Trust losses are not subject to the Division 35 non-commercial loss rules. Instead the trust loss provisions in Schedule 2F ITAA36 apply.
Trust Losses
Trusts and companies both trap their losses. You can’t pass losses in a trust or company to beneficiaries or shareholders the way you do in a partnership. Partners in a partnership share partnership losses. Trusts and companies don’t.
Instead, losses incurred by trusts are trapped in the trust. They are carried forward and may be offset against future trust income if – and this is a big IF – if the trust loss provisions allow.
Net Income
Before you look at when and how a previous trust loss might be offset against income, you first need to determine that income . You can’t offset a loss against net income if you don’t know the amount of that net income.
Net income is defined in s95.
s95: net income…mean the total assessable income of the trust estate calculated…as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions…except…and then it lists a few items not allowed as a deduction.
So let’s assume you have now worked out our net income and the loss you want to offset. The next step is: Can you?
Legal Framework
s95 doesn’t say outright that you can reduce net income by previous trust losses. But it says it indirectly.
s95 lists a few items that are not allowed as deduction. But it doesn’t mention trust losses as non-deductible. And that makes trust losses deductible.
Also , the note to s95 says: A trust may be required to work out its net income in a special way by Division 266 or 267 in Schedule 2F ITAA36 …
Schedule 2F is where the trust loss provisions live. It all happens here.
Schedule 2F
The trusts loss provisions in Schedule 2F of ITAA36 outline when and how what kind of trusts can deduct what current and prior year losses. The provisions also apply to deductions of bad debts.
Schedule 2F is like an Act within the Act. It has its own divisions, subdivisions and sections.
When we refer from here on to a division, subdivision or section, we mean the ones within Schedule 2F.
Kinds of Trusts
What trust provisions apply depends on the type of trust. Schedule 2F distinguishes between fixed trusts (listed or unlisted) and non-fixed trusts. If a non-fixed (discretionary) trust might be a family trust. Each type of trust has to satisfy certain tests in order to carry forward their losses.
Fixed Trusts
In a fixed trust (Division 266) beneficiaries have fixed entitlements to all income and capital.
s272-65: A trust is a fixed trust if persons have fixed entitlements t all of the income and capital of the trust.
These fixed trusts can be listed or unlisted. If listed, they can be ordinary fixed or they can be widely or very widely held. An ordinary fixed trust is a general term used to describe all trusts which are not widely held.
A fixed trust can be a unit trust. Unit trusts have the most complicated trust loss provisions of all.
Non-Fixed Trusts
And then there are non-fixed trusts (Division 267) where beneficiaries don’t have a fixed entitlement to all income or capital.
s272-70: A trust is a non-fixed trust if it is not a fixed trust.
Discretionary trusts are a kind of non-fixed trust that has been set up for the benefit of one or more beneficiaries, but the trustee is given full discretion (hence the name) as to when and what funds are given to the beneficiaries.
Family trusts are a kind of discretionary trust that has made a family trust election for trust loss measures.
s272-75: A trust is a family trust…when a family trust election…is in force.
Let’s focus on non-fixed trusts here.
Tests
To deduct a current or prior year loss, a trust needs to pass certain tests in the trust loss provisions in Schedule 2F.
They all have the same purpose. To ensure that only the trust who incurred the loss gets to deduct the loss and not somebody else.
Don’t Waste a Loss
Imagine you had a trust with an accumulated loss and no profit in sight. Unless you use this loss to offset income, the loss is wasted.
So you have an idea. In fact you have three ideas how to use this wasted loss to your advantage.
1 – You get an outsider to inject income into the trust and then share the benefit of the tax deduction.
Or – 2 – you bring an outsider into the trust to generate a profit within the trust.
Or – 3 – you could sell the trust and the outsider can then use the losses.
All good ideas. Except that Schedule 2F blocks every one of them. Meet the 4 trust loss provisions.
1 – Income Injection Test
When an outsider injects income into a trust to take advantage of the losses, the income injection test in s270-10 disallows the deduction.
The income injection test applies to any trust, fixed, non-fixed, even a family trust, but not an excepted trust. For a family trust this is the only test to pass.
This test has a division entirely to itself – Division 270. The other three have to share a division – Division 267.
2 – Pattern of Distribution
It starts with the pattern of distributions test in Division 267.
s267-30 (2): …the trust must pass the pattern of distributions test for the income year.
This tests looks at who you distributed to over the past 6 years. Always the same group of people. Perfect. You passed.
3 – 50% Stake Test
The 50% stake test is set out in s267-40 and more complex. There is the test time and the test period. There is the threshold group and the individuals in that group. And then there is their stake in the income or capital of the trust.
The 50% stake test applies to any trust except family trusts and excepted trusts.
4 – Control Test
The control test starts with one sentence.
s267-45: A group must not, during the test period, begin to control the trust directly or indirectly.
And then a note in fine print refers to Subdivision 269-E. The control test only applies to non-fixed trusts.
So these are the four trust loss provisions. But there is actually one more.
5 – Same Business Test
And then there is the same business test. Only a listed widely held trust needs to pass the same business test.
The same business test is outlined in Subdivision 269-F and similar to the non-commercial loss rules in Division 35.
What Test
So these are the four or five tests you might need to pass. But which test how and when?
A family trust just has to pass the income injection test and none of the test in Division 267 or 269.
Without a family trust election a non-fixed trust needs to pass the income injection test, but also the pattern of distribution test, 50% stake test and control test. So the full suit of tests in Subdivision 267.
An ordinary fixed trust – so not widely held – needs to pass the income injection test and the 50% stake test.
And a widely held trust also needs to pass the same business test in addition.
And then – last but not least – there is the concept of an excepted trust. An excepted trust doesn’t have to pass any test. But these are rare, so let’s leave those for another day.
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