Family Trust Elections (FTEs), a common practice among family groups, have recently come under increased scrutiny from the Commissioner of Taxation and the Australian Taxation Office (ATO). Given the potentially severe tax and interest implications and an unlimited review period, it is essential to understand the rules.
Understanding FTEs
The FTE regime is contained in Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936) (Schedule 2F) and was enacted on 16 April 1998 to provide concessionary treatment to trusts that validly elected to become ‘family trusts’ for the purposes of the trust loss and debt deductions rules, also contained in Schedule 2F.
The policy underpinning the integrity provisions of the trust loss rules is to restrict the recoupment of prior year and current year tax losses of trusts (does not extend to capital losses) to prevent the transfer of the tax benefit of those losses to persons who did not economically incur those losses at the time they were incurred by the trust. The trust loss rules comprise a string of strict legal tests to recoup a tax loss or claim a bad debt deduction.
However, concessionary treatment is given to trusts that have made an FTE as distributions from these trusts are expected to be made only to members of the ‘family group’ of the individual specified in the FTE (see below) and not to someone who is outside that group who did not economically incur the loss. In this regard, unlike other trusts, family trusts are required to satisfy only the income injection test and then in a modified way to satisfy the trust loss rules. This is a significant benefit and one of the main reasons for making an FTE.
Potential advantages of FTEs
Setting up a family trust election can offer several benefits including:
- Franking credit flow-through: For non-fixed trusts acquiring shares after 31 December 1997, an FTE allows franking credits to pass directly to beneficiaries, even when the small shareholder exemption does not apply.
- Continuity of ownership: Companies where family trusts hold shares can benefit from the continuity of ownership test, treating the family trusts as a single notional individual.
- Small business restructure roll-over: FTEs can apply a modified ultimate economic ownership test for discretionary trusts in section 328-440 of the Income Tax Assessment Act 1997 (ITAA 1997) (small business restructure roll-over), and
- Reduced reporting requirements: Trustees of family trusts are exempt from the trustee beneficiary reporting rules, which broadly require the trustee of a closely held trust to advise the ATO of certain information about distributions to other trusts.
Making a valid FTE
A trustee can elect a trust to be a ‘family trust’ starting from a specified income year. To be valid, the family trust election must meet the following criteria:
The test individual
The FTE must specify a single living individual (the test individual) whose ‘family group’ (defined to include certain natural persons as well as certain companies, trusts and partnerships) is taken into account in relation to the election (and must contain any other information as the Commissioner requires). The individual must be alive at the time the trustee makes the election and the individual can be varied only once.
Submit required forms
The election must be made in writing and in the approved form. The choice to make an FTE, revoke an FTE or vary the test individual is generally made as part of the trust tax return. However, where a tax return is not required, trustees can download and use the Family trust election, revocation or variation form.
Specified income year
The election must specify an income year (the specified year) from which the election applies — this need not be the income year in which the election is made. If an earlier income year is specified, any conferrals of present entitlements or distributions of income or capital of the trust since the beginning of the specified year must have been in favour of members of the test individual’s ‘family group’ (and a slightly modified control test must be passed — refer below).
Family control test
The trust must pass the ‘family control test’ in section 272-87 of Schedule 2F. This test determines whether the test individual or members of the test individual’s family have sufficient control over the trust at the end of the specified income year and, if applicable, from the start of the specified income year to the end of the previous income year.
Understanding Family Trust Distribution Tax
Family Trust Distribution Tax (FTDT) is payable where a family trust or an interposed entity makes a distribution of, or confers a present entitlement to, income or capital to a person who is not the individual specified in the FTE, or a member of their ‘family group’.
FTDT is not an income tax, nor is it ‘assessed’. It is a special tax imposed by the Family Trust Distribution Tax (Primary Liability) Act 1998 where certain conditions in Schedule 2F are breached. Significantly, where directors of a company are subject to FTDT, they are jointly and severally liable to pay the FTDT unless protected by one of the exceptions.
The broad scope of the term ‘distribution’ in sections 272-45, 272-50, 272-55 and 272-60 of Schedule 2F includes not only distributions of income and capital in the ordinary sense but also covers circumstances where the trustee:
- pays (including by way of a loan) or credits money of the entity to the person, or reinvests such money for the person
- transfers property of the entity to, or allows use of property of the entity by, the person
- deals with money or property of the entity for or on behalf of the person or as the person directs
- applies money or property of the entity for the benefit of the person, or
- extinguishes, forgives, releases or waives a debt or other liability owed by the person to the entity.
Significantly, distributions need not be made to beneficiaries of the trust to constitute ‘distributions’ for FTDT purposes. Use of trust property by third parties, rent-free, could fall foul of these rules and enliven FTDT. Unlike Division 7A in Part III of the ITAA 1936, the Commissioner has no power to exercise his discretion and disregard the distribution for circumstances involving an honest mistake or inadvertent omission.
Some issues in practice
This below outlines some of the key issues that can arise when dealing with FTEs.
- FTDT is generally due and payable 21 days after the distribution or conferral of income or capital. General interest charge (GIC) is imposed on any amount that has not been paid within 60 days of the due date (i.e. after 81 days of the distribution or conferral). This can be financially detrimental, considering that FTDT notices have an unlimited review period. To prevent double taxation, however, amounts subject to FTDT are non-assessable non-exempt income (section 11-55 of the ITAA 1997 and 271-105(3) of Schedule 2F).
- Once an FTE is made, it cannot be varied or revoked except in limited circumstances so it is important that, when making an FTE, consideration is given to whether an election should be made even if it can be made.
- The meaning of ‘family’ in section 272-95 of Schedule 2F is extended by section 960-255 of the ITAA 1997 to include certain individuals such as stepsiblings.
- There is no sufficient certainty as to what actions might amount to validly making an FTE. This was seen, for example, by the Federal Court and Full Federal Court in DCT v Widdup (No 2) [2023] FCA 377 and Widdup v DCT [2023] FCAFC 145. In each of these cases, the trustee argued that an FTE had not been made despite statements to the contrary in a series of trust tax returns lodged with the Commissioner. While each of these cases primarily concerned the making of freezing orders, and the primary judge made it clear that the question of whether the trustee had made a valid FTE was a matter to be resolved in separate Part IVC (of the Taxation Administration Act 1953) proceedings, the Full Federal Court made some interesting comments regarding the making of valid FTEs, for example at paragraph 40:
We are satisfied that there is an arguable case that the form published by the Commissioner for the making of a family trust election does not need to be given to the Commissioner and that it is sufficient if the Commissioner is notified that a family trust election in the approved form has been made.
- Since the test individual must not be a deceased individual, issues often arise for the next generation of family members who want to set up new companies and/or trusts but are constrained to some extent from doing so. Succession planning is crucial.
- Selling shares in a company that has made an IEE for the purposes of the FTE rules poses difficulties as the buyer is typically not within the ‘family group’. Distributions to the new owners would lead to unwanted and unavoidable FTDT liabilities. Asset sales can be used instead, but this might not always be the preferred choice.
- A tax agent can, through Online services for agents, generate an FTE and IEE report that shows the entities within a taxpayer’s group that have effective FTEs and IEEs in place. However, this report may not always be current. Accordingly, it is incumbent on the taxpayer to retain all relevant elections for all entities within the group and provide such evidence to their tax agent. It is also incumbent on the tax agent to not rely solely on the generated reports. Rather, tax agents should ensure they have made all proper enquiries with the taxpayer and contacted the ATO directly to confirm.
- Two trusts with two different but related test individuals (say, father and daughter) may come within each other’s family groups where one of those trusts makes an IEE. However, if those trusts hold interests in subsidiary companies, it may be problematic for those subsidiary companies to come within the relevant family group despite the blood relationship of the two test individuals.
Tax Talks: Australia's Tax News Podcast
Episode 18 — FTE Questions
31 October 2024
Jonathan Ortner joins Heide Robson on the ‘Tax Talks’ podcast to explore the complexities of Family Trust Elections. Jonathan shares ten critical aspects of FTEs, including the impact of trust loss provisions on trust loss trading, the importance of selecting an appropriate test individual, and the potential tax implications of FTEs.
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Contact our team to navigate the complexities of FTEs
The rules governing FTEs are complex, broad in scope and can cause tax consequences and interest charges. With little guidance from the courts over the years or the Australian Taxation Office on the issue, this area potentially has far-reaching application. For expert advice on FTEs and the information in this article, contact us using the form below.