Family Trust Elections – is there a mischief, or is the ATO just monetising the complexity?

Now that the ATO’s compliance activity in relation to family trust elections is well and truly underway, stories are starting to emerge in the media of family groups who have unexpected tax liabilities that are reported to be large enough to bankrupt the families. Is this the intended outcome of the rules?

When the law bringing in family trust elections (FTEs) was introduced, the Explanatory Memorandum (for Taxation Laws Amendment (Trust Loss and Other Deductions) Act 1998) explaining the law included the following:

Administrative costs

1.41 There may be administrative costs on the ATO on the collection and recovery of the family trust distribution tax (FTDT). However, the tax will only apply if trusts and relevant interposed entities fail to abide by the election they have made. It is hoped that the tax will never need to be collected.

1.42 The costs to the ATO in administering the trust loss measures may involve making amendments to tax returns.

So, in 1998 the Federal Parliament put on record that they hoped no FTDT would ever be collected. That is manifestly not what is happening now.

I have advised a number of groups, and based on the typical issues, it was not hard to think of a hypothetical situation where the tax rate on income earned by a trust could exceed 80%.

To show how this could arise, take an example of a family who run a business through a company. The company pays out dividends each year to its shareholder, which is a discretionary trust. That trust then pays the dividend as distributions to various family members.

With the right elections, there should be no FTDT liability here.

However, if the elections are not done correctly then that 80% effective tax rate could arise.  Say that when the company started paying dividends, the trust made an FTE nominating Dad.  Due to this, the company is in the same family group as the trust.

When the company pays a dividend, that dividend goes to the trust and the franking credits go with it.  However, if that family trust distributes the dividend to another company which is not part of the family group (and might perhaps be part of a different family group under these rules, or unable to elect into the family group around Dad even though the shareholders are relatives) then the trust is liable for FTDT at 47%.  Further, the trust loses the franking credits attached to the dividend received such that they are not available to reduce the FTDT liability.

The second company then receives income which has had FTDT paid on it.  As it has been taxed, the remaining amount distributed by the trust is non-assessable non-exempt income (NANE) in the hands of the second company, which means it pays no tax.  Where that dividend is later paid out to the individuals who are shareholders of the second company then there may be no franking credits available to attach to it, so the individuals pay tax on the dividend at their marginal rate.  If that is the top marginal rate, then the 47% on the second company’s dividend (which was funded by the 53% of the original income left after the FTDT is paid) is a further impost.

So, in the above example, the tax payable is:

• An initial level of company tax on the first company’s profits – say 30%;
• FTDT at 47% for the trust on the 70% of the initial profit paid as a dividend – this is a further 32.9% on the original pre-tax profit; and
• The individual shareholders in the second company will have tax payable at 47%. This is a final further 17.4% tax when compared to the original profit made by the first company.

All that adds up to 80.3% as the total effective tax rate.  Before any penalties, and before any interest charged.  No wonder there are situations where family groups are having to consider whether FTDT will make them bankrupt.

That is a long way from what Federal Parliament intended when these rules were enacted.  It also shows that the rules are complex and the current compliance approach of applying the tax with no discretion or ability to reduce the liability is a very onerous outcome where there is no real mischief at work.

As yet, there has been no indication from the Federal Government or the ATO that any change is being considered, so we are left with a compliance approach that appears to me at least as being based upon using the complexity in the tax law to raise revenue, rather than considering what is a fair tax rate applicable to income.

——-

Join our Navigating the maze of family trust elections webinar to better understand these complex rules. Click here to register.