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Authorisation Number: 1011773386794

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Ruling

Subject: Non-resident trust distribution to minor beneficiaries

Question 1

Can you, as a minor, receive more than $3,333 per financial year from an overseas trust without being taxed at 46.5%?

Advice/Answers

No

Question 2

Can the trust pay your school fees directly without it impacting on you Australian tax obligations?

Advice/Answers

No

This ruling applies for the following period

Financial year ended 30 June 2011

Relevant facts

The parent and their children are beneficiaries of a discretionary overseas trust.

The trust holds property in the overseas country.

The parent is a one of a number of trustees of the trust but does not control the trust.

The minor beneficiaries have historically received rental and interest income from the Trust.

The objective of the distribution is to pay for their school tuition.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 6AA

Income Tax Assessment Act 1936 subsection 95(2)

Income Tax Assessment Act 1936 section 101

Income Tax Assessment Act 1936 subsection 102AC(1)

Income Tax Assessment Act 1936 subsection 102AE(2)

Income Tax Assessment Act 1936 section 159N

Income Tax Assessment Act 1997 subsection 6-10(4)

Income Tax Rates Act 1986 schedule 11

International Tax Agreements Act 1953 schedule 42

Reasons for decision

Question 1

Summary

Any income received from the overseas trust exceeding the increased tax-free threshold of $3,333 will be taxed at the highest marginal rate.

Detailed reasoning

Residency of Trust

A trust will be a resident trust estate within the meaning of subsection 95(2) of the Income Tax Assessment Act 1936 (ITAA 1936) if at any time in the year a trustee is an Australian resident or the central management and control of the trust is in Australia. By virtue of paragraph 95(2)(a) of the ITAA 1936, a trust estate will be a resident trust estate if a trustee is a resident at any time during the year of income.

The parent is a trustee of the trust who is a resident taxpayer during the relevant year of income. The definition of a resident trust only requires that a trustee of the trust be a resident during the income year as opposed to a majority of the trustees present. As the parent is a resident, the trust is primarily a resident trust in the relevant income year and as such the Trust must lodge an Australian income tax return.

Relevant overseas Tax Agreement

However, in determining the residency of the trust, it is necessary to consider not only the income tax laws, but also any applicable tax treaties contained in the International Tax Agreements Act 1953 (Agreements Act).

The relevant Schedule to the Agreements Act contains the tax treaty between Australia and the overseas country (the Agreement). This Agreement operates to avoid the double taxation of income received by Australian and the overseas country residents.

Article 4 of the Agreement outlines the residency as being:

[f]or the purpose of this Agreement … means a person who is a resident of that State for the purposes of its tax.

Under article 3 of the Agreement, the term 'person' includes an individual, a company and any other body of persons. Therefore a trust will be considered a person under the terms of the agreement.

It is therefore possible that the trust could be a resident for tax purposes of both the overseas country and Australia. Under these circumstances there is a 'tie-breaker test' under article 4(4) of the Agreement which deems the trust to be a resident solely in the place where the effective management is situated.

The trust holds its fixed property in the overseas country. The majority of the trustees reside in the overseas country where the control of the trust remains as the resident trustee does not hold control of the trust. Therefore, under the 'tie-breaker test' in the Agreement, the effective management of the trust is situated in the overseas country and its residency is deemed to be in the overseas country.

Double tax agreement

The distribution received from the overseas trust is foreign sourced income. And as the minor beneficiaries are Australian residents for taxation purposes, amounts of ordinary income and statutory income are included in their assessable income whether the source of the income is in or out of Australia (subsection 6-5(3) of the Income Tax Assessment Act 1997 (ITAA 1997).

As noted earlier, the relevant Schedule to the Agreements Act contains the double tax agreement between Australia and the overseas country.

In terms of the interest income from the trust, Article 11(1) of the Agreement provides that interest arising in one country and beneficially owned by a resident of the other country may be taxed in that other country. Article 11(2) of the Agreement allows the source country to also tax interest but limits the rate of tax to 10% of the gross amount.

This is a similar position in regards to the rental income from the trust where Article 6 of the Agreement which provides that income derived from real property may be taxed by the country in which the real property is situated. As the property is located in the overseas country, the income is primarily taxed in overseas country.

Therefore, where the income received from the overseas trust comprises of rental and interest income, tax on that income is primarily paid in the overseas country.

However, in Australia, the general position is that interest and rental income sourced in the overseas country which is received by an Australian resident is generally subject to Australian tax which is deemed under article 22 of the Agreement as coming from a foreign source. To avoid double taxation, foreign income received by an Australian resident may be eligible for a foreign income tax offset for the foreign tax paid on the interest. The amount of the credit is limited to the Australian tax payable on the income received.

Taxation of minors

Subsection 6-10(4) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes statutory income derived directly or indirectly from all sources, whether in or out of Australia, during the income year. However, Division 6AA sets out special rules that apply in working out the basic income tax liability on the income of minors. These rules apply to income derived by a minor directly or through a trust. The Division 6AA rules apply to any person classed as a prescribed person who receives eligible assessable income.

Subsection 102AC(1) of the ITAA 1936 states that a prescribed person is any person under 18 years of age at the end of the income year, except:

d) a person who is classed as being in a full time occupation;

e) an incapacitated child in respect of whom a carer allowance or a disability support pension was paid or would, but for eligibility tests, be payable; and

f) a double orphan or a permanently disabled person, provided they are not dependant on a relative for support (see subsection 102 AC(2) of the ITAA 1936)

If the minors do not satisfy any of the exceptions they will be considered prescribed persons. Therefore, as the minor beneficiaries both are under 18 years of age and do not fulfil any other criteria outlined in subsection 102AC(1) of the ITAA 1936, they will be considered a prescribed person for the purposes of Division 6AA of the ITAA 1936.

In addition to the exclusions for an 'excepted person', subsection 102AE(2) of the ITAA 1936 also includes provisions that exclude various types of income from being taxed at the special rates. If the money received of the minor is not excepted income the income will be assessable under the special rules of Division 6AA. Under these circumstances, the income received does not fall under any of the categories listed under subsection 102AE(2) of the ITAA 1936 meaning the income is assessable under Division 6AA.

Applicable tax rate

Division 6AA of the ITAA 1936 ensures that special rates of tax and a lower tax free threshold apply in working out the basic income tax liability on taxable income, other than excepted income, derived by a prescribed person. 

Under these rules, "unearned income" of minors over a certain level is taxed at the highest marginal rate of tax. The rules apply to income, including capital gains, derived by the minor directly or through a trust. Where the minor is a resident, the special rules do not apply if the relevant income is $416 or less. Part 1 of Schedule 11 of the Income Tax Rates Act 1986 (ITRA 1986) sets the rate of tax for income subject to Division 6AA to be 46.5% if income exceeds $416.

Low income offset

Certain low-income taxpayers are entitled to a non-refundable tax offset under section 159N of the ITAA 1936. The maximum offset for 2010-11 is $1,500 with the offset phasing out at the rate of $0.04 for every dollar by which taxable income exceeds $30,000 meaning it does not apply once taxable income reaches $67,500. The low income offset is only available to resident individuals as outlined in section 159H of the ITAA 1936.

There are no provision that disqualifies a minor being assessed at Division 6AA rates from entitlement to the offset. As a result, the Division 6AA tax-free threshold for "unearned income" of minors for the financial year ended 30 June 11 is effectively increased from $416 to $3,333.

Therefore, being Australian residents, the minor beneficiaries may claim the full low income offset where the income received from the trust does not exceed $30,000. The effect of which is to increase the tax free threshold to $3,333. Any income received over this increased threshold will be taxed at the top marginal rates of 46.5% as outlined in Division 6AA of the ITAA 1936.

Question 2

Summary

The overseas trust cannot pay the school fees directly without an impact on their taxable Australian income as a benefit has been obtained from the distribution.

Detailed reasoning

Section 101 of the ITAA 1936 deals with the situation where a trustee has discretion to pay or apply income of a trust estate to or for the benefit of specified beneficiaries (for example, by paying using the income to pay the beneficiaries' school fees), and exercises that discretion to pay or apply all or a part of that income to one or more of those specified beneficiaries. The provision subsequently deems a beneficiary to be presently entitled to the amount paid or applied for their benefit.

In the relevant income year, if the trustee were to apply the income derived for the year towards the maintenance of the minor beneficiaries, section 101 of the ITAA 1936 would deem them to be presently entitled to the amount of income applied for their benefit. As a benefit will have received from the distribution of the overseas trust, the benefit will be assessable and will be subject to the tax payable on that amount.