPP). The payer must provide the trust with a payment summary showing this information. Where an amount is shown at Labels C and/or D, the trust must complete the Non-individual PAYG Payment Summary Schedule 2016 (NAT 3422). The trust is entitled to a credit against their tax liability for the amount of tax withheld. The amount of the credit is claimed at Item 6, Label T Tax withheld where ABN not quoted. (ii) Label B Gross payments subject to foreign resident withholding Complete this label only if you are dealing with the return of a non-resident trust where certain payments to foreign residents have been subject to a foreign resident withholding ( FRW ) tax. Broadly, FRW applies to payments made to foreign residents for promoting or organising casino gaming junkets, for entertainment (e.g., payments to foreign musicians) and for sports activities (e.g., payments to foreigners playing tennis in Australia), and for certain construction activities. 110 National Tax & Accountants Association Ltd: August 2016

121 Preparing the 2016 Trust Tax Return Show the gross amount of payments subject to FRW (i.e., after adding back the tax withheld) at Label B. If an amount is shown at Label B, a Non-individual PAYG Payment Summary Schedule 2016 must be completed (NAT 3422). The trust is entitled to a credit against its tax liability for the amount of tax withheld. The amount of the credit is claimed at Item 6, Label U Credit for tax withheld foreign resident withholding. TAX TIP Gross distributions of foreign resident regulated income Where an amount is received from partnerships and/or other trusts consisting of gross distributions of foreign income subject to FRW, it is to be shown at Item 8 Partnerships and trusts (i.e., not at Item 5) with the credit claimed at Item 8, Label U Share of credit for tax withheld from foreign resident withholding. A Non-individual PAYG Payment Summary Schedule 2016 (NAT 3422) does not have to be completed for these distributions. (iii) Labels E and F Assessable government industry payments Government grants, rebates, benefits, bounties and subsidies are generally assessable income in the hands of the recipient if they are received in (or in relation to) the carrying on of a business. This generally includes payments of a capital nature. However, payments relating to the commencement or cessation of a business may not be assessable. Show at Labels E and/or F the total of any assessable Government industry payments received including bounties, cleaner fuel grants, drought relief, employee subsidies, export incentive grants, fuel tax credits, industry restructure and adjustment payments, product stewardship (oil) benefits and producer rebates (WET). Where the amount at Labels E and/or F includes fuel tax credits or a cleaner fuel grant or a product stewardship (oil) benefit, print the letter D in the CODE box at the right of Labels E and/or F. Medical practices should show their Medicare payments at H - Other business income and not at F - Assessable government industry payments. (iv) Labels G and H Other business income Sales/trading income is ordinary income and is included in assessable income when it is derived. In the case of a sale of goods, the income is generally derived when the goods have been physically delivered. Income from the provision of services is generally derived when the service has been provided. Also show in Labels G and/or H, profit from the sale of depreciating assets and work in progress amounts assessable under S of the ITAA Income that is included at Labels C, D, B, E and F should not be included at Labels G and H. If there is a loss at Labels G and/or H print the letter L in the CODE box at the right of Labels G and/or H. Personal Services Income ( PSI ) is included at other Other business income even if the PSI is attributed to an individual. It will then be backed out of the return at Item 5, Label A under Reconciliation items. Where PSI has been derived, Item 30 - Personal services income needs to be completed. National Tax & Accountants Association Ltd: August

122 Preparing the 2016 Trust Tax Return Completing Item 8 - Partnership and trusts Item 8 requires the recording of any distributions a trust receives (or is entitled to receive) either as a partner in a partnership or as a beneficiary of another trust. The information required to complete this section of the return will be contained in the relevant Statement of Distributions provided by the relevant partnership and/or trust. Income received may also be attributable from these distributions to the trust s share of any TFN amounts withheld from interest, dividends and unit trust distributions, franking credits attached to franked dividends and amounts withheld where an ABN was not quoted. Note for averaging purposes, the distributions are required to be reported separately where they relate to PP income or NPP income. TAX WARNING Certain amounts are excluded from Item 8 Certain assessable distributions from partnerships and other trusts are not shown in Item 8 but instead are recorded at the following items: Item 21 (Capital gains) Where the trust received distributions of net capital gains (including net foreign capital gains). Refer to the discussion later in this chapter; Item 22 (Attributed foreign income) or Item 23 (Other assessable foreign source income) Where the trust received distributions of foreign income (excluding net foreign capital gains). It should be noted that if the trust received indirectly any dividends with Australian franking credits that were attributable to distributions from a New Zealand company they also need to be recorded at Item 23. Item 12 (Dividends unfranked amount) Any payment or loan amounts, that is treated as a dividend under Division 7A of the ITAA Note that part of a distribution on which Trustee Beneficiary Non-Disclosure Tax or Family Trust Distribution Tax has been paid is not included in the trust s assessable income and should therefore be excluded from Item National Tax & Accountants Association Ltd: August 2016

123 Preparing the 2016 Trust Tax Return The main components of Item 8 which are required to be completed are as follows: 1. Distribution from partnerships Item 8, Labels A (PP income) and B (NPP income) The gross amount of distributions received from all partnerships (excluding any foreign income with respect to NPP income at Label B) are required to be reported at Labels A and/or B. If the amount at any of these labels is a loss, write L in the box at the right of Labels A and/or B. Where the distribution from a partnership to the trust includes any share of credit for tax withheld from foreign resident withholding under Subdivision 12-FB of the TAA 1953, it is required to be included at Label B. The credit can be claimed at Label U. Where the relevant partnership s statement of distribution includes franked dividends from a company, ensure that both the trust s share of the franked dividend and associated franking credits are included at Label B. Note that the franking credit will also be required to be included at Label D under the share of credits from income (see below). Franked distributions received from a partnership are shown at Label B and not at Label F (see below) at Item 8. If the statement of distribution includes an amount described as dividends or franking credits from a New Zealand franking company or other foreign company, include these at Item 23 - Other assessable foreign source income rather than at Item 8. Note that Label S - deductions relating to amounts shown at A and Z (PP income) is discussed in the Major expense items section later in these notes. 2. Distribution from trusts Item 8, Labels Z (PP income) and R (NPP income) The gross amount received by the trust in relation to assessable distributions from all other trusts, are required to be reported at this item in Labels Z and/or R (excluding any capital gains, foreign income and franked distributions with respect to NPP income at Label R). If the amount at any of the labels is a loss write L in the box at the right of the Labels Z and/or R. A loss at these labels can only be shown if the loss is a component of an overall distribution of income from the same trust. Any such loss would also need to be adjusted to take into account any amounts included at Labels F and G relating to the label for franked distributions from trusts (see below for further discussion). Where there is income (rather than a loss) at either Labels Z and/or R, print the relevant code that best describes the type of trust from which the distribution is made (or at least the type of trust that represents the greatest amount of the distribution). These codes are found in the ATO s 2016 Trust return instructions in Table 1. For example, code S is used where the trust that has made the distribution to the trust you are preparing the return for is a discretionary trust and the main source of income of the trust is from service and/or management activities. Where a distribution from another trust includes any share of credit for tax withheld from foreign resident withholding, it is required to be included (i.e. grossed-up) in Label R (note that the credit can be claimed at Label U). Where the trust receives franked distributions from other trusts, its share of the dividend and relevant franking credits are no longer required to be at Label R. Instead these will be included at Label F - Franked distributions from trusts. Unfranked distributions are still to be shown at Label R. A franked distribution is any dividend distribution with franking credits attached and includes both fully and partially franked trust distributions. If the statement of distribution includes an amount described as dividends or franking credits from a foreign company, including a New Zealand franking company, include these at Item 23 - Other assessable foreign source income rather than at Item 8. If the trust receives, or is presently entitled to, a share of income distributed to it by a closely held trust where Trustee Beneficiary Non-disclosure Tax ( TBNT ) has been paid, this amount should not be included in the trust s assessable income. This equally applies to any amounts distributed to the trust on which Family Trust Distribution Tax ( FTDT ) has been paid. Note that any losses, outgoings or applicable franking credits attached to such income should also be ignored when preparing the trust return. National Tax & Accountants Association Ltd: August

124 Preparing the 2016 Trust Tax Return Note that Label T - deductions relating to amounts shown at B and R (NPP income) and Label G - deductions relating to franked distributions from trusts in Label F are discussed in the Major expense items section later in these notes. 3. Share of credits from income - Item 8, Labels C, D, E, O and U) Any share of credits from income distributed (e.g., franking credits from franked dividends, tax withheld where an ABN or TFN has not been quoted, foreign resident withholding credits, etc.) are to be recorded at the relevant labels to ensure the trust, as a partner or beneficiary, will be able to benefit from these credits Completing Items 9 to 14 The main specific income labels between Items 9 to 14 are reproduced and briefly discussed below. For further details on all of the relevant items, please refer to the 2016 trust return instructions on the ATO website. (i) Rental income - Item 9, Label F (Gross rent) and Labels G, X and H (rental deductions) Show the total rent before any expenses at Label F. The gross amount of rent is generally derived when received. Foreign rent is not recorded here (record this at Item 23 instead) and any GST input tax credits claimed are also excluded. Although Item 9 is an income item, the return requires that all relevant deductions, including interest and Division 43 building write off claims, etc., are recorded here so that the net rent can be calculated and included in the assessable income of the trust. If this amount is a loss, print L in the box at the right of Net Rent. (ii) Gross interest Item 11, Label J Show the gross interest received or credited at Label J (i.e., after adding back any tax withheld), excluding interest received from partnership or trust distributions that are included at Item 8 or foreign interest that is reported at Item 23. Interest is ordinary assessable income and is generally derived when received or dealt with at the trust s direction (e.g., interest credited to a trust s bank account). Tax may be withheld at the rate of 49% from any gross interest paid or credited by an investment body to a trust that did not provide its TFN and did not have an exemption from the requirement to do so. If this has occurred, show any amounts withheld at Label I. Where a TFN withholding has been made, the trust is entitled to claim a credit at Label I TFN amounts withheld from gross interest. 114 National Tax & Accountants Association Ltd: August 2016

125 Preparing the 2016 Trust Tax Return (iii) Dividends Item 12, Labels K, L and M (Dividends) The relevant information to complete this item is found in dividend statements required to be issued by corporate entities when they pay a dividend to its shareholders. Where the corporate tax is attached to the dividend paid, this tax is referred to as a franking credit. A dividend may be fully franked, partially franked or even unfranked at the discretion of the corporate entity making the payment and in accordance with Corporations Law and ASIC rules. An unfranked dividend amount is shown at Label K. A franked dividend amount (the cash component of the distribution) is shown at Label L with the franking credit attached to this dividend recorded at Label M. Where there is a TFN withholding amount, the trust is entitled to claim a credit at Label N TFN amounts withheld from dividends. As per the ATO instructions, if a distribution statement does not adequately distinguish between what is franked and unfranked, simply include the cash component of the dividends paid at Label L - Franked amount and any attached franking credits at Label M - Franking credit. TAX WARNING Certain franking credits are excluded from Item 12 Certain franking credits, and consequently the dividends, are not shown in Item 12 but instead are recorded at the following items: Item 8 (Partnerships and trusts) Where the trust received franking credits indirectly through a partnership distribution or a distribution from another trust, including a managed investment fund (refer to discussion above with respect to Item 8). Item 23 (Other assessable foreign source income) Where the trust received indirectly any franking credits that were attributable to distributions from foreign sources (including a New Zealand franking company). Also, any dividends upon which Family Trust Distribution Tax ( FTDT ) or Trustee beneficiary non-disclosure tax ( TBNT ) have been paid are not included in the trust return at all (nor are any related losses or outgoings or franking credits). (iv) Superannuation lump sums and employment termination payments Item 13 The information required to complete this label of the trust return is generally provided in the form a PAYG payment summary from the relevant payer (either the employer or the trustee of a superannuation fund). Death benefit employment termination payments ( ETP ) and superannuation lumps sums paid to trustees of a deceased estate may need to be reported at this item. Deceased estates are beyond the scope of this seminar, but further reference can be made to the 2016 Trust tax return instructions. National Tax & Accountants Association Ltd: August

126 Preparing the 2016 Trust Tax Return (v) Other Australian income Item 14, Label O (Other Australian income) Show at this label the total of any other gross income, including royalties, bonuses from life insurance companies and friendly societies and foreign exchange gains or losses that have not already been shown as assessable income. If the amount is a loss write L in the box at the right of this label. Any excepted net income received is to be included at Label O and separately shown at Item 14 Excepted net income. Excepted net income is income that will not attract the penalty minor rates for beneficiaries under the age of 18 (such as income from a deceased estate). In addition, a statement to the trust tax return needs to be provided detailing the distributions of excepted income to each beneficiary and listing each beneficiary who is an excepted person. Refer to Appendix 10 of the ATO s Trust return instructions 2016 for details Completing Item 21 Capital gains Whilst we often use the term CGT, it is important to note that there is no separate tax levied on a capital gain (i.e., it is taxed at the relevant marginal rate). Generally, a capital gain arises if a CGT event happens and the capital proceeds from that event exceed the cost base of the asset in respect of which the event occurred. A capital loss will arise if the capital proceeds are less than the asset s reduced cost base. A CGT event is basically a transaction or occurrence specified in the Act, such as the disposal of a CGT asset. Refer to S of the ITAA 1997 for a full list of CGT events. It should be noted that disregarded capital gains such as those relating to a CGT asset acquired before 20 September 1985 are generally not included in the calculation of gross capital gains. A net capital gain arises where the total capital gains for an income year exceed the sum of capital losses for the current year (i.e., current year capital losses), any unused capital losses from a prior income year (i.e., prior year capital losses), and after applying the general 50% CGT discount and the small business CGT concessions (where applicable). A net capital loss arises where the total of all current year capital losses exceed the capital gains derived in that year. A net capital loss is not deductible, but may be carried forward to offset any future capital gains made by the taxpayer. Refer to S (2). The tax paid on a net capital gain derived by a trust will depend on whether, and how, the capital gain is distributed by the trustee to a beneficiary. For example, where the beneficiary is a resident adult, the capital gain will be treated as if it were derived by that beneficiary and forms part of the beneficiary s own net capital gain calculation. Alternatively, if the relevant beneficiary is a non-resident or a minor, the trustee will usually be assessed on the capital gain on their behalf. Also, if a trustee fails to make a beneficiary presently or specifically entitled to a capital gain, then the trustee will be assessed on the gain in its capacity as the trustee of the trust. From the 2011 income tax year, a trustee of a resident trust may also choose (where permitted by the trust deed) to be assessed on a capital gain of the trust. This is only permitted where no beneficiary has received any amount referable to the gain in question during the income year or within 2 months of the end of the income year. The choice can only be made with respect to the whole of the capital gain. Where a trustee makes such a choice, the trustee will be assessed on the capital gain and it will not be taken into account in working out any beneficiary s net capital gain for an income year. It will therefore not be included in any Statement of Distributions at Item 54. Instead the amount of capital gains will be included at Item 55 - Choice for resident trustee to be assessed to capital gains on behalf of beneficiaries. 116 National Tax & Accountants Association Ltd: August 2016

127 Preparing the 2016 Trust Tax Return (i) What is recorded on the tax return? Effectively Item 21 requires an indication at Label G as to whether or not the trust has triggered a CGT event and then requests the inclusion of the net capital gain at Label A - Net capital gain. The ATO instructions request that taxpayers print in the code box next to Label M the code(s) from the list below that describe the CGT exemption(s) and roll-over(s) applied. If the trust applied more than one CGT exemption or roll-over, the instructions request that all of the codes that apply are selected. Alternatively, if a trust is lodging their return by paper, the instructions request that they write the code that represents the CGT exemption or roll-over that produced in the largest amount of capital gain or capital loss deferred or disregarded. A B C D Small business active asset reduction (Subdivision 152-C) Small business retirement exemption (Subdivision152-D) Small business roll-over (Subdivision 152-E) Small business 15 year exemption (Subdivision152-B) E Foreign resident CGT exemption (Division 855) F H I J Scrip for scrip roll-over (Subdivision 124-M) Demerger exemption (Subdivision 125-C) Main residence exemption (Subdivision 118-B) Capital gains disregarded as a result of the sale of a pre-cgt asset K Disposal or creation of assets in a wholly-owned company (Division 122) L Replacement asset roll-overs (Division 124) M N O P Q R Exchange of shares or units (Subdivision 124-E) Exchange of rights or options (Subdivision 124-F) Exchange of shares in one company for shares in another company (Subdivision 124-G) Exchange of units in a unit trust for shares in a company (Subdivision 124-H) Disposals of assets by a trust to a company (Subdivision 124-N) Demerger roll-over (Subdivision 125-B) S Same asset roll-overs (Division 126) X Other exemptions and rollovers National Tax & Accountants Association Ltd: August

128 Preparing the 2016 Trust Tax Return If the trust had gross capital gains or losses for the 2016 income year greater than $10,000, then the Capital Gains Tax (CGT) Schedule 2016 ( the CGT Schedule ) (NAT 3423), must be completed and lodged with the ATO. (ii) Calculating and recording a net capital gain or loss The steps outlined below should be followed to calculate a trust s net capital gain (or loss). Method statement for calculating a net capital gain (or loss) STEP 1 Add up all the capital gains made during the income year, excluding any disregarded capital gains. STEP 2 Reduce the STEP 1 amount by any capital losses arising in the income year. If this results in a negative figure, there is a net capital loss for the year. If there is still an amount remaining, then reduce this amount by any prior year capital losses but not below zero. The unused amount of prior year losses can continue to be carried forward. STEP 3 For any capital gains remaining after STEP 2 that qualify as a discount capital gain reduce the remaining amount by the discount percentage (generally 50%). STEP 4 For each eligible capital gain remaining after STEP 3, apply the small business 50% active asset reduction, the small business retirement exemption, and/or the small business roll-over relief (if applicable). STEP 5 Add up the capital gains remaining after STEP 4 (if any). taxpayer s net capital gain for the year. The sum is the Certain capital gains are disregarded when working out a net capital gain (e.g., a capital gain relating to an asset that is eligible for the Small Business 15-year exemption in Subdivision 152-B or a pre-cgt asset). A taxpayer can choose the order in which capital gains are reduced (e.g., by applying capital losses to any non-discounted capital gains before reducing any discounted capital gains). However, prior year net capital losses must be applied in the order in which they were incurred. If STEP 2 results in a net capital loss, then STEPS 3, 4 and 5 are not required to be completed. Where the capital gain is part of a trust distribution received, the taxpayer must generally apply the same method used by the trustee to calculate the capital gain (e.g., if the trustee applied the Small Business 50% active asset reduction, then the taxpayer must also use this concession). Refer to S (4) of the ITAA EXAMPLE 8 Applying the CGT method statement The Albert Trust made a capital gain of $30,000 on the sale of its business premises during the 2016 income year. The premises satisfy the definition of an active asset for the purposes of applying the CGT Small Business Concessions, and the Albert Trust is a Small Business Entity ( SBE ) and satisfies the basics conditions of eligibility for the SBC concessions. The trust also made a capital loss of $10,000 on the sale of listed company shares. The business premises have not been owned for at least 15 years, therefore the 15-year exemption will not apply. However, the trust is eligible to apply the general 50% discount and the small business 50% active asset reduction in relation to the capital gain made on the business premises. 118 National Tax & Accountants Association Ltd: August 2016

129 Preparing the 2016 Trust Tax Return This will reduce the gross capital gain (after applying the current year capital losses) from $20,000 to $5,000. The trust is also eligible to apply the small business roll-over which reduces the capital gain to nil. The trust will apply the method statement as follows: STEP 1 Gross capital gains $30,000 STEP 2 Less: Capital losses ($10,000) $20,000 STEP 3 Less: General CGT discount (50%) ($10,000) $10,000 STEP 4 Less: 50% active asset reduction ($ 5,000) Less: retirement exemption ($ NIL) Less: roll-over ($ 5,000) STEP 5 Net capital gain $ NIL By applying the method statement, the trust s net capital gain for the year is worked out to be nil. Therefore, 0 is reported at Label A of Item 21 on the trust s 2016 income tax return. However, as the trust s total gross capital gains exceed $10,000, it is required to complete and lodge a CGT Schedule for the year. An appropriately completed 2016 CGT schedule is provided as a handout to the NTAA s 2016 Trusts Basics notes. (iii) Calculating gross capital gains distributed from trusts Where a trust is assessed on a share of another trust s net income that includes a net capital gain, the trust must determine how much of its trust entitlement is attributable to the other trust s capital gain. Under these rules, the trust capital gain is grossed-up in the taxpayer s hands where the capital gain was reduced by the general CGT discount and/or the small business 50% active asset reduction. The special gross-up rules that apply to trust distributions of capital gains operate as follows: 1. if the trust capital gain was not reduced by either the 50% general CGT discount or the 50% active asset reduction, the taxpayer s capital gain is their share of the trust capital gain; 2. if the trust capital gain was reduced under either (but not both) of these concessions, the taxpayer s capital gain is their share of the trust capital gain multiplied by two; and 3. if the trust capital gain was reduced under both of the above concessions, the taxpayer s capital gain is equal to their share of the trust capital gain multiplied by four. Once the gain has been grossed-up, it is treated as if it were derived by the beneficiary who then works out their net capital gain under the method statement. It is this figure that is included at Step 1 of the method statement. For example, if the beneficiary has capital losses in their own name, these must be applied against the grossed-up capital gain before applying the general CGT discount or any of the CGT Small Business Concessions. Where another trust distributes a net capital gain together with other NPP income (e.g., interest), only that portion of the distribution National Tax & Accountants Association Ltd: August

130 Preparing the 2016 Trust Tax Return attributable to the capital gain should be recorded as a Net capital gain on the beneficiary trust s income tax return. The balance is generally recorded as a trust distribution at Label Z or Label R of Item 8 Partnerships and trusts of the trust tax return Completing Items 22 to 23 Foreign income (i) Item 22 - Attributed foreign income deals with certain foreign income a trust may derive indirectly through foreign interests. These issues are beyond the scope of this seminar but for further information on calculating the amounts shown at Labels M, U and X, the 2016 trust return instructions refers to the Foreign income return form guide (ii) Item 23 - Other assessable foreign income requires the trust to include most foreign sourced assessable income and also to identify and claim any entitlement to a foreign income tax offset. Show at Label B - Gross foreign source income, all foreign sourced assessable income, including income distributed to the trust from any other trusts or partnerships and as well as New Zealand franking company dividends and supplementary dividends (include any foreign tax paid on that income). Do not include at Label B any income that is exempt from tax in Australia or treated as non-assessable non-exempt income under S.23AI and S.23AK of the ITAA 1936, any amount of New Zealand imputation credits, any amount of Australian franking credits attached to dividends from a New Zealand franking company (show these at Item 23, Label D), income already shown at Item 22 - Attributed foreign income or any foreign source capital gains or capital losses. Note foreign source capital gains are not included in Item 23 - Other assessable foreign source income; instead they should be included at Item 21 - Capital gains. At Label V - Net foreign source income, show the gross amount shown at Label B - Gross foreign source income less deductions allowable to the trust against such income. Do not take into account debt deductions (interest and borrowing costs) at this label, as they should be claimed at Item 18 Other deductions. If Label V is negative, print L in the box at the right of the amount. Note that foreign losses are no longer quarantined and can be offset against other foreign or domestic income. Finally, show at Label Z - Foreign income tax offsets any amount of foreign income tax paid by the trust on foreign source income. If foreign income tax has been paid by the trust, the entitlement to claim the offset can be passed down to the relevant beneficiaries via the Statement of Distribution. The ATO instructions direct trust taxpayers to complete a losses schedule if the trust has a foreign loss component of tax losses deducted in the 2016 income year or carried forward to later income years, an interest in a controlled foreign company ( CFC ) that has current year losses greater than $100,000 or an interest in a CFC that has deducted or carried forward a loss to later income years greater than $100, National Tax & Accountants Association Ltd: August 2016

131 Preparing the 2016 Trust Tax Return 3. Major expense items Having determined the total assessable income for an income year, the next step in calculating the net income (i.e., taxable income) of a trust is to work out the total allowable deductions. Section 8-1 of the ITAA 1997 sets out the general rules for claiming a tax deduction. Broadly, S.8-1 allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing the taxpayer s assessable income, or is necessarily incurred in carrying on business to gain or produce their assessable income, and is not of a capital, private or domestic nature. Alternatively, a loss or outgoing may be specifically allowed as a deduction under a provision other than S.8-1, such as S which provides a deduction for (non-capital) repairs to incomeproducing depreciating assets. A specific provision may also disallow a deduction for certain expenditure, such as S.26-5 which generally disallows a deduction for fines or penalties. Note that loss or outgoing and expense are used interchangeably in this segment of the notes. TAX TIP Expenses are generally deductible when incurred Generally, an expense is tax deductible in the income year in which it is incurred in deriving the taxpayer s assessable income, even if the expense is unpaid at the end of that year, provided the taxpayer is definitively committed or completely subjected to that liability. An expense is basically incurred when a presently existing liability to pay an amount arises, and the liability is not merely contingent, pending, threatened or expected, such as in the case of a provision for an expense that will be incurred in the future. Refer to TR 97/7. The following is a list of the most common items for reporting expenses incurred by a trust on the trust tax return, depending on the type of expense incurred: (a) Item 5 - Labels P to N (Business expenses) Expenses incurred by a trust (as shown in the P&L) in carrying on a PP or NPP business are required to be reported at the relevant expense label at Item 5, part of which is reproduced below. National Tax & Accountants Association Ltd: August

132 Preparing the 2016 Trust Tax Return Item 5 is generally completed by recording at the relevant expense label (i.e., Labels P to N) the amount of the expense recorded in the P&L of the trust. Any adjustments to the amounts shown at Labels P to N for tax purposes are made at Item 5, Label B Expense reconciliation adjustments under the heading Reconciliation items. A detailed discussion on the expense and reconciliation labels in Item 5 is outlined further in this chapter. (b) Item 8, Labels S or T (Deductions relating to distributions from partnerships or trusts) - The deductible amount of any expense incurred by a trust in relation to assessable distributions from partnerships or other trusts are required to be reported at this item. (i) Label S - Deductions relating to distribution in Labels A and Z This allows the trust to claim any expenses it has incurred that relate to any PP distributions from partnerships and some trust distributions. Note that if these expenses have been reimbursed by the partnership or trust they will not be deductible. In addition, expenses incurred on behalf of other trusts cannot be deducted here by the trust lodging the income tax return. (ii) Label T - Deductions relating to distribution in Labels B and R This allows the trust to claim any expenses it has incurred that relate to any NPP distributions from partnerships and some trust distributions. Note that any deductions relating to a franked distribution from a trust are not claimed here as these should be shown at Label G - Deductions relating to franked distributions from trusts in Label F. If these expenses have been reimbursed by the partnership or trust they will not be deductible. In addition, expenses incurred on behalf of other trusts cannot be deducted here by the trust lodging the income tax return. Typical expenses for both Labels S and T include interest and borrowing cost expenses and/or motor vehicle expenses, etc. Note that if Family Trust Distribution Tax or Trustee Beneficiary Non-disclosure tax has been paid on any trust distributions, this distribution is not assessable and therefore not included on the return. If this is the case, no loss or outgoing incurred in deriving these amounts can be claimed as a deduction. 122 National Tax & Accountants Association Ltd: August 2016

133 Preparing the 2016 Trust Tax Return (c) Item 9 - Labels G, X and H (Deductions relating to rental income) The deductible amount of any expenses incurred by a trust in deriving rental income should be reported at this item. (d) Item 16 - Label P (Deductions relating to Australian investment income) and Label R (Franked distributions) The deductible amount of any expenses incurred by a trust in deriving either dividend from a Listed Investment Company ( LIC ) or unfranked distributions are claimed at Label P. At Label R claim deductions for expenses that directly relate to franked distributions that have not already been claimed at the partnership and trusts Item 8, Label G - Deductions relating to franked distributions from trusts in Label F. (e) Item 18 - Label Q (Other deductions) Any other deductible amounts not already claimed at another item should be claimed here (e.g., tax agent fees, donations, etc). Note that a claim for donations cannot increase or create a tax loss and may need to be reduced if a trust has reported a net loss (at Item 20) for the income year. (f) Item 25 - Label C (Tax losses deducted) Show at this label, the amount of any prior year (revenue) tax losses a trust is entitled to claim for the current income year. National Tax & Accountants Association Ltd: August

134 Preparing the 2016 Trust Tax Return 3.1 Completing Item 5 Business expenses The reporting of business expenses at Item 5 is often confusing because of the differences in the accounting and tax treatment of certain expenses. As a result, the following discussion focuses on the reporting of the key business expenses (at Item 5) of a resident trust that is not an SBE Bad debts written off Section of the ITAA 1997 generally allows a deduction for a bad debt written off in an income year if the debt was previously included in the assessable income of the trust and the debt is bad and not just doubtful (such as where the debtor is bankrupt and has no funds to repay the debt or where reasonable steps have been taken to recover the debt but there is little or no likelihood of recovering some or all of the debt). In addition, the debt must also have been written off by the trust in the income year in which the deduction is to be claimed. TAX WARNING Trusts must satisfy trust loss tests Generally, except in the case of certain trusts such as family trusts or deceased estates, trusts cannot deduct bad debts written off unless they satisfy the applicable tests under the trust loss provisions in Schedule 2F to the ITAA Show at Label F, the total deductible bad debts of the trust. Do not include any accounting provision for doubtful debts show these at Label N All other expenses instead, and then add them back at Label B Expense reconciliation adjustments Capital works deductions Generally, capital expenditure incurred in the construction of capital works (e.g., buildings and structural improvements) used to derive assessable income can be written-off at a rate of 2.5% (or 4% for certain works used in a prescribed manner) from the time construction is complete. Refer to Division 43 of the ITAA Examples of deductible expenditure include structural features which are an integral part of a building (e.g., lift wells) but excludes landscaping costs. A deduction for eligible capital works expenditure should be claimed at Label B Expense reconciliation adjustments (if it has not already been included at an expense label at Item 5) Depreciation expenses (Label K) For tax purposes, taxpayers may claim the decline in value (i.e., depreciation) of depreciating assets they hold and use (or have installed ready for use) in deriving their assessable income under Division 40 of the ITAA 1997 (i.e., the Uniform Capital Allowances, or UCA, rules). Under these rules, the cost of a depreciating asset is generally written-off (i.e., depreciated) over the asset s effective life, as determined using the ATO s published effective life tables or the taxpayer s own estimate. The rate of depreciation depends on whether the prime cost method ( PCM ) or the diminishing value method ( DVM ) is used. Certain depreciating assets are subject to concessional rules, such as horticultural plants, water facilities, and software development expenditure. A taxpayer that is an SBE can choose to use simpler depreciation rules (contained in Subdivision 328-D of the ITAA 1997) instead of the UCA rules. Further, S.40-80(2) provides an immediate write-off for non-business assets costing $300 or less (i.e., assets used mainly to derive non-business income) if they are not part of a set, or one of a number of identical or substantially identical assets, with a total cost of more than $300. Therefore, business assets are generally ineligible for this $300 write-off. However, the ATO allows business taxpayers to claim a full deduction for tangible depreciating assets costing $100 or less which are used in their business (e.g., calculators, etc). Refer to PS LA 2003/ National Tax & Accountants Association Ltd: August 2016

135 Preparing the 2016 Trust Tax Return Taxpayers can allocate certain assets costing less than $1,000 ( low-cost assets ) or existing assets they hold with an adjustable value (i.e., written down value) at the start of the income year of less than $1,000 ( low-value assets ) to a low-value pool ( LVP ). Depreciation is then calculated for the pool, rather than each asset, at a diminishing value rate of 37.5% (18.75% for low-cost assets in the year they are acquired and pooled). All subsequent purchases of low-cost assets must also be allocated to the pool, but taxpayers can choose whether or not to pool lowvalue assets on an asset-by-asset basis. Refer to Subdivision 40-E. The adjustable value of a depreciating asset is the cost of the asset less total depreciation to date (even if the depreciation was not deductible). EXAMPLE 11 Calculating depreciation using an Low Value Pool ( LVP ) Wally s Trust carries on a gardening business and has previously established an LVP. The balance of the pool on 1 July 2015 is $5,000. In May 2016, the trust acquired a chainsaw for $240 (excluding GST). The trust also owns a mower whose adjustable value on 1 July 2015 is $955. The trust decides to allocate this mower to the pool from the 2016 income year. For the 2016 income year, depreciation of the pooled assets is calculated as follows: Opening pool balance (i.e., $5,000) x 37.5% $ 1,875 Add: Cost of chainsaw acquired during the year (i.e., $240) x 18.75% $ 45 Add: Opening adjustable value of mower added to the pool (i.e., $955) x 37.5% $ 358 Depreciation claim for the LVP in the 2016 income year $ 2,278 The closing pool balance as at 30 June 2016 is $3,917 (i.e., $5,000 opening balance + $240 cost of new chainsaw + $955 opening adjustable value of mower $2,278 depreciation for the year). Show at Label K, the accounting depreciation expense (i.e., generally from the P&L of the trust). Make any adjustments to increase or decrease the accounting depreciation amount disclosed at Label K to reconcile (i.e., align) it with the deductible amount for tax purposes at Label B Expense reconciliation adjustments. TAX TIP Different requirements for SBE depreciation Note if the taxpayer is eligible and using the SBE depreciation regime, the amount claimed at this label will be the actual tax depreciation deductions (calculated under the $20,000 immediate write-off rules for 2016 or from the general depreciation pool balance), rather than the accounting depreciation expenses taken directly from the P&L. See the discussion further below about the additional reporting obligations with respect to Item 49 for taxpayers eligible and utilising the SBE depreciation regime. Otherwise, where the SBE depreciation regime has not been utilised, Item 48 (below) must be completed for reporting purposes. National Tax & Accountants Association Ltd: August

136 Preparing the 2016 Trust Tax Return As highlighted above, where the trust is an SBE using the simplified depreciation rules, the amount included at Item 5, Label K will be the deductible amount of depreciation calculated in accordance with those rules, and there will be no need to make an adjustment at Label B. However, the trust will also need to separately disclose these amounts at Item 49 Small business entity depreciating assets (reproduced below). TAX TIP Increase in the SBE immediate write-off from 12 May 2015 In the 2015 Budget, the government announced its intention to increase the Small Business Entity ( SBE ) immediate depreciable asset deduction threshold from $1,000 to $20,000 for assets acquired and installed ready for use from 7.30pm (AEST) 12 May This budget announcement was legislated via the Tax Laws Amendment (Small Business Measures No.2) Act As a result, with respect to the 2016 income year, Item 49, Label A - Deduction for certain assets requires the reporting of any claims made at Item 5, Label K which qualified under the $20,000 immediate write-off threshold. Deductions made during the income year for assets allocated to the general small business pool are separately reported at Item 49, Label B - Deduction for general small business pool. 126 National Tax & Accountants Association Ltd: August 2016

137 Preparing the 2016 Trust Tax Return Balancing adjustments on the disposal of depreciating assets When a trust ceases to hold (e.g., due to a sale) a depreciating asset, a balancing adjustment event will occur, which means the taxpayer may have an assessable or deductible amount for tax purposes. Broadly, if the sale proceeds (i.e. the termination value ) exceed the asset s adjustable value at the time of the event, the excess is assessable to the trust. If the termination value is less than the asset s adjustable value at that time, the difference is deductible. If a balancing adjustment event occurs for an asset in an LVP, the asset is deemed to remain in the pool (even if the taxpayer no longer owns it). Instead, the closing pool balance for the income year (i.e., at 30 June) is reduced by the taxable use percentage of the asset s termination value (effectively, the business use proportion of the asset s value). If this amount exceeds the closing pool balance, the excess is assessable to the taxpayer. If there is a balance remaining, the asset sold nonetheless continues to attract a full year s depreciation claim as this is calculated with reference to last year s closing balance see Step 3 of S (1). Any profit on the sale of depreciating assets is not shown at Item 5, Label K Depreciation expenses, but rather shown at Items 5, Labels G or H Other business income. Any loss on the sale of depreciating assets should be shown at Item 5, Label N All other expenses. If the accounting profit or loss on the sale of a depreciating asset differs from the balancing adjustment amount, an income or expense reconciliation adjustment is required to be made. This adjustment is made by reversing an accounting profit at Label A Income reconciliation adjustments or an accounting loss at Label B Expense reconciliation adjustments. An assessable balancing adjustment amount (for tax purposes) is then added-back at Label A while a deductible balancing adjustment amount is claimed at Label B. TAX TIP Disposal of SBE depreciating assets Where a trust has used the SBE depreciation regime, different reporting is required where any depreciating assets are disposed of. In short, such disposals are dealt with via a reconciliation adjustment. Where a general small business pooled asset is disposed of, the taxable purpose portion of the termination value is deducted from the closing pool balance. If the amount is less than zero, the amount below zero is included in assessable income at the reconciliation labels contained in Item 5 of the 2016 trust return Entertainment expenses Section 32-5 of the ITAA 1997 generally denies a deduction for the cost of providing entertainment by way of food, drink or recreation (or accommodation or travel in connection with providing such entertainment), even if business discussions take place. However, there are some exceptions to this rule. For example, costs incurred in the following circumstances may be deductible: The provision of entertainment-related fringe benefits to an employee or their associate (refer to S and the discussion below regarding the entertainment-related fringe benefits); Meals, accommodation or travel costs incurred for an employee on a business trip; and Meals, accommodation or travel costs in connection with a seminar that runs for at least four hours (excluding breaks) and is not merely a general business discussion refer to S Also, the cost of relatively inexpensive gifts that will be consumed by employees or clients at home (e.g., a bottle of wine) and morning/afternoon teas and light lunches provided by an employer to employees during a work day is usually not entertainment. Therefore, expenditure on these items is generally deductible under S.8-1. Refer to TR 97/17 and IT There is no specific label for entertainment expenses at Item 5. Therefore, show at Label N All other expenses, the total entertainment expenditure recorded in the P&L and reverse the nondeductible portion (if any) at Label B Expense reconciliation adjustments. National Tax & Accountants Association Ltd: August

138 Preparing the 2016 Trust Tax Return Fringe benefits Broadly, a fringe benefit is a benefit provided to an employee and/or an associate of an employee in respect of the employee s employment. Examples include the use of a car or property, the payment or reimbursement of an employee s expense or a Christmas lunch at a restaurant. Employers are liable to pay Fringe Benefits Tax ( FBT ) at the rate of 49% on the grossed-up taxable value of fringe benefits (as calculated under the FBT rules) provided to employees and/or their associates during an FBT year (which runs from 1 April to 31 March the following year). Employers are generally required to pay their (estimated) current year FBT liability in quarterly instalments (as part of each quarterly Business Activity Statement) by 28 July, 28 October, 28 February and 28 April. From a tax perspective, the cost of providing fringe benefits (excluding any GST input tax credit entitlement) and any FBT payable in relation to those benefits is generally tax deductible. The deduction is claimed in the income year in which the expenditure is incurred. TAX TIP Claiming a deduction for FBT instalments accrued If an employer pays their FBT liability quarterly, the fourth quarter instalment is tax deductible in the income year to which the payment relates. For example, the June 2016 quarter FBT payable by 28 July 2016 is tax deductible in the 2016 income year. Refer to TR 95/24. Where an employer was a quarterly payer in the previous income year, practitioners should ensure that the fourth quarter instalment for that year is not claimed again in the current income year when paid (as it should have been claimed in the tax return for the prior income year). (i) The deductibility of entertainment-related fringe benefits For tax purposes, entertainment expenditure is deductible to the extent that it is incurred in providing a fringe benefit (refer to S.32-20). Therefore, the FBT treatment of entertainment expenditure (which is generally classified as either meal entertainment or recreation) can affect the calculation of the tax deductible amount (and any GST input tax credit entitlement). The tax implications of two popular methods for valuing meal entertainment fringe benefits are: 1. The actual entertainment expenditure method under this method, only that part of meal entertainment expenditure that relates to employees and their associates is subject to FBT (unless an exemption applies) and is therefore tax deductible. Meal entertainment provided to non-employees (e.g., clients) is not subject to FBT and is generally not tax deductible; and 2. The 50/50 split method under this method, 50% of the total meal entertainment expenditure is taken to relate to employees and their associates and is therefore tax deductible. The remaining 50% is not subject to FBT, but is also not tax deductible. EXAMPLE 12 Tax deduction where 50/50 split method is used ABC Trust holds a Christmas lunch for employees and key clients at a restaurant. The total food and drink bill was $2,200 (including GST). The trust is registered for GST and uses the 50/50 split method for FBT purposes. Half the expenditure (i.e., $1,100) is subject to FBT. The trust is also entitled to an input tax credit for half the GST included in the bill (i.e., $100). Therefore, $1,000 (i.e., $1,100 $100 GST input tax credit claimed) is tax deductible to the trust (the remainder is not deductible). Expenditure on recreation (another form of entertainment) is also tax deductible to the extent that it is subject to FBT. 128 National Tax & Accountants Association Ltd: August 2016

139 Preparing the 2016 Trust Tax Return (ii) Claiming a deduction for fringe benefits on the trust return There is no specific expense label for fringe benefits or for FBT payments at Item 5. Instead, the cost of fringe benefits provided, as recorded in the P&L, should be shown at the most appropriate expense label at Item 5. For example, the running costs relating to a car fringe benefit provided during the year should be shown at Label L Motor vehicle expenses. The total FBT payments, as recorded in the P&L, should be shown at Label N All other expenses. Make any necessary tax adjustments (to an amount at Item 5) at Label B Expense reconciliation adjustments Hire purchase and luxury car lease expenses Hire purchase agreements are treated as a sale of the asset by the vendor (i.e. the financier) to the taxpayer (i.e. the hirer). For tax purposes, Division 240 of the ITAA 1997 treats the notional sale as being financed by a loan from the financier. The periodic hire purchase payments are treated as payments of principal and interest under the notional loan. Therefore, the taxpayer can claim a deduction for the interest component, calculated in accordance with S The principal components are not tax deductible, but reduce the balance of the notional loan. The taxpayer may also claim deductions for depreciation of the asset, even if title to the asset does not pass until the final payment is made. TAX WARNING Luxury car leases are treated as a hire purchase For tax purposes, the lessor of a luxury car is taken to have notionally sold the car to the lessee (i.e., the taxpayer) for the value specified in the lease agreement and loaned that amount to the lessee to buy the car. Therefore, the lessee is treated as the owner of the car. A car is a luxury car if its cost exceeds the car limit that applies for tax depreciation purposes in the year the lease commences ($57,466 for the 2016 income year and $57,581 for the 2017 income year). Hence, the lease payments must be divided into notional principal and interest components and only the interest portion is deductible. The taxpayer may also claim depreciation of the car (subject to the depreciation car limit). Refer to Division 242 of the ITAA If hire purchase or luxury car lease payments are included at an expense label at Item 5, those amounts should be added-back and the interest component of the hire purchase or luxury car lease payments and depreciation of the asset (if not already included as a tax deduction) should instead be claimed, at Label B Expense reconciliation adjustments Interest expenses Interest on borrowings is deductible (under S.8-1) if it is incurred in deriving assessable income and is not capital in nature. This generally requires an examination of the purpose of the borrowings and the use of the borrowed funds. Note that the fact that the borrowed funds may be used to acquire a capital asset does not necessarily mean that the interest is on capital account. Generally, interest incurred before any relevant income-producing activity has commenced is deductible if it is not incurred too soon and is not preliminary to those activities. Refer to TR 2004/4. Interest incurred after a business has ceased will continue to be deductible if the original funds were used for an income-producing purpose and the nexus between that purpose and the continuing obligation to pay interest has not been broken. It is important that any sale proceeds are applied to reduce the balance of the loan. The nexus is likely to be broken if the taxpayer keeps the loan on foot for reasons unrelated to the former income-producing activities, or where the loan is extended to obtain an ongoing commercial advantage that is unrelated to the original activity when the debt was originally incurred. Refer to TR 2004/4. Show at Label I Total interest expenses, the interest incurred on money borrowed to acquire income-producing assets, to finance business operations or to meet current business expenses. National Tax & Accountants Association Ltd: August

140 Preparing the 2016 Trust Tax Return Lease expenses (excluding luxury cars) Leasing expenses incurred in deriving assessable income (e.g., periodic payments for the lease of a photocopier) are generally deductible under S.8-1 when incurred. However, if a lease agreement provides an option for the lessee to purchase the asset it may be treated as a hire purchase for tax purposes. In this case, the lessee is taken to be the owner of the asset and can claim depreciation and the notional interest component of the lease payments. The ATO expects leases to have realistic residual values that approximate the anticipated value of the asset when the residual is paid out. Refer to IT 28 and TD 93/142. When the residual is paid, title in the leased asset will be transferred to the lessee. This amount is not tax deductible, but may be depreciated from the date of payment. TAX WARNING Adjustment for capitalised leases A leased asset may be included in the Balance Sheet (i.e., capitalised ) for accounting purposes. This generally involves recording the cost/value of the leased asset and the corresponding lease liability in the balance sheet, and expensing the interest and stamp duty portion of the periodic payments in the P&L. Furthermore, the value of the leased asset may be written-off over the period of the lease (this is often referred to as amortisation ). For tax purposes, if the asset is not taken to be acquired under a hire purchase agreement, then the amortisation, interest and stamp duty expenses shown in the P&L must be added back when preparing the tax return. However, the lease payments are tax deductible. Show at Label G - Lease expenses (e.g., amortisation, interest, stamp duty and operating lease rentals) on depreciating assets, as reported in the P&L. Do not include the cost of leasing real estate (show this at Label H Rent expenses). Add-back any non-deductible amount at Label B Expense reconciliation adjustments, and include a decreasing expense adjustment to claim the deductible lease payments if necessary (also at Label B) Legal expenses The deductibility of legal expenses (under S.8-1) depends on whether the expenditure is revenue (e.g., costs in pursuing outstanding customer debts) or capital in nature (e.g., costs relating to the acquisition of a property) and the extent to which it relates to deriving assessable income. Legal expenses of a capital nature are not deductible but may form part of the cost of an asset or, as a last resort, be eligible for deduction under S (regarding Blackhole expenditure). Legal expenses may be specifically deductible under another provision, such as legal costs incurred to discharge a mortgage, which are deductible under S of the ITAA There is no specific expense label for legal expenses at Item 5. Therefore, show at Label N All other expenses legal expenses from the P&L. Any adjustments for non-deductible amounts are made at Label B Expense reconciliation adjustments Motor vehicle expenses The costs of running a motor vehicle used for business purposes (including cars provided to employees or their associates as fringe benefits) are generally tax deductible under S.8-1. If an employer provides a car fringe benefit, no adjustment is required for the employee s private use of the vehicle as the cost is necessarily incurred by the employer in carrying on its business. Show at Label L motor vehicle running expenses such as fuel, repairs, registration fees and insurance premiums (but excluding lease, interest and depreciation expenses) from the P&L. Make any tax adjustments at Label B Expense reconciliation adjustments. Show any lease expenses at Label G, interest expenses at Label I, and depreciation at Label K. 130 National Tax & Accountants Association Ltd: August 2016

141 Preparing the 2016 Trust Tax Return Prepaid expenses Expenditure relating to services to be provided in future income years is called a prepayment. Prepaid expenses incurred in deriving assessable income are deductible under S.8-1. However, the timing of the deduction may be affected by special rules in Division 3, Subdivision H of the ITAA 1936 which generally require a deduction for prepaid expenses to be spread over the eligible service period to which the expenditure relates or 10 years, whichever is less. The eligible service period is the period over which the service will be provided. However, as an exception, a prepayment will be fully deductible when paid if it is for an amount that is less than $1,000, or a payment of salary or wages made under a contract of service, or required by a Commonwealth, state or territory law (e.g., car registration) or by a court order. Other exceptions to the prepayment rules include the 12-month rule for SBEs, which provides an immediate deduction for the full amount if certain conditions are met. Show the amount of any prepaid expenses (as recorded in the P&L) at the relevant expense label at Item 5 (e.g., a prepayment of interest on a business loan should be shown at Label I). Addback the non-deductible portion at Label B Expense reconciliation adjustments. Where a prepayment that was made in a previous income year is deductible in the 2016 income year, claim that amount at Label B Expense reconciliation adjustments. EXAMPLE 13 Claiming prepayments made in a previous year Bay Trust runs a seaside pub from premises it leases. The trust is not an SBE. On 31 May each year, the trust pays $60,000 for lease of the premises from 1 June of that year to 31 May of the following year. The prepayment made on 31 May 2015 only covers 30 days of the 2015 income year (i.e., June 2015). Therefore, the trust is only entitled to claim $4,918 (i.e., $60,000 x 30/366). The balance of $55,082 is deductible in the 2016 income year and, therefore, should have been added-back at Label B Expense reconciliation adjustments of the 2015 tax return. The $60,000 prepayment made on 31 May 2015 covers 336 days of the 2016 year (from 1 July 2015 to 31 May 2016). Therefore, $55,082 (i.e., $60,000 x 336/366) of that payment is deductible in the 2016 income year (and should not have been claimed in the 2015 return) and is claimed at Label B Expense reconciliation adjustments Provisions and reserves in the financial accounts Amounts set aside by a taxpayer in its financial accounts to provide for an expected future liability are not deductible until the expense is actually incurred (i.e., when the taxpayer is definitively committed to that liability) and, therefore, must be reversed in the tax return. Common examples of such provisions include a provision for doubtful debts (a deduction is only allowed for bad debts once actually written off), provisions for long service leave, annual leave, sick leave, etc (these are deductible when paid to the employee refer to S of the ITAA 1997) and provisions for contingent liabilities (e.g., warranty repair costs). Include at Label N All other expenses, any addition to a provision (as reported in the P&L) and then add this amount back at Label B Expense reconciliation adjustments as it is not tax deductible. An adjustment is then made (also at Label B) to claim any deductible amounts paid during the income year (if they have not already been included at an expense label at Item 5) Repairs and maintenance (Label M) Expenses incurred for repairs and maintenance of income-producing assets are specifically deductible under S of the ITAA 1997, to the extent that the expenditure is not of a capital nature. A repair generally involves restoring the asset to its original state or maintaining it in the same condition it was in when it was first acquired. Refer to TR 97/23. National Tax & Accountants Association Ltd: August

142 Preparing the 2016 Trust Tax Return Capital expenditure incurred in relation to an asset may be eligible for depreciation (if it forms part of the asset s cost) or for the write-off under Division 43 (for capital works). Expenditure is usually capital in nature and, therefore, not deductible where it is incurred to remedy defects in newly-acquired assets that existed at the time of acquiring the asset, to enhance or improve the functionality of an asset, or to replace the entire asset rather than to repair a part of it. Add-back any non- Show at Label M, repairs and maintenance expenses from the P&L. deductible expenditure at Label B Expense reconciliation adjustments Superannuation expenses (Label D) Contributions by an employer to a complying superannuation fund on behalf of an employee (under their superannuation guarantee obligations) are deductible in the income year they are paid to the fund (and not simply set aside or journalised). Refer to S of the ITAA There is generally no limit on the amount of contributions an employer trust can claim in respect of an employee (subject to the age related conditions in S of the ITAA 1997 that can limit the type of contributions that deductions can be claimed depending on the employee s age). However, if the amount claimed exceeds the individual employee s concessional contributions cap, the excess is effectively taxed to the individual employee at their marginal tax rate (refer to the Tax Tip below). The concessional contributions cap amount for the 2016 income tax year is $30,000. Note that for the 2016 income tax year, the cap amount for those aged 49 years or over on 30 June 2015 is increased to $35,000. TAX TIP Removal of excess contributions tax from 1 July 2013 Excess concessional contributions arising in the 2014 and later income years in respect of an individual are no longer subject to excess contributions tax ( ECT ) and instead, are included in the individual s assessable income (in the income year in which the excess concessional contributions arise) and taxed at the individual s marginal tax rate. In addition, the individual is entitled to a non-refundable 15% tax offset to reflect the tax already paid in the fund on the excess concessional contributions (i.e., generally at 15%). Individuals impacted by these changes will also be liable to pay an excess concessional contributions charge, to ensure they do not obtain an advantage by deferring the time at which income is assessed. Employers are generally required to provide a minimum level of superannuation contributions for employees, by the 28th day of the month after the end of a quarter, under the Superannuation Guarantee ( SG ) scheme. For the 2016 income year, the minimum amount is calculated as 9.5%, up to a maximum amount per quarter of $50,810 (equivalent to an annual salary of $203,240). This means that no contribution needs to be made on that part of OTE in excess of the relevant quarterly maximum amounts. Refer to SGR 2009/2. An employer who fails to make the quarterly SG contributions by the due date will be liable for the Superannuation Guarantee Charge ( SGC ), which is calculated as the sum of the SG contribution shortfall (reduced by any late payment of the contribution), an administration fee and an interest component. The SGC is not tax deductible. Refer to S of the ITAA Show at Label D, the superannuation expenses from the P&L. If part or all of a payment of superannuation is not tax deductible, this amount should be added-back at Label B Expense reconciliation adjustments. Adjustments for any deductible amounts are also made at this label (e.g., to claim superannuation contributions that were paid in the current income year in respect of a previous income year, but is not included in the P&L). 132 National Tax & Accountants Association Ltd: August 2016

143 Preparing the 2016 Trust Tax Return 3.2 Checklist of common business deductions The following checklist provides a snapshot guide to the general deductibility status of common business expenses. Amounts identified as Tax deductible can generally be claimed in full, in the income year in which they are incurred, unless otherwise stated. Description of expenditure for non SBE taxpayer Advertising and sponsorship expenses (excluding entertainment expenses) Amortisation of goodwill or leases Audit fees (e.g., financial account audits, ATO tax audits, etc.) Bad debts written off Bank fees and charges Borrowing costs (e.g. loan establishment fees, legal costs, mortgage duty, etc.) Buildings and structural improvements Business operating expenses Depreciation of income-producing depreciating assets Donations to an organisation that is a Deductible Gift Recipient Employee bonuses paid or accrued Entertainment expenses subject to FBT Entertainment expenses not subject to FBT Equipment rental and service fees FBT liability payments Freight costs Fuel and oil GST included in the price of expenses incurred by a taxpayer where: the taxpayer is registered for (or is required to be registered for GST); the taxpayer is not registered for GST (or required to be registered for GST) Hire purchase instalment (notional interest component of each instalment paid) Hire purchase instalment (the principal component of each instalment paid) Insurance premiums (business related) Interest on borrowings used for assessable income-producing purposes Land tax on business premises Lease payments (other than luxury car lease payments) Leasehold improvements (e.g., shop fit-out) Leave payments (e.g., annual leave, long service leave, sick leave, etc.) Leave accrued but not paid (refer to S.26-10) Tax deductible? ü û ü ü ü ü û ü ü ü ü ü û ü ü ü ü û ü ü û ü ü ü ü û ü û National Tax & Accountants Association Ltd: August

144 Preparing the 2016 Trust Tax Return Description of expenditure for non SBE taxpayer Legal costs (revenue in nature) e.g., costs to recover customers payments Legal expenses (capital in nature) e.g., cost to acquire business premises Licences (cost of initial business licences) Licences (ongoing to operate a business) Loss on sale of depreciating assets (i.e. deductible balancing adjustment amount) Luxury car lease payments Municipal rates on business premises Payroll tax Penalties and fines Postage Prepayments of excluded expenditure e.g., amounts less than $1,000, required by law/court order, or made under a contract of service (e.g., wages) Tax deductible? ü û û ü ü û ü ü û ü ü Primary producers: Agistment fees Breeding service fees Droving expenses, shearing expenses, etc. Farm management deposits ( FMDs ), subject to the FMD rules Fertiliser, feed and fodder Hire of farm implements Insecticides, weedkillers, fumigant Veterinary fees Printing and stationery costs Provisions and reserves (excluding amounts actually paid) Rent for business premises Repairs and maintenance of income-producing assets (revenue nature only) Salaries, wages and subcontractors fees (other than PSI) Superannuation contributions on behalf of employees Superannuation guarantee charge Tax agent fees for preparation of financial accounts, tax returns, BAS, etc. Trading stock (purchases, decreases in the tax value of closing trading stock) Travel expenses ü ü ü ü ü ü ü ü ü û ü ü ü ü û ü ü ü 134 National Tax & Accountants Association Ltd: August 2016

145 Preparing the 2016 Trust Tax Return Description of expenditure for non SBE taxpayer Water rates on business premises Workers compensation premiums Tax deductible? ü ü Borrowing costs of $100 or less are fully deductible in the year they are incurred. Otherwise, the deduction is apportioned over the lesser of the life of the loan or five years (note: deductions in the first and last years are pro-rated). Examples of borrowing costs include loan establishment fees, mortgage duty, commission to finance brokers, and legal costs. Refer to S of the ITAA Not deductible outright but may be written-off at 2.5% or 4% under Division 43 of the ITAA 1997 (capital works) depending on the date construction is completed. The cost of the asset is generally written-off (i.e., depreciated) over the effective life of the asset or as part of a capital allowances pool (e.g., a low value pool). Refer to Division 40 of the ITAA In some circumstances, entertainment expenses may be deductible to an employer even if the expenses are not subject to FBT. For example, entertainment provided at an eligible seminar that goes for at least four hours. Refer to Subdivision 32-B of the ITAA For tax purposes, a luxury car lease is effectively treated as a hire purchase. Therefore, the lessee may be entitled to claim a deduction for the interest component of the payments and depreciation of the car (up to the depreciation car limit). Refer to Division 242 of the ITAA 1997 and to Item 1 of the table in S of the ITAA Generally, expenditure on services that are not wholly provided within the income year in which the expenditure is incurred (i.e., prepaid expenses) must be apportioned over the period the service is provided (other than the exceptions provided in the checklist). Separate prepayment rules apply for SBEs and non-business individuals. Refer to S.82KZL to S.82KZMD of the ITAA There is generally no limit on the deductibility of employer superannuation guarantee contributions with respect to the income tax year the employer makes the payment to a complying superannuation fund. Note, however, that adverse income tax consequences can apply for an employee who breaches their annual concessional contributions cap. For tax purposes, taxpayers are required to value their trading stock at the end of the year of income either at cost, market selling value or replacement value. Refer to Division 70 of the ITAA If the closing value of trading stock is less than the opening value (plus purchases for the year), for tax purposes, the decrease is tax deductible (whilst an increase in value is included in assessable income). National Tax & Accountants Association Ltd: August

146 Preparing the 2016 Trust Tax Return 4. Reconciling accounting profit to taxable income When preparing the tax return of a trust that carries on business, adjustments are required to be made at Item 5 Reconciliation items of the trust return (see below) to reconcile any differences between the operating profit or loss of the business as shown in the P&L of the trust (reported at Item 5 Business income and expenses), and the net income or loss of the trust for tax purposes (i.e., taxable income or loss). Broadly, adjustments required to be made at Item 5 Reconciliation items are classified as either income reconciliation adjustments or expense reconciliation adjustments. 4.1 Income reconciliation adjustments (Label A) An increasing or decreasing income reconciliation adjustment is required to be made at Label A under Item 5 Reconciliation items in the following circumstances: (a) Increasing ( add-back ) adjustments An adjustment that increases net income (or reduces a net loss) is required if an amount that is assessable for tax purposes was not included as income in the P&L of the trust (and, therefore, is not shown as income at Item 5). For example, bad debts recovered but not reported in the P&L. (b) Decreasing ( subtraction ) adjustments An adjustment that reduces net income (or increases a net loss) is required if an amount treated as income in the P&L of the trust (and shown as income at Item 5) is not assessable for tax purposes (e.g., exempt income). An adjustment may also be required to take into account the impact of timing differences between the accounting and tax treatment of an amount of income. If the total increasing income adjustments exceed the total decreasing income adjustments, the excess is recorded at Label A and added to the accounting profit or loss when performing the tax reconciliation (refer below). If the increasing adjustments are less than the decreasing adjustments, the excess is deducted instead (and an L is placed in the box next to Label A). 4.2 Expense reconciliation adjustments (Label B) An increasing or decreasing expense reconciliation adjustment is required to be made at Label B under Item 5 Reconciliation items in the following circumstances: (a) Increasing ( add-back ) adjustments An adjustment that increases net income (or reduces a net loss) is required when all or part of an expense shown in the P&L of the trust (and as an expense at Item 5) is not tax deductible. For example, legal costs of a capital nature, or a prepaid business expense that must be claimed over the period to which the payment relates. (b) Decreasing ( subtraction ) adjustments An adjustment that reduces net income (or increases a net loss) is required when an amount that is tax deductible is not shown as an expense in the P&L of the trust (and, therefore, is not included as an expense at Item 5). For example, a deduction for a Division 43 write-off for capital works. An adjustment may also be required to take into account the impact of timing differences between the accounting and tax treatment of an expense, such as when borrowing costs are fully expensed for accounting purposes, but tax deductible over five years under S National Tax & Accountants Association Ltd: August 2016

147 Preparing the 2016 Trust Tax Return If the total increasing expense adjustments exceed the total decreasing expense adjustments, the excess is recorded at Label B and added in the tax reconciliation (refer below). If the increasing adjustments are less than the decreasing adjustments, the excess is deducted instead (and an L is placed in the box next to Label B). 4.3 Worksheet for tax reconciliation on the T Return PP Non-PP Total Net profit or loss in the accounts (A)! Plus or minus net income reconciliation adjustments (refer to checklist below): Increasing Income reconciliation adjustments Less: Decreasing Income reconciliation adjustments Sub-total (B C) Plus or minus net expense reconciliation adjustments (refer to checklist below): (B) (C) (D) " Increasing Expense reconciliation adjustments Less: Decreasing Expense reconciliation adjustments Sub-total (E F) (G) # Net income or loss from business (A +/- D +/- G) Label Q Label R! This amount will generally equal Total business income (at Item 5) less Total expenses (at Item 5). " Show the sub-totals at the corresponding labels at Item 5 Income reconciliation adjustments. # Show the sub-totals at the corresponding labels at Item 5 Expense reconciliation adjustments. & If the sub-total at (D) and/or (G) is negative, deduct these amounts from the net profit or loss at (A). The totals at (H) must agree with Item 5, Labels Q, R and S. 4.4 Checklist of common reconciliation adjustments Label S The following tables provide a non-exhaustive checklist of some of the more common business income and expense reconciliation adjustments that may be reported at Item 5. (E) (F) (H) & Common INCOME reconciliation adjustments (non-sbe trust) Income add-backs: (i.e., amounts not shown in the P&L but which are assessable, plus timing differences) Assessable balancing adjustment amounts on depreciating assets $ Bad debts recovered not included in the financial accounts $ Increase in the value of closing stock over opening stock for tax purposes $ Other assessable income not included in the P&L $ Sub-total (show in the relevant columns at (B) in the above tax reconciliation) $ Income subtractions: (i.e., amounts shown in P&L but which are not assessable, plus timing differences) Accounting profit on sale of depreciating assets $ Increase in the value of closing stock over opening stock for accounting purposes $ Personal services income ( PSI ) attributed to an individual $ Income shown in the P&L, but which is not assessable (e.g., exempt income) $ Sub-total (show in the relevant columns at (C) in the above tax reconciliation) $ National Tax & Accountants Association Ltd: August

148 Preparing the 2016 Trust Tax Return Common EXPENSE reconciliation adjustments (non-sbe trust) Expense add-backs: (i.e., expenses shown in the P&L but which are not tax deductible, plus timing differences) Accounting depreciation Accounting loss on sale of depreciating assets Additions to provisions and reserves (e.g., long service leave provided for, but not paid) Amortisation of intangible assets (e.g., leases, goodwill, etc.) Borrowing costs (to the extent they are not deductible in the current income year) Capital expenditure (e.g., certain legal costs or structural improvements) Certain non-deductible expenses relating to PSI Donations (to the extent they are not deductible, or increase or create a tax loss) Entertainment expenditure (to the extent it is not tax deductible) Expenses relating to exempt income Finance lease interest Hire purchase and luxury car lease payments Decrease in the value of closing stock over opening stock for accounting purposes Part of prepaid expenses that are not tax deductible in the current income year Superannuation expenses accrued in the accounts but not paid in the current year Other non-deductible expenses included in the P&L (e.g., penalties and fines) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Sub-total (show in the relevant columns at (E) in the above tax reconciliation) $ Common EXPENSE reconciliation adjustments (non-sbe trust) Expense subtractions: (i.e., amounts not expensed in the P&L but tax deductible, plus timing differences) Blackhole expenses deductible under S Deduction for decline in value of depreciating assets Deductible balancing adjustment amounts on depreciating assets Deductible lease payments in relation to a finance lease (not a luxury car lease) Division 43 write-off for capital works Hire purchase agreements and luxury car leases interest component Decrease in the value of closing stock value over opening stock for tax purposes Part of prepaid expenses deductible this year (but paid in a prior year) Payment of annual leave, long service leave, etc. Portion of borrowing costs deductible in the current year (if not shown in the P&L) Superannuation contributions accrued in a prior year but paid in the current year Other deductible amounts not shown in the P&L $ $ $ $ $ $ $ $ $ $ $ $ Sub-total (show in the relevant columns at (F) in the above tax reconciliation) $ 138 National Tax & Accountants Association Ltd: August 2016

149 Preparing the 2016 Trust Tax Return 5. Net Small Business Income New Label V, net small business income at Item 5 of the 2016 trust tax return has been inserted to reflect the additional 2016 reporting obligations relating to the Small Business Income Tax Offset ( SBITO ). This new tax offset is otherwise referred to as the unincorporated Small Business Entity ( SBE ) 5% tax discount. This new income tax offset, claimable by certain individual beneficiaries of an SBE trust has necessitated the need for a separate calculation of the trust s total net small business income to be made following the tax reconciliation and calculation of an SBE trust s net income or loss from a business at Item 5, Business income and expenses. As discussed in a later chapter entitled Completing the Distribution Statement, new reporting Label Y Share of net small business income has also been inserted into Item 54, Statement of Distribution to facilitate an individual beneficiary s SBITO claim within their own 2016 individual tax return. Following a separate calculation of the SBE trusts net small business income, the resulting figure should be reported at Label V Net small business income (reproduced below). This reporting label needs only to be completed by a trust that qualifies as a Small Business Entity ( SBE ), meaning that it runs a business and passes the relevant $2 million aggregated turnover test. Note, in the 2016/2017 Federal Budget, the Turnbull government have indicated that they intend to increase this turnover threshold (for the purposes of accessing the SBITO) to $5 million from the 2017 income year. The net small business income of an SBE trust is effectively its assessable income from carrying on a small business, less any deductions to the extent that they are attributable to that assessable income. If the trust carries on multiple businesses, the trust's assessable income and attributable deductions are combined in working out the net small business income. Both the SBE trust s net capital gains as well as any Personal Services Income ( PSI ) that was not derived from a Personal Services Business ( PSB ) are excluded from the net small business income of the trust. Additionally, tax-related expense deductions and deductions for gifts and/or contributions are not to be applied to reduce the trust s net small business income. Tax losses from prior income years are also ignored for the purpose of this reporting calculation. 6. Other tax return labels The ATO obtains a vast amount of critical information from the documents lodged with them, such as tax returns, Business Activity Statements and PAYG payment summaries. This information provides intelligence for the ATO to profile taxpayers from an audit perspective, including specific areas of risk for revenue. A lot of the information that must be provided to the ATO has no impact on the calculation of a taxpayer s tax liabilities. Nonetheless, a trust must still provide this information on the relevant forms, and ensure that it is correct. TAX WARNING Incorrect completion may increase risk of audit It is important to complete the financial information in the tax return accurately. The ATO obtains much of its statistics from the tax return, which are then used to profile certain industries for exception reporting purposes. Exception reporting basically involves identifying taxpayers who report statistics outside the norm for their industry. These taxpayers may then be subject to additional verification or audit activity. Items 38 to 47 provide the ATO with information pertaining to the trust s business and professional items that must be completed by a trust that carries on a business and is generally transposed from the relevant financials. National Tax & Accountants Association Ltd: August

150 Preparing the 2016 Trust Tax Return Notes 140 National Tax & Accountants Association Ltd: August 2016

151 Completing the Distribution Statement COMPLETING THE DISTRIBUTION STATEMENT National Tax & Accountants Association Ltd: August

152 Completing the Distribution Statement Notes 142 National Tax & Accountants Association Ltd: August 2016

153 Completing the Distribution Statement Completing the Distribution Statement Once a trustee has successfully distributed trust income to a beneficiary in accordance with the trust deed and law, the beneficiary s entitlement to trust income will effectively determine what percentage of the net (taxable) income each beneficiary will pay tax on. This will culminate in the preparation of the Statement of Distribution at Item 54 of the trust tax return. The Statement of Distribution provides the ATO (and the relevant beneficiary) with certain information including each beneficiary s share of the net (taxable) income (including their share of any net capital gains or foreign sourced income, or any primary production or non-primary production losses distributed as part of overall net income) and their share of any credits (e.g., franking credits). Information from a trust s Statement of Distribution is then primarily used to complete the following labels in each beneficiary s tax return (depending on whether the beneficiary is an individual, company, partnership or another trust): Where the beneficiary is an individual complete Item 13 Partnerships and trusts. Where the beneficiary is a company complete Item 6 Calculation of total profit or loss, Label E Gross distribution from trusts. Where the beneficiary is a partnership or another trust complete Item 8 Partnerships and trusts. 1. Completing the Statement of Distribution A Statement of Distribution must be prepared for each trust beneficiary who has been made presently entitled, or specifically entitled, to trust income (or specifically entitled to a capital gain via a capital distribution). The reporting requirements on the 2016 trust tax return accommodate the developments regarding the taxation of trust income (being, primarily, the recent amendments made to facilitate the streaming of capital gains and franked dividends). In addition, the trust income of the trust must now be reported and included at Item 53, Income of the trust estate. Effectively the income of the trust estate is the total distributable income of the trust that is legally available for distribution to the beneficiaries within the relevant income tax year. As discussed earlier in these notes, the calculation of this amount will depend on the terms of the trust deed and general trust law. The ATO remind trustees (in the 2016 instructions for Item 53) that as this amount is determined in accordance with trust law principles and, where applicable, the terms of the particular trust, it may be different to the accounting income of the trust or the net (taxable) income of the trust for tax purposes. If the trust has made a loss (based on trust law principles) then the amount at Label A should be 0. Note where this is the case, no beneficiary may be made presently entitled to any trust income (as there is none) and as a result any net (taxable) income will generally be assessed to the trustee. The ATO s need for the inclusion of this label arises out of the 2010 High Court decision generally referred to as Bamford (FCT v Bamford & Ors, Bamford & Anor v FCT [2010] HCA 10). This case specifically looked at the definition of income of the trust estate, which resulted in the ATO issuing a decision impact statement outlining a number of principles. National Tax & Accountants Association Ltd: August

154 Completing the Distribution Statement In short, the Bamford decision confirmed a number of key propositions including the fact that the notion of income of a trust estate for trust law purposes and its income for tax purposes are two different concepts. It also confirmed that taxpayers should adopt the proportionate approach when dealing with their trust resolutions and Statement of Distributions. Putting aside the streaming of capital gains and dividends, the proportionate approach requires that a beneficiary include the same percentage of net (taxable) income in their own assessable income as reflected in their proportionate share of the relevant trust income distribution. As a general proposition, the trustee resolutions of a discretionary trust deal with and reflect the trust law definition of income, whereas the Statement of Distribution in the trust tax return has traditionally reported purely the net (taxable) income. It appears that following on from the judicial clarification from the Bamford decision, the inclusion of Item 53 and also Label W, Share of income of the trust estate at Item 54 (discussed further below) reminds trustees that they must distribute the trust income and then apply the proportionate approach when determining each beneficiary s correct percentage share of the net (taxable) income. The instructions require that when preparing the trust return for 2016, what is shown at Label A of Item 53 and Label W of Item 54 should be the trustee s honest determination of what the trust s distributable income is, and each relevant beneficiary s entitlement to that income by year end. This may mean that the trustee has either decided to adopt the ATO s position in TR 2012/D1 or not. Either way, it should reflect what the trustee identifies as the trust income of the relevant trust. TAX WARNING Information matching by the ATO The ATO has indicated that information provided in the Statement of Distribution is used to verify that trust distributions are fully and correctly included in each beneficiary s tax return. Treasury has also attempted to ensure that the ATO has the ability to trace trust distributions down to the ultimate beneficiaries who will pay the tax on the net (taxable) income via the introduction and compliance work around the Trustee Beneficiary (TB) statements and the trustee TFN withholding requirements. 1.1 Primary production versus non-primary production activities Before discussing the Statement of Distribution, it is worth noting that certain amounts (usually trading income) are required to be classified according to whether they have a primary production or non-primary production source. An income or expense will have a primary production source if it is derived or incurred in the course of carrying on a primary production business. Broadly, primary production means production resulting from the cultivation of land, the maintenance of animals for sale (or to sell their bodily produce), the manufacture of dairy produce from raw materials produced by the taxpayer, fishing operations, pearling operations or tree farming. Refer to TR 97/11 and to the definition of primary production business in S.6 of the ITAA 1936 and in S.995-1(1) of the ITAA This distinction between primary production and non-primary production is required because certain tax concessions such as the primary production averaging system are available to individuals operating a primary production business (including individuals who are beneficiaries of a trust that conducts a primary production business). Under the averaging system for primary producers, taxable income is basically evened out over five years to ensure the taxpayer does not pay more tax than a non-primary producer who is on a comparable, but steady, income level. Refer to Division 392 of the ITAA 1997 for further details. 144 National Tax & Accountants Association Ltd: August 2016

155 Completing the Distribution Statement 1.2 Statement of Distribution A guide to the key labels The 2016 Statement of Distribution at Item 54 is reproduced below: National Tax & Accountants Association Ltd: August

156 Completing the Distribution Statement Beneficiary details Each beneficiary has a separate Statement of Distribution in the 2016 trust return and each beneficiary s relevant details need to be included at the top of the statement, including the correct Entity code at Label U. These codes are detailed below: ENTITY CODE Company Fund Individual Partnership Self managed superfund Trust C F I P S T Label V Assessment calculation code This is arguably the most important piece of information on the Statement of Distribution as it indicates both who is to the assessed on the relevant net income (the beneficiary or the trustee) and also at what income tax rate they will be assessed. The 2016 trust return instructions simply require the relevant code be inserted for each beneficiary presently or specifically entitled to the trust income. Where no beneficiary has been made presently entitled to all or a proportion of the trust income, the trustee will be required to complete their own portion of the Statement of Distribution (see below), to ensure that the 2016 trust return has dealt with all of the applicable income. If this is required, the trustee will be liable for any tax payable on this income. 146 National Tax & Accountants Association Ltd: August 2016

157 Completing the Distribution Statement Taxation of minors (children) and trust distributions Before we consider the relevant assessment codes in any detail, it is worth revisiting the concepts surrounding the taxation of minors (children under the age of 18). Where a presently entitled beneficiary is under the age of 18 years at the end of the income year, they will be considered a minor beneficiary and special taxation provisions will apply to any income a trustee distributes to them. Where a minor beneficiary is presently or specifically entitled to any income of the trust, it is the trustee who will primarily pay the applicable tax on behalf of the beneficiary. This tax can then be utilised as a credit by the minor should they be required to separately lodge an income tax return in their own name due to other income or credit entitlements. Unless the minor is an excepted person or the distribution is excepted income (see definitions below) any distribution of trust income to the minor individual in question (often referred to as a prescribed person) will be taxed at penalty rates, effectively (over certain limits) at the top marginal tax rate plus Medicare levy (i.e., 49%). For the 2011 income tax year a minor could generally have assessable income up to $3,333 without attracting any tax due to the combination of the penalty tax rates and the low-income rebate of $1,500. However, from the 2012 income tax year, a minor is no longer entitled to access the low-income rebate with respect to unearned income such as dividends, interest, rent, royalties and other income from property. The new rules apply to these types of income derived either directly or indirectly via a trust distribution. Where the minor is an Australian resident, unearned income will generally not be taxed where the eligible assessable income (i.e., not excepted income see below) is $416 or less. Eligible assessable income between $416 and $1,307 is taxed at 68% on the part of the relevant income exceeding $416 and then eligible assessable income of $1,308 and more is taxed at a flat 47% (plus Medicare levy). Assessment calculation codes The following table is taken from Appendix 12 of the ATO s 2016 trust return instructions: Inter vivos trusts (including discretionary trusts) Resident Where the beneficiary presently entitled to a share of the income of the trust is: Foreign resident over 18 and under a legal disability or an excepted person 25* 125* a prescribed person receiving excepted income only 26* 126* a prescribed person receiving eligible income only 27* 127* a prescribed person receiving excepted and eligible income only 28* 128* a prescribed person receiving eligible income from more than one trust 29* 129* not under any legal disability * a company * a trust the principal beneficiary of a special disability trust 45* 145* Where no beneficiary is presently entitled to a share of the income of the trust: Resident or foreign resident trust where no beneficiary is presently entitled to income Bankrupt estate 37* Resident or foreign resident trust where no beneficiary is presently entitled and to which S.99A(2) of the ITAA 1936 is to be applied * Tax assessable to the trustee National Tax & Accountants Association Ltd: August * 37*

158 Completing the Distribution Statement Deceased estate Resident Foreign resident Where the beneficiary presently entitled to a share of the income of the trust is: under a legal disability 11* 111* not under a legal disability * a company * a trust * Where no beneficiary is presently entitled to a share of the income of the trust: Trust where the deceased person died less than three years before the end of the income year 15* Trust where the deceased person died more than three years before the end of the income year 16* A foreign resident trust 17* * Tax assessable to the trustee An inter vivos trust is a trust that does not arise on the death of a person (as compared to a deceased estate or a testamentary trust). It includes a discretionary trust or a unit trust and as a result will be the most common codes used on trust returns. An excepted person is a minor who will not be subject to the penalty rates applied to trust distributions to children. Due to their circumstances, normal adult marginal tax rates will apply, however, the trustee will pay the tax on their behalf and, if applicable, they can claim a credit for any tax paid by the trustee. A child is an excepted person if, on the last day of the income year, any of the following circumstances applied to them: they were engaged in a full-time occupation (including an office, employment, trade, business, profession, vocation or calling, but not including a course of education); they were entitled to a disability support pension or rehabilitation allowance, or someone was entitled to a carer allowance to care for them; they had a medical certificate that certified that they were disabled, had a physical or mental disability that prevents them from working, or were permanently blind; or they were a person who received little or no financial support from relatives and were either entitled to a double orphan s pension, or were unable to engage in a full-time occupation because of a permanent mental or physical disability. A prescribed person is a beneficiary under 18 years of age at the end of the income year who is not an excepted person (see 2 above). A prescribed person will be subject to penalty tax rates for a minor unless they are receiving excepted income (see 4 below). An amount included in the assessable income of a trust is excepted income only to the extent that it is employment income; income from the estate of a deceased person, or resulted from a will or an intestacy or court order modifying a will or distribution from an intestate estate; income derived from the investment of any property that has been transferred to the trustee for the benefit of that minor beneficiary satisfying the various requirements of S.102AG(2)(c); income derived from the investment of any property representing accumulations of income being from sources indicated above (including where those accumulations were made from income of a prior year). Income from an investment made from sources as described above is excepted income and is taxed at normal adult individual rates. If such an investment is sold or otherwise realised, and the proceeds invested in a different form that represents that earlier property, income from the new investment keeps the character of excepted income. Trust income to which a minor beneficiary, who is a prescribed person, is presently entitled is eligible income except to the extent that the income can be classified as excepted income for the beneficiary. Eligible income is subject to higher tax rates plus the Medicare levy in the hands of both the trustee and the beneficiary. The beneficiary will receive a credit for the tax paid by the trustee. 148 National Tax & Accountants Association Ltd: August 2016

159 Completing the Distribution Statement A Trust is a resident trust if it is not a non-resident trust of Australia. A Trust is a non-resident trust of Australia if, at any time during the income year: no trustee was resident in Australia; and the central management and control of the trust was not in Australia. A trust which is a unit trust will be a resident unit trust for an income year if, at any time during the income year: Either: any property of the unit trust was situated in Australia, or the trustee of the unit trust carried on a business in Australia; and Either: the central management and control of the unit trust was located in Australia, or one or more persons who were residents held more than 50% of the beneficial interests in the income or the property of the unit trust. A deceased estate is a trust that is made up of: (i) the assets of the deceased person (the trust property), (ii) beneficiaries, who are generally those named in the Will of the deceased person, and (iii) the trustee, who is usually appointed by the deceased person s Will Share of income of the trust estate At Label W, Share of income of the trust estate the ATO are requesting that each beneficiary s share of the income of the trust estate that they are presently entitled to be recorded on the Statement of Distribution. In this regard, note that where the trustee has not streamed capital gains or franked dividends, the beneficiary s share of trust income is equal to the amount of trust income to which the beneficiary is presently entitled. However, the process of determining the beneficiary s share of trust income for this purpose is more complicated where the trustee has streamed capital gains and/or franked dividends. In this case, the amount disclosed at Label W will be the sum of any amounts of trust income to which the beneficiary was made specifically entitled (i.e., the amount of trust income that was streamed to the beneficiary), their share of capital gains and franked dividends to which no beneficiary was made specifically entitled (if any) and the amount of other trust income to which they are presently entitled (presumably as adjusted under Division 6E of the ITAA 1936). This figure is also supported by the inclusion of Item 53, Income of the trust estate, which was discussed earlier in this chapter entitled Taxing Trust Income Other labels Label L Credit for tax withheld foreign resident withholding Show each beneficiary s share of any credits for tax withheld from payments that are subject to foreign resident withholding under Subdivision 12-FB of the Taxation Administration Act The total of these amounts must equal the total amount of credit shown on the tax return at Item 6, Label U Credit for tax withheld foreign resident withholding and Item 8, Label U Share of credit for tax withheld from foreign resident withholding. Label N Australian franking credits from a New Zealand company Show each beneficiary s share of any Australian franking credits received from New Zealand companies under the Trans-Tasman regime (including any credits received via a partnership or another trust distribution). Refer to Division 220 of the ITAA 1997 for further details. National Tax & Accountants Association Ltd: August

160 Completing the Distribution Statement Labels A and B Share of income Show each beneficiary s share of income, separated into primary production income and nonprimary production income (except to the extent that the income is shown at other labels in Item 54). If the amount is a loss, print L in the LOSS box. A loss can only be shown here where it is part of an overall trust distribution, whereas an overall loss cannot be distributed. Label A Primary production The trust s primary production income can typically be obtained by referring to the amount disclosed at Item 5 Business income and expenses and Item 8 Partnerships and trusts of the trust return, less any primary production deductions. According to the ATO s 2016 trust return instructions, the amount at Label A, Primary production is worked out by multiplying the primary production income by the beneficiary s percentage share of the trust s income or, in the case where any beneficiary has been made specifically entitled to a part or all of a capital gain or franked dividend, their adjusted Division 6 percentage share. Label B Non-primary production The trust s non-primary production income is, prima facie, the amount disclosed at Item 26 Total net (taxable) income (less primary production income), and excluding the following amounts (because they are reported elsewhere on the Statement of Distribution): amounts attributable to capital gains (disclosed instead at Item 54, Label F); amounts attributable to franked dividends, including the attached franking credit (disclosed instead at Item 54, Label U and Label D see below); and foreign income (disclosed instead at Item 54, Label G and Label H). According to the ATO s 2016 trust return instructions, the amount at Label B, Non-primary production is worked out by multiplying the non-primary production income by the beneficiary s percentage share of the trust s income. Alternatively, in the case where any beneficiary has been made specifically entitled to all or part of a capital gain or franked dividend, their adjusted Division 6 percentage share of all other nonprimary production income, excluding franked distributions (which is disclosed at Label U) and capital gains (which is disclosed at Label F). Label C Credit for tax withheld where ABN not quoted Show each beneficiary s share of any credits for withholdings where an ABN was not quoted. The total of these amounts across all beneficiaries must equal, respectively, the sum of credits at Item 6, Label T Tax withheld where ABN not quoted and Item 8, Label C Share of credit for tax withheld where ABN not quoted. Label U Franked distributions Show at Label U the beneficiary s share of taxable franked dividends (including both the cash component and attached franking credits), regardless of whether or not their entitlement came about as a result of specific entitlement or a present entitlement or both. Note that the franking credit must also be separately disclosed at Label D, Franking credit. Label D Franking credit Show each beneficiary s share of any franking credits received by the trust. This amount across all beneficiaries must equal the sum of those at Item 8, Label D Share of franking credit from franked distributions and Item 12, Label M Franking credit and Item 23, Label D Australian franking credits from a New Zealand franking company. 150 National Tax & Accountants Association Ltd: August 2016

161 Completing the Distribution Statement TAX WARNING Passing the holding period rule for franking credits A beneficiary must be a qualified person to claim franking credits attached to dividends received in respect of shares held through a trust on or after 3pm AEST 31 December It is also necessary for the trustee of the trust to be a qualified person. However, where the shares are held in a discretionary trust, beneficiaries of the trust will generally fail the holding period rule (defined below) unless the trust has made a family trust election ( FTE ). See the chapter Other important trust issues for a further discussion on these elections. Broadly, a taxpayer (including a beneficiary) will be a qualified person if they held the shares at risk for at least 45 days (or 90 days for preference shares) during the qualification period. This is sometimes referred to as the holding period rule. The qualification period commences the day after the taxpayer acquires the shares (or an interest in shares) and ends on the 45 th day (or on the 90 th day for preference shares) after the day the shares or interests became ex-dividend. Therefore, for a beneficiary, the qualification period commences on the day after the day in which the beneficiary acquired interests in the shares through the trust (i.e., the day after the trust acquired the shares). A share or interest becomes ex-dividend on the day after the last day on which a shareholder is entitled to receive dividends on the shares. For example, if a company declares a dividend to be paid on shares held up to 25 June, the ex-dividend day is 26 June (and so the qualification period would end 45 days after that, i.e., on 10 August). However, if a discretionary trust has not made an FTE and distributes franked dividends to a beneficiary, the beneficiary can still be a qualified person if: (a) the beneficiary is an individual; and (b) the total franking credits received by the beneficiary from all sources in that income year are not above $5,000. It is important to note that franking credits received as a beneficiary in a trust (including a trust that has made an FTE) will count towards the $5,000 threshold. Label E TFN amounts withheld Show each beneficiary s share of any credits for withholdings on investment income for not quoting a TFN. The total of these amounts must equal the sum of Item 8, Label E Share of credit for TFN amounts withheld from interest, dividends and unit trust distributions and Item 11, Label I TFN amounts withheld from gross interest and Item 12, Label N TFN amounts withheld from dividends. If the trust has no net income, the TFN amounts must be shown at Label E under the column headed Income to which no beneficiary is presently entitled. Label O Share of credit for TFN amounts withheld from payments from closely held trusts Show at this label each beneficiary s share of credit for any amount withheld by the trustee of a closely held trust from a distribution made to the trust as a trustee beneficiary, where the trust did not provide its TFN. The share of credits is worked out by multiplying the amount of tax withheld by the beneficiary s percentage share of the trust income, or where capital gains or dividends have been streamed (beneficiaries made specifically entitled), by their adjusted Division 6 percentage share. National Tax & Accountants Association Ltd: August

162 Completing the Distribution Statement The total amounts of Label O should equal the sum of TFN amounts withheld on closely held trust distributions shown at Item 8 Partnership and trusts, Label O Credit for TFN amounts withheld from payments from closely held trusts. Note that where the trust distributing the income has been required to withhold under the TFN withholding rules itself as its own beneficiaries have failed to report their TFN, any amounts withheld should not be reported here but rather at Label T, Total TFN amounts withheld from payments. Further information on TFN withholding on payments from closely held trusts is provided below. Label F Capital gains Show each beneficiary s share of any net capital gain of the trust. The total of these amounts from each of the beneficiary s Statement of Distributions will generally equal the amount at Item 21, Label A Net capital gain. Note that the legislation that provides for the streaming of capital gains for tax purposes includes an option for eligible resident trustees to choose to be assessed on capital gains of the trust in certain circumstances. If this option applies, show that share of the trust's capital gains at Label Y under Item 55 - Choice for resident trustee to be assessed to capital gains on behalf of beneficiaries. Capital gains under which this choice has been made should only be shown at Item 55. TAX TIP Additional CGT information required by beneficiaries The beneficiary of a share of trust capital gains requires certain information to complete their own tax return, some of which can be obtained from the trust distribution statement. For beneficiaries of all trusts, the trustee should provide the following additional information: details of any net capital gains to which the small business 50% reduction was applied; the amount of any discount capital gains; and details of any capital gains from collectables. For taxpayers with an interest in a unit trust, the trustee should also provide details of any non-assessable payments, including any tax-exempt and tax-free amounts, small business CGT concessions applied, the amount of any tax-deferred amounts associated with the small business 50% reduction, frozen indexation, building allowance deductions and accounting differences in income. Refer to S (i.e., CGT Event E4). Label G Attributed foreign income Income of Australian residents that accumulates offshore and has not been subject to tax at rates comparable with Australia is taxed under the accruals system, which comprises the attribution rules. Under these rules, specified income of certain foreign entities is included in (i.e., attributed to) the taxpayer's assessable income. Show each beneficiary s share of any attributed foreign income in whole dollars only. The total Label G amounts must equal the sum of any attributed foreign income shown at Item 22 Attributed foreign income. 152 National Tax & Accountants Association Ltd: August 2016

163 Completing the Distribution Statement Label H Other assessable foreign source income Show each beneficiary s share of other assessable net foreign source income in whole dollars only. The total Label H amounts must equal the amount of net foreign source income shown at Item 23, Label V Net. Label I Foreign income tax offset Show each beneficiary s share of any foreign income tax offset entitlements. This amount from all of the statements of distributions must be the same as the amount at Item 23, Label Z Foreign income tax offset. Label R Share of National rental affordability scheme tax offset Show each beneficiary s share of the trust s entitlement (if any) to a Government incentive under the National Rental Affordability Scheme tax offset. The total of these amounts on all of the Statements of Distributions must equal the amount at Item 50, Label F National rental affordability scheme tax offset entitlement. NEW Label M Exploration credits distributed The Exploration Development Incentive (EDI) encourages shareholder investment in small exploration companies undertaking greenfields mineral exploration in Australia. The EDI enables eligible exploration companies to create exploration credits by giving up a portion of their tax losses from greenfields minerals expenditure and distributing these exploration credits to equity shareholders. Where a trust receives exploration credits, the trustee may pass the exploration credits to beneficiaries. To be entitled to benefit from exploration credits, the beneficiary must be an Australian resident for the whole of the income year. Show each beneficiary s share of exploration credits at new Label M Exploration credits distributed at Item 54. The trustee of the trust may be entitled to a relevant proportion of the exploration credit tax offset if the trustee is liable to pay tax because a beneficiary is under a legal disability or no beneficiary is presently entitled. The offset is only available if the trustee is taxed as if it were an Australian resident individual and the relevant beneficiary is also an Australian resident individual. A trustee is not entitled to the exploration credit tax offset to the extent that a beneficiary has already been made entitled to a share of the exploration credit. In these cases, show the trustee's entitlement at Label X Share of other refundable tax offsets at Item 54, Income to which no beneficiary is presently entitled and in which no beneficiary has an indefeasible vested interest, and the trustee s share of credit for tax deducted. NEW Label Y Small business income tax offset information Where the trust is a Small Business entity ( SBE ), show each beneficiary's share of the net small business income at Label Y Share of net small business income at item 54. Work this out by multiplying the trust's net small business income by the beneficiary's proportional share of the trust income. The concept of a trust s net small business income was discussed in the earlier chapter entitled Preparing the 2016 Trust Tax Return. This will assist the relevant individual beneficiaries of their entitlement to the Small Business Income Tax Offset ( SBITO ). Note that beneficiaries who are prescribed persons (i.e., under 18 years of age and not excepted persons) are not entitled to the offset. National Tax & Accountants Association Ltd: August

164 Completing the Distribution Statement Label J S.98(3) assessable amount If you have included an assessment code 139 (non-resident company beneficiaries) or 138 (nonresident individual beneficiaries) at Label V Assessment calculation code you must complete this Item and include an amount at Label J s98(3) assessable amount to ensure that the trustee can pay the appropriate amount of tax on the beneficiary s behalf. Where the trustee is assessable under S.98(3) of the ITAA 1936 in relation to a share of net income of a foreign resident company or individual beneficiary, show: the amount attributable to the period (if any) that the beneficiary was a resident, multiplied by the beneficiary s percentage share of the income of the trust; plus any amount from Australian sources that is attributable to the period the beneficiary was a non-resident multiplied by the beneficiary s percentage share of the income of the trust. Do not include income subject to withholding tax (such as unfranked dividends, interest and royalties), fully franked dividends or amounts on which managed investment trust withholding tax was payable. Where a non-resident corporate beneficiary s share of income includes part of a discounted capital gain, make certain that the amount included in assessable income is doubled so as to ensure the benefit of the discount is not passed to a corporate beneficiary which has no entitlement to the general 50% CGT discount. Also note that where a non-resident individual beneficiary s share of income includes part of a discounted capital gain, the ability to pass on the benefit of the 50% discount may be impacted where the capital gain has accrued after 8 May 2012 due to recent law amendments. Refer to new S and S Label K S.98(4) assessable amount If you have included an assessment code 140 (non-resident trustee beneficiary) at Label V Assessment calculation code you must complete this Item and include an amount at Label K s98(4) assessable amount to ensure that the trustee can pay the appropriate amount of tax on the beneficiary s behalf. Where the trustee is assessable under S.98(4) of the ITAA 1936 on behalf of a non-resident trustee beneficiary, show the amount of net (taxable) income attributable to Australian sources. Do not include income subject to withholding tax (such as unfranked dividends, interest and royalties), fully franked dividends or amounts on which managed investment trust withholding tax was payable. Where a non-resident trustee beneficiary s share of income includes part of a discounted capital gain, make certain that the amount included in assessable income is doubled so as to ensure the benefit of the discount is not passed to a non-resident trustee beneficiary which has no entitlement to the general 50% CGT discount. TAX WARNING Foreign resident beneficiaries Additional information about non-resident beneficiaries must be provided to the ATO if a beneficiary presently entitled to a share of the income of the trust was a non-resident at any time during the income year (i.e., Yes was indicated at Item 29, Label A). 154 National Tax & Accountants Association Ltd: August 2016

165 Completing the Distribution Statement In particular, the trustee is required to show clearly in a separate schedule, full details of a non-resident beneficiary s share of the net (taxable) income of the trust from all sources, details of any withholding and contact details. Refer to the 2016 trust return instructions for further details of what information should be specifically disclosed Trustee Beneficiary (TB) Statements If the trust is a closely held trust and has made a distribution of tax preferred or untaxed income to another trust (a trustee beneficiary), print X at the Yes box (above) in Item 54 to indicate that the trust will be required to make a Trustee Beneficiary (TB) statement. If the trust is not a closely held trust, and/or the trust is not making a distribution to another trust, then print X at the No box on the Statement of Distribution. TAX TIP No trustee beneficiary = no TB statement Where the trust in question has not made a distribution to another trust as a beneficiary, there will be no need to consider making a TB statement. If this is the case, simply print X in the No box (above) in Item 54. Note, however, if the trust is a closely held trust, it will most likely have to consider its reporting obligations under the TFN reporting rules and the annual trustee payment report (discussed below). According to the ATO, it uses this information to check whether the trustee beneficiary s assessable income includes the correct share of the trust s net income, and that its net assets reflect the receipt of any tax-preferred amounts. If a trustee fails to provide the relevant details of trustee beneficiaries by lodging a correct TB statement, it will be liable to pay the Trustee Beneficiary Non-disclosure Tax (TBNT) at 49%. Under S.102UC of the ITAA 1936, a closely held trust is either a discretionary trust, or a trust where up to 20 individuals have between them, directly or indirectly, fixed entitlements to at least National Tax & Accountants Association Ltd: August

166 Completing the Distribution Statement 75% of the income or capital of the trust, but does not include an excluded trust (as defined in that section). Excluded trusts (who are not required to comply with the TB statement measures) include: a trust covered by a Family Trust Election ( FTE ) or an Interposed Entity Election ( IEE ); a unit trust whose units are listed on the stock exchange; a complying superannuation fund, approved deposit fund or pooled superannuation trust; a deceased estate (up to the 5 th anniversary); a trust that forms part of a family group (refer to the chapter Other important trust issues for a further discussion on the definition of a family group ); or a fixed unit trust where tax-exempt entities have fixed entitlements. For the 2016 trust tax return, you make a Trustee Beneficiary (TB) statement (if required) by completing the Statement of Distribution in full for each trustee beneficiary including the beneficiary details and the TB statement information at Labels P and Q, providing details of trustee beneficiaries that are presently entitled to certain income of the trust and tax-preferred amounts. Label P - Tax preferred amounts According to the ATO trust return instructions, a tax-preferred amount is an amount of trust income of the trust that is not included in the assessable income of the trust in working out its net (taxable) income, or an amount of trust capital. Relevant examples include things such as a distribution of trust capital (as per the example 11.3 in Appendix 11 of the ATO s 2016 trust income tax return instructions) or income of the trust for trust law purposes that is not included in the trust s net (taxable) income. This could include things such as: capital gains not included in the trust s assessable income (e.g., pre-cgt gains); return of trust capital to unit holders or beneficiaries; non-assessable non-exempt income; exempt income; or any excess of trust law income over the same trust s tax law income, identified via the reconciliation process. Label Q - Untaxed part of share of net income Again according to the ATO s 2016 trust return instructions, the untaxed part of a share of net income is the trustee beneficiary s share of the net income of the trust less any part that has been taxed under: subsection 98(4) of the ITAA 1936 (with respect to non-resident trustee beneficiaries); Subdivision 12-H of Schedule 1 in the TAA Act 1953 (distributions from managed investment trusts); and trustee beneficiary non-disclosure tax in respect of which the trustee of another trust estate is liable to pay the non-disclosure tax. It is contemplated that this label would include any amounts of the net (taxable) income assessable to beneficiaries (apart from income subject to the provisions above) as a result of any distribution of trust income. Effectively it is income that will be taxed to the beneficiary, as none of the above listed provisions have applied to the distribution. According to the ATO s 2016 trust return instructions, the untaxed part of a share of net income includes interest, dividends or royalties that have been subjected to a withholding tax if these amounts are included in the assessable income of a non-resident trustee beneficiary. 156 National Tax & Accountants Association Ltd: August 2016

167 Completing the Distribution Statement EXAMPLE 1 Untaxed part of a share of the net income The Blue Trust is a discretionary trust and is a closely held trust subject to the trustee beneficiary reporting rules. It has 2 trustee beneficiaries, namely Purple Trust (an Australian resident) and Yellow Trust (a non-resident for Australian tax purposes). Purple Trust s share of Blue Trust s net income is $3,000. Yellow Trust s share of Blue Trust s net income is $10,000 (all attributable to Australian sources). As Yellow Trust is a non-resident, Blue Trust is assessed and liable to pay tax on behalf of Yellow Trust s share of the net income ($10,000) under S.98(4) of the ITAA Therefore, the trustee of Blue Trust does not need to make a TB statement with respect to Yellow Trust s share of its net income as its share has been subject to tax already and therefore is not an untaxed part. A correct TB statement must, however, be made for Purple Trust due to the fact that its share of Blue Trust s net income is an untaxed part of a share of the net income Annual trustee payment report information (TFN reporting rules for closely held trusts) This section of the Statement of Distribution is to be completed by all resident closely held trusts (including family trusts who have made an FTE) where they are subject to the TFN withholding rules that commenced from 1 July The key features of the TFN withholding rules require trustees to: 1. Lodge an Annual trustee payment report containing details of all payments made to beneficiaries (lodged by completing the relevant trust tax return and Statement of Distribution as discussed below). 2. Withhold at 49% where a beneficiary to whom a payment is made fails to report their TFN to the trustee. Where such withholding occurs, the trustee must lodge an Annual TFN withholding report. 3. Lodge a separate TFN report (separate to the trust return Statement of Distribution) every time a new beneficiary reports their TFN to the trustee (subject to transitional rules). The TFN withholding rules apply to most resident closely held trusts, although a number of trusts are excluded trusts and therefore are not required to comply with these measures. Such excluded trusts include: a complying superannuation fund, approved deposit fund or pooled superannuation trust; a deceased estate (up to the 5 th anniversary); a non-resident trust; a unit trust that is listed in the Australian stock exchange and certain unit trusts (including a cash management or property trusts that are subject to existing TFN withholding rules); National Tax & Accountants Association Ltd: August

168 Completing the Distribution Statement employee share trusts, law practice trusts regulated by a state or territory law, and a discretionary mutual fund; and a fixed unit trust where tax-exempt entities have fixed entitlements. In addition, certain beneficiaries are also excluded from these rules including: beneficiaries under a legal disability (e.g., minors); non-resident beneficiaries; a beneficiary for which the trust is liable to pay family trust distribution tax, as the beneficiary is outside the specified family group; a trustee beneficiary where the trustee of the first trust is subject to the trustee beneficiary reporting rules (required to make a TB statement), and certain exempt entities. 1. Annual Trustee Payment Report Labels S and T (along with the relevant details of the beneficiary and their respective trust distribution) are effectively the required Annual Trustee Payment Report, which includes details of all payments made to each beneficiary for the income tax year, even where those beneficiaries have quoted their TFNs and the trustee in question is under no withholding obligations (discussed below). Label S - Distribution from ordinary or statutory income during income year Based on ATO examples and comments in their document TFN withholding for closely held trusts and the 2016 trust return instructions, this label is required to be completed where the trust has made one or more physical distributions during the income year that includes amounts of ordinary or statutory income of the trust for that year, but only to the extent that these distributions exceed the beneficiary s share of the net (taxable) income for that same income year. The 2016 trust return instructions require that only the excess of the physical distribution over the beneficiary s share of the net income of the trust be included at Label S. This is usually because of differences between the share of the beneficiary s net (taxable) income and trust income, where the beneficiary has effectively received a tax-free physical distribution from the trust during the year. Accordingly, the NTAA would argue that any payments made in respect of a prior year unpaid present entitlement would not, in themselves, trigger a requirement to report the paid amount at Label S. Label T - Total TFN amounts withheld from payments Show amounts actually withheld from all payments or distributions to the beneficiary where their TFN was not provided to the trustee (as discussed below). The 2016 trust return instructions request that a trustee not include amounts at Label T for any of the beneficiary s share of amounts that were reported at Item 8 (Partnership and trust distributions to the trust) Label O, credit for TFN amounts withheld from payments from closely held trusts. These are included instead at Item 54 at Label O. The following example is adapted from Example 11.1 contained in Appendix 11 of the ATO s 2016 trust income tax return instructions. 158 National Tax & Accountants Association Ltd: August 2016

169 Completing the Distribution Statement EXAMPLE 2 Completing the Annual trustee payment report The Hill family trust derived $12,000 of interest income and $10,000 of rental income for the 2016 income tax year. It is a closely held trust that has made an FTE (so subject to the beneficiary TFN reporting rules). The net income of the trust = $20,000 This is comprised of $22,000 income minus $2,000 deductions of $1,000 capital allowance (Div 43) and $1,000 other rental expenses. The trust income of the trust = $21,000 This is comprised of $22,000 income minus only the $1,000 worth of rental expenses. The $1,000 capital allowance, according to the trust deed, is chargeable against capital and therefore cannot be taken into account with respect to the trust income calculation. During the year, the $12,000 worth of interest income is physically distributed to Jill (relying on the streaming clauses in the trust deed). Note the streaming of the interest income may still be possible for trust law purposes, but not effective for tax law purposes, as will be demonstrated below when determining Jill s share of the net (taxable) income of the trust. At the end of the year, Jack and Henry are made presently entitled in equal shares to the income of the trust that has not been previously distributed. These amounts remain unpaid as at year end. Jill (who quoted her TFN to the trustee) has a share of net income of $11,428 (12,000/21,000 (trust income) x $20,000 (net (taxable) income)). To complete a correct Annual trustee payment report, the Hill family trust will need to include $11,428 at Label B, Non-primary production and include $572 at Label S, Distribution from ordinary or statutory income during income year (being the difference between the amount distributed to her and her share of the net income ($12,000 minus $11,428). Jack (who quoted his TFN to the trustee) has a share of net income of $4,286 (4,500/21,000 (trust income) x $20,000 (net (taxable) income)). To complete a correct Annual trustee payment report, the Hill family trust will need to include $4,286 at Label B, Non-primary production and include nothing at Label S, Distribution from ordinary or statutory income during income year. Henry (who has not quoted his TFN to the trustee) has a share of net income of $4,286 (4,500/21,000 (trust income) x $20,000 (net (taxable) income)). To complete a correct Annual trustee payment report, the Hill family trust will need to include $4,286 at Label B, Non-primary production and include nothing at Label S, Distribution from ordinary or statutory income during income year, and complete Label T, Total TFN amounts withheld from payments for the amount withheld of $2,100 (rounded) ($4,286 x 49%). If the facts were changed slightly where Jack receives no distribution at all, but rather, Jill and Henry are made presently entitled in equal shares ($4,500 each) to the income of the trust that has not been previously distributed then, while Henry s disclosure requirements would stay the same, Jill s would be adjusted as follows: National Tax & Accountants Association Ltd: August

170 Completing the Distribution Statement Jill would now have a share of net income of $15,714 ((12, ,500)/21,000 x $20,000). To complete a correct Annual trustee payment report for Jill, the Hill family trust will need to include $15,714 at Label B, Non-primary production and include nothing at Label S, Distribution from ordinary or statutory income during income year (as the $12,000 distribution for the year does not exceed her share of net income of $15,714). 2. Withholding obligations A trustee of a closely held trust (the definition is discussed above) is required to withhold at 49% of a beneficiary s share of net (taxable) income unless a beneficiary has provided their TFN to the trustee by the earlier of the physical distribution or by year-end. Withholding is required with respect to both physical distributions and any resolution making a beneficiary presently entitled. The obligation to withhold is triggered at the earliest of any actual distribution to a relevant beneficiary or when they are made presently entitled (generally at year end). Where a trustee is required to withhold under these rules, they must lodge an Annual TFN withholding report containing details of all payments subject to withholding. Additional administrative requirements include the registration for PAYG withholding, the provision of a payment summary to the relevant beneficiary and payment of the amounts withheld to the ATO. If a trustee does have a withholding obligation, they need to remit the amounts annually to the ATO (the normal PAYG withholding remittance cycles do not apply for the purposes of these rules). Any amounts withheld need to be remitted to the ATO by the 28 th day of the month following the month in which the Annual TFN withholding report is due to be lodged, which is generally the 28 th of October. TAX WARNING Additional PAYG registration is required If you are already registered for PAYG withholding for other reasons, you will still need to register for PAYG withholding for closely held trust purposes. Existing PAYG withholding registration for employment or other reasons cannot be used for closely held trust purposes. Beneficiaries can claim a credit in their income tax return equal to the amounts that have been withheld and remitted by the trustee to the ATO. TAX TIP Avoid withholding on distributions by quoting a TFN To avoid triggering a TFN withholding obligation, trustees of closely held trusts and family trusts should ensure that all beneficiaries or potential beneficiaries have quoted their TFN before a distribution is made to them, or before they are made presently entitled to trust income. When trustees obtain a TFN from a beneficiary, there are specific reporting requirements in the form of a TFN report that a trustee must comply with (which is discussed further below). 160 National Tax & Accountants Association Ltd: August 2016

171 Completing the Distribution Statement 3. TFN report (lodged separately from the trust return) Where a beneficiary has quoted their TFN to the trustee in order to avoid the TFN withholding referred to above, the trustee must lodge a TFN report, due on the last day of the month following the end of the quarter in which the TFN was quoted. These reports can be lodged either using a paper version of the TFN report (NAT 73651) or by lodging electronically. If a trust has no new TFNs to report for a particular quarter, then there is no need to lodge the report. EXAMPLE 3 When to lodge a TFN report Siobhan is a beneficiary of the Sov. Hill discretionary trust, which is a closely held trust that has made a family trust election a number of years ago. Siobhan provides her TFN to the trustee of the Sov Hill discretionary trust on the 4 th of July As a result, the trustee of the Sov. Hill discretionary trust will need to lodge a TFN report by the 31 st of October Due to the heavy administrative burden surrounding the collection and more importantly the reporting of each beneficiary s TFN, when these rules were introduced from 1 July 2010, transitional TFN reporting rules were made available for the 2011 income tax year obligations. In particular, a trustee who had an obligation to lodge a TFN report for the 2011 tax year could satisfy the relevant TFN reporting requirements by disclosing the TFN and relevant details of beneficiaries on the Statement of Distribution for the 2010 trust return (rather than lodging a separate TFN report). A further extension was subsequently given to the 2011 income tax year obligations subsequent to this, by requiring that where the 2010 return did not satisfy the relevant requirements for a beneficiary, an annual TFN report could be lodged by: 31 August 2011 for paper lodgers; and the due date of the 2011 trust return for electronic lodgers (generally 15 May 2012). It is important to note that these transitional rules did not extend the time for a beneficiary to provide their TFN to the trustee, but rather it simply extended the time the trustee has to report these TFNs to the ATO. TFNs quoted to the trustee from the 2012 income year and beyond obviously cannot rely upon the 2011 reporting obligation transitional rules discussed above, and as a result trustees should ensure that they lodge any required TFN reports on the quarterly basis. TAX WARNING Dealing with new trust clients When taking on new trust clients that are potentially subject to the TFN withholding regime, it may be difficult to ascertain whether the trustee has correctly reported beneficiary TFNs as there is currently no ATO database that could be used to check this information. In many cases, it will be possible for the new accountant to obtain a copy of the 2010 trust tax return and/or the TFN report lodged with the 2011 trust tax return in order to ascertain which beneficiary s have been covered by the transitional rules discussed above. In the absence of such information, it may be prudent for an agent to adopt a conservative approach for the new client and simply obtain (and report) all relevant TFN s of beneficiaries (and potential beneficiaries) and report them to the ATO. Such a strategy should ensure you protect your clients from committing an offence under the Tax Administration Act and potential fines. National Tax & Accountants Association Ltd: August

172 Completing the Distribution Statement Notes 162 National Tax & Accountants Association Ltd: August 2016

173 A Beneficiary s Perspective A BENEFICIARY S PERSPECTIVE National Tax & Accountants Association Ltd: August

174 A Beneficiary s Perspective Notes 164 National Tax & Accountants Association Ltd: August 2016

175 A Beneficiary s Perspective A Beneficiary s Perspective As noted previously, a trust is not a separate legal entity and, subject to a number of specific exceptions (e.g., the trust is a corporate unit trust or a public trading trust), is not itself a tax paying entity. Rather, the income tax laws relating to trusts operate to tax either the trustee or beneficiary of the trust on the net income of the trust in the year the net income is derived. (a) Taxation of beneficiaries Generally speaking, trust income that is distributed to a beneficiary and which results in the net income of the trust being included in the assessable income of a beneficiary, is not taxed separately in the hands of the trustee, subject to certain exceptions (refer below). Trust distributions are generally assessable to a beneficiary in the year the beneficiary is made presently entitled to a share of trust income (or specifically entitled, as the case may be, in relation to streamed capital gains and franked dividends). The way in which distributions from trusts are shown in a beneficiary s tax return depends on the different components making up the distribution (such details are usually provided by the trustee in the Statement of Distribution, as discussed above). Where an amount of net income is included in a beneficiary s assessable income, it is added to the beneficiary s other assessable income and, after subtracting all relevant deductions, the balance constitutes the beneficiary s taxable income for which they are liable for tax (i.e., before relevant credits and tax offsets). For example, where the beneficiary is: A resident individual: the beneficiary generally must pay tax at the marginal rates applicable to the individual. A resident company: the applicable corporate tax rate will apply. A trustee of another resident trust: the distributions of the trustee beneficiary will generally determine where the tax liability will fall. (b) Taxation of trustees Where no beneficiary is presently entitled to the whole or part of the income of the trust, the liability to pay tax in respect of that share of the trust s net (taxable) income falls on the trustee. Refer to S.99 and 99A. However, in certain circumstances, despite a beneficiary (or beneficiaries) being presently entitled to the whole or part of the income of the trust, the liability to pay tax in respect of the distributed trust income falls (at least in the first instance) on the trustee and not the beneficiary. Common examples of where the trustee is liable to pay tax despite the beneficiary being presently entitled include: A beneficiary who is presently entitled to a distribution of trust income but is under a legal disability (e.g., a minor) refer to S.98(1). A non-resident beneficiary who is presently entitled to a distribution of trust income refer to S.98(2A), (3) and (4). The trustee is liable to pay tax on trust income in their capacity as trustee of the trust and, as such, the trustee is entitled to retain sufficient funds from trust income to pay the tax liability. National Tax & Accountants Association Ltd: August

176 A Beneficiary s Perspective 1. Distributions to resident individuals Generally, if an individual is assessable on a share of net income from a trust, the amount of the distribution is shown at Item 13 Partnerships and trusts of the 2016 income tax return (reproduced below) where 2016 is the income year in which the individual became presently entitled to the trust income, rather than when the distribution was actually received by, credited to, or applied on behalf of the individual. There are three components to Item 13, which broadly are completed as follows: (a) Distribution of income from primary production ( PP ) activities An income averaging (or smoothing ) system applies to individuals carrying on a PP business, which spreads their taxable income over five income years to ensure they do not pay more tax than another individual deriving a comparative, but steady, income from non-pp activities. For the purpose of these averaging rules, an individual who is presently entitled to a share of trust income that includes PP income (or a PP loss, where the loss is part of an overall distribution of income by the trust) is taken to be carrying on the PP business of the trust. 166 National Tax & Accountants Association Ltd: August 2016

177 A Beneficiary s Perspective As such, their share of the PP income or loss is shown at Label L of Item 13. In the case of a loss, write L in the box at the right of Label L. TAX TIP Averaging rules may apply even if no distribution is made Where an individual is a beneficiary of a trust that carries on a primary production business but makes an overall net loss for an income year, the individual may still be eligible to apply the averaging rules (i.e., even though the beneficiary was not required to include anything at this label). To ensure an individual in these circumstances is assessed correctly, write 0 (i.e., zero) at Label L. Refer to S (3) and S of the ITAA (b) Distribution of income from non-primary production ( non-pp ) activities Show an individual s share of any non-pp income (or a non-pp loss that forms part of an overall income distribution by a trust), excluding any net capital gains, franked distributions distributed from a trust to the beneficiary or foreign income (see below), at Label U of Item 13. An individual s share of franked distributions (including any attached franking credits) from a trust is included separately at Label C of Item 13. Note that the amount of franking credit should still be reported separately at Label Q Share of franking credit for franked distributions. If the amount is a loss, write L in the box at the right of Label U. Where a distribution includes other assessable income (such as a net capital gain), the amount of any non-pp losses shown at Label U must be reduced by these amounts, as they will be taken into account when determining other sections of the return (refer below). (c) Share of net small business income For the 2016 income year, new Label E Trust share of net small business income less deductions attributable to that share has been inserted as a result of new reporting obligations relating to an individual s eligibility to the Small Business Income Tax Offset ( SBITO ), which is often referred to as the unincorporated SBE 5% tax discount. An individual s proportionate share of an SBE trust s total net small business income will be required to be reported at Label Y Share of net small business income in the relevant statement of distribution at Item 54 of the 2016 trust return. In addition, the SBE trust s total net small business income is reported at Label V Net small business income of Item 5 of the 2016 trust return. The figure at Label Y of the relevant Statement of Distribution will then be transposed to Label E of Item 13 of the relevant individual beneficiary s 2016 individual tax return, only after being reduced by any available deductions the individual beneficiary has that are attributable to the trust distribution (e.g., interest deductions on a loan used to purchase units in a unit trust). The ATO will then use this information to calculate the individual beneficiary s entitlement to the small business income tax offset. (d) Share of credits from income and/or tax offsets If the trust has had tax withheld or otherwise became entitled to tax credits, it can generally pass on the benefit of these credits when it distributes the income of the trust. The beneficiary s share of credits and offsets are recorded as follows: Show at Label P, the beneficiary s share of credits for tax withheld because of the trust s failure to quote an ABN. Show at Label Q, the beneficiary s share of any franking credits (other than Australian franking credits from a New Zealand company show these at Item 20, Label F) that may be claimed as a franking tax offset. Broadly, a beneficiary is entitled to a franking tax offset if both the beneficiary and the trustee are qualified persons in relation to the dividend. Show at Label R, the beneficiary s share of any TFN withholding tax deducted from interest, dividends or unit trust distributions received by the trust. National Tax & Accountants Association Ltd: August

178 A Beneficiary s Perspective Show at Label M, the beneficiary s credits for TFN amounts withheld from payments from closely held trusts. These credits will generally arise in cases where the beneficiary has not quoted their TFN to the trustee by the time they are made presently entitled to income of the trust. Show at Label S, the beneficiary s share of any tax paid by the trustee on their behalf. Show at Label A, the beneficiary s share of any amounts withheld under the foreign resident withholding provisions or from a managed investment trust fund payment. Show at Label B, the beneficiary s share (if any) of the National Rental Affordability Scheme tax offset claimed by the trust. Details regarding a trust distribution may be provided in a statement received from the trustee (such as in the case of managed funds) or, where the trust is a related entity of the beneficiary, may be found in the trust s tax return (specifically, in the Statement of Distribution) or requested from the tax practitioner who attends to the preparation of the trust s income tax return. A beneficiary may be entitled to claim certain deductions they have personally incurred in deriving their trust distribution (e.g., interest on borrowings used to acquire units in a unit trust). Allowable deductions should be claimed at Label X (for deductions relating to PP income distributions) or Label Y (for deductions relating to non-pp income distributions and franked distributions). Labels I and J (deductions for land care operations, water facilities, fencing asset and fodder storage assets) do not apply to trust beneficiaries. TAX WARNING Exclusion of certain types of income from Item 13 Certain income distributed from a trust is subject to special rules and must be reported elsewhere on the beneficiary s I return. In particular, do not include the following at Item 13: (a) any foreign income from a trust (include this at Item 19 Foreign entities or Item 20 Foreign source income and foreign assets or property); (b) a net capital gain from a trust (include this at Item 18 Capital gains) refer below; (c) income from a public trading or corporate unit trust (show at Item 11 Dividends); (d) that part of a distribution on which Trustee Beneficiary Non-disclosure Tax or Family Trust Distribution Tax ( FTDT ) has been paid. Note that, for Medicare levy purposes, an FTDT amount must be shown at Item A4 Amount on which family trust distribution tax has been paid); (e) any personal services income ( PSI ) attributed from a trust (show this at Item 9 Attributed personal services income). When reporting trust distributions in the I Return, the ATO has identified three areas in which errors are typically made. These are: the reporting of a net capital gain from a trust; the receipt of non-assessable amounts from a trust; and the reporting of PSI attributed from a trust. The following discussion briefly focuses on the correct reporting of these items on the I Return. 1.1 Recording a net capital gain distributed by a trust If an individual is entitled to a share of net income from a trust that includes a net capital gain, do not show the beneficiary s share of the trust s net capital gain at Item 13 (although the balance of any additional distributions should still be reported at Item 13, as discussed above). 168 National Tax & Accountants Association Ltd: August 2016

179 A Beneficiary s Perspective Instead, the beneficiary is treated as having made a capital gain that must be taken into account, along with any other directly triggered capital gains of the beneficiary, in order to calculate the beneficiary s overall net capital gain (if any) to be reported at Item 18 Capital gains of their individual tax return. Where the trust s capital gain was reduced by the 50% general CGT discount and/or the small business 50% active asset reduction, the beneficiary s share of the trust capital gain must be grossed-up in accordance with the special rules in Subdivision 115-C. This effectively requires the reversal of any CGT discounts claimed by the distributing trust. It is these grossed-up amounts of the beneficiary s share of the trust capital gain that must be included (along with any other capital gains) at Label H Total current year capital gains. In working out the beneficiary s net capital gain, the beneficiary will firstly apply their own capital losses against their total gross capital gains (i.e., including their share of the trust s gain grossedup ). This amount is then reduced by the 50% general CGT discount and/or the small business active asset reduction where applicable (e.g., a beneficiary s (grossed-up) share of a capital gain after capital losses is reduced by the 50% general CGT discount and/or the 50% active asset reduction if these concessions were claimed at trust level). Note a corporate beneficiary is not permitted to utilised the 50% general CGT discount and a nonresident individual may have their access reduced or removed, depending on the timing of the CGT event in the hands of the distributing trust. If the beneficiary has an overall net capital gain, this amount is shown at Item 18, Label A Net capital gain in the individual tax return. A net capital loss cannot be deducted against other (non capital gain) assessable income, but is instead carried forward to offset against any gross capital gains derived by the beneficiary in subsequent income years. Show the amount of a net capital loss for the year at Item 18, Label V Net capital losses carried forward to later income years. Note, however, a net capital loss at the trust level cannot be utilised by a trust beneficiary. Such a net capital loss is carried forward by the trust to be offset against the trust s future capital gains Reporting a net capital gain distributed with a revenue loss Situations may arise where the net income of a trust will include a net capital gain as well as a revenue loss (e.g., a loss from a rental property). If the revenue loss is greater than the net capital gain, the trust will have an overall tax loss (which cannot be utilised by a trust beneficiary refer above). However, where a trust s net capital gain exceeds revenue losses made, the trust will still have net income (i.e., taxable income). In this case, based on instructions provided by the ATO, certain mechanisms exist to ensure that in most instances the relevant beneficiaries are not assessed on more than the total taxable income of the trust. The reporting of a beneficiary s share of the net income of the trust will depend on the type of loss incurred by the trust in addition to its capital gain. (a) Where a trust distribution solely comprises a net capital gain and a non-primary production (non-pp) loss. The ATO requires Item 13 and Item 18 to be completed as follows: (i) Record 0 (i.e., zero) at Item 13, Label U. National Tax & Accountants Association Ltd: August

180 A Beneficiary s Perspective (ii) Include the grossed-up amount of the remaining net capital gain (reversing the impact of the general 50% discount and/or the 50% active asset reduction if applied) received from the trust after reducing the net capital gain by the amount of the non-pp revenue loss, at Item 18, Label H Total current year capital gains. This amount will be taken into account in calculating the beneficiary s own net capital gain (reported at Label A). EXAMPLE 1 Capital gain distributed with a non-pp loss David s distribution statement for the 2016 income year shows $7,000 as his share of the net income of a trust. This amount comprises a non-primary production loss of $3,000 and a net capital gain of $10,000 (after the trust applied the 50% general CGT discount). David has no other capital gains for the year, but he made a $2,000 capital loss on the sale of shares. The reduced net capital gain of $7,000 (i.e., $10,000 $3,000 non-pp loss) received from the trust must be grossed-up to $14,000, as the trust applied the general CGT discount. This is reduced to $12,000 after deducting David s capital losses, and then to $6,000 after reapplying the general discount. Therefore, David s 2016 tax return will be completed as follows: show non-pp of 0 at Item 13 (Partnerships and trusts), Label U; show total current year capital gains of $14,000 at Item 18 (Capital gains), Label H, and show a net capital gain of $6,000 at Item 18 (Capital gains), Label A. (b) Where a trust distribution comprises a net capital gain and a PP loss In this case, the ATO requires Item 13 and Item 18 to be completed as follows: (i) Record the beneficiary s share of the PP loss at Item 13, Label L for the purpose of accessing the primary production averaging rules; and (ii) Include a sufficient amount of the trust s net capital gain at Item 13, Label U to ensure that the PP loss at Item 13, Label L is fully absorbed (i.e., so that the net amount included at Item 13 is zero ). The grossed-up amount of any remaining net capital gain must be included at Item 18, Label H, and will be taken into account in calculating the beneficiary s own net capital gain (to be reported at Item 18, Label A). EXAMPLE 2 Capital gain distributed with a PP loss Debbie s distribution statement for the 2016 income year shows that her share of the net income of a trust is $2,000. This amount is comprised of a primary production loss of $5,000 and a net capital gain of $7,000. The trust did not apply the 50% general CGT discount. Debbie has no other capital gains or losses for the year. Therefore, Debbie s 2016 tax return will be completed as follows: show a PP loss of $5,000 at Item 13 (Partnerships and trusts), Label L; show non-pp income of $5,000 at Item 13, Label U (i.e., sufficient net capital gain (i.e., $5,000) to offset the PP loss); show the remaining net capital gain of $2,000 (i.e. $7,000 $5,000 shown at Item 13, Label U) at Item 18 (Capital gains), Label A and current year capital gains of $2,000 at Item 18, Label H. 170 National Tax & Accountants Association Ltd: August 2016

181 A Beneficiary s Perspective 1.2 Dealing with tax-free distributions from a unit trust Some trusts (generally, fixed trusts or unit trusts, including managed funds) may distribute nonassessable amounts (e.g., a pre-cgt profit or an amount shielded from tax under the Division 43 capital works rules) to a beneficiary of the trust. Broadly, non-assessable amounts are not included in the beneficiary s income, but may reduce the cost base of their units or interest in the trust and, therefore, may affect any capital gain or loss made on the eventual disposal of the units or interest. Non-assessable payments generally do not affect beneficiaries of a discretionary trust. Refer to TD 2003/28. If the cost base of the units or interest is reduced below zero in the year the non-assessable amount is paid, the excess is treated as an assessable capital gain of the taxpayer (i.e., CGT event E4 occurs). The capital gain may be reduced under the 50% general CGT discount and/or the CGT small business concessions if the conditions for those concessions are met. A taxpayer cannot make a capital loss from CGT event E4. Refer to S Not all non-assessable amounts paid by a unit trust or a fixed trust reduces the cost base of the taxpayer s units or interest in a trust. That is, certain non-assessable amounts paid by a trust flow through to the taxpayer tax-free. These amounts are often described as tax-exempted amounts or tax-free amounts and include, for example, distributions of an amount representing the 50% general CGT discount. Refer to S Amounts that do reduce the cost base of a taxpayer s units or interest in the trust are often referred to as tax-deferred amounts (e.g., amounts attributable to the Division 43 capital works write-off and/or the small business 50% active asset reduction). EXAMPLE 3 Dealing with non-assessable amounts Sandy owns all the units in the Beach Unit Trust. The units have a cost base of $10,000. In April 2016, the trust made a capital gain of $20,000 from the sale of a rental property that was reduced to $10,000 after applying the 50% general CGT discount. In June 2016, the trust distributed (and paid) $25,000 to Sandy, comprised of the following: (a) An assessable net capital gain of $10,000 from the sale of the property This amount must be taken into account at Item 18 Capital gains of Sandy s 2016 tax return; (b) A tax-free amount of $10,000 in relation to the 50% general CGT discount claimed by the trust This amount does not reduce the cost base of Sandy s units and is not required to be reported on her 2016 income tax return; and (c) A tax-deferred amount of $5,000 in relation to Division 43 building write-off amounts claimed by the trust This amount reduces the cost base of Sandy s units from $10,000 to $5,000. As the cost base is not reduced below zero, CGT event E4 does not result in a capital gain. Furthermore, the $5,000 non-assessable amount is not reported on Sandy s 2016 tax return. If the tax-deferred amount were $15,000 (instead of $5,000), CGT event E4 would result in a capital gain, as that non-assessable amount would reduce the cost base of the units to below zero. As a result, a capital gain of $5,000 (i.e., $15,000 $10,000 cost base) would have to be taken into account at Item 18 Capital gains of Sandy s 2016 tax return. Assuming Sandy has held the units in the Beach Unit Trust for more than 12 months, the CGT 50% general CGT discount will generally apply to the applicable capital gain. National Tax & Accountants Association Ltd: August

182 A Beneficiary s Perspective 1.3 Correctly reporting PSI attributed from a trust Special rules apply in relation to the tax treatment of personal services income ( PSI ) received by a trust, company or partnership (referred to as a personal services entity, or PSE ) that aim to prevent an individual alienating their own PSI by interposing the entity between themselves and the recipient of the services. Broadly, where these rules apply, PSI (less certain allowable deductions) received by a PSE is attributed to the individual who performed the services (i.e., the PSI is included in the individual s own income, and excluded from the business income of the relevant entity), unless the entity derived the income by conducting a personal services business ( PSB ), or the income was promptly paid to the individual as salary or wages. The amount of PSI attributed from a PSE (e.g., a trust) is assessable income of the individual and must be shown at Item 9, Label O Attributed personal services income (rather than at Item 13). Furthermore, the amount of any tax withheld from the attributed income should be shown in the box at the left of Label O. This information can generally be obtained from a PAYG payment summary Business and personal services income (NAT 72545), provided by the PSE. Personal services income that must be attributed to an individual taxpayer is effectively excluded from the net income of the trust via the income reconciliation Labels A and B in Item 5 (Business and income expenses) of the trust return. In addition, a trustee will be required to complete Item 30 of the trust return, indicating if the trust is a PSB (where no formal attribution is required) or not. If a PSE (e.g., a trust) has a net PSI loss, the amount of the loss is also effectively attributed to the individual who provided the services. The individual may use the net PSI loss to reduce their other assessable income, including any non-psi income. A net PSI loss should be claimed at Item D15, Label J Other deductions of the I Return. 2. Distributions to minors Minors (individuals under 18 years old as at 30 June) may be seen as ideal beneficiaries for a share of a trust s income, as often they will be subject to a lower marginal rate. Unfortunately, however, the tax legislation includes special rules that apply in calculating the tax payable on the income of a minor (referred to as a prescribed person ), so as to ensure that minors are not utilised as a tax minimisation tool. In particular, Division 6AA of Part III of the ITAA 1936 heavily discourages income splitting between adults and minors by taxing certain unearned income of a minor, technically known as Eligible Taxable Income ( ETI ), at penalty rates. The applicable Division 6AA resident rates (inclusive of the temporary budget repair levy) applicable to a trustee under S.98(1) for the 2016 income year are as follows: Division 6AA unearned Income (i.e., Eligible Taxable Income ) 2016 resident tax rates $0 $416 Nil $417 $1,307 68% of the excess over $416 $1, % of the entire amount The 2% Medicare Levy is not included, but may apply. Note that where the ETI is under $416 it is added to other non-eti income and subject to normal marginal rates. Or, if greater, the difference between tax on the whole of the taxable income and tax on non-eti taxable income at normal marginal rates. 172 National Tax & Accountants Association Ltd: August 2016

183 A Beneficiary s Perspective Under the Division 6AA penalty tax regime, a resident minor can currently only derive $416 of ETI before tax is payable (by the trustee under S.98(1) on the minor s behalf in the case of a trust distribution). Prior to the 2012 income tax year, this $416 tax-free threshold was effectively increased due to the Low Income Tax Offset ( LITO ). For example, in the 2011 income tax year, the $1,500 LITO resulted in a potential tax-free distribution of $3,333 to a minor. 2.1 Determining when a minor needs to lodge a tax return Generally, Australian resident minors do not have to lodge a tax return if they derive less than $416 of ETI in the 2016 income year. Where a minor s share of the trust s net (taxable) income exceeds $416, the trustee will be assessed pursuant to S.98(1). The trustee assessment assumes the beneficiary s share of the net (taxable) income was the only income derived by the beneficiary (and not subject to any deduction). Where a minor beneficiary has no other assessable income (other than the trust distribution over $416) and they would not be entitled to a refund of tax offsets, then the tax paid by the trustee under S.98(1) is a final tax and the distribution is not otherwise included in the assessable income of the minor. Accordingly, the minor will not be required to lodge an income tax return. Refer to TD 92/159. Where a minor beneficiary has no other assessable income (apart from the trust distribution over $416) and is entitled to a refund of tax offsets (e.g., franking credits), then both the trustee and beneficiary are assessed on the distribution. The beneficiary is allowed a credit for any tax paid by the trustee, allowing the beneficiary to claim a refund of the relevant tax offset via the lodgment of a tax return. Refer to S.100(1A) and S.100(2) of the ITAA TAX TIP Claiming franking credits where no return is required Where a minor does not have to lodge an income tax return as their total dividend income does not exceed $416 and they have an entitlement to a refund of excess franking credits, these credits are claimed by lodging a separate form available on the ATO s website Application for refund of franking credits for individuals. Finally, where a minor beneficiary has other income (in addition to the trust distribution), then the distribution will be assessed to both the trustee and beneficiary and again the beneficiary will be permitted to claim a credit for any tax paid on their behalf by the trustee. Note, however, that the credit can only reduce the tax payable by the beneficiary to nil i.e., the beneficiary will not get a refund of tax paid by the trustee if it exceeds the amount they are personally liable for. Refer to S.100(1) and S.100(2). Where a minor is entitled to a credit for any tax paid by the trustee, with the credit is recorded in their personal tax return at Item 13 Partnerships and trusts, Label S Share of credit for tax paid by trustee. 2.2 Exclusions and exceptions to Division 6AA Whilst most trust distributions to a minor will be caught by the Division 6AA penalty regime, there are a number of carve-outs that allow the income to be assessed at adult rates. A carve-out may apply depending on the child s specific circumstances or the type of trust income in question. For example, a minor may qualify as an excepted person and therefore be taxed at adult rates (with an entitlement to claim the LITO) on all their income. Refer to S.102AC. If a minor is not an excepted person, they are referred to as a prescribed person. Alternatively, if the minor is not an excepted person (i.e., they are a prescribed person ), they may still be eligible for adult rates if they derive excepted assessable income ( EAI ) including excepted trust income ( ETI ). The following diagram highlights the most common circumstances when trust distributions to minors will be taxed at adult rates: National Tax & Accountants Association Ltd: August

184 A Beneficiary s Perspective Is the minor an excepted person? Broadly, a minor is an excepted person under S.102AC, for an income year, if: (a) the minor was engaged in full-time work on the last day of the income year;! and o intends to work full-time for all or a substantial part of the next income year; and o does not intend to study full-time at any time in the next income year; (b) the minor is a person in respect of whom a carer allowance or a double orphan pension (and the minor receives little or no financial support from relatives) that is payable for a period that includes the last day of the income year; (c) the minor is (as certified by medical practitioner), on the last day of the income year: o disabled or permanently blind; o a person who has a continuing inability to work; or o a person who, by reason of a permanent disability, is unlikely to be able to work full-time (and receives little or no financial support from relatives); (d) the minor is the principal beneficiary of a special disability trust; or (e) the minor was in receipt of a disability support pension on the last day of the year. YES NO NO Has the minor derived any excepted trust income? Pursuant to S.102AG(2), the categories of excepted trust income can include the following: (a) Assessable income of a trust estate where the trust resulted from a will, codicil, intestacy or a related court order. (b) Employment income. (c) Income derived from the investment of any property transferred to the trustee for the benefit of the beneficiary for a number of reasons including: the satisfaction for a claim of damages in relation to the loss of parental support or the beneficiary s personal injury, disease or impairment, pursuant to any worker s compensation law, compensation in respect of criminal injuries or directly from a life insurance policy, superannuation fund or employer because of the death of a person, out of a fund established and maintained for necessitous circumstances or even as a result of a family breakdown. (d) Income derived from the investment of certain property that devolved from the estate of a deceased person or from the beneficiary s lottery or prize winnings. YES Division 6AA penalty rates apply to all income of the minor " and cannot be offset by the LITO Division 6AA penalty rates apply to ETI only " (i.e., EAI is taxed at ordinary marginal tax rates) and LITO reduces tax on EAI only # Division 6AA penalty rates do not apply (i.e., tax on all income at ordinary rates and may claim LITO) #! Alternatively, a minor is also an excepted person if they had been engaged in full-time work for a total period of three months or more during the income year (ignoring any period of full-time work that was followed by fulltime study refer to S.102AC(6),(7)), and intends to work full-time for all or a substantial part of the next income year, and does not intend to study full-time in that year. " Subject to a tax-free threshold of $416. # Refer to S.159N of the ITAA 1936 for the eligibility criteria relevant to claiming the LITO. 174 National Tax & Accountants Association Ltd: August 2016

185 A Beneficiary s Perspective 3. Distributions to resident companies Broadly, Australian resident companies are assessed on their share of a trust s net income. Note that the following discussion applies to resident companies only. The taxation of distributions made to non-resident companies is discussed later in these seminar notes. 3.1 Recording trust distributions on the C Return Where a company is presently entitled to a share of trust income, the gross distribution amount (i.e., including the company s share of any credits and/or tax offsets such as franking credits refer below) is generally required to be included at Item 6 (Calculation of total profit or loss), Label E Gross distribution from trusts of the company s tax return (i.e., the C Return) for the income year in which the present entitlement arose. Note that the amount at Label E cannot be a loss. The ATO instructions state that the following amounts are not included at Item 6, Label E: distributions from a public trading trust or a corporate unit trust include these at Item 6, Label H Total dividends instead; any amounts attributable to Australian franking credits received indirectly from a New Zealand company include these at Item 7 (Reconciliation to taxable income or loss), Label C Australian franking credits from a New Zealand company instead; and capital gains distributed from a trust include these at Item 7, Label A Net capital gain. TAX WARNING Reconciliation adjustments may be required The distribution amount required to be recorded at Item 6, Label E is generally the amount shown in the company s P&L. If this amount differs to the taxable distribution amount (excluding amounts required to be reported elsewhere, such as net capital gains), a reconciliation adjustment should be made at the relevant label at Item 7. For example, if the amount shown at Label E (or another income label at Item 6) includes a non-taxable amount, include that non-taxable amount at Item 7, Label Q Other income not included in assessable income. In the CODE box at the right of Item 6, Label E, write the letter from the relevant table included in the ATO instructions that best describes the type of trust from which the distribution was received. Where distributions have been received from several trusts, use the code for the type of trust from which the largest amount was received Reporting a company s share of credits and tax offsets A company is generally entitled to claim its share of credits or tax offsets distributed from a trust. To do so, the amount of the credit or tax offset should be taken into account at the relevant labels in the Calculation Statement of the C Return, including the following: Include at Label H2 Credit for tax withheld foreign resident withholding, the company s share of any amounts withheld under the foreign resident withholding provisions. Include at Label H7 Other refundable credits (refer below), the company s share of any credits for tax withheld from income of the trust for not quoting the trust s ABN or TFN. Include at Label H5 Credit for TFN amounts withheld from payments from closely held trusts, the company s credits for TFN amounts withheld from payments from closely held trusts. National Tax & Accountants Association Ltd: August

186 A Beneficiary s Perspective If a trust distribution includes a share of franking credits attached to dividends on shares acquired by the trust after 31 December 1997, the company will generally only be entitled to claim a franking tax offset where both the trust and the company are qualified persons. Where the distribution is from a discretionary trust, the company will generally only be a qualified person if the trust has made a family trust election. Where these requirements are met, ensure the company s share of the franking credits is included at Item 6, Label E (i.e., do not show the distributed franking credits as a tax reconciliation adjustment at Item 7, Label J Franking credits). Claim the franking tax offset at Label C Non-refundable non-carry forward tax offsets on the Calculation Statement. However, if the qualified person requirement is not met, the company is not entitled to claim any franking credits distributed from the trust and is not assessed on the franking credits. Where this is the case, include the franking credits at Item 6, Label E and a corresponding deduction at Item 7, Label X Other deductible expenses and do not claim a franking tax offset at Label C of the Calculation Statement. To the extent that Family Trust Distribution Tax or Trustee Beneficiary Non-disclosure Tax was paid on a distributed amount, that amount is not assessable to the company and should not be shown anywhere on the C Return. Likewise, any deductions incurred in deriving the excluded amount are not deductible. To the extent these amounts are represented in the accounts they should be backed out at Item 7. Further, any franking credits attributable to the excluded income cannot be claimed by the company and should not be recorded on the C Return. EXAMPLE 4 Recording a trust distribution on the C Return On 30 June 2016, Scorpio Pty Ltd ( the company ) is distributed a $12,000 share of trust income from the Taurus Discretionary Trust ( the trust ) comprised of a $4,000 gross capital gain, $7,000 franked dividend and $1,000 of net business income. The trust has previously made a family trust election that remains in force for the 2016 income year. The company s share of the trust s net (taxable) income for 2016 is as follows: net capital gain of $2,000 (after the trust applied the 50% general CGT discount); franked dividends of $7,000 (with attached franking credits of $3,000); and other assessable income (being net business income) of $1,000. As noted, franking credits of $3,000 are attached to the franked dividends distributed. The company is a qualified person in relation to the particular shares in respect of which the dividends were paid (note: the trust has made an FTE) and, therefore, is entitled to claim the franking credits. As a result, the company will include the grossed-up amount of the distribution in its assessable income for tax purposes. As the trust s capital gain was reduced under the 50% general CGT discount, the company must include the grossed-up amount of $4,000 (i.e., $2,000 x 2) in its assessable income. Note that a company is not entitled to the 50% general CGT discount and, therefore, cannot reduce the grossed-up amount of the trust s capital gain when it is calculating its own net capital gain. Therefore, assuming the company has no other capital gains or losses for the year (and no carry forward capital losses), its net capital gain is $4,000. It follows that, from the company s perspective, the taxable amount of the trust distribution is $15,000, calculated as: $4,000 net capital gain, plus $7,000 franked dividends, plus $3,000 franking credits, plus $1,000 other assessable income. 176 National Tax & Accountants Association Ltd: August 2016

187 A Beneficiary s Perspective How is the trust distribution recorded in the company s 2016 tax return? The trust distribution will be recorded as follows: Item 6 Calculation of total profit or loss Gross distribution from trusts (Label E): $11,000 Item 7 Reconciliation to taxable income or loss Net capital gains (Label A): $ 4,000 Calculation Statement Non-refundable non-carry forward tax offsets (Label C): $ 3,000 This amount is the $12,000 distribution of trust income, less the $4,000 gross capital gain, plus the $3,000 franking credits. There is no reconciliation required in respect of this amount because the assessable amount of this distribution is also $11, Distributions to non-residents The taxation of trust distributions made to non-resident beneficiaries can become complex very quickly. To fully come to terms with how a non-resident beneficiary s share of a trust s net (taxable) income is taxed, consideration needs to be given to the type of income distributed, the type of trust making the distribution and the source of the distributed income. 4.1 Overview of the rules Where a beneficiary is presently (or specifically) entitled to a share of trust income; and is a nonresident at the end of the income year, the trustee will be assessed on the beneficiary s share of the net (taxable) income pursuant to S.98(2A) and (3). The amount on which the trustee is assessed is so much of that share of the net income: (i) as is attributable to when the beneficiary was a resident (i.e., source is irrelevant); and (ii) as is attributable to when the beneficiary was not a resident and is also attributable to Australian sources. Despite the fact the trustee is assessed, the non-resident s share of the net (taxable) income still forms part of their assessable income. Accordingly, the non-resident beneficiary will be required to lodge a tax return (if not already required to do so) and when the beneficiary is assessed, they will be entitled to a credit for the tax already paid by the trustee on their behalf. If the tax paid by the trustee exceeds the tax payable by the beneficiary, the excess is refunded to the beneficiary Tax rates for non-resident beneficiaries Company beneficiaries are taxed at the applicable corporate rate regardless of their residency status. This rate applies to both the trustee and the company assessment. Trustee beneficiaries are taxed at 47% (via a trustee assessment). The tax rates applicable for an adult individual non-resident beneficiary for the 2016 year (inclusive of the temporary budget repair levy but exclusive of the Medicare levy which does not apply to non-residents) are set out in the table below. National Tax & Accountants Association Ltd: August

188 A Beneficiary s Perspective Taxable income $0 $80, % of the entire amount 2016 tax rates for adult non-resident $80,001 $180,000 $26, % of excess over $80,000 $180,001+ $63, % of excess over $180, Interest, royalties and dividends The distribution of interest, royalties, unfranked and franked dividends from a discretionary or fixed trust to a non-resident individual, company or trust beneficiary are taxed under a withholding tax regime, whereby: the non-resident beneficiary is liable to pay the withholding tax; and the trustee is obliged to withhold an amount from the distribution which effectively relieves the non-resident beneficiary from the obligation to pay the withholding tax. Note that, if for any reason the trustee does not withhold the requisite amount, the non-resident beneficiary remains liable for the withholding tax and they will be required to lodge a separate Schedule of additional information with their income tax return. The relevant tax treatment for these types of distributions is summarised in the following table: Source of income The applicable rate Distribution made by a resident discretionary or fixed unit trust 1. Interest, royalties and unfranked dividends Australian or foreign Interest 10% Royalties 30% Unfranked dividends 30% If the payment is made to a resident of a country with which Australia has a Double Tax Agreement ( DTA ), the withholding rate may be reduced (even to nil in some cases). Section 128B of the ITAA 1936 imposes a withholding tax on interest, royalties and unfranked dividends and makes it non-assessable non-exempt income regardless of source, however, some de facto source rules in that provision ensure that withholding will not apply for example where: in relation to interest and royalties, the interest or royalty is wholly incurred by the payer in a business carried on in a country outside Australia at or through a permanent establishment of the payer in that country; or in relation to unfranked dividends, the company paying the unfranked dividend is a non-resident of Australia (i.e., if the company is a resident, withholding applies). 2. Franked dividends Australian or foreign Not applicable. The franked amount of a dividend is nonassessable non-exempt income to the nonresident and is also exempt from withholding tax (i.e., franked dividends are tax-free in the hands of the non-resident). However, a non-resident beneficiary is not able to claim, or benefit from, the franking credit. 178 National Tax & Accountants Association Ltd: August 2016

189 A Beneficiary s Perspective Business and rental income Broadly, a distribution of trust income to a non-resident beneficiary (who is not a trustee) shall be taxed to the trustee (on behalf of the beneficiary) in respect of certain Australian sourced income (other than interest, royalties and dividends), such as business and rental income. Generally, foreign source trust income (including business and rental income), can be distributed to a non-resident beneficiary tax-free. However, certain foreign source income may be assessable to a non-resident, but only where it is attributable to any period during the year when the beneficiary was a resident. Refer to S.98(2A) and 98(3). The tax implications of distributing business and rental income from a discretionary trust or a fixed unit trust to a non-resident beneficiary is summarised in the following table: Non-resident beneficiary Source of income Applicable tax rate Distribution made by a resident discretionary or fixed unit trust Individual and Australian Individuals apply company the non-resident tax rates for adults or minors as relevant (outlined above). Companies apply the applicable corporate tax rate. Foreign Not applicable. No tax is payable. The trustee pays tax (on behalf of the beneficiary) in respect of their share of the net (taxable) income attributable to Australian source business and rental income. The beneficiary is also required to lodge a return including that share in their assessable income (a credit is available for the tax paid by the trustee). Refer to S.98(2A) and (3). Trustee (i.e., another trust) Australian The top marginal rate, being 47% (inclusive of the temporary budget repair levy). If a trustee is a non-resident at the end of the year, the distributing trustee is required to pay tax on behalf of the trustee beneficiary in respect of their share of the net (taxable) income attributable to Australian source business and rental income. Refer to S.98(4). Foreign Not applicable. No tax is payable. The table assumes the beneficiary is a non-resident for the whole year. If this is not the case, refer to S.98(2A), and above, for further implications. If the beneficiary is a non-resident minor and the trust distribution is their only source of income, the minor is not generally required to lodge a tax return. Refer to TD 92/159 and S.100(1). In relation to fixed and/or unit trusts, CGT event E4 does not apply to distributions of foreign source income to a non-resident beneficiary. Refer to S (9) of the ITAA Section 98(4) does not apply to a chain of trusts if the relevant share of net income is attributable to an amount which a trustee, earlier in the chain, was taxed under S.98(4). Furthermore, an amount previously taxed under S.98(4) may also be taxed to an ultimate individual or company beneficiary (under S.98A(3), S.97 or S.100). In this case, a credit is allowed under S.98B Capital gains Where capital gains are distributed from a trust to a non-resident beneficiary, varying tax outcomes and obligations arise for the trustee and the beneficiary, depending on; what type of trust distributes the capital gain (i.e., fixed or discretionary); the source of the capital gain (i.e., Australian or foreign); the type of CGT asset (e.g., is it Taxable Australian Property ( TAP )); and; the identity of the beneficiary (i.e., an individual, company or trust). Where a non-resident makes a capital gain as a result of a CGT event happening to an asset they own directly, it will only be subject to CGT if the asset is TAP. Refer to S (1). National Tax & Accountants Association Ltd: August

190 A Beneficiary s Perspective TAX TIP Taxable Australian Property ( TAP ) Taxable Australian Property is defined in S to include: 1. Taxable Australian real property ( TARP ) which is real property situated in Australia; and/or 2. Indirect taxable Australian real property interests which is basically where the trust holds a minimum 10% in a company or trust (the non-portfolio test) whose assets in turn are more than half made up of TARP, based on market values (the principal assets test). However, where the capital gain is made by a resident trust and distributed to a non-resident beneficiary, the rules start to become somewhat more complicated. How that capital gain is subsequently taxed varies depending on whether the trust is a discretionary trust or a fixed trust. (a) Distributing capital gains from discretionary trusts Where a discretionary trust distributes a capital gain to a non-resident beneficiary, the beneficiary is taken to have made the gain. Unfortunately, the beneficiary cannot rely on the fact the asset is non-tap as per S (1), because the capital gain they are taken to have made is not the result of a CGT event, but is the result of the applicable tax laws dealing with trust distributions. Refer to ID 2007/60. This means that the beneficiary is unable to argue that the capital gain is tax-free because the asset sold by the discretionary trust was non-tap. However, a non-resident beneficiary can generally argue that the capital gain will be tax-free is if it has a foreign source. Refer to S.98(2A)(d). In relation to determining the source of a capital gain, reference should be made to any relevant Double Tax Agreements (DTAs). Therefore, if the capital gain (from TAP or non-tap) has an Australian source, the trustee will still be assessed on behalf on the non-resident beneficiary under S.98. The beneficiary will be allowed a credit for any tax paid by the trustee. The non-resident beneficiary will also be required to lodge a tax return and include the capital gain in their assessable income. As with any capital gain distributed to a beneficiary, they will be required to gross-up the gain (if the 50% general CGT discount and/or the small business active asset reduction have been applied by the trust), before this grossed-up figure is reduced by any capital losses and the 50% general CGT discount and/or small business active asset reduction (if applicable). Refer to S (4). Note however, that since 8 May 2012, non-residents are no longer eligible for the full 50% general CGT discount. However, where the trust acquired the asset prior to 8 May 2012 and/or the beneficiary was a resident for some of the time the trust owned the asset period, a pro-rata discount may be allowed. (b) Distributing capital gains from fixed trusts Where a fixed trust distributes a capital gain to a non-resident beneficiary, S of the ITAA 1997 provides that a capital gain made by a non-resident beneficiary in respect of an interest in a fixed trust is disregarded if the gain is attributable to an asset of the fixed trust that is non-tap. A fixed trust is a trust where entities have fixed entitlements to all of the income and capital of the trust. A fixed entitlement is in turn defined as a vested and indefeasible interest in the income and capital of the trust. Refer S of the ITAA A common example of the different tax treatment that can arise between a discretionary trust and a fixed trust is where a capital gain made on the disposal of listed shares in an Australian company is distributed to a non-resident beneficiary. This is because such assets generally have an Australian source, but almost invariably fall outside the definition of TAP due to the trust s ownership percentage levels within the relevant company. As such, the gain will be assessable to a discretionary trust beneficiary, but will be tax-free to a fixed trust beneficiary. 180 National Tax & Accountants Association Ltd: August 2016

191 A Beneficiary s Perspective (c) Summary CGT tables for capital gains distributed from a trust The following tables provide a summary as to the respective tax treatment of Australian source capital gains from a resident Australian trust to a non-resident beneficiary. Non-resident beneficiary Capital gain on Taxable Australian Property ( TAP ) Source of gain distributed from a resident trust Applicable tax rate Distribution made by a resident discretionary or fixed unit trust Individual and company Australian Individuals Non-resident tax rates for adults or minors. Companies Applicable corporate tax rate. Trust Australian The top marginal rate, being 47% (inclusive of the temporary budget repair levy). Note, the tax treatment is the same whether the gain is distributed by a discretionary or a fixed trust. The trustee pays tax (on behalf of the beneficiary) in respect of their share of the net capital gain. The beneficiary is also required to lodge a tax return. They gross-up the capital gain, apply capital losses and claim any concessions, with the result being their net capital gain which is included in their assessable income (a credit is available for any tax paid by the trustee). Refer to S.98(2A) and (3), S.98A, S.102UX of the ITAA 1936 and S of the ITAA If the trustee beneficiary is a non-resident at the end of the year, the distributing trustee is assessed in respect of the non-resident beneficiary s share of the net capital gain. Refer to S.98(4), S.98B, S.102UX of the ITAA 1936 and S of the ITAA If the beneficiary is not a non-resident for the whole of the income year refer to S.98(2A) for further implications. Note that no CGT discount is allowed for a trustee assessed under S.98(3)(b) or (4) in respect of a company or trustee beneficiary. Refer to S Furthermore, non-resident individuals are generally not eligible to claim the 50% CGT discount on that part of a capital gain that accrued after 8 May Refer to Subdivision 115-B of the ITAA National Tax & Accountants Association Ltd: August

192 A Beneficiary s Perspective Capital gain on non-taxable Australian Property ( non-tap ) distributed from a resident trust Non-resident beneficiary Source of gain Applicable tax rate in 2016 Distribution made by a resident discretionary or fixed unit trust Individual and Australian Individuals company Non-resident tax rates for adults or minors. Companies Applicable corporate tax rate. Discretionary trust The trustee pays tax (on behalf of the beneficiary) in respect of their share of the net capital gain. The beneficiary is also required to lodge a return. They gross-up the capital gain, apply capital losses and claim any concessions, with the result being their net capital gain which is included in their assessable income (a credit is available for any tax paid by the trustee). Refer to S.98(2A) and (3), S.98A and S.102UX of the ITAA 1936 and S of the ITAA Fixed Trust Foreign Not applicable. Discretionary trust Regardless of the source of the capital gain, this amount is not subject to tax because the asset is not TAP. Refer to S of the ITAA It is generally argued that no tax is payable. Refer to S.98(2A) and (3) of the ITAA 1936 and ATO ID 2003/676. Fixed Trust No tax is payable. Refer to S of the ITAA 1997 and S.98(2A) and (3) of the ITAA Trust Australian The top marginal rate, being 47% (inclusive of the temporary budget repair levy). Discretionary trust If the trustee beneficiary is a non-resident at the end of the year, the distributing trustee is assessed in respect of the non-resident beneficiary s share of the net capital gain. Refer to S.98(4), S.98B and S.102UX of the ITAA 1936 and S of the ITAA Fixed Trust Regardless of the source of the capital gain, this amount is not subject to tax because the asset is not TAP. Refer to S (2) and (3) of the ITAA If the beneficiary is not a non-resident for the whole of the income year refer to S.98(2A) for further implications. Note that no CGT discount is allowed for a trustee assessed under S.98 (3)(b) or (4) in respect of a company or trustee beneficiary. Refer to S of the ITAA The discount percentage for a discount capital gain (otherwise available at 50% for individuals) is reduced under S and S of the ITAA 1997 to the extent that an individual accrued capital gains as a beneficiary of a trust while the individual was a foreign or temporary resident after 8 May National Tax & Accountants Association Ltd: August 2016

193 A Beneficiary s Perspective EXAMPLE 5 Recording a distribution in a non-resident s return For the 2016 year, the trust income of the ABC Discretionary Trust ( the trust ) was $42,000, as determined under ordinary concepts (but modified to include gross capital gains): Net capital gain (i.e., not subject to the general 50% discount) $ 20,000 Fully franked dividends $ 7,000 Interest received from Australian bank accounts $ 5,000 Net rent from foreign rental properties $ 3,000 Net rent derived from Australian rental properties $ 7,000 Trust income $ 42,000 The net (taxable) income of the trust for 2016 is as follows: Net capital gain (i.e., not subject to the general 50% discount) $ 20,000 Fully franked dividends (including franking credits of $3,000) $ 10,000 Interest received from Australian bank accounts $ 5,000 Net rent from foreign rental properties $ 3,000 Net rent derived from Australian rental properties $ 7,000 Net income $ 45,000 The trustee resolved to distribute 100% of the trust income to Max, a non-resident individual (adult) beneficiary. The capital gain relates to the sale of a rental property located in Perth (which is therefore an Australian sourced capital gain). The trustee will be taxed on the assessable part of the distribution being $27,000 (i.e., the net capital gain of $20,000 plus the net Australian rent of $7,000) on behalf of the individual at non-resident individual rates. The beneficiary will also be required to lodge an income tax return to include these amounts as assessable income and will be entitled to a credit for the tax paid by the trustee. The foreign rental income and fully franked dividends are not assessable to either the trustee or the non-resident beneficiary and as a result any foreign tax paid and applicable franking credits cannot be claimed. The trustee must withhold tax at a rate of 10% on the interest and remit this amount to the ATO. No further Australian tax is payable on the interest once withholding has been applied. (a) Distribution disclosure for a non-resident beneficiary for the entire income year Based on the individual tax rates for non-residents, the trustee of the trust will be required to pay $8,775 (i.e., 32.5% x $27,000) on the assessable part of the distribution. The trust distribution will be shown on the beneficiary s 2016 I Return as follows: Item 18 (Capital gains): $20,000 at Label H Total current year capital gains; $20,000 at Label A Net capital gain. Item 13 (Partnerships and trusts): $7,000 at Label U Distributions from trusts less net capital gains and foreign income; $8,775 at Label S Share of credit for tax paid by trustee. National Tax & Accountants Association Ltd: August

194 A Beneficiary s Perspective Notes 184 National Tax & Accountants Association Ltd: August 2016

195 Case Study CASE STUDY National Tax & Accountants Association Ltd: August

196 Case Study Notes 186 National Tax & Accountants Association Ltd: August 2016

197 Case Study Case study K9 Discretionary Trust The objective of the following case study is to provide a comprehensive example of the taxation of trust income, from the determination of trust income to the preparation of the income tax return for the trust and its beneficiaries. The case study incorporates many of the key tax issues discussed in these seminar notes including for example: making tax-effective trust distributions; reconciling trust income to the net (taxable) income of the trust; completing key areas of the trust tax return; and reporting each beneficiary s share of the trust s net (taxable) income in their tax return. 1. Background information In 2008, Jim and Jan Mutt commenced to carry on a business of providing grooming, boarding and obedience training services for security dogs used by Australian Customs, government officials and high profile individuals. The business operates through the K9 Discretionary Trust ( the trust ), which is registered for GST. The business also sells a range of dog products including collars, leads, kennels, toys, flea and worming treatments, beds and blankets, treats and dog food. The trust also holds a small parcel of shares for investment purposes. The trustee of the trust is K9 Pty Ltd. Jim and Jan are both directors and equal shareholders of the trustee company. The beneficiaries of the trust include Jim, Jan, their sons Jason (a 21 year old student) and Jack (aged 12), and the family company, Doghouse Pty Ltd. The couple are also the directors and shareholders of the corporate beneficiary (Jim holding 5% and Jan holding the remaining 95%). The Mutt business structure can be illustrated as follows: K9 Pty Ltd (trustee of the trust) K9 Discretionary Trust (Carries on business of providing dog grooming, boarding and obedience training services and sells dog products) Beneficiaries: Jim Jan Jason (student age 21) Jack (minor) Doghouse Pty Ltd Each of the above entities and individuals is an Australian resident for tax purposes. Furthermore, K9 Discretionary Trust is a family trust. That is, the trustee made a family trust election that came into effect on 1 July 2007 (i.e., the 2008 income year) and is still in force. Jim and Jan (being the controlling minds and primary beneficiaries of the trust) receive a phone call from their advisor reminding them of the 30 June 2016 deadline for preparing income distribution resolutions for the trust. They are advised that the distribution of trust income is necessary in order to avoid the trustee being assessed on the net (taxable) income of the trust at the top rate under S.99A of the ITAA 1936 (the trust deed does not contain a default beneficiary). With 30 June fast approaching, Jim and Jan organise a meeting with their advisor to work through the income distribution resolution process for the 2016 income year. National Tax & Accountants Association Ltd: August

198 Case Study 2. The income distribution resolution process Jim and Jan s advisor, Frank, is aware that the income distribution resolution process has fundamentally changed as a result of the government s recent changes to the taxation of trust income and, as such, has called a meeting with his clients mid June to discuss these changes and ensure the trust s income is distributed in a timely and tax-effective manner. 2.1 Client meeting (15 June 2016) On 15 June 2016, Frank (the advisor), Jan and Jim (in their capacity as controlling minds of the trust and other group entities) meet and address the following issues: (a) 30 June deadline Frank advises that the ATO s previous administrative practice of allowing income distribution resolutions to be prepared up to 31 August (two months after year-end) is no longer available and, as such, it is imperative that the trust s resolution be done by 30 June (b) Review of the trust deed This is arguably the most important step in the income distribution resolution process (and also the most overlooked). TAX TIP Ascertain how trust income is determined under the deed Frank, Jim and Jan consult the trust deed to re-visit how income is defined in the deed for the purposes of calculating trust income (under the trust deed) which reveals that the trust s deed provides the trustee complete discretion in determining whether a receipt, profit or gain, loss or outgoing is to be treated on income or capital account. However, the deed also states that, in the absence of the trustee exercising its discretion by 30 June, trust income will be taken to equate to net (taxable) income under S.95 of the ITAA In other words, the trust deed gives the trustee discretion to determine trust income but, if the trustee fails to do so, an income equalisation clause will automatically apply. It was also determined that the deed contains no default beneficiary clause but that it does confer upon the trustee a power to stream (both income and capital). (c) Identify key income amounts and amounts capable of streaming Unfortunately, because the income distribution resolutions must be prepared by 30 June, it is not possible for Frank to have the accounts of the K9 Discretionary Trust completed by that date. However, based on discussions of known events and the accounting data entered by Jan and Jim into their accounting software, it is determined that (amongst other amounts) the key income and expenses amounts derived by the trust basically falls into three categories, being: Franked dividends; Capital gains; and Other trust income (comprised in this case of net business income). This information will be taken into account in determining how trust income should best be distributed to achieve the most tax effective outcome possible (taking into account the constraint of the 30 June deadline). The following table provides an overview of the different types of income (and expenses) the trust has, the extent to which it is (prima facie) taxable and whether it is capable of being streamed (or directed) to a particular beneficiary. 188 National Tax & Accountants Association Ltd: August 2016

199 Case Study Key income and expense amount Capital gain Franked dividend Other income (net) business income Description and analysis The trust derived a $20,000 gross capital gain during the income year from the sale of vacant land. The CGT 50% discount is available in respect of this capital gain and, therefore, the taxable capital gain will be $10,000. The trust derived a $7,000 franked dividend (with a $3,000 franking credit attached). There are related interest expenses to consider but the shares are not negatively geared. The other income derived by the trust consists of (net) business income. Capable of being streamed? Yes Yes No Frank is aware the ATO do not accept that income other than capital gains and franked dividends can be streamed and advises his clients to exercise caution and adhere to this view for the 2016 income year. (d) Identify notional income amounts In light of the ATO s view regarding the inclusion of notional income amounts in trust income (refer to TR 2012/D1 and earlier in the notes), it is prudent to identify whether the trust has derived any notional income amounts. In this case, the $3,000 franking credit constitutes a notional income amount. Frank advises that (notwithstanding the contention surrounding the ATO s draft ruling and the existence of a $1,500 Division 43 claim which constitutes a notional expense amount), the better approach is to ensure that the trust income is calculated in a way that excludes all the franking credits (as this is a simple and effective way to avoid the application of the statutory cap ). Jim and Jan agree with this approach, and this is noted on file. (e) Consider the tax profile of each beneficiary The reason for ascertaining the tax profile of each beneficiary (i.e., prior to any distribution being made) is because it will put Frank, Jim and Jan in the best position to make tax effective trust distributions. Frank ascertains the following information regarding the relevant tax profiles : 1. Jim Jim has derived $100,000 (gross) salary from the business in the 2016 income year and has also derived $12,000 interest on a term deposit held in his name. Jim is on the 39% marginal rate (inclusive of the Medicare levy) and has some capacity before creeping into the 49% bracket (inclusive of the Medicare levy and Temporary Budget Repair Levy). 2. Jan Jan has derived $50,000 (gross) salary from the business in the 2016 income year and also derived $12,000 interest on a term deposit held in her name. Jan is on the 34.5% marginal rate and has some capacity before creeping into the 39% bracket. Jan also has a $5,000 carry forward capital loss in her name (resulting from the sale of shares in 2012). 3. Jack Jack is a minor. He derived no income in the 2016 income year. Following changes to the low income tax offset, if a distribution were directed to Jack, he would pay tax at penalty rates on amounts exceeding $416 (as the trust distribution is eligible income ). 4. Jason Jason is a student and was 21 years old on 30 June He derived $20,000 salary from a part-time job during the 2016 income year. He derived no other income for the 2016 income year. He is on the 19% marginal tax rate and has some capacity before creeping into the next tax bracket. 5. Doghouse Pty Ltd The bucket company holds a number of term deposits. The company derived $30,000 interest income during the 2016 income year. National Tax & Accountants Association Ltd: August

200 Case Study (f) Consider how trust income might best be distributed As noted above, trust distributions must be made by 30 June 2016 (or earlier, if required or permitted under the trust deed) and, therefore, the final accounts will not be available (in fact, in most cases, interim accounts will also not be available). This means that the trustee will not be able to distribute the exact amount of trust income (because it is unknown). However, based on the information obtained above (i.e., including the type and amount of income likely to be derived by the trust and the tax profiles of the beneficiaries), Jim and Jan (in their capacity as directors of the trustee company) should attempt to distribute the trust income in the most effective way possible (given the time constraints noted above). This is a broad-brush approach and, whilst not perfect, it does provide a balance between making a tax effective distribution and ensuring the trust income is distributed by 30 June 2016 (in order to avoid a trustee assessment under S.99A of the ITAA 1936). Taking into account the information above, and subject to further discussion, it is proposed that the trust income (whatever it is ultimately determined to be) may be distributed as follows: Capital gains: wholly streamed to Jan Mutt (expected to be approximately $20,000); Franked dividend (net of directly relevant expenses): wholly streamed to Jan Mutt (expected to be approximately $4,000); and Other trust income: distributed to the beneficiaries of the trust, taking into account their tax profiles (e.g., their marginal tax rate etc.). This is expected to be approximately $100,000. (g) Determine how trust income will be determined The next step is to think about how trust income will be determined under the trust deed. More specifically, in light of the fact the trustee has discretion to determine trust income under the trust deed (refer above) it is necessary to specifically state how that discretion will be exercised. Of course, this should be done in a manner that will allow the proposed distributions (set out above) to be achieved. Of note are the following objectives: To stream 100% of the gross capital gain to Jan Frank notes that the simplest way to achieve this is to include the gross capital gain in trust income (which can then be distributed via an income distribution resolution to Jan); and To exclude the notional income amounts (i.e., the franking credit refer above). TAX TIP Ascertain how trust income is to be determined In light of the objectives above, Jim and Jan (in their capacity as directors of the trustee company) agree (and file note) that, pursuant to the terms of the trust deed, the trustee will exercise discretion such that trust income will (broadly) equal: (a) Income less expenses (excluding capital gains) as per the accounting records (which, it is decided, will generally be determined according to ordinary concepts to ensure the franking credit is excluded from the accounting records and trust income); plus (b) Gross capital gains. 2.2 Client meeting (29 June 2016) Jim and Jan reconvene (with Frank) on 29 June 2016 to sign and date the income distribution resolutions (i.e., in their capacity as directors and shareholders of the trustee company). The resolution reflects the discussions and (proposed) decisions made at the earlier meeting, as well as matters considered between the parties during subsequent discussions. Refer below for a basic income distribution resolution effecting the distribution of trust income of the K9 Discretionary Trust for the 2016 year (refer Tax Warning below regarding its purpose). 190 National Tax & Accountants Association Ltd: August 2016

201 Case Study K9 PTY LTD A.C.N AS TRUSTEE FOR THE K9 DISCRETIONARY TRUST RESOLUTIONS OF DIRECTORS Determination of Income: RESOLVED THAT, the Trustee determines that the income of the Trust for the year ending 30 June 2016 comprises: (a) all those amounts being income for the purposes of the accounting records of the Trust ( Accounting Records ), less the expenses and outgoings of the Trust for the year ending 30 June 2016 attributed to those amounts for the purpose of the Accounting Records, other than amounts included under paragraph (b) below; and (b) the amount remaining of each capital gain (as defined under subsection 995-1(1) of the ITAA 1997) made in the year ended 30 June 2016 remaining after the recoupment for the purposes of the Accounting Records of any capital losses. Distribution of Income: RESOLVED THAT, the following classes or categories of income of the Trust for the year ending 30 June 2016 are hereby set aside for the benefit of the following beneficiaries, and in the following amounts and/or proportions, as set out in the table below: 1. The total amount of capital gains included in trust income: 100% to Jan Mutt. 2. The total amount of franked dividends remaining after deducting any expenses directly relevant to those franked dividends: 100% to Jan Mutt. 3. All other income not described above: The first $20,000 to Jason Mutt; The next $50,000 to Jan Mutt; The next $15,000 to Jim Mutt; and The balance (if any) to Doghouse Pty Ltd. Declaration: We, the undersigned, hereby declare that we are in favour of the resolutions set out above /.. / (Jim Mutt) Date signed..... /.. / (Jan Mutt) Date signed National Tax & Accountants Association Ltd: August

202 Case Study TAX WARNING Purpose of the income distribution resolution The inclusion of the resolution in the case study is merely to assist with understanding the process of how trust income is determined and distributed (albeit at a basic level). The resolution it is not intended for use other than for illustrative purposes within the context of this case study. Further, any references within the resolution are to a fictitious trust deed. The reasoning behind the trustee s income distributions (as noted above) includes the following: Beneficiary Distribution Why? Jason Jan Jim The first $20,000 of other trust income. The next $50,000 (after Jason s entitlement is satisfied) of other trust income. 100% of the gross capital gain and 100% of the franked dividend are streamed to Jan. The next $15,000 (i.e., after Jan s entitlement is satisfied) of other trust income. A distribution to Jason will utilise his relatively low marginal tax rate. Streaming the capital gain to Jan will utilise her carry forward capital losses. Streaming the franked dividend will utilise her lower marginal tax rate. The distribution to Jim recognises his (relatively) higher marginal tax rate. Doghouse P/L The remainder This provides a balance beneficiary in the event of an upwards amendment to trust income. Distributions to the bucket company are limited in light of the ATO s views regarding bucket company UPEs and Division 7A. Specifically, for commercial reasons, the trust wishes to retain use of the UPE funds indefinitely and Jim and Jan are of the view that placing the UPE on sub-trust, or under a complying loan agreement, will likely create cashflow pressure in the future. Jack Nil Because it is not possible to ascertain precise figures for trust income and net income, the decision was made to make no distribution to Jack Mutt (a minor). This protects against a potential assessment at penalty rates. 3. The financial accounts of the trust Using the information provided by Jim and Jan, as prepared on their accounting software, Frank has prepared the following financial accounts for the financial year ended 30 June The accounts have been prepared to reflect the calculation of trust income under ordinary concepts, modified only to include any gross capital gains. 192 National Tax & Accountants Association Ltd: August 2016

203 Case Study K9 Discretionary Trust ABN Profit and Loss Statement for the year ended 30 June 2016 u $ Revenue from business operations: Fees for boarding, training and obedience services 1,200,000 Gross sales of dog products 1,000,000 2,200,000 Less: Cost of sales of dog products Opening stock 80,000 Plus: Purchases (including freight charges) 920,000 Less: Closing stock (100,000) 900,000 Gross profit: 1,300,000 Net franked dividend income: Gross cash dividends received 7,000 Less: Interest expenses investment loan (3,500) Net franked dividend 3,500 Gross capital gain: Gross capital gain on sale of vacant land 20,000 20,000 Sub-total 1,323,500 Less: Expenses Advertising costs 50,000 Bank charges 2,500 Cleaning costs (for kennels) 80,000 Depreciation expenses 25,500 Dog grooming supplies 312,100 Non-deductible entertainment expenses 3,500 Food and meals etc. for boarding dogs 150,000 Heating and electricity costs 37,000 Interest expenses business loan 31,400 Motor vehicle running expenses 40,100 Printing, postage and stationery 28,900 Rates and insurance 39,500 Salaries and wages 300,000 Superannuation contributions 22,500 Tax agent fees 14,000 Telephone 32,500 Vet expenses 30,500 Workers compensation 8,500 1,208,500 Net Profit (and trust income) 115,000 u All amounts are GST-exclusive. National Tax & Accountants Association Ltd: August

204 Case Study K9 Discretionary Trust ABN Balance Sheet as at 30 June 2016 Current Assets $ $ Cash at bank 30,900 Petty cash Trade debtors 100,000 89,900 Trading stock on hand 100,000 80,000 Total Current Assets 231, ,010 Non-current Assets Depreciating assets at cost 95,000 85,000 Less: Accumulated depreciation (49,000) (45,000) Freehold land and buildings at cost 970,000 1,070,000 Shares in Australian listed companies at cost 68,000 68,000 Total Non-current Assets 1,084,000 1,178,000 Total Assets 1,315,010 1,348,010 Current Liabilities Bank overdraft 23,000 21,000 Trade creditors 124, ,000 Net GST payable 31,000 25,000 Total Current Liabilities 178, ,000 Non-current Liabilities Bank loan (interest only) 80,000 Business bank loan (interest only) 280, ,000 Investment loan (interest only) 50,000 50,000 Loan from beneficiaries 470, ,000 Total Non-current Liabilities 800, ,000 Total Liabilities 978,000 1,126,000 Net Assets 337, ,010 Trust Funds: Settled sum Unpaid beneficiary entitlements 337, ,000 Total Trust Funds 337, , National Tax & Accountants Association Ltd: August 2016

205 Case Study 4. Review of the financial accounts Following a review of the financial accounts (and supporting records), the previous 2015 trust tax return and after discussions with Jan and Jim, the following tax issues have been identified which are relevant to the taxation of trust income and the preparation of the trust s 2016 tax return: Item Description Balance Sheet Current assets Trading stock Trading stock is valued at cost for both accounting and tax purposes. Therefore, no adjustment is required to the value of trading stock in the financial accounts. Balance Sheet Non-current assets Depreciating assets at cost (Depreciation expenses) Freehold land and buildings at cost (Disposals Profit on sale of land) (Division 43 deduction for Capital works) This account includes the cost of a second hand van acquired on 23 April 2016 for $10,000, funded using the business loan. The van will be used for transporting dogs between their owner s homes and the kennel or training facilities. No tax adjustment is required in this regard. For tax purposes, the trust is entitled to depreciation of $28,500 on an effective life basis. However, the depreciation in the P&L is $25,500 (a $3,000 difference). Therefore, an increasing expense reconciliation adjustment of $25,500 is required to reverse the accounting expense and a decreasing expense reconciliation adjustment of $28,500 is required to claim the deductible amount. The account movement relates to the sale of vacant land, which the trust acquired in 2011 for $100,000 and sold in June 2016 for $120,000. The land was not used for any purpose and was surplus to the trust s needs. The sale resulted in a gross profit (and a gross capital gain) of $20,000, which is included in accounting profit (and in trust income, as permitted under the trust deed). For tax purposes, the net capital gain made by the trust is $10,000 (i.e., after applying the 50% general CGT discount to the nominal capital gain of $20,000). No other CGT concessions apply and the trust has no other capital gains or losses. The net capital gain of $10,000 is required to be reported in the trust return in the manner set out below. Furthermore, the trust must complete a CGT Schedule as the nominal capital gain (i.e., $20,000) exceeds $10,000. The boarding kennels and training yards are adjacent to the business premises situated on freehold land owned by the trust and were constructed in 1998 at a cost of $60,000. For the 2016 income year, the trust is entitled to a deduction for the construction costs under Division 43 (at the 2.5% rate). This has not been included in the accounts (nor is it included in trust income) and, therefore, a decreasing expense reconciliation adjustment of $1,500 (i.e., $60,000 x 2.5%) should be made to claim this amount. Balance Sheet Non-current liabilities Loans During the year, the trust repaid the principal owing on an interest-only bank loan. The business bank loans were primarily used to purchase the business freehold. Interest on these loans is included in the P&L and the interest is deductible (i.e., no tax adjustment is required). The trust continues to pay interest on a $50,000 investment loan that was used to purchase shares in Australian listed companies. The interest on this loan (totaling $3,500 is deductible and is taken into account in determining Jan s attributable franked dividend amount (i.e., in respect of the streamed franked dividend). National Tax & Accountants Association Ltd: August

206 Case Study Item Description Balance Sheet Trust funds Unpaid beneficiary entitlements This account comprises amounts owed by the trust to beneficiaries for unpaid distributions made in the prior year and the 2016 distributed profit, as follows: Beneficiary 2016 UPE 2015 UPE Jim Mutt $32,000 ($17,000 + $15,000) $17,000 Jan Mutt $173,500 ($100,000 + $73,500) $100,000 Jason Mutt $78,400 ($58,400 + $20,000) $58,400 Jack Mutt $1,600 ($1,600 + $ Nil) $1,600 Doghouse P/L $51,500 ($45,000 + $6,500) $45,000 Total (check) $337,000 $222,000 The 2016 UPE balances are made up of the opening balance from 2015 plus the distributions of trust income in 2016 (which remain unpaid). Refer below. Each year, UPEs owing to Doghouse P/L are held on sub-trust and have not created Division 7A loans owing by the trust to the company. Profit and Loss Statement Income SBE Revenue Dividends received The trust is not a Small Business Entity ( SBE ) for the 2016 income year. The trust did not derive any income during the income year that was subject to withholding for failure to quote an ABN or TFN. Franking credits of $3,000 are attached to the dividends received. The trustee is a qualified person in relation to the dividends and has previously made a family trust election that is still in force to allow franking credits to flow through to beneficiaries. The franking credits are not included in accounting profit (nor trust income). Note that the assessable dividend of $7,000 and the franking credits of $3,000 must be recorded at Item 12: Dividends, Label L: Franked amount and Label M: Franking credit respectively, as set out below. Profit and Loss Statement Expenses Borrowing costs (relating to the business loan) Non-deductible entertainment expenditure A review of the Reconciliation items made in 2015 tax return of the trust has revealed that borrowing costs of $3,750 are being claimed over five years, in accordance with S The deductible portion for the 2016 income year is $750. Therefore, a decreasing expense reconciliation adjustment of $750 is required to claim the deductible portion of borrowing costs paid in an earlier income year (and not included as an expense in the P&L for the 2016 income year). The entertainment expenses relate to an annual Christmas lunch for staff at a local restaurant. The actual method is used and the cost of food and drinks provided to employees is exempt from FBT under the minor benefits exemption. However, where the FBT minor benefit exemption applies, no deduction can be claimed. Refer to S of the ITAA Therefore, an increasing expense reconciliation adjustment of $3,500 should be made to add-back this non-deductible expenditure. Note: A review of all other expenses included in the P&L (and not mentioned above) has established that they are incurred in carrying on business and are fully deductible. 196 National Tax & Accountants Association Ltd: August 2016

207 Case Study 5. Reconcile trust income and net income The next step to determining the taxation of trust income and preparing the trust return is to set out the amount of trust income and net (taxable) income, and what each is comprised of. In this case, the accounts have been prepared to reflect the trust income and this approach is recommended. The trust income can then be reconciled to the trust s net (taxable) income (i.e., which broadly represents the amount that is subject to tax, as determined under S.95. Trust income $ 115,000 Comprised of: Net franked dividends $ 3,500 Capital gains (gross) $ 20,000 Other (net) business income $ 91,500 $ 115,000 The accounting profit is the same as trust income, as calculated above. The net franked dividend is calculated as $7,000 cash dividend less $3,500 directly related interest expenses. Note that this amount does not include franking credits. The (net) business income is calculated as gross profit of $1,300,000 less expenses of $1,208,500. The trust income can be reconciled to the trust s net (taxable) income as follows: Trust income (refer above): $115,000 Less: CGT 50% discount available on the $20,000 capital gain: ($10,000) Additional depreciation claim for tax purposes: ($ 3,000) Division 43 capital works claim for tax purposes: ($ 1,500) Additional borrowing costs for tax purposes: ($ 750) ($ 15,250) $ 99,750 Add back: Assessable franking credit (not included in trust income): $ 3,000 Non-deductible entertainment expenses: $ 3,500 $ 6,500 Net (taxable) income: $106,250 Net (taxable) income $106,250 Comprised of: Net franked dividends $ 3,500 Franking credits $ 3,000 Net capital gain $ 10,000 Other (net) business income $ 89,750 $ 106,250 Trust income is reconciled to net (taxable) income above. The net franked dividend is calculated as $7,000 cash dividend less $3,500 directly related interest. The other (net) business income is calculated as $91,500 as per trust income calculation less the additional depreciation claim and the adjustments for Division 43, borrowing costs and entertainment. National Tax & Accountants Association Ltd: August

208 Case Study 6. Who pays tax on the net (taxable) income? After establishing the amount of trust income (being $115,000) and the amount of net (taxable) income (being $106,250) and what each is comprised of, and prior to preparing the trust return, it is necessary to determine which beneficiaries (or the trustee, as the case may be) will pay tax on the net (taxable) income of the trust, and the amount they must include in the assessable income. This information must be disclosed in the trust return and each of the beneficiaries returns. For ease of reference the trust income and the net (taxable) income are reproduced as follows: Income items Trust income Net (taxable) income Net business income $91,500 $89,750 Net franked dividend $3,500 $3,500 Franking credit Nil $3,000 Discount capital gain $20,000 $10,000 $115,000 $106,250 The trustee company (K9 Pty Ltd) of the trust distributed the trust income as follows: Capital gains: Jan Mutt: 100% of the capital gain included in trust income (being $20,000). Franked dividend: Jan Mutt: 100% of the net franked dividend included in trust income (being $3,500). Other trust income: Jason Mutt: The first $20,000 of other trust income; Jan Mutt: The next $50,000 (after Jason s entitlement is satisfied) of other trust income; Jim Mutt: The next $15,000 (after Jan s entitlement is satisfied) of other trust income; Doghouse P/L: The remainder (i.e., $6,500) (this is the balance beneficiary ). 6.1 Who pays tax on the net capital gain? In short, Jan does. Jan is specifically entitled to 100% of the gross capital gain (i.e., because 100% of the net financial benefit of the capital gain was wholly streamed to her, as reflected in the income distribution resolution) and this entitlement was documented in writing in an appropriately worded income resolution by 30 June As such, based on the method statement contained in the body of the seminar notes, the capital gain is taxed to her as follows (refer generally to Subdivision 115-C of the ITAA 1997): Step 1: Share of the (gross) capital gain $20,000. Jan received 100% of the net financial benefit referable to the gross capital gain. Step 2: Attributable capital gain $10,000. Jan received a 100% share of the gross capital gain, therefore, she picks-up 100% of the taxable capital gain, being $10,000. Step 3: Apply the gross-up rules Jan is taken to have a grossed-up capital gain of $20,000 (being double the $10,000 attributable capital gain). Refer to S Step 4: Calculate Jan s net (taxable) gain $7,500. Jan has carry forward capital losses of $5,000, therefore the method statement first reduces her capital gain from $20,000 to $15,000 (i.e., $20,000 - $15,000). This is reduced by the CGT 50% discount to $7, National Tax & Accountants Association Ltd: August 2016

209 Case Study 6.2 Who pays tax on the net franked dividend and the franking credit? In short, Jan does. Jan is specifically entitled to 100% of the franked dividend (i.e., because 100% of the net financial benefit, being the net franked dividend, was wholly streamed to her, as reflected in the income distribution resolution) and this entitlement was documented in writing in an appropriately worded income resolution by 30 June As such, based on the method statement contained in the body of the notes, the franked dividend (and franking credit) is taxed to her as set out below (refer Subdivision 207-B of the ITAA 1997). Note that the net financial benefit referable to the franked dividend is $3,500 (i.e., cash dividend of $7,000 less directly related (deductible) expenses of $3,500). The franking credit amount is $3,000 (calculated as 30/70 x $7,000). Step 1: Share of the franked dividend $7,000. Jan s share of the franked dividend is $7,000 as she received 100% of the net financial benefit referable to the dividend. Step 2: Attributable franked dividend $3,500. The net franked dividend is $3,500. Jan s attributable franked dividend is $3,500 based on her 100% share of the franked dividend. Step 3: Share of the franking credit Based on Jan s 100% share of the franked dividend, her share of the franking credit is $3,000 (being 100% of the franking credit). Step 4: Assessable income amount Jan includes the $3,500 attributable franked dividend and the $3,000 franking credit in her assessable income (a total of $6,500). However, she is also entitled to a $3,000 franking tax offset. TAX TIP Summary of the tax treatment of the franked dividend In summary, as 100% of the franked dividend was streamed to Jan, she is assessed on the net franked dividend included in the trust s net (taxable) income as well as the attached franking credit (she is also entitled to a franking tax offset of $3,000). 6.3 Who pays tax on the other trust income? Income amounts, other than capital gains and franked dividends (in this case, net business income), is assessed to the beneficiaries under the proportionate approach. However, as the trust has franked dividends and/or capital gains in addition to the other income, Division 6E will apply to modify the way beneficiaries are assessed under Division 6 to avoid double counting, basically by excluding capital gains and/or franked dividends (streamed and unstreamed) that have already been assessed (in this case, 100% to Jan). Based on the method statement in the body of the notes, the other trust income is taxed to the trust beneficiaries as set out below. The components of the formula in Division 6E are as follows: 1. Division 6E present entitlement to trust income for each beneficiary is as follows: (a) Jason: $20,000 (no adjustment is required). (b) Jan: $50,000 (the capital gain and franked dividend amount is excluded for Division 6E). (c) Jim: $15,000 (no adjustment required). (d) Doghouse P/L: $6,500 (no adjustment required). National Tax & Accountants Association Ltd: August

210 Case Study 2. Division 6E trust income $91,500 (i.e., $115,000 less $20,000 gross capital gain included in trust income, less $3,500 net franked dividend). 3. Division 6E net (taxable) income $89,750 (i.e., $106,250 less $10,000 discount capital gain, less $3,500 net franked dividend, less $3,000 franking credit). In the case of the K9 Discretionary Trust, the formula in Division 6E is applied as follows: Beneficiary Div. 6E present entitlement Percent of Div. 6E trust income Share of Div. 6E net (taxable) income Jason $20,000 22% $19,745 Jan $50,000 55% $49,363 Jim $15,000 16% $14,360 Doghouse P/L $6,500 7% $6,282 Total (check) $91, % $89,750 Note that the Division 6E trust income amount is $91,500 as calculated above. The total of the Division 6E present entitlement amounts is equal to Division 6E trust income. Note also that the percentages in this example have been rounded. This is the amount of other income included in the trust s net (taxable) income, which the beneficiaries are assessed on (in this case other income comprises only (net) business income). 6.4 Summary of who pays tax on net (taxable) income The following table provides a summary of how the trust income was distributed, as well as each beneficiary s share of the net (taxable) income of the trust. The way in which the trust income, net (taxable) income and the trust distributions are reflected in the trust and beneficiary returns (as relevant) is then set out below. Beneficiary Share of Trust Income Capital gain Share of net (taxable) income Franked dividend Franking credit Other income Total Jim $15, $14,360 $14,360 Jan $73,500 $10,000 $3,500 $3,000 $49,363 $65,863 Jason $20, $19,745 $19,745 Jack $ Nil $ Nil Doghouse P/L $6, $6,282 $6,282 Total $115,000 $10,000 $3,500 $3,000 $89,750 $106,250 Jan s share of trust income is comprised of other (business) income of $50,000 as well as a gross capital gain of $20,000 and a net franked dividend of $3,500 (both of which were streamed to her). All other beneficiaries have a share of trust income, which is comprised of only business income. This is the taxable net capital gain and net franked dividend respectively. This is the net capital gain included in the trust s net (taxable) income; it is grossed-up when dealt with at the beneficiary level, which basically means that this is not necessarily the amount of the capital gain included in the beneficiary s assessable income. In this case, because Jan has capital losses in her name, she is only required to include $7,500 in her assessable income, as explained above. 200 National Tax & Accountants Association Ltd: August 2016

211 Case Study 7. Completing the relevant tax returns This section of the notes addresses the issue of how the trust tax return should be completed (including the distribution statement) and how the trust distributions are reflected in each of the beneficiary returns (i.e., being, Jim, Jan, Jason and Doghouse Pty Ltd). This is intended as a guide only, reference can be made to the relevant instructions for further guidance. 7.1 Completing the trust tax return The trust is required to make various disclosures on the trust tax return. The simplest way to understand what disclosures are required (in respect of the K9 Discretionary Trust) is to split the analysis into disclosures for capital gains, franked dividend and the other (business) income of the trust. The statement of distribution will then be considered below Disclosing capital gains At Item 21: Capital gains, Label A: Net capital gain of the trust s tax return, the trust must report the $10,000 net capital gain included in net (taxable) income, as illustrated below. The net capital gain of the trust is equal to the taxable capital gain noted above (in relation to the taxation of the capital gain streamed to Jan). This is because the trust has only one capital gain in the 2016 income year. Refer also to S of the ITAA None of the listed exemptions or rollovers has application here, therefore the trust answers No at Label M. Note that the trust is also required to complete a CGT Schedule in 2016 because it has (gross) capital gains of greater than $10, Disclosing franked dividends and franking credits The following disclosure is required on the trust tax return in respect of net franked dividends and franking credits included in the trust s net (taxable) income: (a) Item 12: Dividends, Label L: Franked amount The trust discloses the (gross) franked dividend amount here, being $7,000 and the $3,000 franking credit at Label M: Franking credit. (b) Item 16: Deductions, Label R: Franked distributions Expenses that are directly related to franked distributions are disclosed here, therefore the trust must disclose $3,500 directly related interest expense at this label. National Tax & Accountants Association Ltd: August

212 Case Study Disclosing other trust income In the case of the K9 Discretionary Trust, the other trust income is comprised only of (net) business income. In this regard, note that the design of the trust tax return is such that a tax reconciliation is required where an accounting profit or loss arises from carrying on business. The reconciliation is done at Item 5: Business income and expenses Reconciliation items. Where a trust derives income that is required to be reported elsewhere on the trust tax return (generally, a net capital gain or non-business income such as dividends and interest), a tax reconciliation at Item 5 is not required to be completed in respect of that income. Instead, the assessable amount is shown at the relevant item on the return (as illustrated above). The process for completing a tax reconciliation of the accounting profit from carrying on business to the net income derived by the K9 Discretionary Trust from that business (and the subsequent determination of the trust s overall net income or loss) involves the following steps: (a) Step 1: Record the business income and expenses The trust must record all business income and expenses from the P&L (sorted according to whether they relate to a primary production ( PP ) or a non-pp business carried on by the trust) at the relevant income and expense labels at Item 5. In the case of the K9 Discretionary Trust, the business income of $2,200,000 must be reported at Item 5, Label H (Non-primary production): Other business income (and in the Totals column). Business income is comprised of fees for boarding, training and obedience services of $1,200,000 and gross sales of dog products of $1,000,000 (refer to the financial statements). Note that the amounts reported are GST exclusive. The various business (non-primary production) expenses per the accounts must also be reported at Item 5 at the relevant label (and in the Total column), as illustrated below. Note that Label N: All other expenses catch the expenses that are not picked-up at a specific label. In the case of the K9 Discretionary Trust, the other expenses are comprised of the following amounts: Advertising costs $50,000 Bank charges $2,500 Cleaning costs $80,000 Dog grooming supplies $312,100 Non-deductible entertainment $3,500 Food and meals for boarding dogs $150,000 Heating and electricity costs $37,000 Printing, postage and stationery $28,900 Rates and insurance $39,500 Salaries and wages $300, National Tax & Accountants Association Ltd: August 2016

213 Case Study Tax agent fees $14,000 Telephone $32,500 Vet expenses $30,500 Workers compensation $8,500 $1,089,000 All amounts are reported on a GST-exclusive basis. Furthermore, note that costs of sales, depreciation, interest (related to the business), motor vehicle running costs and superannuation contributions are recorded at the specific labels provided at Item 5, as illustrated below. The effect of recording the above entries at Item 5 is an accounting profit from the business of $91,500 (i.e., $2,200,000 total business income less $2,108,500 total business expenses) compared with $115,000 shown in the profit and loss statement. The difference of $23,500 is attributable to the dividends shown at Item 12: Dividends, interest expenses for the investment loan shown at Item 16: Deductions relating to Franked Distributions and the net capital gain required to be shown at Item 21: Capital gains (rather than Item 5). (b) Step 2: Record all reconciliation adjustments This step involves setting out all increasing and decreasing reconciliation adjustments required to income and expenses shown at Item 5. At Label B: Expense reconciliation adjustments, the trust must report expenses shown in the profit and loss which are not deductible and deductible expenses which are not included in the profit and loss. For the K9 Discretionary Trust, the expense reconciliation amounts are as follows: Increasing adjustments (i.e., expenses shown in the P&L but which are not deductible): Accounting depreciation $ 25,500 Non-deductible entertainment $ 3,500 $ 29,000 [B] National Tax & Accountants Association Ltd: August

214 Case Study Decreasing adjustments (i.e., deductible expenses not shown in the P&L): Tax depreciation $ 28,500 Deduction for borrowing costs $ 750 Division 43 capital works deduction $ 1,500 $ 30,750 [A] Net decreasing expense reconciliation adjustment $ 1,750 [A] [B] The $1,750 net decreasing expense reconciliation adjustment is reported at Item 5, Label B: Expense reconciliation adjustments. An L must be recorded in the box to the right of Label B because the decreasing adjustment exceeds the increasing adjustment. Note that Item 5 also includes a label for income reconciliation adjustments, Label A: Income reconciliation adjustments. This is used to report (business) income not shown on the P&L that is assessable and (business) income shown on the P&L that is not assessable. The K9 Discretionary Trust has nothing to report at this label for the 2016 income year. (c) Step 3: Calculate net income or loss from the business To complete the tax reconciliation, calculate the net income or loss from business as follows: Total business income (refer above) $ 2,200,000 Less: Total expenses (from Label O: Total expenses) ($ 2,108,500) Plus: Net increasing income reconciliation adjustments $ Nil Less: Net decreasing expense reconciliation adjustment ($ 1,750) Net income from business $ 89,750 Show the net income from business of $89,750 at Label R (i.e., under non-primary production ) and at Label S (i.e., under Totals ): (d) Step 4 Calculate total net income or loss Step 4 involves calculating the trust s total net income or loss to be reported at Item 26: Total net income or loss of the trust tax return. This is the overall net income of the trust from all activities, not simply from carrying on a business, and is calculated as the total assessable income less the total allowable deductions of the trust, as set out below: Net income or loss from business (refer Item 5, Label S above) $ 89,750 Plus: Assessable franked dividends (refer Item 12, Label L above) $ 7,000 Plus: Assessable franking credits (refer Item 12, Label M above) $ 3,000 Less: Deductions relating to franked dividends (refer Item 16, Label R above) ($ 3,500) Plus: Assessable net capital gain (refer Item 21, Label A) $ 10,000 Taxable income $ 106, National Tax & Accountants Association Ltd: August 2016

215 Case Study Show the taxable income calculated above of $106,250 at Item 26: Total net income or loss: Key financial information (Items 32 to 35) The trust must also report key financial information on the trust return at Items 32 to 35. The information that must be reported is all current assets, total assets, all current liabilities and total liabilities. This information typically reflects the information contained in the balance sheet Business and professional items (Items 36 to 53) Items 36 to 53 of the trust return require disclosure of certain business and professional items. The business and professional items that require disclosure by the K9 Discretionary Trust are set out below. The information included in this part of the trust return can generally be obtained from the relevant financials. In this regard, note that the total salary and wage expense, the payments to associated persons and the UPEs owing to private company labels are calculated as follows: (a) Item 43, Label L: Total salary and wage expenses The figure of $300,000 is calculated as $300,000 salary & wages (from the P&L). Code A denotes that salary and wages are mainly included in the amount reported at All other expenses at Item 5: Business income and expenses. (b) Item 44, Label M: Payments to associated persons The figure of $164,250 is calculated as Jan s salary of $50,000 plus Jim s salary of $100,000 plus superannuation guarantee of $14,250 made on their behalf (i.e., $150,000 x 9.5%). (c) Item 46, Label Y: Unpaid present entitlement to a private company The figure of $51,500 is calculated as $45,000 (the balance of the unpaid present entitlement in respect of Doghouse Pty Ltd on 1 July 2015) plus $6,500 (its current year distribution). The Code X denotes that, during the income year, the trust did not make a payment attributable to an unrealised gain that reduced a present entitlement, or make a loan, or forgive a debt in favour of a shareholder (or associate) of the corporate beneficiary. (d) Item 48, Label B: Other depreciating assets first deducted The figure of $10,000 is included at this label, representing the purchase price of the second hand van acquired on 23 April 2016, to be used for transporting dogs between their owner s homes and the kennel or training facilities. National Tax & Accountants Association Ltd: August

216 Case Study The trustee will also need to indicate if, for tax depreciation purposes, they self-assessed the effective life of any of the assets at Label C. The answer in this case is no, as the trust will rely on the Commissioner s determination of effective life. The trustee would also answer in the negative to the question Did you recalculate the effective life for any of your assets in this income year? at Label D. The trustee would also need to complete Label E, Total adjustable values at end of income year, which should represent the written down value of the depreciating assets from a tax point of view. It is assumed for the purpose of this case study that this figure is $40, National Tax & Accountants Association Ltd: August 2016

217 Case Study Income of the trust estate (Item 53) Show the income of the trust estate, being $115,000 in the case of the K9 Discretionary Trust at Item 52, Label A: Income of the trust estate: Statement of distribution (Item 54) The statement of distribution contained in Item 54 of the trust return requires completion. It is at this label that the details of the trust distributions are reported. The distributions made to each beneficiary must be reported separately, as shown below. As no beneficiary of the K9 Discretionary Trust is a trustee beneficiary, Label P and Label Q (which relate to the TB (trustee beneficiary) statement) do not need to be completed. The TB statement was discussed earlier in the notes. Furthermore, Label S and Label T in the distribution statement, which relate to annual trustee payment reporting, do not need to be completed for any of the beneficiaries of the K9 Discretionary Trust. This is because there have been no physical distributions of income over and above any beneficiary s share of the net (taxable) income (i.e., the trust distributions are represented by unpaid present entitlements). These rules are discussed elsewhere in the notes. (a) Statement of distribution Jim Mutt The trust distributed only other (business) income to Jim. His share of trust income is $15,000 and his share of net (taxable) income (comprised only of business income) is $14,360. The relevant assessment code for Jim is 30 (resident beneficiary not under a legal disability). An extract of the relevant parts of the statement of distribution for Jim is as follows: National Tax & Accountants Association Ltd: August

218 Case Study (b) Statement of distribution Jan Mutt The trust distributed other (business) income to Jan, in addition to wholly streaming the trust s capital gain and net franked dividend to her. Her share of trust income is $73,500 and her share of net (taxable) income is comprised of $10,000 (net capital gain), $3,500 (franked dividend, net of directly relevant expenses), $3,000 (franking credits) and $49,363 (other (business) income). The relevant assessment code for Jan is 30 (resident beneficiary not under a legal disability). Note that the amount required to be disclosed at Label U: Franked distributions, is $6,500, being the amount of Jan s share of the net franked dividends and the amount of the franking credit (i.e., $3,500 net franked dividend plus $3,000 franking credit in this case). The franking credit must also be included at Label D: Franking credit. An extract of the relevant parts of the statement of distribution for Jan is as follows: (c) Statement of distribution Jason Mutt The trust distributed only other (business) income to Jason. His share of trust income is $20,000 and his share of net (taxable) income (comprised only of business income) is $19,745. The relevant assessment code for Jason is 30 (resident beneficiary not under a legal disability). An extract of the relevant parts of the statement of distribution for Jason is as follows: 208 National Tax & Accountants Association Ltd: August 2016

219 Case Study (d) Statement of distribution Doghouse Pty Ltd The trust distributed only other (business) income to Doghouse Pty Ltd. Its share of trust income is $6,500 and share of net (taxable) income (comprised only of business income) is $6,282. The relevant assessment code for Doghouse Pty Ltd is 34 (resident company). National Tax & Accountants Association Ltd: August

220 Case Study 7.2 Recording each beneficiary s share of the trust s net income in their 2016 tax return The following is a summary of how each beneficiary must report their share of the trust s net income in their own tax return for the 2016 income year. (a) Extract of Jim s personal income tax return K9 Discretionary Trust distributed trust income of $15,000 (comprised of other income) to Jim. His share of the other trust income included in the trust s net (taxable) income was $14,360. Jim is only required to report his share of the net (taxable) income in his personal return. Jim must report an amount of $14,360 at Item 13: Partnerships and trusts, Label U: Share of net income from trusts less capital gains, foreign income and franked distributions: (b) Extract of Jan s personal income tax return K9 Discretionary Trust distributed trust income of $73,500 to Jan (comprised of other business income, a capital gain and franked dividend). Jan s share of the trust income included in the trust s net (taxable) income is reported as follows in her personal tax return: 1. Share of net capital gain - $10,000. Under the gross-up rules (refer to S ), Jan is required to gross-up her (100%) share of the trust s net capital gain of $10,000 to $20,000 (i.e., double the amount because the trustee claimed the CGT 50% discount). The $20,000 amount must be reported at Item 18, Label H: Total current year capital gains. After applying her capital losses ($5,000) and the CGT 50% discount, Jan s net capital gain is $7,500 (refer above). This amount is reported at Item 18, Label A: Net capital gain. Note that Jan s only capital gain for 2016 was the capital gain streamed to her from the trust. 2. Share of net franked dividend - $3,500 and share of franking credit - $3,000. Jan must disclose $6,500 at Item 13: Partnerships and trusts, Label C: Franked distributions from trusts. This is her $3,500 attributable (or taxable) franked dividend amount (determined above) plus her share of the franking credit (being, $3,000). Jan must also disclose $3,000 at Item 13: Partnerships and trusts, Label Q: Share of franking credit from franked dividends. This is her 100% share of the franking credits. 210 National Tax & Accountants Association Ltd: August 2016