Family trust elections made before year end may be invalid

By Alexis Kokkinos - June 28, 2019

Recent discussions with the Australian Taxation Office confirm that it is the ATO’s view that family trust elections (FTE) and interposed entity elections (IEE) may be invalid where they are made by an entity prior to the end of the income year in the first year it comes into existence (even if all conditions are satisfied after year-end). It is therefore always prudent to ensure that FTEs and IEEs are signed after year-end to avoid a dispute with the ATO on the issue.

If you are a member of a family trust that has needed to make an interim distribution to family members during the 2019 financial year and one or more of those family members have established a new entity to receive the distribution, do not hesitate to contact your Pitcher Partners representative to review these arrangements and determine how the ATO’s views on this election may apply to your own situation.

What are the rules about?

A family trust election or interposed entity election allows entities (companies, trusts and partnerships) to become members of a “family group” so that they may be able to receive distributions from other entities within that group without family trust distribution tax of 47% applying. Further, in the case of FTEs, there are various benefits obtained by making the election including simpler utilisation of prior year tax losses (for the trust itself and any subsidiary trusts or companies), ensuring beneficiaries can utilise franking credits, providing potential access to the small business restructure roll-over provisions and providing an exception to the trustee beneficiary reporting rules.

How are the elections made?

FTEs and IEEs must be made in writing in the approved form. An FTE requires details of the “specified individual” and the year of income from which the election is to be effective. An IEE requires details of the family trust in respect of which the IEE is being made and the year of income from which the election is to be effective. The ATO releases a form for each election following the end of the financial year. At the time of this article, the 2018 income year form is the latest that is available.

What are the requirements for a valid election?

A requirement common to either election is that the entity making the election must pass the family control test at the end of the income year specified in the election. The test broadly requires the specified individual and/or members of that individual’s family to control the trust or have the majority ownership in the case of a partnership or company.

The system of making FTEs and IEEs is essentially one of self-assessment. The ATO portal will record the details of the elections made (e.g. specified individual and specified year) and the entity will be required to record its FTE and IEE status in each subsequent tax return. However, these recorded details say nothing of the validity of the election made.

When can an election be made?

The common practice is for an election to be made with the tax return for the income year that is to be specified in the election. However, an election can be made as far back as the 2005 income year if certain conditions are met, namely that the entity has not made a distribution of income or capital outside of the specified individual’s “family group” since the start of that specified year and passes the family control test at all times in that period.

What is the concern?

There are cases where a family trust may need to make an interim distribution to family members and the family members establish a new entity to receive the distribution. Where different advisors look after different family members, it is often prudent to ensure that a new recipient trust has made a valid FTE. Accordingly, trusts may purport to make an election prior to the year end of 30 June.

While the possibility of retrospectively making FTEs and IEEs is well understood, there are less commonly known issues with entities hoping to make an election as soon as possible, particularly in the year of the entity coming into existence. This is due to the requirement that the entity must pass the family control test at the end of the income year specified in the election.

The ATO view is that this requirement therefore invalidates any election that is made specifying the current income year. For example, the ATO view provided to Pitcher Partners is that an election made in May 2019 specifying the 2019 income year will not be valid as the family control test is not passed at that time as this can only be satisfied at the end of 30 June 2019.

If such an election is made, the election will in all likelihood be recorded on the ATO systems and in the taxpayer’s internal records, but (due to the reasons outlined above) may not be valid. If the family control test is passed on 30 June 2019, the view provided by the ATO is that this will not solve the problem as it will not validate the previously invalid election. The election will need to be made again on or after 1 July 2019.

Therefore, there may be a risk that many taxpayers have made elections on the mistaken assumption that they are valid.

Can an invalid election be rectified? 

The ability to specify an earlier year in an FTE or IEE may assist in rectifying an invalid election. However, the more time that passes, the greater likelihood that the entity may have failed the family control test or distributed outside the family group since the start of the income year specified. In the case of an FTE, if the specified individual has died, it cannot be made specifying that individual even if that individual were alive in the specified income year.

It is noteworthy that a “distribution” for these purposes can involve informal distributions such as a non-commercial loan or the provision of an asset on non-arm’s length terms (e.g. free use of a holiday home to a friend or cousin, aunt or uncle).

While a trust can make an IEE in respect of a valid FTE that had specified that individual, this will only bring the trust making the IEE into the “family group” to alleviate any exposure to family trust distribution tax. An IEE does not offer any of the other benefits that an FTE provides despite imposing the same restrictions on the trust as an FTE.

What actions should be taken?

It is critical to consider if clients may have made elections that were not valid and whether there is scope to make a retrospective application. We note that family trust distribution tax has no period of review and is a self-executing tax that accrues the general interest charge soon after the tax becomes due and payable with directors also possibly jointly and severally liable for the debt where a company or corporate trustee becomes liable.

For trusts that seek to make a family trust election as soon as possible (e.g. where a discretionary trust is established to receive a franked distribution and no other family trusts are appropriate for this purpose), it is critical to ensure that the election is not made prior to 30 June of the income year it comes into existence. Steps can be taken to ensure that the election is made on 1 July when it will first be valid to do so.

There will always be a risk in such a situation that the FTE cannot be made if the proposed specified individual dies prior to that date. It may be possible for the recipient trust to make an FTE specifying a related individual and an IEE in respect of the distributing trust. This creates complexity as the distributing trust (and potentially other entities that will receive distributions from it) may also need to make an IEE in respect of the new recipient trust to be able to receive future distributions from it. This narrows the class of beneficiaries (without triggering family trust distribution tax) to entities that are members of both family groups.

It may therefore be prudent for dormant trusts to be established with valid FTEs in place to prevent these unexpected election outcomes from arising in future years.

Finally, for family groups concerned with the view taken by the ATO, it may be worthwhile conducting a due diligence on all FTEs made and signed by the group to ensure that the documents have been signed post 30 June in the year in which the trust was created.

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