Trust distributions – the game has changed
On 23 February 2022 the Commissioner released three draft administrative pronouncements and one Taxpayer Alert which could significantly impact on trust distributions and how they are taxed.
The contents of these pronouncements are both voluminous and complex and are still being digested, but essentially relate to the Commissioner’s views on the operation of two integrity measures – section 100A and Division 7A.
What is it?
Section 100A is an anti-avoidance provision that has the potential of imposing a penal tax outcome where one person (beneficiary) is made presently entitled to trust income, but another person effectively receives the benefit of the income. The provision was originally introduced (way back in 1979) to attack aggressive tax avoidance arrangements, but it is worded so broadly that it can technically apply to much more commonplace circumstances.
If it applies, the relevant trust income is generally subject to tax within the trust under section 99A at the top marginal rate of tax (currently 47%).
Historically, many taxpayers and their advisers have taken comfort from the rule in section 100A that ‘ordinary family or commercial dealings’ are excluded from the operation of section 100A.
What is changing?
In recent years, it has become evident that the Commissioner has been looking to apply section 100A to circumstances well beyond its originally intended targets, and yesterday made public his detailed (preliminary) views on this troublesome provision in the form of:
- Draft Taxation Ruling 2022/D1 – Income tax: section 100A reimbursement agreements
- Taxpayer Alert TA 2022/1 – Parents benefitting from the trust entitlements of their children over 18 years of age
- Draft Practical Compliance Guideline 2022/D1 – Section 100A reimbursement agreements – ATO compliance approach
Whilst administrative guidance on this difficult subject is welcomed from a clarity perspective, the preliminary views expressed will present challenges to many and could fundamentally change the tax planning considerations for trusts and beneficiaries.
What does this mean?
Whilst the detail of these lengthy and complex draft pronouncements is still being digested, we note the following key points:
- the Commissioner has expressed a very broad view of circumstances to which section 100A could apply
- the Commissioner has expressed a very narrow view of when the ‘ordinary family or commercial dealing’ exception is likely to apply.
The Commissioner has indicated that section 100A could apply to the following circumstances, including:
- gifts from individual trust beneficiaries on low marginal tax rates to other family members with a higher marginal tax rate – for example, gifts or reallocations from adult children that have unpaid trust distributions to their parents.
- a pattern of behaviour involving continuous gifts from beneficiaries back to the trust or even circumstances involving accumulation of unpaid trust distributions with the funds being retained in the trust
- non-commercial loans between family members funded by income distributions from a trust
- manipulation of income of the trust estate and net income.
The examples referred to above have far reaching implications for trusts and their beneficiaries (including corporate beneficiaries). The approach that Commissioner proposes to adopt represents a significant departure from arrangements that many family groups will have adopted in the past.
The Taxpayer Alert TA 2022/1 specifically identifies circumstances which the Commissioner regards as high risk in relation to distributions to children of parents who control a discretionary trust. The TA not only addresses 100A, but indicates the distributions may be legally ineffective or subject to Part IVA.
When will this new approach apply from?
The draft ruling indicates that the approach will apply retrospectively as well as prospectively, subject to some concessions set out in Draft Practice Compliance Guideline PCG 2022/D1. This is significant, as section 100A (being originally intended for aggressive tax avoidance measures) is not subject to any statutory time limits – it can be applied retrospectively indefinitely, without the usual limitations upon the Commissioner.
Unfortunately, the draft PCG only provides limited concessions for arrangements entered into prior to the release of the pronouncements referred to above. In very broad terms, certain pre-existing arrangements that are regarded as relatively benign will not be reviewed by the ATO. The limits to these concessions is one of the elements of the new suite of drafts that we believe is worthy of further dialogue and submissions in an effort to seek an outcome that is less harsh.
The PCG also provides something of a ‘heat map’ for taxpayers and advisers to rate the risks of arrangements under section 100A.
Division 7A – complying subtrusts no longer permitted
In addition to the section 100A developments, the Commissioner has also issued a draft determination in relation to Division 7A (TD 2022/D1: when will an unpaid present entitlement or amount held on sub-trust become the provision of financial accommodation). Whilst this TD is quite lengthy, the essence of it is that the Commissioner has announced a prospective (from 1 July 2022) change to his previous approach under which he allowed unpaid trust distributions owing to a company beneficiary to be put on interest-only terms for a 7 or 10 year period (depending on the interest rate). The new approach will be more challenging for taxpayers in that such unpaid entitlements will need to be put on complying Division 7A loan terms, which broadly require both interest and principal repayments annually.
Section 100A in particular is a very technical and difficult provision and there is much to digest in the pronouncements referred to above. SW will be considering the draft guidance in detail and propose to make submissions to the ATO prior to the finalisation of these pronouncements.
Another factor to bear in mind (which is also referred to by the Commissioner in the draft ruling) is that the recent Guardian case concerning the operation of section 100A (refer to SW summary here: Guardian case – section 100A win for the taxpayer (sw-au.com), which was decided in favour of the taxpayer, is subject to appeal. The draft views expressed appear to have been formed without any major regard to this decision, so the outcome of this appeal will be particularly relevant in this context.
In addition to making submissions to the ATO in respect of these drafts, SW will be closely monitoring developments in this area and will keep its clients well informed as circumstances evolve.