Both the ATO and the Courts have confirmed that it is critically important that trustees properly consider which beneficiaries should receive distributions and how those distribution entitlements are satisfied. These developments highlight that trustees cannot be passive in their trust distribution decisions. It is therefore important that trustees take these developments into account when exercising their discretions relating to the distribution of trust income.
Background
In 2022, the Victorian Court of Appeal in Owies v JJE Nominees Pty Ltd¹ (“Owies”), considered whether the trustee of a family discretionary trust had failed to give adequate consideration to the circumstances of two beneficiaries of the trust. In doing so, the Court highlighted that an aggrieved beneficiary may be able to challenge prior year distributions and have them declared void and have the trustee removed.
At the same time, the Australian Taxation Office (“ATO”) finalised guidance on the application of a provision of the Income Tax Assessment Act 1936 (Cth) (“ITAA 1936”) – section 100A – dealing with what are referred to as “reimbursement agreements” that targets distributions that are part of an arrangement to provide a benefit to someone other than the beneficiary. The guidelines focus on beneficiaries receiving the benefit of their trust distributions. Failure to adhere to these guidelines runs an increased risk that the ATO could seek to apply section 100A, resulting in the trustee being assessable on the relevant share of the net (taxable) income of the trust at 47%.
Together with the ATO’s success in numerous cases involving the application of the general anti-avoidance rule (Part IVA) and specific anti-avoidance rule (section 100A) to trust distributions, it is critically important for trustees to ensure that they have considered the ATO’s guidelines on section 100A properly.
Consider Owies case before year-end
A1. What is important about Owies case?
Two of the three Primary Beneficiaries of the Owies Family Trust took action against the trustee (a company controlled by their parents) claiming that, in making distributions over a period of years, it breached its fiduciary duty to give “real and genuine consideration” to their needs. One of those beneficiaries had suffered from a number of medical conditions that had impacted her ability to work full time with consequent financial implications for her. That these circumstances had not factored into the trustee’s distributions decisions was important to the court’s decision.
The beneficiaries were successful in obtaining an order that the trustee be removed and replaced by an independent trustee, such that the family no longer had control over trust distributions. The court also noted that the beneficiaries may have been successful in having prior distributions being declared void and an order for compensation to be paid.
The case was one where the trustee could not demonstrate that it had properly considered the needs of the beneficiaries of the trust when making trust distributions, especially where a beneficiary had special financial needs because of their circumstances.
While the Owies decision may not have established new principles, it is a timely reminder of the important role of a trustee and how critical it is for the trustee to demonstrate that it has had “real and genuine consideration” of the beneficiaries needs and circumstances before making distribution decisions.
A2. What should trustees consider with respect to Owies?
Trustees should consider their year-end distribution processes to ensure they can demonstrate that they have made reasonable inquiries of beneficiaries and have considered whether beneficiaries of the trust have special needs. To the extent that a trustee is unsure as to whether their year-end distribution process deals with an Owies case scenario, trustees should consider discussing the issue with their legal advisors.
Consider section 100A guidance material on reimbursement agreements
A3. What is important about the section 100A guidance?
The term “reimbursement agreement” refers to a situation in which a beneficiary’s distribution entitlement arises out of, or in connection with, an arrangement that a) involves a benefit being provided to a person other than the beneficiary, b) is intended to have the result of reducing someone’s tax liability, and c) was entered into outside the course of ordinary family or commercial dealing.
Generally, where a beneficiary receives their distribution entitlement (and applies the entitlement for their benefit) this provision should not apply. However, the risk that section 100A will apply rises if the beneficiary does not receive their distribution entitlement and (or) a benefit is provided to another person or entity through that distribution entitlement.
Practical Compliance Guideline PCG 2022/2 (“PCG 2022/2”) outlines a number of scenarios and explains the likelihood of ATO compliance activity to determine whether to apply section 100A. Green zone arrangements will only be examined to confirm that further ATO investigation is not warranted while red zone arrangements will, as a matter of priority, be analysed to determine whether they are high risk.
A4. What are green zone arrangements?
These are arrangements with a low risk of ATO compliance activity. Green zone arrangements fall into two broad categories.
- The first covers distributions to an individual where the entitlement is paid within two years and used to benefit the beneficiary, their spouse and (or) dependants.
- The second covers distributions where the trust retains the funds representing the beneficiary’s entitlement. However, there are strict limits on how the trust can use the funds. In addition, if the beneficiary is an individual, that individual must be involved in the management of a business carried on by the trust or they (or their spouse) must control the trust. If the beneficiary is a company or trust, the unpaid entitlement must be covered by a Division 7A (7-year) complying loan.
PCG 2022/2 then proceeds to enumerate eleven features which, if associated with what would otherwise be a green zone arrangement, will deny the arrangement a green zone rating. These include situations where the arrangement is in the red zone (see below), the beneficiary gifts or lends their entitlement to another, where the amount included in the beneficiary’s assessable income is significantly more than their share of distributable income or where income flows to a non-resident through an interposed company beneficiary.
Additionally, distributions will not be within the green zone if the trustee fails to notify the beneficiary of their entitlement, or the beneficiary fails to lodge a tax return or omits the entitlement from their tax return.
A5. What are red zone arrangements?
These are arrangements where the ATO will seek to undertake compliance activity. If, as a result of that initial work, the ATO categorise the arrangement as high-risk it is likely to be followed up with a tax audit. Red zone arrangements include:
- Gifts or loans: Distributions to adult beneficiaries that are then paid to the beneficiary’s parents (by way of gift, loan, or other means) which are purported to be in respect of living expenses that were incurred by the parents before the beneficiaries had turned 18 years old. Similarly, distributions to a non-resident relative, which is then used to benefit (by way of loan, gift, or other means) a resident beneficiary.
- Circular distributions: Situations where a trust owns all of the shares in a company and distributes to the company in one year and in the subsequent year, the company uses the after-tax amount of the distribution to pay a fully franked dividend back to the trust. These steps are then repeated in later years. The ATO indicate that they will still review these arrangements, regardless of whether the subsequent distribution may be made to another taxpayer.
- Substantial timing differences: Arrangements where the amount to be included in calculating the beneficiary’s taxable income is significantly more than the distribution to which the beneficiary is entitled and the difference is the result of deliberate actions that affect the computation of trust distributable income.
- Losses: Situations involving a beneficiary outside the family group that has tax losses and the economic benefit associated with the trust entitlement is not utilised by the beneficiary.
A6. What should trustees consider with respect to the section 100A guidance material?
When making year-end trust distribution resolutions, it is important to step back and examine the overall arrangement to determine whether they would be classified as a ‘green zone’, ‘red zone’ or ‘other’ arrangement. Where the arrangement is classified as an ‘other’ arrangement, trustees should consider the risk of section 100A applying to that distribution. Given the complex nature of section 100A and the ATO guidance material, it is important for trustees to engage with their advisors to properly consider this in respect of their year-end distributions.
Trust distributions and anti-avoidance provisions
A7. How has the ATO been successful in applying anti-avoidance rules to trusts?
In addition to the section 100A guidance material, the ATO have been successful in applying Part IVA and section 100A to trust distribution cases. All of these cases demonstrated a permanent tax saving through the use of a trust and the choice of distributions.
In FCT v Guardian AIT Pty Ltd² (“Guardian FFC”) the Full Federal Court held that Part IVA could apply to distributions to a corporate beneficiary. In brief, that case involved the corporate beneficiary subsequently distributing the after-tax amount of its entitlement to a non- resident as a fully franked dividend with no further Australian tax payable. Had the trust distributed its income directly to the non-resident the overall Australian tax paid would have been higher. The decision in Guardian is discussed in detail in our earlier Bulletin (link).
In B&F Investments Pty Ltd as trustee for the Illuka Park Trust v FCT³ , the taxpayer unsuccessful challenged the application of section 100A where significant timing differences occurred in respect of a buy-back of shares in a controlled company. In this case, the taxable dividend from the buy-back was assessable to a company, whereas the economic benefits in respect of the buy-back were retained in the trust (allowing for future tax-free distributions to individuals).
A8. What should trustees consider with respect to the anti-avoidance provisions?
While these cases demonstrate that the ATO can be very successful in applying the anti-avoidance provisions with respect to trust distributions, it needs to be noted that both cases involved a permanent tax benefit that would otherwise have accrued to the taxpayers. The ATO has released its decision impact statement on Guardian confirming that the decision does not (effectively) change its guidance on section 100A. Accordingly, provided that taxpayers consider the section 100A guidance material and ensure that risks have been reduced in respect of trust distributions, we believe that there should be a low risk of the ATO apply the anti-avoidance provisions to trust distributions.
What are the next steps?
The developments referred to above highlight that trustees need to understand the terms of the trust deed and the identity and needs of the beneficiaries so as to properly inform their distribution decision. Trustees should reach out to their legal and accounting advisors for assistance in understanding these matters.
The ATO are becoming much more active in reviewing trust distributions and these developments highlight that distributions driven predominantly by the tax outcome achieved are increasingly likely to attract ATO attention.
It is critical that clients consider how these developments might apply to their circumstances and that year-end process ensure that they have considered these very important developments. Clients should contact their Pitcher Partners representative to review their situation and determine what action is required well before 30 June.
¹ [2022] VSCA 142.
² [2023] FCAFC 3.
³ [2023] FCAFC 89 being the taxpayer’s appeal against the decision in BBlood Enterprises Pty Ltd v Commissioner of Taxation [2022] FCA 1112.
