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Lecture 2

Lecture 2 - Trusts

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Queensland University of Technology

LECTURE 2 – TRUSTS What is a Trust?  A trust comprises a fiduciary relationship where which a person (called the trustee) holds and administers property (ie. assets) under the terms of a trust deed for the benefit of someone else (ie. the beneficiaries of the trust). o A “trust" is not defined in the ITAA 1936 or 1997  The four essential elementsof any trust are: (a) A trustee;  The trustee is the legal registered owner of the property and the business manager of the trust.  The trustee controls and administers the trust property (assets of the trust).  A trustee can be a natural person or a company.  Any person (including a company) who acts as a trustee can be sued. (b) Trust property;  The trust property refers to the property (assets) of thetrust held by the trustee. (c) A beneficiary or beneficiaries; and  The beneficiaries have the beneficial interest in the trust property.  The beneficiaries are usually listed in the trust deed.  A trustee can also be a beneficiary of the trust, but not the sole beneficiary (a) An obligation in respect of trust property.  The trustee has a fiduciary obligation to act in the best interests of the beneficiaries.  The trustee is required to undertake a range of duties and obligations and to exercise certain powers in relation to the trust property. o These duties, obligations and powers are usually found in the trust deed. The Advantages and Disadvantages of a Trust Advantages  Flexibility in distributing income and vesting assets in beneficiaries taking into account marginal tax rates;  More family and commercial flexibility than other types of structures (ie. Income splitting);  Asset protection from creditors  Receive 50% CGTdiscount  Trusts can distribute excess income to a corporate beneficiary thereby capping the family’s maximum tax rate at 30%;  Attribution of income ie. Identifying certain classes of income of the trust and then allocating portions of these income classes to different beneficiaries (eg. A beneficiary might receive franked dividends only);  Confidentiality of trading results – a discretionary trust is not subject to the regulation of companies. o Apart from lodging tax returns (which are confidential), information cannot be accessed;  Succession planning – usually, discretionary trusts have wide classes of beneficiaries who may range from grandparents down to grandchildren; and  Trusts are generally cheaper to operate. Disadvantages  If the trust income is not distributed, then it may be subject to a penalty rate of tax (taxed at the highest marginal rate) or distributed to beneficiaries with higher incomerather than lower income,  When trust losses are not distributed to beneficiaries, they are carried forward to set off against future income.  Loss of control of assets as the trustee makes all the decisions (i.e. distribution etc),  Complex and costly to set up and administer and requires ongoing legal and accounting advice. Types of Trusts There are three (3) common types of trusts covered byDivision 6 of the ITAA (1936): (a) Discretionary Trusts  Terms give the trustee a wide discretion to determine which beneficiaries are entitled to distributions of the income and/or capital of the trust on a year-by-yearbasis. o Offers opportunities for income splitting due to flexibility in the distribution of income and capital o Each year, the trustee decides how much to distribute to each beneficiary (if any).  This often makes the discretionary trust popular as a tax planning vehicle for family businesses. o AKA family trust.  Can stream different types of income if the trust deedallows it  Can divert business, property or asset income ONLY (b) Fixed Trusts  A fixed trust is a trust where the beneficiary’s entitlements to a share in the income or capital of the trust are fixed under the terms of the trust deed.  A fixed trust usually entitles the beneficiary to receive a fixed percentage of the net income of the trust estate (eg. pay 50% of the net income of the trust estate to John Smith, 25% to Mary Smith and the remaining 25% to Alice Smith). o Common set up when parties are not family (c) Unit Trusts  A unit trust is a type of fixed trust.  Unit holders' capital and income entitlements are determined in proportion to the number of units held in the trust. o For example, if Peter Reid owns 30 of the 100 units of the unit trust, he is entitled to 30% of the net incomeof the trust estate for that year.  Unit trusts are commonly used where investors, who are not related to each other, wish to pool their resources together to purchase property orother formsof investment. Taxation of Trust Income  A trust is not a separate legal entity. It cannot have a taxable income. It cannot pay income tax in its own right. o However, a trust is considered a taxpayer because it derives income. A trust is required to lodge a trust income tax return (Section95 ITAA 1936).  In the trust tax return, the trust includes its assessable income and deducts its allowable deductions on the basis that it is a resident taxpayer. o The difference between the trust’s assessable income and its allowable deductions is called the “net income ofthe trust estate”.(NITE)  Once the net income of the trust estate has been ascertained, profit is distributed by the trustee to each beneficiary named in the trust deed to be included in their respective income tax returns. o Regardless of whether there has been a cash distribution of the profit or not.  Trust income distributed to a beneficiary retains the same character it had in the hands of the trustee. o If a trust derives interest income, rental income, franked dividends, business income and a capital gain, these types of income retain their character when eventually distributed to each of the beneficiaries.  The net incomeof the trustestate must be distributed at the end of each incomeyear. o If the trustee does not distribute all of the net income of the trust estate to the beneficiaries, the trustee is assessed the tax at the topmarginal tax rate plus Medicare Levyof 46.5%.  If the trust derives a net loss, the loss is notdistributed to the beneficiaries. o The loss is trapped in the trust and must be carried forward to be offset against income in a future year Legal Disability and Presently Entitled  As trusts are not separate legal entities, the liability to tax between the trustee and the beneficiaries is apportioned according to whether each beneficiary is: (i) Under a legal disability; and (ii) Presently entitled to a share of the net income ofthe trust estate. (Div 6 (Sections 95 to 102)of ITAA 36)  This determines whether the trustee pays the tax on behalf of the beneficiary or whether the beneficiary includes the income in their tax return and pays tax themselves. Legal Disability  Not defined in the ITAA (1936) or ITAA (1997).  There are three (3) classesof persons are considered to be under a legal disability for trust and tax law purposes: o A minor who is under the age of 18 on the last day of the year of income; o A bankrupt; or o An insane or mentally incapable person.  In these instances, where a beneficiary is under a legal disability, the trustee is required to lodge the beneficiary’s income tax return on theirbehalf and pay the tax owing in respect of the trust distribution. o The situation may arise where the beneficiary may also lodge their own tax return. o In this instance, in order to prevent double taxation, the beneficiary is taxed at their marginal tax rate when they lodge their owntax return.  However, the beneficiary is entitled to a tax credit for the amount of tax assessed and paid by the trustee in respect of the trust distribution (Section 100(2)). Present Entitlement  A beneficiary is presently entitled to a share of the net income of the trust estate if they have a right to demand and receive immediate payment of their share of the net incomeof the trust o A beneficiary is not presently entitled if there is some condition or restriction imposed by the law or by the trust deed itself which means that the beneficiary is not able to receive immediate payment in cash of their share of the net income of the trust.  The taxation of the beneficiary’s share of the net income of the trust estate depends on whether the beneficiary is presently entitled and/or under a legal disability.  The ITAA 1936 also deems that a beneficiary will be presently entitled in certain circumstances. The two deeming provisions are: o Section 101 ITAA 1936: A beneficiary of a discretionary trust will be deemed to be presently entitled when the trustee exercises their discretion to distribute to thebeneficiary. o Section 95A(2) ITAA 1936: A beneficiary will be deemed to be presently entitled to income when they have a vested and indefeasible right to income even though they are not presentlyentitled to that income. (i) If Beneficiary is Presently Entitled Not under a Legal Disability:  If a beneficiary is "presently entitled" and not under a legal disability, a resident beneficiary includes the distribution in their personal income tax return and pays tax at their marginal tax rate. (Section 97(1)(a)) o However, where the beneficiary is a non-resident, the trustee is required to pay the tax owing on the beneficiary’s share of the net income of the trust estate at the non-resident beneficiary’s marginal tax rate. (Section 98) Under a Legal Disability:  If a beneficiary is "presently entitled" but is under a legal disability, the trustee pay the tax owing on the beneficiary’s share of the net income of the trust estate at the beneficiary’s marginal tax rate. (Section 98(1)(a)) o Where the only source of income derived by a beneficiary who is under a legal disability is a distribution from one trust, the beneficiary is not required to lodge a tax return (TD 92/159). (ii) Beneficiary Not Presently Entitled  If a beneficiary is not presently entitled, and the trustee distributes all or part of the net income of the trust estate to that beneficiary, then the trustee is assessed and is liable to pay tax on the beneficiary's share of the net incomeof the trust estate under either Section 99 or 99Aof the ITAA (1936). Section 99A:  Under Section 99A, the trustee is required to pay a flat 46.5% tax on the distribution made to a beneficiary that is not presently entitled. Section 99:  Instances will arise where the trustee has no alternative but to distribute money to a beneficiary even if the beneficiary is not presently entitled. This may occur in the case of deceased estates and bankruptcy. o Instead of the trustee paying the top marginal tax rate of 46.5%, the Commissioner has the discretion to tax the beneficiary at their marginal tax rate under Section 99.  This gives the income the benefit of being taxed on a sliding or progressive scale. Table1: Who PaystheTax? BeneficiaryisPresently Beneficiaryis Not Entitled PresentlyEntitled Beneficiaryisnotunder Beneficiarypays Trusteepaysthetax a legal disability thetax onbehalfofthe (Section97(1)(a)) beneficiary (Section99/99A) Beneficiaryisundera Trusteepaysthetax Trusteepaysthetax legaldisability onbehalfofthe beneficiary onbehalfofthe atmarginaltaxrates beneficiary (Section98(1)(a)) (Section99/99A) Discrepancy between Trust Income and Taxable Income  Accounting net profit (or “trust law income”) will not always equate to net income of the trust estate (“tax law income”) (Section 95 ITAA 1936). There are several reasons for this discrepancy: o There are some items of accounting revenue which are not assessable for income tax purposes (eg. exempt income); o There may be some items which are assessable for taxation purposes, but not considered revenue for accounting purposes (eg. franking credits); o In terms of deductions, there are several expenses recorded in the income statement which are not tax- deductible (eg. Provisions for bad debts, annual leave, entertainment provided to clients etc); and o There may be some items which are deductible for income tax, but are not shown as an expense in the income statement (eg. Capitalised research and development expenditure).  When there is a discrepancy between net income for tax purposes and net income for trust law or accounting purposes, Division 6 (ITAA 1936) applies.  There are two differing views: (a) Proportionate View o The proportionate view starts with the proportion of trust (accounting) income to which each beneficiary is presently entitled.  This approach is preferred by the commissioner and is to be used. o Provided that there are one or more beneficiaries who are presently entitled to the whole of the trust law/accounting income of a trust estate, the net income for tax purposes will be distributed among those same beneficiaries proportionately and there will be no undistributed income.  If entitled to 100% of accounting income = entitled to 100% of tax income. (b) Quantum View o Under the quantum view, it is considered that the beneficiary is only presently entitled to the amount of income calculated for trust law/accounting purposes. o Should the net income of the trust estate (as calculated by section 95) exceed trust law net income, the excess is assessable to the trustee (usually at top marginal rates under section 99 of the ITAA 1936. Streaming Tax Distributions  Trust income distributed to a beneficiary retains the same character it had in the hands of the trustee. o Therefore, if a trust receives franked dividend income, a distribution of that income to a company beneficiary results in the beneficiary:  Receiving a credit in its franking account;  Receiving a notional amount of assessable income (ie. The franking credit gross-up); and  Being entitled to a tax offset equal to the share of franking credit. Does the Commissioner Allow Streaming of TrustDistributions?  Franked dividends to be streamed to specific beneficiaries provided the following three (3) conditions are met: o The terms of the trust deed do not require mixing of income which would prevent the trustee distributing specific types of income; o The trustee accounts for each type of income separately, thus enabling tracing of the source of each trust distribution to a specified beneficiary; and o The trustee resolves, and it is clearly reflected in the trustee’s distribution resolution, that specific types of income are to be distributed to different beneficiaries. (TR 92/13)  The same principle should apply to streaming of other types of income from a discretionary trust if the above three conditions are met. How Capital Gains are Taxed in Trusts  The CGT treatment of most trusts are similar to individuals - trusts are eligible to use the indexation method or the CGT discount method. o A trust is eligible for a 50% discount on any capital gain, provided it has held the asset for more than 12 months from the date of acquisition.  No discount is allowed for a trustee assessed under section S99A.  Where the net income of a trust includes the discounted capital gain, that part of a beneficiary’s share of the net trust income attributable to a discounted capital gain must be grossed up by multiplying the capital gain by two.  The grossed-up amount is treated as the beneficiary’s capital gain for the purposes of applying any capital losses before the beneficiary applies the CGT discount, if any, that is appropriate to that beneficiary (Section 115-215). Trust Losses and Trust Loss Provisions  The aim of the trust loss provisions (Schedule 2F – Sections 265-5 to 272-140) is to restrict the recoupment ofprior year and current year tax losses of trusts in order to prevent the transfer of the taxbenefit of those losses. o The measures achieve this aim by examining whether there has been a change in the underlying ownership or control of a trust or whether certain schemes (ie. income injection) have been entered into in order to take advantageof the trust’s losses.  Broadly, a trustcannot deduct current and prior year losses if it fails to satisfy certain tests relating to ownership or control of the trust.  The tests must be satisfiedat all times during the “test period”. o The test period is generally the period from the income year in which the loss was incurred to the income year in which the loss is being recouped.  The first step in applying the trust loss provisions is to classify the type of trust. For the purposes of the trust loss provisions, trusts are classified as one of three types: (a) Fixed Trust o A fixed trust is a trust in which persons have fixed entitlements to all of the incomeor capital of the trust.  This typically includes fixed and unit trusts. (b) Non-Fixed Trust o A non-fixed trust is simply a trust that is not a fixed trust.  Non-fixed trusts typically include discretionary trusts. Can include a trust with a partially fixed component (c) Excepted Trust o An excepted trust includes family trusts, complying superannuation funds (CSF), approved deposit funds (ADFs), pooled superannuation trusts (PST), deceased estates within the first five years of administration. Once the type of trust has been categorised, the test(s)that need to be satisfied are summarised below. Trust Loss Tests Type of Trust 50% Stake Same Pattern of Control Income Test Business Distribution Test Injection Test s Test Test 1. Fixed Trust Unlisted widely held
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