We are seeing cases where legal personal representatives (LPRs) have left themselves vulnerable to claims by tax exempt beneficiaries for not giving due consideration to the possibility of making them presently entitled to trust income during the estate administration.
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 make the charity entitled to the income. 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 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 inheritance that Monty had left it.
Present entitlement to income of trust estate
For tax purposes, a deceased estate is treated as a trust and an LPR as a trustee. 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 new 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 by 30 June. 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.
A beneficiary is presently entitled to trust income if they have a present or immediate right to demand payment of it from the trustee. Tax Ruling IT 2622 acknowledges that a beneficiary can be presently entitled to income prior to the completion of the administration of an estate.
However, in certain situations, a tax-exempt beneficiary may be taken to not be presently entitled to income (or capital included in the beneficiary’s share of adjusted net income) for tax purposes. Anti-avoidance rules were introduced at the same time as the rules to allow streaming of capital gains and franked distributions. While the rules were aimed at discretionary trusts, they nonetheless apply to deceased estates and testamentary trusts. So, an LPR making an exempt beneficiary presently entitled must ensure that they satisfy these rules. If a beneficiary is taken not to be presently entitled, the beneficiary’s share of net income will be assessed to the LPR.
For tax purposes, a tax-exempt beneficiary is treated as not being presently entitled to income of a trust if the trustee failed to pay or notify the beneficiary of their entitlement within two months of the end of the relevant income year. If the ‘pay or notify’ rule applies, the trustee is taxed on the beneficiary’s share of the net income.
However, the Commissioner has the discretion not to apply the rule when the trustee fails to pay or notify on time. In exercising the discretion, the Commissioner must consider the following factors:
- the circumstances that led to the trustee failing to notify or pay the amount within two months of the year end.
- the extent to which the trustee has taken actions to try to correct the failure and how quickly those actions were taken.
- whether the trustee has applied to the Commissioner to exercise his discretion previously.
- any other relevant matters.
In the example above, Daryl would need to pay the income to the charity or at least notify it of its entitlement by 31 August or he will be assessed on all of the net income.
A trustee of a testamentary trust can inadvertently trigger the ‘pay or notify’ rule. For example, on the death of a life tenant, the trustee may overlook the obligation to notify tax exempt remainder beneficiaries of their entitlements within the two-month period after the end of the financial year.
Section 100AB is designed to overcome the exploitation of the proportionate approach whereby a charity can be made presently entitled to all of the income of a trust so that tax can be avoided on a capital gain that is enjoyed by another entity. This is demonstrated in the example of the Explanatory Memorandum.
Section 100AB applies if there is a difference between a beneficiary’s present entitlement to trust income (as a percentage) and their ‘present entitlement’ to the trust estate reflected in the trust’s adjusted net income (as a percentage). The provision operates by assessing the executor having regard to the amount by which the percentage entitlement to income exceeds the entitlement to adjusted net income.
The concept of present entitlement to the trust estate (that is reflected in the adjusted net income of the trust) is relevant only for section 100AB purposes. The present entitlement can be an entitlement to income and/or capital. ‘Present entitlement to trust income’ is a concept that has been considered by the Courts on many occasions. The High Court decision in the Union Fidelity Case determined amongst other things that:
12.…..When a beneficiary has been paid his share of the income of the estate in respect of a tax year, he no longer satisfies the description of a beneficiary who is entitled to a share of the net income of the estate for that year.….
As a consequence of that decision, the ITAA 1936 was amended to introduce subsection 95A(1) which provides that a beneficiary will continue to be presently entitled to trust income notwithstanding that it has been paid to them or applied for their benefit.
However subsection 95A(1) was not amended to provide that a beneficiary’s entitlement to trust capital exists for a year notwithstanding that it has been paid to them.
So, for example, if an entitlement to trust capital was created by an executor and paid to the beneficiary before the end of the income year, it may be that there is a mismatch between the relevant percentages and the executor would need to seek an exercise of the discretion in subsection 100AB(5) in order to avoid an assessment by reason of section 100AB.
In exercising the discretion, the Commissioner is to consider:
- the circumstances that led to the difference between the Division 6 percentage exceeding the benchmark percentage
- the extent of mismatch between the exempt entity’s adjusted Division 6 percentage and the benchmark percentage
- the extent to which the exempt entities actually received distributions from the trust estate in respect of the year of income
- the extent to which the exempt entity and other beneficiaries were entitled to benefit from amounts representing the net income of the trust.
Taking the previous Daryl example, assume that he had also made a discount capital gain of $200,000 from the sale of a property. The income of the trust remains $250,000 but the net income is now $350,000. The adjusted net income is $450,000 (as the CGT discount is added back).
Daryl, determines that he does not require the $450,000 for the purposes of the estate administration and makes an interim distribution to the charity before 30 June. At year end the charity is presently entitled to 100% of the income of the trust (by virtue of subsection 95A(1)); however its present entitlement to the adjusted net income may be 55% [($250,000/$450,000) x 100].
Without the exercise of the discretion, the exempt entity’s entitlement to income would be taken to be 55%. Therefore, Daryl would be assessed on 45%of the net income. (45%x $350,000 = $157,000).
Clearly the case is one in respect of which it was intended that the discretion should be exercised:
- the discrepancy arose as a result of the operation of the deceased’s Will and the general law of succession and the fact that there is no deemed present entitlement rule in respect of an amount of capital paid to a beneficiary during the year
- no other entity will benefit from an amount attributable to the capital gains
- a similar result could be achieved by making the entities specifically entitled to various capital gains.
It may be preferable not to have to rely on the exercise of a discretion after year end. So, you should seek the exercise of the discretion prior to the end of the income year (allowing sufficient time for the ATO to respond) or withhold payment of any distribution until after 30 June.
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.