Summary
If you are involved in a discretionary trust (commonly known as a family trust), then you need to know that the ATO are on the warpath. Where your trust is used to shift income to family members on lower tax brackets – you might be in for a nasty surprise soon.
The ATO is seeking to essentially tax trust distributions given to family members that do not actually receive that money, at the top tax rate.
WHAT IS THE ATO ATTACKING?
In short, where you split your income with family members to use their lower tax thresholds to reduce your tax. The ATO is concerned that the people actually using and benefiting from the money, are not the ones paying tax on the money.
The ATO (and the Law) also refer to this as a “reimbursement agreement”, but we will note that this isn’t necessarily the best name to describe what this situation is.
THE ATO'S ROLE
We’re going to be really clear at the outset – the ATO doesn’t make the Laws, it just administers them. Unfortunately our Laws are far from black and white, so the ATO needs to interpret them and hold a position on how it sees those Laws applying in the real world.
The ATO can be wrong (and has been many many times).
In this case, the ATO is looking to “clarify” (i.e. change) its interpretation of a little known piece of Law loosely called “reimbursement agreements” under Section 100A of the Income Tax Assessment Act 1936.
THE RULES YOU NEED TO KNOW
It is crucial to understand how a trust works and some of the legal background.
Keeping it simple, a trust is an arrangement where Person A (the trustee) holds assets for the benefiit of Person B (the beneficiary). This can be multiple people and even entities (e.g. companies, other trusts, super funds, charities, etc). Typically, most “family trusts” involve Mum & Dad acting as trustee, holding assets for the benefit of the entire family. When the trust makes money (either from investments or running a business), the trustees then decide on who will benefit from the trust and receive those profits.
None of the above is in dispute.
The following principles are the crux of the issue and need to be at the forefront of your mind:
- Under Trust Law, whoever is chosen to benefit from the trust is legally entitled to physically receive that money.
- Under Tax Law, whoever is chosen to benefit from the trust has the obligation to include that income in their tax return.
- The process of “choosing” the people to benefit is referred to as “distributing” the income of the trust.
Commonly, Mum & Dad operate in a trust, make money, and then distribute that money in whatever way minimises their tax with little regard to the first point above “whoever is chosen is legally entitled to receive that money”. Being family, none of the the children, parents, grantparents, etc ever ask for that money, and effectively gift it back to Mum & Dad.
This is essentially a “reimbursement agreement”. As outlined earlier, the people paying tax on the money are not the ones getting the benefit of the money – and this is what the ATO are looking to change.
Section 100A is far from simple however, which is why trusts for many years been doing what they have been doing. For Section 100A to apply the purpose of the arrangement must be to reduce tax – which sounds easy, but in reality is far from it because it is easy to argue there are other purposes for doing this and lower tax is a happy side benefit.
A common argument is that as a parent, raising children cost money (lots of money), and the purpose of distributing income to the children is so they can contribute towards the cost of their own living (and repaying previous costs). Children pay board from their wages all the time, why can’t they pay board from a trust distribution instead?
The above is somewhat supported by a carve-out in the Law that exempts “ordinary commercial or family dealings”. Just consider how broad a sentence that is. How can anyone purport to know exactly what situations are included and excluded.
And herein lies the difficultly. The ATO have seemingly accepted this argument for 40 years (we’ve never heard of the ATO ever challenging arguments like this), presumably because the way Section 100A is written forces the ATO to prove that the purpose of the arrangement is to reduce tax AND isn’t an ordinary family dealing.
WHAT IS THE ATO DOING?
The ATO have released a draft tax ruling, basically saying that where a trust distributes to one person, but a different period uses the money, then the ATO will seek to use Section 100A (i.e. call it a “reimbursement agreement”) and will adopt a much stricter interpretation of “ordinary commercial or family dealings”.
If subject to these rules, trust distributions will be taxed at the top tax rate.
The Law hasn’t changed, but the ATO’s interpretation of them has. We’re unsure how successful the ATO will be if and when someone takes this to court, but it is clear that the ATO is looking to crack down on trust distributions.
WHAT DO YOU NEED TO DO?
Two things…
Firstly, decide how keen you are to push the rules. If you want to distribute to your kids so they can pay their board and contribute to their living (for example), that’s fine. You’re aware of the ATO’s position and you need to be ready should the ATO target you.
Secondly, you need to ensure all your backing paperwork is there. A trust distribution to your children can only valid if the trust has paperwork backing it up. If the ATO fail on the above, it’s really easy for them to target your record keeping.
If you are serious about being protected, call us. We can help ensure that you have the paperwork you require and that you fully understand what the ATO is doing and where the pitfalls are.
