Grab yourself a cup of coffee for this particular article, because you're going to need it.
This note focuses on the importance of staying on top your family trust deeds. It's a little lengthy but please stay with me on this if you can (and if not, just call me)...
Out of date Trust Deeds cause problems. Most Family Trust Deeds before 2008 need updating for:
- Streaming provisions
- Franking credits
- Attribution to distribute capital gain
- Extension of the Capital Gains Tax regime into Family Trusts
- Definition of Net Income
- Loss Recoupment
- Bank loans
- Lawyer signed loaning certificate
The Streaming Provisions
Streaming in your old Family Trust Deed allows each category of income to retain its own character. Each category is distributed to exactly the desired beneficiary. With streaming, you place different income into separate accounts. Thus, it is possible to trace the source of each Trust distribution to a particular beneficiary.
The ATO states that 'the Trustee must be validly empowered to selectively allocate each category of income'. That is, the Trust Deed itself must contain the ability to stream income. Most old Family Trust Deeds, including many brand new Family Trusts, fail to adequately deal with the full list of categories. Without proper streaming in your trust deed, the categories of income merge and can't be untangled. The old Family Trust Deed must be updated first.
Here is one example:
Your old Family Trust sells a rental property and realises a capital gain. This capital gain is received into the Trust. It is part of the Trust's net income. Correctly drafted, streaming provisions allow the capital gain to be distributed to one particular beneficiary. Another category received by the trust was franked dividends. They are also part of the Trust’s income. However, because of streaming the dividends don't merge with the other categories of income, such as the capital gain. The dividends are not “mixed” with the capital gains tax income. The dividends can be distributed to another beneficiary.
At times your Trust may include gross income from franked dividends. A resident beneficiary in your Family Trust (other than a Trustee of another Trust estate) is entitled to a franking rebate if:
- a share of net Trust income is included in the beneficiaries' assessable income; and
- some or that entire share of net Trust income is attributable to a franked dividend included in the assessable income of the Trust estate.
Notwithstanding wide discretionary powers being conferred on a Trustee, a Trustee’s discretion to selectively allocate dividend income to a beneficiary to the exclusion of another may be fettered by the terms of the Trust or by Trust law operative in the relevant jurisdiction. You don’t want that. Therefore, the lawyers will insert a clause in your Trust Deed which expressly empowers you to selectively allocate particular types of income to beneficiaries.
Attribution to distribute capital gain
When the Trust derives net capital gain in the net income of the Trust, then the Trustee needs the power to distribute that part of the net income to certain beneficiaries. The beneficiaries are treated by the Commissioner of Taxation as having accrued a capital gain. It may be that one beneficiary has carried forward capital losses and another has carried-forward revenue losses. In this case, there are tax advantages in distributing the net capital gain to the beneficiary who has suffered the prior capital losses.
For some old Family Trusts, the Commissioner may take the view that either:
- both beneficiaries are treated as having been presently entitled to a proportionate amount of the net capital gain and other net Trust income; or
- the net capital gain loses its character and therefore no part of the Trust distribution is characterised as being a net capital gain.
Both outcomes are generally unfavourable.
You now have the power to attribute.
Ongoing extension of the Capital Gains Tax regime
Your Deed of Variation should allow you to account separately and keep separate any funds received from different sources. Your Trust Deed will be amended to allow the Trustee to account separately and keep separate any funds received from different sources. For example, sources may include:
- capital gains
- any dividend income (of all natures)
- income having an allowance for depreciation (inclusive of depreciation of buildings and plant and equipment
- any income from Superannuation investments or annuities
- income from deceased estates and Trusts (including testamentary Trusts) whether trading, investment or otherwise
- franked distributions
- credit trading income
- primary production income
- income from personal exertion
- rents and other property income
- foreign source income
Definition of Net Income
A Trust distribution often allows you to pay less tax. You normally distribute to the family members that are on the lowest tax rates. If you fail to distribute, then the Trustee (as the tax payer) pays the tax at the highest marginal tax rate.
You distribute Trust income to the pool of potential beneficiaries. If you don’t distribute any part of the Trust income, then the Trustee is assessed on that part of the ‘net income’ at the highest marginal tax rate.
There is a difference between ‘Trust income’ within the taxation legislation. Net income of the Trust estate is the taxable income of the Trust. A beneficiary is entitled to the Trust income. But they are taxed, instead, on the net income.
The Deed of Variation allows you to:
- define Trust income appropriately; and
- make valid distributions.
The Trustee has the power to determine not to recoup carried forward losses, to have distributable income, which can be applied to various beneficiaries. If you did not have that power, there could be a situation arising where there is no income of the Trust estate to distribute. According to the ATO, the Trustee is assessed on the capital gain. To make matters worse a corporate Trustee is taxed on the grossed up capital gain, without recourse to the tax legislation.
We have arranged for specialist trust and taxation law firm to review your Deed at no cost - this offer is exclusive to Westmount clients only.