The Australian Tax Office have released a long awaited draft tax rulings on the tax treatment of trust distributions to family members. In effect the ATO are looking at tax strategies which arrange for family trusts to allocate trust profits to family members (or companies) that are potentially on a lower tax rate where that person does not effectively enjoy the trust distribution.
In short the allocation of trust profits is a sham. The beneficiary of the trust profits actually never receives the profits and, in some cases, was never even aware that the family trust had allocated profits to them.
The Tax Office draft papers are considered in Draft Tax Ruling TR 2022/D1, Draft Practical Compliance Guideline PCG 2022/D1 and Taxpayer Alert TA 2022/1.
The section of law at the current focus is “section 100a”.
What is the mischief?
Taxation law is primarily intended to be a result of “life”. If a tax outcome is derived that fundamentally has no basis of reality occurring it is likely to fail. And while the tax law contains a general provision (Part IVA) to consider all of taxation – the area of law considered is directed at family trusts allocating trust profits tax effectively within the family but in reality is not following the allocation of profits.
The Jones Family Trust allocated $20k of profits to Steve Jones (18) who is at university studying.
Steve does not pay tax on the $20k profits. Steve’s parents, the trustee of the The Jones Family Trust, arrange for Steve to sign a document gifting the $20k back to them when Steve signs the tax return.
Steve signs both the tax return and the additional document with no real understanding of what he has done.
At no point in time did the trustee’s have any intention of Steve ever being allocated the trust profits. The decision to allocate profits to Steve is subject to a “reimbursement agreement” and subject to the penalty tax law provisions in s100a.
What are the key danger signs the ATO is looking at?
If the ATO are going to attack your family trust they have four key indicators.
1. There is a reimbursement agreement
At the time of making the allocation of the trust profits there must be an agreement which effectively ensures that the recipient of the trust profits will not enjoy those profits.
And sadly, the presence of such an agreement will be deemed to have arisen by looking at the activities of the relevant parties after the event has taken place. So even if no formal agreement was drafted the actions of the parties (like an immediate gift back) will be sufficient to imply that an agreement was in place.
2. Somebody else enjoyed the trust profits
Effectively this requires that the recipient of the trust profits did not actually physically receive those profits. The profits (in cash for example) can be retained by the trustee or those profits could have been enjoyed by another family member who is potentially on a higher income.
3. The overall tax liability decreased
While the recipient will potentially incur a higher tax liability had not the allocation of profits did not occur: the overall family tax liability will have decreased as a result of the decision to allocate profits to the person on the lower taxable income (like Steve discussed above).
4. The agreement is not an ordinary family or commercial dealing
If the decision to allocate trust profits to a family member is an ordinary dealing that a family will do then the law will not apply. However the ATO have given significant guidance on how this will be applied.
A family trust allocates profits to a young adult.
The young adult uses the profit allocation to repay the parents the cost of their private education.
In this instance the Tax Office are saying that it is not ordinary for young adults to repay the cost of educating and raising them while they were minors and effectively had no control over the costs.
A family trust allocates trust profits to a young adult.
The trust pays cash to the young adult and uses that cash as a deposit on their first home.
This example is acceptable as a “one off” transaction. However if it happened year-in year-out then the dealing is beyond that of an ordinary family arrangement.
Where to from here?
It is worth noting that family trusts exist for a range of reasons other than to reduce tax. So the panicked talk that “family trusts are over” is not correct.
Further, the ATO positions are only in draft format with the public consultation process still in place. And with our senior role with the Tax Institute we have been tasked with preparing a detailed written response to improve the ATO position.
The ATO position, for wealthy families, will be subject to heavy scrutiny for a Next 5,000 review so historical allocations of profits should be reviewed generally.
The importance of ongoing documentation (prepared at the correct time) for trust profit allocations is critical for ongoing tax governance. If tax governance documents, like family trust resolutions, are lacking, then the ATO are likely to ask further questions and increase review time.
The accounting for family trust payments might need to be reviewed. Historically some beneficiaries might have been paid their trust allocations (through holidays, housing costs or grandchildren’s school fees) and these costs might have been incorrectly recorded by internal bookkeepers. This might be an appropriate time to ensure prior payments have been recorded properly.
At Westcourt our primary skillset is tax strategy for family owned businesses. Our deep knowledge of one area has given us an appreciation for family dynamics and how the real life interplay of a family ties into the tax outcomes and tax positions that the family can have.
If the money matters in your family and you have a family trust – the tax outcomes become important. Talk to Westcourt today about the tax law on family trusts and how you can make sure that your discretionary trust enjoys great tax outcomes in a safe and controlled way.