ASF TAKEAWAYS: The finalised tax ruling and its interpretation will have a significant impact on trust distribution arrangements going forward. The era of distributing to adult children to utilise lower tax brackets may just have come to an end.
Trustees and their advisers will need to ensure and monitor that the entitlements to beneficiaries fall under the green zone, or otherwise the distributions could be invalidated and the trustees liable to pay tax at 47%.
Cases such as the Guardian and the BBlood Enterprises case are going to significantly impact and drive the narrative on the application of s.100A, and we await these decisions prior to undertaking any steps.
Since the release of the draft tax ruling TR 2022/D1 in February 2022, the profession has been awaiting, with bated breath, the final iteration in order to assist clients in dealing with this 'new' approach. The ATO released its final guidance on s.100A of the ITAA 1936 in late December 2022, and has tended to take a softer, more considered approach.
Nonetheless, TR 2022/4 and PCG 2022/2 will have a significant impact on the manner in which the income of a trust is distributed to corporate beneficiaries and/or adult beneficiaries. Trustees and their advisors will need to monitor trust arrangements on an ongoing basis (see ATO compliance approach below). It is important to note that TR2022/4 applies to trust arrangements both before and after its issue and should be read in conjunction with PCG 2022/2.
WHEN WILL S.100A APPLY?
Broadly, three requirements must be satisfied in order for section 100A to apply;
- a beneficiary is made presently entitled to trust income and it relates to a reimbursement agreement;
- The agreement must provide for a benefit to be provided to a person other than the beneficiary who is presently entitled to the trust income; and
- at least one of the parties enters into the agreement for a purpose of reducing tax.
A reimbursement agreement is defined as an agreement that provides for money to be paid, property transferred, or services or other benefits provided to someone other than the beneficiary.
Note that if the arrangements are entered into in the course of an ordinary family (including cultural reasons) or commercial dealings, or if there is no tax reduction purpose, s.100A will not apply.
The ATO plans to invalidate trust distributions that breach s.100A, which would mean that the tax would be levied on the trustee of the trust at 47%, along with potential penalties.
An example where section 100A could apply:
a trust distributes income that consists solely of interest income to a foreign person.
as the foreign person resides in a country where a DTA exists, the trust distribution is subject to interest withholding tax at a rate of 10%.
before the foreign resident is made presently entitled, the trustee agrees to pay the cash to a resident beneficiary.
the resident beneficiary would have been taxed at a rate of 47%.
REIMBURSEMENT AGREEMENTS - CASE LAW
The key principle required by s.100A is that a reimbursement agreement exists before it can apply. This is because the present entitlement of the beneficiary must arise out of the reimbursement agreement. Put another way, a reimbursement agreement must exist prior to the trustee signing the distribution of income minutes for a particular financial year.
In the recent decision handed down by the Full Federal Court in Commissioner of Taxation v Guardian AIT Pty Ltd as trustee for Australian Investment Trust [2023] FCAFC 3, reimbursement agreements were considered in detail. The court's decision makes it clear that there needs to be a good deal more than inferences and conjecture for a reimbursement agreement to exist. There needs to be a clear consensus arrived at between the two minds.
In the Guardian case, trust income was distributed to a corporate beneficiary, returned as a franked dividend to the trustee (the sole shareholder) in the following year, and then distributed to a non-resident individual (this is typically described as the 'washing machine' arrangement). The effect of the transactions was to convert the original trust income into franked dividend income, which had the result of capping the tax on the income at the corporate rate, compared to the higher rates that would have applied if the original trust income had been distributed to that individual directly. The Commissioner contended the transactions occurred as a series of steps under an agreement which was a ‘reimbursement agreement’ to which section 100A would apply.
The Courts disagreed, on the simple premise that the reimbursement agreement must precede the present entitlement. A beneficiary's present entitlement to income of the deceased estate is determined on the last day of each income year (30 June). The taxpayer was able to produce sufficient evidence (both written and orally) that the decision to pay out the dividend and place the UPE on Division 7A loan terms occurred after the present entitlement arose.
Note: in this author's opinion, it is conceivable that this decision is reversed on appeal. Furthermore, the case did not actually consider the application of s.100A, but rested on a distinction.
THE ATO COMPLIANCE APPROACH
As per PCG 2022/2, the ATO has explained how it differentiates risk and will apply compliance activities in connection to section 100A. It sets out a number of scenarios that would be considered high risk; it also indicates that arrangements in place pre 1 July 2004 are low risk of compliance activities.
A brief summary of arrangements that the ATO considers low risk include:
The funds are paid to a joint bank account that the beneficiary holds with their spouse and the funds are used to meet household expenditure. It doesn't matter if the funds are used to pay for only one of the spouse's expenses.
The present entitlement is physically paid or applied for the beneficiary’s benefit within a two year period. However, this is subject to some exclusions. For example, if the funds are physically paid to the beneficiary within two years but the beneficiary then gifts these funds to another beneficiary, then this won’t necessarily be considered a low-risk scenario.
The funds are retained by the trustee and certain conditions are met, including that the funds are used as working capital in a business carried on by the trust and the beneficiary controls the trustee.
Arrangements that are treated as ordinary family or commercial dealings in TR 2022/4, such as;
- distributions to parents who subsequently gift it to the child to fund a
house deposit;
- trust distributions to an adult child but repaid to parents in lieu of
university fees paid. The ATO stipulates that these are expenses that an
adult would typically bare themselves.
However, the following scenarios are generally considered high risk from a section 100A perspective:
Adult children are made presently entitled to income, but the funds are paid to a parent in relation to expenses incurred before the beneficiary turned 18, for example, school fees, holidays and extracurricular activities. The ATO views these are parental expenses.
The beneficiary is a company or trust with losses and the beneficiary is not part of the same family group as the trust making the distribution.
A beneficiary company or trust returns the funds to the trustee (i.e., circular arrangements).
The beneficiary is issued units by the trustee of the trust (or a related trust) with the amount owed for the units being set-off against the entitlement.
the beneficiary is a private company that uses its trust entitlement to fund a distribution that is made directly or indirectly to a non-resident.
WHAT CAN YOU DO TO AVOID S. 100A APPLYING?
At this point, the solutions available to clients appear to be as follows;
1) Pay the beneficiary
Since s.100A deals with reimbursement agreements, where a beneficiary spends the money on themselves, you can be reasonably certain that the ATO will not try to apply s100A. The beneficiary must be paid their entitlement within two years of being made presently entitled to the amount (there are options for payments to be made for UPE's past the two year timeframe, but the PCG imposes other conditions which is outside the scope of this blog).
It is important to note that the beneficiary must spend the entitlements on themselves. The entitlement cannot be gifted to anyone. If the entitlement is gifted (in whole or partly) and it does not meet the narrow requirements of the green zone scenarios above, the arrangement runs the risk of being invalidated under s.100A.
2) Stay green
The ATO has provided a narrow number of circumstances where the arrangements would fall under the green zone, and as such, would not be captured under s100A.
This requires advisers and trustees to be very familiar with the green zone scenarios and examples in the ATO guidelines. However, don't be surprised at how often the trust arrangements cannot be brought within the green zone. This is particularly so when regard must be given to: [1] the somewhat narrow situations that constitute the green zone and [2] when those arrangements are then excluded from the green zone under paragraph 32 of the PCG.
The ATO stance is that it would not commit compliance resources for arrangements in the green zone. However, the ATO does not state that s.100A would not apply. Therefore a separate audit engagement could see the green zone arrangements being assessed for s100A.
3) Don't have a 'reimbursement agreement'
In discussion with Tax lawyers and colleagues, it has been flagged that s.100A cannot apply if no reimbursement agreement exists. However, until the Guardian case is finalised (should it be appealed), and other cases consider how and when reimbursement agreements arise, this pathway would be the least preferred safeguard.
The team at ASF are continuing to monitor this evolving arrangement and will provide more guidance as the cases progress in the Courts.