When it comes to family trusts, not all distributions are created equal, particularly with distributions from a family trust to a company whose directors have a certain kind of discretion. The Commissioner of Taxation has signalled that such distributions could trigger the severe family trust distribution tax.
Companies are often the beneficiaries of trusts, for various reasons. The constitutions of companies will frequently provide their directors with a broad discretion to declare and pay dividends on one class of shares to the exclusion of any others which may be on issue. You should be cautioned that distributions from a trust to a company (the directors of which have such discretion) could be subject to family trust distribution tax.
What is an FTE and why make one?
A trust is a ‘family trust’ at any time when a family trust election (FTE) in respect of the trust is in force. Broadly, making an FTE simplifies the rules for the recoupment of tax losses, allows for franking credits (greater than $5,000) to be distributed to beneficiaries, simplifies the rules for the recoupment of company losses by allowing a company (in which the trust is a shareholder) to pass an ownership test, and is used to satisfy the requirements of the small business restructure CGT rollover relief.
However, if the trustee of a trust makes an FTE, it is advisable to ensure that any conferral of a present entitlement or distribution of the trust’s income and capital is made to certain limited individuals/entities (who are defined by reference to a “test individual” and their “family group”). Where such a present entitlement is conferred or a distribution is made to an individual/entity who isn’t a member of the family group, then the trustee is liable to pay family trust distribution tax at 47 per cent on the amount or value of the distribution or present entitlement.
Making an FTE
When making an FTE, the trustee must nominate a test individual whose family group is taken into account for the purposes of the election.
The ‘family group’ of the test individual is defined to include members of the test individual’s “family”, the trust in respect of which the FTE is made, other trusts with the same test individual, entities which have made an election to be a member of the test individual’s family group (an Interposed Entity Election) and entities owned by members of the test individual’s family.
For these purposes, in order that a company can be considered to be “owned” by members of a test individual’s family, the test individual, their family and other trusts with the same test individual must have fixed entitlements (directly or indirectly), and for their own benefit, to all of its income and capital.
“Fixed entitlement” in respect of a share of the income or capital of a company, is defined in section 272-10 of Schedule 2F of the ITAA 1936 to mean that:
(1) If a shareholder in a company holds shares carrying the right to receive some or all of the dividends that may be paid by the company, the shareholder has a fixed entitlement to a share of the income of the company equal to the percentage of the total dividends represented by the dividends that the shareholder has a right to receive.
(2) If a shareholder in a company holds shares carrying the right to receive the whole or part of any distribution of the paid - up share capital of the company in the event of any return of capital to shareholders, the shareholder has a fixed entitlement to a share of the capital of the company equal to the percentage of the total distribution represented by the amount that the shareholder has a right to receive.
Therefore, at any point in time, a shareholder may be regarded as having fixed entitlements to a share of income equal to the percentage of dividends that they have a right to receive, and a fixed entitlement to capital equal to the percentage of the capital they are entitled to receive.
Distributions to corporate beneficiaries of a family trust
As noted above, directors will frequently have a broad discretion to declare and pay dividends on one class of shares to the exclusion of any others which may be on issue. It is of concern that the Commissioner of Taxation (‘the Commissioner’) has expressed the view that distributions from a family trust (ie. one in respect of which an FTE is in force) to a company whose directors have such discretion could result in a liability to family trust distribution tax.
Private Binding Ruling (Authorisation number 1051714149928), issued by the Commissioner in July 2020, concerned a company which had issued different classes of shares with equal capital and discretionary dividend rights. All of the shareholders of the company were members of the family of the test individual of a family trust. Not unusually, the company’s constitution provided its directors with the discretion to declare and pay dividends on one or more classes of shares to the exclusion of any other classes, or at different rates.
Notwithstanding that all of the company’s shareholders were members of the test individual’s family and that those persons collectively held the entirety of the fixed entitlements to the company’s income and capital, the Commissioner determined that, individually, each shareholder did not have a fixed entitlement to any of the dividends of the company. This was because the dividends may, with the exercise of the directors’ discretion, be declared and paid to one or more of the shareholders of other classes of shares to the exclusion of theirs.
According to the Commissioner:
33. An entitlement that relies upon the exercise, or non-exercise, of a discretion to distribute dividends or capital would have a fixed entitlement of 0%. In respect of Company A, the directors have the discretion to declare dividends on one or more classes of shares to the exclusion of other classes of shares or at different rates (Clause X.Y).
34. Based upon this, there would be no fixed entitlements to income in this company, although there are fixed entitlements totalling 100% in respect of capital. This would then mean that, for the purposes of subsection 272-90(5), no entity (let alone a family member) has fixed entitlements to the income of this company and it will not form part of the family group.
Based on the Commissioner’s view expressed in the above ruling, where the constitution of a company gives its directors the power to declare and pay dividends on one class of shares to the exclusion of any other classes, but there is only one class of shares on issue (all of which are held by a test individual and/or their family group), it seems that distributions of the income and capital of a family trust to that company would not be subject to family trust distribution tax.
However, where multiple classes of shares in such a company are on issue, it’s possible that its various shareholders do not have a fixed entitlement to some or all of the company’s dividends. This is because the dividends may, with the exercise of the directors’ discretion, be paid on one or more of the classes of shares to the exclusion of theirs. Therefore, unless the company was covered by an Interposed Entity Election (‘IEE’), it would not be included in the test individual’s family group and any conferral of a present entitlement or distribution of income and capital made by the relevant family trust to it would be subject to family trust distribution tax. Notably, in the circumstances described in the abovementioned ruling from the Commissioner, there is a risk that the company could not make an IEE, because it would not pass the 'family control test’
If this position is correct (noting that there is no clear authority nor further guidance on the Commissioner’s view), then trustees of family trusts should carefully review the constitution (and shareholders’ agreement) of any corporate beneficiary to whom they intend to distribute income or capital and which has more than one class of shares on issue, to ensure such distributions would not result in a liability to family trust distribution tax at 47 per cent.
Alternatively, they should consider whether:
Their corporate beneficiaries could and should make interposed entity elections
Various other strategies may be suitable and appropriate, eg. ensuring that the sole shareholders of corporate beneficiaries are discretionary trusts, and
Even whether they should make/revoke family trust elections.
By Chris Balalovski, business services partner, BDO in Australia
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