Family Trust Elections & FTDT: The Tax Issue Back in Focus (Part 2)

0:00
You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

In Part 1, we discussed family trust elections and how they can look quite administrative until they all go wrong.

0:20
In this part, we'll be talking about when it all goes wrong and family trust distribution tax.

This is one of the most topical areas with significant consequences for clients and advisers.

To do so, I'm joined again by Ani Tuna, Special Counsel within Velocity Legal's Tax team.

0:38
Welcome, Ani.

Thanks, Andrew. Thanks for having me back. This is a really exciting episode.

Well, I think it's exciting. I think you think it's exciting too.

I do, I do, because there are so many issues here.

I think everyone thought no one really paid too much attention to family trust distribution tax.

0:58
It's an awful acronym, and now we're just starting to see big stuff in the media about this, both in the ATO and also in the press as well.

Yeah, that's right. Working in tax, you don't really get the juicy stuff.

1:16
You know, if you're working in criminal law or family law, you might see articles in the Financial Review or even popular media.

But in tax, we don't really get that more interesting popular interest. But yeah, this has really spiked and it's probably one of the more recent areas where we are seeing the work that we do day-to-day in the headlines, and it's because the dollars are huge.

1:40
Absolutely.

So maybe let's go to that case that's being reported all through the media, the Thomas case. We'll come back to the mechanics and stuff later on. But let's just go through that case.

If anyone's interested, they can look it up.

1:57
Thomas Family Trust distribution tax. There are lots of articles, but what's the issue there?

And I think it's a good one because it's representative of this broader issue.

Yeah, I think the headline that the AFR used when it first came out or was in the media was, you know, how a mistake cost a family $13 million.

2:17
Doesn't get more sensational than that.

Yeah. It is, except for that I think there was a previous article a couple of months earlier where they said, you know, family groups could go bankrupt as a result of FTDT.

So I feel like $13 million was probably a softer entry point.

But yeah, so it was all the AFR was reporting on the Thomas family, a wealthy Adelaide-based family.

They're involved in, I think, seafood and other food processing.

2:45
And it was all around what I think was caused by a change of accounting firms.

And as we discussed in the first episode, a lot of the problems that do end up arising from family trust elections and FTDT, which we'll talk about in a second, that acronym, often will arise because of lack of information or lost documentation.

3:05
So what happened here is that the Thomas family had their previous accountants and they had a trust that had been established way back when, I think in the early 80s, the Chris Thomas Family Trust.

And that trust continued on.

3:24
So in the year 2000, quite some time later, the accounting firm went and made a family trust election for the Chris Family Trust, and when they did that they made Chris the test individual.

So basically, they made that election for the group to be formed around Chris. Super important.

3:41
They continued.

Four years later, so in 2004, the Thomas family changed their accounting firm and a new accountant was appointed.

And in 2005, that accounting firm went and made a family trust election.

Purported to.

3:56
Yeah, purported to. Good wording.

Yeah, it's almost like allegedly.

They purported to make a family trust election with a different test individual for that same trust. So they made a test individual being Chloe, which was another family member.

Now, as you say, that's a problem because, as we talked about in the first episode, you can only have one valid family trust election.

4:19
Now, assuming the first election made by the earlier accounting firm was valid, the test individual was actually Chris and that election was active as of 2000.

But the problem here was this other accounting firm, not realising that there was one in place, continued on thinking that it was actually Chloe who was the test individual.

4:38
That wouldn't have been a problem of itself.

Yeah, but it's what happens after that.

That's right. And generally, it's not a problem because it would be unusual, although it could happen, for them to have picked a test individual that's so far removed from the original test individual that the family group would be wildly different.

4:56
I think where the bigger problem became though was that they actually then created a new trust. This was sometime later, in 2019.

So we're now talking like 14 years had gone by.

They made a new trust, and that trust, thinking that they already had one trust in the group with Chloe as a test individual, they made another trust.

5:17
And that trust, rightly in their minds, they made Chloe the test individual for that trust too.

That's them up.

Yeah, that's right.

So in their minds, taking back what happened back in 2000, they were doing the right thing. They had a big group. They wanted the two trusts to be part of the same family group.

So they made sure they both had the same test individuals.

5:35
And there were also other companies and stuff that had been incorporated, all of which they made sure were part of this Chloe family then.

So at this point, we're still okay because nothing's happened.

But the problem is, and I think this was in 2020, a dividend was paid to the trust, the Thomas Family Trust, which then made its way through the group.

5:58
Because the Thomas Family Trust had a family trust election with Chloe, they thought that they could then distribute through the other trusts that had Chloe as a test individual, and the franked dividend flowed through.

The ATO then probably picked up the phone and said, hey, just letting you know, the Thomas Family Trust actually has a family trust election.

6:20
They have a family trust election that was made in 2000, and it's a different test individual to Chloe.

And on the basis that that's a valid election, when you purported or when you did distribute those dividends from the Thomas Trust through to the other trust that had Chloe as the test individual, that distribution was outside of the group, because you had Thomas as the test individual for the first trust and unfortunately you have Chloe for the other.

6:47
You've got a mismatch.

You've got a mismatch.

So that's what gave rise to this $13 million problem, because a distribution was made outside of the family group. And at the time that it was made, it was a genuine mistake because they didn't realise there was an original distribution or, sorry, an original election made.

7:04
So you can see this all occurred because of a genuine mistake, because at the time that someone signed that form or someone prepared that form, they weren't aware of what had already happened.

And you can feel quite a lot of sympathy because, you know, if you're thinking back to, as we went into in Part 1, what was the point of these rules in the first place?

7:20
They were a bit of an integrity measure, right? Just keep it within the family and, you know, big picture sense, things are being kept within the family.

Yeah, that's right.

In a technical sense for the rules, maybe they're not, resulting in this massive tax liability.

7:36
Yeah. And there would have been a fix, or at least they've attempted to make that fix. And we're not quite sure where that's gone because the reporting, and as far as we're aware and what's being reported in the media, it's been filed with the Federal Court, but we don't really know where it's gone.

The key here is, and what you might be wondering at home is, well, couldn't they have just fixed it?

7:54
Wasn't there a fix here? Couldn't they have gone somewhere and said, hey, help us, we've got this big problem. It's going to cause us $13 million worth of family trust distributions tax. What can we do?

The fix could be potentially, not so much for the Chris Family Trust because that's a really old family trust election way back in 2000, let's say, but the newer trust that's got Chloe as the test individual.

8:17
In some cases, you might actually be able to vary the test individual.

So in an ideal world, if you find out soon enough that this has occurred, and when I say soon enough, that should generally be within four years of the start of the election.

You should be able to go back and vary and say, oh, we didn't know at the time, we might need to vary Chloe.

8:37
We've just realised we'll change it to Thomas, as long as there's nothing made in those four years. We should be good.

And that's actually what they've done, or we've understood based on the reporting that they've done. The new accountants have actually gone and they've done it a couple of times.

They've attempted to amend a return in 2021.

8:53
I think in the new returns that were done, they've done the variation in those. I think they've separately lodged a variation to do everything. They've made it abundantly clear that they want to make this variation.

The reporting says that the ATO is not commenting on that, so I'm not sure what the ATO's position is on whether or why those variations were not valid.

9:15
From the reporting, it seems like they could have been made within that four year time period, but it'd be interesting to see what the ATO's position is as to why they don't think that variation is valid, because the variation could have been the solve.

Yeah, it's interesting. I guess the best practice would just be advice before the big transactions are done, of course.

9:33
Yeah. But yeah, I believe that they've paid the money under protest because otherwise the interest accrues on it and so forth.

So I think that will be one that's really, really interesting to follow.

I wanted to just bring it back to, I guess, that case is one. It's sort of the tip of the iceberg, I guess, the one that's reported in the media.

9:51
But there are so many of these out there, and you don't want to be the one that's in that situation.

Can you just step through, I guess, what is family trust distribution tax and why should we be really worried about it?

10:08
Yeah. So I guess like all things, actually maybe not so much all things, but as I say to my kids, if you're going to get something, you usually have to pay, you have to give something in return.

Yep.

So we talked about the benefits of a family trust election earlier, and there are quite a few reasons why you'd make one and benefits you'd get from making a family trust election.

10:27
But with that comes the cost of doing so.

And the cost, so to speak, is that once you create that family and you promise, you put your hand up and you say, look, I'm promising to create a family around this particular individual.

If you distribute outside of that individual's group, then you're whacked with this 47%.

10:47
So the highest marginal tax rate, including your Medicare levy, you're whacked with this tax, family trust distribution tax, almost as a penalty for distributing outside.

Of your promise.

Yeah, effectively, that's right. So that's what you want to avoid.

11:03
And the thing about family trust distribution tax, it makes it so unique to other types of penalties or taxes that we think of, and it's not actually a penalty, it is actually a tax, is that it actually starts from the day in which, or the assessment for the family trust distribution tax happens pretty much at the time at which you make that distribution.

11:25
So you don't lodge a tax return or anything like that.

If you made that distribution 10 years ago, then your family trust distribution tax assessment arose 10 years ago.

So debt sitting there that no one knows about.

Sitting there, that's right.

And I think you've got 60 days for it to be unpaid from 10 years ago to actually pay it.

11:44
And then if not, interest accrues.

Now, I guess you could say it's perhaps a little bit unfair because at the time, the taxpayer may not, like the Thomas family, they may not have even realised that what they did was going to result in distribution tax.

So not only is the assessment there, but all along they're accruing interest, which is perhaps one of the other reasons why the Thomas family would have just paid the family trust distribution tax to put a plug on any further general interest charge or interest charges accruing.

12:14
And as we know, you might want to remove the risk of doing so and then fight it later, basically.

It's really interesting, the point you make that unlike anything else, it's sort of this debt created out of the ether.

And with other sort of tax provisions, if you make a mistake 10 years ago, so long as it's a genuine mistake, then you can have some sort of finality that no one's going to go back and look at it, or the ATO cannot go back and amend for it.

12:31
But this is one where 30 years are running, and 30 years could potentially be gone on back, and that can blow out even further as this keeps going.

Yeah. And it's interesting you say potentially can go back.

Interestingly, the ATO doesn't actually have any discretion on the family trust distribution tax.

12:53
So yes, they might show some leniency with the interest, which they can in some circumstances, but the actual tax itself, you'll find that they'll just say, sorry, our hands are tied.

We actually have no discretion.

So when we see it coming in front of our desks, the ATO tends to find a final point and they'll say, look, we're looking at family trust distribution tax for this particular period of time.

13:12
And yeah, sometimes they probably could have gone even further back.

But technically speaking, once they look at it and they identify it, they don't actually have, even if there's no fraud or evasion or anything like that, they've got no ability to change their minds or apply any discretion, which is the hardest part.

And it's the reason why you see articles in the Financial Review saying that, as we know and we've seen, there are groups that have got family trust distribution tax in the, not tens of millions, but potentially hundreds of millions.

13:55
And a large portion of that is interest.

And the other thing is that if it's a distribution, someone's possibly already paid tax on it.

Let's say 10 years ago that it was actually taxed and someone did pay the tax at that point in time, but now they've also got the 47.

14:11
So you can effectively get 70, 80% sort of tax rates, kind of.

Yeah, and then there's the issues with the franking credits and things like that.

So basically, it's one of those things that if it's occurred, you hope that it occurred due to a genuine mistake.

14:27
Like we said, it's occurred because someone read the portal wrong or there was an election somewhere that someone didn't know, because once it does occur, that's a problem.

So I think to where we started from, being that we all know now that this is a huge ATO risk area.

I think the action point, and we're doing it a lot with family groups, is you've got to sit down now and go, okay, we can't just close our eyes and put our heads in the sand.

14:55
If we have a problem, we may not even be able to make a variation, but let's identify it. If we do have a problem, can it be fixed?

If it can't be fixed, don't create further problems going forward.

But I think that's the key. Be proactive because you know the ATO is looking at it, and you don't want to create any of those problems going forward or looking back.

15:12
Yeah. I think that's an excellent point.

We've touched on this concept of family group and we've sort of hinted at these concepts.

I guess, yeah, to your point earlier, it's relatively straightforward to work out which individual people are within a group.

Are they related to me or not one of the certain relations?

15:33
But I think, and correct me if I'm wrong, that where there's real issues, like companies and trusts, there's a lot of confusion and myths about those situations.

Yeah, that's right.

I mean, it's not very common that the Henshaw Family Trust will very generously want to distribute to the neighbour or anything like that.

15:55
So we don't generally have those kinds of problems. It's where there's entities in the group.

So this happens in large groups where they might have multiple entities. Think about property development where every time they do a new development, they'll have a new trust or a new entity set up.

Or a group that has evolved over time.

You know, dad started a business years and years earlier.

16:14
Then the family, you know, the sons and the daughters got involved.

Got into something else.

Yeah, that's right.

So you look at this structure diagram and there are properties in some entities, you've got the trust in another, but there's a trust involved that's made a family trust election.

16:31
And to get the best tax outcome for the entire group, you want to be able to have the flexibility to distribute throughout that group.

And so you want to make sure that every entity in that group is part of the family, companies and trusts.

However, it's quite difficult to determine whether they are part of that trust family group.

16:52
So as we said earlier, when you have two trusts and they've both made family trust elections with different test individuals, they're not part of the same family group.

You distribute there, you've got a problem.

There's this other concept which we've alluded to called interposed entity elections way back when.

17:09
I think the philosophy used to be, oh, just make a family trust election and make an interposed entity election as well.

I don't really know whether we understood why we were doing it.

But without going into detail, an interposed entity election just really limits you even further.

Sometimes you need to make an interposed entity election, and you make those for a company or a trust or a partnership you want to be part of the group.

17:33
But I would just say that if you're making an interposed entity election, you need some advice just to make sure that you actually understand what that's doing.

They're not simple.

They are so not simple.

And where the problems arise is when someone originally made both of those, and then you try and look at the group and work out who's included, and they're not.

17:51
And the other difficulty arises because there's two definitions of group here.

So we haven't touched on how you make a family trust election, but there are certain tests that you have to satisfy.

That group for the purposes of those tests is called the family.

18:07
But for family trust distribution tax, it's called the family group.

Now, it's very easy to get those concepts mixed up because they sound very similar, but the definition of both is different.

And in this age where we're trying to do things as quickly as possible, if you put that into ChatGPT or try and Google it, it's very easy to get confused as to which group you're looking at for which purpose.

18:30
And I think that's also where the problems have arisen as well.

And some of the situations, you say, okay, interposed entity elections, we can fix it.

I mean, some of the situations just cannot be fixed, correct?

Yeah, there's no way. There is no way around it.

This is a problem.

18:46
We've got unlimited periods of review, or not even periods of review. It's just debts that have existed.

Interest is accruing.

Maybe there's some liability on the advisers.

It's a real nightmare situation and no discretion for the ATO either.

19:02
Yeah. And you can see how, even going through that description of the group, you had the dad or the mum who's the patriarch or the matriarch way back when.

That's an evolution, even if it hasn't changed accounting firms or advisers.

We're talking about a group that has evolved in what it's doing and the people in the family.

There might be divorces, people have died, there are new companies that have been set up.

19:26
And it's not uncommon when we see some of these large private groups where the brothers and sisters don't talk to each other anymore.

So you might have all been part of the same family, and we structured it so that you all have the same family trust elections, but now you're looking at it and they're going, oh, well, you want to split everything up.

19:42
Yeah, Bob wants to go this way and Karen wants to go this way. And now we want to know how to fix it.

So simple to start with, but, you know, two episodes in and we could probably have another three to lead in. It's not that simple at all.

And Ani, you mentioned the word distributions, distributing income, but my understanding is with family trust distribution tax, it can be as simple as.

20:04
You know, you've got a group and there's two trusts, and one's lending money to the other or it's allowing the assets to be used by the other.

Yep. We haven't seen this yet, but it won't be long before the ATO starts looking at this a little bit closer too.

But yeah, the definition of distribution for these purposes is so broad.

20:22
It's not just a distribution to income and capital as we would normally understand it.

It could include non-arm's length loans or an interest-free loan.

It could include use of a private, sorry, private use of a trust asset, like for example, a family home that's being used for family or for friends or other people outside the group.

20:44
So yes, the big dollars are probably going to come from the distributions, but could also come from those large loans and then other uses as well.

And I believe the ATO's view, at least I don't think it's tested, but is that even if the person's not even a beneficiary, then family trust distribution tax could apply if it's, say, a loan to a friend or something like that.

21:03
Absolutely. Yeah.

So where these trusts do things outside of the family group or outside of the family, you need to be really careful.

And that's why, I mean, it's not uncommon for us to say that ideally you want to make all of those loans on arm's length terms anyway.

But yes, as you say, if it's not for consideration and it's not on arm's length terms, it could certainly be a distribution outside the family group.

21:25
One other question I wanted to ask is you talked about, okay, you're going to generally have a simpler life if you can align the test individual.

If you've got multiple trusts, if you're going to align the test individual in the family trust elections, you're generally going to have an easier time.

Your issues really arise when you've got different ones.

21:42
So you perhaps say, okay, well, just make sure that never happens.

But I think a common situation is you've got someone who is the test individual of one trust and then has passed away and then another trust wants to be set up.

And my understanding is the ATO's view is that you can't nominate a dead person.

21:58
Yeah, you can't nominate a dead person.

However, in practice, I have seen the very last almost bedside attempt at signing off on a family trust election where you haven't done so.

Look, the planning tip is that, in those groups where, and it wasn't unusual back in the earlier days where you went as high up as possible.

22:21
So you went to the highest grandparent as possible in those groups.

You want to be reviewing the age and the health of those individuals.

Ideally, if you're in a group that's likely to need other trusts in the future, you just set up discretionary trusts.

You might have a bank of, say, five or 10 or as many as you might need.

22:39
Very common.

And you just set them up as dormant trusts with the test individual as a test individual while they're alive, so that when they do pass, you can continue using those trusts and you have a bank to rely on as you go.

And we saw that during COVID, it was one of the things that we were very quickly reviewing, any private family group that had elderly test individuals.

23:00
We were just setting up as many trusts as we could and setting up structures just to plan for it.

Because once they die, they're still a test individual of the original trust, but I can't create any new trusts that have that same test individual.

There's so much assumed or concepts that have to be built on to.

We've had to spend two episodes essentially to get to this point with a lot of assumed knowledge anyway.

23:22
But trying to explain these concepts, particularly when they're quite unfair to clients, can be really difficult.

Yeah, it seems a bit unfortunate to say we get excited.

I think I always have to add the disclaimer.

23:37
Look, I'm excited because it's an interesting area of tax that has a lot of complexity to it.

Less excited for the clients because it is often a really unfortunate situation.

Yeah.

Anyway, out of time for this episode, although we could spend a lot of time talking about family trust distribution tax.

23:53
If I'm going to ask you for one takeaway, if you're an adviser, what's the number one takeaway?

I'm a firm believer that the warnings and the lights are flashing to say family trust elections are in the absolute firing line.

24:09
And we've just talked about how terrible the consequences could be.

I think my tip would be to keep this as your number one thing at the moment in private or family groups where you're reviewing and checking whether there's anything you should be aware of and planning for the future.

So this is the point in time where you start to be proactive and fix up anything that needs to be fixed.

24:30
So get the advice and do what's necessary so you don't end up hopefully at the head of the AFR for a sensational headline.

Yeah. I think that's well said, well put.

I wanted to thank you once again for being part of this episode, and I encourage any listeners to reach out to Ani if they have any questions about family trust elections or family trust distribution tax.

24:51
Fantastic. Thank you very much. Appreciate it, Andrew. Thanks for having me on.