On 23 February 2022, the ATO released a long-awaited draft ruling, guidelines and a taxpayer alert all relating to trust distributions that have associated ‘reimbursement agreements’. Generally, these arrangements involve trust distributions to low taxed family members or family companies where the benefit of the distribution is diverted away from the beneficiary to another family member that would otherwise pay a higher rate of tax if the trustee distributed directly to them.
ATO crack down on family trust distributions
On 23 February 2022, the ATO released a long-awaited draft ruling, guidelines and a taxpayer alert relating to trust distributions that have associated ‘reimbursement agreements’. Generally, these arrangements involve trust distributions to low taxed family members or family companies where the benefit of the distribution is diverted away from the beneficiary to another family member that would otherwise pay a higher rate of tax if it was distributed directly to them.
Draft Taxation Ruling TR 2022/D1 sets out the Commissioner’s view on trust reimbursement agreements under s100A in Division 6 of the Income Tax Assessment Act 1936 including the ATO’s interpretation of the exclusion for ‘ordinary family or commercial dealing’. Draft Practical Compliance Guideline PCG 2022/D1, provides the ATO’s proposed approach to compliance activity in relation to reimbursement agreements. Both draft TR 2022/D1 and draft PCG 2022/D1 are mainly targeting trust distributions from family discretionary trusts to lower taxed family members where there is a repayment, reimbursement or financial accommodation by the beneficiary back to the trust or to another family member etc. The Taxpayer Alert TA 2022/1, however, specifically deals with family trust distributions to adult children where the funds are offset against loan accounts of the parents or paid to the parents to compensate them for the children’s upkeep before they became adults etc.
What’s the purpose of s100A?
Broadly, s100A is an anti-avoidance provision that targets arrangements where a beneficiary is presently entitled to trust income, but the economic benefit is received by another person other than that beneficiary and has the purpose of reducing any person’s tax liability. If s100A applies, a deeming rule operates such that the beneficiary will not be considered presently entitled to the diverted income, but instead the trustee is liable to tax at the top marginal tax rate.
Commissioner’s view in draft TR 2022/D1
The Commissioner’s preliminary view in draft TR 2022/D1, is that for s100A to apply:
- There must be a legally effective present entitlement to trust income that arose to a beneficiary to a share of trust income in connection with a pre-existing ‘reimbursement agreement’. While the agreement must be in existence before the present entitlement arose, the Commissioner considers the conduct of parties before and after the present entitlement arose to be relevant factors to decide whether an agreement exists.
- Under the agreement, the benefit arose to someone other than the presently entitled beneficiary - this may include a loan, release or postponement of debt, and is not limited to actual ‘reimbursements’
- A purpose of reducing someone’s income tax liability exists - that person need not be a party to the agreement, and an actual tax reduction need not have been achieved. The purpose of an advisor to the party can also be imputed to the party.
- The agreement does not fall within the ordinary family or commercial dealing exception. The test of whether a dealing qualifies within the exception is described as an evaluative standard to be applied based on the facts of each case. The transactions must be able to be explained as achieving regular “familial or commercial ends”, e.g. simply having all parties as family members does not alone engage the exception. Further, the presence of tax-driven features in an agreement will be relevant to determine if an agreement is in the course of ordinary dealing.
ATO’s interpretation of ‘ordinary family or commercial dealings’
In draft TR 2022/D1, the ATO has provided a definition of what is an ordinary family or commercial dealing in which they conclude that where there is a purpose of tax saving in the arrangement it would be difficult to say it is an ordinary family or commercial dealing. This is particularly pertinent where the beneficiary does not call on the distribution and has a lower tax rate than other family members.
However, each case has to be considered carefully and there are a number of examples of family arrangements in draft TR 2022/D1 that show where s100A could apply and also where it is unlikely to apply. This is illustrated in the following examples.
Example 1: non-commercial loan between family members
The Jones Family Trust includes in its class of beneficiaries Mr and Mrs Jones and their three adult children Amy, Ben and Claire. Each year, the trustee resolves to make each of these beneficiaries presently entitled to 20% of the trust income.
In one year, Mr Jones lends Amy an amount which is similar to the amount of trust income he is presently entitled to. He does this to help Amy move out of home. The loan requires Amy to pay Mr Jones back the principal when her financial circumstances permit and without interest.
Although the terms of the loan are not commercial, in these circumstances, a genuine interest-free loan from parent to child because of their family relationship is explicable as an arrangement entered into in the course of ordinary dealing.
Absent other factors, s100A may not apply under the exclusion for ‘ordinary family or commercial dealing’.
Example 2: circular flow of funds (‘Washing Machine’ distributions)
The trustee of a discretionary trust owns the shares in a private company. The company is also a beneficiary of the trust and it undertakes no substantial business activity. The directors of the trustee company and the beneficiary company are the same (or related) individuals.
The trustee makes the company beneficiary presently entitled to all, or some part of, trust income at the end of year 1 and distributes it to the company in year 2 before the company lodges its year 1 income tax return.
The company includes its share of the trust's net income in its assessable income for year 1 and pays tax at the corporate rate.
The company pays a fully franked dividend to the trustee in year 2, sourced from the trust distribution, and the dividend forms part of the trust income and net income in year 2.
The trustee makes the company presently entitled to all, or some part of, the trust income at the end of year 2 (possibly including the franked distribution). The arrangement is repeated.
There is a benefit to the trustee (in that capacity). The agreement provides for the payment of income from the trustee to the company on the understanding (inferred from the repetition in each income year and their common control) that the company would pay a dividend to the trustee of a corresponding amount (less the tax paid).
Absent evidence to the contrary, the concerted steps taken by the trustee and company indicate contrivance. The arrangement appears to be designed to achieve a reduction in tax that would otherwise be payable had the trustee simply accumulated the income. The arrangement is unlikely to be considered to have been entered into in the course of ordinary dealing. The ownership structure and, particularly, the perpetual circulation of funds, do not appear to serve ordinary commercial purposes.
In these circumstances, the ATO may consider that s100A is likely to apply.
Decision in Guardian AIT Pty Ltd ATF Australian Investment Trust
An important development relating to s100A was the recent Federal Court decision in Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation (Guardian case), which is currently on appeal by the Commissioner to the Full Federal Court. This case concerned arrangements similar to example 2 above involving distributions of trust income to a newly incorporated corporate beneficiary, which in turn distributed dividends back to the trust. The Federal Court found in favour of the taxpayer and concluded the arrangements did not constitute a 'reimbursement agreement' for the purposes of s100A of the ITAA 1936 as the arrangements were part of ordinary family or commercial dealings.
Despite the ATO losing the Federal Court decision in the Guardian case, they are still targeting circular 'washing machine' distributions from trusts to companies where the funds are paid back to the trust as franked dividends the next year and again distributed to the company.
Draft PCG 2022/D1
The draft PCG provides the ATO’s proposed compliance approach to s100A and sets out how the ATO differentiates risk for a range of trust arrangements to which s100A might apply.
The guidelines denote the different risk ratings with the ATO’s usual four coloured risk zones:
- White (low risk) for arrangements entered into in income years ending before 1 July 2014
- Green (low risk)
- Blue (medium risk)
- Red (high risk).
The ATO has said it will not generally dedicate new compliance resources to consider the application of s100A to white and green zone arrangements (unless a pre-1 July 2014 arrangement would come with the blue or red zone).
Under TA 2022/1, the ATO is reviewing trust arrangements where parents enjoy the economic benefit of trust income appointed to their children who are over 18 years of age (children).
This may typically involve discretionary family trust arrangements where the controller’s (parent’s) adult children are made presently entitled to trust income, but the income is used to meet the expenses of the parents. The entitlements are ‘satisfied’ by the children directing (or purportedly directing) that the amounts be paid to their parents or applied against any beneficiary loans owned by the parents.
Under the arrangement, the parties may argue the children are required to repay their parents for their share of family costs or for expenses incurred in relation to their upbringing (e.g. private school fees and uniform costs or their share of family holidays).
The ATO is concerned taxpayers are entering into these arrangements to access tax-free thresholds and lower marginal tax rates of family members, rather than ordinary familial considerations. The ATO considers these arrangements may to be a sham or Part IVA or the reimbursement agreement rules may apply.
However, example 3 in the Taxpayer alert also indicates the ATO considers section 100A will not apply where the adult children’s current year expenses are paid by the trustee and there are trust distributions made to the adult children but paid by being offset against the expenses paid by the trustee. For example, the payment of university tuition fees or rent/ board of the adult children.
Date of Effect
When finalised, draft TR 2022/D1 and draft PCG 2022/D1 will apply to arrangements both before and after 23 February 2022 (their date of issue). It is important to note that amended assessments in relation to section 100A are not subject to the usual two or four year amendment period so there is an unlimited amendment period.
However, under draft PCG 2022/D1, for entitlements conferred before 1 July 2022, the ATO will stand by its administrative position published in Trust taxation - reimbursement agreement (first published in July 2014) to the extent it is more favourable to the taxpayer’s circumstances than draft PCG 2022/D1. This may be problematic as that administrative position did not give much of an explanation of what is an ordinary family and commercial dealing and only gave some examples where the provision clearly does or does not apply. So, unless the circumstances fit into one of the examples 2,3 or 4 in the ATO’s 2014 published position (i.e. where s100A clearly does not apply), the ATO may consider applying the approach in PCG 2022/D1 to pre-1 July 2022 situations.
There is a further concession for pre-1 July 2014 situations in that the white zone in the PCG (no compliance action) relates to years before 1 July 2014, but this will not apply if:
- It is outside the green zone and:
- The ATO is otherwise considering your income tax affairs for those years
- You have entered into an arrangement that continues before and after that date
- The trust and beneficiary tax returns that were required to be lodged for those years were not lodged before 1 July 2017.
Following many years of unclear judicial interpretation of the ‘ordinary family or commercial dealings’ exclusion in s100A, it was hoped the ATO would provide much needed clarity of its meaning with the release of draft TR 2022/D1 and draft PCG 2002/D1. However, it would appear the ATO has not provided an interpretation that is any clearer, but it has provided a number of examples that at least indicate the types of arrangements that ATO considers to both be, or not be, ordinary family or commercial dealings to which section 100A could apply. However, there may be many taxpayers and advisers who dispute the ATOs fine line between the two.
BDO is considering making a submission to the ATO on Draft Tax Ruling TR 2022/D1 and Draft PCG 2022/D1, particularly that the ruling and PCG should not apply retrospectively. This submission is due on 8 April 2022.
If you would like further information on any of the above, please contact a tax adviser in your local BDO office.