The ATO recently finalised two pronouncements in relation to their views and compliance approach for a key set of laws targeting tax avoidance through trusts. Elements of the draft versions released earlier this year were somewhat impractical, and out of step with other integrity laws enacted in recent decades.
Following is a snapshot of some welcome improvements to Taxation Ruling TR 2022/4, which sets out the ATO’s views on these laws, and Practical Compliance Guideline PCG 2022/2, which sets out whose tax affairs will be subject to investigation, and whose will not. More importantly, we lay out the elephant in the room that every person with trusts wants addressed, and will be the subject of much discussion and debate in the lead-up to trust income appointment decisions by 30 June next year and beyond.
Final ATO pronouncements
Our initial comment on this latest development in the section 100A story is available here. To restate the key issue, the kinds of scenarios possibly – but not necessarily – offending this anti-avoidance provision can be succinctly summarised as follows:
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 purpose of achieving a tax saving.
The point of the above is that the “someone else” probably sits on a higher income tax rate, and thus would have borne a greater tax impost had the trust income been appointed to them. But instead, they get the benefit of the underling funds at a higher after-tax rate. There is also the exclusion from section 100A, being arrangements entered into in the course of ordinary family or commercial dealing. Where the line is drawn as to what constitutes ordinary dealing continues to be a bugbear of uncertainty.
There are a number of components along the journey to offending section 100A, but if it is found that you have, the result is that the trustee is assessed on that income at 47%, and penalties and interest may apply. The “someone else” mentioned above can include the trust itself. For example, the beneficiary does not request payment of their entitlement beyond the amount needed to pay any income tax liability, and the trust retains and reinvests the funds.
Will the ATO review your tax affairs?
The PCG has a risk zone system. It’s all about where the ATO chooses to apply its compliance resources – that is, whom they will review, and whom they won’t. For example, it sets out 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. Scenarios falling into the red zone are regarded as high risk, and the ATO will investigate further. The ATO is not saying you have offended section 100A if your circumstances fall into the red zone. Rather, they are merely saying that you are engaging in activity that is likely to offend section 100A, and an examination of the specifics of your circumstances is warranted. There are only two possible outcomes from that examination:
- The ATO comes to the view that you have offended section 100A; or
- They come to the view that you have not offended section 100A.
If your circumstances do not fall within the green zone, but also aren’t a red-zone scenario, you are in a void whereby it is a case-by-case consideration of your particular circumstances. If the ATO taps you on the shoulder, they will likely investigate further, again with the above two possible outcomes.
Drafts missed the target
A problem with the draft PCG was that it did not take account of other integrity rules enacted after section 100A. For example, circumstances that are perfectly compliant with the integrity rules for trusts deducting losses, utilising the various mechanisms those rules created for the very purpose of achieving tax integrity, would nonetheless have fallen into the red zone. (The draft did not mention any of those other integrity rules, nor the integrity-achieving mechanisms.) This would likely have resulted in a poorly targeted application of compliance resources, with the ATO reviewing taxpayers who have not engaged in any tax mischief.
It is pleasing to see that the ATO has listened to feedback on the draft versions. Several of Nexia’s suggestions, including redressing the above deficiency, have been adopted into the final version. This has manifested in an expanded green zone, incorporating a number of additional scenarios like the above – recognising the tax integrity achieved through other integrity rules – and thus shifting them from the red zone in the draft version to the green zone in the final. This will result in a far better targeting of the ATO’s compliance resources.
However, there is still much concern and uncertainty that we will need to discuss, debate and process over the coming months.
The elephant in the room
The circumstance – which is very common – that is the elephant in room over which uncertainty remains is this:
You appoint trust income to your adult children, pay down their entitlement to the extent of their income tax liability, retain the remaining funds in the trust for investment, working capital in a business, or apply to some other use.
The above takes us back to the succinct summary earlier above of what section 100A targets. Notably, the final PCG places the following two scenarios in the green zone:
- The entitlement is paid out to the beneficiary within two years.
- The entitlement is retained for longer, and the beneficiary is either:
- You and/or your spouse – and you are controllers of the trust; or
- The beneficiary (eg, your adult child) is employed in the management of a business conducted by the trust.
There are additional requirements for the above scenarios to be in the green zone, but the key point is that the ATO has set some boundaries – arguably arbitrary to an extent – within which they regard as low risk. Again, being outside those boundaries does not mean you have offended section 100A – it means the ATO will likely examine further, and again, one of those abovementioned outcomes will arise from the examination.
Common elephants
Consider these two common scenarios:
- Your trust holds passive investments. You appoint income to your adult child, pay down their entitlement only to the extent needed to cover their tax liability, reinvest the remaining underlying funds, and that continues beyond two years.
- Your trust operates a business. You appoint income to your adult child who is not employed in the business, or is employed, but not in a management role, and the rest plays out as per above.
Both of the above scenarios are not within the green zone, but neither are they red-zone scenarios. They are in that void where an examination of the fuller details is required. Historically, absent any obvious tax mischief, the above scenarios were generally viewed as arising from the course of ordinary family dealing, and thus not offending section 100A. However, the ATO is implicitly saying that that is not necessarily so. And that right there is the uncertainty with which we will be grappling over the coming months and beyond.
Talk to your trusted Nexia advisor – we’ll certainly be talking to you in due course – about managing your trust income appointment decisions in light of these final pronouncements from the ATO.
