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Wednesday, 16 March 2005
Page: 18

Senator CHAPMAN (10:19 AM) —The Tax Laws Amendment (2004 Measures No. 7) Bill 2005 introduces some 11 different schedules amending the tax acts across a range of issues, all of which are very welcome initiatives of the Howard government. Some of them were commitments made in the last budget; others were commitments made during the election period. As I say, they are all very welcome, including the introduction of the 25 per cent entrepreneurs tax offset, the removal of the current requirement for small businesses to use the STS accounting method to enter the simplified tax system and, as Senator Watson has referred to in some detail, the incentive designed to encourage petroleum exploration in Australia’s remote offshore areas in relation to concessions regarding the resource rent tax.

Another very welcome initiative is that contained in schedule 8 of the bill, which provides greater flexibility, reduced compliance costs and ongoing certainty surrounding family trust elections and interposed entity elections. This was an announcement made in the 2004-05 federal budget and will allow family trust elections and interposed entity elections to be made at any time in relation to an earlier year of income. These are elections that are made under the trust loss rules in schedule 2F of the Income Tax Assessment Act. Generally speaking, a trust that makes a family trust election needs to pass a reduced number of tests in order to carry forward and/or recoup losses under the trust loss rules. Furthermore, family trust elections allow tracing for the purposes of applying the continuity of ownership test for the purposes of recouping losses in companies, and also allow franking credits attached to dividends received by a trust to be passed through to beneficiaries of that trust. It will allow entities that generally make interposed entity elections to receive distributions from trusts that have made family trust elections, also without the imposition of a penalty tax on such distributions.

The implementation of this very welcome initiative does give rise to the opportunity to address a number of other deficiencies and inappropriate income tax consequences that arise from the requirement for making family trust and interposed entity elections. They are unintended consequences, I believe, of a far too restrictive legislative framework. I have to say to the minister that I warned at the time that this legislation was being considered by the Senate Economics Legislation Committee, I think way back in 1997, that these unintended consequences would arise.

This legislation was drafted far more widely than was needed to deal with the issues that it sought, quite legitimately, to prevent, such as trading in trust losses and trading in franking credits. Indeed, this legislation was a sledgehammer to crack a nut. I fear this is the case with a lot of tax legislation that comes before us these days—it is drafted far more widely than is necessary to deal with the perceived problem. I notice a nod from Senator Murray agreeing with me. Another example of that was the legislation which came before the Senate Economics Legislation Committee last year dealing with the payment of defined benefit pensions by self-managed superannuation funds. That legislation is currently under review.

I have had drawn to my attention a submission from the Institute of Chartered Accountants which has gone to the Minister for Revenue and which seeks certain other changes to the family trust election requirements to overcome some of these unintended consequences. As I understand it, the institute sought for those changes also to be incorporated in this legislation. I think it is a matter for regret that they have not been incorporated in this bill. I certainly hope they will receive positive and favourable consideration from the minister and be incorporated in future legislation.

One of the issues that that submission raises is the definition of a family group for the purposes of family trust election. Under the current legislation a family group includes any parent, grandparent, brother, sister, nephew, niece, child or grandchild of the so-called test individual; or the test individual’s spouse or the spouse of any of those people. There does not seem to be any policy rationale for placing a generational limit on the definition of a family, especially given that the typical life of a trust—certainly of those trusts that were set up in the 1960s and 1970s—is 80 years. The life of trusts that have been established more recently, since the abolition of the perpetuity laws by states, is perhaps infinite. Those trusts commonly extend into the fourth generation and beyond. The consequence of this under the current legislation is that many family trusts will eventually have to distribute outside this narrowly defined family group and then be subject to a penalty tax, the family trust distribution tax.

This issue of family definition also raises a much larger issue in relation to family trusts—what I would call the de facto death duties that apply to them under current legislation. As I said a moment ago, many family trusts were established in the 1960s or the 1970s before the states, either legislatively or in practical effect, abolished the laws against perpetuity; hence, trusts typically had a vesting date of 70 or 80 years, after which the assets would be distributed to beneficiaries, typically individuals or another trust.

However, I am advised that, following the introduction of capital gains tax in 1984, the ATO regards the vesting of a trust as a capital gains tax event—in effect, a death duty: the imposition of a substantial tax on what is in effect an intergenerational transfer of assets, when no such tax applies to similar transfers between individuals since the very welcome abolition of death and estate duties following widespread community pressure to eliminate this unfair tax about 30 years ago. Hence a problem does exist currently, although I guess it something of a sleeper because in most instances it will probably be another 20 years or so before many trusts start to reach their vesting dates.

The introduction of the family trust election requirement has worsened this situation. By applying a penalty tax rate to trust distributions to generations beyond grandchildren of the test person, the legislation effectively shortens the life of family trusts in many instances to less than the defined vesting date. It is highly likely that grandchildren will expire before the defined vesting date—effectively shortening the life of the trust. As I mentioned earlier, for more recent trusts, which do not have a vesting date, this requirement has the practical effect of applying one.

I believe the government must eliminate this de facto death duty on family trusts. To achieve this, the legislation should be amended to allow the family group relating to a family trust election to include any lineal ancestor or descendant of the test person. If it is regarded as essential to limit the extent of distributions in any particular year, then this provision could be supplemented by a provision that distributions can be made to no more than five successive generations in any particular year—that is, the number of generations which currently make up the family group. If, in a subsequent year, it was desired that a distribution be made to, for example, great-grandchildren, then it would not be possible to make a distribution to grandparents and so on. The second change required is that, for trusts that have not already taken advantage of the state’s abolition of laws against perpetuity, legislation should be initiated to allow trust deeds to be amended to achieve this without it being defined as a capital gains tax event. Alternatively, the law should be amended to provide that the vesting of a trust is not a capital gains tax event.

Other issues which are raised in the submission by the Institute of Chartered Accountants include the difficulty in revoking a family trust election. In general, family trust elections are irrevocable, except in relation to certain fixed trusts; however, this power to revoke family trust elections is never exercised because there are simply no, or very few, trusts that fall within the definition of a fixed trust for the purpose of trust loss rules. The definition of a fixed trust in relation to trust loss rules is much narrower than the general commercial view of what constitutes a fixed trust. In that context it would be appropriate to review and modify the definition of a fixed trust.

There is also no discretion allowed for the Commissioner of Taxation to allow the revocation of a family trust election. The Institute of Chartered Accountants have highlighted numerous examples of errors that have been made by both taxpayers and tax practitioners in the preparation of family trust elections, including the specification of incorrect test individuals and the making of family trust elections that were not required.

These errors are largely attributable to the excessive complexity of the trust loss rules and the legislation. Therefore it would be appropriate to provide the commissioner with a discretion to allow certain terms of a family trust election to be changed in the event of an inadvertent error or where a family trust election was made where it clearly was not necessary. That situation also applies with regard to the revocation of interposed entity elections.

The institute also suggests that a choice should be given to revoke elections after losses or debt deductions have been utilised. It was, as I understand it, the objective of the trust loss rules to ensure that only those who economically suffered a loss benefited from the eventual recoupment of that loss. If that is the case, then there is no need for the rules to continue to apply to trusts that have made family trust elections where the losses have already been fully recouped or that no longer have any debt reductions. Once there are no losses or debt reductions in a trust, there is no policy reason to continue to confine distributions to members of the test individual’s family group. The taxpayers should have the choice to revoke a family trust election if a trust no longer has losses or debt reductions.

The institute has also identified problems that relate to the death of a test individual. It has also raised the issue of extending the advantages of making a family trust election to interposed entity elections. Currently, interposed entities that make interposed entity elections suffer the same restrictions as family trusts making a family trust election but they do not enjoy the advantages that a family trust election provides. There are a number of other issues raised by the Institute of Chartered Accountants in its submission to the Minister for Revenue that highlight the various ways in which the current legislation is commercially inhibiting, and they are areas that also require detailed examination and, I believe, a positive response.

As Senator Watson said, we do not want to delay this current legislation; however, I did want to raise those issues. I think they are issues on which the government should take the initiative and respond positively, particularly the issues highlighted in the submission from the Institute of Chartered Accountants and the issue of what I believe is very much an unintended consequence of this legislation, which is the de facto capital gains tax or death duty that, in effect, currently applies to family trusts.