ATO cracks down on the hidden loophoole around family trusts

For years, many Australians, particularly those operating businesses, have used family trust structures as a wealth creation vehicle.

The Australian Tax Office (ATO) has previously put trust distributions and their tax treatment under the microscope but have now refocused their attention to Section 100A 'Reimbursement Agreements'.

This could significantly impact on the overall tax position of any family trust distributions caught by Section 100A.

What is Section 100A?

Section 100A is an integrity rule in the tax legislation aimed at situations where income of a trust is appointed in favour of a lower taxed beneficiary, but the economic benefit of the distribution is provided to another individual or entity.

Trust distributions that are captured under Section 100A generally result in the trustee being tax at the top rate of tax (45%, before interest and penalties are imposed).

Section 100A has been around since the late 1970s. It was historically only applied by the ATO in blatant schemes involving loss entities and circular distributions.

Who can expect to be audited?

Recently, the ATO has provided guidance outlining a wider range of examples where they consider that s100A will apply and thus be the focus of more compliance activities moving forward (e.g. audits). Ultimately, the ATO has narrowed its view of "acceptable" arrangements, with the aim of reducing the legitimate tax planning benefits that are afforded to Family Trusts.

For example, the ATO has outlined its concerns with arrangements whereby trusts purport to distribute income to the adult children of the controllers of the trust but the economic benefits of the distribution (i.e. the underlying cash) is instead paid to the parents of the adult children.

The common feature of the arrangements is that trust income is appointed between members of the family group but in substance it is the parents who exercise control over and enjoy the economic benefit of the income.

Why is the ATO focusing on parents?

The arrangements the ATO is concerned about are those which are more properly explained by the tax outcomes obtained, including the accessing of tax-free thresholds and lower marginal tax rates of family members, rather than ordinary familial considerations.

The ATO is particularly concerned where the economic benefit of the arrangement is enjoyed by the parents because:

• the children are paying amounts for expenses that would ordinarily be met by their parents, or
• the children's entitlements are otherwise being applied for the benefit of the parents either directly or indirectly, or by the charging of excessive amounts, and/or
• there are elements of contrivance.

The ATO is also concerned with arrangements involving other family members of controlling individuals who have lower marginal tax rates than those of the controlling individual.

What happens if you're audited?

Assessments issued in each of these scenarios would likely result in the distribution being taxed at the highest marginal income tax rate under s100A, potentially resulting in substantial increases in the tax liability of the trustee or the parents, as well as incurring interest on any unpaid tax and potentially severe penalties.

Section 100A is an anti-avoidance provision that can apply to a trust distribution where a trust makes a beneficiary presently entitled to the income of the trust and the present entitlement arose out of a "reimbursement agreement". The beneficiary in such circumstances will be deemed to not have a present entitlement to the trust income and the trust distribution will be invalidated.

The term "reimbursement agreement" is very broadly defined; there does not need to be an agreement in writing and the agreement does not need to provide for a "reimbursement". It means an agreement to provide a benefit to or for a person, other than the presently entitled beneficiary.

Who is excluded from s100A?

"Ordinary family or commercial dealings" are excluded from s100A. To be in the course of ordinary dealing, the transactions between family members and their entities must be capable of explanation as achieving normal familial or regular commercial ends.

The ordinary family or commercial dealings exclusion does not apply simply because all parties to an agreement are members of the same family. In addition, if an arrangement has features suggesting it is being driven by tax outcomes, it will be invalidated.

The ATO's view of the arrangements outlined above is that the ordinary commercial dealings exclusion will be disapplied because the arrangement has the effect of avoiding tax on the net income of the trust by utilising the lower marginal tax rate applying to the children in circumstances where the benefit of the arrangement is, in substance, enjoyed by the parents.

Where s100A applies, the ATO has the power to assess the trust distribution to the trustee of the trust, rather than the beneficiary made presently entitled to the income, at the top marginal rate of tax.

The ATO's updated guidance focuses primarily on trust distributions made to adult children, corporate beneficiaries, and entities with losses. The individual circumstances for each Family Trust will ultimately determine the level of risk and likelihood of a Section 100A review.

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