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The ATO has released its final position on how it will apply some integrity rules dealing with trust distributions – changing the goal posts for trusts distributing to adult children, corporate beneficiaries, and entities with losses. As a result, many family groups will pay higher taxes because of the ATO’s more aggressive approach.
Section 100A
Section 100A of the tax legislation is a critical integrity rule aimed at situations where the income of a trust is distributed to a beneficiary, but the economic benefit of the trust distributions is directed to another person or entity. This rule applies when a ‘reimbursement agreement’ exists at or before the time the income is appointed to the beneficiary. Importantly, distributions from trusts made to minor beneficiaries or beneficiaries under a legal disability are not subject to section 100A.
When trust distributions fall under the scope of section 100A, the trustee, rather than the beneficiary, is taxed on the income at penalty rates. This can result in significantly higher tax liabilities. Although section 100A has been part of tax law since 1979, the Australian Taxation Office (ATO) has recently provided much clearer guidance on how it interprets and enforces this rule, bringing greater scrutiny to trust distributions that may be considered high risk.
Key Conditions for Section 100A to Apply
For section 100A to impact trust distributions, the following conditions must be met:
- Present Entitlement Linked to a Reimbursement Agreement: The beneficiary must be entitled to income from the trust, and this entitlement must relate to a reimbursement agreement.
- Benefit to a Third Party: The agreement must provide for a benefit to someone other than the beneficiary who is presently entitled to the trust income.
- Tax Reduction Purpose: At least one party to the agreement must have a purpose of reducing income tax liability for a year of income.
These conditions make it essential to scrutinize any arrangements involving trust distributions to ensure compliance and minimize risk.
High-Risk Scenarios for Trust Distributions
Certain trust distribution practices are now flagged as high risk by the ATO. Historically, many relied on exclusions to section 100A, such as the ‘ordinary family or commercial dealing’ exception, to safeguard their arrangements. However, this exception is now under increased scrutiny.
For instance, consider a university student over 18 with no income who is made presently entitled to $100,000 of trust income. If the student transfers these funds, less taxes paid, to their parents to reimburse past expenses, this could be deemed high risk. Here, the parents ultimately receive the benefit of the trust distributions, while the student’s lower marginal tax rate is utilized.
Another high-risk scenario involves circular distributions. For example, a trust may distribute income to a company owned by the trust, which then pays dividends back to the trust. This cycle repeats, creating circular arrangements the ATO views as attempts to avoid tax on trust distributions.
Other examples of high-risk trust distributions include:
- Beneficiaries with losses receiving distributions while not being part of the same family group as the trust making the distribution.
- Funds returned to the trustee by a company or trust entitled to trust distributions, creating circular arrangements.
- Issuance of units by the trustee of a trust (or related trust) where the value of the units is less than the subscription price.
- Adult children receiving distributions with funds ultimately paid to their parents for past expenses incurred before the children turned 18.
Safeguarding Your Trust Distributions
If you operate a discretionary trust, it’s vital to review your trust distribution arrangements in light of the ATO’s updated guidance. Documentation is key. Ensuring detailed records of how trust distributions are applied for the benefit of beneficiaries is essential to demonstrate compliance.
The ATO’s approach to trust distributions under section 100A applies to entitlements both before and after the guidance was published. However, for entitlements arising before 1 July 2022, the ATO generally won’t pursue arrangements that are low risk under the new guidance or that complied with previous guidance on trust reimbursement agreements.
Next Steps
With the ATO intensifying its focus on trust distributions, proactive action is critical. Regularly reviewing and updating your trust distribution practices can mitigate risk and protect against adverse tax consequences. Consulting with a tax professional experienced in trust law will help ensure that your arrangements comply with section 100A and avoid penalties.
Trust distributions remain a powerful financial tool, but they must be managed carefully in today’s regulatory environment to ensure they remain effective and compliant.
Read more about trust distributions from the CPA Australia.
