Trust Losses and Family Trust ElectionsDaniel Summerson

• Historical Context• Trust Losses

- Fixed v Non-Fixed - Applicable Tests- Test Periods

• Family Trust Elections- Concessions- Restrictions- Test Individual- Family v Family Group

• Interposed Entity Elections

Content

• Tax Losses were once a valuable commodity. They were openly traded.• Prior to 1953 it was common to see advertisements in the financial press

for the sale of companies with losses.• The government has since introduced increasingly complicated legislation

in order to prevent the trading in losses.• Deductions are now denied if they do not reflect an underlying economic

loss. (Substance over form & Matching Principles).• From 2005 – 2010, $21 billion in losses were disallowed by the ATO, over

half were capital losses.

Tax Losses – Historical Context

• Fixed v Non-Fixed– Fixed if there are ‘Fixed Entitlements’.– Fixed Entitlements are ‘Vested and Indefeasible’ interests in income or capital of the trust.– Vested interests are either :– ‘in possession’ - presently existing right to enjoyment; or– ‘in interest’ - presently existing right to future enjoyment.

– Indefeasible interests are interests that cannot be varied by the exercise of a power by the trustee or another person.

– Vested and Indefeasible not defined in the tax law – look at the Deed!

– Why do we care about the type of trust?– Different tests apply.

Trust Losses – Establishing the Type of Trust

The Tests

Unfortunately, a lot of our clients have non-fixed (discretionary) trusts.Therefore, we must look at all four tests.Important note: Many unit trusts which might be regarded as ‘’fixed’’ may in fact be non-fixed if there is any element of discretion in relation to entitlement of income or capital. Again, look at the deed.

Test Fixed Trusts Non-Fixed Trusts

Pattern of Distributions Yes

Control Yes

50% Stake Yes Yes

Income Injection Yes Yes

• Applies to non-fixed trusts only.• Cannot be applied if the trust did not distribute income or capital in the

income year and at least one of the six earlier income years.• Is used to prevent the use of a prior year’s loss in an income year if the

same individuals have not received income or capital distributions between the loss year and the year in which the losses are sought to be applied.

• Satisfied if:– a.) individuals x,y,z received > 50% of all ‘test year’ income and capital distributions– b.) individuals x,y,z received >50% of all income year income and capital distributions

Pattern of Distributions Test

Pattern of Distributions – Test Period

• Can the test be applied?– The trust must be non-fixed– There must have been a distribution in the income year and in one of the other eligible

years as per slide seven.

• Application:– Use slide seven, steps 1-3 to establish a test year. If no test year can be established, the

test cannot be applied.

• Variation in distributions?– If the distributions vary between the income year (year loss is sought to be applied) and

the test year, the smallest aggregate distribution must be used to determine whether the >50% test is met as per slide six.

Pattern of Distributions Test - Application

• The mild-mannered Megan trust is non-fixed. There are five beneficiaries as listed: Jo, Sarah, Paris, Dominique and Sandy.

• The trust incurred a loss in the 2012-2013 income year and seeks to use the loss in the 2013-2014 income year.

Pattern of Distributions – Example

Percentage of Income Distributions Percentage of Capital Distributions

Income Year Jo Sarah Paris Jo Dominique Sandy

2007-2008 50 25 25 50 25 25

2008-2009 50 25 25 50 25 25

2009-2010 50 25 25 50 25 25

2010-2011 33 33 34 33 33 34

2011-2012 33 33 34 10 20 70

2012-2013 0 0 0 0 0 0

2013-2014 50 25 25 70 10 20

Pattern of Distributions - Example

• Can the POD test be applied?– Yes, there was income and/or capital distributed in the income year, and in one of the six

earlier years.

• Working out the test years using slide seven:– Start with the loss(trigger) year and work backwards. The first year in which income

and/or capital was distributed was the 2011-2012 year. – Therefore, the test years are the 2011-2012 year and the year in which the loss is sought

to be applied (2013-2014 year).

• Do the distributions vary at all?– Yes, therefore we must use the smallest distribution for each beneficiary and aggregate

the total. – The income distribution aggregate is 83% (Jo 33, Sarah 25 and Paris 25). Therefore the

income test is passed.– However, the capital distribution aggregate is only 40% (Jo 10, Dominique 10 and

Sandy 20). Therefore, the capital test is failed and the loss cannot be recouped.

Pattern of Distributions - Solution

• Applies to non-fixed trusts only.• Is met if no group begins to control the trust during the test period.• Is used to prevent the use of a prior year’s loss in an income year if the

same ‘group’ has not maintained control between the loss year and the year in which the losses are sought to be applied.

• A group can be:a.) A person;b.) A person and one or more ‘associates’, orc.) two or more ‘associates’ of a person

• Associate is a very broad term; it can be relatives, partners in a partnership, the trustee of a trust under which the taxpayer (or an associate) is a beneficiary, and a company that is ‘sufficiently influenced by’ or ‘controlled’ by a taxpayer (or an associate).

The Control Test

• A group has control if:– It has the power to obtain the beneficial enjoyment of the trust income or capital; or– It is able to control the application of trust income or capital; or– It is able to gain control of the power to do either of the above.; or– It’s directions, instructions or wishes would be acted upon by the trustee, either by

obligatory (explicit) or customary (implicit) expectations; or– It has the power to remove or appoint the trustee; or– It acquires more than a 50% stake in the trust income or capital.

• Important Note:– Control is not deemed to have changed if a member of the controlling group has died,

become incapacitated or suffered a marriage breakdown.

The Control Test – What is Control?

• A discretionary trust, established for the Summerson family and the Labiris family, has a $0.25 loss in year 1 which it seeks to deduct in year 2.

• During year 2, the Summerson family obtain a court order to have the trustee (Bill Labiris) removed due to him gambling all of their income away at the pokies.

• The control test is not met as the Summerson group begins to control the trust during the test period.

The Control Test - Example

• The 50% stake test applies to both fixed and non-fixed trusts.

• It is applied to determine whether there has been a change in ownership of a trust under which there are fixed entitlements (in a fixed or non-fixed trust).

• To apply the 50% stake test to a non-fixed trust:– There must have been individuals with more than a 50% fixed stake in the income

and/or capital at any time during the test period.

The 50% Stake Test – Non-Fixed Trusts

• To pass the 50% stake test as a non-fixed trust:– The same individuals must have had more than a 50% stake in the income or capital

during the periods:– a.) The start of the loss year to end of income year in which loss is applied; or– b.) The time when the individuals began to have more than a 50% stake to the end of

income year in which the loss is applied.

• Important Note: For non-fixed trusts, the 50% stake test is applied separately to income and capital. If there was never a fixed entitlement to capital, only the income is subject to the test.

Passing the 50% Stake Test – Non-Fixed Trusts

• A non-fixed (hybrid) trust incurs a loss in the 2012-2013 year.• It wishes to apply that loss to income earned in the 2013-2014 year.• At the start of the loss year, Daniel and Nick both have fixed entitlements

to 20% of the income. Thus, only 40% is held under fixed entitlement.• David acquires a fixed entitlement to 25% of the income at 01/12/2012.

Now 65% is held under fixed entitlement. These percentages are maintained until 30/06/2014.

• The 50% stake condition is now passed as there was more than 50% held under fixed entitlement between 01/12/2012 (during the loss year) and 30/06/2014 (the end of the recoupment year).

• Capital would be treated separately.

50% Stake Test – Non-Fixed Trusts - Example

• Is applied differently to fixed trusts.

• The test must be satisfied in respect of both income and capital.

• The test applies continuously.

• There is a second chance to pass – an alternative test for fixed trusts.

50% Stake Test – Fixed Trusts

• Applies to fixed trusts only.• Is a second chance to pass the 50% Stake Test.

• Can be applied if:– The majority of fixed entitlements are held by non-fixed trusts – Those non-fixed trusts pass the following tests;– a.) Pattern of Distributions Test– b.) 50 % Stake Test– c.) Control Test

Alternative Test

• Is an anti-avoidance provision.• Applies to all trusts.• Is failed when:

– 1.) The trust has an allowable deduction.– 2.) There is a ‘scheme’ under which:– a.) assessable income is derived by the trust;– b.) an ‘outsider’ provides a benefit to the trustee, a beneficiary or associate of either;– c.) the trustee, a beneficiary or associate of either provides a benefit to the ‘outsider’– 3.) The benefits discussed above occurred because of the existence of the allowable

deduction. i.e. they were not merely incidental.

• Scheme has the same meaning as in Part IVA of the ITAA1936.

Income Injection Test

• Benefits received from and provided to an ‘outsider’ may result in the income injection test being breached.

• In relation to normal fixed and non-fixed trusts the term ‘outsider’ means anyone other than:– the trustee;– a person with a fixed entitlement to trust income or capital.

• Therefore, in the case of most discretionary trusts, anyone other than the trustee is an ‘outsider’.

• In the case of family trusts, the term ‘outsider’ is relaxed.

Outsiders

• Must be passed for either an FTE or an IEE to be made.

• Must be passed at the end of the income year for which the election is made.

• The test individual and/or members of the test individual’s family must ‘control’ the trust.

• Control has the same meaning as the control test in slide 13.

Family Control Test

• A family trust is created when a family trust election is made.

• A family trust is eligible for concessional treatment.

• No 50 % Stake Test• No Control Test• No Pattern of Distributions Test.

• Makes the first 20 slides irrelevant.

• Only Income Injection Test is applicable.

Family Trusts – Why Elect to Create One?

• Prior year and current year losses can be deducted along with bad debts (subject to meeting the income injection test).

• The trust can pass the 45 day holding period allowing franking credits to pass through to beneficiaries.

• The family trust is treated as a single individual when applying COT to companies held by the trust (no tracing required).

• An interposed entity can apply to be part of the family group.

• Caveat: With a family trust election in place, the trustee cannot distribute to a person outside of the family group without incurring family trust distribution tax (FTDT). FTDT is imposed on the trustee at 46.5% and is in addition to any tax payable by a beneficiary.

Family Trusts – Tax Concessions

• An individual must be chosen (test individual) when an election is made.• The test individual’s ‘family group’ is taken into account for family trust

purposes.

• Important note: ‘family group’ is not the same as ‘family’. • A member of the test individual’s family is excluded from the category

’outsider’ for income injection test purposes.• A member of the test individual’s family group is not necessarily excluded

from being an ‘outsider’ for income injection purposes. Family group can contain a much broader group of people than family.

Family Trusts – The Test Individual & The Family Group

The Test Individual’s Family

• Everyone in the previous slide, plus;• Previous spouse of anyone in the previous slide before marital breakup.• Previous widow/er of anyone in the previous slide who is now remarried.• Previous stepchild of anyone in the previous slide before marital breakup.• A trust covered by the family trust election.• A trust with the same test individual as this trust.• An entity that has made an ‘Interposed Entity Election’ with the trust.• An entity in which a fixed entitlement to all of the income and capital is

due to the above mentioned entities.• If the test individual and all family members are dead, their estates.

• A lot of people/entities.

The Test Individual’s Family Group

• Aim of revocation or variation:– To get around the FTDT applied to distributions to ‘outsiders’.

• Revocation conditions:– The FTE was not required during its election period (losses were not utilised, franking

credits were not accessed and bad debts were not deducted).– Revocation occurs within 5 years of the FTE being made.

• Caveat: Once a Family Trust Election has been revoked, the trust can never make another.

Family Trust Elections – Revocation or Variation

• Variation Conditions:

• The specified individual (test individual) can be varied if both;

• a.) The new individual was a family member of the original test individual.

• b.) All previous distributions were made within the new individual’s family group.

Family Trust Elections – Revocation or Variation

• An entity interposed between the family trust and its members.

• Elections may be retrospective (to the 2004 year).

• Elections generally are not revocable unless stringent measures are met.

• An interposed entity can generally only make an interposed entity election for one family trust.

Interposed Entities

• The entity becomes a member of the family group. Therefore it can;

• Receive distributions from the family trust.

• Make distributions to entities within the family group.

• Avoid FTDT.

Why Make an Interposed Entity Election?

• Entities are automatically included in the test individual’s family group if;• It is a company, partnership or an ordinary fixed trust; and

• 100% of the fixed entitlements to the income and capital are held by:

• a.) the test individual;• b.) members of the test individual’s family; or• c.) the trustee of a trust that has the same test individual; or• d.) a trust that made a family trust election.

When is an Interposed Entity Election Not Required?

Is an Interposed Entity Election Required?

• There are lots of tests surrounding the eligibility of applying trust losses.

• Most of them can be negated by making a Family Trust Election.

• FTEs and IEEs must be made after careful deliberation.

• Once made they are difficult to revoke.

• Sometimes they may not be necessary.

• Check Deeds.

Summary

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