On 17 February 2020 the Australian Financial Review ran an article titled ‘Fresh scrutiny of trust payouts to beneficiaries’.
For clients who may have seen the article, we wanted to further explain the issues, so that clients with family trusts are not unnecessarily alarmed.
The essence of the article, is that if family trusts are used to distribute income (or capital gains) to children who are over 18 (or other low income beneficiaries), then the ATO may look to apply an anti-avoidance provision (known as Section 100A).
This can occur in situations where the beneficiary reimburses the trust or other beneficiaries (for example if a child reimburses a parent) in a way which suggests that they were never the intended beneficiary.
We have set out below an example as a discussion point.
The ‘Magic Family Trust’ derives income of $200,000 in a given tax year.
Mr and Mrs Johnstone as the directors of the Trustee company – decide to distribute $130,000 to Mrs Johnstone and $70,000 to Earvin Johnstone Junior who is now 20 years of age.
On the $70,000 distributed to him Earvin pays significantly less tax than Mrs Johnstone would have paid, because Earvin is still studying and does not earn an income.
On the trust distribution Earvin pays $15,697 of tax whereas Mrs Johnstone would have paid approximately $27,500 on that additional $70,000, had the distribution been made to her.
Discussions between Mrs Johnstone and Earvin lead to a transfer of funds from Earvin’s bank account to Mrs Johnstone on the basis that it is ‘family income’ and Mrs Johnstone will spend or invest those funds as she decides.
If this scenario was reviewed by the ATO, they may seek to apply Section 100A to the affairs of the Johnstone’s. Although there is effectively an exception for ‘ordinary family dealings’ it is not clear whether a court would agree that the arrangement above would be considered as such.
In our example it would be necessary to determine what Mrs Johnstone did with the money and if the funds were effectively used for Earvin’s benefit. For example the AFR article says that “in some cases, senior external lawyers and barristers have been engaged by the ATO to review spending on household costs, family holidays, cars and a range of other living expenses.’
However if the funds were clearly used for something which did not benefit Earvin then in our view Section 100A would be likely to apply.
Section 100A would have the effect of treating Earvin as never being entitled to the income. It means that the Magic Family Trust could potentially be assessed to pay tax at 47% on the $70,000 distributed to Earvin, excluding penalties (which would be applied).
That would increase the tax to $32,900 excluding penalties, compared to the $15,697 that Earvin would have originally paid.
ATO Ruling pending
The Australian Financial Review article also reports that the ATO is developing a public ruling which will discuss interpretational issues associated with Section 100A.
It is hoped that the public ruling will outline the ATO’s views on the ‘ordinary family dealing’ exception, so that taxpayers can have certainty about what type of arrangements will be acceptable to the ATO when it comes to distributing trust income.