The High Court on 30 March 2010 provided important guidelines for determining key aspects of trust income and the interaction of trust law concepts with income tax law rules in FCT v Bamford & Ors, Bamford & Anor v FCT [2010] HCA 10 (Bamford's case); particularly with respect to the taxation treatment of distributions to beneficiaries of trust income including capital gains.

The two main issues considered and the conclusions unanimously reached by the High Court are summarised as follows:

1 What is 'income of the trust estate' for the purposes of section 971?

The High Court agreed with the Full Federal Court that 'income of the trust estate' referred to distributable income that was ascertained by the trustee according to accounting principles and the trust deed. On this basis and rejecting any argument that this concept should exclude statutory income (including capital gains), the capital gain made by the trust, which the trustee had resolved (in accordance with the trust deed) to distribute as income, was 'income of the trust estate'.

Trust deeds should be reviewed given the importance attributed to them in determining the 'income of the trust estate' by the High Court's decision in Bamford's case - particularly in respect of the trustee's discretion in determining what amounts are income and capital. The High Court provided useful guidance on the proper approach to interpreting Division 6 - Taxation of Trusts, as well as the interrelationship of sections 95, 96 and 97, impacting both beneficiaries and trustees.

2. How is the beneficiary's share of the 'net income' of the trust estate calculated for the purposes of section 97?

The High Court also agreed with the decision of the Full Federal Court and a number of earlier decisions that the 'proportionate view' (rather than the quantum approach/fixed quantum) was the correct approach to determine the beneficiary's share of the net income where the net income of a trust for tax purposes exceeds its accounting income. Under the 'proportionate view', a beneficiary is assessable on a share or proportion of the trust's net income equivalent to the proportion of the trust income to which the beneficiary is presently entitled to at the end of the year.

Background History

The determination of 'income of the trust estate' and how beneficiaries of a trust are taxed in respect of this income has been a controversial issue for many years. There have been a number of Federal Court decisions opining on these issues but no High Court decision.

The ATO released Practice Statements Law Administration PS LA 2009/7 which outlined its views after the Full Federal Court decision in Bamford's case2. The ATO and the taxpayers were not satisfied with the decision reached by the Full Federal Court in Bamford's case resulting in an appeal and cross appeal to the High Court. In light of the important issues in the case, the ATO provided funding to the taxpayer to appeal to the High Court.

The High Court's decision in Bamford's case (rejecting appeals on two issues) will provide greater clarity in respect of these issues. Further, the conclusions in this case will not just be confined in their application to discretionary trusts but will have a far broader impact on trusts generally including large listed trusts and other widely held trusts, including wholesale trusts and retail trusts.

Facts

This case arose out of a typical family discretionary trust.

2000 Income Year

The trust calculated its income after deducting certain payments. The trustee, pursuant to its discretion under the trust deed, sought to allocate specified amounts of the trust income for the year to particular beneficiaries (Mr and Mrs Bamford) and the residual to the Church of Scientology (Church). However, the trust income was insufficient to cover the specified amounts to be allocated and Mr and Mrs Bamford were each distributed a lesser amount and no amount was distributed to the Church.

The ATO disallowed certain deductions which resulted in the trust's taxable income exceeding its income. The ATO included the additional income in each of the assessable incomes of Mr and Mrs Bamford in proportion to their earlier distributions pursuant to section 97. As a result, a dispute arose in respect of the correct approach (proportionate, quantum or an amalgam of the two) in allocating this additional income (either to Mr and Mrs Bamford or to the trustee) for the purposes of Section 97 which is discussed below.

2002 Income Year

The trust realised a net capital gain from the sale of certain real property after the utilisation of carried forward losses arising as a result of claiming deductions which were later disallowed by the ATO. The deed for the trust did not define income but included a provision which gave the trustee the power to determine in its absolute discretion whether any amount was income or capital. The capital gain was treated as a revenue item in the trust's profit and loss account. The trustee distributed the capital gain equally to Mr and Mrs Bamford who included this amount in their tax returns.

As a result of the ATO disallowing the deductions, the losses were no longer available which gave rise to an increased capital gain amount. The ATO considered that the capital gain was not included in the 'income of the trust estate' for section 97(1) purposes as it was not 'income according to ordinary concepts' and on this basis there was no income of the trust estate to which this section could apply resulting in the trustee being assessed under section 99A. This resulted in a dispute in relation to the meaning of 'income of the trust' which is discussed below.

Detailed Consideration of the Issues

Proportionate view

The High Court in Bamford's case decided that the 'proportionate view' (rather than the quantum approach/ fixed quantum) is to be applied where the net income of a trust for tax purposes exceeds its accounting income and approved the analysis of Sundberg J in Zeta Force Pty Ltd v Commissioner of Taxation (1998) 84 FCR 70 (Zeta Force's case) where he stated the following at 74-75:

"The words 'that share' in par (a)(i) refer back to the word 'share' in the expression 'a share of the income of the trust estate', and indicate that the same share is to be applied to an income amount calculated according to a different formula (taxable income as opposed to distributable income). Since the income amount may differ according to which formula is applied, the natural meaning to give to 'share' where it appears for the second time is 'proportion' rather than 'part' or 'portion'. When Parliament wanted to convey the latter meaning, as it did in ss 99 and 99A, it used the word 'part'.

The contrast between the expressions 'share of the income of the trust estate' and 'that share of the net income of the trust estate' shows that the draftsman has sought to relate the concept of present entitlement to distributable income, and not to taxable income, which is, after all, an artificial tax amount. Once the share of the distributable income to which the beneficiary is presently entitled is worked out, the notion of present entitlement has served its purpose, and the beneficiary is to be taxed on that share (or proportion) of the taxable income of the trust estate."

This is consistent with the Full Federal Court's decision in Bamford's case - see paragraph 42 (Emmett J) of that judgement.

Income of the Trust Estate

The High Court agreed with the Full Federal Court that 'income of the trust estate' referred to distributable income ascertained from appropriate accounting principles and the trust deed. In particular, the High Court approved the analysis of Sundberg J Zeta Force's case where he stated the following at 74:

"The words 'income of the trust estate' in the opening part of s 97(1) refer to distributable income, that is to say income ascertained by the trustee according to appropriate accounting principles and the trust instrument. That the words have this meaning is confirmed by the use elsewhere in Div 6 of the contrasting expression 'net income of the trust estate'. The beneficiary's 'share' is his share of the distributable income."

On this basis, the High Court held that 'income of the trust estate' in section 97(1) included capital gains (that is, statutory income) made by the trust, which the trustee had resolved (in accordance with the trust deed) to distribute as income. Accordingly, this capital gain was assessable to Mr and Mrs Bamford and the trustee should not have been assessed on this amount of the capital gain pursuant to section 99A.

This is also consistent with the Full Federal Court's decision in Bamford's case - see paragraph 43 of that judgement.

Present Entitlement

In respect of the phrase 'present entitlement', the High Court in Bamford's case approved in paragraph 37 the comments made in Harmer v Federal Commissioner of Taxation (1991) 173 CLR 264 at 271, where it was held that a beneficiary would be so entitled if, and only if,

"(a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and

(b) the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment."

© DLA Phillips Fox

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This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances.

1. All section references are to the Income Tax Assessment Act 1936 unless otherwise expressly indicated.
2. [2009] FCAFC 66.