TAX IN PRACTICE TRUST LOSSES

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1 TAX IN PRACTICE TRUST LOSSES JANUARY 2012

2 ABOUT PRACTISING TAX Practising Tax is a specialist tax information provider. Practising Tax is a team of passionate tax professionals with diverse experience ranging from Big 4 accounting firms, top tier law firms, private practice, ATO and tax education providers. Practising Tax is unrivalled in the quality, accuracy and approachability of its product. We pride ourselves on ensuring that our clients get the most up-to-date, easy to understand and practical tax information available. CONTACT DETAILS Melbourne PO Box 6152 Hawthorn VIC 3122 Ph: (03) Fax: (03) Jenny Daborn jdaborn@practisingtax.com.au Karen Goodfellow kgoodfellow@practisingtax.com.au Sydney PO Box A415 Sydney NSW 1235 Ph: (02) Fax: (02) Daniel Biancardi dbiancardi@practisingtax.com.au 2012 Practising Tax Pty Ltd. Except as permitted by the Copyright Act 1968, these materials must not be reproduced in whole or in part without the express written consent of Practising Tax Pty Ltd. These materials are intended to be used as a guide only. They should not be relied upon as a substitute for professional advice regarding actual facts or circumstances. Practising Tax Pty Ltd, its employees and agents do not accept any liability for any injury, loss or damage resulting from any person acting, or refraining to act, in reliance on all or part of these materials.

3 TABLE OF CONTENTS INTRODUCTION... 1! OVERVIEW OF TYPES OF TRUSTS AND THE TESTS THAT APPLY... 2! 50% STAKE TEST... 5! ALTERNATIVE 50% STAKE TEST... 6! APPLICATION TO NON-FIXED TRUSTS... 7! PATTERN OF DISTRIBUTIONS TEST... 8! DOES THE PATTERN OF DISTRIBUTIONS TEST APPLY TO THE LOSS TRUST?... 8! IS THE PATTERN OF DISTRIBUTIONS TEST PASSED BY THE LOSS TRUST?... 8! PRIOR YEAR PATTERN OF DISTRIBUTION TEST... 9! CONTROL TEST... 10! INCOME INJECTION TEST... 11! TRUST LOSS TESTS - ILLUSTRATIONS... 14! ILLUSTRATION - 50% STAKE TEST... 14! ILLUSTRATION - ALTERNATIVE 50% STAKE TEST... 16! ILLUSTRATION - PATTERN OF DISTRIBUTIONS TEST... 18! ILLUSTRATION - INCOME INJECTION TEST... 20! Page i

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5 INTRODUCTION The trust loss provisions were introduced in April 1998, generally with effect from 9 May The trust loss provisions are contained in Schedule 2F of the ITAA The trust loss provisions are an integrity measure designed to restrict the tax benefit of a loss to those who beneficially incurred the loss. That is, the rules ensure that the tax benefit of a current or carry forward loss deduction cannot be transferred to a person who did not bear the economic effect of the loss when it was incurred. The rules are similar in objective to the company loss rules, but with essential differences to reflect the different characteristics fundamental to trusts 1. The trust loss provisions essentially operate by examining whether there has been a change in underlying ownership or control of a trust or whether certain schemes have been entered into in order to take advantage of a trust's losses or other deductions. The trust loss provisions apply to: current year revenue losses; prior year revenue losses; and bad debt deductions. The trust loss measures do not apply to capital losses. 1 Second reading speech Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1998 Page 1

6 OVERVIEW OF TYPES OF TRUSTS AND THE TESTS THAT APPLY The trust loss provisions apply differently depending on what type of trust has incurred the loss. Note: The trust loss provisions are comprehensive and apply to all types of trust, from widely held trusts that are listed on the Australian stock exchange, to small family trusts. This case study, however, will focus on only those trusts that are more relevant to a typical public practice client. Page 2

7 Definition of trust type Trust type Fixed trust Definition A trust where persons have fixed entitlements to all the income and capital of the trust (s ). To have a fixed entitlement to income and capital of the trust, the beneficiary must have a vested and indefeasible interest in a share of income or capital of the trust (s 272-5). To this end, the trustee!s ability to issue or redeem units at full value will not automatically result in a unit holder!s interest being defeasible. Note: A unit trust is not necessarily a fixed trust. That is because a clause in a unit trust deed which allows the trustee to issue units at a discount or redeem them at greater than full value will result in beneficiaries not having vested and indefeasible interests in all the income and capital of the trust. For the purposes of the trust loss rules, fixed trusts may take on a number of forms: a non-widely held fixed trust; a widely held fixed trust, which covers: an unlisted widely held trust; a listed widely held trust; an unlisted very widely held trust; and a wholesale widely held trust. Non-fixed trust A trust that is not a fixed trust (s ). Family trust Excepted trust A trust that has made the election to be a family trust for the purposes of the trust loss measures (s ). The following are excepted trusts: a family trust; a complying superannuation fund, complying approved deposit fund or pooled superannuation trust; deceased estates, up until end of the income year in which the fifth anniversary of the death occurs; and a unit trust where tax exempt bodies have fixed entitlements, directly or indirectly, to all the income and capital of the trust. (Section ) There are a number of tests that may be applicable depending on the type of trust. These are outlined in the table below. Page 3

8 Prior and current year losses and debt deductions - tests that apply to each type of trust for it to be able to deduct a loss or debt Type of trust 50% stake test Pattern of distribution test Control test Income injection test Fixed trust!! Non-fixed trust!!!! Family trust! Excepted trust (other than a family trust) Notes: 1. Where the!standard" 50% stake test is not passed, the trust may be able to pass an alternative 50% stake test (outlined below). 2. A listed widely held trust which fails the 50% stake test, may be able to pass the same business test. Important: A trust must satisfy all of the applicable tests to be able to deduct the relevant loss. Page 4

9 50% STAKE TEST To pass the 50 percent stake test: the same individuals must have more than a 50 percent stake in the income of a trust; and the same individuals (who may be different from those above) must have more than a 50 percent stake in the capital of the trust; at all times from the beginning of the loss year to the end of the income year. (Section ) Individuals will have a more than 50 percent stake in the income or capital of the trust where, between them, they hold directly or indirectly, and for their own benefit, fixed entitlements to a greater than 50 percent share of the income or capital of a trust. Note: Important points to note with the 50% stake test: the trust must trace through to individuals that hold the fixed entitlements; more than 50% of the fixed entitlements must be held by individuals - a bare 50% will not be sufficient to pass the test; and it is not necessary for the same individuals to hold the income and the capital entitlements to pass the test. The following rules exist to allow fixed entitlements to be traced through interposed entities to those individuals who ultimately hold the fixed entitlements (s ). Page 5

10 Tracing Rules Interposed entity Company Tracing rule If a shareholder in a company holds shares carrying the right to receive dividends or any distribution of the paid-up share capital, the fixed entitlement is: Shareholder!s entitlement to distribution Section Partnership Fixed trust Complying superannuation fund Total distribution Where the partner, under a partnership agreement has an entitlement to a share of income that cannot be varied, that percentage will be the fixed entitlement. Where the partner does not have a fixed entitlement, the Commissioner can exercise a discretion to treat the partner as having a fixed entitlement taking into account: the circumstances in which the share is able to be varied; the likelihood of the variation happening; and the nature of the partnership. A beneficiary that has a vested and indefeasible interest in a share of income or capital of the trust holds a fixed entitlement. Where the fund has more than 50 members, the fixed entitlements are deemed to be held by an individual. Where the superannuation fund has 50 or fewer members, each member is treated as having a fixed entitlement in an equal proportion Family trust Fixed entitlement is deemed to be held by an individual Alternative 50% stake test The alternative 50 percent stake test is an alternative test that can be satisfied where the normal 50 percent stake test is failed (s ). Page 6

11 To pass the alternative 50 percent stake test all of the following conditions must be satisfied: 1. at all times during the test period non-fixed trusts (other than family trusts) must hold fixed entitlements to 50 percent or more of the income or capital of the trust, or an interposed fixed trust or company must hold all the fixed entitlements of the trust and a non-fixed trust (other than a family trust) must hold fixed entitlements to 50 percent or more of the income or capital of the interposed trust or company; 2. the trust holding the fixed entitlements in the loss trust or the interposed entity, as the case may be, must have held those entitlements at all times during the test period; 3. at the beginning of the test period individuals must not have had a greater than 50 percent stake in the income or capital of the trust; and 4. each non-fixed trust (other than an excepted trust) must satisfy: the pattern of distributions test; the prior year pattern of distributions test; the 50 percent stake test; and the control test, assuming that the non-fixed trust had incurred the loss instead of the fixed trust. Application to non-fixed trusts The 50 percent stake test applies to a non-fixed trust only if individuals have more than a 50 percent stake in the income or capital of the trust (s ). That is, individuals must hold directly or indirectly, and for their own benefit, fixed entitlements to a greater than 50 percent share of the income or capital of a trust. If this is not the case, then the 50 percent stake test does not apply. Note: The 50 percent stake test is not relevant to a typical discretionary trust, as no entities hold fixed entitlements to income or capital of the trust. Page 7

12 PATTERN OF DISTRIBUTIONS TEST When considering the pattern of distributions test, two questions may need to be answered: 1. Does the pattern of distributions test apply to the loss trust? 2. If so, is the pattern of distributions test passed by the loss trust? Does the pattern of distributions test apply to the loss trust? The pattern of distributions test applies only where a non-fixed trust distributed income and/or capital: in the income year (or within two months after its end); and in at least one of the six earlier income years. (Section ) Where the above conditions are not satisfied the pattern of distributions test is not one of the tests that must be satisfied by the loss trust. Note: The pattern of distributions test is relevant only to carry forward tax losses and debt deductions. It has no application for current year losses or debt deductions. Is the pattern of distributions test passed by the loss trust? To pass the pattern of distributions test a trust must, before two months after the end of the income year, distribute: directly or indirectly to the same individuals, for their own benefit, a greater than 50 percent share of all test year distributions of income; and directly or indirectly to the same individuals (who may be different from those above), for their own benefit, a greater than 50 percent share of all test year distributions of capital. Page 8

13 What is a test year distribution of income or capital? A test year distribution of income or capital is the total of all distributions of income or capital (as the case may be) made by the trust in periods set out below, provided the period does not start more than six years before the start of the income year. The test years are: 1. the period from the start of the income year until two months after its end; and: 2. if the trust distributed income before the loss year - the income year, before the loss year, that is closest to the loss year; or 3. if item 2 above does not apply and the trust distributed income in the loss year - the loss year; or 4. if neither item 2 or 3 above applies - the income year, closest to the loss year, in which the trust distributed income; and: 5. each intervening income year between the one in item 1 and the one in item 2, 3 or 4. (Section ) Note: Where a trust does not distribute the same percentage of income or capital for every test year distribution, the trust is taken to have distributed to the individual the smallest percentage that it distributed for any of the test year distributions (s ). Prior year pattern of distribution test Section provides that a trust that was prevented from deducting a tax loss in an earlier income year because it failed the pattern of distribution test cannot deduct that loss in a later year. Page 9

14 CONTROL TEST The control test provides that a group must not, during the test period, begin to control the trust directly or indirectly (s ). A group is: a person; a person and one or more associates 2 ; or two or more associates of a person. (Section (5)) SECTION (1) CONTROL A NON-FIXED TRUST A group controls a non-fixed trust if: (a) (b) (c) (d) (e) (f) the group has the power, by means of the exercise of a power of appointment or revocation or otherwise, to obtain beneficial enjoyment (directly or indirectly) of the capital or income of the trust; or the group is able (directly or indirectly) to control the application of the capital or income of the trust; or the group is capable, under a scheme, of gaining the beneficial enjoyment in paragraph (a) or the control in paragraph (b); or the trustee is accustomed, under an obligation or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the group; or the group is able to remove or appoint the trustee; or the group acquires more than a 50% stake in the income or capital of the trust. Note: Special rules exist for determining whether control has changed in the case of death or marriage breakdown. The test period is the same as above for the 50 percent stake test, namely the period from the beginning of the loss year to the end of the income year. 2 Associate is defined in s 318 and is extremely broad Page 10

15 INCOME INJECTION TEST The income injection test is designed to prevent a trust from utilising deductions, where a scheme or arrangement exists to take advantage of the deductions. The income injection test is failed if: A deduction (of any kind) is available to the trust for the year; Under a scheme, the following happen (in any order): the trust derives an amount of assessable income in the year; an outsider to the trust, directly or indirectly, provides a benefit to the trustee, a beneficiary in the trust or to an associate of the trustee or beneficiary; and the trustee, a beneficiary in the trust or an associate of the trustee or beneficiary, directly or indirectly, provides a benefit to the outsider to the trust or an associate of the outsider; and It is reasonable to conclude that: the trust derived the scheme assessable income; or the outsider provided the benefit; or the trustee, beneficiary or associate provided the benefit, wholly or partly, but not merely incidentally, because the deduction would be allowable. (Section (1)) Note: Rules also exist to prevent persons that were outsiders of the trust entering into arrangements to enable them to take advantage of a deduction by ceasing to be an outsider (s (2)). Page 11

16 Key definitions Benefit Money, a dividend or property (whether tangible or intangible) A right or entitlement (whether or not property) Services The extinguishment, forgiveness, release or waiver of a debt or other liability The doing of anything that results in the derivation of assessable income Anything that, disregarding the preceding points, is a benefit or advantage (Section ) Outsider Non-family trust Anyone other than the trustee of the trust or a person with a fixed entitlement to a share of the income or capital of the trust (s (2)) Family Trust The trustee of the trust A person with a fixed entitlement to a share of the income or capital of the trust The individual specified in the trust's family trust election A member of the individual's family A trust with the same individual specified in its family trust election A company, partnership or trust that made an interposed entity election to be included in the individual's family group A fixed trust, company or partnership where: the individual specified in the trust's family trust election one or more members of the individual's family, or the trustees of one or more family trusts, provided the individual is specified in the family trust election of each of those family trusts or any combination, had fixed entitlements, directly or indirectly, and for their own benefit, to all of the income and capital of the entity (s (1)) Note: The broader definition of outsider for a family trust ensures that income can be injected into a family trust from within the family group without fear of the income injection test being failed. Page 12

17 The Explanatory Memorandum to Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1998 provides the following flowchart as an overview of the income injection test 3 : 3 Taken from Chapter 10 Page 13

18 TRUST LOSS TESTS - ILLUSTRATIONS Illustration - 50% stake test The Outback Unit Trust is a fixed trust that has three unit holders, namely Colin, Fleur and Cruiser Pty Ltd. Cruiser Pty Ltd is owned equally by Colin and Fleur. Page 14

19 In 2007, when their eldest son Jeremy turns 21 years of age, Cruiser Pty Ltd issues Jeremy with an equal shareholding in the company for market value. The resulting ownership structure is as follows: During the 2006 and 2007 income year the Outback Unit Trust incurred revenue losses as a result of rising costs. In 2008 however, a lucrative contract has resulted in a substantial profit. Does the Outback Unit Trust pass the 50% stake test? The first step it to determine the test period to which the 50 percent stake test applies. The test period will be as follows: Page 15

20 The relevant tracing rules then need to be applied to determine whether the same individuals have more than a 50 percent stake in the income and capital of the trust throughout the test period. Fixed entitlement held by Before change in ownership After change in ownership Colin 25% 25% Fleur 25% 25% Colin via Cruiser Pty Ltd 25% (50% x 50%) 16.65% (50% x 33.3%) Fleur via Cruiser Pty Ltd 25% (50% x 50%) 16.65% (50% x 33.3%) Total 100% 83.3% Note that Jeremy s interest is not taken into account as he did not hold any fixed entitlements at the beginning of the test period. As more than 50 percent of the fixed entitlements are held directly and indirectly by Colin and Fleur throughout the test period (i.e. both before and after the only change in ownership) the 50 percent stake test has been satisfied. Illustration - Alternative 50% stake test The Alpha Unit Trust has carry forward revenue losses from a previous year, which it is looking to recoup in the current year. Charlie and the Bravo Discretionary Trust have always been the only unit holders of the Alpha Unit Trust. The Bravo Discretionary Trust is a non-fixed trust that has not made a family trust election. In addition the Bravo Discretionary Trust would pass all the relevant trust loss tests if it needed to. Page 16

21 Assuming that the Alpha Unit Trust is a fixed trust it needs to satisfy the 50 percent stake test. However the 50 percent stake test cannot be passed as individuals hold only a bare 50 percent of the fixed entitlements of the Alpha Unit Trust. It is not possible to trace through the Bravo Discretionary Trust. As such it is necessary to apply the alternative 50 percent stake test. Application of the alternative 50% stake test Condition 1. At all times during the test period non-fixed trusts (other than family trusts) must hold fixed entitlements to 50 percent or more of the income or capital of the trust, or an interposed fixed trust or company must hold all the fixed entitlements of the trust and a non-fixed trust (other than a family trust) must hold fixed entitlements to 50 percent or more of the income or capital of the interposed trust or company. 2. The trust holding the fixed entitlements in the loss trust or the interposed entity, as the case may be, must have held those entitlements at all times during the test period. 3. At the beginning of the test period individuals must not have had a greater than 50 percent stake in the income or capital of the trust. 4. Each non-fixed trust (other than an excepted trust) must satisfy: the pattern of distributions test; a prior year pattern of distributions test; the 50 percent stake test; and the control test, assuming that the non-fixed trust had incurred the loss instead of the fixed trust. Satisfied? Yes Yes Yes Yes Accordingly the alternative 50 percent stake test is passed by the Alpha Unit Trust. Page 17

22 Illustration - Pattern of distributions test The Tango Discretionary Trust operates a dance studio. In the 2007 income year it incurred a revenue loss, however in all other years since it began trading in 2005 it has made a profit, and has distributed its profit to its three primary beneficiaries as follows: Kristen 40% 50% Nil 30% Sam 40% 50% Nil 20% Priscilla 20% 0% Nil 50% The Tango Discretionary Trust is looking to claim its 2007 loss as a deduction in the 2008 income year. Does the pattern of distributions test apply to the Tango Discretionary Trust? Yes, the pattern of distributions test applies as there has been a distribution in the current year and in at least one of the previous six years. Is the pattern of distributions test passed by the Tango discretionary Trust? In determining whether the pattern of distributions test is passed by the Tango Discretionary Trust it is first necessary to identify the test year distributions of income. The test year distributions of income or capital for the Tango discretionary Trust are as follows: distributions made in the period from 1 July 2007 to 31 August 2008; as the Tango Discretionary Trust distributed income before the loss year, distributions made in the period from 1 July 2005 to 30 June 2006 (being the income year, before the loss year, that is closest to the loss year); and distributions made in the period from 1 July 2006 to 1 July 2007 (being the intervening income year between the ones identified above). Page 18

23 Given the Tango Discretionary Trust distributes different percentages of income in each of the test years, the rule in s applies and the trust is taken to have distributed to each of Kristen, Sam and Priscilla the smallest percentage distributed for any of the test years. Distribution made Distribution taken into account Kristen 50% 30% 30% Sam 50% 20% 20% Priscilla 0% 50% 0% Total 50% As individuals need a greater than 50 percent share of all test year distributions of income or capital to pass the pattern of distributions test, the test is not satisfied and the loss cannot be deducted. Tip: Ensure that pattern of distributions test is considered before making any distributions after a loss year. Page 19

24 Illustration - Income injection test Mum and Dad are the beneficiaries of both the Profit and the Loss Trust. The Profit Trust carries on business activities and is mostly in a profit position. Its distributions vary from year to year depending on the tax position, cash flow and other requirements of Mum and Dad. The class of beneficiaries is quite wide and includes a corporate beneficiary and the Loss Trust. The Loss Trust conducts investment activities. It holds a negatively geared rental property. Due to the negatively geared rental property, the Loss Trust is mainly in a loss position. In the 2008 income year the Profit Trust made a distribution to the Loss Trust. After deducting its tax loss from that amount of assessable income the Loss Trust made a tax free distribution to Mum and Dad. Both trusts are non-fixed and non-family trusts, and each trust has a separate corporate trustee. Page 20

25 Will the income injection test apply to deny the carry forward loss deduction? 1. Under a scheme: Application of the income injection test Did the trust derive an amount of assessable income? Did an outsider to the trust directly or indirectly provide a benefit to the trustee, a beneficiary of the trust or to an associate of either the trustee or the beneficiary? Did the trustee, beneficiary or associate directly or indirectly provide a benefit to the outsider to the trust or to an associate of the outsider? 2. Is it reasonable to conclude that: the trust derived the scheme assessable income; the outsider provided the benefit; or Yes. A trust distribution is assessable income. An outsider of a non-fixed non-family trust is anyone other than the trustee. As the trustee of Profit Trust is not the trustee of the Loss Trust, it is an outsider. (Note to not be an outsider to the trust, the trustee must be acting in their capacity as trustee, hence even if both the Profit and the Loss Trust had the same trustee, the distribution from the Profit Trust would still be from an outsider as the trustee would be acting in its capacity as trustee of the Profit Trust.) By receiving the distribution, the Loss Trust was able to make a distribution to Mum and Dad. Mum and Dad are associates of the Profit Trust, the outsider, as they are beneficiaries of the Profit Trust. It would be reasonable to conclude that the arrangement was entered into wholly or partly, because a deduction was available as each year the distributions are varied to ensure the most appropriate outcome for Mum and Dad from both a tax and cash flow position. the trustee, beneficiary or associate provided the benefit; wholly or partly, but not merely incidentally, because the deduction would be allowable? It is therefore concluded that the income injection test is failed, such that the Loss Trust is unable to take advantage of its tax loss to reduce its tax payable. The loss, however, may be available to be utilised by the Loss Trust in future years. Page 21