House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 6 - Fixed trusts

Overview of fixed trust rules

6.1 Division 266 sets out the circumstances in which a fixed trust will not be able to deduct a prior year loss or debt deduction or will have to calculate its net income and tax loss for the current year in a special way.

6.2 The way in which the rules apply depends on the kind of fixed trust being considered. There are five kinds of fixed trust for the purposes of the legislation, as follows:

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fixed trusts other than widely held unit trusts (ordinary fixed trusts);

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unlisted widely held trusts;

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listed widely held trusts;

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unlisted very widely held trusts; and

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wholesale widely held trusts.

6.3 The characteristics of each of these kinds of trust is described in broad terms in Table 6.1.

6.4 A more detailed discussion of the definitions of each kind of widely held unit trust is contained in Chapter 13.

6.5 A family trust (a type of 'excepted trust') that is also a fixed trust will not be affected in any way by the tests in Division 266. The rules in Division 266 will not, therefore, prevent a family trust from deducting prior or current year losses or debt deductions. Also, other excepted trusts (as defined - see paragraphs 13.71 to 13.74) are not affected by Division 266.

6.6 At the heart of the tests for determining whether fixed trusts can deduct losses, etc. is whether there is a significant change in those individuals who have direct or indirect fixed entitlements in the trust. Fixed entitlements are readily quantifiable and will give an accurate picture of those who will receive income or capital of the trust. This in turn will be a reliable indicator of whether there has been a change in the individuals who can benefit from the losses and other deductions of a fixed trust. Indirect fixed entitlements can only be traced through fixed entitlements in interposed entities.

What is a fixed trust?

6.7 A fixed trust is a trust where all of the income and capital of the trust is the subject of fixed entitlements held by persons [section 272-65] . Thus, for example, where some part of the income or capital of a trust may be distributed at the discretion of the trustee or another person, the trust is not a fixed trust. ^[F6]

6.8 A fixed entitlement to income or capital of a trust is a vested and indefeasible interest in the income or capital (see paragraphs 13.3 to 13.13). A person includes a natural person, a company, a trustee or the partners in a partnership.

When can't a fixed trust deduct a tax loss of an earlier income year?

6.9 The Bill sets out rules to determine when a fixed trust (including the different kinds of widely held unit trust) cannot deduct a prior year tax loss. The following flow charts outline, in broad terms, when each of the different kinds of fixed trust cannot deduct a prior year loss.

When do the prior year loss rules for fixed trusts have to be applied?

6.10 As set out in the above flow charts, a fixed trust is affected by the proposed rules, as they relate to prior year losses, if:

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in the income year it has a tax loss from an earlier income year that is, ignoring the rules in the Bill, deductible;

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it was a fixed trust of the relevant kind or kinds at all times in the test period ;

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it was not an excepted trust at all times in the test period. [Subsections 266-25(1), 266-75(1) and (2), 266-110(1) and 266-150(2)]

What is the test period for prior year loss purposes?

6.11 The test period is made up of the income year in which the tax loss was incurred, the income year being examined and all intervening income years [subsections 266-25(1), 266-75(1) and (2), 266-110(1) and 266-150(2)] . For example, a fixed trust incurs a loss in Year 1. In Year 3 it seeks to recoup that loss. The test period in this case is Year 1 (the loss year), Year 3 (the current income year) and Year 2 (the intervening income year).

6.12 The test period for an unlisted very widely held trust is different to what is described above in that it excludes any start-up period of the trust (see paragraphs 13.84 to 13.86 for the meaning of a start-up period). Thus, for unlisted very widely held trusts, the test period is so much of the period beginning at the end of the start-up period and ending at the end of the income year. [Subsection 266-150(2)]

When can't a fixed trust deduct a prior year loss?

6.13 If the conditions outlined in paragraph 6.10 are met then the fixed trust cannot deduct the prior year tax loss unless it passes the 50% stake test [subsection 266-25(2), 266-75(3), 266-110(2) and 266-150(1); sections 266-40, 266-90, 266-125 and 266-165] . For ordinary fixed trusts and listed widely held trusts, there are also alternative conditions which, if satisfied, will allow the trust to deduct a loss even if the 50% stake test is failed (see paragraphs 6.18 to 6.24 for ordinary fixed trusts and paragraphs 6.25 to 6.30 for listed widely held trusts).

50% stake test

6.14 The 50% stake test is used in determining whether there has been a change in ownership of a trust with fixed entitlements. A trust passes the 50% stake test if:

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the same individuals have fixed entitlements, directly or indirectly, to more than 50% of the income of the trust at the relevant times; and

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the same individuals (not necessarily the same as those that hold fixed entitlements to income) have fixed entitlements, directly or indirectly, to more than 50% of the capital of the trust at the relevant times. [Subsection 269-55(1)]

6.15 Where a widely held unit trust has a large number of direct or indirect unit holders, it may be practically difficult to determine with precision the identity of all individuals that hold fixed entitlements directly or indirectly for the purposes of applying the 50% stake test. A special rule is provided so that in the case of a widely held unit trust, the 50% stake test will be passed where it is reasonable to assume that the requirements of the 50% stake test are met. [Subsection 269-55(2)]

6.16 Table 6.2 shows the relevant times when the necessary stake has to be held for each kind of fixed trust.

6.17 The effect of these requirements is that widely held unit trusts need to test for continuity of ownership only when there is abnormal trading in the trust's units and, in the case of unlisted widely held trusts, at the end of an income year of the trust. Further detail on the 50% stake test is provided at paragraphs 9.22 to 9.33. The meaning of the abnormal trading concept is set out in Division 269 and is discussed below at paragraphs 9.2 to 9.21.

Alternative condition for ordinary fixed trusts held 50% or more by non-fixed trusts

6.18 Where all the fixed entitlements in a fixed trust are held by a non-fixed trust in which there are no fixed entitlements, no individuals will have any fixed entitlement to the income and capital of the fixed trust (see paragraphs 13.28 and 13.29). This is because a person who is merely a potential beneficiary under a non-fixed trust does not have an entitlement to income or capital of the trust and thus does not own anything which is capable of being taken into account in applying the 50% stake test (and correspondingly, does not suffer the economic loss). The 50% stake test would also be failed in circumstances where the fixed trust is wholly owned, directly or indirectly, by another fixed trust or a company which, in turn, is held 50% or more by non-fixed trusts.

6.19 Thus, for example, where the majority of the fixed entitlements in a fixed trust are held by a non-fixed trust in which there are no fixed entitlements (e.g. a discretionary trust), the 50% stake test cannot be satisfied by the fixed trust.

6.20 The effect of this is that, in the absence of any special provision, a fixed trust (not being a family trust) which has losses may lose those losses solely because half or more of the interests in the trust are held directly or indirectly by a non-fixed trust with no or insufficient fixed entitlements. The difficulty does not arise if the non-fixed trust is a family trust. This is because a fixed entitlement held by a family trust is treated as if it were held by an individual (see subsection 272-30(2)).

When can the alternative condition be applied?

6.21 The alternative condition for ordinary fixed trusts may allow such trusts to deduct their losses even though they may not be able to pass the 50% stake test. This condition will apply where individuals do not , directly or indirectly, hold fixed entitlements to more than 50% of the income or capital of that fixed trust [subsection 266-45(4)] and either of the two conditions below are met.

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Fixed entitlements to 50% or more of the income or capital of a fixed trust must be held by a non-fixed trust or trusts (other than family trusts). [Paragraph 266-45(2)(a)]

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Both of the following are satisfied:

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all the fixed entitlements to income and capital of the fixed trust are held, directly or indirectly, by another fixed trust or a company (the holding entity ); and

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a non-fixed trust or trusts (other than family trusts) hold fixed entitlements to a 50% or greater share of the income or capital of the holding entity. [Paragraph 266-45(2)(b)]

When is the alternative condition met?

6.22 There are two requirements that must be satisfied if the alternative condition is to be met, as set out below.

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Where the fixed trust is held directly by the non-fixed trusts, there must be no change in the persons directly holding fixed entitlements to shares of the income or capital of the fixed trust nor the percentage of their shares. Where the fixed trust is held, directly or indirectly, by a holding entity (see paragraph 6.21), this requirement is instead applied to the holding entity rather than the fixed trust. [Subsection 266-45(3)] .

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Every non-fixed trust (that is not a family trust or other excepted trust) that holds fixed entitlements in the fixed trust, directly or indirectly, must satisfy the relevant tests that apply to non-fixed trusts if they stood in place of the loss trust [subsection 266-45(5)] .

6.23 For prior year loss purposes, the loss deductibility tests for non-fixed trusts are a 50% stake test, a control test and a pattern of distributions test. The pattern of distributions test is, however, not applicable for current year loss purposes. The tests that apply for debt deduction purposes depend on whether the debt was incurred in a prior income year or the current income year.

6.24 Where the requirements in paragraph 6.22 are satisfied, the loss can be deducted by the trust.

Alternative condition for listed widely held trusts : same business test

6.25 For listed widely held trusts only, the proposed legislation has a same business test which allows the trust to deduct a prior year loss even if the 50% stake test is not satisfied when there is abnormal trading in the trust. This means the loss is still deductible if such a trust passes the same business test (in relation to the time immediately before the first abnormal trading that results in failure of the 50% stake test) in the part of the test period that occurs after the abnormal trading [paragraph 266-125(2)(b)] . The terms of the same business test are set out in Division 269 and are discussed at paragraphs 9.70 to 9.77.

Example

6.26 A listed widely held trust with a prior year loss fails the 50% stake test after an abnormal trading. However, the trust carries on the same business from the time the 50% stake test is failed until the end of the test period as it carried on immediately before the abnormal trading. The trust also does not derive assessable income from any business or from any transaction which causes the trust to not meet the requirements of subsections 269-100(3), (4) and (5). The trust is, therefore, not prevented by Division 266 from deducting the loss.

Application of same business test to listed widely held trusts where prior year loss made up of debt deduction

6.27 Section 266-135 provides an additional condition for the deduction of a prior year loss by a listed widely held trust, where the loss is wholly or partly made up of a debt deduction. It is applicable where a listed widely held trust has failed the 50% stake test in relation to the debt deduction but has been able to utilise the deduction because the same business test is met. Section 266-135 is the equivalent of section 80F of the ITAA 1936, which applies to companies.

6.28 In the absence of a special safeguarding provision, the 50% stake test and the same business test which applies to listed widely held trusts could be manipulated in relation to debt deductions of a trust. A listed widely held trust which incurs a debt prior to failing the 50% stake test on abnormal trading of units could, for example, postpone changing its business until an income year subsequent to the one in which the debt had been written off as bad (i.e. outside the test period for bad debts). The bad debt could thus be included as the whole or part of a tax loss and be available for deduction in a subsequent year. The debt would not have been disqualified for deduction under the 50% stake test that needs to be satisfied for prior year loss purposes as the change in ownership will have occurred before the start of the test period.

6.29 To be able to deduct the whole or part of a prior year loss deduction created by a debt deduction, section 266-135 requires the listed widely held trust to satisfy the same business test from the time of the failure of the 50% stake test discussed in paragraph 6.27 to the end of the income year in which the loss is to be deducted. This requirement has to be met if the Commissioner considers that the trust satisfied the same business test in the test period that applies for debt deductions so as to secure the debt deduction. The provision effectively disqualifies the debt deduction and thus precludes it from being deducted as the whole or part of a tax loss.

Example

6.30 A listed widely held unit trust which has a debt and has failed the 50% stake test since the debt was incurred writes off the debt as bad in a later year of income. In that later income year the trust postpones entering into transactions that would be of a kind that would cause it to fail the same business test in that year. The trust would not fail the 50% stake test that applies to prior year losses as the change of ownership has occurred before the commencement of the test period for prior year losses, i.e. the beginning of the income year in which the debt is written off. The Commissioner can apply section 266-135 so that the trust is required to satisfy the same business test from the time of the failure of the 50% stake test until the end of the year in which that part of the trust's tax loss that relates to the debt is recouped. This will effectively disallow a deduction for the debt.

When can part of a prior year tax loss be deducted by a fixed trust?

6.31 If a fixed trust (including a widely held unit trust) cannot deduct a prior year tax loss because it does not meet the conditions set out above, then it may still be able to deduct part of the tax loss which is properly attributable to part of the loss year [subsections 266-50(1), 266-95(1), 266-130(1) and 266-170(1)] . This will only apply if the change in ownership that leads to the inability of the trust to deduct the loss occurs in the loss year.

6.32 The trust can only deduct part of the tax loss if, assuming the part of the loss year was a whole loss year, it meets the conditions discussed at paragraphs 6.14 to 6.30. [Subsection 266-50(2), 266-95(2), 266-130(2) and 266-170(2)]

Example

6.33 In Year 1, a fixed trust incurs a tax loss. During that year there is a change in ownership of the trust which results in it failing the 50% stake test. It is thus prevented from carrying forward all the loss. During the period after the change in ownership to the end of Year 2 (the current income year) the trust meets the condition that would allow it to carry forward a tax loss. The trust may deduct the part of the loss that is attributable to the period of the loss year that occurs after the change in ownership.

When does a fixed trust have to work out its net income and tax loss in a special way? (current year losses)

6.34 The Bill also sets out rules to determine when a fixed trust (including the different kinds of widely held unit trust) cannot deduct current year losses. These rules are intended to prevent a person unfairly gaining the benefit of tax losses generated from deductions which are properly attributable to only part of the income year.

When do the current year loss rules for fixed trusts have to be applied?

6.35 A fixed trust is affected by the rules, as they relate to current year losses, if:

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it was a fixed trust of the relevant kind or kinds at all times in the income year being examined (called the test period ); and

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it was not an excepted trust at all times in the test period. [Sections 266-30, 266-80, 266-115 and 266-155]

6.36 In the case of an unlisted very widely held trust, the test period excludes so much of the income year that falls within the start-up period of the trust. [Section 266-155]

When must a fixed trust work out its net income and tax loss in a special way?

6.37 If the conditions outlined in paragraph 6.35 are met then the fixed trust must work out its net income and tax loss in a special way unless it meets the conditions set out in the Bill [sections 266-30, 266-80, 266-115, 266-155] . These conditions are the same as those that apply for prior year loss purposes (refer to the discussion at paragraphs 6.14 to 6.26).

6.38 There is one exception and that is that an unlisted widely held trust only needs to meet the 50% stake test when there is abnormal trading in the trust's units (i.e. the test does not also need to be applied at the end of the income year). This is because the purpose of the current year loss rules is to split the income year up into periods and calculate a net income or tax loss for each period (see Chapter 8). It is therefore not relevant whether there has been a change in underlying majority beneficial ownership at the end of the income year.

When can't a fixed trust deduct a bad debt or deduction in respect of a debt/equity swap? (debt deductions)

6.39 The Bill sets out rules to determine when a fixed trust (including the different kinds of widely held unit trust) cannot deduct a bad debt deduction or a deduction relating to a debt/equity swap under section 63E (called 'debt deductions' in this Explanatory Memorandum). These rules are intended to prevent a person getting the deduction where the person did not economically incur the debt to which the deduction relates. (Bad debts may be deductible under sections 51 or 63 of the ITAA 1936 or sections 8-1 or 25-35 of the ITAA 1997).

When do the debt deduction rules for fixed trusts have to be applied?

6.40 A fixed trust is affected by the rules, as they relate to debt deductions, if:

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in the income year it has, ignoring the rules in the Bill, an allowable bad debt deduction or an allowable deduction under section 63E;

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it was a fixed trust of the relevant kind or kinds at all times during the test period ; and

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it was not an excepted trust at all times in the test period. [Sections 266-35, 266-85, 266-120 and 266-160]

What is the test period for debt deduction purposes?

6.41 The test period for debt deduction purposes depends on when the debt is incurred. If the debt is incurred in a year before the deduction arises, the test period runs from the time the debt is incurred through to the end of the income year in which the deduction is available. If the debt is incurred in the income year in which the deduction arises, the test period is the income year. [Sections 266-35, 266-85, 266-120, 266-160]

6.42 In the case of an unlisted very widely held trust, the test period excludes so much of the period mentioned above that falls within the start up period of the trust. [Section 266-160]

When can't a fixed trust deduct a debt deduction?

6.43 If the conditions outlined in paragraph 6.40 are met then the fixed trust cannot deduct the debt deduction unless it meets the conditions set out in the Bill [sections 266-35, 266-85, 266-120, 266-160] . These conditions are the same as those that apply for prior year loss purposes (refer to the discussion at paragraphs 6.14 to 6.26).