Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 5 - Family trusts
Overview of the family trust provisions
5.1 The definition of family trust is crucial to the operation of the provisions. Family trusts (as defined) that distribute only to members of the family group will normally not be affected by the proposed amendments. The income injection test applies to family trusts only where income is injected into them from outside the family group. Also, concessional tracing rules apply where a family trust is interposed between an entity and the ultimate owners of that entity (see subsection 272-30(2)).
5.2 This Chapter explains the main provisions that are relevant to family trusts.
When can a family trust deduct prior or current year losses or debt deductions?
5.3 The trust loss measures, other than the income injection test, do not prevent a family trust (as defined) from deducting prior or current year losses or debt deductions. However, this will be the case only if the trust is a family trust at all times in the test period that is relevant to the deduction.
5.4 Table 5.1 briefly summarises the test period for the various deductions.
| Type of deduction | Test period |
|---|---|
| Prior year loss | The period from the beginning of the loss year to the end of the income year in which the loss is to be recouped (see paragraphs 6.11 and 7.8) |
| Current year loss | The income year (see paragraphs 6.35 and 7.24) |
| Debt deduction | If the debt is incurred in an income year before the deduction arises - the period from the time the debt is incurred until the end of the income year |
| If the debt is incurred in the income year in which the deduction arises - the income year | |
| (See paragraphs 6.41 and 7.30) |
5.4 The income injection test, as it applies to family trusts, is explained in Chapter 10. The income injection test does not apply where members of the family group inject income into a family trust with losses.
What is a family trust?
5.5 Subdivision 272-D sets out the rules that define a family trust and the related concepts of members of the family group and members of the family of an individual.
5.6 A trust will be a family trust where the trustee of the trust has made an election (known as a family trust election ) under section 272-80 that the trust be a family trust and the election is in effect [section 272-75] .A consequence of the family trust election system is that any distributions (broadly defined) outside the family group of the family trust by the trust or relevant interposed entities will be taxed at the top marginal rate applying to individuals plus Medicare levy.
5.7 A discretionary trust has as its class of beneficiaries the following:
- •
- Jill, Jack (Jill's husband) and their children; and
- •
- any company or trust in which any of those individuals have an interest.
5.8 The trust makes a family trust election specifying Jill as the relevant individual. The trust makes distributions (as defined) only to Jill, Jack and their children. Subject to the income injection test, the trust can deduct its prior and current year losses and debt deductions. No family trust distribution tax is payable on the distributions as they are made only to Jill and members of her family group. If the trust distributed income or capital outside the family group, family trust distribution tax would be payable on the distribution.
What are the rules for making a family trust election?
5.9 If the trustee makes a family trust election the trust will be a family trust for the purposes of Schedule 2F. The election needs to specify an income year from which it is to take effect. [Subsection 272-80(1)]
5.10 If the election is to be made, it must be made by the trustee in the trust's return of income for the specified income year. If the trust is not required to lodge a return in the year that the trust wants to make the family trust election, the trustee must make the election in writing to the Commissioner in an approved form. The election must be given either within 2 months after the end of the income year or such later time as the Commissioner allows. [F3] [Subsection 272-80(2)]
5.11 The family trust election must specify an individual as the individual whose family group is the subject of the election. This would be the same person as the test individual referred to in section 272-95. In addition to specifying an individualthe election must also specify such other information as the Commissioner requires [subsection 272-80(3)] . This information would include:
- •
- the name of the trust;
- •
- the address of the trust including its country of residence;
- •
- the beneficiaries of the trust at the time the election takes effect; and
- •
- any other particulars that the Commissioner may require.
The trust must be controlled by the family
5.12 A trust cannot make a family trust election unless it is controlled by the relevant family from the time the election comes into effect. To this end the trustee cannot make a family trust election if the trust does not pass the 'family control test' at least at the end of the income year [subsection 272-80(4)] . The family control test for trusts is set out in subsections 272-87(1) and (2) (see paragraphs 5.28 to 5.30).
A family trust election is irrevocable unless the trust is a fixed trust
5.13 A family trust election is generally irrevocable [subsection 272-80(5)] . However, a family trust that is a fixed trust is able to revoke a family trust election if some or all of the interests in the trust are disposed of to non-family members or if any of the persons holding them cease to be family members.
5.14 The conditions that are used to determine whether an election for a fixed trust can be revoked are set out below. [Subsection 272-80(6)]
- •
- At the beginning of the income year specified in the family trust election, some or all of the specified individual, members of his or her family and other family trusts of the same individual must beneficially hold, directly or indirectly, fixed entitlements to shares of all the income and capital of the trust. [F4]
- •
- At a time after the beginning of that income year when the trust is still a fixed trust, the individuals beneficially holding, directly or indirectly, some or all of the fixed entitlements must change. The change must mean that the specified individual, family members and relevant family trusts (or any combination of them) no longer beneficially hold, directly or indirectly, fixed entitlements to shares of all the income and capital of the trust. The time could be before the time of lodgement of the tax return containing the family trust election.
5.15 Notification of the revocation will need to be included in the trust's return of income for the income year in which the family ceases to so hold fixed entitlements to all the income and capital of the trust. If the trust is not required to lodge a return in that year, the trustee must notify the revocation in writing to the Commissioner in an approved form. In this case, the revocation must be given either within 2 months after the end of the income year or such later time as the Commissioner allows. [Subsections 272-80(7)]
5.16 The revocation must specify the time set out in the second dot point in paragraph 5.14 as the time when the revocation takes effect. [Subsections 272-80(8)]
5.17 At the commencement of the 1998-99 income year, all the fixed entitlements in a fixed trust are beneficially owned by Jill and Jill's spouse, Jack. The trustee elects to be a family trust from that income year specifying Jill as the test individual. On 1 August 2000, Jack and Jill sell their fixed entitlements to Brian. Brian is not a member of Jill's family. The trustee may revoke the family trust election in the trust's 2000-01 tax return. The revocation would take effect from 1 August 2000 (the time when Jill and her family members ceased to beneficially hold all the fixed entitlements in the trust).
When is a family trust election in effect?
5.18 Table 5.2 sets out the times when a family trust election is in effect (and thus when the trust concerned is a 'family trust'). [Subsections 272-80(9) and (10)]
| The election has not been revoked | The election has been revoked | |
|---|---|---|
| The trust passes the family control test at all times in the income year specified in the election | All times after the election commencement time | All times from the election commencement time until the time specified in the revocation (see paragraph 5.16) |
| The election commencement time is the start of the income year specified in the election. | The election commencement time is the start of the income year specified in the election. | |
| The trust does not pass the family control test at all times in the income year specified in the election but does pass that test at the end of that income year | All times after the election commencement time | All times from the election commencement time until the time specified in the revocation (see paragraph 5.16) |
| The election commencement time is the first time from which the trust passes the family control test continuously until the end of the year of income. | The election commencement time is the first time from which the trust passes the family control test continuously until the end of the year of income. |
A trust may make both a family trust election and interposed entity elections in some cases
5.19 A trust may make both a family trust election and one or more interposed entity elections (as referred to in section 272-85) provided all elections are made in relation to the same individual as specified in the family trust election. [Subsection 272-80(11)]
What are the rules for interposed entities to make an election?
5.20 Members of the family of the individual specified in the family trust electioncan receive distributions of income and capital from the family trust through interposed companies, trusts and partnerships. Where family members (including another family trust of the same specified individual) do not have fixed entitlements, directly or indirectly, and for their own benefit, to all the income and capital of the interposed entity, it will be necessary for the interposed entity to make an election (known as an interposed entity election ) before it can be included as part of the family group. [Subsection 272-85(1)]
5.21 If an interposed entity election is made, it must be made in the return of income of the interposed company, trust or partnership. It can be made for an income year that is later than the year of income in which the family trust election under section 272-80 is made. For example, a trust may commence distributing to an interposed entity in an income year later than the year in which it made a family trust election. If a partnership, company or trustee is not required to furnish a return for an income year the interposed entity election must be lodged with the Commissioner in writing in an approved form within 2 months after the end of the year of income or such later time as the Commissioner allows. [Subsection 272-85(2)]
5.22 An interposed company, trust or partnership may need to be part of the family group after a particular date in the income year (e.g. from a date when a family trust wants to commence making distributions to the entity). Because of this, the interposed entity election must specify a date in the income year from which the election takes effect. This could be the start of an income year or any day during an income year. [Subsection 272-85(1)]
5.23 The election will need to specify the family trust to which the election relates, the individual specified for the purposes of that trust and such other information that the Commissioner may require [subsections 272-85(1) and (3)] . This information would include the following:
- •
- the name of the entity;
- •
- the address of the entity including its country of residence;
- •
- the shareholders, partners or beneficiaries of the entity at the time the election takes effect; and
- •
- any other particulars that the Commissioner may require.
The interposed entity must be controlled by the family
5.24 An interposed entity election cannot be made for a company, partnership or trust unless it is controlled by the relevant family from the time the election comes into effect. To this end, the election cannot be made if the entity does not pass the 'family control test' at least at the end of the income year [subsection 272-85(4)] . The family control test is set out in section 272-87 (see paragraphs 5.28 to 5.32).
An interposed entity election is irrevocable
5.25 An interposed entity election made by the partners in a partnership, a company or trustee is irrevocable [subsection 272-85(5)] . There is no need to provide for the revocation of an interposed entity election for a fixed interest entity wholly owned by a family. This is because such entities can be members of a family group without the need to make an interposed entity election (see Table 5.4)
When is an interposed entity election in effect?
5.26 Table 5.3 sets out the times when an interposed entity election is in effect. [Subsection 272-85(6)]
| Times when the entity passes the family control test | Times when the election is in effect |
|---|---|
| The entity passes the family control test at all times from the start of the day specified in the election until the end of the income year in which that day falls | All times after the start of the specified day |
| The entity does not pass the family control test at all times from the start of the day specified in the election until the end of the income year in which that day falls but does pass that test at the end of that income year | All times after the first time from which the trust passes the family control test continuously until the end of the income year |
Can more than one interposed entity election be made by an entity?
5.27 An interposed entity can make an interposed entity election in respect of more than one family trust election if the individual specified in respect of each family trust election that has been lodged is the same [subsection 272-85(7)] . An interposed entity may want to make more than one election because, for example, two family trusts of the same test individual will want to make distributions to the same interposed entity.
When does a trust pass the family control test?
5.28 For the purposes of making a family trust election or an interposed entity election a trust passes the family control test at a particular time when certain persons control the trust at that time. The persons are some or all of the individual specified in the relevant family trust election, members of his or her family and a professional legal or financial adviser to the family. [Subsection 272-87(1)]
5.29 The control test for this purpose is essentially the same as the control test applying to non-fixed trusts (see paragraph 9.59) [subsection 272-87(2)] The test looks at, among other things, who can control the application of income or capital of the trust. This is why a professional legal or financial adviser to a family might be part of the controlling group of a family trust (e.g. the adviser might be one of the directors of the trustee company).
5.30 However, a person could only be a controller as a professional legal or financial adviser if the person became a controller because of their status as such an adviser, rather than in a personal capacity. Also, any fixed entitlements in the trust beneficially owned by the adviser will not be counted in determining whether the family control test is passed (i.e. they are not counted for the purposes of paragraph 272-87(2)(f)).
When does a company or partnership pass the family control test?
5.31 A company or partnership which proposes to make an interposed entity election passes the family control test at a particular time when certain persons beneficially hold between them, directly or indirectly, fixed entitlements to more than 50% of the income or capital of the company or partnership. The persons are some or all of the individual specified in the relevant family trust election and members of his or her family. [Subsection 272-87(3)]
5.32 Because the control test for companies and partnerships only looks at who beneficially owns interests in the entity, any control influenced by a professional legal or financial adviser to a family is not relevant to determining whether the family controls the entity.
5.33 The Bill identifies those persons (including natural persons as well as a company, a trustee or partners in a partnership) who are members of the family group of the individual specified in a family trust election. Whether a person is a member of the family group is determined by reference to the distribution of income or capital that is made to that person [subsection 272-90(1)] . The distribution may be made by a family trust or by an interposed entity that has made an interposed entity election. In the discussion in this Chapter, the term 'distribution' of income or capital includes a conferral of a present entitlement to income or capital.
5.34 The members of the family group in relation to a distribution, as set out in subsections 272-90(2) to (10) , are explained in Table 5.4 on the following pages.
| Members of the family group | Comments |
|---|---|
| A member of the family of the individual specified in the family trust election | The person must be such a member at the time of the distribution. A person will be a family member if, in relation to the test individual, that person is one of the persons listed in section 272-95. |
| Certain family controlled or owned trusts | These are:
|
| Certain family controlled or owned companies | These are:
|
| Certain family controlled or owned partnerships | These are:
|
| Some financial institutions and their subsidiaries | These are such institutions or subsidiaries to whom distributions are made by certain companies that are small or medium enterprises and that have made an interposed entity election in relation to a family trust - see the explanation in paragraphs 5.36 to 5.39. |
| Certain persons or bodies when the individual specified in the family trust election and all the members of his or her family are dead at the time of the distribution | These are:
|
| Certain funds, authorities or institutions in Australia to whom tax deductible gifts may be made | These are those listed in the tables in subsection 78(4) or covered by paragraph 78(5)(a) or mentioned under items 1 or 2 of the table in section 30-15 of the ITAA 1997. However, they will only be in the family group where section 78A would not apply to deny a deduction if one were allowable under section 78, or Division 30 of the ITAA 1997, for the distribution. Section 78 and Division 30 of the ITAA 1997 provide for the deductibility of gifts. |
| Certain bodies all of whose income is exempt from income tax | These are:
|
5.35 Section 78A of the ITAA 1936, referred to in Table 5.4, is an anti-avoidance rule that applies where tax deductible gifts are given. Except in the case of death of all family members, the relevant funds, authorities or institutions covered by the gift provisions and the tax exempt bodies are included in the family group subject to compliance with section 78A. This will ensure, as far as possible, that they can not be used as a conduit to transfer the tax benefit of a family trust's losses.
Members of the family group in relation to distributions by SMEs
5.36 In the 1996-97 Budget, the Government announced that it would provide concessional income tax treatment in relation to equity investments made by lending institutions in small and medium enterprises (SMEs). A consequence of a lending institution making an equity investment in an SME is that it may receive dividends or capital from the SME. It is possible that an SME could be a company that has made an interposed entity election under the proposed trust loss measures. The SME legislation was included in the Taxation Laws Amendment Act (No. 3) 1996 and the Taxation Laws Amendment Act (No. 1) 1997 .
5.37 Certain persons are included in the family group in relation to a distribution of income or capital by a company that is an SME (within the meaning of section 128TK of the ITAA 1936) where the SME has made an interposed entity election. The persons are those for which the following requirements are met:
- •
- the person has acquired a threshold interest in the SME (within the meaning of section 128TJ of the ITAA 1936) on or after 1 July 1996; and
- •
- the person is an Australian financial institution or a subsidiary (within the meaning of section 128TL of the ITAA 1936) of such an institution;
- •
- the person is not an associate of the SME; and
- •
- the distribution is in relation to a dividend or return of paid-up capital distributed to the person in respect of the ordinary shares forming part of its threshold interest in the SME. [Subsection 272-90(10)]
5.38 To be part of a threshold interest in an SME, the ordinary shares must have been issued to the person on or after 1 July 1996. Accordingly, under subsection 272-90(10), a person will not be a member of the family group in relation to dividends and returns of paid-up capital on shares issued before 1 July 1996.
5.39 An Australian financial institution is defined in section 317 of the ITAA 1936. Under this definition, an Australian financial institution is a bank within the meaning of the Banking Act 1959 , a person who carries on State banking within the meaning of paragraph 51(xiii) of the Constitution, a registered corporation within the meaning of the Financial Corporations Act 1974 and a life assurance company within the meaning of section 110 of the ITAA 1936.
Who are members of the test individual's family?
5.40 The members of the family of the individual specified in the family trust election (i.e. the test individual ) are as follows:
- •
- the test individual's spouse;
- •
- a child, child of a child, parent, grandparent, brother, sister, nephew or niece of the test individual or the test individual's spouse;
- •
- a spouse of such a child, parent, grandparent, brother, sister, nephew or niece. [F5] [Subsection 272-95]
5.41 By virtue of the definition of 'child' in subsection 6(1) of the ITAA 1936, a child includes a step-child, adopted child or ex-nuptial child. The phrase 'child of a child' is used in defining a family member to ensure that the definition of 'child' applies to grandchildren of the test individual. Note also that the term 'spouse' is defined in subsection 6(1) of the ITAA 1936 to include a de facto spouse.
5.42 A reference to an individual in any of the above categories does not include an individual in the capacity of trustee.
What are the consequences if a family trust or interposed family entity makes a distribution outside of the family group?
5.43 A special tax, called family trust distribution tax, is payable in certain circumstances by a family trust or trust, company or partnership that has made an interposed entity election. This will be the case if income or capital of the trust, company or partnership is distributed to persons other than those in the family group or if such persons become presently entitled to the income or capital. The term distribution is defined in Subdivision 272-B (see paragraphs 13.51 to 13.61).
5.44 The tax is payable at the top marginal rate applying to individuals, plus Medicare levy, on the amount or value of the income or capital. Chapter 11 provides a detailed explanation of when family trust distribution tax may become payable and how it is to be paid.
What if a family trust holds a fixed entitlement in an entity?
5.45 A family trust is given special treatment when fixed entitlements in another trust, company or partnership have to be traced to individuals who are the underlying beneficial owners of those fixed entitlements. Where a fixed entitlement is held, directly or indirectly, by a family trust, the trustee of the family trust is taken to be an individual who holds the fixed entitlement for its own benefit. This removes the need to trace fixed entitlements held through family trusts. Paragraph 13.42 provides more detail on this issue.
Information requirements relating to non-resident family trusts and interposed family entities
5. 46 There are special information requirements if a family trust or trust, company or partnership that has made an interposed entity election is a non-resident. These are explained in Chapter 12.