House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 8 Increasing flexibility for family trusts

Outline of chapter

8.1 Schedule 8 to this Bill amends Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936) to provide more flexibility to family trusts in relation to the trust and company tax loss, bad debt deductions and franking credit trading rules. These amendments achieve this by allowing family trust elections and interposed entity elections to be revoked or varied in certain limited circumstances, and by broadening the definition of 'family' and 'family group'.

8.2 All legislative references in this chapter are made to Schedule 2F to the ITAA 1936 unless otherwise stated.

Context of amendments

8.3 The trust loss rules protect the integrity of the income tax system by preventing the tax benefits arising from the recoupment of trust losses and bad debt deductions being transferred to persons who did not bear the economic loss or bad debt when it was incurred. This measure 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 to take advantage of a trust's losses.

8.4 Generally, family trusts are subject to concessional treatment and most of the specific trust loss rules do not apply to family trusts that have made a family trust election.

8.5 A trust becomes a family trust if it makes a family trust election in respect of an individual. By specifying the individual (the test individual), the family group is established to which distributions can be made without penalty. An interposed entity election may be made by a company, trust or partnership to be included in the family group. A family trust election or interposed entity election is irrevocable, although a family trust election may be revoked in certain circumstances where the trust is a fixed trust.

8.6 Family trust elections are also used for the franking credit trading rules and the company tax loss recoupment rules. Under the franking credit trading rules, franking credits attributable to dividends paid to the trustee of a discretionary trust cannot usually be passed through to the beneficiaries of the discretionary trust, unless the total amount of franked credits received directly or indirectly by an individual beneficiary is less than $5,000 per year (ie, a 'qualified person' as a small shareholder) or the trust makes a family trust election. Under the company tax loss recoupment rules, where a discretionary trust is a shareholder of a company seeking to recoup tax losses, the company has a greater chance of passing the continuity of ownership test if the trust has made a family trust election.

8.7 These amendments increase flexibility for taxpayers with family trusts while maintaining the integrity of the income tax system. This is achieved by:

•

allowing family trust elections and interposed entity elections to be revoked in certain limited circumstances;

•

allowing the test individual specified in a family trust election to be changed in certain limited circumstances;

•

broadening the definition of 'family' to include lineal descendants of family members;

•

ensuring that the death of a family member does not by itself result in another family member ceasing to be a member of the family; and

•

exempting distributions made to former spouses, former widows/widowers and former step-children from family trust distribution tax by including them within the definition of 'family group'.

Summary of new law

8.8 These amendments will allow a family trust election to be revoked unless tax losses have been recouped (or bad debt deductions or franking credits have been claimed) during a specified period where the recoupment (or claim) was only possible because of the family trust election.

8.9 The specified period begins at the start of the income year specified in the family trust election and ends on the last day of the income year immediately prior to the income year specified in the revocation.

8.10 Also, an interposed entity election may now 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 at the election commencement time, or at a later time, where the entity becomes a wholly-owned member of the 'family group' (the meaning of which is amended by this Schedule).

8.11 These amendments also allow a once-off variation to the test individual specified in a family trust election. A variation will be available where the new test individual was a member of the original test individual's family at the election commencement time. However, the variation will not be available if there has been a conferral of present entitlement to (or distributions of) income or capital of the trust (or of an entity for which an interposed entity election has been made in relation to the trust) outside the new test individual's family group during the period in which the election has been in force.

8.12 These amendments also include former spouses, former widows/widowers and former step-children within the definition of 'family group' in section 272-90 thereby exempting them from family trust distribution tax. These persons however remain an 'outsider to the trust' for the purpose of the income injection test in Division 270.

8.13 The amendments also expand the definition of 'family' to include any lineal descendant of a nephew, niece or child of the test individual or the test individual's spouse. Furthermore, an amendment is made to ensure that the death of a family member does not by itself result in another family member ceasing to be a member of the family.

8.14 Finally, these amendments ensure that where trustees of different trusts have made family trust elections in respect of the same test individual, they are also included within the definition of 'family group'. They will also not be an 'outsider to the trust' for the purposes of the income injection test in Division 270.

Comparison of key features of new law and current law

Detailed explanation of new law

Revocation - family trust elections

8.15 These amendments allow family trust elections to be revoked in certain limited circumstances. Currently a revocation can only be made for a family trust that is a fixed trust provided that certain conditions are met. Under these amendments, a family trust election can now be revoked unless:

•

tax losses have been recouped by the trust or another entity in an income year during the period between the start of the income year specified in the family trust election and the end of the income year immediately prior to the income year specified in the revocation and the trust or the other entity could not have recouped the losses if the election had not been in force. A 'tax loss' does not include a capital loss, as the meaning of 'tax loss' is set out in section 272-140;

•

deductions for bad debts have been claimed by the trust or another entity during the same period (see above) and the trust or the other entity could not have claimed the deduction if the election had not been in force; or

•

a beneficiary of the trust in an income year over the same period (see above) received a franked distribution indirectly through the trust and paragraph 207-150(1)(a) would have applied in relation to the distribution if the election had not been in force. That is, if the beneficiary was not a qualified person in relation to the distribution for the purposes of Division 1A of former Part IIIAA of the ITAA 1936.

[Schedule 8, item 3, subsection 272-80(6A)]

8.16 These amendments prevent a revocation of an election being made where the election allows another entity to claim a tax loss or bad debt deduction [Schedule 8, item 3, paragraphs 272-80(6A)(a) and (b)] . 'Another entity' refers to a related company that the family trust has a membership interest in or a related trust that the family trust has a fixed entitlement to (see Example 8.2).

8.17 Table 8.1 outlines when the 'election is in force'. [Schedule 8, item 4, subsection 272-80(9)]

8.18 The revocation of a family trust election must be in respect of an income year that occurs before the end of the fourth income year after the income year specified in the family trust election. [Schedule 8, item 3, paragraph 272-80(6B)(a)]

8.19 For a family trust election that was made prior to four income years before the start of the income year in which this Bill receives Royal Assent, the trustee of the family trust has until the end of the income year following the one in which this Bill receives Royal Assent to revoke the family trust election. [Schedule 8, item 3, paragraph 272-80(6B)(b)]

8.20 If a revocation 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. A revocation needs to be made in the trust's tax return for the income year in which the revocation occurs. [Schedule 8, item 4, subsection 272-80(8)]

8.21 If the trustee is not required to furnish a return, the revocation needs to be given to the Commissioner of Taxation (Commissioner) by the end of two months after the end of the income year specified in the revocation. The Commissioner has a discretion to allow for a revocation to be lodged by a later date. [Schedule 8, item 4, subsection 272-80(8)]

Example 8.1

The Ton 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 Ton Trust recouped its $20,000 carried forward tax losses having satisfied the income injection test applicable to family trusts.

The Ton Trust has determined that had it not made the family trust election it would have satisfied the applicable non-fixed trust tests (ie, 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 trustee of the Ton Trust may revoke the family trust election by the end of the second income year after the start of the income year in which this 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.

Example 8.2

Assume the following structure and facts:

All legislative references in this example are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Fred Company is owned 60 per cent by the Smith Trust, 20 per cent by Jo and 20 per cent by Jim. This existing ownership structure has been in place since the 2002-03 income year.

Smith Trust is a discretionary trust with no beneficiaries having fixed entitlements to the income and capital of the trust.

At the start of the 2005-06 income year Fred Company has carried forward tax losses of $100,000 incurred between 2002-03 and the start of the 2005-06. Fred Company has $120,000 taxable income (prior to the application of tax losses) in the 2005-06 income year.

Fred Company wants to recoup its carry forward tax losses in the 2005-06 income year.

To recoup its losses, section 165-10 requires Fred Company to satisfy either the continuity of ownership test (section 165-12) or if it fails this test, the same business test (section 165-13). For the purpose of this example, assume also that Fred Company has a change of business in the 2004-05 income year and therefore it would fail the same business test.

Generally the continuity of ownership test in section 165-12 requires that during the ownership test period, the same persons had more than 50 per cent of the voting power, rights to dividends, and rights to capital distributions. Fred Company is unable to demonstrate that it satisfies these conditions. It can only trace 40 per cent of the interests in itself, held by Jo and Jim, as there are no beneficiaries of the Smith Trust with a fixed entitlement to any part of the trust, and hence indirectly, having an interest in Fred Company that can be counted under section 165-12.

In this situation there are two options for Fred Company to satisfy the conditions in section 165-12:

•

section 165-207 provides that one or more trustees of a 'family trust' that own shares, controls voting or has a right to receive a percentage of a dividend or distribution of capital is taken to own those shares beneficially:

•

therefore using this provision the trustee of the Smith Trust can make a family trust election. Fred Company could then, using section 165-207, satisfy the requirement of section 165-12; and

•

therefore this family trust election would allow Fred Company to satisfy section 165-12 and, having the benefit of the family trust election, recoup its losses in the 2005-06 income year; and

•

Fred Company will also have access to the alternative test in section 165-215 and provided the four conditions in that section are met, it may be able to rely on that provision to satisfy section 165-12:

•

in this scenario section 165-215 looks at the Smith Trust and asks if it would have satisfied the non-fixed trust tests in section 267-20 of Schedule 2F to the ITAA 1936 had it incurred the losses and not the company. Essentially, if the ownership and control tests for the Smith Trust have been satisfied for the ownership test period and the other conditions in section 165-215 are met then the conditions in section 165-12 are taken to be met.

If the alternative test in section 165-215 is passed, then Smith Trust would not need to make a family trust election to allow Fred Company to recoup its losses. In this scenario, the Smith Trust is allowed to revoke its family trust election provided other conditions in subsection 272-80(6A) of Schedule 2F to the ITAA 1936 are also satisfied.

If the Smith Trust is required to make a family trust election in order for Fred Company to recoup its losses, the Smith Trust cannot revoke its family trust election.

Example 8.3

The Ha 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 Ha - $3,000;

•

Mrs Ha - $5,000; and

•

Lyn (child) - $5,000.

Mr Ha also received $4,000 of franking credits from holding shares directly.

If a family trust election was not made, Mrs Ha and Lyn can utilise their franking credits as they are within the $5,000 threshold for the small shareholder exemption in Division 1A of the former Part IIIAA of the ITAA 1936. Mr Ha 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 Ha 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 Ha will be a qualified person in relation to the distribution for the purposes of Division 1A of former Part IIIAA of the ITAA 1936.

As paragraph 207-150(1)(a) would have applied to the franked distribution if the family trust election had not been in force the trustee cannot revoke the election.

Revocation - interposed entity elections

8.22 An amendment is made to subsection 272-85(5) 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 (the test individual) at the election commencement time. [Schedule 8, item 6, subsection 272-85(5A)]

8.23 An interposed entity election may also be revoked where the entity is a member of the family group, within the meaning of subsection 272-90(5) or 272-90(3A) (ie, is or becomes wholly-owned by family members), of the test individual after the election commencement time. [Schedule 8, item 6, subsection 272-85(5A)]

8.24 Any interposed entity elections made in respect of the family trust for which a family trust election has been revoked are automatically revoked at the same time as the family trust election revocation. [Schedule 8, item 6, subsection 272-85(5B)]

8.25 Revocation of an interposed entity election must be in respect of an income year that occurs before the end of the fourth income year after the income year specified in the interposed entity election. Where the interposed entity becomes part of the family group after the election commencement time, interposed entity elections are allowed to be revoked for an income year that occurs before the end of the fourth income year after the income year the entity became part of the family group. [Schedule 8, item 6, subsection 272-85(5C)]

8.26 For interposed entity elections that were made prior to four income years before the start of the income year in which this Bill receives Royal Assent, revocations can be made by the end of the income year following the one in which this Bill receives Royal Assent. [Schedule 8, item 6, subsection 272-85(5C)]

8.27 If a revocation is to be made, it must be made by the company, partners in the partnership or trustee of the trust, in writing and in the approved form. It must also specify the income year from which the revocation is to be effective. A revocation needs to be made in the entity's (ie, company, partnership or trust) return for the income year specified in the revocation. [Schedule 8, item 6, subsection 272-85(6)]

8.28 If the entity is not required to furnish a return, the revocation needs to be given to 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. [Schedule 8, item 6, subsection 272-85(6)]

8.29 Table 8.2 outlines when the 'election is in force'. [Schedule 8, item 6, subsection 272-85(6A)]

8.30 The 'election commencement time' is outlined in Table 8.3. [Schedule 8, item 6, subsection 272-85(6B)]

Variation of a test individual

8.31 Under these amendments, a test individual specified in a family trust election is allowed to be changed, once only, where:

•

the new test individual was a member of the original test individual's family at the election commencement time; and

•

no conferrals of present entitlement to, and distributions of, income or capital 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.

[Schedule 8, item 2, subsection 272-80(5A)]

8.32 This is intended to deal with the situation where a trust has chosen the wrong test individual in its family trust election but the trust had acted in the past as if the proposed new test individual was always the test individual. On this basis, the new test individual must have been alive at the election commencement time.

8.33 Table 8.4 outlines when the 'election is in force'. [Schedule 8, item 4, subsection 272-80(9)]

8.34 The variation of a test individual must be made for an income year that occurs before the end of the fourth income year after the income year specified in the family trust election. [Schedule 8, item 3, paragraph 272-80(6B)(a)]

8.35 For family trust elections that were made prior to four income years before the start of the income year in which this Bill receives Royal Assent, the trustee of the family trust has until the end of the income year following the one in which this Bill receives Royal Assent to vary the test individual. [Schedule 8, item 3, paragraph 272-80(6B)(b)]

8.36 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. A variation needs to be made in the trust's return for the income year specified in the variation. [Schedule 8, item 4, subsection 272-80(8)]

8.37 If the trustee is not required to furnish a return, the variation needs to be given to the Commissioner by the end of two months after the end of the income year specified in the variation. The Commissioner has a discretion to allow for a variation to be lodged by a later date. [Schedule 8, item 4, subsection 272-80(8)]

8.38 The test individual may also be varied if, as a result of a family law obligation arising from a marriage breakdown, the control of the trust passes to the new test individual and/or his/her family members. Specifically, if an order, agreement or award of a kind mentioned in paragraphs 126-5(1)(a) to (f) of the ITAA 1997 results in the control of the trust passing to the new individual and members of the new individual's family, the test individual specified in the family trust election may be varied. The new individual or a group comprising the new individual and members of the new individual's family have control of the trust for this purpose if any of the paragraphs in paragraphs 272-97(2)(a) to (g) are satisfied in relation to a group consisting of the new individual or the new individual and members of the new individual's family. For example, if the group is able (directly or indirectly) to control the application of the capital or income of the trust, or if the group has more than a 50 per cent stake in the income or capital of the trust. [Schedule 8, item 2, subsections 272-80(5C) and (5D)]

Certain former family members

8.39 Any conferral of present entitlement to, or distributions of, income or capital of the trust are exempt from family trust distribution tax where the conferral is upon or the distribution is to a person who is a former spouse, a former widow/widower or a former step-child. This is achieved by including these persons in the definition of 'family group' in section 272-90. [Schedule 8, item 8, subsection 272-90(2A)]

8.40 A former spouse refers to a person who was a spouse of either the primary individual or a member of the primary individual's family before a breakdown in the marriage. The definition of 'breakdown in the marriage' is contained in section 272-140. [Schedule 8, item 8, paragraph 272-90(2A)(a)]

8.41 A former widow or widower is a person who was a widow or widower of either 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. [Schedule 8, item 8, paragraph 272-90(2A)(b)]

8.42 A former step-child is a person who was a step-child of either the primary individual or a member of the primary individual's family, before a breakdown in the marriage of the primary individual or the member of the primary individual's family. [Schedule 8, item 8, paragraph 272-90(2A)(c)]

8.43 Despite the fact that these persons are considered to be members of the test individual's family group, they are not included in the definition of 'family' under section 272-95. [Schedule 8, item 8, subsection 272-90(2A)]

A trust with the same primary individual

8.44 An amendment has been made to the definition of an 'outsider to the trust' in section 270-25 to ensure that any trust that has made a family trust election in respect of the same test individual is not an 'outsider' for the purposes of the income injection test in Division 270. These amendments also ensure that such a trust is also a member of the primary individual's family group without the need to make an interposed entity election. [Schedule 8, items 1 and 9, paragraph 270-25(1)(da) and subsection 272-90(3A)]

Example 8.4

The trustees of the Chan Investment Trust and the Chan 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.

The Chan Trading Trust will be able to distribute to the Chan Investment Trust because the Chan Investment Trust will be part of the Chan Trading Trust's family group.

The Chan Investment Trust will be able to offset its losses against a distribution from the Chan Trading Trust because:

•

as a family trust it will only be required to satisfy the income injection test in order to utilise its losses; and

•

the income injection test will be satisfied because the Chan Trading Trust will not be an outsider to the trust.

Definition of 'family'

8.45 Amendments have been made to the definition of 'family' in section 272-95 to allow for changes in beneficiaries of the trust over time. The definition is amended to also include lineal descendants of a nephew, niece or child of the test individual or the test individual's spouse. [Schedule 8, item 10, section 272-95]

8.46 For the purposes of determining the lineal descendants within the meaning of 'family' in section 272-95, an adopted child, step-child or ex-nuptial child of a person is to be taken into account. [Schedule 8, item 10, subsection 272-95(3)]

8.47 A person does not cease to be a family member merely because of the death of any other family member. [Schedule 8, item 10, subsection 272-95(2)]

Example 8.5

The trustee of the Vu Trust has made a family trust election pursuant to section 272-80 and has specified Harry as the test individual.

Harry's spouse, Athena has a child, Jasmine, from a previous relationship, Harry's step-child. Since making the family trust election, Athena has died.

Harry has not formally adopted Jasmine under any state or territory adoption law.

Jasmine remains a step-child of Harry even after the death of Athena. However, she will cease to be a step-child at the time Harry remarries or enters into a de facto relationship. Nonetheless, Jasmine will remain a member of Harry's family group in respect of the Vu Trust, because she will be a former step-child under subsection 272-90(2A). Therefore, any distributions to Jasmine will not be subject to family trust distribution tax.

If instead Harry and Athena had divorced, Jasmine would become a former step-child, and while not a family member, would remain a member of the family group. Accordingly, any distribution to Jasmine would not be subject to family trust distribution tax.

8.48 A new definition of 'specified individual' is inserted in section 272-140 of Schedule 2F to the ITAA 1936. This provision deals with the situation when a test individual for a family trust is varied under these amendments. A reference in Schedule 2F to a person specified in a family trust election is a reference to:

•

if the family trust election has not been varied - the person originally specified in the election for the purposes of subsection 272-80(3); or

•

if the family trust election has been varied under these amendments - the person most recently specified.

[Schedule 8, items 11 to 13, section 272-140]

Application and transitional provisions

8.49 These amendments apply to the income year in which this Bill receives Royal Assent and to later income years. [Schedule 8, item 14]