A recent Court of Appeal decision in New South Wales has held that "unrealised capital gains" can form part of "income" for trust law purposes (i.e. as part of "Trust Law Income").
While this does not mean that more tax will necessarily arise to the Trust or Beneficiaries, there are potential tax consequences.
The first is that net income for tax purposes (i.e. "Tax Law Income") flows to beneficiaries in the same proportion as Trust Law Income (as per Bamford's Case). Accordingly, in order to know how much Tax Law Income each beneficiary receives, it is important to understand carefully what is and is not included in Trust Law Income.
The practical consequence is that you need to be very careful when determining (and distributing) the Trust Law Income of your Trust at the end of each year. If you recognise an unrealised increase in the value of the Trust’s assets in the Trust’s accounts, then this will form part of the Trust Law Income of the Trust for that year.
Secondly, there is also a planning opportunity here. In the past, if your Trust did not have sufficient Trust Law Income to make a trust law distribution to a beneficiary, then any Tax Law Income, and associated tax law credits (like franking credits, foreign tax credits, etc) were stuck in the Trust - and were assessable to the Trustee.
Following the logic of this Case, in this scenario the Trustee may revalue certain assets - and thereby create sufficient Trust Law Income to take with it any associated Tax law Income and tax law credits through to beneficiaries. This is, of course, subject to the terms of the Trust Deed allowing this.
Action points:
- Understand the concepts of "Trust Law Income" and "Tax law Income";
- Understand how your Trust Deed defines Trust Law Income;
- Properly account for Trust Law Income each year in accordance with your Trust Deed; and
- Property distribute Trust Law Income each year in accordance with your Trust Deed.
If you require assistance with this, please contact Andrew on 1300 654 590 or email him on andrew@scla.com.au.
Further details of the Case:
Clark v Inglis [2010] NSWCA 144
This Case heard an application for leave to appeal and the appeal concurrently. The appeal was from a decision of Justice Brereton in the Equity Division of the New South Wales Supreme Court.
Brereton J’s judgment related to a discretionary family trust (the Trust), the beneficiaries of which were a Dr Inglis, his second wife, four children of his first marriage and the one child of his second marriage. The Trust had a corporate trustee of which Dr Inglis was the dominant shareholder (he held 8 of the 10 shares in the company). Dr Inglis was also a director of the corporate trustee, along with his second wife and one of the children of his first marriage.
The funds of the Trust were invested in shares, and the trust property had come to be worth approximately $2 million by late 2007.
For the first 16 years of the existence of the Trust, its accounts valued the share portfolio at the lower of cost and net realisable value.
In 1999 a new accountant took over the Trust’s accounts, and instead prepared its accounts on the basis of revaluing the shares to market and taking the net movement (up or down) as income or expense. There was an increase in the market value of the shares in all but one of the financial years up to 30 June 2006, meaning that a significant amount of income was recorded. In all those years, the income was distributed to beneficiaries of the Trust despite the fact that the increase in the value of the shares was unrealised. Dr Inglis lent back his income to the Trust.
Dr Inglis died in October 2007, leaving a Will which provided that the “debt” owed to him by the Trust (being the loaned income from the shares) formed part of his Estate.
The two key questions that came before the Court on appeal were:
- Could the trustee lawfully treat changes in the market value of the shares as income and distribute it to the beneficiaries?; and
- Did the trustee determine (under a clause in the Trust Deed) that the changes in the market value of the shares were trust income?
With respect to the first question, the applicants (being the trustee company and the children of Dr Inglis) submitted that the unrealised gain on the shares could not be characterised as income.
The court heard the evidence of three accountants on this issue. All three accountants agreed that it was permissible to treat the unrealised gains as income of the Trust.
Accordingly, the Court found that the trustee could lawfully treat the market increases in the value of the shares as income and distribute it to the beneficiaries of the Trust.
The court noted that its finding was not supported by any law (other than the Trust Deed), but instead relied on accounting standards and practices in relation to income.
With respect to the second question, which was a question of fact, the applicants submitted that unrealised capital gain is not property, either under the Trust Deed or at law. It followed that the trustee would have had to have made a determination under the Trust Deed to treat the unrealised increase in the share value as income. The applicants then argued that no such determination had been made by the trustee.
The court found that the unrealised capital gain could be treated as income, with Allsop P saying at [37]:
“The treatment by the accounts of “movement in net market value of investments” as income was effect, in all the circumstances, to characterise such as income under the trust deed ... On this basis, as I have said, no determination under cl 6(f) was required.”
The court made order granting leave to appeal and then dismissing the appeal.
