Bills Digest No. 98   1997-98 Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997


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WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

CONTENTS

Passage History

Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997

Date Introduced: 1 October 1997
House: House of Representatives
Portfolio: Treasury
Commencement: Royal Assent. However, refer to the end of the main provisions section for the date of application for the various measures.

Purpose

The Bill will impose a general restriction on trusts claiming a deduction for prior year losses. Losses will be able to be deducted for certain trusts where the relevant provisions of the Bill are complied with. The Bill also exempts certain categories of trusts from the denial of the deduction, with family trusts (as defined) being one of the more important categories of exempt trusts. As well, many investment vehicles which use a trust structure, such as complying superannuation funds, will also be exempt from the proposed rules.

Background

The treatment of losses incurred by trusts in previous years, which are currently allowed as a deduction for the trust, was placed on the taxation agenda in the 1995-96 Budget.

Prior to the Budget announcement, losses incurred by trusts could be carried forward to offset income in later years unless the trust deed or a law required that the loss be met from the capital of the trust. There was no restriction on the period that the losses may be carried forward. Also, while companies were required to satisfy either the continuity of business or continuity of ownership tests to be able to carry forward losses, trusts were not required to satisfy either of these tests, so that the trustee or the matters that the trust may deal in may have altered from the time that the loss was incurred and the deduction is claimed in a later year or years. This led to a trust being a more favourable vehicle than a company in many circumstances where the person finally entitled to the income wishes to minimise their tax. The 1995 Master Tax Guide, published before the 1995 Budget announcement, commented:

The absence of restrictions on the deductibility of carry forward trust losses has given rise to some trafficking in 'loss trusts'. These transactions normally involve an alteration to the relevant deed of trust, the appointment of a new trustee or, alternatively, the acquisition of a corporate trustee by new shareholders...(1)

The major reasoning for the desire to use previous years losses is that they can generally be acquired for less than the value of the loss to the holder of the trust. For example, if a trust has substantial prior losses but little income that the losses can be offset against, the trust will not be able to access the full value of the potential deductions from the prior losses. However, if a trust with sufficient income to be able to offset the prior year loss deductions were to acquire the prior year losses of the other trust, it would be able to fully utilise the deductions available from the prior year losses. In such circumstances, it is in the interests of both trusts to reach an agreement regarding the value of the prior year losses to the acquiring trust, which will generally be a price between the value to each trust. In such circumstances both trusts will benefit but the revenue will suffer.

However, it should be noted that there are many reasons not connected with taxation for a business, particularly a small or medium family business, to be established on a trust rather than company basis. A major reason for the use of a trust rather than a company in a family business is the ability of discretionary trusts to vary their distributions according to the needs of the various beneficiaries and to include distant relatives as beneficiaries even if they do not receive regular distributions from the trust (although this can also be used to distribute income to those in the lowest tax position to minimise the amount of total tax payable).

The 1995-96 Budget announced substantial changes to the ability of trusts to carry forward their losses in an attempt to protect the revenue. The major feature of the proposed changes was to place trusts in much the same position as companies with regard to prior year losses. The main differences between the treatment of companies and trusts in the proposals was that:

  • the continuity of business test would only apply to corporate unit trusts and public trading trusts;
  • an 'income injection' test would apply to deny a deduction where income, or other consideration, is injected into the trust that is to take advantage of the loss, so that a loss cannot be acquired, funds injected into the trust and income offset by the losses; and
  • there would be special rules for family trusts and discretionary trusts.

The proposed changes, along with a number of other measures, were contained in Taxation Laws Amendment Bill (No. 4) 1995 but the provisions relating to trust losses were notpassed by the Senate and the Taxation Laws Amendment Act (No. 4) 1995 did not contain the provisions relating to trust losses. Among the reasons for the Senate rejecting the provisions dealing with trust losses were:

  • the tests contained in the Bill were such that there was doubt as to whether genuine business losses could continue to be carried forward;
  • the measures would have a significant impact on small businesses operated through trusts;
  • there would be significant compliance costs for large trusts which would have to trace the underlying interests in the trust to satisfy the continuity of ownership test; and
  • there was insufficient time to properly scrutinise the measures.(2)

The explanatory memorandum to that Bill estimated that the measures would raise $90 million in 1995-96, $185 million in 1996-97, $155 million in 1997-98 and $65 million in 1998-99.

The legislation lapsed with the dissolution of Parliament for the 1996 General Election. The policy of the new government was set out in the 1996 Budget when it was announced that the policy would be pursued but would be modified. Major changes related to:

  • easing of the rules relating to family trusts so that if an eligible trust elects to be treated as a family trust there will be no need for the trust deed to be changed to remain eligible to carry forward losses;
  • allowing a fixed trust that is more than 50% owned by a discretionary trust to continue to carry forward losses;
  • modification of the income injection test;
  • easing of rules where trusts are used as a legitimate business vehicle;
  • changes in the rules relating to the tracing of the ultimate owners of trust to reduce compliance costs; and
  • the adoption of a number of amendments proposed by the former government.(3)

It was also proposed that the changes would have effect from the date of the original announcement, 9 May 1995. However, transitional provisions for family trusts will be extended until 1 July 1997.

An exposure draft of the proposed legislation was released in February 1997. In a response to the draft legislation, the Australian Taxpayers' Association (ATA) commented: 'Legislation remains extremely complex and still has an undue impact on the vast majority of farms and small businesses with no involvement in loss trafficking.'(4)

Further modifications to the proposed rules were announced in the 1997-98 Budget. The main change related to family trusts with a contribution of funds into the trust not to be considered a breach of the income injection test if the contribution is made by a member of the family. In a related measure, the definitions of 'outsider' and 'family member' were altered. The change in the definition of what constitutes a family trust has received considerable attention. The main differences in the definition proposed to operate after 13 May 1997 and that contained in the original 1995 Bill is that former spouses and their relatives are not included in the definition of a family in this Bill, the aunt, uncle and great grandparent of the test individual were included under the 1995 Bill but excluded under this Bill and that to be eligible under the 1995 Bill a child of a parent, brother, sister, nephew or niece of the test individual would have only been included in the definition of a family if they were capable of benefiting on the death of the test person. Under this Bill there is no requirement that such people be capable of benefiting under the death of the test individual. The original definition will apply until the date of the announcement of the changes to the definition of a family. The Press Release announcing the changes also noted that the Government was continuing to examine other matters than had been commented on since the draft legislation was introduced. As a result of these considerations, there have been some further, relatively minor, changes to the legislation before it was introduced into Parliament.

The legislation has received some unfavourable comments:

ATA maintains that the Bill will adversely effect small businesses and farmers. Principal to the ATAs concerns are who will be considered to be family members for a family trust to be able to carry forward losses. A Press Release from the ATA states:

The Government has created the extraordinary situation that certain family members who:

  • could claim or successfully dispute an inheritance from a deceased estate;
  • could be the subject of child support obligations under the Child Support Assessment Act; or
  • are dependants for superannuation purposes;

are not allowed to be members of family trusts under the proposed legislation.

This means that many small businesses will have to chose between:

  • the potential loss or postponement of legitimate claims for losses incurred during business downturns (which may threaten the very viability of those small businesses); and
  • removing key family members from a share of the present or future beneficial ownership of the business.(5)

However, it must be noted that as the definition of a family is expanded the possibility of a family trust being used as a tax minimisation vehicle will increase.

In regard to the general tax position of trusts, as distinct from the position regarding the carrying forward of tax losses which is addressed by this Bill, the Commissioner of Taxation, in a speech to CEDA on 10 September 1997 put forward the view that trusts should be taxed in the same manner as companies. This view was based on the argument that both companies and trusts were extensively used for business purposes and the choice of the most appropriate vehicle should not be based on taxation considerations but on the different nature of the two entities. The Commissioner also indicated that a discussion paper on the general issue of taxation of trusts would be released.

While this Bill contains differences to the original proposals, the revenue implications are substantially the same as those for the original proposals. The explanatory memorandum to the Bill estimates that this Bill will save $90 million in 1995-96; $185 million in 1996-97; $160 million in 1997-98; $75 million in 1998-99; and $20 million in each of the next two years.

Main Provisions

Schedule 1 of the Bill will insert a new Schedule 2F, titled Trust losses and other deductions, into the Income Tax Assessment Act 1936 (ITAA).

Exempted Trusts

Exempted trusts will not be subject to the rules contained in the Bill. An exempted trust is one which during the period in question:

  • is a family trust;
  • is a complying superannuation fund, complying approved deposit fund or a pooled superannuation fund;
  • is the trust of a deceased estate during the period between the time of death to the fifth anniversary of the death; or
  • is a fixed trust that is a unit trust and people who are tax exempt have fixed entitlements for their own benefit to all of the income and capital of the tax (proposed section 272-100).

Family Trust

A significant amount of the comments on this Bill concern the effect it will have on family trusts, particularly those that are used to operate small businesses and farms. The term is defined in proposed section 272-75 to be a trust where an election under proposed section 272-80 has been made. This proposed section allows a trust to make such an election when it satisfies the family control test. The family control test is contained in proposed section 272-87 and provides that the trust must consist of:

  • a primary trust representative nominated in the election (this alleviates the need for trust deeds to be changed); or
  • members of representative person's family (which is defined in proposed section 272-95 to be a parent, grandparent, sister, brother nephew, niece, child or child of a child of the person or their spouse and the spouse of any of the above people, including the representative person, but note that a different definition applies prior to the 1997 Budget - refer to the applications provision at the end of this Digest); or
  • a combination of the above categories; or
  • except where the above people have more than 50% control of the income or capital of the trust, people in the above categories and a legal or financial adviser to any members of the family.

(It may be noted that the definition of a family excludes certain groups such as cousins.)

In addition, the members of the trust must have a degree of control of the activities of the trust. This will be satisfied in a number of situations, including

  • the group has the power to obtain the beneficial enjoyment of the capital or income of the trust;
  • the group can control the use of the capital or income of the trust;
  • the group can gain either of the above two matters;
  • the trustee is either accustomed or obliged to act in accordance with the directions or wishes of the group;
  • the group is able to remove the trustee; or
  • the group has a stake in more than half of the income or capital of the trust.

If a trustee of a family trust elects to have the trust treated as a family trust, a company, partnership or trust may elect to be included in the family group if it satisfies the family control test at the end of the year. To satisfy the family control test, such a body must consist of either the individual specified in the election, one or more members of the person's family or the individual and one or more members of that person's family, who have fixed entitlements to more than 50% of the capital or income of the company, partnership or trust.

Proposed sections 266-40 and 266-45 contain the tests that must be satisfied for a deduction for loss to be claimed. The first test is the 50% stake test. This test will be satisfied for a period where at the beginning and end of the period the same individuals have fixed entitlements to more than 50% of the income, or the same individuals (who may be different people to those entitled to the income) have fixed entitlements to more than 50% of the capital of the trust (this is a form of a continuity of ownership test). If this test is not satisfied, the trust must meet the non-fixed trust stake test. This test contains four conditions that must be met.

  1. At all times during the period under consideration non-fixed trusts (ie discretionary trusts) held fixed entitlements to at least 50% of the income or capital of the trust; or a fixed trust or company held, directly or indirectly, all of the fixed entitlements to the income and capital of the trust and non-fixed trusts held fixed entitlements to 50% or more of the capital or income of the holding trust or company.
  2. The entity holding the fixed entitlements must have held those interests during the period under consideration.
  3. At the beginning of the period under consideration, individuals must not have held more than 50% of the capital or income of the trust.
  4. The final condition relates to the whether other provisions of the Bill would prevent the deduction being claimed if the non-fixed trust was a fixed trust. The actual rule to apply depends on the provision under which the non-fixed trust is claiming the deduction on the basis that it satisfies the test.

Family Trusts Making a Distribution Outside the Family

Where a trust has elected to be a family trust and a distribution is made, or an entitlement is given, to a person who is neither listed in the trust deed nor a member of the family group; or such a distribution or entitlement is made to a person who falls within the trust deed or family group and is the trustee of another trust, tax, calculated according to the Family Trust Distribution Tax (Primary Liability) Bill 1997, will be payable. Similar rules will apply where the distribution is made to an intermediatory trust, partnership or company which then makes a distribution as described above. The family group is defined to be:

  • the trustee and the members of their family;
  • an interposed entity where an election has been made by that entity to be included in the family group;
  • entities owned by the family;
  • listed funds, authorities and institutions (these are bodies listed in the ITAA and includes bodies such as research institutions, funds that provide money to public or non-profit hospitals and funds that provide money for certain educational institutions);
  • certain tax exempt bodies under the ITAA (such as religious, scientific and charitable institutions);
  • if the primary individual and all of their family are dead - the estate of members of the family group will be the family group; and
  • a person who has acquired a threshold interest in a small or medium business that has elected to be a member of the family group, where the person is an Australian financial institution or a subsidiary of an Australian financial institution which is not an associate of the small or medium business (defined in the ITAA on a number of ground including a value of $50 million or less).

Proposed Division 271 also contains provisions that will allow the Commissioner to request information from the primary trust or an interposed body relating to distributions to non-residents. If tax becomes payable under the proposed Division and the trust is a non-residents family trust, the Commissioner has determined that it is unlikely that the tax will be paid and the trustee of the trust is a non-resident or the management and control of the trust is outside Australia, then:

the trustee/s of a trust, or director/s of the company if the trust is a company, who has a fixed entitlement to income or capital of the trust, will be liable to pay the amount of tax if, after considering the matters contained in proposed section 272-30 the Commissioner is of the opinion that the trust or company is holding the funds for that individual's benefit.

Similar rules apply where the interposed entity is a partnership. Additional tax will apply where the tax due is not paid within 60 days of it becoming due. The rate of additional tax will be 16%. The rules aim to ensure that if a family trust attempts to use an overseas entity to channel funds through and use the family trust rules to gain an otherwise unallowable deduction, extra tax will be imposed on the Australian entity that is sufficiently connected with the funds. This is also achieved by making local trustees and directors personally liable unless they have sufficient reasons to be excluded.

In certain circumstances where a family trust has an interest in another trust, the family trust may be required to provide certain information to the Commissioner if they are to take advantage of the concessions available for family trusts. This will be where the following conditions are met:

  • the trust deducted prior year losses, did not work out its income in accordance with Division 268, a deduction has been claimed for a debt and would not have been able to claim the deductions if it had not satisfied the relevant provisions of this Bill;
  • the Commissioner must be satisfied that the conditions would not have been satisfied unless one or more of the trusts was a family trust;
  • in relation to at least one of the family trusts, either the trustee is a non-resident or the central management and control of the trust is outside Australia; and
  • notice is given by the Commissioner for the production of information within the later of either 5 years after the end of the year of income for which the deduction is claimed and the period for which records are required to be kept (generally 5 years but this may be extended in certain cases where the assessment process has not been completed).

Where the conditions are met, the Commissioner may require the trustee to provide information on present entitlements and the distribution of the capital and income of the trust. If the information is not supplied, the trust will be taken to have never satisfied the conditions necessary to carry forward the losses and a fixed trust will be required to use Division 268 to determine its income.

Fixed Trusts

Proposed section 266-25 provides that where a trust is in a position to deduct losses from previous years, was a fixed trust during the year of income, was not a widely held trust and was not an exempt trust, the trust will not be able to claim a deduction for prior losses unless it meets the conditions contained in proposed sections 266-40 or 266-45 (see above).

Fixed trust: defined in proposed section 266-65 to be a trust where the beneficiaries have a fixed interest in the trust. This may be compared to a discretionary trust where the trustee determines the distribution to the various beneficiaries.

Widely held trust: This term is defined to be a unit trust that is a fixed trust and in which up to 20 individuals do not have control of 75% or more of the income or capital of the trust.

Unlisted Widely Held Trusts

An unlisted widely held trust is an unlisted unit trust that is a fixed trust where 20 or fewer individuals do not have a right to 75% or more of the capital or income of the trust and the rights attached to the units cannot be varied or abrogated so as to lead to 20 or fewer individuals having such rights. An unlisted unit trust will be taken to be very widely held, and so notwidely held, if it has at least 1 000 unit holders, all of its units have the same rights and, if the units are redeemable, the price is determined on their net asset value. As well, a trust will not be a widely held unit trust if it is a wholesale widely held trust (ie. a unit trust at least 75% of the units are held by certain types of investment trusts and companies and the amount subscribed by each unit holder is at least $500 000). Proposed section 266-75 will also apply to a trust that was an unlisted widely held trust at some time in the loss year and was a listed widely held trust at all other times in the year.

The operative provision of proposed section 266-75 is that such trusts will not be able to claim losses unless proposed section 266-90 is satisfied. The test is that if abnormal trading in the trust has occurred (see below), or the financial year has ended the trust must have passed the 50% stake rule (see above) at the beginning and end of the period under consideration. Abnormal trading is defined in proposed sub-division 269-B to be when:

  • there is abnormal trading in the units of the trust having regard to the timing of the trades, the number of units traded, any connection between the trade and prior trading;
  • if the trustee knows or reasonably suspects that there is trading relating to an acquisition or merger;
  • 5% or more of the units of the trust are traded in a single transaction;
  • there is suspected trading of 5% or more of the units of the trust. (The definition of when this will occur is quite vague and, as it comprises an objective, reasonably suspect, test could be the subject ofsignificant legal action if it is disputed that the trustee did not reasonably suspect that the trading was part of abnormal trading. The test to be applied is that the trustee knows, or reasonably suspects, that a person either with or without associates have acquired or redeemed 5% or more of the units in the trust in 2 or more transactions and that they would not have done so if the trust did not have a loss or other deduction);
  • if more than 20% of the units in the trust were traded within a 60 day period;
  • if the trustee knows or reasonably suspects that a stakeholders interest in the trust has, during the period under consideration, fallen below the 50% stake holding;
  • if a unit trust that has fixed entitlements to all of the capital and income in another trust and this arrangement changes it will be taken to be abnormal trading unless there is another trust that continues to hold the right to the income and capital of the other trusts (ie. the final trust continues to have rights to the income and capital of the other trusts so that there is no change in the final distributions of the trusts); or
  • however, if there is there is an issue of additional units in proportion to current holdings and this would result in any of the above rules being breached, it will not be considered to be abnormal trading.

Proportional deductions are allowed where the trust satisfied proposed section 266-90 for the period of the year for which the deduction is allowable.

If proposed section 266-90 does not apply, special rules will apply in the calculation of income and losses. Proposed subdivision 268-B provides for a year to be divided into different periods with each period ending at the time that there is abnormal trading in the units of the trust or when the 50% stake test is not satisfied. Proposed section 266-95 allows for proportional deduction of a loss for those periods when the test was satisfied.

For a widely held trust, a deduction will be denied for past losses unless the conditions contained in proposed section 266-125 are satisfied and proposed section 266-135 does not deny the deduction. The conditions that must be satisfied are that:

  • there was no abnormal trading in the trust; or
  • there was abnormal trading but after the abnormal trading the 50% stake test was still satisfied or the same business test was satisfied (basically this will be where the trust carries on the same business before and after the test time, does not derive income from a business of a different kind and did not start a new business during the test period).

Proportional deductions will be allowed for periods during which the conditions are satisfied (proposed section 266-130).

The effect of abnormal trading on unlisted very widely held trusts and wholesale widely held trusts is dealt with in proposed subdivision 266-E. A deduction for prior losses will be denied unless either of the following conditions are met:

  • there was no abnormal trading during the test period; or
  • there was abnormal trading but the 50% stake test was satisfied during the test period.

If the conditions are not satisfied, the trust will be required to calculate its income and losses in accordance with proposed Division 268 (see above).

Non-fixed Trusts

A non-fixed trust will not be able to claim prior losses unless the following conditions are met:

  • if the trust made a distribution of income in the year of income or within 2 months after its end and made a distribution within any of the earlier 6 previous years, or distributed capital within those times, then the pattern of distribution test must be satisfied. The pattern of distribution test is dealt with in proposed subdivision 269-D and will be satisfied where the trust distributed at least 50% of the income distributions to the same people in all distributions during the test year and the trust distributed 50% of any capital distributions to the same people in all distributions of capital made during the test year (the people to who the income and capital may be distributed in satisfying this test may be different so long as each group remains the same). The year under consideration will generally be the year in which the distribution/s are made plus 2 months after the end of that year, although previous years may apply in certain circumstances. There are also special rules where all the funds available have not been distributed and people have a fixed entitlement to a share of that income (in which case it will be deemed to have been distributed in accordance with the fixed entitlement); where no distribution is made because of an individuals death or breakdown in their marriage, in which case certain fixed distributions are to be ignored (ie if because of either of these events the distribution eventually goes to a person other than when the original distribution was made).

There is also an anti-avoidance test.

The deduction for prior year losses will also be denied if the control test is not satisfied. To satisfy this test the follow must occur:

  • the trust has not failed the pattern of distribution test in previous years;
  • during the test period, the same person or persons held a stake in more than 50% of the income or capital of the trust; and
  • a group must not begin to control the trust. This is defined in proposed subdivision 269-E to be if the group can exercise power to obtain benefits from the trust, the group is able to control the application of the income or capital of the trust, the trustee is accustomed, obliged or otherwise acting in accordance with the wishes of the group, the group can appoint or remove the trustee, or the group acquires 50% or more of the capital or income of the trust. In certain cases of death, marriage breakdown and incapacity, changes in the group will be disregarded so long as the beneficiaries remain the same before and after the new group takes control.

If the trust is a non-fixed trust and there is not a continuous more than 50% stake in the income or capital during a test period and a group has begun to take control of the test, the income and deductions of the trust must be worked out in accordance with proposed subdivision 268.

Anti-Avoidance

Proposed division 270 contains general provisions dealing with situations where an outsider of the trust has, directly or indirectly, provided a benefit to the trust and the trust has provided a benefit to the outsider and the events occurred to receive an allowable deduction. If such a scheme exists, the deduction will be denied.

Application

Generally, the provisions will have effect where the income year is 1994-95 or later years. However, where the relevant provision refers to a test period, as do the operational provisions, the provisions are taken to commence at the time of the 1995 Budget announcement. For non-fixed trust distributions, the Bill will apply to distributions after 28 September 1995. Amendments relating to losses from foreign trusts will apply from 1 October 1997. The definition of family contained in the Bill will apply from Budget time (7.30 pm on 13 May 1997) and prior to that date a family will be taken to be:

  • the test individual and their spouse or former spouse;
  • the parent, brother, sister child nephew or niece of the test individual, their spouse or former spouse;
  • a child of any of the above who is capable of benefiting on the death of any of those individuals;
  • a grandparent or great-grandparent aunt or uncle or the test individual,
  • a child of the test individual; and
  • a spouse or former spouse of any of the above.

Endnotes

  1. CCH, 1995 Australian Master Tax Guide, p. 1311.
  2. Senate, Hansard, 1 December 1995.
  3. Treasurer, Press Release, 20 August 1996.
  4. Australian Taxpayers' Association, Press Release, 8 October 1997.
  5. Ibid.

Contact Officer and Copyright Details

Chris Field
11 November 1997
Bills Digest Service
Information and Research Services

This paper has been prepared for general distribution to Senators and Members of the Australian Parliament. While great care is taken to ensure that the paper is accurate and balanced, the paper is written using information publicly available at the time of production. The views expressed are those of the author and should not be attributed to the Information and Research Services (IRS). Advice on legislation or legal policy issues contained in this paper is provided for use in parliamentary debate and for related parliamentary purposes. This paper is not professional legal opinion. Readers are reminded that the paper is not an official parliamentary or Australian government document.

IRS staff are available to discuss the paper's contents with Senators and Members
and their staff but not with members of the public.

ISSN 1328-8091
© Commonwealth of Australia 1997

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Published by the Department of the Parliamentary Library, 1997.

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Last updated: 12 November 1997

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