The University of Sydney-    Classic Texts in Australian and International Taxation Law

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19. Chapter 15 Income Taxation in Relation to Trusts and Partnerships

15.1. In Chapter 7 there is reference to those cases where the determination of net income is made in relation, not to an individual, but to an intermediary through which income moves to individuals. The cases in point are trusts, partnerships and companies. The present chapter is concerned with the manner in which income is dealt with when the intermediary is a trust or a partnership.

15.2. There is a fundamental difference between the manner of taxing trusts and partnerships and the manner of taxing when the intermediary is a company. The determination of net income of a trust or a partnership is made simply as a step in calculating the taxable incomes of the beneficiaries under the trust (though some of the net income may have to be taxed to the trust because there is no appropriate beneficiary) or the taxable incomes of the partners. In the case of a company the determination is made as a step in calculating the taxable income of the company. A shareholder in a company is then taxed on dividends he receives from the company, the income character of those dividends generally being unrelated to the income character of the company profits from which they were paid. The recognition that a company is, nevertheless, only an intermediary lies behind recommendations in Chapter 16 for imputing to its shareholders some of the tax paid by the company.

15.3. Under the Income Tax Assessment Act, the manner of taxing in the case of trusts and partnerships requires a method of allocating the amount of the net income between the beneficiaries or the partners in accordance with the provisions of the trust instrument or partnership agreement. Under Division 6 of Part III (sections 95-102), the net income derived from the assets comprising the trust estate is allocated in accordance with the entitlement of each beneficiary ‘to a share of the income of [the] trust estate’. Under Division 5 of Part III (sections 90-94), partnership net income is allocated in accordance with the ‘individual interest’ of each partner. ‘Share of the income of [the] trust estate’ refers to the entitlement of a beneficiary to participate in the income of the trust estate, in the trust law sense of income: a fraction of the net income—the tax law concept—is allocated to the beneficiary corresponding with the entitlement. ‘Individual interest’ presumably refers to the entitlement of a partner to share in profits, a fraction of the net income being allocated to him corresponding with this entitlement. The method of allocating has not given rise to evident difficulties in the case of partnerships, but as will be seen it sometimes gives rise to unfairness in the case of trusts.

I. Trusts

15.4. The scheme of the provisions of Division 6 of Part III of the Act, which has parallels in other common law countries, involves the calculation of the ‘net income of a trust estate’ (in general, net income in the sense of those words in Chapter 7) of a year of income and the allocation of that net income, for purposes of determining the incidence of tax on it, between the beneficiaries and the trust estate. The allocations to beneficiaries are made in terms of their ‘present entitlements’ to trust income. There is judicial opinion that at least those parts of Division 6 which depend on the calculation of the net income of the trust estate have no application when income is derived from a foreign source. The discussion in this section of the chapter assumes that no foreign


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element is involved: in other words, that the income has an Australian source and the trustee and beneficiaries are Australian residents. International aspects are separately considered later.

15.5. If a beneficiary becomes entitled to part of the income of a trust and later that part is distributed to him, the income will be taxed under Division 6 when the entitlement arises, and no further tax will be charged under Division 6 when the income is actually received by the beneficiary. However, if the beneficiary receives an amount, out of the income of the trust, before he becomes entitled to the amount under the terms of the trust, he is, it seems, subject to tax on what he receives by virtue of section 26(b). This section (a survival of provisions predating those now embodied in Division 6) includes in income for tax purposes ‘beneficial interests in income derived under any … trust’. Its effect is, presumably, to tax the amount received, and the manner of taxation intended by Division 6 is thereby defeated. In the Committee's view the legislation should provide that income of a trust to which a beneficiary is entitled or to which he becomes entitled is taxed only under the provisions of Division 6. A provision akin to that in section 101, discussed in paragraph 15.10, will be required to ensure that where an amount is received in advance of the beneficiary becoming entitled, it will enter the calculation of the ‘present entitlement’ of the beneficiary for purposes of allocating net income of the trust to him.

15.6. The allocation of net income to a beneficiary should involve the consequence that the character of any item of that net income is carried through to the beneficiary. The provisions of Division 6 explicitly recognise this as far as exempt income is concerned and it is understood that the Commissioner follows this principle in regard to other items of income. In the Committee's view, the Commissioner's practice should be followed, and supported by express provisions which will, for example, ensure that entitlement to tax credits in relation to dividends received, under the Committee's company tax proposals in Chapter 16, also carries through to the beneficiary.

15.7. The allocation of net income of the trust between beneficiaries and the trustee involves initially determining how much of the net income is to be taxed as income of the beneficiaries, the remainder, if any, then being taxed as income of the trust. A number of issues arise in applying the concepts used in this allocation. These relate to the meaning of ‘present entitlement’, and the interrelationship in this regard of tax accounting and trust accounting; the meaning of present entitlement where the beneficiary is under a disability; the consequences of differences between net income of the trust estate and trust income; the treatment of distributions from income that has been taxed as income of the trust; the rate of tax applicable to the income taxed as income of the trust; and the treatment of losses suffered by the trust.

Present Entitlement

15.8. The meaning of present entitlement has been the subject of a number of judicial decisions. In general, a beneficiary is presently entitled to trust income when he can claim immediate payment from the trustee. Where there is a right to income of a deceased estate, there cannot be a present entitlement until the administration of the estate has proceeded to the point where the personal representative becomes a trustee. This occurs when the personal representative has completed the performance of his executorial duties of getting in the assets, paying or providing for the debts, funeral and testamentary expenses and legacies and then holds the remainder of the property in the estate in trust for one or more of the beneficiaries. There are unresolved questions as to the manner of taxation when the personal representative becomes a trustee in the course of a tax year of income. Assuming the trust accounting year and


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the tax accounting year correspond, the question whether the net income of the trust estate prior to the personal representative becoming a trustee is to be taxed as income of the trust or as income of the life tenant may be thought to depend on the appropriateness of a trust account being taken on the change in status of the personal representative. There is no guidance in the Act or the judicial authorities. The matter is further complicated by the fact that the personal representative may complete his executorial duties in relation to one part of the estate but have further duties to perform in relation to another part. A similar problem arises where a contingent interest in a trust becomes a vested interest during a year of income. The Commissioner's present practice, it is understood, is to assess the beneficiary on the income for the whole of the year of income during which the executor's administration is completed or the interest vests unless the trustee can show, by taking accounts when he completes his duties as executor or when the interest vests, that the income should be divided between the trust and the beneficiary. In the Committee's view, the Act should be changed to follow this practice; however, the requirements as to accounts should be sufficiently flexible to allow for the situation where the administration is completed in relation to part of the estate but not in relation to the balance.

15.9. There are unresolved issues when the trust accounting period, which may for example, end on each anniversary of the death of the testator or the making of the settlement, differs from the tax year of income. Where the trust estate carries on a business, clearly there can be no present entitlement of a person with a right to income until the time for taking the accounts of the business, and it is the person who then has the right to income who will be presently entitled. As the law is now framed, if there is no beneficiary presently entitled to trust income of any period to which net income of the trust estate relates, the relevant net income is taxed as income of the trust. In the Committee's view, there should be provisions requiring that the trust accounting period be treated as a substituted tax accounting period; it might be necessary also to require that the tax payable be adjusted to prevent a trust accounting period that differs from the normal tax accounting period being used as a method of deferring tax.

15.10. The point was made in paragraph 15.5 that an actual receipt of money or a benefit from the trust by a person with a right to income should be treated as a receipt of an amount to which the beneficiary is presently entitled. Another situation also calls for comment. A trustee may have a discretion to pay or apply income for the benefit of a beneficiary. Where he acts in exercise of such a discretion, section 101 provides that the beneficiary is deemed to be presently entitled to the amount so paid or applied. In the result the amount will go to determine the allocation of net income of the trust estate to be taxed to that beneficiary. The trustee's exercise of his discretion may be made at some time after the taking of the trust accounts for a year and will be treated by him as having been made from the trust income of that year. As the law stands, it is not clear whether the effect is to deem the beneficiary presently entitled to a share of the income of the year in question. Clearly in the interests of finality of assessment it is necessary to control the tax consequences that can flow from the trustee's exercise of his discretion. The Committee recommends that where the discretion is exercised within three months of the end of the trust accounting period and the trustee appropriates income of that period for the payment, the beneficiary should be deemed to be presently entitled to the amount of the income of the period thus paid or applied for his benefit. If the exercise and the appropriation are made more than three months from the end of the trust accounting period, the Commissioner should be given a discretion to treat the amount paid or applied in the same way.

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15.11. Where the trustee, in exercising a discretion of the kind just considered, appropriates income of a still earlier period, there are no tax consequences. The net income of the trust estate in that earlier period will already have been taxed either to the beneficiaries or to the trust.

15.12. The meaning of the phrase employed in section 101, ‘pay or apply … for the benefit of … beneficiaries’, is a matter of some doubt. Similar words used in a trust instrument or a statute giving a discretion to the trustee have been invested with a very wide meaning. The Committee recommends later in this chapter that where income is accumulated in a trust estate, any part of the corresponding net income of the estate that is not taxed to any beneficiary should bear tax at the maximum marginal rate. Section 101 will therefore, even more than now, offer a prospect of escaping tax at a high rate where an effective application for the benefit of a beneficiary on a lower rate is made. If the words of section 101 are given the wide meaning they have been given in other contexts, a resettlement of trust income on trusts under which the beneficiary has only a contingent entitlement to capital and income will serve to take the part of the net income of the trust estate that is resettled out of reach of the maximum marginal rate. In the Committee's view a resettlement of trust income should only be allowed to operate in this way if the terms of the resettlement give the beneficiary an absolute right to the corpus and to the income from it. If any wider meaning is to be attached to the words in section 101, the prospect arises that a beneficiary in the original trust may have a present liability for tax in respect of money to which he has no present entitlement and to which he has no vested right.

15.13. The notion of present entitlement to a share of the income of a trust estate does not depend on the source of moneys in fact used by the trustee in satisfying the rights of a beneficiary. In general, a person receiving an annuity from a trust is taxed on the amount he actually receives, whatever the source of the moneys used by the trustee. Where, however, the annuity is charged on income of the trust it should to this extent be taxed under the provisions of Division 6. Assume, for example, that the terms of a trust instrument provide for payment of an annuity of a set amount out of income, with a direction to the trustee to resort to corpus if the income is insufficient. If the income proves sufficient, the amount of the annuity should be treated as a share of the income of the trust and taxed under the provision of Division 6. If the annuity is only in part covered by the income, it should to the extent covered be treated as a share of the income of the trust and the balance not covered by income should be taxed as income under the general provisions of the Act.

Present Entitlement of a Beneficiary under a Disability

15.14. The interpretation of present entitlement as meaning a right to claim immediate payment from the trustee would appear to prevent a person under a disability (for example, a minor), who cannot enforce payment because he cannot give a valid receipt, from ever being presently entitled except when a deeming provision like section 101 operates. But this consequence would conflict with the evident intention of section 98 which contemplates that a person under a disability may be presently entitled. The interpretation of ‘presently entitled’ as including a situation where a person is prevented only by his disability from claiming immediate payment, which has been adopted in one judicial decision, should, in the view of the Committee, be confirmed.

15.15. Where a person under a disability is presently entitled to income of a trust, tax on his allocation of the net income of the trust estate must be paid by the trustee as the agent of the beneficiary (section 98). The allocation must nonetheless be included


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in a return by the beneficiary if he has income from any other source. The tax paid by the trustee is a credit against tax assessed on the beneficiary's income from all sources (section 100). However, the tax credit apparently cannot give rise to a refund. A beneficiary may have deductible outgoings exceeding his income from sources other than the trust and may fairly claim to be over-taxed. In the Committee's view, the tax credit in these circumstances should be available as a refund. Alternatively, section 98 should be repealed. Basically it appears to be designed to ensure the collection to tax on income assessable to a minor and, to a limited extent, to other persons under legal disability. There are undoubtedly many cases where minors derive income directly and in their own right from dividends, interest and rent, and the Committee is not aware of any difficulties in collecting tax in these cases. If section 98 is retained there will need to be further provisions to make the refund available and to give effect to the proposal elsewhere in this report for assessing the unearned income of a minor at a rate of tax based on the income of the parent. The need for these provisions would be avoided and the law simplified if section 98, and consequently section 100, were repealed. In cases of difficulty the special garnishee provisions in section 218 would be available to the Commissioner.

Net Income of the Trust Estate and Trust Income

15.16. The amount of trust income to which a beneficiary is presently entitled determines the fraction of net income of the trust estate on which he is subject to tax. Trust income is a concept of trust law, its amount depending on principles of trust law and the terms of the trust instrument. Net income of the trust estate is a concept of tax law which owes much to the example of trust law, but its elements differ in significant ways.

15.17. Net income for tax purposes may exceed trust law income. Thus bonus shares may not in all cases be trust income; they may nevertheless be income for tax purposes. The value, for tax law purposes, of stock on a grazing property may be less than the value for trust law purposes and this may give rise to an amount of deemed income for tax purposes when the stock is sold. A premium received on the grant of a lease may be trust income, in which event it will be spread over the period of the lease; when such a premium is income for tax purposes, the whole amount is included in income in the year of receipt. Prudent management of a trust may demand more generous depreciation provisions than the tax law allows, and trust law may require a deduction against trust income of the costs of non-permanent improvements which are not deductible in determining net income for tax purposes.

15.18. When net income for tax purposes exceeds trust income, the scheme of Division 6 may be thought to operate unfairly. While generally it may be true that income for tax purposes is simply a figure for calculating tax on the trust law income, there are important respects in which this is not so. To the extent, for instance, that income for tax purposes includes bonus shares which, under the trust instrument, form part of corpus, it seems unfair for the whole of this income to be used to calculate the tax to be paid by the beneficiary entitled to income and who, if he has no interest in corpus, has no claim to those shares. The Committee recommends that where the trust income to which the income beneficiary is presently entitled is less than the net income of the trust estate, he should as a general rule be taxed on an amount equal to his entitlement to trust income and the excess income for tax purposes should be taxed to the trust.

15.19. This rule is clearly appropriate whenever the tax that would thus be paid by the trust is, on trust accounting principles, charged against corpus and the beneficiary has no interest in corpus. Where the tax is charged against corpus but the income


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beneficiary has an interest in corpus, the appropriateness of the rule will depend on the extent of his interest. If he has the entire vested interest in corpus, there is good reason to tax him by reference to the whole of his share in the net income of the trust and, indeed, if there is another income beneficiary to tax him by reference to the excess in relation to that beneficiary as well. If he has a less interest in corpus, the reason is not so compelling. The Committee, however, sees administrative difficulties in a qualification of the general rule which would make the taxing of the income beneficiary on the amount of the excess depend on the extent of the beneficiary's interest in corpus and a prediction of how the trustee would charge the tax if the excess were taxed to the estate and not to the beneficiary.

15.20. The appropriateness of the general rule when the tax that would be paid is charged against income also varies with the circumstances. Consider, for example, a lease premium the whole of which is income for tax purposes in the year it is received by the trust but only an apportioned amount of it is, in that year, trust income to which the income beneficiary is presently entitled. In this case, tax on the excess in the year of receipt is clearly not a charge on corpus but a charge on trust income spread over the period of the lease. The appropriateness of the general rule will depend on the way in which trust accounting deals with tax paid on the excess. If it is spread only over the years after the first year, the income beneficiary of the first year will be taxed on an amount undiminished by tax on the excess. In subsequent years the income beneficiary will receive an amount diminished by a part of the tax on the excess but will not be subject to tax on what he receives, his receipt being a distribution from income already taxed. This, on balance, would appear to produce a satisfactory result. If any part of the tax on the excess is charged against income in the first year, there are mathematical complications in determining the amount of the excess, and the income beneficiary in the first year, who will receive no more than the income beneficiaries of later years, is the only one to be subject to tax on what he receives.

15.21. The general rule may be thought less appropriate where the excess results from depreciation being applied in determining the trust income from letting a building and depreciation being denied in determining the income for tax purposes. In the first year the amount to which the income beneficiary is presently entitled will be undiminished by tax to be paid by the trust on the excess. In the following year, however, there will be a smaller amount to which the income beneficiary is presently entitled, since his entitlement will have been diminished by the tax paid by the trust on the excess. The excess will thus increase each year at a diminishing rate and eventually stabilise. The point of stabilisation will depend on the tax rate applied to the excess. In this illustration the function of spreading the tax liability more fairly between income beneficiaries of different years is not apparent.

15.22. Though the general rule is thus more appropriate in some cases than others, the Committee prefers the certainty of a single rule to a rule which, in the interests of a more refined expression of fairness, is subject to exceptions. There may, however, be justification for allowing the income beneficiary (or in the case of a minor beneficiary, the trustee) an election to be taxed on the excess as part of his income. The election would offer an avenue of escape from what in a particular case might be an unfair rate of tax otherwise applying to the excess. There is of course a possibility of the election being used as a method of avoiding tax, for example where the person ultimately entitled to corpus has a substantial income and the income beneficiary only a modest one or where the income beneficiary has an interest in several trusts. The possibility


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could be controlled by restrictions on the election: for instance, election might be expressly denied if the income beneficiary has no interest in corpus or an interest in corpus significantly less than his interest in income, and there might be a requirement that the election can be made only in respect of one trust.

15.23. A special situation arises when a deceased estate is taxed on income derived during the course of administration and the assessment is paid by the trustee after the administration is complete and a beneficiary is now presently entitled to income. The Committee proposes that, in general, income derived during the course of administration should be taxed at rates determined on the assumption that the income is that of an individual as under the present section 99. If the trustee has provided for payment of the tax out of the income, no problems arise. If, however, he charges the tax against income of the later year in which the tax is paid, there will be an excess in that year to which the general rule would be applicable. The Committee sees no reason why the tax consequences may not be left to depend in this way on the trust accounting followed by the trustee.

15.24. The difference between trust income and net income of a trust estate due to the trustee having met an assessment to income tax imposed on the trust estate may be thought to have some parallel in the situation arising when the trustee meets an assessment, under section 98, as agent for the beneficiary under a disability. It should be made clear, however, that the general rule proposed in paragraph 15.18 has no application in this situation. Tax is paid by the trustee as agent and is recoverable by him from the entitlement of the beneficiary; but this should not affect the amount of the entitlement of the beneficiary for purposes of the operation of the scheme of Division 6.

Accumulating Income

15.25. The scheme of Division 6 involves taxing the trust on that part of the income of the estate for tax purposes which is not taxed in the hands of a beneficiary or in the hands of the trustee as agent for a beneficiary. The phrases ‘accumulating income’ and ‘accumulated income’ are used in this chapter to refer to such income. They are not intended to extend to income to which a beneficiary is presently entitled that is retained by the trustee.

15.26. There are two questions to be considered in this regard. The first is the appropriate treatment of distributions made from accumulated income already taxed to the trust; the second is the rate of tax to be applied in taxing the trust.

15.27. Although not the subject of an express exemption, it is a clear inference from Division 6 that a distribution from accumulated income which has been taxed to the trust is not subject to tax in the hands of the beneficiary receiving the distribution. The argument in any case would be that income which has been accumulated, more especially when it has been taxed, has ceased to have the quality of income when it is distributed; it is, in effect, received by the beneficiary as capital.

15.28. It would therefore be a radical departure from the scheme of Division 6 to follow the scheme in relation to companies and tax the beneficiary on distribution, with appropriate credit for tax paid by the trust. The Committee does not favour any such change. The giving of credit, which ought in principle to be a full credit, would involve major administrative difficulties.

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15.29. If there were a strong case on equity grounds for this radical departure, these administrative difficulties might not be thought too high a price to pay. The basic approach of Division 6 to the taxing of trust income is the allocation of that income to the beneficiaries who alone are taxed on it. The equity question therefore arises only in relation to income that cannot be allocated because there is no beneficiary with a vested claim to it. In the case of company income, there will almost invariably be shareholders with vested interests in the income at the time it is derived by the company; and where they are low-income shareholders, taxing the company on undistributed profits and not taxing the shareholders on later distribution is inequitable. The Committee does not, however, see a similar case in equity for attempting to relate the tax on accumulated income of a trust to the tax situation of persons who, at the time income was derived, had no more than contingent interests in that income.

15.30. What is a proper rate of tax to apply to the accumulating income? Until 1964 such income was taxed in all cases as if it were the income of an individual. In that year an alternative was introduced whereby the income is in some circumstances subject to tax at a flat rate (currently 50 per cent) unless the Commissioner is of the opinion that it would be unreasonable to tax it in this way. The alternative was introduced to overcome tax avoidance practices to which the Ligertwood Committee drew attention in 1961. Bizarre possibilities in minimising tax are introduced when multiple incomes, each separately taxed, can be created by setting up a multiplicity of trusts, all in the interests of one person.

15.31. As a measure to defeat tax avoidance, the alternative provision has serious shortcomings. For one thing, the rate of 50 per cent which Parliament has set leaves a tax advantage where the marginal rate of the person who it is intended will ultimately receive the income is higher than 50 per cent. For another, the provision has no application to a trust created by a will or resulting from an intestacy. In general the Committee sees no reason for distinguishing between the inter vivos trust and the testamentary trust. A multiplicity of testamentary trusts in the interests of the one person is not unlikely. In any event, the inter vivos vesting of assets in a testamentary trust, which has been held not to give rise to a new trust, defeats whatever purpose might be served by the distinction.

15.32. The Committee recommends that the rate of levy on income taxed to a trust should, in general, be the maximum marginal rate applying to an individual taxpayer. The rate will discourage the setting up of accumulation trusts having tax avoidance as their object; moreover, where there is no beneficiary with a vested interest there is, except in some circumstances which might be the subject of special provisions, no obvious reason for preferring any other rate. Possible special provisions applying another rate are considered in the following paragraphs.

15.33. Where the estate of a deceased person is in course of administration and income is taxed to the estate, it is not unreasonable to regard the estate as a projection of the personality of the deceased. This would involve retaining the present law by which the income in question is taxed as the income of an individual. Similar treatment should continue to be given, too, to moneys received by the estate that would have been income of the deceased person had he received them in his lifetime: these are treated as income of the estate under section 101A.

15.34. It follows from paragraphs 15.16–15.24 that, except where an election is exercised, the excess of income for tax purposes over income for trust purposes will be taxed as income of the trust. One might be tempted to argue that in situations of this kind there is unlikely to be any need to discourage tax avoidance by the prospect of


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having to pay the maximum marginal rate. But if a lesser rate of tax is applied to the excess, there would still be scope for tax avoidance, for example through the adoption by the trust instrument of trust accounting rules designed to limit the amount of trust income. There will nevertheless be cases where, as in the illustration in paragraph 15.21 involving the lease premium, the application of the maximum marginal rate to the excess appears unfair. A compromise, in the Committee's view, is for the amount by which the income of the trust calculated in accordance with income tax principles exceeds the income calculated in accordance with trust law principles to be taxed as the income of an individual who is not entitled to any concessional deductions but who is subject to a minimum rate of tax. The minimum rate should be a specified percentage which is less than the rate of 50 per cent at present applied under section 99A. The exception should not be available if the Commissioner reaches the view that the discrepancy between the two amounts of income has been deliberately brought about by a provision in the trust instrument inserted for the purpose of reducing the incidence of income tax.

15.35. The common form of will provides for the accumulation of income and the payment of that income to a child of the testator on the child reaching a certain age or, perhaps, marrying before that age. It seems inappropriate for the income arising from a trust of this sort to be taxed at the maximum marginal rate. The Committee considers that this income should be also taxed as the income of an individual who is not entitled to any concessional deductions but who is subject to a minimum rate of tax. Again, the minimum rate should be a specified percentage which is less than the rate of 50 per cent at present applied under section 99A. This exception should be limited to income arising under a trust created by will to which a child of the testator has a contingent entitlement, being income accumulated during the minority of the child.

Losses of Previous Years

15.36. While the scheme of Division 6 goes some distance towards treating income moving through a trust to a beneficiary in the same manner as income derived directly by a beneficiary, there are respects in which this is not so. The treatment of accumulated income is one instance. Another is the treatment of losses.

15.37. The present law, while taxing an income beneficiary on a share of the income subject to tax by reference to his present entitlement to income of the trust, does not allow him a deduction of an equivalent share of a loss for tax purposes suffered by the trust. Such a loss suffered by the trust is normally carried forward as a deduction against income otherwise subject to tax in a later year in accordance with the general principles for the application of losses established by the Act. Where there has been a loss for tax purposes in a particular year, there will normally have been a trust law loss in that same year. In this case, if the trust law loss is carried forward and charged against the trust law income in the later year in determining the amount of the entitlement of an income beneficiary, the tax law loss will be carried forward in determining the net income of the trust estate in that later year. If, however, the trust law loss is not charged against the trust income in the later year in determining the amount of the entitlement of an income beneficiary, the deduction of the tax loss is denied in determining the net income of the trust estate for purposes of the tax liability of that beneficiary in the later year. There is an exception to the rule denying the carry forward of the tax loss: the rule is not applied where the income beneficiary has an interest, presumably any interest, in the corpus of the trust estate. Where the income is accumulating income, the carry forward of the tax loss is allowed.

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15.38. It has been put to the Committee that the law should allow the income beneficiary a current deduction against his other income of a loss suffered by the trust. Where, under trust law, a loss is carried forward against future income, the denial to the income beneficiary of a deduction for the amount of a tax loss incurred by the trust in the current year seems to the Committee generally appropriate. If there is a prospect of a different income beneficiary replacing the present one in a later year, allowing the deduction to the present income beneficiary would not only produce complications but operate unfairly. In the later year the amount of trust income, but not the income of the trust for tax purposes, would be diminished by the trust loss.

15.39. Where, under trust law, a loss is charged against corpus, the denial to the income beneficiary of a current deduction also seems generally appropriate. In this case, too, there is the prospect that the income beneficiary will not be the person who in fact bears the loss.

15.40. It follows from the preceding paragraphs that a tax loss will not be deductible, whether the trust law directs that the loss be charged against corpus or directs that it be made good from future income of the trust, if the trust is terminated before the tax loss is fully absorbed. In the latter instance, the loss, in substance, will be borne by corpus so that in both instances the capital of the trust will have been diminished. Where there is a tax loss, which is thus not deductible, there is a case for treating it as deductible against the part included in income of any capital gains arising on the termination of the trust. This proposal is again raised in Chapter 23.

II. Partnerships

15.41. The scheme of Division 5 of Part III of the Act involves calculating the ‘net income’ of the partnership (in general, net income in the sense of those words in Chapter 7) of a year of income and the allocation of that net income, for the purpose of determining the incidence of tax on it, between the partners. The allocations are made in terms of the ‘individual interests’ of the partners in the net income. A partner has an individual interest in partnership profits. It is only as a term of speech that he can be said to have an individual interest in net income. Net income is, after all, merely a figure used in determining the liability to tax on partnership profits.

15.42. All the net income is allocated to the partners and taxed in their hands. While the partnership is an intermediary recognised for the purpose of tax accounting, it is not in any circumstances a taxable entity.

15.43. From the judicial opinion that Division 6 has no application to income of a trust derived from a foreign source, it seems a proper inference that Division 5, too, has no application to foreign-source income. The discussion in this section of the chapter assumes that no foreign-source element is involved: in other words, that the income has an Australian source and the partners are Australian residents.

Net Income of a Partnership and Partnership Profits

15.44. The profits of the partnership as determined by partnership law and the partnership agreement will not necessarily be the same as the net income of the partnership. In some situations the partnership profits will be greater than the net income: special tax concessions by way of accelerated depreciation and investment allowances may be available to the business carried on by the partnership. More probably, partnership profits will be less than the net income. The partnership agreement may


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require that provision be made for contingent liabilities and higher depreciation charged than is allowable in calculating net income. Whatever the amount of partnership profits, only the amount of the net income will be brought to tax in the hands of the partners. The scheme of Division 5 thus ensures that no greater tax is imposed than would have been the case had the income not moved through the intermediary.

15.45. The amount of partnership profits is not, however, irrelevant. It is necessary in many cases to know the amount in order to fix the individual interests of the partners, on the basis of which the net income is allocated to the partners. Where the interests of the partners are simply expressed as fractions of profits, there will be no need to look to the amount of partnership profits. But where the interests of the partners are to some extent expressed as, say, salary or interest on capital contributed, the determination of an individual interest will require a calculation of the amount of profit in order to determine the proportion of the profits of the partnership to which the partner is entitled.

15.46. Division 5 determines exclusively how a partner is to be taxed on the net income of the partnership. Actual distribution to a partner, whenever it occurs, does not involve any derivation of income by the partner.

15.47. The allocation of net income to a partner carries through to the partner the quality of exempt income that may attach to that income. There is an express provision in Division 5 to this effect. Presumably the individual interest of a partner, for this purpose, must depend on the taking of the partnership accounts and any appropriation of profits that distinguishes the income appropriated by reference to its source. It may be necessary to ensure, by express provision, that the quality of being a dividend is carried through in order that the tax credit in respect of dividend income proposed by the Committee in Chapter 16 be available to a partner.

15.48. Where expenditure is incurred by a partnership engaged in prospecting for minerals or in mining development, deductions may be available if there is income from mining or, in some circumstances, any other income to absorb them. The Act does not at present appear to make the deductions available against non-partnership income of the partners. It may be appropriate to remove the doubt by specific provisions for the carrying through of the deductions to the individual partners.

Treatment of Losses

15.49. The treatment of partnership tax losses differs from the treatment of tax losses of a trust. A tax loss is not carried forward by the partnership in determining the net income of the partnership in a subsequent year. It is distributed to the partners in accordance with the individual interests of the partners. ‘Individual interests’, for this purpose, refers to the liability of a partner to share in losses.

15.50. A partnership agreement may provide for the payment of a salary to a partner. The salary in a particular year may be greater than the net income of the partnership or may be payable though a tax loss has been incurred by the partnership. The application of the individual interests of the partners to determine the allocation of the net income or of the tax loss becomes, in these circumstances, a difficult exercise. The present practice of the Commissioner in accepting an allocation agreed to by the partners, where there is no suggestion that a tax advantage is the objective of the allocation, seems to be satisfactory. The practice may involve a result which, curiously, taxes one partner on an amount of net income and allows the other a loss. However, the principle is preserved that, when the tax consequences for the partners


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are combined, no more is taxed than the net income of the partnership or no greater loss is allowed than the tax loss.

Payments by Surviving Partners to Retired Partner or to Estate of Deceased Partner

15.51. A professional partnership agreement may provide that payments be made to a retired partner or to the estate of a deceased partner out of fees received after the retirement or death, the amounts of the payments being determined by reference to the individual interest of the former partner in work in progress at the date of his retirement or death. In the Committee's view there should be express provisions making the amounts income of the retired partner or net income of the estate. At the same time it should be made clear that these amounts are not net income of the partnership of the remaining partners.

15.52. Where the partnership agreement or a new agreement provides for payments to a retired partner or to the estate of the deceased partner which amount to a share of profits derived after the date of retirement or death, the share of profits may be taxed twice. It may be taxed as income of the retired partner, or of the estate, as a series of periodical receipts. It will be taxed also as net income of the partnership of the remaining partners. There is a contrast with the consequences that flow where payments of a similar kind are made by a company to a retired executive or to the dependants of a deceased executive. They will be income of the retired executive or the dependants but may be deductible by the company. They will be deductible as a business expense or under section 78(1)(c), in the latter case to the extent to which, in the opinion of the Commissioner, they are sums paid in good faith in consideration of the past services of the employee in business operation carried on by the company. It may appear anomalous that the company is differentially treated. The company may be no more than a partnership that has adopted a different legal form. It will be anomalous if a company is so treated and a company elects, in accordance with the proposals in Chapter 16, to be taxed as a partnership. In the Committee's view there should be a provision under which a deduction will be allowable to a partnership for payments made to a retired partner. A number of conditions ought to be imposed. One condition would follow the model of section 78(1)(c) and require that the Commissioner form the opinion that the payment was made in good faith in consideration of past services to the partnership. Another would require that the payment be in a form making it income of the person receiving it: in this respect the condition would be more restrictive than that imposed by section 78(1)(c).

15.53. Alternatively, provisions might be adopted that would follow the United States law, whereby the retiring partner continues to be a partner for income tax purposes until all payments to which he is entitled have been received. In this event, there would need to be some provision requiring a re-allocation of partnership income where the payment is excessive having regard to past services.

III. International Aspects

Trusts

15.54. As briefly indicated in Chapter 7, the bases on which Australia asserts jurisdiction to tax income are residence in Australia of the person beneficially deriving income and source in Australia of the income. Residence in Australia of a trustee intermediary is not asserted as a basis of jurisdiction. The provisions of Division 6 are not in their terms founded on any basis of jurisdiction. There is judicial opinion that


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those provisions of Division 6 depending on the notion of net income of a trust estate apply only to income having an Australian source.

15.55. A number of consequences follow:

• (a) Even though the trustee is an Australian resident, foreign-source income to which a non-resident is entitled through a trust is not subject to Australian tax.
• (b) Even though the trustee is an Australian resident, foreign-source income accumulating in a trust is not subject to Australian tax.
• (c) Foreign-source income to which an Australian resident is entitled through a trust may be subject to Australian tax in his hands but only when he receives that income: entitlement to receive is not a derivation.
• (d) Even though foreign-source income has been paid to an Australian resident, it is arguable that it is still not taxable in his hands if it has previously been accumulated by the trust or retained for him because he was under a disability. The argument would be that he has received, not income, but an amount paid to him in satisfaction of his interest in the trust.
• (e) When instead of paying it to him, the trustee has applied foreign-source income for the benefit of a beneficiary, the application may not give rise to a receipt within the meaning in (c) so as to consitute a derivation of income by the beneficiary.

15.56. All except the first of these consequences involve some escape from or deferral of Australian tax, which the Committee considers unacceptable. Australia should assert a wider jurisdiction to tax income moving through a trust intermediary and Division 6 should be adapted to apply to any such income in relation to which jurisdiction is asserted. The following proposals are made:

• (a) Where an Australian resident beneficiary is presently entitled to foreign-source income derived by a trust estate, that income should be subject to tax in his hands, in the same manner as Australian-source income is taxed under the present Division 6. Present entitlement for this purpose will include deemed entitlement arising from a payment or application for the benefit of the beneficiary.
• (b) Where an Australian resident beneficiary receives a distribution from income of a trust estate that has been accumulated, and the income has not been subject to Australian tax in the hands of the trustee, it should be taxed in the hands of the beneficiary.
• (c) Where income is accumulating, and the trustee is an Australian resident, or for other reasons the trust is to be regarded as an Australian trust, the income should be subject to Australian tax in the hands of the trustee. If subsequently such income is distributed to a non-resident beneficiary, there ought to be an appropriate refund of Australian tax. If, on the other hand, it is distributed to an Australian resident there will be no further tax on the income in the hands of the beneficiary.

15.57. It will be necessary to provide against an assignment to a non-resident by an Australian resident beneficiary of the latter's interest in accumulating income. In proposal (b) such an assignment would defeat the taxing provision; in proposal (c) it would generate an unjustified refund. It may also be necessary to provide that a change of residence by an Australian resident beneficiary shall not preclude an assessment under any of the proposals.

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15.58. The implementing of these proposals will require extensions to the scheme in Division 6. Net income of the trust estate should include foreign-source income. An Australian resident beneficiary presently entitled, or deemed to be presently entitled, to that income would be taxed in the same manner as any beneficiary is now subject to tax in respect of Australian-source income. A non-resident beneficiary would of course be exempt in respect of foreign-source income. Accumulating foreign-source income would be subject to Australian tax in the hands of the trustee where the trust is an Australian one. A distribution from accumulated foreign-source income that has not been previously subject to Australian tax would be taxed to an Australian resident beneficiary receiving it. A distribution to a non-resident from accumulated foreign-source income of an Australian trust would not be subject to Australian tax in the hands of the beneficiary and there would be a refund of Australian tax imposed on that income.

15.59. The notion of an Australian trust will have to be defined. Residence in Australia of a sole trustee or a majority of the trustees should be sufficient to make the trust an Australian one. Management and control of the trust in Australia should also be sufficient. The latter aspect is further considered in Chapter 17.

15.60. The Committee's proposals will give rise to a number of problems that are to a degree avoided by the present limited assertion of jurisdiction. Where the foreign-source income has borne foreign tax, relief against double taxation will be necessary. Where Australian tax is imposed on a distribution of accumulated income, there will be difficulties in applying the relief in respect of foreign tax paid some years before, especially if the relief is in the form of a tax credit. The onus that the law imposes on the taxpayer will assume special significance.

15.61. It will be necessary, to a greater extent than at present, to distinguish in the trustee's accounts between Australian-source and foreign-source income. There will be a question whether the character of a beneficiary's entitlement, or the character of a distribution made to him, is to be determined by the law or by an appropriation by the trustee. If the trustee's action governs, he may be able to limit Australian tax by the appropriation of foreign-source income to a non-resident beneficiary. Alternatively, the law could provide a formula by which any income, for purposes of the tax liability of a beneficiary, will include Australian-source and foreign-source elements in proportions reflecting the amounts of these elements held in the trustee's accounts.

15.62. A potential liquidity problem faces a taxpayer whenever a liability to tax is imposed on money that has not been remitted to Australia. The liquidity problem in the present context inheres in a scheme of taxation by reference to present entitlement as distinct from actual receipt. The problem in its wider context is considered in paragraphs 22.60 and 22.61.

Partnerships

15.63. The view was expressed in paragraph 15.43 that Division 5 applies only to income with an Australian source. The manner of taxing an Australian resident partner on partnership income with a foreign source must depend on other provisions of the Act. It is at least arguable that there is no derivation of such income by a partner until the partnership account has in fact been taken and the amount of his entitlement determined. Even then derivation might be doubted when the partner does not have control and disposal of the amount to which he is entitled. In the Committee's view Division 5 should be extended so that the calculation of net income is made in relation


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to income from all sources. It will be necessary expressly to limit the net income taxable in the hands of a non-resident partner so that it includes only Australian-source income. As in the case of a trust, there will be a question, in this regard, whether the partners should be free to determine, by an appropriation in the partnership accounts, what is the source of a partner's income. Where a partner is an Australian resident, the question will also bear on the entitlement to exemption or tax credit by way of double taxation relief.