Trust structures have become increasingly popular in Australia in recent years. There are a number of reasons for this, but the most crucial factor is that trusts offer investors, families, and business owners asset protection and a way to distribute income in a tax-effective manner.
For example, with discretionary trusts, trustees have the discretion to distribute income amongst the beneficiaries depending on their marginal tax rate. Trusts also provide greater flexibility regarding asset protection and estate planning.
But, as with any investment strategy, trusts come with pros and cons that you must consider before making any kind of decision. A potential drawback you might not have considered, for example, is that when a trust incurs a loss, that loss generally remains ‘trapped’ in the trust. This is because the current tax laws do not allow trustees to utilise tax losses by distributing them to beneficiaries.
It is, however, possible to carry those losses forward and offset them against the trust’s assessable income in future years, thus reducing the amount of income the trust has to distribute, including capital gains.
This strategy can be a useful way to minimise the overall tax burden for the trust beneficiaries, and it is something trustees should keep in mind when preparing their annual tax returns.
Here’s how it works:
Using a Trust Loss to Reduce the Taxable Income of Your Trust
If you incur a tax loss while operating your business or holding an investment in a trust, you can’t distribute the loss to the trust’s beneficiaries. The losses must be carried forward within the trust indefinitely until you can offset the loss from the trust’s net income in the future.
Unfortunately, the non-distribution rule allows individuals to traffic their trust losses. Investors and business owners devised various schemes to bypass, and once the Australian government got a hold of this, they introduced strict requirements surrounding trust losses and how trustees can use them to reduce future income for tax purposes.
Essentially, trustees are allowed to deduct losses that are “trapped” within the trust as deductions against income that the trust generates in the future. To do so, there are certain tests that the trust must satisfy first.
These tests will vary depending on the types of trust, including:
- Fixed trusts
- Non-fixed trusts
- Excepted trusts
So, to apply the trust loss regime correctly to a particular trust, it is necessary to determine the type of trust and the types of tests applicable to it.
What are the Different Types of Trusts for the Purpose of Carrying Forward Losses?
As mentioned above, in Australia, there are three main types of trusts: fixed, non-fixed, and excepted.
Fixed Trusts
According to the Income Assessment Act, a fixed trust is where the entitlements of the beneficiaries are determined at the time the trust is created and are not subject to change. This means that the trustee does not have discretion over how to distribute the trust property or assets – beneficiaries receive a fixed entitlement.
A common example of a fixed trust is a unit trust, where each unit holder is entitled to a set number of units.
Non-Fixed Trusts
A non-fixed trust, also called a discretionary trust, is a trust where the trustee has discretion over how to distribute the trust property or assets among the beneficiaries. The beneficiaries do not have set entitlements; instead, they depend on the trustee’s discretion.
Excepted Trusts
Excepted trusts do not fall into either the fixed or non-fixed category. The two most common types of excepted trusts in Australia are superannuation funds and trusts of deceased estates
What Tests Apply When Carrying Forward a Trust Loss?
When determining whether or not your type of trust can carry forward capital losses and offset them against future income that beneficiaries have to pay tax on, you need to consider all the tests that apply.
There are five different types of tests, again depending on the type of trust structure:
1. Income Injection Test
The income injection test applies when a beneficiary causes an increase in the trust’s distributable income by injecting amounts from outside the trust. If the ATO believes that the “income injection” was specifically made to benefit from the trust loss, the deduction won’t be allowed.
2. 50% Stake Test
Non-fixed trusts need to pass the 50% stake test before the trust can carry forward and deduct any losses. The test entails determining whether or not the same beneficiaries held more than a 50% stake in the trust income or capital from the start of the loss year to the end of the current income year.
3. Pattern of Distributions Test
The third test is the pattern of distributions test, which requires that you distribute income from your trust in a pattern that is similar to the previous six years. If the same group has been receiving benefits from the trust, then you will pass the test and the loss can be deducted from the assessable income.
4. Same Business Test
The same business test requires that you carry on the same business in subsequent years as the one in which the loss was incurred.
5. The Control Test
In the event that a group begins controlling a trust between the beginning of the loss year and the end of the income year in which the trustee seeks to claim the deduction (the test period), the trust’s tax losses and debt deductions are not deductible.
How Can Property Tax Specialists Help?
Trusts are a popular investment vehicle in Australia, offering many benefits such as asset protection, tax minimisation and flexibility in how income and assets are distributed. However, trusts can also be complex structures, especially regarding tax obligations.
The different types of trusts are subject to different tax rules, and how losses are distributed can also be complicated. As a result, it is essential to seek professional advice when setting up a trust.
A tax specialist can help you navigate the complex laws and regulations, and ensure that your trust is structured in the most tax-effective way possible.
Here at Property Tax Specialists, we understand the important role that trusts can play in an investors journey and a business owner’s tax planning for their family group. We can review your individual situation including objectives, type of investments, investment and exit strategy, and provide general advice if a trust is suitable.
We can also assist with trust formation and ongoing compliance, including lodgment of tax returns and preparing financial statements. We have a team of experienced tax agents who can provide advice on all aspects of trust tax law.
Contact us today to find out how we can help you.
Key Takeaways
Taxes can be a tricky area for even the most experienced business owners or investors. When it comes to trusts, there are a few additional considerations to keep in mind. For example, trustees in Australia cannot distribute tax losses to beneficiaries.
This means that if the trust has incurred a loss, it can only be used to offset future income. The ATO has proposed five different tests that must be met before a tax loss can be claimed as a deduction. As this is a complex area of trust tax law, it is advisable to contact a tax specialist for guidance.
By doing so, you can ensure that your trust is in compliance with all applicable laws and regulations.
