The way that trusts are taxed depends on whether there are beneficiaries who are ‘entitled’ to particular ‘things’.
There is often confusion about the different ‘entitlement’ tests. This newsletter explores three forms of ‘entitlement’ referred to in the income tax legislation, how they interact and how they arise in the context of a deceased estate or testamentary trust. It is important to note at the outset that although a deceased estate is not a trust for general law purposes, it is treated as a trust for tax purposes.
Absolute entitlement to trust asset
Absolute entitlement is a concept that is relevant in the context of the capital gains tax provisions. The legislation treats a trustee as the relevant owner of a CGT asset unless there is a beneficiary who is absolutely entitled to the asset as against the trustee. [A CGT event also happens if a beneficiary becomes absolutely entitled].
If there is a beneficiary who is so entitled, then any capital gain or loss from the asset is taken to be made by the beneficiary themselves rather than by the trustee. That is, the gain or loss is not taken into account in working out the trust’s net capital gain.
The absolute entitlement rules operate only for CGT purposes. Strictly, if the asset is used to produce income or a loss, that income or loss is taken into account in calculating the net (or taxable) income of the trust and is assessable under the general rules that apply to trusts. In practice however, many people treat the absolutely entitled beneficiary as having made the income or loss directly. The disconnect between the CGT and income rules was recognised by the Board of Taxation which made recommendations to government following a self-initiated review.
The ATO’s views about when a beneficiary is absolutely entitled to a trust asset are set out in Draft Taxation Ruling TR 2004/D25. Essentially, that draft ruling expresses the view that a single beneficiary who has an absolute vested interest in an asset and who can demand that the asset be transferred to them or at their direction, is absolutely entitled to the asset.
Critically, the ATO takes the view that multiple beneficiaries cannot be absolutely entitled to a single trust asset. The ruling also says that a trustee’s right of indemnity does not prevent absolute entitlement.
Since TR 2004/D25 was published, there have been a number of cases that have considered the concept of absolute entitlement including Oswal v Commissioner of Taxation  FCA 745. In that case Edmonds J expressed the views that a trustee power of sale and a trustee’s indemnity can prevent absolute entitlement.
How might this issue arise in the context of a deceased estate? One way might be in relation to the passing of an asset to a beneficiary. The ATO has taken the view in Taxation Determination TD 2004/3 that an asset will ‘pass’ to the beneficiary of a deceased estate when the beneficiary becomes absolutely entitled to the asset as against the estate’s trustee (whether or not the asset is later transmitted or transferred to the beneficiary). The TD contains this example:
John bought a block of land after 20 September 1985. John died on 21 June 2002. In his Will John appointed his solicitor, Maria, as his executor and trustee of his estate and left the land to his son Peter.
Following the period of administration, during which Maria collected in all of John’s assets and paid all of his debts, Peter had a vested, indefeasible and absolute interest in the land and was able to direct how it was dealt with. Therefore, he became absolutely entitled to the land and the land ‘passed’ to him.
At Peter’s suggestion Maria sold the land and paid the proceeds to Peter rather than transfer the land to him.
The capital gain from the sale of the land is made by Peter because at the time it was sold, the land had passed to him.
The capital gain does not form part of the net income of the trust arising under John’s Will.
[Note that the answer would be different if John had left the land to Peter and his wife as only a single beneficiary can be absolutely entitled to a trust asset.]
More information: Draft Taxation Ruling TR 2004/D25 Board of tax review
Present entitlement to income of trust estate
Prior to the introduction of the rules that allow for streaming of capital gains and franked dividends, the general rules for taxation of trusts were contained in Division 6 of Part III of the ITAA 1936 (Division 6). The rules for taxation of trust capital gains and franked distributions are now contained in Subdivisions 115-C and 207-B of the ITAA 1997 respectively. However, to the extent that no beneficiaries are specifically entitled to gains or franked distributions, the rules operate in a similar manner to Division 6.
Division 6 operates by assessing the net income of a trust to those beneficiaries who are presently entitled to the income of the trust. To the extent that there is some income to which no beneficiary is presently entitled (or if there is no trust income), the trustee will be assessed.
It is important to understand that the ‘net income’ of a trust and its ‘income’ are separate concepts. ‘Net income’ is a statutory concept and is basically the amount that would be the taxable income of the trust if it were assumed that the trustee was a resident taxpayer. Income on the other hand takes its general law meaning. So, in the case of a deceased estate it is ordinary income – because there is no trust deed to modify it. For a testamentary trust however, the income will be determined in accordance with the Deed. The ATO’s views about the meaning of income of a trust estate are set out in Draft Taxation Ruling TR 2012/D1.
A beneficiary is presently entitled to trust income if they have a present or immediate right to demand payment of it from the trustee. For tax purposes, an entitlement in respect of a particular income year must exist by 30 June; otherwise the trustee will be assessed. The ATO views about present entitlement in the context of a deceased estate are set out in Income Tax Ruling IT 2622.
Importantly, that ruling acknowledges that a beneficiary can be presently entitled to trust income that is paid to them prior to the completion of the administration of an estate. We are seeing cases where a trustee (that is, the executor or administrator) has left themselves vulnerable to claims by beneficiaries for not giving due consideration to the possibility of making them presently entitled.
Daryl is the executor of his brother Monty’s Will. Monty left his entire estate to a gift deductible charity.
For various reasons, including the settlement of family maintenance claims, the administration of the estate was delayed. The income of the estate for a particular year was $250,000 and its net income was $250,000.
Near the end of that year it was clear that Daryl would not need the $250,000 estate income to satisfy debts or other claims, however he did not pay the income to the charity. Daryl was assessed on the net income of the trust and paid tax of $89,055.
However, if Daryl had made the charity presently entitled to the income (in this instance by paying it to them) no tax would have been payable. The charity, being presently entitled to all of the estate income, would have been assessable on all the net income however no tax would have been payable because it was an exempt entity. In effect the charity lost $89,055 of the bequest that Monty had left it.
[Note section 100AA of the ITAA 1936 would not apply as the income would have to be paid to the beneficiary if they are to be regarded as presently entitled during the administration period.]
More information: Income Tax Ruling IT 2622 TR 2012/D1
Specific entitlement to capital gains and franked distributions
The final form of entitlement that we will canvas is ‘specific entitlement to capital gains and franked distributions’. The concept of specific entitlement underlies the streaming rules that were introduced in 2011. Prior to the decision in Greenhatch v FCT, many people held the view that if a trustee made a beneficiary presently entitled to income of a particular character, the beneficiary would be taken to be assessed on that part of the net income that had that character. It was thought that tax could be reduced by appointing income to beneficiaries with particular characteristics, for example, to the extent that capital gains were part of the income of the trust it could be directed (and therefore assessed) to a beneficiary who was entitled to the CGT discount.
The streaming rules for capital gains and franked distributions now ensure that result for specifically entitled beneficiaries. However, it is important to note that streaming of other categories of income is not effective for the purposes of Division 6 (although it may be for withholding tax purposes). Broadly, a beneficiary is specifically entitled to a trust capital gain or franked distribution if:
- it has received or can reasonably expect to receive all of the net financial benefit referable to the gain or franked distribution and
- that benefit is recorded in its character in the accounts or records of the trust as referable to:
- the capital gain – by no later than 2 months after the end of the income year; or
- the franked distribution – by the end of the income year.
There are rules that ensure that amounts of net income assessed to beneficiaries based on specific entitlement are not also assessed on the basis of present entitlement.
In the same way that it might be relevant to consider whether a beneficiary should be made presently entitled to income during the administration of an estate or under a testamentary trust, a trustee should also consider whether it is appropriate to make a beneficiary specifically entitled.
More information: Streaming of capital gains and franked distributions
Feel free to contact our team should you want to discuss this topic further and potentially have clients who may be in this situation.
This publication is not intended to be and should not be used as a substitute for taking taxation advice in any specific situation. The information in this publication may be subject to change as taxation, superannuation and related laws and practices alter frequently and without warning. Neither BNR Partners Pty Ltd, our employees or agents are responsible for any errors or omissions or any actions taken or not taken on the basis of this publication.