TAXATION DISCRETIONARY TRUSTS - TAXATION TREATMENT CONTENTS Page 1. Introduction To Discretionary Trusts... 3 2. Determination Of Discretionary Trust Profit... 3 3. Discretionary Trust Taxable Income... 3 4. Comparison To Partnerships... 4 5. Trustees Trust Distribution Minutes... 4 6. Discretionary Trust Paying Tax... 4 7. Capital Gain... 5 8. Trust Distributions To Children... 5 9. Trust Losses... 5 10. Bad Debts... 6 11. Tests Which Apply To A Discretionary Trust To Determine Whether A Claim Can Be Made For Prior Year Losses, Current Year Losses Or Bad Debts... 6 12. Family Trusts... 6 13. Family Trust Election... 6 14. Family Control Test... 7 15. Distributions Of Income From A Family Trust... 7 16. Distributions From A Family Trust To An Interposed Entity... 8 17. Income Injection Test... 9 18. Family Trusts - Is This The Right Election To Make?... 10 19. Tests That Apply To Determine Deductibility Of Trust Losses And Bad Debts For A Discretionary Trust That Is Not A Family Trust... 10 20. Control Test... 10 21. Pattern Of Distribution Test... 11 22. Income Injection Test For Discretionary Trusts Which Are Not Family Trusts... 11 23. Treatment Of Losses In A Company If A Discretionary Trust Owns More Than 50% Of The Shares In The Company... 12 24. Capital Gains Tax Issues For Discretionary Trusts... 12 - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 1
25. Accounting - v - Taxable Income... 13 26. Trading Entities... 13 27. Small Business Entities... 13 28. ATO Ruling On The Future Use Of Trusts With Company Beneficiaries... 14 29. Professional Advice... 15 ADDENDUMS 012-046A Flow Chart - Tests For Determining Whether A Discretionary Trust Is A Family Trust... 16 012-046B Flow Chart - Distribution From A Family Trust... 17 012-046C Flow Chart - Additional Test That A Family Trust Has To Satisfy... 18 012-046D Flow Chart - Tests That A Trust Has To Satisfy To Claim Losses Or Bad Debts... 19 - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 2
TAXATION DISCRETIONARY TRUSTS - TAXATION TREATMENT 1. Introduction To Discretionary Trusts A detailed commentary on Discretionary Trusts including comments on: Settlor Trustee Trust Deed Beneficiary Business Activities Appointor Distribution of Profits and Capital Gains Asset Protection Beneficiaries Accounts Trustee s Actions, and Trustee s Minutes These are all contained in Paper 003-020 - Discretionary Trusts. 2. Determination Of Discretionary Trust Profit A Discretionary Trust prepares its financial accounts comprising: Trading and Profit & Loss Account Balance Sheet In a similar manner to that adopted by other business entities. For further information, refer to the following papers: Paper 005-015 - Trading And Profit And Loss Statement Paper 005-025 - Balance Sheet There is no special treatment in the financial accounts other than an indication that profits have been distributed to beneficiaries and the Balance Sheet would contain details of beneficiaries Accounts. (These relate to profits that have been distributed to beneficiaries, which have not been physically paid to them). 3. Discretionary Trust Taxable Income In preparing a Discretionary Trust estimate of taxable income, consideration has to be given to the treatment of prior year losses, current year losses and bad debts. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 3
If there has been a material change in the underlying beneficial interest of the beneficiaries in the Discretionary Trust then income tax deductions will probably not be available for prior year losses, current year losses and bad debts. In all other aspects, similar adjustments are made in the determination of taxable income as those made in other types of business entities. 4. Comparison To Partnerships If a taxable loss is incurred by a Partnership then that loss can be distributed to the partners who can then utilise their share of the loss to offset against other income received that year. For further information, refer to Paper 003-015 - Partnership. This is not the position in a Discretionary Trust. If the Discretionary Trust incurs a taxable loss there is no distribution of the loss to the beneficiaries. The loss remains in the Discretionary Trust to be offset against the taxable income of the Discretionary Trust in the following years (subject to there being no material change to the underlying beneficial interest by the beneficiaries in the Discretionary Trust or a family trust election has been made). If a family trust election is not made, it is extremely difficult for a trust to be able to utilise prior year losses. 5. Trustees Trust Distribution Minutes Trustees have to meet prior to the 30 th June each year to decide on the distribution of income earned by a Discretionary Trust. Trustees decision should be recorded in writing as a Minute of a Trustees' Meeting. If the trust minutes are invalid, this could result in a trustee being assessed at a full marginal rate of tax due to no beneficiary being presently entitled, if no default beneficiary is included in the Trust Deed. If the trustees have not been reviewed recently, it is recommended that you have a discussion with your accountant. Trust Deeds that do not deal with capital gains and franking credits could result in the trustees being assessed on these amounts at the full marginal rate of tax due to no beneficiary being presently entitled. Care should be taken in the drafting of trust minutes because poorly drafted minutes could result in trust distributions being taxed at higher rates in higher income earning beneficiaries hands instead of in the hands of a lower income earning beneficiary. The Australian Taxation Office (ATO) has announced that it will be auditing trusts to ensure that valid minutes of meetings of trustees relative to the distribution of income of the trusts are held prior to the 30 th June each year. This highlights the need for tax planning for each trust during an income year and not at the end of the income year, in order to ensure proper distribution are agreed to, and that the trust minutes are prepared confirming the decision of the trustees prior to the 30 th June each year. 6. Discretionary Trust Paying Tax In normal circumstances a Discretionary Trust does not pay income tax. A Discretionary Trust does pay income tax where the trustee has not distributed the taxable income for the year. This is at a penalty rate - 45% plus Medicare Levy 1.5%. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 4
Normally a trustee makes a distribution to the beneficiaries, who then have to include the amount of the trust distribution in their own income tax returns and add the trust distribution to all other earnings and pay income tax at the marginal rates for their total taxable income. Trustees of Discretionary Trusts must disclose in the trust's income tax return the identity and tax file number of the ultimate individual or company who will beneficially receive any trust distributions i.e. the "trustee beneficiary". Failure to disclose the names of the trustee beneficiaries will result in the trustee being assessed income tax on that distribution at the highest rate, plus Medicare Levy (currently 45% + 1.5%) - known as "Trustee Beneficiary Non Disclosure Tax". 7. Capital Gain Under most Trust Deeds the trustee has the discretion to distribute a capital gain to any beneficiary of the trust. This enables the gain to be distributed to individual family members who do not have other significant income and therefore are subject to a lower marginal rate of taxation. If the Trust's net income includes a capital gain, taxation relief may be available (Refer to Item 25). 8. Trust Distributions To Children Taxation rates applying to the income of minors (including trust distributions for 2012/13), who were residents of Australia, not excepted persons and have no excepted income, are as follow:- 2012/2013 Income (excluding excepted income) Tax Rates $0 $416 Nil $417 Over 46.5% 9. Trust Losses The taxation laws control the treatment of tax losses. These laws are to discourage taxpayers from selling tax losses. Similar tests have been introduced to trusts, as those that apply to companies, relative to the claiming of losses carried forward. For further information, refer to the following papers: Paper 003-030 - Companies Paper 012-045 - Company Tax A trust must now satisfy certain tests before prior and current year losses can be deducted. Losses carried forward are not deductible where there is a change in the persons who will benefit from the deduction compared to the persons who were the beneficiaries when the trust actually incurred the losses. For losses incurred in the current year, if a specific test is not complied with, the income year is divided into periods and the net income or loss is calculated for each period. If the tests are not complied with, a deduction will not be allowable for a specific period. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 5
10. Bad Debts The taxation laws control the treatment of bad debts. Similar tests have been introduced to trusts, as to those that apply to companies, relative to the claiming of bad debts. A trust must now satisfy certain tests before bad debts can be deducted. Bad debts will not be deductible where there is a change in the persons who will benefit from the bad debt deduction compared to the persons who were the beneficiaries when the trust concluded the transaction relating to the ultimate bad debt being incurred. If the specific test is not complied with, the bad debt cannot be written off and claimed as a tax deduction. 11. Tests Which Apply To A Discretionary Trust To Determine Whether A Claim Can Be Made For Prior Year Losses, Current Year Losses Or Bad Debts The tests for determining whether these losses are deductible are: If the Discretionary Trust resolves to be a Family Trust (Refer to Item 12). The Discretionary Trust has to pass the Income Injection Test (Refer to Item 17). If the Discretionary Trust does not resolve to be a Family Trust (Refer to Item 18). The tests to be complied with are: Control Test (Refer to Item 20) Pattern of Distribution Test (Refer to Item 21) Income Injection Test (Refer to Items 17 and 22) 12. Family Trusts A Discretionary Trust will be a Family Trust where the trustee of the trust makes an election (Family Trust Election) (Refer to Item 13) that the trust will be a Family Trust. The election has the effect for the income year for which it was made as well as later income years. In normal circumstances the election is generally irrevocable, (but it can be revoked in limited circumstances) and once made any distributions of income or capital outside the family group by the trust or relevant interposed entities will be assessed at the top marginal tax rate plus Medicare Levy (Family Trust Distribution Tax - 45% plus 1.5% Medicare levy). The Family Trust only has to satisfy one (1) test - this is the Income Injection Test (Refer Item 17) - in order to be able to claim deductions for current year losses, prior year losses and bad debts. Discretionary Trusts which do not make an election to be a Family Trust must satisfy the other tests. 13. Family Trust Election The election to be treated as a Family Trust may be made at any time in relation to an earlier income year rather than having to include it in the income tax return for the year in which the election is made. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 6
The option to make the election at any time can only be effected if:- the trust passes the Family Control Test; and any actual distributions of income or capital of the trust have been made to the individual specified in the election or to members of that individual's family group. The election must specify an individual, known as the Test Individual as the individual whose family group is to be taken into account in relation to the election. The election must specify: the name of the trust the address of the trust, including the Country of Residency the beneficiaries of the trust at the time the election takes effect A trust cannot make a Family Trust Election unless it passes the Family Control Test (Refer Item 14) from the time the election comes into effect until the end of that income year. 14. Family Control Test To enable a Discretionary Trust to pass the Family Control Test, the Discretionary Trust must be controlled by one of four (4) specified family groups. The four (4) specified family groups are: the test Individual also called the primary individual. one or more members of the primary individual s family. the primary individual and one or more members of the primary individual s family. any person mentioned above and a legal or financial adviser to the primary individual or to a member of the primary individual s family. A group will control a trust if: it has 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 it is able (directly or indirectly) to control the application of the capital or income; or the group is capable, under a scheme, of gaining such beneficial enjoyment or control; or the trustee is accustomed, under an obligation, or reasonably 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. The Discretionary Trust needs only to pass the Family Control Test during the tax year in which the election first applies. 15. Distributions Of Income From A Family Trust Once a Family Trust Election has been made, distributions of income or capital can only be made to members of the family group of the primary individuals without attracting the top progressive rate of tax plus the Medicare Levy (called Family Trust Distribution Tax). - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 7
The family group comprises any of the following of the test individual or the test individual s spouse: spouse child grandchild parent grandparent gay spouse brother sister nephew niece The family group includes the spouse of such a child, grandchild, parent, grandparent, brother, sister, nephew or niece and the lineal decedents for a nephew, niece or child of the individual or the individual's spouse. A person does not cease to be a family member merely because of the death of another family member. A flow chart highlighting the tests for determining whether a Discretionary Trust is a Family Trust is shown in Addendum 012-046A. 16. Distributions From A Family Trust To An Interposed Entity If a Family Trust makes a distribution to an interposed entity (partnership, company or trust), that entity must also make a similar election i.e. to only distribute to the test individual s family group in respect of distributions of income and capital otherwise the Family Trust will be subject to Family Trust Distribution Tax (45% plus 1.5% Medicare levy). This election is called The Interposed Entity Election. The interposed entity election need not be made at the same time that the Discretionary Trust has made the election to be deemed to be a Family Trust. In the election the interposed entity must specify the date from which the election takes effect. It should be before the date of the distribution from the Family Trust. The Interposed Entity Election must specify: the Family Trust to which it relates the test individual 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 The interposed entity must also pass the Family Control Test at the end of the income year. A flow chart showing distributions from a Family Trust to an Interposed Entity; Election Necessary; if distribution not in accordance with the election - Family Trust Distribution Tax imposed at 45% plus 1.5% is contained in Addendum 012-046B. An Interposed Entity Election is irrevocable. When buying a company or trust an enquiry should be made as to whether an Interposed Entity Election has been made. If it has been and profits are distributed to the new owners, the tax rate will be 45% plus 1.5% Medicare levy. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 8
An Interposed Entity Election may be revoked where:- the election was made for an entity that was already included in the family group of the test individual specified in the Family Trust Election at the election commencement date; or at a later time, the entity became wholly owned by members of the family group. An Interposed Entity Election is automatically revoked if the Family Trust Election, to which it relates, is revoked. 17. Income Injection Test If income has been injected into the trust in connection with a scheme and the losses are used to shelter what would otherwise have been assessable income, then the deduction of those losses against the income injected may be disallowed. The Income Injection Test applies not only to current and prior year losses, but also to any current year deductions. If the test is not satisfied then all deductions claimed by the trust in the current year could be disallowed. Basically the Law states that, if a scheme is devised to take advantage of the deductions, then those deductions may be disallowed. Prior year losses and current year deductions will be disallowed when under a scheme: the trust derives an amount of assessable income (scheme assessable income); an outsider provides a benefit to the trustee or a beneficiary or to an associate of either of them; the trustee, a beneficiary or an associate provides a benefit to the outsider or their associate; and it is reasonable to conclude the trust derived the scheme assessable income or the outsider provided the benefit wholly or partly, but not merely incidentally, because the deduction would be allowable. An outsider to a trust does not include: If the trust is a Family Trust: the test individual or a member of his/her family, or; a company, partnership or trust that has made an Interposed Entity Election where the election was in force when the scheme commenced, or; a trust, company or partnership if some or all of the following persons had fixed entitlements to all the income and capital of the entity: - the test individual or - members of the test individual s family or - family trusts of the test individual The trustee of the Discretionary Trust or a person with a fixed entitlement to a share of the income or capital of the Trust. A Flow Chart outlining the additional test that a Family Trust has to satisfy is set out in Addendum 012-046C. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 9
18. Family Trusts - Is This The Right Election To Make? If a Discretionary Trust elects to be treated as a Family Trust, then it only has to satisfy one test - the Income Injection Test. However if the Discretionary Trust does not elect to be a Family Trust, then it must satisfy the Control Test, the Pattern of Distribution Test and the Income Injection Test. One matter that trustees of Discretionary Trusts will have to consider before electing to become a Family Trust is whether the narrow definition of the Family prejudicially effects the future operations of the Discretionary Trust and it s ability to make distributions to a wide range of people. However by making an election to be a Family Trust the trustees will have: ensured that the beneficiaries can utilise franking credits on shares acquired by the trust; enable the utilisation of carried forward losses in the trust; enabled the trust to be able to obtain a tax deduction for bad debts; allows any company in which the Discretionary Trust holds more than a 50% interest to carry forward losses. In any event, the election to be a Family Trust needs only to be made in some future time when the Discretionary Trust has incurred a loss. 19. Tests That Apply To Determine Deductibility Of Trust Losses And Bad Debts For A Discretionary Trust That Is Not A Family Trust These tests apply to any Discretionary Trust, which has not resolved to be a "Family Trust": Control Test (Refer Item 20) Pattern of Distribution Test (Refer Item 21) Income Injection Test (Refer Item 17) The Discretionary Trust must satisfy all of these tests. If the Discretionary Trust fails one (1) test then its current and prior year losses and bad debt deductions cannot be claimed as an income tax deduction. A Flow Chart outlining tests that a trust (which is not a Family Trust) has to satisfy to claim losses or bad debts is outlined in Addendum 012-046D. 20. Control Test To pass this test the control of the Discretionary Trust must stay with the same group of people throughout the test period. The test period is the tax year in which the loss or bad debt arose and the tax year in which the loss or bad debt is deducted and all intervening years. A group is: a person a person and one (1) or more associates two (2) or more associates of a person - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 10
A group will control a Discretionary Trust if: it has power to obtain beneficial enjoyment (directly or indirectly) of the capital or income of the trust; or it is able (directly or indirectly) to control the application of the capital or income; or it is capable, under a scheme of gaining such beneficial enjoyment or control; or the trustee is accustomed, under an obligation or reasonably expected to act in accordance with 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. Special rules apply to cover the situation of the death, divorce or incapacity of a person in the group. If a person has retired (but the beneficiaries haven't changed) application can be made to the Taxation Commissioner to utilise his discretion to treat the control tests as not having been failed. 21. Pattern Of Distribution Test This test applies if the Discretionary Trust distributed income or capital in the income year and in one of the preceding six (6) years. The test is used in determining whether a Discretionary Trust can deduct prior year losses and bad debt deductions. The test basically requires the Discretionary Trust to have distributed its income to the same individuals for a number of years. To satisfy the test the Discretionary Trust must have distributed more than 50% of the income, directly or indirectly, to the same individuals for their own benefit in each year in the relevant period, not necessarily in the same proportions. The relevant period is the start year, the end year and each intervening year. The start year is the earliest: if the Discretionary Trust distributes income before the loss year - the year in which the Discretionary Trust distributed income that is closest to the loss year within the previous six (6) years; of the loss year if the Discretionary Trust distributed income in the loss year; of the income year in which the Discretionary Trust distributed income that is not before the loss year, but is closest to the loss year. The end year is the income year being examined. The test applies in the same way to distributions of capital. To pass the Distribution of Capital Test, the distributions need not be to the same individuals as those to whom income is distributed. It should be noted that where an individual receives different percentages of income or capital in different years, the smallest percentage is taken into account in determining the calculation of 50%. 22. Income Injection Test For Discretionary Trusts Which Are Not Family Trusts The same Income Injection Tests apply as detailed in Item 17. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 11
23. Treatment Of Losses In A Company If A Discretionary Trust Owns More Than 50% Of The Shares In The Company If a Discretionary Trust owns more than 50% of the shares in a company, that company will have to satisfy some specific tests before it can claim an income tax deduction for carried forward losses. To claim carry forward losses a company must satisfy the continuity of ownership test. This test requires more than 50% of shares to be held by similar persons when the loss was incurred and when it was recovered. Whilst the Discretionary Trust had been the shareholder when the loss was incurred and when it was recovered the Australian Taxation Office takes the view that where shares are held by a Discretionary Trust those shares are not beneficially held by any person and therefore reliance can not be placed in the Continuity of Ownership Test. However, as long as a company is able to demonstrate that it carries on the same business, it would be able to pass the Same Business Test and be eligible to utilise the carry forward losses. The courts have held that the same business means the business must be virtually identical to when the losses occurred to when the losses are being utilised. Care must be taken that the business has remained the same if any prior year losses have been claimed. The specific tests, which can be applied, are as follows: If the trust has resolved to be a Family Trust then the Family Trust Concession applies. The effect is that the trustee of the Family Trust will be treated as the owner of the shares as an individual. The trust must also satisfy the Income Injection Test. The trustee will then be able to satisfy the continuity of ownership test (if the trust owns more than 50% of the shares in the company); or The Alternative Condition. The Alternative Condition can only apply where 50% or more of the income or capital of the company has been held throughout the relevant period (all times during the loss year and the income year) by a Discretionary Trust. If this condition can be applied then two (2) additional requirements must be met: Throughout the relevant period there must be no change to any of the shareholders interests in the company. Every Discretionary Trust that holds, at any time in the relevant period, fixed entitlements in the company must satisfy the Income Injection Test, Control Test and Pattern of Distribution Test. 24. Capital Gains Tax Issues For Discretionary Trusts Discretionary Trusts have to bring to account net capital gains earned during a year. Net capital gain is the total of the trust's capital gains earned in that year reduced by any capital losses incurred in that year or capital losses carried forward from any earlier year. (Capital losses can only be offset against capital gains, not offset against normal taxable income - for further information refer to Paper 012-020 - Capital Gains Tax - Introduction). - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 12
25. Accounting - v - Taxable Income One issue which can give rise to considerable difficulties for a discretionary trust is where the trust income differs to the taxable income. Trust income is determined by each trust deed and general accounting principles whereas taxable income is determined by the application of the Income Tax Assessment Acts of 1936 and 1997. Where the income of a trust estate differs from the taxable income, the net income is to be distributed to beneficiaries based on their proportionate entitlement to the trust income as decided in Zeta Force Pty Ltd -v- FCT, Cajkusic -v- FCT and Bamford -v- FCT. To demonstrate, the AB Trust has a profit of $40,000 for 2009, but has a taxable profit of $100,000 due to a large capital gain. At year end the AB trust then distributes the profits 25% to A and 75% to B. Under trust law principles, A would be entitled to $10,000 of the trust's profits with B entitled to $30,000. For taxation purposes, A and B would be taxed on 25% and 75% of the $100,000 profit in proportion to their share of the trust profit and would include $25,000 and $75,000 as their taxable distribution from the AB Trust. This causes difficulties when the trust has a loss for the year for accounting purposes but under tax law has a distributable profit due to a capital gain. This will result in the taxable profit being assessable to the trustee at penalty rates under s99a in most situations. For example, the AB Trust has a loss of $15,000 for 2009, but has a taxable profit of $45,000 due to a large capital gain. Under the proportionate approach, neither A nor B would include any portion of this $45,000 as a taxable distribution and the trustee would be assessed on this amount at penalty rates. The ATO has released PSLA 2010/11 which may help alleviate this problem in certain circumstances. 26. Trading Entities A Discretionary Trust is an effective vehicle out of which to operate any business, provided this business is operated by individuals who are related. When unrelated individuals or families operate in business together, an alternative structure would be recommended, such as a Company, Partnership or Trust. This is due to the laws which prevent a trust from being able to use tax losses from prior years, bad debts and franking credits without a family trust election being made and, if a Family Trust Election is made, the family trust distribution taxes which arise when distributions are made to individuals outside the test individual s family. 27. Small Business Entities A Discretionary Trust may be eligible for the small business entity regime if it satisfies two basic conditions: carries on business; and has an aggregated turnover of less than $2,000,000. If eligible, the Discretionary Trust will be able to access the following concessions, subject to any additional criteria relevant to each concession: simplified depreciation rules simplified trading stock rules special rules in regards to prepaid expenses accounting for GST on a cash basis paying GST by quarterly instalments access to the small business CGT concessions FBT car parking exemption PAYG instalments based on GDP adjusted notional tax - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 13
two year period for amending assessments entrepreneurs' tax offset 28. ATO Ruling On The Future Use Of Trusts With Company Beneficiaries On the 2nd June 2010, the ATO released Taxation Rule 2010/03 Income Tax Act: Division 7A Loans: Trust Entitlements. If a trust is being utilised in your business and one or more companies are beneficiaries, then this ruling could apply. The ruling is only the Commissioner of Taxation opinion. This does not necessarily make him correct, however until this matter is litigated in a court of law the Commissioner of Taxation's opinion will dictate how the Australian Taxation Office deals with taxpayers and their taxation affairs. The ruling expresses the Commissioner of Taxation's opinion on the circumstances in which a private company, with a "present entitlement to an amount" from an associated trust, makes a loan to that trust in circumstances where funds representing that "present entitlement" remain intermingled with funds of the trust. Division 7A is a provision of the Income Tax Assessment Act 1936 which involves companies and non-company taxpayers. In very broad terms, it creates a loan between a company and an associated taxpayer whenever the company does any of the following with the associated taxpayer: loans money; advances money; provides credit or any other form of financial accommodation; or makes a payment on their behalf. Where a Division 7A loan arises, it will become a "deemed automatic dividend" to the associated taxpayer, unless a 7 year unsecured or 25 year secured loan agreement is put in place before the relevant income tax return is lodged. If a business is conducted via a trust structure and, at the end of the year, distribution of profits is made to a company beneficiary (often done because of the corporate lower tax rate) and the trust does not actually physically pay cash to the company, in this scenario the payment will be treated as a Division 7A loan which will result in an "automatic deemed dividend" being paid by the company to the associated taxpayer i.e. the trust. This applies for trust distributions to companies made after the issuing of the ruling by the Australian Taxation Office with an effective commencement date of 16 December 2009. For company beneficiary trust distributions pre 16 December 2009, the position of the Commissioner is that they are to be "grandfathered' (i.e. not Division 7A loans). Each case, however, is to be considered on its individual facts. The consequence for this is that the company will be deemed to have paid a dividend to the trust. These dividends will more than likely have franking credits attached which will also reduce the company's franking account balance. This dividend and attached franking credits will be assessable income to the trust which will then have to distribute this profit to a beneficiary. This will increase the new beneficiary's taxable income resulting in increased tax payable; although this will be partly offset by any attached franking credits. There are a number of possible solutions available with regards to how trust distributions are going to be treated for businesses: Do nothing This will result in an immediate dividend each year. This will also probably add to taxation burdens. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 14
Implement a new Division 7A Loan Agreement every fiscal year This solution is complicated in that separate loan agreements will need to be prepared each year. This solution requires interest to be paid by the trust and the company needs to include the interest as income. The trust could physically pay the trust distribution to the company The difficulty that this may present is having the available funds in the trust to pay the trust distribution and also to be able to get the cash out of the company. Change operating structures Consideration could be given to changing operating structures by incorporating the company and utilising the capital gains tax rollover elections, to have the discretionary trust owning the shares in the company and putting the business into the company structure. Sale of business Sell the business from the trust to a company/partnership/sole trader structure and utilise the small business capital gains tax concessions and general discount to reduce/eliminate capital gains tax and increase the businesses cost base. If you are operating your business through a trust and you have companies as beneficiaries, it is recommended that you seek accounting advice on the ongoing suitability of your current structure having regard to this ATO Ruling. 29. Professional Advice The taxation treatment of Discretionary Trusts is very complicated. Before establishing a Discretionary Trust or making the election to become a Family Trust, it is recommended that you seek appropriate professional advice from a professional accountant and solicitor. - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 15
ADDENDUM 012-046A 012-046A Flow Chart - Tests For Determining Whether A Discretionary Trust Is A Family Trust DISCRETIONARY TRUST Election to be FAMILY TRUST Only revokable in specific circumstances Distributions outside the Family Group Will be taxed at 45% plus 1.5% Medicare levy (Family Trust Distribution Tax) Must nominate Must pass one control test TEST INDIVIDUAL FAMILY CONTROL TEST Family Group to whom distributions can be made or to:- Child Grandchild Parent Grandparent Brother Sister Nephew Niece Spouse Test individual's Spouse Gay spouse Child Grandchild Parent Grandparent Brother Sister Nephew Niece 1. Test (Primary) Individual 3. Primary Individual and Members of Primary Individual's Family 2. Primary Individual's Family 4. Any person of 1,2,3 and a Legal or Financial Adviser to the Primary Individual or to a member of the Primary Individual's Family - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 16
012-046B Flow Chart - Distribution From A Family Trust ADDENDUM 012-046B DISTRIBUTION FROM A FAMILY TRUST TO AN INTERPOSED ENTITY; ELECTIONS NECESSARY; IF DISTRIBUTIONS NOT IN ACCORDANCE WITH THE ELECTION - FAMILY TRUST DISTRIBUTION TAX IMPOSED AT 45 plus 1.5% medicare levy DISCRETIONARY TRUST Election to be FAMILY TRUST (Only revokable in specific circumstances) Interposed Entity Election INTERPOSED ENTITY Partnership Company Trust If distribution not in accordance with the Election Tax at 46.5% on all distributions If made interposed Entity Election Must pass one control test FAMILY CONTROL TEST TEST INDIVIDUAL 1. Test (Primary) Individual 2. Primary Individual's Family Child Grandchild Parent Grandparent Brother Sister Nephew Niece Spouse Test individual's Spouse Child Grandchild Parent Grandparent Brother Sister Nephew Niece 3. Primary Individual and Members of Primary Individual's Family 4. Any person of 1,2,3 and a Legal or Financial Adviser to the Primary Individual or to a member of the Primary Individual's Family - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 17
012-046C Flow Chart - Additional Test That A Family Trust Has To Satisfy ADDITIONAL TEST THAT A FAMILY TRUST (WHICH IS A DISCRETIONARY TRUST) HAS TO SATISFY ADDENDUM 012-046C DISCRETIONARY TRUST Elected to be FAMILY TRUST Nominated Passed TEST INDIVIDUAL FAMILY CONTROL TEST Must satisfy INCOME INJECTION TEST Income must not be injected to offset a loss that is provided by an "Outsider" - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 18
ADDENDUM 012-046D 012-046D Flow Chart - Tests That A Trust Has To Satisfy To Claim Losses Or Bad Debts TESTS THAT A TRUST (WHICH IS NOT A FAMILY TRUST) HAS TO SATISFY TO CLAIM LOSSES OR BAD DEBTS DISCRETIONARY TRUST CONTROL TEST PATTERN OF DISTRIBUTION TEST INCOME INJECTION TEST Control with the same group of people when loss incurred and when deducted for income tax purposes. 50% of the income distributed to the same individuals in the Start Year, End Year and each intervening Year. Income must not be injected to offset a loss that is provided by an "outsider". - ESS BIZTOOLS Pty Ltd - ACN: 078 451 439 Page 19
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