In 1998 the trust tax loss measures in Schedule 2F of the Income Tax Assessment Act (ITAA) 1936 (Schedule 2F) were finally enacted to curb the unscrupulous trade in trust tax losses.
Income injection test
An essential and not so well understood retardant of the trade in these measures is the income injection test (IIT). Neither the term income injection nor the words inject or injection are in Schedule 2F. Nevertheless the test is there in Division 270 of Schedule 2F under the heading Schemes to take advantage of deductions.
The ITAAs and Schedule 2F, in particular, have much jargon which is in italics in this post.
Unlike some other tests in Schedule 2F, such as the stake test and the control test, which are both applicable to non-fixed trusts, transgression of the IIT doesn’t disqualify a trust from using all of its tax losses including carry forward prior year tax losses. A trust that fails the IIT is precluded from offsetting otherwise tax deductible tax losses against (taxable) assessable income (only) to the extent of scheme assessable income.
Scheme assessable income is what is “injected”.
How the IIT works
As an anti-avoidance provision designed for wide reach, the IIT in Division 270 of Schedule 2F is so expressed. Scheme, as is usual in anti-avoidance laws in the ITAAs, is widely defined and an outsider or outsider to the trust, is pervasive under the IIT. In the case of a trust that isn’t a Schedule 2F family trust (a 2FFT) an outsider to the trust is a (any) person other than the trustee of the trust or a person with a fixed entitlement to income or capital of the trust: see section 270-25(2) of Schedule 2F.
Scheme assessable income arises where (in any order):
- the trust earns assessable income;
- an outsider to the trust directly or indirectly provides a benefit (also widely cast – can be money, property or anything else of benefit set out in section 270-20 – which may be but need not be the scheme assessable income) to the trustee of the trust, a beneficiary of the trust or an associate of either of them; and
- the trustee of the trust, a beneficiary of the trust or either of them provides a benefit to the outsider to the trust or an associate wholly or partly, but not incidentally, because the deduction is allowable to the trust.
Context of the IIT
With this broad formula the IIT in the tax trust loss measures of Schedule 2F can be contrasted to the business continuity test that applies to company tax losses under Division 165 of the ITAA 1997. An injection by, viz. a benefit from, an outsider to the trust or an associate that can produce income in the trust, against which unrelated tax losses might otherwise have been deducted, gives rise to scheme assessable income against which tax losses cannot be deducted.
When the IIT applies – outsiders
So let us say:
- a private company with profits and a family discretionary trust (FDT) with tax losses but no current income producing activity of its own are controlled by a family;
- the FDT owns shares in the company; and
- the company pays dividends to the FDT.
A clear distinction between a FDT and a 2FFT needs to be understood. Schedule 2F refers to a “family trust”, i.e. a 2FFT, as a trust that has made a family trust election (FTE). A 2FFT in comparison can be a FDT, a fixed trust or a unit trust that has lodged a FTE which is in force. A FDT can be called a family trust in common parlance but a FDT will be a non-fixed trust under Schedule 2F; that is, not a Schedule 2F “family trust” until it lodges a FTE to become a 2FFT.
At least initially (see below), the company in my example is an outsider to the trust. There the benefit to the trust of the dividends is the scheme assessable income. The benefit to the company and its associates viz. the family, is that income tax isn’t payable on the dividends to the extent tax losses of the trust can be deducted against assessable income of the trust and the parties can’t disprove that this tax advantage of declaring dividends to the FDT shareholder was more than incidental.
How a family trust election can modify how the income injection test is applied
To avoid losses to the extent of so imputed scheme assessable income being denied to the trust under the IIT:
- the trustee of the trust can make a FTE and become a 2FFT, and;
- the company can make an interposed entity election (IEE).
The FTE would need to cover the period, in the case of carry forward tax losses of the trust, from when the losses were incurred by the FDT/2FFT to when they are sought to be deducted against assessable income (for tax) by the FDT/2FFT.
Companies and trusts that have a FTE or an IEE in place are excluded from being outsiders to the trust. The IIT is then an IIT of modified operation which can still be failed but the IIT will now only fail where benefits flow from and to a now reduced, less pervasive, range of outsiders to the trust. but is not failed when the flow is between 2FFTs. interposed entities and individual family members that are taken to be a part of the family group under Schedule 2F: see sub-section 270-25(1) of Schedule 2F.
Downside of a family trust election
Where a company, trust of partnership (Entity) meets the family control test viz. the Entity is controlled by the family group viz. a family, and is so eligible to become a part of a family group by way of a FTE or an IEE then the prospect of family trust distributions tax (FTDT), which is distinct from trust income tax and only applies to 2FFTs, needs to be considered.
Once an Entity lodges a FTE or an IEE then distributions by the Entity outside of the family group of the individual specified in the FTE or IEE, as the case may be, are caught by FTDT at the highest marginal income tax rate.
A FTE or an IEE is a de facto limitation by way of tax penalty on beneficiaries to whom income and capital of a 2FFT can be distributed.
Upside of a family trust election
A FTE can be lodged by a trust with commencement from when or before its prior year trust losses were incurred so the modified IIT can apply from that time to prevent scheme assessable income arising. That is so, so long as the commencement date of the trust as a 2FFT is no earlier than 1 July 2004. This is sometimes known or understood as “backdating” but that, like the use of the term “family trust” itself in Schedule 2F, is a misnomer and selecting a past commencement date for a 2FFT is lawful and allowed under Schedule 2F.
So long as a 2FFT can keep its distributions within the family group and so avoid FTDT, lodging a FTE or an IEE will be dually beneficial to the parties and the beneficiaries of the 2FFT to whom the franked dividends are on-distributed in my example once tax losses of the 2FFT are exhausted and the 2FFT has (positive) trust income as:
- current and prior year losses can be offset by the trustee of the 2FFT against the dividends which are assessable income when received by the 2FFT where a FTE is in effect over the required periods and an IEE is in effect for the company so the company is within the family group; and
- the 2FFT can meet the holding period rule and beneficiaries of the 2FFT to whom the franked dividends received by the 2FFT are distributed, after losses have been so offset, can then use franking credits on the dividends: see section 207-145(1)(a) of the ITAA 1997 and under the heading THE HOLDING PERIOD RULES REGULATING ACCESS TO FRANKING CREDITS at Family trusts – concessions | Australian Taxation Office https://is.gd/Nck0zS.
Reasons to be a 2FFT
The Australian Taxation Office at Family trusts – concessions https://is.gd/Nck0zS: lists five main “reasons” (actually imperatives for accessing tax concessions) why a trustee of a trust may want to make a FTE and become a 2FFT:
- accessing trust tax losses to deduct them against trust assessable income;
- to trace eligibility for company losses through a trust;
- access of beneficiaries of a trust to franking credits under the holding period rules;
- relief from the trustee beneficiary reporting rules; and
- access to the small business restructure rollover in Sub-division 328-G of the ITAA 1997.
Schedule 2F doesn’t apply to deny capital losses that can be offset against capital gains under section 102-5 of the ITAA 1997.