Beneficiaries 

Most trust deeds of discretionary trusts will list the primary beneficiaries of the trust being those persons (or entities) specifically named in the trust deed as the objects (i.e. potential beneficiaries) of the trust. As a corollary the general beneficiaries of a trust are those entities or class of entities who are potential eligible beneficiaries based on their relationship to the primary beneficiaries under the trust deed. Accordingly, if a husband-and-wife are the sole primary beneficiaries of a trust, any company or trust under which they may potentially benefit may be regarded as a general beneficiary based on their relationship with such primary beneficiaries if the definition of general beneficiaries under the trust deed is based on this association. 

Distributions by the trustee

The trust deed should also be reviewed to identify the specific clauses which empower the trustee to distribute trust income to beneficiaries, and which set out what the trustee must do in order to make a beneficiary presently entitled to a share of trust income by the required time. Compliance with such a clause is critical as an object (i.e. potential beneficiary) of the trust only obtains a vested and indefeasible right to a distribution upon the trustee validly exercising their discretion under the trust deed to appoint them as a beneficiary. Hence, the trustee’s distribution resolution should include references to the relevant clauses identified under the trust deed which grant the power to the trustee to make a beneficiary presently entitled to trust income. 

Tax Impacts of Potential Distributions 

Upon identifying the range of potential beneficiaries, the trustee will in practice be required to consider the tax impacts that a distribution of trust income may have on the trust or beneficiaries from an income tax perspective. In particular, the trustee will need to take into account certain restrictions that are effectively placed on the making of distributions to particular beneficiaries from an income tax perspective which may limit the nature of the distribution made or the amount of tax payable on such a distribution. For example, the trustee may distribute certain amounts of trust income or capital to particular beneficiaries so that the discretionary trust can satisfy the pattern of distributions test or the 50% stake test in recouping prior year tax losses. 

In addition, a trustee of a discretionary trust may also make a distribution of 20% or more of trust income and/or capital to a particular beneficiary in the year that the trust has made a capital gain so that beneficiary is regarded as a significant individual for the purposes of the discretionary trust claiming the 15 years exemption or the retirement exemption under the Capital Gains Tax (CGT) small business concessions. 

However, the three major restrictions imposed under the income tax law on the making of such distributions comprise the following: 

1. The proportionate approach which places limits on the capacity of the trustee to engage in income splitting amongst the beneficiaries. 

2 The limits placed on the definition of the income of the trust estate under Draft Taxation Ruling TR 2012/D1 which provides that trust income cannot include ‘notional amounts’ that are only recognized for income tax purposes.

3 The existence of a family trust election which would deter a trustee from making a distribution of trust income (and therefore related net income) to a beneficiary who is outside the family group which would be subject to punitive family trust distribution tax. 

Proportionate Approach 

The trustee makes a beneficiary presently entitled to a share of the income of the trust estate (being the distributable income calculated in accordance with the trust deed) under section 97(1) of the ITAA (1936) that beneficiary will be assessed on an equivalent share of the trust’s net income (being the trust’s taxable income as calculated under section 95(1) of the ITAA (1936)). Accordingly, where a beneficiary becomes presently entitled to, say, 50% of the income of the trust estate (as reflected in the distributable income shown in the trust’s accounts) that beneficiary will be proportionally entitled to 50% of the net income of the trust for tax purposes (as disclosed in the trust’s tax return). The application of this proportionate approach effectively precludes the trustee from distributing specific amounts of trust income to particular beneficiaries based on a ‘quantum’ approach as once the fractional interest of the beneficiary to trust income is determined the beneficiary will be presently entitled to an equivalent fractional share of the trust’s net income. Thus, once the percentage share of trust income is set there is no capacity to further income split the resulting net income amongst the beneficiaries. 

Limits on trust income for ‘notional amounts’ 

Determining the amount of the income of the trust estate for the year is vital to the process of establishing the proportionate share of net income upon which presently entitled beneficiaries will be assessed. Whilst acknowledging that the income of the trust estate will be based on the definition of that term contained in the trust deed, the Commissioner of Taxation has also taken the view in Draft Taxation Ruling TR 2012/D1 that ‘notional income amounts’ which are only recognised for income tax purposes cannot constitute income of the trust estate for trust law purposes. In reaching this view, the ATO contend that there is a statutory limitation on the meaning of income of the trust estate imposed under Division 6 of the ITAA (1936) in that income of the trust must represent a net accretion (i.e. increase) to the income derived by the trust during a particular year which is distributable to beneficiaries. This will be the case irrespective of how the particular trust deed otherwise defines income of the trust estate. As such, this approach essentially places a cap on the amounts of income which can otherwise be included in trust income to which beneficiaries may be made presently entitled. The rationale for the above view is that notional amounts of income which arise in the calculation of the trust’s net income for a particular year cannot represent a net accretion (i.e. increase) to trust income as they are ‘tax-only’ amounts which do not represent any tangible net increase in the value of trust property for that year. Hence, if the trust deed includes an income equalisation clause which defines trust income as being the net income of the trust for a particular year the ATO view is that such trust income must exclude notional tax-only amounts. Such notional income amounts will include, amongst others, franking credits, deemed dividends arising under Division 7A of the ITAA (1936) and a capital gain arising because the operation of the market value substitution rule where no capital proceeds are received on the disposal of an asset. 

Distributions made outside the family group A further important issue for a trustee to consider when contemplating a distribution of trust income to a particular beneficiary is whether the trust has previously lodged a family trust election. To recap a family trust election is a one-off election made in writing by the trustee of the trust nominating that the trust will be treated as a family trust albeit only for certain purposes of the income tax law. 

In particular, the lodgment of a family trust election will: 

• Simplify the rules that must be met by a trustee of a discretionary trust in recouping trust losses; 

• Enable a subsidiary company of such a trust to trace its beneficial ownership for the purposes of satisfying the continuity of ownership test in recouping its tax losses; and 

• Retain a beneficiary’s entitlement to use franking credits on franked dividends distributed by the trustee of the discretionary trust where the 45 days holding period rule cannot otherwise be satisfied. 

Where such an election has been made a test individual will have been nominated which will establish the members of the family group as the identity of all eligible family members will be determined by reference to that primary individual. However, where a distribution is made to a particular beneficiary who is outside the test individual’s family group such a distribution will be subject to family trust distribution tax which is levied at the highest effective marginal tax rate being currently 47%. 

Thus, a trustee of a discretionary trust must exercise caution so that a distribution is not made to a person or entity which would be eligible to receive such a distribution under the trust deed where that beneficiary is not also a member of the elected family group. Where such a distribution is made it will be subject to family trust distribution tax at the above punitive rate of 47%. 

This article is for informational purposes only and does not form part of our advice. Please contact our team if you need any assistance. 

Claire Chang, 0497 131 419, claire.chang@changadvisory.com.au, wechat: clairechang26 

Michelle Cui, 0433 539 870, michelle.cui@changadvisory.com.au, wechat: michellejc