Tracey Dunn, Associate Director, RSM Australia

Family trust arrangements - the Commissioner's new approach – is this the end of discretionary trusts as a tax-effective structure for family wealth creation and intergenerational asset transfer?

On 23 February 2022, the Australian Taxation Office (ATO) issued long-awaited guidance on discretionary trusts and the application and operation of section 100A of the Income Tax Assessment Act 1936 (ITAA 1936). 

The ATO simultaneously issued updated guidance setting out the ATO’s current view on Division 7A, trusts and unpaid present entitlements owing to corporate beneficiaries.  The guidance is set to have a significant impact on discretionary trusts in Australia, particularly in familial arrangements where trusts are used for business and investment purposes and trustees have (or intend to) distribute income of the trust to adult beneficiaries over the age of 18 (adult child beneficiaries) or corporate beneficiaries.

The guidance issued by the ATO is comprehensive and the implications far too complex to address adequately in a short article.  The key takeaway is that the ATO’s administrative approach to discretionary trusts is now clear and there may be common family arrangements that now not acceptable under the Commissioner's compliance approach.

Family groups and trustee taxpayers are urged not to panic as the ATO’s view is not law, and there will be many ‘common’ family arrangements involving discretionary trusts that will continue to be low risk.  Clients who have discretionary trusts within their family groups are encouraged to contact both their taxation and legal advisors to assess risk and take remedial action where required.

Section 100A was introduced in 1978 as an anti-avoidance measure to deal with ‘trust stripping’ and tax avoidance and applies to ‘reimbursement arrangements’.  The scope of s 100A is however extremely broad, and in the context of discretionary trusts, may generally have application where a trust beneficiary (usually with a low marginal tax rate) is made specifically entitled to income of the trust, but another person or entity enjoys the benefit of the funds representing the income distribution.  An exception to s 100A being where the ‘arrangement’ is an ‘ordinary commercial or family dealing’. 

It is apparent from the guidance (Draft PCG 2022/D1) issued by the ATO on s 100A that in the absence of clear and current case law on what constitutes an ‘ordinary commercial or family dealing’ for the purposes of s 100A the ATO intend to target arrangements where a trustee has made an adult child or corporate beneficiary presently entitled to income of the trust estate, but another person has the actual benefit of the funds representing the income distribution.  The ATO expressing the view that just because something happens frequently, or is accepted as a common practice, doesn’t mean it is an ordinary commercial or family dealing for the purposes of s 100A.

The sting in the tail being that where the Commissioner of Taxation (Commissioner) applies s 100A, it will open an unlimited period of review for the ATO and could result in the trustee being assessed on part or all of the trust income at the highest marginal tax rate.

TR 2022/D1 INCOME TAX: SECTION 100A REIMBURSEMENT AGREEMENTS

Draft Taxation Ruling TR 2022/D1 sets out the Commissioner's view on s 100A and sets out the type of arrangements the ATO will generally target. 

TR 2022/D1 clearly sets out the Commissioner's intention to target trusts where there is a lack of commerciality or the existence of ‘fictitious facts’ surrounding an entitlement to income of the trust. 

Examples in the draft ruling include (but are not limited to) arrangements where:

• Distributions have been made to an adult child beneficiary and the entitlement to the funds representing those distributions have been applied for the benefit of another person (usually the parents),
• Where an entitlement to income has been ‘gifted’ back to the trustee (or a parent) or otherwise forgiven,
• Where there is a circular flow of funds (e.g., where the trust is a shareholder in a corporate beneficiary); and,
• Where a trust acquires an equity interest in a corporate beneficiary under a share buy-back arrangement involving members of the family group (often the parents). 

The ruling, whilst still in draft form, is intended to have application before and after the date the final ruling is issued.  This has raised some concern amongst taxation professionals given the ATO have been working on draft s 100A guidance for more than 6 years, have delayed the issue of the guidance numerous times and, have provided no real indication during this time of their intention to target distributions made to adult child beneficiaries.  The lack of certainty for trustees and beneficiaries around the ATO’s tax administration approach will no doubt cause concern and may leave trustees at risk of assessments arising from distributions that were made within the trustee’s power.

PCG 2022/D1 SECTION 100A REIMBURSEMENT AGREEMENTS – ATO COMPLIANCE APPROACH

Practical Compliance Guideline PCG 2022/D1 which sets out the Commissioner's compliance approach in dealing with s 100A and should be read in conjunction with TR 2022/D1. 

PCG 2022/D1 applies a risk zone approach with white, green, blue and red zones, each zone representing the ATO view on the types of arrangements that will attract a low, medium and high-risk compliance approach.  The examples set out in PCG 2022/D1 are not exhaustive however as an example, a green (low risk) arrangement will include where the trustee has made a distribution of income to an individual, the funds representing the income are physically paid to a bank account held by the individual and/or their spouse.  A red zone (high risk) arrangement includes where a trustee makes an adult child beneficiary presently entitled to income of the trust, but artificially reduces the entitlement to call on the income by applying expenses incurred by the parents when the beneficiary was a minor (referred to as ‘parenting’ costs) to reduce the amount owing to the beneficiary. 

The PCG will have application both before and after its date of issue, however taxpayers can rely on ATO guidance issued in July 2014 (and available on the ATO website) where it is more favourable to their circumstances than the risk approach set out in the PCG.

TA 2022/1 TRUSTS: PARENTS BENEFITTING FROM THE TRUST ENTITLEMENTS OF THEIR CHILDREN OVER 18 YEARS OF AGE.

Coinciding with TR 2022/D1 and PCG 2022/D1, the ATO also issued Taxpayer Alert TA 2022/1 which sets out the Commissioner's view on trust distributions to adult child beneficiaries and the type of arrangements that will attract the Commissioner's attention. 

Importantly TA 2022/1 not only provides a warning to taxpayers, but also for advisers, with Promoter Penalties and disciplinary action threatened against Tax Agents where schemes are identified.

The tax alert specifically addresses arrangements where a beneficiary has not been made aware of their entitlement and steps have been taken by the trustee and/or their advisors to artificially reduce that beneficiary’s entitlement to income of the trust by applying historical costs of parenting.  The costs being ‘parenting’ costs incurred when the beneficiary was a minor (e.g., school fees, food & board), calculated on an arbitrary basis, not incurred by the trustee (or within the trustee’s powers) and not supported by any contemporaneous evidence. The intention of the arbitrary ‘offset’ being to facilitate the benefit of the trust income by the parent, not the adult child beneficiary.

TD 2022/D1 INCOME TAX: DIVISION 7A: WHEN WILL AN UNPAID PRESENT ENTITLEMENT OR AMOUNT HELD ON SUB-TRUST BECOME THE PROVISION OF ‘FINANCIAL ACCOMMODATION’?

The final piece of guidance issued with this suite is Taxation Determination TD 2022/D1 which essentially closes the door on the use of sub-trust arrangements. 

Sub-trust arrangements have been used in certain circumstances post 16 December 2009 where a trustee made a corporate beneficiary presently entitled to trust income, did not place the entitlement under a complying Division 7A loan agreement and did not intend to call on the trustee for immediate repayment.  TD 2022/D1 represents a shift in the Commissioner's view from that expressed in TR 2010/3 and PS LA 2010/4.

From 1 July 2022, where a trustee makes a distribution of income to a corporate beneficiary, and the beneficiary does not call on the trustee for immediate repayment, the Commissioner will now take the view, the failure to call for repayment will be financial accommodation for the purposes of Division 7A ITAA 1936.

Failure to repay the unpaid present entitlement in full, either by cash payment or by holding a specific trust asset on sub-trust for the corporate beneficiary may result in the application of a deemed assessable Division 7A dividend to the trustee.  Where the trust places a separate asset on sub-trust for the corporate beneficiary, the present entitlement will be taken to have been paid in full, however if the trust intermingles the asset with trust assets, Division 7A will apply.

It is proposed that TR 2010/3 and PS LA 2010/4 will be withdrawn from 1 July 2022.  The Commissioner's updated guidance, whilst not law, could effectively make the statutory provisions under Subdivision EA ITAA 1936 dealing with payments made to shareholders and associates of a trust where an unpaid present entitlement is owed to a corporate beneficiary, irrelevant.

For Accountants and Advisers assisting their clients with such matters, further information and support can be obtained through RSM here.

Disclaimer: The content of this Bulletin is general information only. It is not legal advice. The statements and opinions are the expression of the author, not Law Central, and have not been checked for their accuracy, completeness or changes in the law. Law Central recommends you seek professional advice before taking any action based on the content of this Bulletin.

Related documents:

• Family Trust
• Div 7A Loan Agreement
• Company (ELodgement)

Related webinars:

• Webinar - Testamentary Trusts 101
• Webinar On Demand - Fixing Family Trust Deeds - Mistakes made pre and post establishing a Trust
• Webinar On Demand - Introduction to Family Trusts - the basics