Family Trust Distribution Tax: A sleeper issue for growing families

By Jonathon Leek Legal Practitioner Director, Deloitte Legal

Family Trust Elections (“FTEs”) and Family Trust Distribution Tax (“FTDT”) have been a feature of the income tax landscape since 1998. Tax lawyers and accountants should be familiar with them. But they need to be on guard against that familiarity breeding complacency. As children grow up, spread their wings, establish their own business and investment vehicles, and engage their own advisers, the essential “family group” may not be what the family thinks it is. In that case, there is a risk of inadvertently triggering the imposition of FTDT at the rate of 47%.

Making an FTE entitles the trust to access certain tax concessions. In summary, the tax concessions a family trust may access are as follows: • the carry forward and utilisation of trust losses is easier for a family trust because only a modified “income injection test” needs to be passed; • the carry forward and utilisation of company losses is easier because the “continuity of ownership test” applicable to the loss company does not require tracing of ownership through a family trust; • a family trust is able to satisfy the “holding period rule” thereby enabling beneficiaries to more easily benefit from franking credits attached to dividends received by the trustee; • the small business restructure roll-over relief from capital gains tax includes special rules for family trusts; and • family trusts are excluded from the trustee beneficiary reporting rules. There are, therefore, good reasons for making an FTE. The trade-off, however, is that FTDT is imposed when distributions are made outside the family group.

A “family trust” is a trust in respect of which an FTE is in force.1 The trustee of a trust may make an FTE if it passes the “family control test” for the income year to be specified in the election.2 As the name suggests, the family control test requires the trust to be controlled by members of a particular family in one of a number of specified ways.3 An FTE must be made in writing and in the approved form.4 Importantly, it must specify an individual as the individual whose family group is to be taken into account in relation to the FTE.5 Subject to certain limited exceptions, once made,

More often than not, the individual specified in an FTE is the notional head of the family at the time of making the FTE. Broadly, the family group then comprises: • the parents, grandparents, brothers and sisters of the specified individual or the specified individual’s spouse; • the nephews, nieces and children of the specified individual or the specified individual’s spouse; • the lineal descendants of the nephews, nieces and children of the specified individual or the specified individual’s spouse; • the spouses of the specified individual and of anyone mentioned above; • the trust in respect of which the FTE was made; • other trusts with an FTE in force that specifies the same individual; and • companies, partnerships and trusts in respect of which Interposed Entity

Elections (“IEEs”) have been made.7

Broadly, FTDT is payable by the trustee of a trust where:

• the trustee has made an FTE or a company, the partners in a partnership or the trustee of a trust have made an

IEE to be included in the family group in relation to a family trust; and • the trust, company or partnership makes a distribution of, or confers a present entitlement to, income or capital to a person other than the individual specified in the FTE or a member of that individual’s family group.8 Where FTDT is payable by the trustee of a family trust, it is payable on the amount or value of the income or capital distributed or to which the entitlement relates at the rate of the highest marginal rate of tax applying to an individual plus the Medicare Levy (currently 47%).9

As previously noted, the individual specified in an FTE is more often than not the notional head of the family at the time the FTE is made. At that time, the children of the specified individual may be small children or young adults. But those children will grow up, spread their wings and make their own mark. They may become involved in the family business and eventually take control of it. Or they may start businesses of their own. For example, if the individual specified in an FTE was middle aged with children when FTDT was introduced in 1998, those children may now be aged in their 30s or 40s.

The FTDT risk creeps in when those grown-up children start to establish their own business and investment vehicles. And the risk is exacerbated where the children engage lawyers and accountants different from those engaged by the notional head of the family. This is because, when a new trust is established for the benefit of a grown-up child and that child’s family, the natural tendency will be to make the child the individual specified in the FTE for the new trust. However, in that case, the new trust may not be a member of the family group in relation to the original trust. This is because the FTEs for the original trust and the new trust specify different individuals.10 In addition, multiple IEEs cannot be made in respect of more than one trust, unless the individual specified in each FTE is the same.11 To illustrate, assume that Trust 1 carries on a successful business established decades ago. The trustee of Trust 1 has made an FTE that specifies Individual A (the founder of the business) as the individual whose family group is to be taken into account in relation to the FTE. Individual A has a daughter, Individual B. Individual B is a member of Individual A’s family group. As such, Individual B may receive distributions of income or capital from Trust 1 without triggering FTDT. Individual B grows up and starts her own business. Individual B’s tax adviser (who is different from Individual A’s tax adviser) advises Individual B to establish a new trust (Trust 2) and have the trustee make an FTE specifying Individual B as the individual whose family group is to be taken into account in relation to the FTE. Assume also that Trust 2 cannot make an IEE to be included in the family group of Individual A. In the income year ended 30 June 2019, Trust 1 has net income from the continuing success of the business carried on by Trust 1. In contrast, Trust 2 makes a tax loss due to the start-up nature of the business carried on by Trust 2. The tax advisers agree that Trust 1 should distribute income to Trust 2 with the intention of utilising the tax loss made by Trust 2 against the income made by Trust 1. The result is that the distribution from Trust 1 to Trust 2 is liable to FTDT at the rate of 47% and payable by the trustee of Trust 1. This is because Trust 2 is not a member of Individual A’s family group. This result will come as quite a surprise to Individual A and Individual B (not to mention their tax advisers) who were expecting no tax payable on the distribution in the belief that the distribution would be offset by the tax loss made by Trust 2.

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If faced with a liability to FTDT, consideration may be given to whether or not the beneficiary can disclaim the distribution to them. Whether or not a disclaimer will be effective will depend on all of the facts and circumstances. Carter v Commissioner of Taxation12 is a recent decision of the Full Federal Court on the retrospective effectiveness of disclaimers. In that case, disclaimers were held to have retrospective effect, although it remains important that the distribution be disclaimed before it is accepted by the beneficiary. The Commissioner has sought special leave to appeal to the High Court from the decision of the Full Federal Court in Carter.

In circumstances where disclaiming the distribution may be an option, it will be necessary to consider the consequences before doing so. The relevant income may be assessed in the hands of another beneficiary or the trustee depending on the terms of the trustee resolution and the trust deed.13

Assuming the distribution cannot be disclaimed, other consequences will flow from a liability to FTDT. The first consequence flowing from the above example is that the tax loss that would otherwise have been utilised should remain available to Trust 2 to offset future income. But the most important consequence is that future distributions by Trust 2 and downstream companies, partnerships and trusts should be nonassessable, non-exempt (“NANE”) income to the extent those future distributions are attributable to the distribution from Trust 1.14 Accordingly, those future distributions should not be liable to tax again in the hands of the recipient. In that sense, the imposition of FTDT may prove to be a timing difference rather than a permanent difference. But the timing difference may be significant and come at an inopportune time for the family. The provision that deems future distributions to be NANE income is, however, imperfectly drafted and largely untested. For example, while it is clear that a distribution from Trust 2 to a corporate beneficiary will be NANE income, it is not as clear as it should be that a subsequent distribution from the corporate beneficiary to an individual shareholder (e.g. a dividend) will be NANE income in the hands of the shareholder. But that is the policy intention and should be the outcome.

Growing families and their tax advisers need to coordinate their tax affairs. Communication is essential. In the absence of communication, unintended tax consequences may be encountered. Considerable thought needs to be given to the making of FTEs and IEEs. The knee jerk response of naming the family member that is instructing the tax adviser as the specified individual in an FTE needs to be resisted. The making of IEEs also needs to be strategic given the restrictions imposed on the making of multiple IEEs. The FTEs and IEEs that have been made should also be periodically reviewed. As noted above, once made, an FTE generally cannot be varied or revoked. An FTE may be varied to specify a new and different individual but generally only in respect of an income year that occurs during the period starting at the beginning of the income year specified in the original FTE and finishing at the end of the fourth income year after the income year specified in the original FTE. 15 Accordingly, there is a limited window to vary but it may only be done once.16 However, the new individual must be a member of the original individual’s family group, and it must be the case that no income or capital has previously been distributed outside the new individual’s family group.17 In summary, it pays to communicate critical tax decisions within growing families and take care with FTDT.

1 Section 272-75 in Schedule 2F to the Income Tax Assessment Act 1936 (Cth) (“ITAA 1936”). 2 Subsection 272-80(1). 3 Section 272-87. 4 Subsection 272-80(2). 5 Subsection 272-80(3). 6 Subsection 272-80(5). 7 Sections 272-90 and 272-95. 8 Division 271 in Schedule 2F to the ITAA 1936. 9 Family Trust Distribution Tax (Primary Liability) Act 1998 (Cth). 10 Subsection 272-90(3A). 11 Subsection 272-85(7). 12 [2020] FCAFC 150. 13 Sections 97, 98, 99 or 99A of the ITAA 1936. 14 Section 271-105. 15 Subsection 272-80(6B). 16 Subsection 272-80(5B). 17 Subsection 272-80(5A).