Mastering Family Trusts: Navigating Family Trust Elections & Interposed Entity Elections with Confidence

With the Australian Taxation Office (ATO) intensifying its scrutiny on FTEs and IEEs, it is imperative for tax agents to navigate these elections with precision.  Tax agents need to be able to grasp the complexities of FTEs and IEEs. These elections offer significant tax concessions but come with stringent requirements and potential pitfalls, including the imposition of Family Trust Distribution Tax (FTDT) when distributions are made outside the family group. This article will guide tax agents through the implications of making an FTE or IEE, outline the steps to make these elections, and provide practical examples to illustrate common scenarios and strategies to avoid FTDT liabilities.

The birth of FTDT

Since its introduction in 1998, FTEs were established to allow trusts to access specific tax concessions by electing to be treated as family trusts, thereby simplifying the use of carry-forward tax losses and enabling easier access to franking credits at the cost of placing restrictions on beneficiaries to whom distributions would normally flow to. IEEs were introduced to extend these benefits and restrictions to bring other entities within the family group, ensuring that distributions to these entities would not trigger FTDT. FTDT is a punitive tax imposed at a rate of 47%, and was designed to prevent tax avoidance by imposing a significant penalty on distributions made outside the designated family group where such tax is imposed under Family Trust Distribution Tax (Primary Liability) Act 1998. Over the years, the way these mechanisms apply has evolved and become more complex, including due to the family group extending to multiple generations.

All references to legislation are made to Schedule 2F to the Income Tax Assessment Act 1936 unless stated otherwise.

Underlying concepts

A trust will be a family trust at any time when a FTE is in force per section 272-75. The FTE will be in force after the beginning of the specified income year. The requirements for making a valid FTE are set out in section 272-80 and summarised as follows:

• must be in writing and in the approved form;
• specify an individual to whom the family group of the trust will be structured;
• the family control test in section 272-87 must be passed at the end of the specified income year chosen in the election;
• an FTE generally cannot be varied or revoked;
• only one FTE can be made in respect of such trust; and
• the primary individual/test individual must be alive at the time of making the FTE.

In addition, for a company, partnership or trust to be included in the family group of the individual specified in the FTE, a valid IEE is required to be made. These requirements are set out in section 272-85 and summarised as follows:

• must be in writing and in the approved form;
• IEE to contain information as the Commissioner requires, including specifying an individual to whom the family group of the trust will be structured and such trust with the valid FTE;
• the family control test in section 272-87 must be passed at the end of the specified income year chosen in the election;
• an IEE generally cannot be varied or revoked;
• It is possible to make multiple IEEs where the individual specified in each of the FTEs is the same.

When FTDT can arise

A liability for FTDT arises for a trust with a valid FTE or an entity with a valid IEE where:

• The family trust makes a distribution outside the family group; or
• An interposed trust distributes outside the family group; or
• An interposed partnership makes a distribution outside the family group; or
• An interposed company makes a distribution (i.e. a dividend) outside the family group; or
• Information is not provided to the Commissioner is respect of non-resident distributions.

The family group as defined in section 272-90, and hinges on the primary individual (test individual) who is used as the starting point to trace or create links to other entities to join the group. The ‘family’ of the primary individual is a subset criteria to determine whether a company, partnership or trust should also be included in the family group. The term ‘family’ is defined in section 272-95 which is premised on the test individual and only considers individuals.

Hot Tip: If you want a valid reason to leave the crazy aunties, uncles and cousins out of your ‘family’ dinners – just say, “sorry, section 272-95 told me you’re not part of the family”.

If a distribution is made outside the family group then the entity which made the distribution is subject to the FTDT at a rate of 47%. Directors of any relevant company are also personally exposed to the FTDT liability.

Validity of an FTE

A trustee who makes an FTE to which any of the criteria in section 272-80 is not satisfied, the FTE is not valid and as such, no family trust exists. In addition, the Commissioner’s view is that if any entity other than the trustee makes the election, that election is invalid.

An invalid FTE would indicate that FTDT would not apply as there is no family trust. Naturally, the usual tax concessions accessible under a FTE are denied where the FTE is invalid. These generally relate to recouping losses (as noted earlier) and the passing of franking credits through the trust.

This raises the question, “Does the invalidity of the FTE made allow the trustee to make a new FTE to nominate a different or same test individual noting that a trust can only ever make one FTE?”

The only case which came close to answering the validity of an FTE is Deputy Commissioner of Taxation v Widdup (No 2) [2023] FCA 377 (Widdup) – however, we are still left without a full answer.

Issues with Widdup’s case

Despite the limited guidance from the ATO and the courts regarding the validity of a FTE and IEE, the profession eagerly anticipated clarity from the Widdup decision only to be left somewhat disappointed.

The key facts of Widdup are as follows:

1. In the 2010 trust tax return, the trustee indicated that a FTE had been made for the 2009 financial year (FY). From the 2009 to 2017 FYs, each tax return indicated that an FTE was made in 2009.
2. During this period, income was distributed to members of the Widdup family.
3. In October 2017, the trust made an $8 million capital gain, which was distributed to Fidelity Pacific Life Insurance Company Limited, a company incorporated in Canada.
4. For the trust’s 2018 tax return, the FTE and IEE sections were left blank.
5. Upon reviewing the return, the ATO found that the company was not part of the family group at the time it was conferred a present entitlement to the capital gains.
6. Widdup and Mrs. Widdup, as directors of the Trustee, were deemed jointly and severally liable for family trust distribution tax pursuant to section 271-15.
7. The question asked to the court by the taxpayer was whether the Deputy Commissioner lacked the power to impose liability for FTDT and that the issue of the notices for FTDT was not a bona fide exercise of power (misfeasance and maladministration).

Nicholas J decided in favour of the ATO. Although the taxpayer contended that the family trust election form was not prepared, nor signed and never lodged with the ATO, the mere acknowledgement that an FTE has been made in the trust’s tax return for the relevant years was held to be sufficient to concede that an FTE has been made per section 271-15.

The decision in Widdup was left open-ended for the following questions which were not considered:

1. Does the Commissioner have the ability to specify the test individual where the FTE form has not been completed and no individual has been specified?
2. Is the FTE invalid and therefore the trust is not a family trust such that no FTDT liability can arise?

Other issues which can arise

In addition to these questions, we have assisted clients with the following issues:

1. If an error is made in an IEE where conflicting information is shown such that it is not certain to which trust the IEE relates:
   1. whether the election is valid; and
   2. If it is valid then whose family group is the IEE in respect of?
2. Is the FTE invalid where the trustee has not signed or sighted the FTE document?
3. If an election is invalid, can a new election be made?

How we can assist

The FTE and IEE provisions are complex and difficult to circumnavigate due to limited guidance to assist with its application. With greater ATO compliance focus on the topic, it’s imperative for advisors to complete the FTEs and IEEs correctly to avoid the 47% FTDT. If you find that the questions discussed in this article resonate with your clients, our subject matter experts at Webb Martin Consulting are here to help.

——-