Please note that the legislation has now passed and has received Royal Assent
ABOUT THIS PROGRAM
Tax Laws Amendment (2007 Measures No.4) Bill 2007 contains a number of amendments to the trust loss rules - in particular those relating to a family trust election and its consequences.
Many of these changes are long overdue and introduce some long needed flexibility into the family trust regime.
This program examines the intended changes to the family trust election rules, including:
The program includes practical case studies.
Changes to Family Trust Election Rules
When the family trust election rules were first announced in 1995, the Federal Treasurer indicated that they were being introduced to stop, amongst others, the trafficking of trust losses, and to try to put the recoupment of losses by trusts on the same footing as recoupment of losses by a company. The rules that were introduced, contained in Schedule 2F of the Income Tax Assessment Act 1936, go well beyond this and place significant restrictions on the ability of trusts to recoup trust losses, and claim bad debt deductions.
In essence, the trust loss rules seek to prevent deductions for losses or bad debts (as well as foreign losses), being transferred to persons who did not bear the economic loss or the loss arising from the bad debt when it was incurred. The legislation achieves this aim by examining whether there has been a change in underlying ownership or control of a trust or whether certain schemes have been entered into in order to take advantage of the trust losses.
An important concession to these general rules, however, is that where a family trust election is made, concessional treatment is available in respect of the ability to recoup the losses and claim bad debt deductions. Once a trust has elected to be a family trust, distributions are effectively restricted to entities and people that form part of the family group relevant to a “test individual”. Whilst under trust law distributions may be made to any eligible beneficiary, a special tax, called a “family trust distribution tax” is imposed in respect of any distribution made to an entity that is outside the family group relevant to that test individual. Accordingly, the making of a family trust election effectively limits the distribution to those within the family group.
In addition, family trust elections are also used to facilitate the flow through of franking credits through discretionary trusts, as well as ensure losses are able to be carried forward under the company loss recoupment rules (assuming the shares in the company are held by a trust).
Tax Laws Amendment (2007 Measures No.4) Bill 2007 (“No 4 Bill”) contains a number of amendments to the trust loss rules, and in particular those rules relating to the making of a family trust election, and the consequences arising therefrom. These amendments are the first set of substantial changes made to the trust loss rules since they were enacted. Many of these changes are long overdue and introduce some long needed flexibility into the family trust regime. This will be achieved through the following:
At the time of writing this paper, the No. 4 Bill has not yet passed into legislation. It is anticipated however that it will ultimately be passed into legislation, even if there is a change in Government. This paper will seek to explore the changes in detail and provide practical examples of the application of these changes.
Revocation of Family Trust Elections
Under the legislation before these changes, a family trust election can only be revoked if the trust involved is a fixed trust, and provided that certain conditions are satisfied.
The amendments introduced in the No 4 Bill, however, will allow family trust elections to be revoked unless either of the following applies (section 272-80 of Schedule 2F of the Income Tax Assessment Act 1936):
Under the amendments, the family trust election can be revoked in respect of a year that occurs before the end of the fourth year after the year specified in a family trust election. In other words, if a family trust election is made in, say, 2003, the trust has until the end of the 2007 year in order to revoke the family trust election. A special transitional rule has been introduced, however, in respect of family trust elections that were made more than four years before the start of the year in which the No 4 Bill receives Royal Assent. In this situation, the trustee of the family trust will have until the end of the year following that in which the Bill receives Royal Assent to revoke the family trust election. For example, if we assume the Bill receives Royal Assent during the year ended 30 June 2008 (it was passed by the House of Representatives on 13 August 2007 and is currently before the Senate), the trustee of a family trust will have until 30 June 2009 in which to revoke any family trust elections that were already made. If revocation is to be made, it must be made by the trustee in writing and in the approved form. It must also specify the year in which revocation is to be effective, and is to be made in the trust tax return for the income year in which the revocation occurs.
Whilst this amendment appears welcoming, in practice the writer does not believe it will be of significant benefit. This is because the conditions that need to be satisfied in order to revoke the family trust election are generally the same issues that force a trust to make a family trust election in the first place. In other words, it is, in practice, usual for a trust to make a family trust election where either carry forward losses or bad debt deductions have been claimed, or there has been a desire to flow through franking credits.
Revocation of Interposed Entity Elections
In addition to family trust elections, amendments have been made to allow an interposed entity election to be revoked where the election was made for an entity that was already included in the family group of the individual specified in the family trust election. This will occur where, for example, a family trust has distributed income to a company, the shareholders in which are individuals that fall within the family group relevant to the test person.
Further, an interposed entity election that was made in respect of a family trust will also be automatically revoked where the family trust election is revoked.
Under current law, an interposed entity election is irrevocable.
The same time period explained above in relation to the revocation of family trust elections applies to the revocation of interposed entity elections. If a revocation is to be made, it must be made by the entity in writing and in the approved form. It must also specify the year from which the revocation is to be effective.
The ability to revoke interposed entity elections will potentially have a broader application. For example, if a company had incorrectly elected to be an interposed entity, the ability to revoke that election will allow a change in ownership of that company to occur without future distributions from that company being affected by the previous election.
Variation of Test Individual
The writer believes that in practice, more benefit will be obtained from the ability to vary the test individual as well as the extension of the family group which is explained below.
As readers would be aware, under the original rules, it was not possible to vary the test person in relation to a family trust election. This often led to harsh results, given that the test person defined who was or who was not included in the family group, and failure to nominate the most appropriate test person could lead to significant tax implications.
The amendments proposed in the No. 4 Bill are intended to deal with the situation where a trust has chosen the wrong test person in its family trust election, but has always acted in the past as if the proposed new test person was always the test individual. On this basis, the new test individual must have been alive at the time of the original election.
In order to nominate a new test person, that person must be a member of the original test individual’s family at the election commencement time and no conferrals or distributions of income or capital must have been made (by the trust or an interposed entity) outside the new test individual’s family group during the period in which the election has been in force. The time period that applies in which the test individual can be varied is the same as that for revocation of family trust elections. If a variation is to be made, it must be made by the trustee in writing and in the approved form. It must also specify the income year from which the revocation is to be effective.
It will also be necessary to amend the test individual in relation to, for example, any trusts that have elected to be an interposed entity in relation to that particular family trust. This does not arise out of the legislation, but rather the application of the amendment to a client with a group of trusts. .
For example, under the current legislation, where a a trust makes an interposed entity and family trust election, any trustee beneficiaries must, when making the interposed entity election, nominate the same test person in order to fall within the same family group. Under the proposed law, if the trust making the distribution varies its test person, it will also be necessary for the trustee beneficiary to nominate the same test person. If not, it cannot receive any further distributions from the original trust.
In addition to the above, the amendments also provide that the test individual may be varied if, as a result of a family law obligation arising from a marriage breakdown, the control of the trust passes to a new test person and/or their family members.
This is a once-off variation.
Distributions to Former Family Members
One of the significant difficulties under the current legislation is that if a test person and their spouse were to divorce, distributions to the ex-spouse would be outside the family group and therefore subject to family trust distributions tax. This would have a significant impact on the distributions, as very often distributions needed to be made from the family trust as a result of the divorce settlement. Accordingly, the need to be careful with the timing of when the divorce takes place, and/or the nomination of any test individual, is extremely important.
Many of these sensitivities, will be removed with the amendments proposed in the No. 4 Bill. Under these amendments, any distributions made to a former spouse, former widower or a former step child of a test person will not be subject to family trust distributions tax, as these people will be included in the definition of ‘family group’ (refer to section 272-90(2A) of Schedule 2F of the Income Tax Assessment Act 1936).
A former widow or widower is a person who was a widow or widower of the primary individual or a member of the primary individual’s family, and who has a new spouse that is not a member of the primary individual’s family. The same principles apply in relation to former step children. As discussed previously this will have a significant benefit for trusts involved where there is a marriage breakdown and for estate planning purposes.
Amendment to Interposed Entity Rules
An amendment has been made to the definition of ‘outsider’ in Section 270-25 to ensure that any trust that has made a family trust election with the same test individual is not an outsider for the purposes of the income injection test. This amendment will ensure that such trusts will be a member of the individual’s family group without the need to make an interposed entity election.
Again, this amendment does not change significantly the law in relation to the previous position. However, by no longer requiring interposed entity elections to be made, it will enable a significant number of entities to apply the law without unintentionally breaching it i.e. by failure to make all of the correct elections.
Definition of Family
Amendments have been made to the definition of ‘family’ in Section 272-95 to include the following:
All of the above amendments will apply to the year in which the Bill receive Royal Accent and to later income years.
At this stage, there appears to be no objection to the legislation from the Labor Party. Accordingly, even if the No. 4 Bill is not passed by both houses of Parliament prior to the election being called, it would be expected that the legislation would be re-introduced and passed at some stage before 30 June 2008 and therefore have effect from that time.
As evident from the above, it is clear that the changes introduced in the No. 4 Bill enhance significantly the operation of the trust loss election rules, and ameliorate many of the concerns raised in relation to their harsh applications in prior years. As further consequences arise, it is expected that the Government of the day would take further steps to amend these rules.
Case Study 1: Unable to Revoke- new law provides no benefit
The Halls Family Trust is a discretionary trust which holds a share portfolio acquired after 31 December 1997. For the 1999-2000 income year, there were no tax losses recouped but the trustee distributed dividends in such a way that franking credits being allocated to the beneficiaries are as follows:
Mr Halls also received $4,000 of franking credits from holding shares directly.
Without a family trust election The Halls Family Trust would not be able to distribute the $3,000 franking credits to Mr Halls as Mr Halls would exceed the $5,000 threshold for the small shareholder exemption in Division 1A of the former Part IIIAA of the ITAA 1936. Mr Halls can only utilise the $4,000 of franking credits attaching to the shares held directly if the 45-day holding period rule is satisfied. In order for Mr Halls to also utilise his $3,000 of franking credits from the trust, the trustee made a family trust election effective from the start of the 1999-2000 income year. Consequently Mr Halls will be a qualified person in relation to the distribution for the purposes of Division 1A of former Part IIIAA of the ITAA 1936.
Applying Current Law
The trust would not be able to revoke the family trust election, as the trust is not a fixed trust.
Applying Proposed Law
Whilst the new law allows discretionary trusts to revoke a family trust election, under s272-80 of Schedule 2F (ITAA36) an election can be revoked unless a beneficiary who received a franked distribution would have been denied the franking credits if the election had not been made.
As Mr Halls is only entitled to the franking credits because of the family trust election, as he exceeds the $5,000 threshold, the family trust election cannot be revoked.
Case Study 2: Revoking an election under transitional rules
The Tim Trust is a discretionary trust that made a family trust election specifying the 1999-2000 income year with an election commencement time of 1 July 1999. For the 1999-2000 and 2000-01 income years the trust accrued tax losses of $20,000. In the 2002-03 income year, the Tim Trust recouped its $20,000 carried forward tax losses having satisfied the income injection test applicable to family trusts.
The Tim Trust has determined that had it not made the family trust election it would have satisfied the applicable non-fixed trust tests (i.e., the 50 per cent stake test, the pattern of distributions test, the control test and the income injection test) and therefore would have been able to recoup the $20,000 of carried forward tax losses, without the need for the family trust election. The current income year is 2006-2007.
Appling Current Law
As a discretionary trust, the Tim Trust would not be able to revoke the family trust election.
Applying Proposed Law
The Trustee may revoke the family trust election within four years of the election being made. As the election was made in the 1999-2000 income year, the revocation must be made by the year ended in 2003/2004. As it is now 2006-2007, the revocation period has passed.
However the trustee of the Tim Trust may revoke the family trust election under the transitional rules, where an election was made more than four years before the Bill receives Royal Assent. Thus, the election may be revoked by the end of the second income year after the start of the income year in which the Bill receives Royal Assent. If the revocation is to be effective from the start of the income year in which Royal Assent is received, it must be made in the trust’s return for that income year. If a return is not required, it must be lodged with the Commissioner by the end of two months after the end of that income year. The Commissioner can allow for the revocation to be lodged at a later date.
Case Study 3: Definition of Outsider
The trustees of the Barry Investment Trust and the Judy Trading Trust have each made a family trust election specifying Roy as the test individual in the respective family trust elections pursuant to section 272-80. Barry Investment Trust is in losses, Judy Trading Trust has made a profit.
Applying Current Law
Family trusts that have specified the same test individual in their family trust elections are not members of the same family group. A family trust must also make an interposed entity election to become a member of another family trust’s family group. Thus Barry Investment Trust and the Judy Trading Trust are outsiders for the purpose of the income injection test. This means that if Judy Trading Trust distributes income to the Barry Investment Trust, Barry Investment Trust will not pass the income injection test required to claim its carry forward losses, as the Judy Trading Trust is an outsider. Further, the Judy Trading Trust would have made a distribution outside its family group and would incur a liability to family trust distributions tax.
Applying Proposed Law
An interposed entity election is not required under the proposed law. Thus the family trust elections are sufficient to include both trusts within each other’s family group and thus will not be considered as outsiders. This means that if Judy Trading Trust distributes income to the Barry Investment Trust, Barry Investment Trust will pass the income injection test in order to claim its carry forward losses, as the Judy Trading Trust is part of the Barry Investment Trust’s family group and thus is not an outsider.
The Barry Investment Trust will be able to offset its losses against the distribution from the Judy Trading Trust because:
Case Study 4: Family Group
The John Discretionary Trust has made a family trust election, with John as the test individual. John’s spouse is Ann who has a child, Jason, from a previous relationship. Jason is therefore John’s step-child. Since making the family trust election, Ann and John have divorced and John has remarried.
Applying Current Law
As John has remarried, Jason is no longer the step child of John. As a result Jason is no longer part of John’s family group. Any distributions from the Trust made to Jason will be subject to family trust distribution tax.
Applying Proposed Law
Under s270-90 despite the divorce and John being re-married, Jason will remain within the definition of a family group as a former step child. Therefore, any distributions to Jason will not be subject to family trust distribution tax.