Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 1 - General Outline
1.1 The Taxation Law Amendment (Trust Loss and Other Deductions) Bill 1997 will insert Schedule 2F, dealing with trust losses, into the ITAA 1936. This Schedule sets out rules that have to be satisfied by trusts before a deduction is allowed for prior year and current year losses and certain debt deductions.
1.2 There are also three complementary Bills. Two of these impose a special tax which may become payable under the measures. These are the Family Trust Distribution Tax (Primary Liability) Bill 1997 and the Family Trust Distribution Tax (Secondary Liability) Bill 1997 . The third complementary Bill, the Medicare Levy Consequential Amendment (Trust Loss) Bill 1997 , makes a consequential amendment to the Medicare Levy Act 1986 . Separate Bills are necessary for constitutional reasons.
1.2 The proposed trust loss legislation was presented to the Parliament by the previous Government as part of the Taxation Laws Amendment Bill (No. 4) 1995 . The Government announced in the 1996-97 Budget that it would proceed with the trust loss measures and that the general commencement date would remain as 9 May 1995, the date of the previous Government's announcement in the 1995-96 Budget.
1.3 The Bill is broadly along the same lines as the 1995 Bill. However, a number of significant changes have been made generally to reduce the adverse impact on taxpayers. Many of the changes were made having regard to representations received on the measures including submissions made on an exposure draft of the legislation which was released for public comment on 10 February 1997.
1.4 The purpose of the trust loss measures is to restrict the recoupment of prior year and current year losses and debt deductions of trusts in order to prevent the transfer of the tax benefit of those losses or deductions. The tax benefit of losses is transferred when a person who did not bear the economic loss at the time it was incurred by the trust obtains a benefit from the trust being able to deduct the loss. The measures are intended to prevent a significant leakage of revenue that has resulted from the transfer of the tax benefit of trust losses.
1.5 The measures achieve this aim 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.
1.6 The implementation of this measure involves amending the tax law to insert a new Schedule dealing with trust losses. This Schedule sets out tests that have to be satisfied by trusts before a deduction is allowed for prior year and current year losses and certain debt deductions.
1.7 The measures apply to two broad categories of trusts referred to in the measures as fixed trusts and non-fixed trusts. Non-fixed trusts include discretionary trusts.
1.8 There are different kinds of fixed trust. These are ordinary fixed trusts and several kinds of widely held unit trust. These are unlisted widely held trusts, listed widely held trusts, unlisted very widely held trusts and wholesale widely held trusts.
1.9 There are also excepted trusts. These are family trusts, some superannuation funds, deceased estates within a reasonable administration period and unit trusts with unit holders that are exempt from income tax.
1.10 The tests apply to two different types of arrangement under which the tax benefit of trust losses can be transferred, i.e. through change in ownership or control or income injection schemes.
1.11 The tests apply so that if certain events occur, a trust:
- may be prevented from deducting its tax losses of earlier income years; and
- may have to work out in a special way its net income and tax loss; and
- may be prevented from deducting certain amounts in respect of debts (e.g. bad debts) incurred in the income year or earlier income years.
1.12 For fixed trusts, these consequences will flow if there is not continuity of majority beneficial ownership of the trust. Generally, the 50% stake test applies to determine this. Ordinary fixed trusts have to test ownership continuously. However, widely held unit trusts only have to test ownership when there is abnormal trading in their units or, in some cases, when an income year ends. Listed widely held trusts can avoid these consequences if they pass the same business test.
1.13 Widely held unit trusts with a large number of unit holders could face difficulties in testing for changes in ownership. A special rule is provided for widely held unit trusts so that the ownership test will be passed where it is reasonable to assume that the requirements have been met.
1.14 For non-fixed trusts, the consequences in paragraph 1.11 will follow if there is not continuity of majority beneficial ownership of the trust (50% stake test) or if control of the trust changes. In some cases, the consequences will also result if there is a 50% or greater change in the pattern of distributions of the income or capital of the trust.
1.15 The tests do not apply to excepted trusts, including family trusts.
1.16 In testing for ownership under the 50% stake test, interests in a loss trust must be traced through to individuals. Interests may be held directly by individuals or indirectly through an interposed company, trust or partnership.
1.17 In some cases it may be difficult to trace interests through to individuals. Special tracing rules exist in certain circumstances to overcome difficulties caused by the nature of the interests held or because of the practical difficulties in tracing through certain types of entities. For example, a special tracing rule exists where interests are held by certain complying superannuation funds. The interests are treated as being held by an individual for its own benefit. A similar concessional rule applies where an interest is held by a family trust.
1.18 An ordinary fixed trust in which the interests are held 50% or more by non-fixed trusts will not be able to satisfy the 50% stake test. This is because individuals do not own anything which is capable of being taken into account in applying the 50% stake test. A special rule applies which will allow the losses of the fixed trust to be deducted provided that certain conditions are satisfied. This includes the necessity for all the non-fixed trusts that hold interests in the fixed trust to satisfy the tests that apply to non-fixed trusts if they stood in place of the loss trust.
1.19 If a trust is involved in an income injection scheme to take advantage of deductions it may be prevented from making full use of them under the income injection test. Under these schemes, income is injected into trusts with losses or other deductions so that no tax is payable on the income.
1.20 The income injection test will only apply where an 'outsider' to the loss trust seeks to take advantage of the deduction. In general terms, the outsider must provide a benefit to the trust and a return benefit must be given to the outsider. Also, either of the benefits, or the income injected under the scheme, must have been provided or derived wholly or partly, but not merely incidentally, because of the deduction.
1.21 This test does not apply to excepted trusts other than family trusts. However, in the case of family trusts, members of the family or other entities in the family group can inject income into the family trust to take advantage of its losses.
1.22 Asset out above, family trusts are subject to concessional treatment and most of the trust loss provisions do not apply to them. Changes in ownership or control of a family trust do not have the consequences explained above provided the trust is a family trust at all the relevant times. However, the rules dealing with income injection schemes do apply to family trusts where persons outside the family group inject income.
1.23 A trust becomes a family trust for the purposes of the measures if it makes a family trust election. A consequence of making the election is that a special tax, called family trust distribution tax, is payable where a family trust gives income or capital to persons who are not members of the family group. This tax is levied at the top marginal rate applying to individuals, plus Medicare levy.
1.24 The family group for the purposes of the family trust rules includes companies, partnerships and trusts that have made an interposed entity election. A consequence of making an interposed entity election is that family trust distribution tax is payable where the interposed entity gives income or capital to persons who are not members of the family group.
1.25 In the case of a family trust that is a fixed trust the family trust election can be revoked provided that certain conditions are met. In the case of a fixed trust, company or partnership it is not necessary to make an interposed entity election where family members have fixed interests to all the income and capital of the entity.
1.26 The family trust distribution tax ensures that the tax benefit of losses of a family trust cannot be transferred to non-family members. This is necessary because, as discussed above, a family trust does not need to meet the tests relating to changes in ownership or control or, in many cases, the income injection test.
1.27 Special rules apply to ensure that the trust loss measures cannot be avoided where non-resident entities are concerned. For example, if a non-resident entity elects to be a family trust, the Commissioner will need to know whether the trust is meeting the distribution requirements for family trusts. The Commissioner is provided with information-gathering powers to enable the collection of information about certain non-resident entities. These provisions need only be considered by resident entities who are relevantly connected to non-resident entities.
1.28 It may be difficult to collect family trust distribution tax that is payable by non-resident entities. The Commissioner is able to collect the tax payable from connected resident entities where it is not paid after a certain period.
1.29 Subject to certain transitional arrangements, the proposed measures will apply to transfers of the tax benefit of trust lossesfrom 7.30 pm Eastern Standard Time (EST) on 9May 1995. The debt deduction provisions will apply to transfers of the benefit of bad debt and other relevant deductions from 7.30 pm EST on 20 August 1996. The narrower definition of family members will apply from 7.30 pm EST on 13 May 1997. An amendment to section 160AFD of the Act to prevent the transfer of the tax benefit of quarantined foreign losses applies from the date of introduction of the legislation into Parliament.
1.30 Certain arrangements have been included to alleviate the impact of the measures in the transitional period. The transitional rules include the following:
- rules which allow a trust to convert to a family trust as well as special rules about making family trust or interposed entity elections in the transitional period;
- rules that apply to joint venture fixed trust arrangements that are in existence on or before the 1996-97 Budget time so that they will not unreasonably be affected by the 50% stake test where one of the parties sells their interests to the other or a third party.
1.31 Persons who use trusts to operate businesses or to carry on investment activities will be impacted by the proposed amendments.
1.32 The trusts that will be affected are those which have deductions including prior year losses. In the 1995-96 income year the number of trusts that lodged tax returns as at 7 July 1997 totalled 372,449. The return data shows that these trusts operate across all industry sectors. The number of trusts with prior year losses in the income year 1995-1996 from primary production income was 5,636 and 49,166 from non-primary production income. The total amount of prior year losses returned was $5,160 million.
1.33 Types of trusts that will not be required to apply the tests are excepted trusts.
1.34 The measures will impact on the ATO which will administer the measures.
1.35 There will be costs of compliance for trusts in monitoring the ownership of trust interests to ensure that the continuity of ownership test is satisfied. Before a fixed trust (including widely held unit trusts) can deduct a loss or deduction it may be necessary for the trust to apply the 50% stake test and, in the case of non-fixed trusts, to apply the pattern of distributions test or 50% stake test for changes in ownership.
1.36 In the case of fixed trusts the following rules will have the effect of reducing these costs:
- the special tracing rules as outlined in paragraph 1.17;
- for widely held unit trusts the concessional rules as outlined in paragraphs 1.12 and 1.13;
- the availability of the same business test to listed widely held unit trusts.
1.37 In determining whether a fixed trust held 50% or more by non-fixed trusts is able to meet the test outlined in paragraph 1.18 there will be costs for the fixed trust in monitoring whether the non-fixed trusts pass the tests that apply to non-fixed trusts.
1.38 There will be some compliance costs during the transitional period for family trusts in lodging a family trust election and also for those entities that need to make an interposed entity election to be included in the family group. These costs will be minimal.
1.39 Apart from some initial compliance costs which will be minimal, a family trust that distributes only to members of the family group will generally not be affected by the measures.
1.40 Resident entities will incur compliance costs if the Commissioner seeks to obtain certain information from them about relevantly connected non-resident entities (see paragraph 1.27).
1.41 There may be administrative costs on the ATO on the collection and recovery of the family trust distribution tax. However, the tax will only apply if trusts and relevant interposed entities fail to abide by the election they have made. It is hoped that the tax will never need to be collected.
1.42 The costs to the ATO in administering the trust loss measures may involve making amendments to tax returns.
1.43 It is estimated overall that the administrative costs to the ATO will be small.
1.44 The initial estimated cost of taxpayer compliance with the measures is $9m and the recurrent costs are $1.5m.
1.45 The proposed measures will prevent a significant erosion of the tax base that would otherwise arise from the transfer of the benefit of trust losses. The gain to revenue is estimated to be:
1.46 The trust loss measures are intended to prevent leakage of revenue that was occurring through the transfer of the tax benefit of trust losses. There are no provisions in the income tax law similar to those which apply to companies which effectively regulate the deductibility of trust losses against current and future income.
1.47 These measures deal with what is considered to be an anomaly in the current treatment of trusts and will improve the efficiency and equity of the taxation system.
1.48 After introduction into Parliament of the previous Government's trust losses legislation in September 1995, consultations with tax professional and industry bodies occurred at officer level. These consultations were taken into account before the Government announced in the 1996-97 Budget that it would proceed with the measures.
1.49 The proposed trust loss legislation was subsequently issued as an exposure draft for public comment on 10 February 1997. A large number of submissions were received from industry and professional bodies, and individual tax professionals and taxpayers. Submissions received during the consultation period were considered in the course of finalising the legislation. The Government has responded to those submissions by making certain changes to the proposed measures.
1.50 Most significantly:
- the measures will now allow income injection schemes within a defined family group;
- family trust elections made by fixed trusts can be revoked when the trust is disposed of;
- fixed interest interposed entities that are wholly owned by the family do not need to make an interposed entity election to be included as part of the family group; and
- 100% owned subtrusts of widely held unit trusts will be treated in the same way as their parent trusts.
1.51 The trust loss measures improve the equity and efficiency of the taxation system and will prevent the transfer of the tax benefit of trust losses. While the measures will impose some compliance costs on taxpayers, this is outweighed by the benefits of improving the integrity, equity and efficiency of the taxation system.
1.52 The ATO and Treasury will monitor this taxation measure on a continuing basis. The ATO's existing consultative arrangements include the National Tax Liaison Group.
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