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Trusts – Capital Income vs Ordinary Income

By Jan Frank (Tenk Loubser Inc., Somerset West)

Why is it necessary to make the distinction?
The distinction must be made due to the fact that there are income tax, imposed on income received by the tax payer, and capital gains tax, imposed on the capital gain received by the tax payer. Thus an immediate distinction is seen for taxation purposes. In some trusts, income is distributed to some beneficiaries and capital gain to others. It is therefore, because of these two reasons that we need to make a clear distinction between capital and income.

What is capital?
For trust and estate purposes, any gain or loss arising from the sale of an asset is considered to be of capital nature. This must also include any expenses incurred during the normal maintenance and sale of the asset. Examples will include broker fees on the sale, repairs, maintenance and a portion of accounting fees. Please note that these expenses are not deductable for capital taxation purposes.

What is income?
Income is generally defined as any income produced by an asset, excluding the profit made on the sale of an asset, or from a business. Examples will include income like interest, dividends, rent received and business profits.

The impact on the beneficiaries, trustees and distributions
Sometimes the application of the normal rules as to what is capital and what is income can result in a degree of unfairness as between the interests of beneficiaries entitled to income and those entitled to capital. The problem arises when little or no detailed accounting records were kept and a distribution now needs to be made. The trust deed must distinguish between capital and income beneficiaries (and whether or not they have a discretionary or vested right). Firstly, the obligations of the trustees are to manage the assets, keep accounting records, and distribute any or all income and capital to the beneficiaries. They will however not be able to keep to their obligations if no distinctions are made between income and capital. How will they then be able to make the necessary and correct distributions? Secondly, the income or capital beneficiary may unfairly receive the incorrect distribution(s). This in turn can lead to unhappy beneficiaries which, according to their rights, may keep the trustees responsible for the wrong distribution(s).

Trustees have a fiduciary roll to perform. They need to act in the best interest for the beneficiaries and be custodians for the assets held. We must always remember that there were specific instructions from the donor to allocate capital and income to certain beneficiaries. The trustees must respect and abide to the donor’s instructions, as per the trust deed. From the above we can see the importance of keeping accurate accounts and why we need to distinguish between capital and income.