s100A – Extra Scrutiny on Trust Distributions
Posted on April 11, 2022 by Ashley DawsonRecent changes to the way trust distributions will be assessed by the ATO could have a major impact on the tax planning decisions of many family groups, especially those with adult children. In this article we explore those changes and outline some of the challenges they pose for trustees and their advisors.
Where we came from
On 23rd February 2022 the Australian Taxation Office released a draft tax ruling (TR 2022/D1) updating their interpretation of the tax law surrounding distributions made by family trusts. They also released a guide on how taxpayers can best comply with this updated interpretation (PCG 2022/D1). The specific section of the income tax law covered by these documents is s.100A of the Income Tax Assessment Act 1936.
Section 100A is an integrity provision aimed at preventing trustees from making a beneficiary entitled to trust income without also transferring to them the financial benefits of that entitlement. Under the legislation the distribution can be deemed invalid where it is determined the intention of the distribution was to gain a tax benefit by distributing profits to a beneficiary on a lower income tax rate than the person(s) who ultimately receive the financial benefits. The provision also targets scenarios where the profits are retained in the trust and a beneficiary with a lower tax rate than the person(s) who control the trust is made entitled to the retained profits. In both scenarios, the key facts are:
- That the beneficiary who is made entitled to the distribution does not receive the financial benefits of the distribution,
- Making the beneficiary entitled to the distribution will achieve a better tax result than making the person(s) who received the financial benefit entitled to the distribution,
- There is a connection between the entitled beneficiary and the recipient of the financial benefits, and
- The arrangement made is inconsistent with ordinary dealings between such parties.
In practice, the above normally refers to a situation where a beneficiary of a trust is made entitled to a distribution for income tax and trust law purposes, however no funds are transferred to the beneficiary. Instead, the beneficiary will allow another person, generally a family member, to make use of the funds either within the trust (in the case of retained profits) or to fund their own personal expenses (an offsetting arrangement).
Previously such arrangements could be managed within family groups by either offsetting historical expenses against a future trust entitlement or using ‘love and affection’ letters. When offsetting historical expenses, a trustee (typically a parent) would record the cost of expenses they paid for a person (typically a child) and in the future make the person entitled to a trust distribution equal to the expenses paid. Common expenses included education, sports and board. Love and affection letters achieved a similar result, however rather than offset the distribution against expenses the beneficiary instead gifted their entitlement to another person (typically a child gifting their entitlement to a parent). The other person would then use the beneficiary’s entitlement to offset funds they had drawn out of the trust to fund their lifestyle. Both arrangements hinged on the idea that is ordinary for families to share wealth and benefits and therefore the distributions did not meet the condition noted at point 4 above. Therefore, s100A did not apply.
Where we are now
In drafting TR 2022/D1 the ATO have expressed a very narrow view of what constitutes ordinary family dealings. They have noted that:
- Arrangements that could be covered by s100A are not excluded from its operation simply because the parties are all from the same family,
- Arrangements that appear to be driven by tax outcomes as opposed to family objectives cannot be excluded from s100A, and
- The fact that such arrangements are widespread in the community is not a valid defence against the operation of s100A.
This narrow view greatly restricts the kind of arrangements that are outside the scope of s100A. If we specifically consider the offsetting arrangements and love and affection letters discussed previously, the ATO’s opinion is that it is not normal for parents to seek to recover the cost of raising children from the children themselves and that these costs are instead being recognised only to achieve a tax outcome. In considering love and affection letters the ATO’s opinion is that it is not normal for families to make substantial gifts of cash and that once again these arrangements are being entered into solely to achieve a tax outcome.
In PCG 2022/D1 the ATO have gone further and given examples of scenarios they consider to be in the green (low risk), blue (medium risk) and red (high risk) zones. A scenario that falls within the green zone has no risk of compliance action from the ATO, a blue zone scenario risks further questions and follow up from the ATO to justify the actions taken and a red zone arrangement is all but certain to trigger the application of s100A and potentially further audit activities.
Key examples that fall into the red zone are:
- An adult child is made entitled to a trust distribution and gifts the amount to their parents to repay costs such as school fees and extra-curricular activities from prior years
- An adult child is made entitled to a trust distribution and gifts the amount to their parents to be deposited into an account they control or used to offset their loan account with the trust.
Examples of arrangements that would fall into the blue zone include:
- An adult child of the trustee is made entitled to a trust distribution and this entitlement is offset against board paid to live at home at an arms-length value
- An adult child of the trustee is made entitled to a trust distribution and this entitlement remains unpaid and owing to the child. The funds are used within the trust to fund working capital
- An adult child of the trustee is made entitled to a trust distribution and this entitlement remains unpaid and owing to the child. Rather than draw on the entitlement, the adult child gifts the entitlement back to the trustee to use within the trust.
Other arrangements, particularly where the distribution made to an adult child is offset against future expenses such as university fees, the purchase of a car or computer, or other items not normally covered by the child-parent relationship, are not as falling within the green zone.
In practice the ATO is effectively killing the use of offsetting arrangements and love and affection letters by making these changes. Both tools were widely used across the community by family groups to manage their tax affairs and preserve wealth within the group.
Our Assessment
Despite being a draft ruling at this stage we consider it reckless to act outside of the recommendations in the ATO’s updated interpretation of s100A. These changes significantly reduce the potential for families to manage their tax affairs through trusts and some groups will need to rethink their tax planning strategies. Families that continue to arbitrarily split income with adult children are at real risk of being reviewed or audited by the ATO and, should this draft ruling be finalized without significant changes, will have little to no defence for their actions. Regarding the recent comments from parliament that suggest governments from either side of politics will review s100A in light of the ATO’s announcement, we are hopeful this will bring clarity to the issue but in the meantime continue to encourage caution in how families approach the issue. Ministers on both sides of politics noted that the ATO may be straying into policy development with its recent actions and that this was the domain of the parliament only. They also noted that s100A was potentially being applied to arrangements it had never been intended to target and that the level of public concern warranted a prompt response. Based on these comments we are hopeful action will be taken on the issue shortly after the upcoming federal election.
Over the past week we have been contacting our affected clients to discuss how the changes impact their family specifically. Aside from discussing the personal impact of these changes with clients, we have also been hard at work developing a series of strategies to allow families to manage their affairs firmly within the bounds of s100A. If you have further concerns about how these changes affect your personal situation, please contact us and we are happy to help you plan any necessary changes prior to 30 June 2022.