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TAX IN PRACTICE

TRUST LOSSES

JANUARY 2012

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Trust Losses 1.2

Page i

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!


Trust Losses 1.2

Page 1

INTRODUCTION

The trust loss provisions were introduced in April 1998, generally with effect from

9 May 1995. The trust loss provisions are contained in Schedule 2F of the ITAA 1936.

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 trusts1.

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


Trust Losses 1.2

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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.


Trust Losses 1.2

Page 3

Definition of trust type

Trust type Definition

Fixed trust A trust where persons have fixed entitlements to all the income and capital

of the trust (s 272-65).

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 272-70).

Family trust A trust that has made the election to be a family trust for the purposes of

the trust loss measures (s 272-75).

Excepted trust 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 272-100)

There are a number of tests that may be applicable depending on the type of trust.

These are outlined in the table below.


Trust Losses 1.2

Page 4

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.


Trust Losses 1.2

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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 269-55)

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 272-20).


Trust Losses 1.2

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Tracing Rules

Interposed

entity

Tracing rule Section

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

Company

Total distribution

272-10

Partnership 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.

272-15

Fixed trust A beneficiary that has a vested and indefeasible interest in a

share of income or capital of the trust holds a fixed entitlement.

272-5

Complying

superannuation

fund

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.

272-25

Family trust Fixed entitlement is deemed to be held by an individual. 272-30

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 266-45).


Trust Losses 1.2

Page 7

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 267-40). 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.


Trust Losses 1.2

Page 8

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 267-30)

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.


Trust Losses 1.2

Page 9

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 269-65)

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 269-70).

Prior year pattern of distribution test

Section 267-35 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.


Trust Losses 1.2

Page 10

CONTROL TEST

The control test provides that a group must not, during the test period, begin to

control the trust directly or indirectly (s 267-45).

A group is:

• a person;

• a person and one or more associates2; or

• two or more associates of a person.

(Section 269-95(5))

SECTION 269-95(1) CONTROL A NON-FIXED TRUST

A group controls a non-fixed trust if:

(a) 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

(b) the group is able (directly or indirectly) to control the application of the capital or income

of the trust; or

(c) the group is capable, under a scheme, of gaining the beneficial enjoyment in paragraph

(a) or the control in paragraph (b); or

(d) 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

(e) the group is able to remove or appoint the trustee; or

(f) 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


Trust Losses 1.2

Page 11

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 270-10(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 270-10(2)).


Trust Losses 1.2

Page 12

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 270-20)

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 270-25(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 270-25(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.


Trust Losses 1.2

Page 13

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 test3:

3 Taken from Chapter 10


Trust Losses 1.2

Page 14

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.


Trust Losses 1.2

Page 15

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:


Trust Losses 1.2

Page 16

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.


Trust Losses 1.2

Page 17

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 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.

Yes

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.

Yes

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.

Yes

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.

Yes

Accordingly the alternative 50 percent stake test is passed by the Alpha Unit Trust.


Trust Losses 1.2

Page 18

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:

2005 2006 2007 2008

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).


Trust Losses 1.2

Page 19

Given the Tango Discretionary Trust distributes different percentages of income in

each of the test years, the rule in s 269-70 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

2006 2008

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.


Trust Losses 1.2

Page 20

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.


Trust Losses 1.2

Page 21

Will the income injection test apply to deny the carry forward loss deduction?

Application of the income injection test

1. Under a scheme:

Did the trust derive an amount of

assessable income?

Yes. A trust distribution is 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?

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.)

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?

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.

2. Is it reasonable to conclude that:

• the trust derived the

scheme assessable

income;

• 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?

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.

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.

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