Edited version of private ruling

Authorisation Number: 1011709921438

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Ruling

Subject: Application of trust loss measures to trust distribution received by Trust 2 from the Trust 1

Question

Do the trust loss measures apply to any distributions made from Trust 1 to Trust 2?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commences on:

1 July 2009

Relevant facts and circumstances

Trust 1 has net income to distribute to its beneficiaries.

Trust 2 has tax losses available from previous years.

Trust 2 was established on during a previous income year. The principal's parents were the trustees at that time. A business was operated by this trust up until a later income year, when it was closed as it was making losses. These losses are still available as a deduction within that entity.

Income tax returns were lodged by Trust 2 up to and including the some time ago.

Trust 2 has been inactive since that time.

The only known asset of Trust 2 since the business closed is the $10.00 settlement sum.

Trust 1 was established during a previous income year by the principal. The trustee is the company, which is controlled by the principal

Trust 1 holds shares and several investment properties.

Trust 2 completed a family trust election in a previous income year, but the specified year is a previous income year. No specific start date was provided on the election lodged. When this election was made, the principal's father was listed as the test individual.

There is no record of the test individual being adjusted from the principal's relative.

At the time of the preparation of the ruling, there is no family trust election in existence for Trust 1.

The second recommendation of the legal advice is that the principal's parents relinquish all control over the two trusts.

In relation to Trust 2, the principal's parents have been trustees since virtually the commencement of that trust. The principal has been a trustee for about ten years.

A resolution of trustees showing that the principal's parents have retired as trustees of Trust 2 is attached. This leaves the principal as the trustee of the Trust 2.

A deed of retirement of trustee has also been prepared relating to the retirement of the principal's parents from Trust 2. This deed was dated and stamped during a recent income year.

A deed of renunciation has been prepared relating to the renunciation of all interest in Trust 1 by the principal's parents. This deed is dated and stamped during a recent income year.

A copy of the trust deed for Trust 2 has been attached.

A copy of the trust deed for Trust 1 has been attached.

The principal has advised that there are no interposed entity elections lodged for either Trust 2 or Trust 1.

A request for further information was made and the following information was obtained.

There have been no distributions of capital or income for the period after the 1996-97 income year when the business ceased. There was some uncertainty whether about prior years, but there are doubts that any of these prior years resulted in a distribution been made for the relevant period.

The trustee of Trust 1 was asked whether the distribution to the Trust 2 would be made as a cash distribution, or as a form of unpaid present entitlement. The answer was that it would be paid in cash at the time of the distribution.

Reasons for decision

Summary

The income injection test within the trust loss provisions will not apply to any distributions made from Trust 1 to Trust 2.

This means that Trust 2 would be able to deduct its prior year losses against the distribution received from Trust 1, provided that Trust 2 is a valid beneficiary of the Trust 1, is presently entitled to a share of the net income of that trust, and all income tax returns for Trust 2 are lodged with the ATO for all of the years of income between the year where the prior year loss was incurred, and the year in which the prior loss will commence to be claimed.

Detailed reasoning

Schedule 2F of the Income Tax Assessment Act 1936 (ITAA 1936) sets out the rules relating to the application of the trust loss measures.

Section 272-80 of Schedule 2F of the ITAA 1936 sets out the requirements for family trust elections.

Section 272-85 of Schedule 2F of the ITAA 1936 sets out the requirements for interposed entity elections.

Section 267-20 of Schedule 2F of the ITAA 1936 denies the deduction of a tax loss in a non-fixed trust unless all of the required conditions have been satisfied.

Section 272-100 of Schedule 2F of the ITAA 1936 defines an excepted trust to include a family trust for the purposes of this schedule, a complying superannuation fund, a deceased estate within 5 years of death, and some unit trusts.

Section 270-10 of Schedule 2F of the ITAA 1936 outlines the income injection test to apply where the trust derives assessable income or a benefit from an outsider to the trust. This test does not apply to some excepted trusts.

Section 270-25 of Schedule 2F of the ITAA 1936 defines an outsider to be any person or entity other than those listed in the section.

In this case, Trust 2 has unused prior year losses from the 1996-97 and earlier years. Trust 1 does not have any unused tax losses. Therefore this ruling will concentrate on the application of the trust loss measures to Trust 2 only.

The first issue is the existence of the trust. Trust 2 has been dormant since a previous income year, but is still within the original vesting date several years after its creation during a previous income year. There is no evidence to show that the trust has vested early.

The basic requirements of a trust are a trustee (there were up to three during this dormant period), who holds asset(s) on behalf of beneficiaries (there are still beneficiaries alive). The facts of the ruling request indicate that there is at least one trust asset, as the original $10.00 is still with the original trust deed according to the applicant. Therefore it can be concluded that whilst Trust 2 has been dormant since a previous income year, it still exists as an entity as all of these requirements have been passed.

The second issue is the lodgement of income tax returns. No income tax returns have been lodged after a previous income year as the trust did not trade. However, in order to be able to utilise the earlier year tax losses, all of these intervening income tax returns will need to be lodged with the ATO before the losses could be made available. The need to prepare these income tax returns should not be a serious problem, as the facts indicate that the trust did not trade during this period.

The third issue is the family trust election. Trust 2 originally lodged a family trust election that applied from a previous income year. This election has not been revoked since then. The original test individual was the principal's father, and he is still the test individual.

Sub-section 272-80(5A) of Schedule 2F of the ITAA 1936 allows a variation to the test individual subject to some conditions being satisfied. The replacement test individual must have been a member of the family group of the previous test individual. As the replacement test individual is the son of the test individual, this condition would be satisfied, as he is a member of the family group. The next condition is that distributions of income or capital must only have been made to members of both family groups. As no distributions of income or capital have been made during this time, as the trust did not trade or hold any significant assets, then this requirement has been passed.

The last requirement is a time limit. According to sub-section 272-80(6B) of schedule 2F of the ITAA 1936, variations to the family trust election, (including to the test individual), can only be made during either of these two periods:

· starting at the beginning of the year specified in the election, and ceasing at the end of the fourth year after the income year specified in the election, or

· starting at the beginning of the income year that the sub-section commenced operation, and ceasing at the end of the subsequent income year.

The first time limit applies from 1 July 1998 to 30 June 2003, so this period has now lapsed. The section commenced operating on 24 September 2007, so the second time limit is from 1 July 1997 to 30 June 2009, and this period has also lapsed.

Therefore, as both time limits have now lapsed, there is no provision available to change the test individual of Trust 2. The legislation does not allow for any extensions of time to lodge any variations to family trust elections. This means that the principal's relative is currently the test individual and he will remain the test individual as the legislation does not allow the test individual to be changed after 30 June 2009 in this case.

The definition of excepted trust as outlined in section 272-100 of Schedule 2F of the ITAA 1936 is as follows:

(a) a family trust for the purposes of this schedule,

(b) a complying superannuation fund or complying approved deposit fund,

(c) a deceased estate within the first five years of death,

(d) a unit trust with exempt entities holding 100% of the income and capital of the trust.

In this case, Trust 2 will pass paragraph (a) of section 272-100 of Schedule 2F of the ITAA 1936 as it has a valid family trust election. It will not pass any of the other paragraphs.

As Trust 2 is a family trust for the purposes of Schedule 2F of the ITAA 1936, then this means that there is only one trust loss test that needs to be satisfied. This is the income injection test. All of the other tests are either deemed satisfied or are not applicable to trusts that have a valid family trust election.

The income injection test, outlined in section 270-10 of Schedule 2F of the ITAA 1936, prevents the trust from claiming an otherwise allowable deduction if the trust derives assessable income during the year, and the trust receives a benefit from an outsider, and the trustee or a beneficiary provides a benefit to the outsider or an associate of an outsider, and it is reasonable to conclude that the assessable income was derived wholly or partly due to the existence of the allowable deduction.

There is one exception to this test being triggered. If the trust is an excepted trust under paragraphs 272-100(b), (c), or (d) of Schedule 2F of the ITAA 1936, then this test will not apply. Trust 2 is an excepted trust under paragraph 270-100(a) of Schedule 2F of the ITAA 1936 only. Therefore this exception to the application of the income injection test will not apply.

Therefore, going back to section 270-10 of Schedule 2F of the ITAA 1936, there are a few steps to be considered.

Note that, 'family' is defined in section 272-95 of Schedule 2F of the ITAA 1936 to include a parent, grandparent, brother, or sister of the test individual or their spouse. Also included in the definition are children, nephews or nieces of the test individual or their spouse, and any lineal descendants of these people.

The first one is whether there is an outsider involved. Section 270-25 of Schedule 2F of the ITAA 1936 defines an outsider to be any person or entity other than:

· the trustee of the trust,

· a person with a fixed entitlement to income or capital of the trust,

· the test individual,

· any member of the test individual's family,

· a trust with the same test individual specified in its family trust election, or

· any company, trust or partnership that has an interposed entity election with the trust which was in force when the scheme commenced.

The source of assessable income under review in this ruling is an assessable trust distribution from Trust 1. Trust 1 is not the trustee or an individual person, so the first four parts of the definition do not apply. This leaves the last two parts to consider.

Trust 1 does not have a family trust election currently lodged with the ATO, so the fifth part of the definition, (a trust with the same test individual), cannot apply.

Trust 1 does not have an interposed entity election with Trust 2 lodged with the ATO, so the sixth part of the definition cannot apply.

Consequently, Trust 1 is considered to be an outsider to Trust 2. This means that the requirements of section 270-10 of Schedule 2F of the ITAA 1936 must be considered.

The first requirement is that what is being considered is a scheme. A scheme is defined to be any arrangement, or any plan, proposal, action, course of action, or course of conduct. This means that the definition of scheme is very wide, so the intention of the applicant to distribute a share of the net income of Trust 1 to Trust 2 in future years would come within that definition, so there is a scheme for the purposes of the section.

The second requirement is that the scheme must result in the thrust deriving some assessable income. The application of the scheme would result in a trust distribution from Trust 1 being included as part of the assessable income of Trust 2 under section 97 of the ITAA 1936, as it would be a beneficiary presently entitled to a share of the net income of Trust 1. Therefore this requirement has been satisfied.

The third requirement is that the outsider directly or indirectly provides a benefit to the trustee, a beneficiary, or an associate. Benefit is defined to be money, a dividend, property (tangible or intangible), a right, an entitlement, a service, the extinguishment of a debt (including by forgiveness, waiver, or release), or the doing of anything that results in the derivation of assessable income, or anything not already listed that is a benefit or advantage.

This is a very wide definition, so the present entitlement to the trust distribution (whether paid or unpaid) would mean that the outsider has provided a benefit to the trust.

The fourth requirement is that the trustee, a beneficiary, or an associate of them provides a benefit to the outsider of the trust or any of its associates.

Associate of a trust is defined to include any entity that benefits from the trust, and if that list includes any natural persons, then all of their relatives, partnerships, trusts from which the natural persons benefit, and companies controlled by the natural persons. Relatives of a natural person include their spouse, or parent, grandparent, brother, sister, uncle, aunt, nephew, niece, or lineal descendants (included adopted children) of the natural person or their spouse. The spouse of any of the people listed is also included as a relative.

There is one exception to that requirement. The associates of the outsider can not be members of the family group of the first trust as well.

In this case, Trust 1 itself does not receive a benefit as there is no change to its circumstances before the scheme took place, or after the scheme was completed. If Trust 1 was able to retain the funds in the form of an unpaid present entitlement, then it would have received a benefit. However, the facts indicate that any monies distributed from Trust 1 to Trust 2 would actually be paid to the beneficiary. Therefore there would be no benefit to Trust 1 as it does not keep the distribution as an unpaid present entitlement.

The most likely person to benefit would be the principal (or possibly a family member), as, if the scheme did not exist, that person would be the presently entitled beneficiary of Trust 1, who then would have paid income tax on the distribution, but after the scheme is completed, they are no longer the presently entitled beneficiary of the trust.

As the principal is the trustee of the Trust 2, he (or possibly a family member) would have access to the same funds from Trust 1 after they were distributed to Trust 2, as they would be able to be distributed out to him (or a family member) as corpus. However, income tax would not be payable as Trust 2 is utilising its prior year losses and so is not paying any income tax on the distribution, so the entire trust distribution is now available to the person, as opposed to only the after tax amount of the trust distribution previously available. Therefore the principal (or possibly a family member) would be receiving an overall benefit by not paying the income tax he or she previously paid, but the person still has indirect access to the distributed funds from Trust 1.

However, the principal is a beneficiary of both trusts, and so is associated with both trusts. Therefore, he cannot be an outsider to Trust 2, so the income injection test cannot apply to any benefit that has been conferred upon him as a result of the operation of the scheme. The same would apply to any other person who is part of the family group set by the family trust election lodged by Trust 2.

The result is that the income injection test does not apply to Trust 2 as the requirements of section 270-10 of schedule 2F of the ITAA 1936 have not been satisfied in relation to the scheme as outlined in the ruling request.

This means that Trust 2 would be able to deduct its prior year losses against the distribution received from Trust 1, provided that Trust 2 is a valid beneficiary of Trust 1, is presently entitled to a share of the net income of that trust, and all income tax returns for Trust 2 are lodged with the ATO for all of the years of income between the year where the prior year loss was incurred, and the year in which the prior loss will commence to be claimed.