Topic 8 – Partnerships and Trusts

Statutory law – ITAA 36

Chapters 17 and 18

What is a partnership?

• Section 995-1 of ITAA 1997 defines a partnership as:– “an association of persons carrying on business as partners or in

receipt of ordinary income or statutory income jointly, but does not include a company”

• two limbs to definition:

– association of persons is the general law notion of a partnership

– second limb treats joint owners of income producing property are partners for tax but may not be partners for general law

FCT v McDonald

• Partnership of husband and wife owning investment properties as joint tenants – passive investments.

• Partnership agreement wife 75% of profit and husband 25% and in the case of a loss husband 100%.

• Husband claimed a partnership loss. Federal Court held that if the partners want to vary a normal tax partnership of a 50/50 arrangement then they must satisfy the general law definition of a partnership.

What is a joint venture?

• Joint ventures do not derive income jointly and are individually liable for the costs of operating the joint venture.

• Joint venturers are entitled to their share of the product of the joint venture which they sell independently

• each joint venture party can make their own elections, re - tax treatment

• any election made by partnership is binding on all partners

Who can be a partner?

• Any person can be a partner under general law

• Under tax law a child under 18 cannot be a partner

How do we create a partnership?

• 2 or more people up to a maximum of 20 • there should be a written partnership agreement• have a business name registered, ABN and TFN • joint ownership of assets and liabilities• partnership bank account• partnership financial accounts• proof of capital introduced by partners• entitlement to share of profits

Taxation of partnership income

• partnership does not pay tax – s 91 , ITAA 36

• but must lodge a tax return – s 91

• each partner taxed on share of net partnership income or loss

• if a loss in the partnership each partner can claim their share of loss

Treatment of special partnership items

• partner’s salary - not an expense to the partnership but an advance of net income of the partnership – Re: Scott v FCT

• interest paid to partner on initial capital introduced is not an expense to partnership – not deductible, but interest on overdraft using home as security, deductible or to borrow money to buy into a partnership deductible - Roberts and Smith v FCT– TR 95/25)

• superannuation contributions for partners are not deductible to the partnership

Treatment of special partnership items

• the individual partners claim the superannuation as a tax deduction in their own tax return

• interest on money loaned to the partnership is deductible to the partnership

• partner’s drawings are not deductible to the partnership

• partnership income retains it character in the hands of the partner e.g. exempt income

Division 207–B, ITAA 97

• Franked dividends paid to a partnership or the trustee of a trust.

• The benefit of the imputation credits are received indirectly by the partners and the beneficiaries.

• The net income of the partnership or trust includes the value of the imputation credits.

• The partner then obtains the benefit of the franking credits when distributed to them as a share of the partnership profit – cash and imputation credits.

Calculation of partnership income

• net income = assessable income less allowable deductions

• partnership losses are distributed to the partners

• note impact of exempt income of partnership on losses

• loss must be reduced by exempt income – Div 36

Partner’s salary

• Partnership not a separate legal entity – made up of individuals

• Partners cannot be employed by themselves• IT 2218 - if reasonable Tax office will allow

“salary” as a deduction in calculating partnership net income if partnership agreement drawn in that way.

• 22 May 2002, IT 2218 withdrawn – Re Scott v FCT – salaries put partnership into a loss and losses used by other partners

Partner’s life insurance and superannuation

• premiums for life insurance are not deductible to the partnership

• no deduction for superannuation paid by the partnership for partner

• partner claims the deduction himself

Real and effective control of partnership income

• partners under 18 income is subject to Div 6AA – Income of Minors

• taxed at normal rates if reasonable for work done

• if not reasonable then it will be taxed at top marginal rate of income tax – 46.5%

Other issues

• Everett assignments – transfer of equitable interest

• Issues with partnerships– trading stock – calculated at the partnership

level– Depreciation – claimed as a deduction at the

partnership level.– capital gains tax – taken at the individual level

Example - CGT

• Bill and Jim establish an accounting partnership on the basis of a 50% interest each. Bill and Jim purchase an office to run the practice from, and the partnership pays rent. Bill and Jim are the registered proprietors of the real property.

• When the office is sold, any capital gain is included in the assessable income of the individual partners – 50% each. Discount of 50% would apply to each individual.

Changes in a Partnership

• Partnership agreement drafted so that the business continues when death, retirement or admission of new partner, otherwise new partnership and tax return.

• Work in progress, depreciating assets, trading stock, bad debts – how accounted for?

• Work in progress – assessable when sold by former partner, s 15-50 and deductible by new partner, s 29-95.

• Trading stock – notional disposition in the hands of the remaining partners at market value.

• Depreciating assets – rollover relief, s 40-340.

Taxation of Trusts

Division 6 – Trust Income, ITAA 36, over half a million in Australia and a

legitimate way to split income.

Taxation of Trusts

Definition:

It is the relationship which exists between an

owner of an asset (the trustee) and another

person (the beneficiary) in which the trustee is

obligated to the beneficiary for the benefits of

owning the asset (the trust property).

Parties in a trust

SETTLOR -

Gives property - $20 – to the

TRUSTEE -

To hold the property on behalf of the

BENEFICIARIES

In a discretionary trust – members of the family – very wide scope

Establishing a Family Trust

• An appointer is nominated in the trust deed with the role to appoint the trustee. In effect they can control the trust by having this power. If the appointer is also a beneficiary and becomes bankrupt, then the Trustee in bankruptcy may be able to claim assets of the trust – no asset protection

• The deed of settlement is usually 40 pages in length, signed by the settlor and trustee. The Corporations Act and ASIC have no control over trusts.

• The trustee applies for an ABN, TFN and registration for GST with the ATO. No other registration is required. No stamp duty is payable

Aspects of a trust

1. The assets ‘settled’ can be any type of property. Settlor usually settles $20 to establish the trust

2. If the settlor retains the power to revoke the trust or obtain a beneficial interest in the trust income, the Commissioner may impose additional tax: s.102 ITAA 1936. Usual for accountant to be the settlor

3. There may be more than one trustee and the trustee may be a company. Usual for a company.

Aspects of a trust

4. The trust may be created by: – Will – Testamentary Trust– Settlement inter vivos - that is, while the

settlor is alive – deed of settlement– Operation of law - Bankruptcy

5. Although no documentation is necessary to create a trust, a written trust deed is normally used – Deed of Settlement

Two main types of trusts

1. Fixed trusts: the beneficiary’s right to income and perhaps corpus is pre-determined (fixed) by the terms of the trust deed, e.g. Unit trust

2. Discretionary trusts: any rights to trust property a beneficiary may have is dependent on the trustee exercising its discretion in the beneficiary’s favor.

Taxation of trust income

The aim of the ITAA 36:1. To impose tax on either the beneficiary or the

trustee, if no beneficiary “presently entitled” and not under a legal disability.

2. The beneficiary is the primary target – the trustee will pay the tax where the beneficiary cannot be taxed.

3. Trust a “flow through” structure, not assessed on its income.

Taxation of trust income

The allocation of tax liability for trust income

primarily depends on whether:

1. A beneficiary is presently entitled to the income; and

2. Whether such a beneficiary is under a legal disability.

Vegners v FCT

• Mr. Vegners distributed income to his former wife from the family trust that ran his consulting business.

• Mrs. Vegners received the money but did not include it in her tax return as she believed it was from a property settlement. The Federal Court held that she was liable to pay income tax on the distribution as she was ‘presently entitled’ to the distribution even though not aware of the trust.

Harmer v FCT

• What is meant by the term ‘presently entitled’ – 1. beneficiary has an interest in the income which is both vested in interest and possession2. beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement is ascertained and the trustee has the funds available.

The issue was who should pay income tax on the interest earned on money held in trust by Solicitors pending the outcome of a court case.

Harmer v FCT

• The Solicitors were assessed on the income as trustees pursuant to s 99A and tax at 48.5%.

• Solicitors argued that there were beneficiaries presently entitled and capable of paying income tax at their own rates – less than 48.5% (now 46.5%).

• High Court held: no beneficiaries presently entitled and trustees must pay income tax under

s 99A.

Taxation of trust income

Presently entitled1. The beneficiary must have an immediate right to

receive or demand the trust income or have it applied according to his or her direction.

2. A beneficiary under a discretionary trust is not presently entitled until the trustee exercises its discretion in their favor.

3. A beneficiary who is a non-resident at the end of the year of income is not presently entitled.

Taxation of trust income

Legal disability

1. Beneficiaries who cannot give a valid discharge to the trustee in respect of payments made to them.

2. These include minors, undischarged bankrupts, intellectually impaired persons.

Taxation of trust income

Scenario 1: Beneficiary presently entitled andnot under a legal disability• The beneficiary is taxed on his/her share of the

trust income: s.97 • If the beneficiary is a non-resident, his/her share

will be taxed first in the hands of the trustee at the rates applicable to non-residents - s.98(3)&(4)

• The beneficiary is also taxed on the income but is allowed a credit for the tax already paid by the trustee -s.98A(1)

Taxation of trust income

Scenario 2: Beneficiary presently entitled but

under a legal disability

1. Trustee is taxed at the rate applicable to the beneficiary: s.98 The tax is calculated as if the trust income was the only income of the beneficiary and no deductions were available.

2. If the beneficiary derives other income, the trust income is added to that other income and the beneficiary is taxed on the total. However, the beneficiary is entitled to a tax credit for any tax paid by the trustee: s.100

Taxation of trust income

Scenario 3: No beneficiary is presentlyentitled• Trustee is taxed under s.99A - at the maximum

rate of personal income tax – a flat 45% + Medicare levy – 1.5%

• Trustee will be taxed under s.99 - taxed at ordinary marginal rates if the Commissioner believes it is unreasonable to apply the s.99A rate - As in the case of a testamentary trust

Taxation of trust income

Steps for determining the tax allocation:1. Determine the net income of the trust.2. Determine whether any beneficiaries are presently

entitled.3. Where a beneficiary is presently entitled, allocate the net

income to that beneficiary for assessing purposes under: S.97- directly to the beneficiary if there is no legal disability. S.98- to the trustee if the beneficiary is under a legal disability

4. Assess the trustee - under s 99 or s 99A - on the residue of the net trust income not allocated to any of the beneficiaries.

Dwight v FCT

• Deemed statutory present entitlement – under s 95A, introduced in 1980. Where a beneficiary has a vested and indefeasible interest in trust income but is not presently entitled, then beneficiary deemed to be presently entitled.

• Trustee does not pay income tax at the penalty rate.

• Case concerned money held on trust as security for costs for a court case in Australia.

• Designed to cover situations where the money is not actually distributed to beneficiary.

Taxation of trust income-other aspects

1. Although the trust is not a separate legal entity it must lodge an annual return.

2. The distribution to the beneficiary retains the character it had when derived by the trustee.

3. Trust losses are not distributed to the beneficiary – they are carried forward and may be offset against future income derived by the trust.

4. One of the great advantages of trusts is the access to income splitting however the Commissioner may utilise Part IVA if the trust was formed for avoidance purposes

“Net Income” – Tax and Accounting Issue

• Discrepancy as to what is income for tax and trust law purposes and for financial accounting purposes

• Income is distinguished from the capital (corpus) of the trust• If the trust does not have capital then it cannot exist – trustee must

protect the capital• But, for tax purposes, a capital gain is treated as income – s 6-10, but

this represents the capital of the trust• Example: receipt of rent from a commercial building but also a

deduction for the capital allowance. The income for trust law income is higher than the income for tax purposes. Similar situation with a franked dividend.

• Two approaches – Proportionate view or the Quantum view. The proportionate view is acceptable.

Zeta Force v FCT

• Problem involved the difference between the accounting income of the trust and the tax law income of the trust. The difference was a timing difference on the recognition of income and deductions – pre-payment of stock.

• Accounting profit - $908,221, tax profit - $1,335,554. The difference was not distributed to the beneficiaries. Who should pay tax on the difference.

• Section 97 contemplates the proportionate view.

Zeta Force v FCT

• If the proportionate view is adopted then each beneficiary is held to have received a taxable distribution in ‘proportion’ to their trust law distribution.

• If the ‘quantum’ view is adopted then the trustee pays tax under s 99A at the top rate, 48.5% (now 46.5%).

• The proportionate view is best.

Other Benefits

• Dividends can be distributed to a beneficiary and carry the imputation credit as a tax offset.

• Capital gains can be distributed to an individual beneficiary and the individual can claim the 50% CGT discount

• Unit trusts taxed in exactly the same way as discretionary trusts

Minor Beneficiaries – Under 18 years

• Division 6AA prevents income being distributed to minors with little or no income tax being paid

• Division 6AA applies to tax the income distributed to a minor beneficiary

• If minor an “excepted person” or the income is not classified as “excepted assessable income” then penal rates of tax apply

Division 6AA – Tax rates for minors

• Tax rates

- $0 – $416 = Nil

- $417 – $1,307 = 66% of the excess over $416

- Over $1,307 = 45% of the total amount of income that is not

excepted income

Minors (cont)

• Minors receiving income under a testamentary trust – the trustee pays tax at the normal marginal rates for an adult, i.e. first $6,000 tax free

• Minors in employment are taxed at the normal marginal rates as are minors under the care of the Social Security Act, s 102AE and s 102AE, ITAA 36

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