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Ruling

Subject: Income and deductions of fund established under a will to receive rent from life tenant and pay expenses of estate property and life tenant.

Question 1:

Is the rent paid to the trustee considered to be part of the income of the trust estate for trust purposes?

Answer:

Yes

Question 2:

Is the rent paid to the trustee considered to be included in the determination of the net income of the trust estate for the purposes of subsection 95(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer:

Yes

Question 3:

Is the income generated from the support fund to be included the tax return for the estate of the deceased, or a separate testamentary trust?

Answer:

A separate testamentary trust, which is also the trust in which the property of the deceased is being held.

Question 4:

Are deductions for vehicle expenses, electricity charges, telephone, internet, foxtel, cleaner and funeral expenses deductible against the rental income?

Answer

Question 4:

If the property is let to the life tenant under a life remainder provision in the will, at a value considered to be less market value, are the deductions limited to the amount of the rental income for the trust estate.

Answer:

No

This ruling applies for the following periods:

Income years ended 30 June 2011, 30 June 2012 and 30 June 2013

The scheme commences on:

6 March 2011.

Relevant facts and circumstances

A person's will provide for the following:

· The deceased's residence (including contents) and a motor vehicle (collectively referred to in the will as 'the property') were given to their trustee upon trust to hold and to permit their partner to have the use benefit and enjoyment thereof,

· during the partner's lifetime;

· until the partner's death;

· until the partner commences to live in a defacto relationship with any other person in the property; or

· until the partner either no longer wished or was unable to enjoy the benefit of that provision.

[The last three dot points above will be referred to in this ruling as "termination events"]

For the better enjoyment, servicing and management of the above trust, an amount of money was to be set aside from the estate (the support fund).

The support fund was to be invested and applied in meeting the following expenses:

· all rates and taxes levied or charged against the property

· the registration, third party and comprehensive insurance and repairs and maintenance of the motor vehicle

· electricity charges

· telephone land line rental and call charges

· internet costs

· Foxtel charges (or similar cable charges if Foxtel is no longer suitable)

· property maintenance to the satisfaction of the trustee

· fortnightly costs of a house cleaner

· property and contents insurance

· the partner's funeral expenses including cremation

· All such expenses as set out above were to be submitted to the trustee for payment.

Throughout the whole of the period of the partner's occupancy and use of the property the partner was to pay to the trustee a specified amount of rent per fortnight, to be credited back into the support fund and not varied without the partner's written consent.

In the event the partner inherited from the estate of the partner's parent a sum in excess of an amount specified in the will then, until the termination of the life tenancy, only the following expenses would continue to be paid from the support fund:

· all rates and taxes levied or charged against the property.

· the registration, third party and comprehensive insurance and repairs and maintenance of the motor vehicle.

· property maintenance to the satisfaction of the trustee.

· fortnightly costs of a house cleaner.

· property and contents insurance.

From and after the earliest termination event to occur the trustee was to hold the property (including any part of the support fund than remaining) in equal shares as tenants in common for those of the deceased's children who survived the deceased.

The rest of the estate of the deceased was to be given to her trustee upon trust to sell, call in and convert the same to money and, after paying all debts funeral and testamentary expenses, to hold the balance in equal shares as tenants in common for the deceased's children.

Relevant legislative provisions

Income Tax Assessment Act 1936, subsection 95(1)

Income Tax Assessment Act 1936, subsection 99A(2)

Income Tax Assessment Act 1936, subsection 99A(3)

Income Tax Assessment Act 1936, section 101

Income Tax Assessment Act 1997, section 6-5

Income Tax Assessment Act 1997, section 8-1

Reasons for decision

Question 1:

The will has described the regular payment by the life tenant as rent, and it is an amount the life tenant 'shall' pay. The life tenant is therefore under a legal obligation from the will to make a regular, recurrent payment to the trustee, who is therefore acting in the capacity of a landlord.

The will also makes it plain that the rent paid covers occupancy and use of the property, being the collective term for the deceased's house, contents, and motor vehicle.

There is no provision in the will directing the trustee to act in a particular way should the life tenant default in rent payments. Consequently the trustee would act according to their powers as a trustee and landlord in general law.

There is no information about why the deceased specified the payment as rent in the will, or why the deceased placed that obligation on the life tenant. Nor is there any information concerning the personal circumstances of the life tenant such as income, age, family connections, work capacity or other assets/income.

It is not the role of the Commissioner to rule on the intentions of the deceased, or to ascertain the terms of the will (or the resulting testamentary trust) as the deceased saw them. However, in making this Private Ruling some guidance is given by the principles set out in Re Gulbenkian's Settlement [1970] AC 508; [1968] 3 All ER 785.

Essentially, the trust instrument is initially examined using ordinary concepts of language. As Lord Upjohn put it,

..words must be given their natural meaning, the clause should be read literally and in accordance with the ordinary rules of grammar. (Re Gulbenkian's Settlement, at AC 522; All ER 790)

Where dispute arises, or there is doubt or inconsistency, the Courts must interpret the expressed intentions of the settlor and affected parties to give a reasonable meaning to the terms of the trust.

The Macquarie Dictionary, [Multimedia], version 5.0.0, 1/10/01, defines 'rent' as

· a return or payment made periodically by a tenant to an owner for the use of land or building.

· a similar return or payment for the use of property of any kind

We consider the rent is income according to ordinary concepts in the hands of the trustee, under section 6-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

The phrase 'ordinary concepts' is derived from the judgment of Jordan J of the New South Wales Supreme Court in Scott v. C of T (NSW) (1935) 3 ATD 142. Jordan J essentially stated that, in the absence of a statutory or specific definition of the term "income", deciding what receipts are counted as income requires consideration of what, in the '...ordinary concepts and usages of mankind...' would be considered to be income. Specific statutory provisions or other determinations may also affect the categorisation of other receipts as income, or the taxable quantum of certain receipts.

In Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199; (1987) 71 ALR 28; (1987) 18 ATR 693; 87 ATC 4263, the Court stated,

The periodicity, regularity and recurrence of a receipt has been considered to be a hallmark of its character as income in accordance with the ordinary concepts and usages of mankind. (87 ATC, at page 4370)

A basic principle is that the character of the receipt must be determined from the point of view of the recipient and not from the standpoint of the payer or some other person.

In McLaurin v. Federal Commissioner of Taxation (1961) 104 CLR 381, Dixon CJ, Fullagar and Kitto JJ, in a joint judgment of the High Court, held (at p 391):

...in point of law it would plainly be unsound to allow a determination of the character of a receipt in the hands of the recipient to be affected by a consideration of the uncommunicated reasoning which led the payer to agree to pay it.

In Scott v. Federal Commissioner of Taxation (1966) 14 ATD 286, Windeyer J also expressed the view that whether or not a particular receipt is income depends upon its quality in the hands of the recipient.

Again, in The Federal Coke Company Pty Ltd v. Federal Commissioner of Taxation 77 ATC 4255, Bowen CJ stated (at p 4264):

When one is considering the character of an amount received by a taxpayer, the enquiry must start with the question: what is the character of the receipt in the hands of the taxpayer?

Court decisions have also held that neither the source of a receipt, nor the use to which it is put by the recipient, is determinative of its character as income.

The second part of question 1 is to consider if the rent is accounted for in determining the "net income of the trust" for tax purposes. Subsection 95(1) of the ITAA 1936 essentially defines "net income" of a trust estate as the total assessable income of the trust as calculated under the ITAA 1936 and ITAA 1997, less all allowable deductions, with a couple of exceptions.

One exception is that, for a life tenant of a trust, losses of prior years that are required to be met out of trust corpus are not allowed as a deduction against assessable income in determining the income of the beneficiary. This would be relevant if the determination of net income in one income year produces an overall loss that required payment out of the support fund. That loss, while carried forward in accounting terms, would not be accounted for in determining net income of the trust for tax purposes in the succeeding year if the trust otherwise made a positive net income in that succeeding year.

Given the finding that the rent is income according to ordinary concepts we consider that the rent is also assessable income for the purposes of section 6-5 of the ITAA 1997 and subsection 95(1) of the ITAA 1936.

Further consideration

On 28 March 2012 the Commissioner issued Draft Taxation Ruling TR 2012/D1 Income tax: meaning of 'income of the trust estate' in Division 6 of Part III of the Income Tax Assessment Act 1936 and related provisions. This ruling, although a draft for comment, sets out the Commissioner's view on the subject of what constitutes 'income of the trust estate'.

The ruling states that there is no statutory definition of the phrase 'income of the trust estate' as used in Division 6 of the ITAA 1936 (which covers trust taxation). The meaning will therefore depend principally on the terms of the particular trust and on general trust law. Paragraphs 7-8 of the ruling hold that 'income of the trust estate' must be

· Measured in respect of distinct years of income,

· A product 'of the trust estate', and

· An amount in respect of which a beneficiary can be made presently entitled.

Criterion 1 is clear.

Criterion 2 essentially means that something that formed part of the trust estate at the start of on an income year cannot itself, for Division 6 purposes, be treated as income of the trust for that year. Paragraph 71 of TR 2012/D1 states that, for trust law purposes, income of a trust is essentially that which is a 'product of', or 'flows from', the trust property. The example given is rent for the letting of property.

Criterion 3 holds that 'income of the trust estate' is not a reference to the gross income of the trust, but rather a reference to the net amount of income to which a beneficiary could be made presently entitled or is accumulated in the trust. In other words, it refers to the "distributable income". Consequently,

...the 'income of the trust estate' for Division 6 purposes must therefore be represented by a net accretion to the trust estate for the relevant period. (paragraph 13)

Paragraph 13 of TR 2012/D1 goes on to say,

Specifically, for these purposes, the income of a trust estate for an income year cannot be more than the sum of:

· the accretions to the trust estate (whether accretions of property, including cash, or value) for that year;

· less any accretions to the trust estate for that year which have not been allocated, pursuant to the general law of trusts (as that may be affected by the particular trust instrument), to income [and therefore cannot be distributed as income]; and

· less any depletions to the trust estate (whether depletions of property, including cash, or value) for that year which, pursuant to the general law of trusts (as that may be affected by the particular trust instrument), have been allocated as being chargeable against income.

In determining the "net income of the trust estate" the trustee will have to bear in mind the views of the Commissioner as set out in the draft ruling and any subsequent final ruling.

Question 2:

We consider that a testamentary trust has been established under the will to hold the trust property. The will also directed the trustee to set aside a lump sum from the estate, to be held by the trustee in a support fund, which to be invested by the trustee and applied by the trustee to meet certain specified expenses relating to the management of the property and life tenancy.

The creation of that testamentary trust means that the terms of the will have been met in that regard and the estate of the deceased is not the entity responsible for that property during the term of the life tenancy.

The will directs that the rent paid by the life tenant to the trustee is credited back into the support fund.

We consider that these provisions mean that, in practical terms, the support fund acts as part of the testamentary trust holding the property; it is not a separate trust from the trust over the physical property. This is supported by the proviso in the will that once the life tenancy ceases, the property (including the remaining part of the support fund) be held by the trustee for the deceased's children.

Therefore the income generated by the support fund would be returned in a separate testamentary trust and not in the estate return of the deceased.

Question 3:

It is taken that the phrase "rental income" refers to the agreed fortnightly payment provided for under the will (as subsequently varied by agreement).

"Deduction" in this matter may mean two things,

· A deduction or debit for an expense paid out of the trust income and accounted for under general accounting principles and trust law, and

· A deduction accounted for under subsection 95(1) of the ITAA 1936 in the determination of the "net income of the trust estate".

Meaning (a) can not be ruled on by the Commissioner as it does not involve a question of tax law for which a private binding ruling may be given.

Meaning (b) is a tax-law question and a ruling may be made.

Subsection 95(1) of the ITAA 1936 provides that

net income, in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions, except deductions under Division 393 of the Income Tax Assessment Act 1997 (Farm management deposits) and except also, in respect of any beneficiary who has no beneficial interest in the corpus of the trust estate, or in respect of any life tenant, the deductions allowable under Division 36 of the Income Tax Assessment Act 1997 in respect of such of the tax losses of previous years as are required to be met out of corpus.

The calculation of trust net income involves applying the formula in section 4-15 of the Income Tax Assessment Act 1997 (ITAA 1997). That formula accounts for an entity's assessable income as considered under Division 6 of the ITAA 1997, less deductions claimable under Division 8 of the ITAA 1997.

For a life tenant, prior year losses of the trust that were generated by the payment of expenses that had to be met by the trustee out of the trust's capital are not accounted for when determining the net income of the trust for tax purposes.

To be deductible under subsection 8-1(1) of the ITAA 1997 against rental income derived by the trustee the expense must be a charge against the trustee, i.e. the trustee has incurred the liability for payment of the expense. In this respect, the situation is akin to a normal rental property situation of landlord versus tenant.

Expenses relating to the maintenance and upkeep of the property are:

· the rates and taxes on the property;

· the motor vehicle costs as listed in the will - registration, third party and comprehensive insurance; repairs and maintenance;

· property maintenance;

· house cleaning costs;

· property and contents insurance.

Motor vehicle costs

Regarding the motor vehicle costs, petrol was not included in the listed categories. It is assumed therefore that the life tenant will bear that expense. It appears from the specific wording of the will that the trustee would be unable to pay petrol costs, either from the fortnightly rent or from the support fund. The cost would then fall upon the life tenant directly.

Oil and other lubricants, as another vehicle consumable, would arguably fall in the costs of maintenance and therefore be covered by the rent. However this may fall for discussion between the life tenant and the trustee.

House and contents insurance

Clearly, the house insurance would be covered. What is less clear is "contents". The will includes in the property of the trust the deceased's residence and all the contents therein, which could be taken to mean all contents as at the date of death. It is not known if the deceased intended to include any personal property of the life tenant contained in the property at the time of death, although it is possible that they did so, based on the description of the beneficiary as their 'partner'. This must be determined by the trustee.

The will is silent about whether subsequent purchases of personal chattels by the life tenant are to be covered by the contribution to contents insurance provided for in the will. This might ultimately fall for negotiation between the trustee and the life tenant.

Living expenses

Expenses such as electricity, foxtel, internet and telephone may be a charge against the life tenant, i.e., the life tenant is personally liable. In that case, those expenses are not an expense against rental income, even if met by the trustee. This is irrespective of who - tenant or trustee - actually pays the expense. If they are met by the trustee they are trust outlays in respect of meeting the terms of the will. Therefore they are not deductible to the trustee under section 8-1 of the ITAA 1997.

They may be paid by the trustee out of the support fund, but are not deductible in determining "net income of the trust estate" under subsection 95(1) of the ITAA 1936.

Funeral expenses

The funeral expenses would not be deductible to the trustee under section 8-1 of the ITAA 1997 as they bear no connection to the generation of rental income under ordinary concepts. They would therefore not be counted for the purpose of subsection 95(1) of the ITAA 1936. The funeral expenses would be a charge against the capital of the support fund. In any event, the funeral expenses will be incurred after the life tenant has died and, presumably, payment of rent will have ceased. Consequently there would be no connection to the assessable income of the trust.

Further, the terms of the will make it plain that the payment of funeral expenses actually might never be incurred by the trustee, particularly if the life tenancy is terminated before the death of the tenant (e.g., if the life tenant voluntarily terminates the tenancy). Moreover, should the life tenant actually inherit the stipulated sum from their parent's estate, then the will stipulates, by the omission of funeral expenses from the list of valid expenses, that the Fund shall not pay the funeral expenses.

Other unlisted charges

Other charges against trust income may arise in determining trust net income for tax purposes, and which have not been considered in the will. The calculation of trust net income for tax purposes is carried out as if the trust were an individual, with certain provisos. One such charge might be depreciation in respect of furniture and fittings, given the "rent" is considered to be assessable income of the trust.

Since this may involve an interpretation of the will and the intention of the deceased no determination can be made in this ruling.

TR 2012/D1

TR 2012/D1 considers the question of expenses and outgoings, and whether they are allocated against income or capital (paragraphs 73-75). The allocation is generally taken as being that income must bear ordinary outgoings of a recurrent nature, such as rates and taxes, and interest on charges and incumbrances. Capital must bear all costs, charges and expenses incurred for the benefit of the whole estate. However, apportionment may be applied if a single expense can be shown to be incurred for the benefit of an income beneficiary.

However, in this matter, the will provides for no income beneficiary of the testamentary trust. For example, the life tenant does not have a right to a distribution of net trust income. All they are entitled to is the application of the rent payments to various expenses of their use of the property. Should there be surplus trust income it remains to be assessed to the trustee.

Question 4:

The question is taken as meaning "deductions" for taxation purposes in determining the net income of the trust under subsection 95(1) of the ITAA 1936.

In general trust law and accounting terms the only issue would be if the payment of expenses is made out of trust income or is made out of trust corpus.

For tax purposes the limitation of deductions to the rental income received is not considered applicable.

The will contains no basis for the calculation of the fortnightly rent. Facts have not been provided to show the commercial rent chargeable in the open market on a similar property in the area. Also, the will specifies no mechanism for calculating any increase in that amount; e.g. by reference to movements in mean rentals for the area. These then become matters for the trustee to determine.

The will can be read as providing that the rent paid by the life tenant is in respect of their occupancy and use of the property.

Taxation Ruling IT 2167 Income tax: Rental properties - non-economic rental, holiday home, share of residence, etc. cases, family trust cases is relevant to the arrangement. If applicable, it is one authority for limiting any deductions to the level of income derived.

IT 2167 deals with various rental property scenarios, including non-economic rentals and family trust cases. Apportionment - as provided for in subsection 8-1(2) of the ITAA 1997 - may be applied to such arrangements, if the rent is considered to be assessable income. Apportionment may include limiting the deductions to the level of rent received.

This matter is not one where only nominal rent is paid and therefore not considered to be assessable income. The decision in Federal Commissioner of Taxation v. Groser (1982) 65 FLR 121; (1982) 13 ATR 445; 82 ATC 4478 (Groser) concerned a person charging nominal rent of $2 per week ($104 per year) to his disabled brother to allow the brother to live in the taxpayer's residence. There was no rental agreement or lease. Expenses claimed against the rent produced a net loss. The Court held that the rent was not assessable because it was a contribution to the funds out of which the taxpayer defrayed the costs of care for his brother. In addition, the care of his brother was considered to be the principal aim of the taxpayer. Further, the Court held that, even if the rent was assessable, the deduction claimed would be limited to the amount of rental income received.

Groser is not considered applicable in this instance, owing to the clearly non-commercial nature of the transaction in Groser and the finding that the rent received was not assessable income.

A different result was obtained in Federal Commissioner of Taxation v. Kowal (1984) 15 ATR 125; 84 ATC 4001 (Kowal). In Kowal the Court found the taxpayer had two motives; provision of a good home for his mother at a reasonable cost to her, and the earning of assessable income over time. After finding that the predominant motive was the earning of assessable income, and accepting that the rental income was assessable, the Court apportioned the outlays to 80 percent. The result in Groser was clearly distinguished. The presence of a lease, plus increases in rent charged, and the facts that the income received was the taxpayer's to do with as he wished, rather than expend on his relative (as was the case in Groser) were important.

IT 2167 also considers situations where the trustee of a family trust purchases a domestic residence and then rents it to family beneficiaries. Often heavily geared, the trust discloses rental income and claims a deduction for property outlays. Depending on the financing arrangement, the deductions may also include interest on borrowings directly incurred by the trustee, or repayments of interest to a person who lent money to the trustee to facilitate the purchase.

IT 2167 holds that rent derived in such situations should not be accepted as assessable income and hence deductions are not allowable.

We consider the situation in this matter does not match the trust discussion in IT 2167.

The Federal Court case Madigan v. Federal Commissioner of Taxation (1996) 68 FCR 12; (1996) 33 ATR 164; 96 ATC 4640 concerned the tax law income received by a beneficiary of a trust. The question was whether the trustee of the trust could deduct outgoings in full or part. The trustee leased a property to the taxpayer's father at 25 percent of market rate. The outgoings were for accountancy fees, insurance, land tax, rates, repairs and maintenance, interest, cleaning and gardening. The rent was set at 25 percent of market rental. The Commissioner subsequently allowed 25 percent of the outlays claimed.

The Court found the trustee had two aims. The first was to provide accommodation to the children of the taxpayer's father, who were beneficiaries of the trust. The second was to obtain rental income. The Court held that the case was one suitable for apportionment, owing to the private or non-income producing concerns. The Commissioner's assessment regarding the rental deductions was upheld.

The decision in the High Court of Australia case Fletcher & Ors v. Federal Commissioner of Taxation 91 ATC 4950; (1991) 22 ATR 613 ('Fletcher') may also be relevant.

In Fletcher the taxpayer entered in to a complex annuity investment scheme, involving the purchase of an annuity by a partnership. The purchase was financed by a round robin of bills of exchange. The end-result was that only a fraction of the purchase price was actually paid by the taxpayer, but substantial tax deductions would be available. Large taxable receipts that would have become available to the taxpayer in the later years of the scheme could be avoided.

The principle that emerged from Fletcher was that, where a disparity existed between an outlay and the related income said to have been derived from that outlay, it was appropriate to examine the subjective motives of the taxpayer. This involves a consideration of the wider factual situation and the various advantages to be gained by the taxpayer; i.e. the production of assessable income versus another unrelated objective (for example, the generation of large deductions while simultaneously negating the possibility of generating the expected assessable income).

The Fletcher case led to the issue of Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings, which ruled that

6. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective (e.g., to derive exempt income or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher at 91 ATC 4957-8; 22 ATR 621-3.

In this matter we consider that there is no 'other objective' relating to the outgoings. The outgoings are to be met by the trustee under the terms of the will. Therefore the apportionment principle in Fletcher is not applicable. Limitation of the deductions to the amount of income generated by the trust is not applicable.

Payments of expenses that can not be made from trust income (since that would generate a loss) would require payment from trust capital (e.g. the support fund) and the resultant loss cannot be offset against income of subsequent years under subsection 95(1), as described above).