From the outset there is no mischief with a discretionary trust distributing to a beneficiary that is a private company, provided of course, that the company is an eligible beneficiary of the trust.
However, add into that simple mix the generally universal non-payment of such entitlements to the company and the Income Tax law, then mischief starts to brew.
One mischievous process involves a circular technique whereby a company that is owned by the trust is made presently entitled to the net income of the trust (or a portion thereof) in year 1 and the entitlement is then extinguished by the company paying a fully franked dividend back to the trust in Year 2 on or before the Year 1 lodgment day for the trust’s income tax return.
Dividend offsets as described above are not subject to the anti-avoidance rules contained in section 109R involving loan repayments.
At Webb Martin Consulting we have been slightly concerned with arrangements involving a trust distribution to a company as described above.
Although technically nothing in Division 7A prevents this type of arrangement, it was always questionable whether the arrangement would pass the ‘smell test’ from a commercial perspective.
A recent call from a client prompted this newsletter because guess what? The ATO also seem to have some issues with this arrangement.
As noted earlier nothing within Division 7A prevents the above ‘circular’ distribution technique, however, the ATO seems to take the view that the arrangement is a ‘reimbursement agreement’ to which section 100A of the ITAA 1936 applies.
At a basic level, section 100A is targeted at trust income being diverted to third parties and away from the truly intended beneficiaries. In return, the truly intended beneficiaries (or their associates) receive what is hoped to be a non-taxable amount or benefit.
The provision operates by deeming the actual beneficiaries not to be presently entitled to the diverted income, with the trustee assessed on the diverted income at the top marginal tax rate (plus the Medicare levy).
Senior contacts at the ATO have unofficially confirmed there is no specific audit project focusing on reimbursement agreement arrangements, however the examination of such arrangements is part of a checklist of risks that they will look at with every SME group when conducting tax compliance activities.
The ATO has published these in its Building Confidence document (the new version of their former yearly tax compliance program). The document includes the risks extracted below re: reimbursement arrangements.
Trusts – potential reimbursement agreements
We focus on arrangements that may constitute reimbursement agreements which involve distributions to lower taxed associates, while the economic benefit is directed to another entity – usually a controller of a privately owned group or an operating entity within such a group.
We are concerned about whether such arrangements are ordinary family or commercial dealings, or appear to be entered into with a tax avoidance purpose.
Section 100A of the ITAA 1936
Trust taxation – reimbursement agreement
Clicking on the second link above and scrolling through to example 5 will show the ATO conclusion that in their view a circular distribution technique as described at the start of this newsletter will attract the application of section 100A absent any further factors to explain the arrangement.
The taxing times for trusts continue,so expect more ATO focus on the use of section 100A in relation to distribution arrangements within family groups where distributions are made to corporate beneficiaries, loss entities or low tax beneficiaries and the use of the funds is diverted elsewhere in a non-commercial manner.
As to whether the safe harbor of an ordinary family dealing in these instances can apply will most likely be up to the courts to decide.