On 24 January 2023, the Full Federal Court released its decision in FCT v Guardian AIT Pty Ltd ATF Australian Investment Trust [2023] FCAFC 3 (Guardian Decision). This decision is important because it concerns both s100A of the Income Tax Assessment Act 1936 (“ITAA 1936”) on trust reimbursement agreements, and the application of the general anti-avoidance provisions in Part IVA ITAA 1936 to discretionary trust distributions. The decision still leaves unanswered questions about s100A, including a clear definition of an ‘ordinary family or commercial dealing’ which remains a key area of contention.
Prior to the release of the Guardian decision, the Australian Taxation Office (“ATO”) released its long awaited Final Ruling TR 2022/4 (“Ruling”) and Practical Compliance Guide PCG 2022/2 (“PCG”) on 8 December 2022. The Ruling deals with complex interpretative issues in relation to s100A while the PCG tries to mark out some areas where the ATO will not apply its audit resources, as well as arrangements that will definitely attract audit attention.
The ATO views expressed in the Ruling and PCG did not vary substantially from the views expressed in draft TR 2022/D1 (“Draft Ruling”) and PCG 2022/D1 (“Draft PCG”), which were released on 29 April 2022.
Date of effect
The Ruling states it is applicable both before and after its release. However, the PCG states that the ATO will not commit compliance resources to arrangements arising before 1 July 2022 if reasonable care has been taken in applying the ATO administrative position published on the ATO website in 2014. While this appears to be helpful for taxpayers, the ATO’s 2014 administrative position was vague, limited in its scope, and does not define what is an ‘ordinary family or commercial dealing’.
Overview of Section 100A
Section 100A is an anti-avoidance provision seeking to prevent a tax benefit arising where under a pre-existing agreement between two or more people:
- a beneficiary is made presently entitled to a share of trust income
- a party other than the beneficiary receives a benefit in some way, shape or form
- at least one of the parties to the agreement has a purpose of reducing the amount of tax that would otherwise be paid
- the agreement was not entered in the course of an ordinary family or commercial dealing.
Where Section 100A applies, the beneficiary is deemed to never have been made presently entitled to the share of trust income and therefore the trustee is assessed at the top marginal tax rate for individuals.
While the ATO’s position and compliance approach in relation to Section 100A appears to be largely unchanged from the Draft Ruling and Draft PCG, the Final Ruling and PCG provide further detail and examples, particularly in relation to the meaning of ‘ordinary family or commercial dealing’.
Ordinary family or commercial dealing
In determining whether an arrangement is entered in the course of ordinary family or commercial dealing, the Ruling indicates that while each step in an arrangement may be seen as ‘ordinary’, you have to consider whether the whole arrangement meets the requirement. The Ruling also sets out factors that may preclude an arrangement from being classified as being in the course of ordinary family or commercial dealing, including elements of contrivance, excess complexity, and undertaking steps that would not otherwise be required to achieve the desired commercial or family objective. Usefully, the Ruling and PCG provide a number of examples of arrangements that would be carried out in the course of ordinary family and commercial dealing.
The Ruling also acknowledged several cultural factors that may indicate ordinary family dealings. Examples provided focused on customs of gifting by both younger family members to parents or grandparents following their departure from the workforce, as well as grandparents providing gifts to younger family members. However, taxpayers with arrangements of this nature resulting in substantial tax benefits, whether intentional or not, would be well advised to obtain advice from a tax professional.
PCG
In finalising the PCG, the ‘traffic light’ risk assessment system included in the Draft PCG remains but reduced to three risk zones as opposed to four in the Draft PCG. The risk zones in the PCG are:
- the Red Zone (higher risk)
- the Green Zone (low risk)
- The White Zone (no ATO compliance action on matters arising before 2014).
Red Zone Arrangements
The PCG outlines a number of Red Zone arrangements exhibiting high risk characteristics that would result in the ATO dedicating compliance resources to consider the application of section 100A as a matter of priority. These arrangements generally involve an element of contrivance or redirection of trust distribution benefits to parties other than the beneficiary being made presently entitled. They include the following scenarios:
- a low tax rate individual adult beneficiary being made presently entitled to trust income where the financial benefit is directed towards a high tax rate parent or other relative by way of a gift or loan
- where either a trustee, parent or other relative has in previous years incurred expenditure on behalf of an adult individual beneficiary when they were a minor and in the current year the adult individual beneficiary is made presently entitled to a trust income distribution, but instead of paying the adult beneficiary their trust entitlement, it is applied against amounts owed to the trustee, parent, or other relative in respect of the earlier expenditure.
Guardian and ‘washing machine’ arrangements
The ATO have also included in the Red Zone ‘washing machine’ arrangements. In these arrangements a private company owned by a discretionary trust is made presently entitled to a share of income. The entitlement is then distributed by the private company as a fully franked dividend to the trust in the following income year. The discretionary trust then makes the private company presently entitled to that franked dividend, with the potential for the same process to be conducted again each subsequent year so it allows the trust to have access to the funds without Division 7A applying.
In the Guardian Decision, the Full Federal Court found that s100A did not apply to a similar fact pattern. This was because the taxpayer showed that at the time the distribution to the company was made there was no agreement to pay the dividend in the subsequent year.
Green Zone Arrangements
The PCG describes the following Green Zone scenarios that the ATO deem to be of low risk and therefore to which the ATO would not seek to devote compliance resources:
- distributions that are used to benefit the beneficiary, their spouse, or dependents, or applied on their behalf within two years of the beneficiary becoming presently entitled
- where the trustee retains the present entitlement funds for more than two years and the trustee only uses or holds the funds in the working capital of a business that it carries on, or to fund an asset that it holds, or for lending to an associate on commercial terms.
There are a number of examples in the PCG and Ruling that fit these Green Zone scenarios including:
- a trust established under a will for a minor beneficiary where the trustee will retain the corpus and income until the beneficiary attains the age of 25
- a trust distribution to a parent who uses the funds to pay the deposit on a house that their adult daughter is purchasing
- trust distributions to a company beneficiary with tax losses where the company beneficiary uses the funds to satisfy its own commercial/business expenses.
However, the PCG and Ruling identify situations that may on the face of it fall into the Green Zone but contain features that would result in them being excluded, as described below.
Exclusions from the Green Zone
The PCG outlines characteristics that would result in the arrangement falling out of the Green Zone, because they have risk factors or characteristics of interest to the ATO. These factors include where:
- the unpaid distribution is converted to a loan or is disclaimed by the beneficiary or is gifted (other than to a deductible gift recipient)
- an unpaid distribution to a corporate beneficiary is offset against a franked dividend paid by the corporate beneficiary
- distributions to loss companies or trusts to allow them to fund distributions to members
- private companies using trust entitlements to fund distributions directly or indirectly to a non-resident.
Compliance issues also feature in the exclusions including where:
- beneficiaries have not lodged tax returns
- a beneficiary’s share of income, franked income or capital gains distributed by the trust has been understated for a year of income
- the trustee has failed to notify the beneficiary of their entitlement prior to the trust lodging its tax return (or being required to lodge its tax return if it is late).
White Zone
White Zone arrangements are those that arose before 1 July 2014. The ATO will not commence compliance action for these arrangements unless the ATO is otherwise considering the taxpayer’s income tax affairs for those years, or the arrangement continues after 1 July 2014.
Scenarios not in any zone
The PCG explicitly states that it does not provide guidance relating to the ATO’s compliance approach for arrangements that do not fall into any of the zones. However, just because an arrangement is not in any of the zones does not necessarily mean section 100A applies. The ATO has noted the principles to be used in determining whether Section 100A applies in these situations including:
- whether a benefit has been provided to a person other than the beneficiary
- the presence of complexity and contrivance or the possibility of that benefit being provided in a more direct way
- the arrangement resulting in significantly less tax being paid compared to the benefit having been provided more directly.
Taxpayers with arrangements that fall outside any of the zones would be well advised to seek advice from a tax professional and to consider the possibility of obtaining a private binding ruling from the ATO for further comfort.
BDO Comment – section 100A
While there is much to technically quibble about in relation to the Ruling and PCG – not least their retrospective application – they do at least set out areas of safety where trustees can be reasonably confident of not being the subject of ATO review.
Anyone outside those areas of safety – particularly those with arrangements where the ultimate user of a trust distribution is not the same as the beneficiary made entitled to the income by the trustee - should take urgent advice. Contact your BDO tax adviser for further guidance.
BDO Comment – Part IVA
While the ATO lost on its s100A arguments in the Guardian Decision, it did have a win in relation to the application of Part IVA to the arrangement. Part IVA is the general anti-avoidance provision of the tax law. Using Part IVA to attack discretionary trust distributions has several advantages for the ATO over s100A, including a more clearly defined tax avoidance purpose requirement, and the requirement to ignore tax costs when considering alternative courses of action available to the trustee.
In our view, it is likely that we will see much more emphasis by the ATO on pursuing discretionary trusts using Part IVA in the near future.
For more information on Section 100A, please contact your BDO tax adviser.