House of Representatives

Explanatory Memorandum

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

Chapter 7 - Non-fixed trusts

Overview of non-fixed trust rules

7.1 Division 267 sets out the circumstances in which a non-fixed trust will not be able to deduct a prior year loss or debt deduction or will have to calculate its net income and tax loss in a special way.

7.2 Since non-fixed trusts are different in nature to fixed trusts, different rules apply to determine whether a non-fixed trust can deduct a prior year or current year loss or debt deduction. Non-fixed trusts are different to fixed trusts because it is not possible to determine who has a vested and indefeasible interest in all the income and capital of the trust. This is because the trustee or some other person will generally have a discretion as to who will benefit under the trust and/or what the amount of the benefit will be. Alternatively, the interests of persons in the trust may change because vested interests may be defeated or the vesting of the interests is conditional. It is not, therefore, possible to apply the same continuity of ownership test that applies to fixed trusts. Instead, the pattern of distributions or control of the trust are tested to give a picture of the individuals who benefit from the trust.

7.3 Some non-fixed trusts, however, have both fixed and discretionary elements. In these circumstances it is possible to examine the fixed entitlements to determine some of those who will benefit under the trust.

7.4 A family trust (a type of 'excepted trust') that is also a non-fixed trust will not be affected in any way by the tests in Division 267. The rules in Division 267 will not, therefore, prevent a family trust from deducting prior or current year losses or debt deductions. Also, other excepted trusts (as defined - see paragraphs 13.71 to 13.74 below) are not affected by Division 267.

What is a non-fixed trust?

7.5 A non-fixed trust is any trust which is not a 'fixed trust' [section 272-70] . Thus a non-fixed trust could include a large range of trusts from those that are purely discretionary to those that are fixed but where some or all of the entitlements in the trust are defeasible. Trusts that have both fixed and non-fixed elements (hybrid trusts) are also non-fixed trusts for the purposes of the proposed legislation.

When can't a non-fixed trust deduct a tax loss of an earlier income year?

7.6 The Bill sets out rules to determine when a non-fixed trust cannot deduct a prior year tax loss. The following flow chart outlines, in broad terms, when a non-fixed trust cannot deduct a prior year loss.

When do the prior year loss rules for non-fixed trusts have to be applied?

7.7 A non-fixed trust is affected by the rules, as they relate to prior year losses, if:

•

in the income year it has a tax loss from an earlier income year that is, ignoring the rules in the Bill, deductible; and

•

it was a non-fixed trust at any time in the test period ; and

•

it was not an excepted trust at all times in the test period. [Subsection 267-20(1)]

What is the test period for prior year loss purposes?

7.8 The test period is made up of the income year in which the tax loss was incurred, the income year being examined and all intervening income years. [Subsection 267-20(1)]

What are the conditions to be met if a prior year loss is to be deducted?

7.9 If the conditions in paragraph 7.7 are met then the non-fixed trust cannot deduct the prior year tax loss unless it meets all three conditions set out in the Bill. Two of the conditions may not be applicable to a particular trust for a particular period. If this is the case, the trust does not need to meet the condition that is not applicable. [Subsection 267-20(2)]

7.10 The three conditions relate to:

•

the pattern of distributions of the trust - this test will not be applicable if relevant distributions have not been made by the trust [sections 267-30 and 267-35] ;

•

fixed entitlements to income or capital of the trust - this test will not be applicable if individuals never hold, directly or indirectly, fixed entitlements to more than 50% of the income or capital of the trust in the test period [section 267-40] ;

•

control of the trust - this condition will apply to all non-fixed trusts [section 267-45] .

7.11 The details of the three conditions are set out below. The meaning of important concepts and tests used in determining whether these conditions are satisfied are set out in Division 269 and are discussed in Chapter 9.

What is the pattern of distributions condition?

7.12 The first condition in paragraph 7.10 for non-fixed trusts examines the pattern of distributions of income and capital of the trust over a period to determine whether there has been an effective change in those who benefit under the trust. To this end, the trust must pass the pattern of distributions test for the income year [subsection 267-30(2)] . This test compares trust distributions of income and capital of the year of recoupment and the relevant years in the previous 6 years. Also, the trust must not have failed the pattern of distributions test in relation to the loss in a previous year of income [section 267-35] . The pattern of distributions test does not apply to family trusts as defined.

7.13 The condition relating to pattern of distributions must be satisfied by a non-fixed trust if the trust distributed income and/or capital in the income year (or within two months of its end) ^[F7] and in at least one of the six previous income years. [Subsection 267-30(1)]

What is the 50% stake condition for non-fixed trusts?

Income

7.14 The 50% stake condition applies for income if individuals have fixed entitlements (called a stake ) to more than 50% of the income of the trust at any time in the test period (called the test time ). If this is the case, then at all times from the test time to the end of the test period, the same individuals must hold more than a 50% stake in the income of the trust. These individuals can be some or all of those who hold fixed entitlements to income of the trust at the test time [subsections267-40(1) and (2)] . The meaning of the 50% stake concept is set out in Division 269 and is discussed below at paragraphs 9.22 to 9.33.

Example

7.15 A non-fixed trust has a loss incurred in the 1997-98 income year which it seeks to recoup in the 1998-99 income year. At the start of the 1997-98 income year, Jack and Jill each have fixed entitlements to 25% of the income of the trust. On 1 January 1998, Ben acquires a fixed entitlement to 25% of the income of the trust meaning that, from that time, 75% of the income of the trust is the subject of a fixed entitlement. The 50% stake condition for income is therefore applicable to the trust. At the end of the 1997-98 income year, Ben disposes of 20% of his share to Bill but Jack and Jill continue to hold their 25% shares, and Bill continues to hold 5%, to the end of the 1998-99 income year. The Trust passes the 50% stake condition for income because Jack, Jill and Ben have maintained more than a 50% stake in the income of the trust from 1 January 1998 to the end of the 1998-99 income year.

Capital

7.16 A 50% stake condition in the same terms applies for capital of the trust. [Subsections 267-40(1) and (2)]

Commissioner's discretion

7.17 The Commissioner has a discretion to treat a non-fixed trust as having met the 50% stake condition in certain circumstances. This discretion is intended to provide a mechanism to prevent any unreasonable results in particular cases.

7.18 The discretion can be exercised where:

•

some or all of the individuals cease to have a stake in more than 50% of the income or capital of the trust (whichever is applicable); and

•

the Commissioner considers it fair and reasonable to treat the trust as having met the 50% stake condition having regard to the likely way in which the trustee or any other person will exercise any discretion to distribute income or capital and to any other matter. [Subsection267-40(3)]

Example

7.19 At the start of a test period, there are fixed entitlements to 51% of the income and to 100% of the capital of a non-fixed trust. These are all held by Jack. The other 49% of income is the subject of a discretion of the trustee. During the test period, Jack sells 2% of his fixed entitlement to income to Jill. As a result, the trust fails the 50% stake condition because the same individuals no longer hold fixed entitlements to more than 50% of the income of the trust.

7.20 One of the matters which it would be relevant for the Commissioner to take into account in determining whether or not to exercise the discretion is whether Jill or Jack will receive any distributions of income from the share of the trust's income that is subject to a trustee's discretion.

What is the control condition?

7.21 The control condition is that no group (i.e. a person and/or his or her associates, either alone or together) must begin to control the trust in the test period (whether directly or indirectly) [section 267-45] . The meaning of control is set out in Division 269 and is discussed at paragraphs 9.58 to 9.69.

When can part of a tax loss be deducted by a non-fixed trust?

7.22 If a non-fixed trust cannot deduct a tax loss because it does not meet the 50% stake or control conditions, then it may still be able to deduct part of the tax loss attributable to part of the loss year [section 267-50] . This provision works in a similar way as it works for fixed trusts (see the discussion above at paragraphs 6.31 to 6.33).

When does a non-fixed trust have to work out its net income and tax loss in a special way? (current year losses)

7.23 The Bill also sets out rules to determine when a non-fixed trust cannot deduct current year losses.

When do the current year loss rules for non-fixed trusts have to be applied?

7.24 A non-fixed trust is affected by the rules, as they relate to current year losses, if:

•

it was a non-fixed trust at any time in the income year being examined (called the test period ); and

•

it was not an excepted trust at all times in the test period. [Section 267-60]

When must a non-fixed trust work out its net income and tax loss in a special way?

7.25 If the conditions in paragraph 7.24 are met then the non-fixed trust must work out its net income and tax loss in a special way unless it meets both conditions set out in the Bill. One of the conditions may not be applicable to the circumstances of the trust in question. If this is the case, the trust does not need to meet that condition. [Section 267-60]

7.26 The two conditions relate to:

•

fixed entitlements to income or capital of the trust - this test will not be applicable if individuals never hold, directly or indirectly, fixed entitlements to more than 50% of the income or capital of the trust in the test period [section 267-70] ;

•

control of the trust - this condition will apply to all non-fixed trusts [section 267-75] .

7.27 These two conditions apply in exactly the same way for the relevant test period as they apply for the prior year loss rules for non-fixed trusts (see paragraphs 7.14 to 7.21 above).

When can't a non-fixed trust deduct a bad debt or deduction in respect of a debt/equity swap? (debt deductions)

7.28 The Bill also sets out rules to determine when a non-fixed trust cannot deduct a bad debt deduction or a deduction relating to a debt/equity swap under section 63E (these are called 'debt deductions' in this Explanatory Memorandum). (Bad debts may be deductible under sections 51 or 63 of the ITAA 1936 or sections 8-1 or 25-35 of the ITAA 1997).

When do the debt deduction rules for non-fixed trusts have to be applied?

7.29 A non-fixed trust is affected by the rules, as they relate to debt deductions, if:

•

in the income year it has, ignoring the rules in the Bill, an allowable bad debt deduction or an allowable deduction under section 63E;

•

it was a non-fixed trust at any time during the test period ; and

•

it was not an excepted trust at all times in the test period. [Sections 267-25 and 267-65]

What is the test period for debt deduction purposes?

7.30 As with fixed trusts, the test period for debt deduction purposes depends on when the debt is incurred. If the debt is incurred in a year before the deduction arises, the test period runs from the time the debt is incurred through to the end of the income year in which the deduction is available. If the debt is incurred in the income year in which the deduction arises, the test period is the income year.

When can't a non-fixed trust deduct a debt deduction?

7.31 If the conditions outlined in paragraph 7.29 are met then the non-fixed trust cannot deduct the debt deduction unless it meets the conditions set out in the Bill.

7.32 If the debt is incurred in a year before the deduction arises, the conditions are those relating to the pattern of distributions, control and fixed entitlements. These are the same conditions that apply to non-fixed trusts for prior year loss purposes (see paragraphs 7.12 to 7.21) [section 267-25] . However, for the purposes of determining a 'test year distribution' of income, paragraph 9.39 should be read as though the references to the loss year were references to the year the debt was incurred.

7.33 If the debt is incurred in the year the deduction arises, the conditions are those relating to control and fixed entitlements. These are the same conditions that apply to non-fixed trusts for current year loss purposes (see paragraphs 7.14 to 7.21). [Section 267-65]