House of Representatives

Explanatory Memorandum

Circulated By the Authority of the Treasurer, the Hon Wayne Swan MP

Chapter 4 - Special Disability Trusts - changes to the taxation of unexpended income

Outline of chapter

4.1 Schedule 4 to this Bill amends Division 6 of the Income Tax Assessment Act 1936 ( ITAA 1936) so that the unexpended income of a Special Disability Trust (SDT) is taxed at the relevant principal beneficiary' personal income tax rate rather than automatically at the top personal tax rate plus the Medicare levy.

4.2 All legislative references in this chapter are made to the ITAA 1936 unless otherwise specified.

Context of amendments

4.3 In 2006, SDTs were introduced to assist families and carers to make private financial provision for the current and future care and accommodation needs of a family member with severe disability - referred to as the principal beneficiary. The benefits of establishing these trusts are a gifting concession of up to $500,000 combined for eligible family members of the principal beneficiary and an assets test exemption of up to $551,750 indexed annually for the principal beneficiary. In order to access these concessions the trust must be established in accordance with Part 3.18A of the Social Security Act 1991.

4.4 These amendments ensure that the taxation of the unexpended income of a trust is not a disincentive to the establishment of an SDT.

4.5 SDTs are currently taxed in accordance with the general rules for the taxation of trusts in Division 6 of the ITAA 1936. Whether the beneficiary or the trustee pays tax under these rules depends on a range of factors, including whether the beneficiary is presently entitled to a share of the income of the trust and whether they are under a legal disability.

4.6 Broadly, the principal beneficiary of an SDT is deemed to be presently entitled to the income of the SDT that is expended for their care and accommodation, in accordance with section 101. This amount is then included in the assessable income of the principal beneficiary under section 97 if they are a resident, or section 98A if they are a non-resident where they are not under a legal disability. Alternatively, if the principal beneficiary is deemed to be presently entitled to the income of the SDT and is under a legal disability, the trustee of the SDT is assessed on their behalf under section 98.

4.7 Where the income of an SDT is not fully expended on the care and accommodation of the principal beneficiary, this unexpended income is retained in the trust. The trustee of the trust is assessed on this income under section 99A at penalty rates of tax - being 46.5 per cent.

4.8 On 15 May 2008 the Senate referred a number of matters relating to SDTs to the Community Affairs Committee for inquiry and report by 18 September 2008, including:

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why more families of dependents with disabilities are not making use of the current provisions to establish SDTs;

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the effectiveness of Part 3.18A of the Social Security Act 1991;

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barriers in the relevant legislation to the establishment of SDTs; and

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possible amendments to the relevant legislation.

4.9 In its report, which was tabled on 16 October 2008, the Committee highlighted that the tax arrangements that apply to SDTs diminish their value for carers and people with disabilities.

4.10 As part of the 2009-10 Budget the Government announced that it would tax the unexpended income of an SDT at the principal beneficiary's personal income tax rate rather than at the top personal tax rate plus the Medicare levy.

4.11 These amendments address one of the tax issues identified by the Senate Standing Committee on Community Affairs and are designed to ensure that taxation is not a disincentive to the establishment of an SDT.

Summary of new law

4.12 These amendments ensure that from the 2008-09 income year all of the net income of an SDT is brought to tax at the marginal tax rate of the principal beneficiary of that SDT.

4.13 To achieve this result, these amendments provide that the net income of an SDT is, in the first instance, assessed to the trustee of the trust. The entire amount of the net income of the SDT may then be included in the assessable income of the principal beneficiary. To ensure that the net income of the SDT is not effectively taxed twice, an offset is provided to the principal beneficiary for the amount of tax paid or payable by the trustee where the net income of the SDT is also assessed to the principal beneficiary.

Comparison of key features of new law and current law

Detailed explanation of new law

4.14 In order to ensure that all of the net income of an SDT is taxed at the marginal tax rate of the principal beneficiary, these amendments make a number of modifications to the operation of Division 6.

Eligibility for these modifications

4.15 The modifications made by these amendments to Division 6 only apply in relation to a year of income where a trust estate is an SDT at the end of the income year . [Schedule 4, item 3, subsection 95AB(1)]

Example 4.1

Andrea is an elderly single parent who has a son John, who is severely disabled. During the 2008-09 income year Andrea decides to establish an SDT in order to provide for John's future care and accommodation.

The SDT is established on 1 June 2009. It is assessed taking into account the modifications to Division 6 provided for in section 95AB for the entire 2008-09 income year.

4.16 Where a trust estate is not an SDT at the end of an income year the trust estate is subject to the ordinary operation of Division 6.

Example 4.2

On 1 January 2009, Casey, who is the principal beneficiary of the Ackroyd SDT, passes away. Due to Casey's death, the Ackroyd SDT ceases to be a complying SDT as the trust does not have a principal beneficiary.

The net income of the Ackroyd trust is assessed in accordance with the ordinary operation of Division 6 for the entire 2008-09 income year.

Present entitlement to the income of an SDT

4.17 Division 6 relies on the concept of present entitlement in order to determine how and to whom the net income of a trust is assessed. Under Division 6, a beneficiary is only assessable on a share of the trust's net income if they are presently entitled to a share of the income of the trust estate. If there is a share of the income of the trust estate to which no beneficiary is presently entitled, the trustee of the trust is assessed on that share of the net income of the trust under section 99A or (where applicable) section 99.

4.18 As the Social Security Act 1991 currently places a number of restrictions upon how the income of an SDT can be applied, it is common for the principal beneficiary of an SDT not to be presently entitled to all of the income of the SDT. The result under the current law is that a portion of the net income of the trust remains in an SDT at the end of the income year and is assessed to the trustee at penalty rates under section 99A, reducing the amount that can be applied for the future care and accommodation of the principal beneficiary.

4.19 These amendments treat the principal beneficiary of an SDT as if they are presently entitled to all of the income of the SDT. This change ensures that there is no net income of an SDT that is assessed to the trustee under section 99A, even where income is retained in the trust at the end of the income year, increasing the amount available for the care and accommodation of the principal beneficiary in future income years . [Schedule 4, item 3, subsection 95AB(2)]

Example 4.3

Sammy and Scott are an elderly couple. Their daughter Rachel is severely disabled. Sammy and Scott establish an SDT in order to provide for Rachel's care and accommodation needs.

In the 2008-09 income year, the SDT has income of $15,000. The SDT's net income is also $15,000. The trustee of the SDT applies $10,000 for Rachel's reasonable care and accommodation costs and retains the remaining $5,000 in the trust.

Rachel is deemed to be presently entitled to all of the $15,000 of the trust's income for the 2008-09 income year although $5,000 of the income is retained in the trust.

SDT has no income for an income year

4.20 Currently where a trust does not have any trust income for the purposes of section 97 or 98, but has net income as defined under the tax law, the trustee of the trust is assessed under section 99A on the whole of the net income of the trust.

4.21 These amendments ensure that where an SDT has no trust income but has net income, the SDT is treated as if it has income. In addition, where paragraph 95AB(4)(a) operates to treat the trust as if it has income, the principal beneficiary of the SDT is treated as being presently entitled to all of that income . [Schedule 4, item 3, paragraph 95AB(4)(b)]

4.22 This treatment ensures that the trustee of an SDT is not assessed under section 99A, ensuring that the whole of the net income of the SDT is assessed at the marginal tax rate of the principal beneficiary . [Schedule 4, item 3, subsection 95AB(4)]

Example 4.4

Andrew is the principal beneficiary of the Walker SDT.

In the 2008-09 income year, the Walker SDT has no trust income but has net income of $5,000 from the sale of a parcel of shares.

Although the trust does not have any income for the 2008-09 income year, it is treated as if it has income for the purposes of Division 6.

In addition, Andrew is treated as if he is presently entitled to all of the income of the trust.

Resident principal beneficiary treated as being under a legal disability

4.23 In order to tax the unexpended income of an SDT at the marginal tax rate of the principal beneficiary, these amendments ensure that the income of the SDT is in the first instance assessed to the trustee of the trust and then (in relevant circumstances) to the principal beneficiary of the trust.

4.24 This approach to taxing a trust's net income currently applies under subsection 98(3) and section 98A where a beneficiary is a non-resident at the end of an income year and under subsection 98(1) and section 100 where a beneficiary is under a legal disability and has income from other sources (or is a beneficiary in more than one trust).

4.25 There is no mechanism in the existing law that allows this approach to be adopted where the beneficiary of a trust is a resident and is not under a legal disability. In order to tax the income of an SDT at the marginal tax rate of the principal beneficiary, these amendments treat principal beneficiaries of SDTs, who are residents at the end of the income year, as if they are under a legal disability for the purposes of Division 6 . [Schedule 4, item 3, subsection 95AB(3)]

4.26 This treatment ensures that the net income of an SDT is always taxed to the trustee in the first instance under subsection 98(1) and then if appropriate, included in the principal beneficiary's assessable income under section 100 along with any relevant tax offset.

Example 4.5

Rummana is an Australian resident and is not under a legal disability. She is the principal beneficiary of the Chang SDT for the 2008-09 income year.

The Chang SDT has income (and net income) of $10,000 for the 2008-09 income year. Pursuant to the trust's deed, $5,000 is applied for Rummana's reasonable care and accommodation costs. The remaining $5,000 is accumulated in the trust.

Rummana is treated as if she is presently entitled to the entire income of the Chang SDT and under a legal disability. Consequently, the trustee of the Chang SDT is assessed on the entire $10,000 of net income in accordance with subsection 98(1).

Offset for an amount paid or payable by the trustee of an SDT

4.27 Under the existing law, where both the trustee and beneficiary of a trust are assessed on all or part of the net income of a trust, an offset is provided to the beneficiary for the tax paid or payable by the trustee. In particular, where the trustee is assessed under subsection 98(1) and the beneficiary under section 100, an offset is available to the beneficiary under subsection 100(2). This avoids double taxation.

4.28 Where the amount of tax paid by the trustee of a trust, on behalf of the beneficiary under subsection 98(3) exceeds the beneficiary's individual tax liability under subsection 98A(1), the Commissioner of Taxation (Commissioner) is obliged to pay to the beneficiary an amount equal to the difference between the two amounts in accordance with paragraph 98A(2)(b). Currently there is no requirement for the Commissioner to make such a payment in relation to the offset provided for under subsection 100(2).

4.29 To ensure that all of the net income of an SDT is taxed at the marginal tax rate of the principal beneficiary, subsection 95AB(5) of these amendments provides for an appropriate portion of the offset available to the principal beneficiary to be refunded where the tax assessed to the beneficiary is less than the amount of tax the trustee is liable to pay under subsection 98(1). The refundable amount, determined under subsection 95AB(5), is subject to the existing refundable tax offset rules in Division 67 of the Income Tax Assessment Act 1997.

Example 4.6

In the 2008-09 income year, Mark is the principal beneficiary of the Lang SDT. Mark is a resident, is not under a legal disability and has a part-time job during the 2008-09 income year from which he earns $5,000.

During the 2008-09 income year, the Lang SDT earns income of $25,000. The net income of the trust is also $25,000.

The trustee of the Lang SDT applies $20,000 for Mark's reasonable care and accommodation costs during the income year and retains the remaining $5,000 in the trust.

Mark is treated as if he is presently entitled to all of the income of the Lang SDT and under a legal disability. The trustee of the Lang SDT is therefore assessed on the entire $25,000 in accordance with subsection 98(1). However as Mark has also derived income from his part-time employment, he is required to include the entire income of the SDT in his assessable income under subsection 100(1).

Mark is assessed on $30,000 at his marginal rates of tax for the 2008-09 income year. He is also able to offset any tax paid or payable by the trustee of the Lang SDT on the $25,000 of trust net income against his individual assessment.

Before the 2008-09 income year Mark would have been assessed on $25,000 at his marginal rates of tax and the trustee of the Lang SDT would have been assessed on $5,000 at 46.5 per cent.

Example 4.7

In the 2008-09 income year, Maria is the principal beneficiary of the Barker SDT. She is a under a legal disability and is an Australian resident. She derives $5,000 of income during the 2008-09 income year from other sources.

The Barker SDT has income of $35,000 for the 2008-09 income year. The net income of the trust is also $35,000. The trustee of the Barker SDT applies $20,000 for Maria's reasonable care and accommodation costs and retains $15,000 in the trust.

As a result of these amendments, the trustee of the Barker SDT is assessed on the entire $35,000 under subsection 98(1). However as Maria has also derived income from other sources she is required to include the entire income of the SDT in her assessable income.

Maria is assessed on $40,000 at her marginal rates of tax for the 2008-09 income year. She is also able to offset any tax paid or payable by the trustee of the Barker SDT on the $35,000 of trust net income against her individual assessment.

Before the 2008-09 income year Maria would have been assessed on $25,000 at her marginal rates of tax and the trustee of the Barker SDT would have been assessed on $15,000 at 46.5 per cent.

Minor principal beneficiaries

4.30 Under the existing law, principal beneficiaries of SDTs who are minors are generally treated as excepted persons under section 102AC. These amendments put this outcome beyond doubt and ensure that all minors who are the principal beneficiaries of SDTs are excepted persons for the purposes of section 102AC . [Schedule 4, item 4, paragraph 102AC(2)(d)]

Application and transitional provisions

4.31 These amendments apply for the 2008-09 income year and later income years . [Schedule 4, item 8]