ATO developments impacting discretionary trusts

Who does this affect?

Anyone using a discretionary trust as part of their financial arrangements may be impacted by this ATO guidance which outlines their view on the operation of section 100A of the Income Tax Assessment Act (ITAA 1936). Given the breadth and complexity of the guidance, covering all the potential implications is beyond the scope of this alert and instead we focus on key aspects.

The key takeaway, in practical terms, is the ATO’s approach to trust distributions will likely impact many discretionary trust distributions and some common family trusts arrangements are now at high risk of ATO review.

How did we get here?

Section 100A is not new – it has been around for more than 40 years and, while introduced as an anti-avoidance measure to deal specifically with so-called ‘trust stripping’ tax avoidance arrangements of the late 1970’s, the wording of the provision is broad. There has always been some concern as to how else the ATO may apply it. Broadly, the section can apply when the following criteria are met:

• Trust appoints income to Beneficiary A
• Under any arrangement B gets the economic benefit of that income
• The tax imposed is less than if the income had been appointed to B
• The tax purpose was the purpose of the arrangement

There is an exception to section 100A where the ‘arrangement’ is an ‘ordinary commercial or family dealing’. Until now there has been a lack of clarity on what that exception means, as regards “ordinary family dealing”. As the term is undefined in the legislation and as there is no clear case law explaining the term there has been no real clarity as to what might be excepted.

The ATO view – low, medium and high risk scenarios

The ATO addresses this lack of clarity by providing guidance on the meaning of the exception and the application of section 100A in a range of what it describes as low, medium and high risk scenarios.

The primary focus of the ATO guidance is clearly distributions from discretionary family trusts to adult children of the controllers of the Trust. Specifically any arrangement where those adult children receive a present entitlement to trust income but some or all of the real economic benefit ends up with others typically their parents/guardians. While clearly spelled out in both TR 2022/D1 and PCG 2022/D1, the ATO further emphasises this as perhaps the key focus area by simultaneously releasing Taxpayer Alert TA 2022/1: Parents benefitting from the trust entitlements of their children over 18 years. The key point being adult children made beneficiaries of trust income but by means of an arrangement between the parties (be that via gift, offset or similar) ultimately the parents getting the economic benefit of that income. See the following Example 1 from TA 2022/1:

Example 1

The ABC Trust’s beneficiaries include the members of the ABC Family.

David is the sole trustee of the ABC Trust. David and his wife Rani have two children, Jenny (aged 22) and Paul (aged 19), who live with them in the family home. David and Rani have an existing mortgage on the home. Jenny and Paul are both full-time students and during the 2020–21 income year, they each earned approximately $12,000 from casual employment.

During the 2020–21 income year, the ABC Trust derives income of $720,000 (the trust’s net income is also $720,000).

A resolution of the trustee of the ABC Trust dated 30 June 2021 shows both Jenny and Paul are each presently entitled to $160,000 of the income of the ABC Trust, with David and Rani each presently entitled to $200,000.

Jenny and Paul are not paid any amounts. Instead, David transfers an amount equal to their entitlements to the mortgage offset account that he and Rani maintain. Jenny and Paul’s entitlements are recorded as having been fully paid in the accounts of the ABC Trust. David pays Jenny and Paul’s tax liabilities in relation to their entitlements from his personal funds.

David has taken these actions as Jenny and Paul have agreed that their entitlements from the ABC Trust will be managed by David for the benefit of all family members. David has determined that those entitlements should be applied to reduce the debt on the family home.

This arrangement raises the concerns mentioned in this Alert. By entering this arrangement, the purported $160,000 entitlements of both Jenny and Paul are not subject to the top marginal tax rate. David has not managed the entitlements for the benefit of all members of the family. The arrangement has the result that the post-tax amounts of Jenny and Paul’s entitlements have been diverted to meet their parent’s individual liabilities in circumstances where their parents would have been able to meet them. David and Rani receive the same economic benefit from that income as if it had been appointed to them directly, but without the amounts being included in their assessable income and subject to tax at a higher marginal tax rate. The arrangement involving the making of the trust distributions and use of those amounts appears to be motivated by the tax outcome achieved rather than ordinary familial objectives.

How the ATO views this example

Basically, the ATO asserts that such an arrangement is not an ordinary family dealing because of its tax driven motivations. They further dismiss the argument that it becomes ordinary merely because it is commonplace. Fundamental to their position is that you have distributed to the adult children while, by whatever means, ensuring most or all the economic benefit of the income goes elsewhere, typically to parents or to the Trust itself.

What are the implications of section 100A applying?

Any application of section 100A risks the targeted trust distribution being deemed to have not occurred for tax purposes and instead the income reverts to the trustee and is taxed at the top marginal tax rate (47%) plus potentially significant penalties.

Where to now?

It is important to understand that while TR 2022/D1 and PCG 2022/1 represent the views of the ATO they aren’t law, rather they are the Commissioner’s view of the law. In the recent decision in the Federal Court ‘Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation [2021] FCA 1619’ (Guardian) the Commissioner lost his section 100A argument with the Court finding against the Commissioner on all the key requirements of 100A including that the arrangement was an ordinary family dealing. The Commissioner doesn’t agree with that decision and has appealed to the Full Court of the Federal Court and in the interim has largely dismissed its impact on TR 2022/D1. Should the ATO lose its appeal, it would likely necessitate some changes of position, at least as regards some arrangements targeted in their guidance. In addition, the Commissioner has conceded there is uncertainty as to the correct application of 100A by specifically requesting that the tax community identify arrangements that can be put to the Courts through his test case program. In doing so the Courts would ultimately determine the law. So, in short, these matters aren’t settled but they do reflect the current ATO position, and that position is problematic for several commonplace trust distributions.

Given the risk-based approach outlined in PCG 2022/D1, we will need to consider section 100A as regards both recent and ongoing trust distribution arrangements and certainly as we approach trust distributions for year ending 30 June 2022. We will do so while continuing to engage with the ATO regarding our concerns about the technical merits of their draft position and about the practical implications of their proposed compliance approach. Further, we will closely monitor the progress of the Guardian appeal through the Federal Court. These guidelines from the ATO do require action, but they don’t necessitate panic. We do need to review arrangements in a considered way.