Use trusts? This year is a turning point
Last year, we covered the re-emergence of interest in a particular set of anti-avoidance rules applying to trusts. Section 100A in the tax law targeted promoted “trust stripping” schemes in the 1970s used by a relatively small number of wealthy people. However, trusts are now widely used such that anyone with a trust is capable of offending section 100A, and the Australian Taxation Office (ATO) has commenced a program of review. Accordingly, you ought to give attention to this ahead of making the required trust income appointment decisions by this 30 June.
The ATO finalised two key pronouncements last December. The first was Taxation Ruling TR 2022/4, which sets out the ATO’s views on the various components of section 100A. It’s worth noting that rulings are not law; they merely set out the ATO’s views. The second pronouncement was Practical Compliance Guideline PCG 2022/2, which sets out whose tax affairs will be subject to investigation, and whose will not. The PCG applies from this current financial year onwards, which is why 2022-23 is a turning point.
But what is the “tax mischief” in which you are supposedly capable of engaging?
The tax mischief
In broad terms, you appoint your trust’s net income each year to one or more beneficiaries. A beneficiary discloses their appointed income in their tax return for the year and is assessed for income tax and Medicare levy. Although there are a number of components to section 100A, here is the crux of the mischief it targets:
You appoint trust income on paper to a beneficiary on a lower tax rate, but someone else gets the benefit of the underlying funds, and there is a tax saving.
There is also a general exclusion from section 100A, being arrangements “entered into in the course of ordinary family or commercial dealing”. This phrase is not defined, and so is open to interpretation. You’ll be hearing those words a lot over the next few months and beyond.
Given all of the above, in the lead-up to trust-income appointment decisions you must make by 30 June 2023, the issue that will draw the most attention, spark the most discussion, and maybe cause some angst, is this:
Appointing trust income to your adult children.
Imagine appointing trust income to your adult child, on which income tax into the 21-cent bracket (including Medicare levy) is borne. That of itself may well be fine, but further imagine that you took the underlying money, meaning you have 79-plus cents in the dollar in your hands. If you had instead appointed the trust income to yourself – after all, you took the money – and paid, say, the top rate of 47 cents, you would have had only 53 cents in your hands. You can see the tax mischief possibly in play – riding on the coattails of someone else’s lower tax rates.
Where section 100A is taken to apply, it has the effect of the trustee being assessed at 47%, and penalties may apply.
But I don’t do that. Still…
What if you don’t take that money? As is the norm, you most likely would partially pay out the income appointed to your child to cover their tax liability. But then perhaps you retain the after-tax funds in the trust for reinvestment. Well, here’s the thing. The trust itself counts as a “someone else” who can get the benefit of the underlying funds. So, retaining the after-tax funds in the trust for reinvestment can fall into the realm of tax mischief to which the ATO could apply section 100A.
This is where the conversation really gets going, because you might have been doing the above for years, with section 100A never even rating a mention. The general view was always that such arrangements arguably fell into that “ordinary family or commercial dealing” exclusion. Building family wealth, from which the family collectively benefits, and yes, making use of family members’ lower tax rates – the same people who one day will take control of, and continue to benefit from, that wealth – has always seemed pretty ordinary. However, the ATO in TR 2022/4 says not necessarily so. So then, what are the prospects of the ATO reviewing your affairs?
The PCG sets out a coloured risk zone system. It’s all about whom the ATO will review, and whom they won’t. It lays down a series of scenarios falling into the Green zone, which the ATO considers low risk of offending section 100A, and thus won’t investigate any further. For example, you can fall into the Green zone if you appoint all of your trust income to you and/or your spouse – thus bearing income tax at your personal rates. Scenarios falling into the Red zone are regarded as high risk, and the ATO will investigate further.
Fortunately, the ATO listened to feedback on the draft ruling and PCG issued earlier last year, with a number of changes in the final versions. For example, three of Nexia’s recommended changes to the PCG were adopted. This resulted in a reduced Red zone, removing scenarios the draft captured whereby there was genuinely no mischief, and an expanded Green zone, adding scenarios that appropriately warrant no attention.
Where your circumstances do not fall into any of the Green-zone scenarios, but also are not in any of the Red-zone ones, you are in a “no-zone” void. In other words, your circumstances do not fit neatly into an “okay” Green-zone scenario, but neither are they setting off Red-zone “alarm bells”. Accordingly, your circumstances need to be considered on a case-by-case basis. And that common scenario above – after-tax trust income appointed to your adult children is reinvested in the trust – lands in that no-zone void.
It’s worth noting that there is one variation of the above circumstance that can fall into the Green zone. In addition to a few other conditions, it’s where your trust conducts a business, and your child is employed in the management of that business.
What to do
If your circumstances fall into that no-zone void, where do you stand? Unhelpfully, it’s a case by case consideration, which reflects the absence of clear goal posts as to what constitutes arrangements “entered into in the course of ordinary family or commercial dealing”. The reality is that no tax advisor could say with certainty that any particular circumstances in the no-zone void would meet that ordinary-dealing exclusion.
If you have been making use of your adult children’s lower tax rates, resulting in having more funds available for reinvestment in your trust, we have thought up some criteria that we believe could only help your case.
No guarantees, but if your no-zone circumstances meet the following criteria, you are affording yourself the chance for making a good argument that your circumstances arise from ordinary family or commercial dealing:
- Your child is aware of their trust entitlement and the amount
- Your child is aware that they have the power to call upon any amount of their entitlement at any time
- Both you and your child understand that if your child does call upon all or any part of their entitlement, you must pay it
- Any payment per above is the end of the matter. That is, the money paid out is now your child’s, with which they can do as they please
- There are no arrangements for the above money to find its way to you
- To the extent your child allows their entitlement to remain unpaid, they are broadly aware of how the funds are invested in the trust, they are confident that the funds are being managed competently, and they are confident that in time they will come into control of the trust
The above requires some openness with your adult children as to your financial affairs housed in your trust(s) – after all, by appointing income to them, you are choosing to involve them closely in your financial affairs.
We need to talk
If your children historically have not been aware of their entitlement owing to them, and you prefer that they be kept in the dark, there’s a discussion to be had there. If you are fairly certain that, if your child became aware of their entitlement, they would call for payment and spend it unwisely, we need to talk. If you simply don’t want to pay out any part of your child’s entitlement – perhaps because you view the underlying assets as “your” wealth – we need to talk.
For these and many other reasons arising from the 30-page ruling and 43-page PCG, we need to talk. And we certainly will be as you head towards making your trust-income appointment decisions before this 30 June and beyond.