ATO changes approach to Trusts and Distributions

Late last month, the Australian Taxation Office (ATO) released a package of new guidance material that directly targets how trusts distribute income. Many family groups will pay higher taxes (now and potentially retrospectively) as a result of the ATO’s more aggressive approach under the existing section 100A rules. (Knowledge Shop, Mar 2022)

Family trust beneficiaries at risk

The integrity rule under section 100A in the Income Tax Legislation, is aimed at situations where the taxable income of a trust is apportioned in favour of a beneficiary, but the economic benefit (cash) of the distribution is provided to another individual or entity.

If trust distributions are caught by section 100A, then this generally results in the trustee being taxed at penalty rates rather than the beneficiary being taxed at their own marginal tax rates.

ATO redrawing the boundaries of what is acceptable

Section 100A has been around since 1979 but to date, has rarely been invoked by the ATO except where there is obvious and deliberate trust stripping at play. However, the ATO’s latest guidance suggests that the ATO is now willing to use section 100A to attack a wider range of scenarios.

 The ATO’s guidance sets out four ‘risk zones’ – referred to as the white, green, blue and red zones – which will determine the ATO’s response:

White zone

This is aimed at pre-1 July 2014 arrangements. The ATO will not look into these arrangements unless it is part of an ongoing investigation, for arrangements that continue after this date, or where the trust and beneficiaries failed to lodge tax returns by 1 July 2017.

Green zone

Green zone arrangements are low risk arrangements and are unlikely to be reviewed by the ATO, assuming the arrangement is properly documented.  The ATO suggests that when a trust appoints income to an individual but the funds are paid into a joint bank account that the individual holds with their spouse, or where parents pay for the deposit on an adult child’s mortgage using their trust distribution as a one-off arrangement, then these would ordinarily be a low-risk scenarios.

Blue zone

Arrangements in the blue zone might be reviewed by the ATO. The blue zone is basically the default zone and covers arrangements that don’t fall within one of the other risk zones. The blue zone is likely to include scenarios where funds are retained by the trustee, but the arrangement doesn’t fall within the scope of the specific scenarios covered in the green zone.

Red zone

Red zone arrangements will be reviewed in detail. These are arrangements the ATO suspects are designed to deliberately reduce tax, or where an individual or entity other than the beneficiary is benefiting.

Who is likely to be impacted?

Adult children

High on the ATO’s list for the red zone are arrangements where an adult child’s entitlement to trust income is paid to a parent or other caregiver to reimburse them for expenses incurred before the adult child turned 18.

For example, school fees at a private school, or where a loan (debit balance account) is provided by the trust to the adult child for expenses they incurred before they were 18 and the entitlement is used to pay off the loan.

Circular distributions

The ATO also indicated that circular arrangements could fall within the scope of section 100A. For example, this can occur when a trust owns shares in a company, the company is a beneficiary of that trust and where income is circulated between the entities on a repeating basis. For example:

• The trustee resolves to appoint income to the company at the end of year 1.

• 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 income, and the dividend forms part of the trust income and net income in year 2.

• The trustee makes the company presently entitled to some or all of the trust income at the end of year 2 (which might include the franked distribution).

• These steps are repeated in subsequent years.

Loss Entities

Distributions from a trust to an entity with losses could also fall within the red zone unless it is clear that the economic benefit associated with the income is provided to the beneficiary with the losses. If the economic benefit associated with the income that has been appointed to the entity with losses is utilised by the trust or another entity, then section 100A could apply.

 Company entitlements

As part of the broader package of updated guidance targeting trusts and trust distributions, the ATO has also released a draft determination dealing specifically with unpaid distributions owed by trusts to corporate beneficiaries. If the amount owed by the trust is deemed to be a loan then it can potentially fall within the scope of another integrity provision in the tax law, Division 7A.

The new guidance represents a significant departure from the ATO’s previous position, and as a result the management of trust distributions and unpaid entitlements will need to change.

As such, to ensure that your circumstances are not adversely impacted by the change in approach, we recommend that a review of your affairs be undertaken in the current year.

Need Cordner Advisory to help?

If you have concerns or require further information in the meantime, please do not hesitate to contact our team who can provide you with guidance.
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