Guide on Trust Funds – Part 15
Problem when trust income is defined to equal taxable income
Some trust deeds contain a ‘hard-wired’ definition of income in the form of an income equalisation clause (‘IEC’). As such the trust income will equal net (taxable) income and the trustee has no discretion to otherwise determine the trust income. Hard-wired IECs are not that common in modern trusts deeds. In many cases, the existence of an IEC will not create any special issues for a trustee when distributing the trust income. It will be generally true to say that for each $1 of trust income a beneficiary is ‘presently entitled’ to, they will include $1 of the trust’s net (taxable) income in their assessable income.
However, there may be some limited cases where IEC will pose some difficulties for trustees. This is due to the view held by the ATO that trust income, for the purposes of S.97 of the ITAA 1936, cannot include a notional amount (i.e., a fiction created by the ITAA that does not represent an increase in the value of the trust assets) because it does not represent something a beneficiary can be ‘presently entitled’ to.
When an IEC forces the trustee to include a notional amount in trust income potential issues can arise. This is because the trust income determined under the deed may (in the opinion of the ATO) exceed the trust income for the purposes of S.97. The ATO is effectively placing a ‘statutory cap’ on the S.97.trust income.
Relevance of trust income
The concept of trust income is important as it is this amount to which beneficiaries are made ‘presently entitled’. To the extent the trust income is fully distributed to the beneficiaries, the trustee will not be assessed under S.99A. Nor will any default beneficiaries be assessed.
Once a beneficiary’s entitlement to trust income is determined it is converted to a percentage and applied to the trust’s net (taxable) income to ascertain the amount the beneficiary includes in their assessable income (or upon which the trustee is assessed under S.98). This is referred to as the ‘proportionate approach’.
Trust deed contains an IEC – no notional amounts
Where the trust has no ‘notional amounts’, the trust income calculated under the deed will be the same as the trust income for the purposes of S.97. Whilst the ‘proportionate approach’ still technically applies, each beneficiary will include in their assessable income the same dollar amount of trust income to which they are ‘presently entitled’.
Trust deed contains an IEC – notional amount
Where the trust has ‘notional amounts’, (i.e., amounts that form part of the net (taxable) income but do not represent an increase in the assets of the trust) the trust income calculated under the deed will be the greater than the trust income for the purposes of S.97. If the trustee purports to distribute the deed income, the amount to which the beneficiary is ‘presently entitled’ will be different to that calculated than if the S.97 income were used to determine that percentage entitled.
Dealing with notional amount
To the extent the net (taxable) income includes a notional amount and the trustee is aware of this prior to 30 June financial year end (i.e., prior to distributing the trust income), the trustee can modify the amount to which each beneficiary will be ‘presently entitled’ so as to control the amount they will be required to include in their assessable income.