The ATO is increasing its scrutiny of family discretionary trusts (FTs) to ensure compliance with the family trust election (FTE) and interposed entity election (IEE) provisions in Schedule 2F of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936).
Quite a number of these reviews are linked to the ATO’s ‘Next 5,000 private groups’ program involving Australian resident individuals and their associates who control net wealth of more than $50 million and above, many of whom use FTs.
Often these reviews involve matters such as an FT’s financial year end trustee distribution resolutions, unpaid present entitlements (UPEs), Division 7A loans, s 100A reimbursement agreements and other tax risks relating to trusts and private companies. In this series of articles, however, we focus on FTEs and IEEs, as some of the family trust distribution tax (FTDT) liabilities recently published in the media exceed hundreds of millions of dollars, with some even said to reach into the billions annihilating generations of family wealth.
Accordingly, it is imperative that trustees and their advisers are aware of the implications where a trust has previously made, or is considering making, an FTE, or where an entity such as a trust, partnership or company has previously made, or is considering making, an IEE. Without careful and ongoing management, distributions of both income and capital to outsiders of the ‘family group’ are exposed to 47% FTDT.
Part 1 of this series provides a general overview of FTEs, including the making an election and who can receive a distribution without being subject to FTDT (ie, who’s in the ‘family group’).
We will examine other related issues in this series including IEEs, franking credits, the meaning of the term ‘distribution’, FTDT and the general interest charge (GIC), which in some cases can be much greater than the FTDT liability itself.
References to legislation are references to Schedule 2F of the ITAA 1936 unless stated otherwise.
What is an FTE?
An FTE is typically an election made by the trustee of a non-fixed trust (eg, an FT) under s 272-80 that effectively restricts the range of beneficiaries of a trust to the family group of the primary individual specified in the election. Distributions made to individuals and entities outside of the family group of the primary individual specified in the election are subject to FTDT. (While it is possible for other trusts, partnerships and companies to make an FTE or IEE, we will focus on FTs in this article).
The FTE must also specify a commencement time, being a prior income year. The relevant trust must have passed the family control test at the end of the relevant income year specified in the election for a valid election to take place. The family control test is contained in s 272-87 which broadly requires that the primary individual and their family control the trust.
Importantly, the primary individual specified in the election must be alive at the time the election is made. This can restrict flexibility in relation to estate planning, eg, a deceased primary individual cannot be the primary individual for an FTE made in relation to a testamentary trust resulting from their will in respect of their deceased estate.
Why make an FTE?
An FTE enables the trust to receive certain tax concessions, including in relation to carrying forward tax losses on revenue account (note that capital losses under the capital gains tax regime are not subject to Schedule 2F) and passing on franking credits in relation to dividends distributed by the trustee to a beneficiary. While there are some other concessions flowing from making an election, these are generally the two key reasons for making an election.
We will discuss these aspects in further detail in a future article.
Who is in the ‘family group’?
Note that where an FT has made an FTE a distribution of income and capital outside the family group, is still allowed but will give rise to FTDT.
In broad terms, s 272-90 provides that the family group of a primary individual comprises the following:
- certain members of the primary individual’s family set out in s 272-95 (the annexure to this article contains a diagram of the primary individual’s family);
- certain former family members including a former spouse of a family member and a widowed spouse who has remarried;
- a trust that makes the FTE (with the primary individual specified);
- a trust that has made an FTE with the same primary individual specified;
- an entity that has made an IEE with the same primary individual specified; and
- certain entities that have not made an IEE where the primary individual, members of their family or trustees of FTs that have made an FTE with the same primary individual have (between them) fixed entitlements directly or indirectly, and for their own benefit, to all of the income and capital of the entity.
* NB: When referring to the primary individual for the purposes of determining family members, the legislation in Schedule 2F refers to this individual as a ‘test individual’ rather than a primary individual. These terms are of often used interchangeably when describing the relevant individual.
It is critical to know which individuals and entities form part of the family group so that distributions do not give rise to FTDT. In particular:
- aunts, uncles and cousins are not considered family members for the purposes of s 272-95; and
- it is possible for a person to be part of the family group but not a family member (eg, a former spouse). Only fixed entitlements held by family members are relevant for determining whether an entity forms part of the family group, without making an IEE or for passing the family control test (ie, fixed entitlements held by a former spouse in a company or partnership will not count for these purposes).
