Benchmark percentage rule
This rule is to prevent manipulation of differences between the trust's income and net income.
The trust income is determined in accordance with the trust deed while its net income is determined in accordance with tax law. The two amounts can be different.
Under the rule, if a tax-exempt beneficiary's share of a trust's income is less than their share of the trust's net income, the trustee is generally taxed on the excess share of the trust's net income.
When the rule applies
The benchmark percentage rule applies to a trustee if an exempt beneficiary is presently entitled to an amount of trust income and the exempt beneficiary's adjusted Division 6 percentage exceeds its benchmark percentage – unless:
- the exempt beneficiary is an exempt Australian Government agency
- the trust is a managed investment trust (or treated like one for the purposes of Division 275 of the ITAA 1997)
- the affected amount is already subject to the pay or notify rule (the same amount will not attract the operation of both rules).
Adjusted Division 6 percentage
The adjusted Division 6 percentage is the exempt beneficiary's entitlement to the trust's income as a percentage of all of the trust's income, but ignoring any capital gains or franked distributions that any beneficiary or the trustee is specifically entitled to (that is, ignoring capital gains and franked distributions that were effectively streamed by the trust).
The benchmark percentage is the tax-exempt beneficiary's present entitlement to any amount that forms part of the trust's adjusted net income, expressed as a percentage. It's calculated as follows:
The amount the tax exempt beneficiary is presently entitled to from the trust estate, to the extent that the amount forms part of the trust’s adjusted net income
The trust's adjusted net income
Adjusted net income
A trust's adjusted net income is its net income:
- reduced by any capital gains or franked distributions a beneficiary is specifically entitled to
- increased by any CGT discounts and small business concessions that may have been applied to any remaining capital gains
- reduced by any amounts that do not represent net growth of value to the trust estate (other than amounts included under Part IVA of the ITAA 1936, which deals with schemes to reduce income tax).
The effect of the last dot point is to exclude amounts that, unlike monetary additions or acquisitions of property, do not increase the economic value of the trust estate. Examples of these amounts include:
- franking credits
- loans that are treated for tax purposes as a dividend under Division 7A of Part III of the ITAA 1936 (as any loan funds received will be coupled with a corresponding liability to repay)
- the part of a capital gain for tax purposes that exceeds the capital gain made for trust purposes as a result of the market value substitution rules applying.
How the rule is applied
Effectively, if a share of the trust's net income would be notionally assessed to a tax-exempt beneficiary, and that share exceeds the beneficiary's entitlement to the trust's income, the trustee is taxed on the difference.
That is, if the benchmark percentage rule applies, the exempt beneficiary is treated as not being – and never having been – presently entitled to the amount of trust income that's attributable to the percentage by which the beneficiary's adjusted Division 6 percentage exceeds its benchmark percentage.
Instead, the trustee is taxed (generally under section 99A of the ITAA 1936) on the corresponding share of net income, unless we exercise our discretion not to apply the rule.
Example: how the rule is applied
In 2015–16, the Pepper Trust generates $5,000 of rental income and a non-discount capital gain of $95,000. The trust has no expenses or capital losses. The net income of the trust is $100,000 (being the $5,000 rental income and $95,000 capital gain).
The trust deed does not define income for the purposes of the trust nor does it enable the trustee to treat capital receipts as income. Accordingly, the capital gain is not trust income. The trust income is therefore $5,000.
The James Trust and Nick are beneficiaries of the Pepper Trust. The James Trust is an exempt entity.
The trustee appoints all of the income, $5,000, for that year to the James Trust. Three months after the end of the income year, the trustee also distributes a portion of the trust's capital worth $95,000 to Nick. The trustee complies with section 100AA of the ITAA 1936 and notifies the James Trust of its entitlement by 31 August 2015.
Nick is not specifically entitled to the Pepper Trust's capital gain because the legislative requirements for a specific entitlement have not been met. As such, section 100AB does not disregard the capital gain.
The James Trust’s adjusted Division 6 percentage is 100% as it is presently entitled to all of the trust income:
However, the James Trust's benchmark percentage is only 5%:
The James Trust's adjusted Division 6 percentage exceeds its benchmark percentage by 95%.
The James Trust's share of the Pepper Trust's net income that it is notionally assessed on is confined to $5,000, being its benchmark percentage (5%) of the net income of the trust (0.05 x $100,000).
The trustee of the Pepper Trust is therefore assessed (under section 99A of the ITAA 1936) on $95,000, being the remaining 95% of the net income of the trust.
To avoid this outcome, the trustee of the Pepper Trust could instead have made Nick specifically entitled to the capital gain because a trust's benchmark percentage is calculated disregarding amounts to which a beneficiary or the trustee is specifically entitled. To make Nick specifically entitled to the capital gain, the trustee would need to record the capital distribution to Nick in the records of the trust as referable to the capital gain and ensure Nick's entitlement arose within two months of the end of the income year. Nick, not the trustee, would then be assessed on the capital gain pursuant to Subdivision 115-C of the ITAA 1997.
End of example
We have a discretion not to apply the benchmark percentage rule if it would be unreasonable for it to apply.
To exercise the discretion, we must consider the following factors:
Specific anti-avoidance rules in sections 100AA and 100AB prevent trustees from using tax-exempt entities to avoid tax. These are called the 'pay or notify' rule and the 'benchmark percentage' rule.
- the circumstances that led to the tax-exempt beneficiary's entitlement to the trust's income being less than its entitlement to the trust's net income, and the extent of the difference
- the extent to which the tax-exempt beneficiary received distributions for that year
- the extent to which other beneficiaries had an entitlement to or would benefit from the trust's income for the relevant year
- any other relevant matters.