How ‘fixed’ are your clients’ unit trusts and what are the possible ramifications for misclassifying?

The concepts of a ‘fixed entitlement’ and ‘fixed trust’ are central to certain areas of the tax law affecting trusts, specifically around the conditions for access to the small business CGT concessions, recoupment of prior years’ tax losses and family control test/family trust election (to name a few).

To be a fixed trust, a beneficiary’s income and capital entitlement must be vested and indefeasible. Due to the nature of discretionary trusts, beneficiaries of such trusts do not have a vested interest and therefore do not have a fixed entitlement to either the income or capital of the trust. Accordingly, discretionary trusts are a type of non-fixed trust.

What about unit trusts? There seems to be (in the author’s opinion) some misunderstanding that all (or majority of) unit trusts are a type of fixed trust. Perhaps the conclusion drawn is primarily predicated on the unitholders’ income and capital entitlement being determined by reference to the number of units that they own; unlike a discretionary trust where income and capital entitlement is based on the trustee’s discretion in exercising its distributive power.

Practitioners are well aware that following the Federal Court decision in Colonial First Statement Investments Ltd v FCT [2011] FCA 16, very few trusts will be able to satisfy the definition of ‘fixed trust’ in s. 272-65 of Schedule 2F ITAA 1936 without the Commissioner’s discretion. Accordingly, if the classification of a unit trust as a ‘fixed trust’ is incorrect, there may be inadvertent taxation consequences.

This article seeks to highlight (in broad terms) the potential tax ramifications in the situation where a unit trust has been inappropriately treated as a ‘fixed’ trust. Please note that this list is not exhaustive.

Potential ramifications

SBCGT concessions: Connected entities

In the context of the small business CGT concessions, specifically with regard to establishing entities that may potentially be connected with a taxpayer, the test for connection is based on ‘control’ as determined under s.328-125 ITAA 1997. Different control tests apply depending on the entity type. Broadly, for an entity other than a discretionary trust, control is determined by reference to fixed income or capital entitlements, voting rights (for a company) or net income of a partnership. For a discretionary trust, control is determined by the ability to control the trustee, or by reference to historical income or capital distributions for the 4 years preceding the test year.

The concept of connected entities is essential for the purposes of the maximum net asset value test, the aggregated turnover test and in some instances the active asset test. Thus, an incorrect classification of a unit trust as a ‘fixed trust’ will result in the wrong control test being applied. The consequence is that it could either expand or restrict the category of entities that would otherwise be connected to the taxpayer trust if the appropriate control test had been applied. Moreover, there is a risk that access to the SBCGT concessions could be compromised. The misclassification of a unit trust being a fixed trust may also lead to incorrect claims being made for the SBCGT concessions or contributing the otherwise exempt capital gains amount into a complying superannuation fund; the resultant effect includes a shortfall in the tax liability that would otherwise be payable if the concessions were available, excess concessional/non-concessional contributions tax for breaching the relevant contribution caps, general interest and administrative penalties (to name a few).

For illustration purposes, consider the following: the ABC Unit Trust sold its business in FY2024. The unitholders are Mr. Jones (19%), his wife Mary (19%) and their two sons and spouses (Paul/Martha, and Clive/Sally) (15.5% each). Mr. Jones is the sole director and shareholder of the trustee company.

If the ABC Unit Trust was appropriately characterised as a fixed trust, then the respective unitholders’ unithholdings alone do not constitute a controlling interest (the requisite controlling interest requirement being 40% or more). Accordingly, none of the unitholders are connected with ABC Unit Trust.

In contrast, if the ABC Trust is a non-fixed trust because, for example, the trust deed permits (amongst other things) the trustee to distribute income/capital to a beneficiary to the exclusion of other beneficiaries (including the unitholders), or to issue units of different classes, the ‘connected’ relationship will be determined based on the control test for a discretionary trust. Given that Mr. Jones is the sole director of corporate trustee (Trustee Co), he will be seen to have the ability to control the trustee unless there is evidence to suggest otherwise. In this case, Mr. Jones is connected with ABC Unit Trust for the periods that he is the sole director of Trustee Co; the effect is that the group of entities that may potentially be connected to ABC Unit Trust could be expanded to include not only Mr. Jones but companies, other trusts or partnerships that he controls (based on the relevant control tests as outlined above).

SBCGT concessions: Significant individual/CGT concession stakeholders

The concepts of significant individual/CGT concession stakeholders are also fundamental for qualifying for access to the SBCGT concessions, specifically the small business retirement exemption and the small business 15-year exemption. The test to establish the existence of a significant individual/CGT concession stakeholder is determined by reference to an entity’s small business participation percentage interest (SBPP). For a fixed trust, a beneficiary’s SBPP is based on their percentage income and capital entitlement (and if they are different the smaller). For a non-fixed trust, a beneficiary’s SBPP is based on actual income and capital distribution in an income year (and if they are different the smaller).

Using the above example scenario, if ABC Unit Trust is a fixed trust, then based on the unitholders’ interests, the unit trust does not have any significant individuals for FY2024 or earlier years (due to each unitholder’s unitholdings being less than the 20% threshold to establish a significant individual). In the absence of establishing a significant individual/CGT concession stakeholder, the trust would be precluded from being able to qualify for the relevant exemption(s) that it is seeking to apply.

On the other hand, if the ABC Unit Trust is indeed a non-fixed trust, and if the trust deed permits the trustee to appoint income and capital to beneficiaries irrespective of their unitholdings, this would provide flexibility to strategically manage trust distribution for FY2024 to benefit a specific beneficiary. For example, the trustee could appoint 90% of the income and capital to Mr. Jones and 10% to his wife, notwithstanding their unitholdings. This in turn could assist the ABC Unit Trust with satisfying the qualifying conditions for access to the small business retirement exemption. Had the ABC Unit Trust been appropriately classified as a non-fixed trust, the trustee could have managed trust distributions in past years so as to establish a significant individual each year in the context of accessing the small business 15-year exemption.

Prior year tax losses

Another critical area of the tax law where the concept of fixed and non-fixed trust is a feature is the trust loss provisions. Different trust loss tests apply depending on the characteristics of the loss-making trust. For a fixed trust, the trust loss tests are the 50% stake test (or the alternative non-fixed trust stake test as applicable) and the income injection test. For a non-fixed trust there are four loss tests (i.e., the 50% stake test (if applicable), pattern of distribution test, control test and the income injection test). So, being able to correctly classified a unit trust as fixed or non-fixed is fundamental for determining the appropriate trust loss tests to apply.

Family trust election & family control test

Due to the complexity of the trust loss rules, in order to make recouping losses easier, most loss-making trusts would choose to make a family trust election (FTE) in order to qualify as a family trust. By becoming a family trust, it defines the family group for which distributions can be ‘injected’ to the loss-making trust without being at risk of the income injection test applying. However, before a trust can make the proposed FTE it must pass the family control test.

Using the above example, if ABC Unit Trust is a fixed trust, based on its ownership structure, arguably the 50% stake test would likely be met. If ABC Unit Trust was receiving income that the income injection test might otherwise apply to, it could choose to make a FTE and this requires the trust to pass the family control test for the relevant testing period(s). If Mr. Jones is selected to be the individual specified in the FTE, then the family control test would likely be met because the group comprising Mr. Jones in his capacity as sole director of Trustee Co is able to control the conferment of income and capital. Alternatively, the group comprising members of the test individual’s family (a defined term) has more than a 50% stake in the income or capital of the trust.

That said, unit trust structures are often utilised by unrelated parties for business ventures. Consider a scenario where the ABC Unit Trust is now owned by Mr. Jones (50%), a third-party investor (40%) and Paul Jones, his son (10%). Mr. Jones and the third-party investor serve as co-directors of Trustee Co. Under the family control test, if the ABC Unit Trust were deemed to be a fixed trust, it could potentially meet the requirement, as Mr Jones and a member of his family, Paul collectively hold more than a 50% stake in the income or capital of the trust.

Now suppose ABC Unit Trust had mistakenly operated under the assumption that it was a fixed trust for several years and had a FTE in force all these times. ABC Unit Trust being a non-fixed trust means the unitholders’ income and capital entitlements are not fixed. So, whilst Mr. Jones and Paul constitute the group for the purposes of the family control test, they do not have any stake in the income or capital of the unit trust. Mr. Jones is a co-director of Trustee Co; this suggest it is unlikely Mr. Jones alone would be capable of, or has the ability to, make unilateral decisions to the exclusion of the other director in regard to for example the appointment of income or capital, the appointment or removal of the trustee (and so forth). In the absence of any group being able to control the ABC Unit Trust in the manner set out in s.272-87 Schedule 2F ITAA 1936, the FTE it had made would be considered to be invalid. Consequently, if ABC Unit Trust had in the past claimed deductions of its accumulated tax losses against income which had been ‘injected’ into the trust from Mr. Jones’ family group, the deductions would have been invalidly claimed. Another possible scenario is where ABC Unit Trust had been in receipt of frankable distributions in past years (whether from its direct shareholdings or from trust distributions from Mr. Jones family group), the associated franking credits would have been invalidly passed on to its unitholders.

Where to from here – PCG 2016/16

The ATO has issued guidelines to assist taxpayers establish whether or not it is necessary to seek the Commissioner’s discretion to treat the interest in a trust including a unit trust as being ‘fixed’ for the purposes of the trust loss provisions. Practical Compliance Guidelines PCG 2016/16 outlines a non-exhaustive list of the factors that the Commissioner will consider when deciding whether to exercise his discretion. It also includes several safe harbour categories and if a trustee satisfies the conditions for one of the categories, they can manage the trust as if the Commissioner had exercised his discretion to treat the trust as being ‘fixed’. PCG 2016/16 also specifies a list of other legislative provisions for which it applies.

Considering the potential tax ramifications if a unit trust is incorrectly misclassified as a ‘fixed’ trust, it would be advisable for practitioners and their trustee clients to carefully consider PCG 2016/16.

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