The effect of indirectly receiving a franked distribution through trusts

Will the payment of a franked distribution from a corporate tax entity, franked with a franking percentage of 100%, flowing through various trusts, and ultimately out to the beneficiary, carry the relevant franking credits under Division 207 of the Income Tax Assessment Act 1997 (ITAA 1997) and will the beneficiary be entitled to a tax offset pursuant to section 207-45 of the ITAA 1997?

Yes. The beneficiary will be entitled to a tax offset pursuant to section 207-45 of the ITAA 1997 if it can demonstrated that the attached distribution, franked with a franking percentage of 100%, flows indirectly through the various trusts under Division 207 of the ITAA 1997.

In the 2005-06 income year Company A is a wholly-owned company of the family investment trust A, an elected family trust.

Another related trust, trust C owns 100% of the units in trust B. Trust B is a beneficiary of family investment trust A.

Individual D is a beneficiary of trust C and is the head of the family investment trust group and is entitled to 100% of the net income of trust C.

Company A will pay to its shareholder the family investment trust A, a franked distribution. The family investment trust A will in turn make a franked distribution which will pass through trust B and C, to individual D.

The following are the relevant distributions:

A franked distribution of $7.0M (with franking credits of approximately $3.0M), franked with a franking percentage of 100%, will be paid from company A to its shareholder, the family investment trust A.

The family investment trust A will then make an interim distribution of $7.0M (with franking credits of approximately $3.0M) to trust B.

Trust B will offset the franked distributions against its carry forward tax losses as at 30 June 2006 of approximately $6.0M.

Trust B will then make an interim distribution of its net income to its beneficiary, trust C.

Trust C will then make a distribution of all its net income to individual D as its beneficiary.

Division 207 of the ITAA 1997 deals with the effect of receiving franked distributions. Subsection 207-5(3) of the ITAA 1997 provides that if a franked distribution is made to a member that is a trustee of a trust, an amount equal to the franking credit on the distribution is also included in the member's assessable income. Subsection 207-5(4) of the ITAA 1997 ensures that a tax offset in relation to that distribution is only available to an entity (who may be a beneficiary or a trustee) if the distribution flows indirectly to it and does not flow indirectly through it to another entity. The tax offset is equal to its share of the franking credit on the distribution.

Subdivision 207-B of the ITAA 1997 deals with the effect of receiving a franked distribution through certain partnerships and trusts. Subsection 207-35(1) of the ITAA 1997 provides that if a franked distribution is made in an income year to an entity that is a trustee of a trust and the entity is not a corporate tax entity nor the trustee of a complying superannuation entity, then the assessable income of the trust for that income year includes the amount of the franking credit on the distribution. Subsection 207-35(2) of the ITAA 1997 ensures that this amount is in addition to any other amount included in that assessable income in relation to the distribution under any other provision of the ITAA 1936 or ITAA 1997. If all or a part of this amount of assessable income is then distributed, or flows indirectly, to an entity that is a beneficiary or the trustee of a trust and this entity has an amount of assessable income for that year that is attributable to all or a part of the distribution then, in accordance with subsection 207-35(3) of the ITAA 1997, the entity's assessable income for that year also includes so much of the franking credit as is equal to its share of the franking credit on the distribution.

Pursuant to section 207-50 of the ITAA 1997, a franked distribution will be taken to flow indirectly to a beneficiary or the trustee of a trust if the distribution is made to a trustee of a trust or flows indirectly to the trustee of the trust as a partner or beneficiary (paragraphs 207-50(3)(a) and 207-50(4)(a) of the ITAA 1997), and; either the beneficiary has a share of the trust's net income under paragraph 97(1)(a) of the ITAA 1936 or an individual interest in the trust's net income under paragraph 98(1)(a) or 98(1)(b) or 100(1)(a) or 100(1)(b) of the ITAA 1936 (paragraph 207-50(3)(b) of the ITAA 1997), or the trustee is liable to be assessed on a share of the trust's net income in respect of a beneficiary under section 98 of the ITAA1936 or assessed on all or part of the trust's net income for that year under section 99 or 99A of the ITAA 1936 (paragraph 207-50(4)(b) of the ITAA 1997),

and

The entity's share of the franked distribution as calculated in section 207-55 of the ITAA 1997 is a positive amount, whether or not the beneficiary or trustee actually receives any of that share. That is, the entity must have an entitlement to part or all of the franked distribution.

For the purposes of working out an entity's share of the franked distribution, it is also necessary to describe where a franked distribution flows indirectly through an entity. In accordance with subsection 207-50(5) of the ITAA 1997, this occurs where there is an entity (intermediary entity) and the franked distribution flows through that entity to another entity (the focal entity).

Pursuant to subsections 207-55(1) and 207-55(2) of the ITAA 1997 an entity's share of the franking credit is taken to be a notional share because an entity may not actually receive its share of the franked distribution (that is, the concept is defined so that it is undiminished by deductions of the trustee of a trust through which a franked distribution flows). Even though the entity does not receive an amount of the franked distribution because deductions exceed the amount of the franked distribution, the franking benefits may still flow through to the beneficiary.

An entity's share of a franked distribution is determined under the table in subsection 207-55(3) of the ITAA 1997. This calculation is used to determine the entity's share of the franking credit on a franked distribution where the distribution flows indirectly. A focal entity's share of a franked distribution is calculated by reference to the intermediary entity's share of the franked distribution to which the intermediary entity is entitled. Column 2 in the table provides the intermediary entity's share and column 3 in the table provides the focal entity's share. In the case of trusts, the table operates so that if deductions exceed assessable income (that is, there is a loss) there can be no amount which flows indirectly through it to another entity (column 2 in item 3 in the table in subsection 207-55(3) of the ITAA 1997).

Section 207-57 of the ITAA 1997 operates to determine the amount of an entity's share of the franking credit on a franked distribution. The following formula operates to allocate the franking credit: Amount of the *franking credit on the *franked distribution (Entity's *share of the *franked distribution) / Amount of the *franked distribution * denotes a term defined in section 995-1 of the ITAA 1997

Pursuant to section 207-45 of the ITAA 1997, an entity that is the ultimate recipient of a franked distribution to whom a distribution flows indirectly is entitled to a tax offset for that income year equal to its share of franking credit attached to the distribution. The ultimate recipients of a franked distribution are the recipients that can use the tax offset and include individuals, corporate tax entities, trustees that are liable to be assessed under section 98, 99 or 99A of the ITAA 1936 or trustees of eligible entities within the meaning of Part IX of the ITAA 1936.

Pursuant to subsection 207-35(1) of the ITAA 1997, family investment trust A will include in its assessable income in respect of the 2005-06 income year the amount of $3.0M as the franking credit on the distribution of $7.0M. This amount represents the gross-up and is in addition to the franked distribution of $7.0M. Family investment trust A's net income will be $10.0M. In coming to this conclusion, it is determined that the distribution made by company A to family investment trust A is a frankable distribution pursuant to sections 202-40 and 202-45 of the ITAA 1997 and that the distribution is franked in accordance with section 202-5 of the ITAA 1997, namely that company A is an Australian resident franking entity, that has made a frankable distribution to which it has allocated franking credits.

Pursuant to subsection 207-35(3) of the ITAA 1997, trust B will include in its assessable income for the 2005-06 income year the amount of $3.0M as its share of the franking credits on the distribution. This amount is in addition to the franked distribution received by trust B of $7.0M from family investment trust A. Trust B's net income will be $10.0M. After deductions for tax losses, the net income of trust B will be approximately $4.0M. This result is a consequence of the franked distribution from company A flowing indirectly to trust B as a beneficiary pursuant to subsection 207-50(3) of the ITAA 1997. Family investment trust A (being the intermediary entity) receives a franked distribution, trust B (being the focal entity) has a share of the family investment trust A's net income for that income year (the share amount) that is covered by paragraph 97(1)(a) of the ITAA 1936. Furthermore, trust B's share of the distribution as determined under column 3 of item 3 in the table in subsection 207-55(3) of the ITAA 1997 is a positive amount. Therefore, trust B's share of the franking credit on the franked distribution, pursuant to section 207-57 of the ITAA 1997, will be $3.0M.

Trust C will include in its assessable income for 2005-06 income year the amount of $4.0M. Pursuant to subsection 207-35(3) of the ITAA 1997, this amount will include its share of the franking credit of $3.0M on the distribution received from trust B. The trustee of trust B (being intermediary entity) receives a franked distribution, trust C (as the focal entity) has a share of trust B's net income for that income year (the share amount) that is covered by paragraph 97(1)(a) of the ITAA 1936. Trust C's share of the distribution under column 3 of item 3 in subsection 207-55(3) of the ITAA 1997 is a positive amount. Therefore, trust C's share of the franking credit on the franked distribution, pursuant to section 207-57 of the ITAA 1997, will be $3.0M.

Trust C will then make a distribution of all its net income of approximately $4.0M to individual D as its sole beneficiary. Individual D will include in its assessable income for the 2005-06 income year the amount of $4.0M. Pursuant to subsection 207-35(3) of the ITAA 1997, this amount will include its share of the franking credit of $3.0M on the distribution received from trust C. In coming to this conclusion it is determined that a franked distribution flows indirectly through trust B and trust C in accordance with subsection 207-50(5) of the ITAA 1997. The franked distribution ultimately flows indirectly to individual D pursuant to subsection 207-50(3) of the ITAA 1997. The trustee of trust C (being the intermediary entity) receives a franked distribution, individual D (as the focal entity) has a share of trust C's net income for that income year (the share amount) that is covered by paragraph 97(1)(a) of the ITAA 1936 and individual D's share of the distribution under column 3 of item 4 in subsection 207-55(3) of the ITAA 1997 is a positive amount. As 100% of the net income and franking credits will flow to individual D under the terms of the trust deed, individual D's share of the franking credit pursuant to section 207-57 of the ITAA 1997 will be $3.0M. Individual D will be entitled to a tax offset equal to their share of the franking credit on the distribution pursuant to section 207-45 of the ITAA 1997.