The ATO has announced a major crackdown on the taxation of family trusts. In a long-awaited series of draft rulings, the ATO has focused on common tax planning strategies involving distributions to private companies and family members. This crackdown means that family groups will urgently need to reconsider how they are using their family trust.
This article focuses on distributions to private companies. Please refer here for the article focusing on distributions to family members.
What are unpaid present entitlements?
Most family trusts will have private companies as actual or potential beneficiaries.
Because companies pay tax at a significantly lower rate than individuals (i.e. 25% or 30% depending on a number of factors), it isn’t uncommon for family trusts to distribute ‘residual’ amounts (after all relevant individuals have been considered and/or distributed to) to a private company. These companies are often referred to as a company/corporate beneficiary, or more colloquially, a bucket company.
A common practice has been for the family trust to distribute sufficient cash to the company to pay its income tax liability on the distribution but retain the balance of the funds in the trust for investment or use in business activities. These undistributed funds are referred to as Unpaid Present Entitlements or ‘UPEs’. The approach gave the best of both worlds – the company tax rate on income and access to the 50% CGT discount on future capital gains.
Are unpaid present entitlements a problem?
Historically, UPEs did not present a tax problem in their own right, as long as the trust retained the funds and used them in its business and/or investment activities. If the trust lent the funds to individuals or other trusts, Division 7A could be triggered. But retention by the trust did not pose a problem.
Just before Christmas of 2009, the ATO released a draft ruling that the UPEs were ‘loans’ for tax purposes. This was an unexpected change to a long standing ATO position. It meant that the UPE itself would be subject to Division 7A, which would significantly impact on the use of corporate beneficiaries.
The ATO provided some administrative relief – the seven or 10-year interest only arrangements and the sub-trust arrangements – that family trusts have been working with for the last 12 years. These ‘work arounds’ have their own issues and have resulted in the ATO developing further administrative practices to manage them. All of this leads to complexity, but it enabled the use of corporate beneficiaries to be maintained.
There was always the option to convert the loans to standard Division 7A loans, but this was unattractive to many family groups.
TD 2022/D1 – the end of an era
On 23 February 2022, the ATO released TD 2022/D1.
In TD 2022/D1, the ATO simply takes the view that UPEs in the context of trusts and private companies with the same ‘directing mind’ are purely and simply loans for Division 7A purposes and should be treated in the same way all other Division 7A loans are treated.
This view is intended to be applied to UPEs arising on or after 1 July 2022 (i.e., FY23 onwards). The seven and 10-year interest only loan arrangements will be a thing of the past.
Sub-trusts will still be allowed but will be subject to a tighter regime. Holding an unpaid distribution on trust for the particular beneficiary who is presently entitlement to the amount is a concept based in trust law. When a trustee implements a sub trust consistent with their obligations under trust law, a deemed dividend is unlikely to arise for tax purposes. Where the funds are utilised by the trust more generally, the ATO is of the view that financial accommodation is being provided to the trust and a Division 7A loan, and potential deemed dividend, will arise.
There are some interesting timing considerations in the draft guidance. For trusts that distribute a fixed dollar sum to a company, the ‘financial accommodation’ will effectively arise at the distribution time (normally 30 June) and the UPE will need to be either repaid or placed on Division 7A terms before the lodgement date of that year.
For trusts that distribute a percentage of income to a company (even if this is 100%), the ‘financial accommodation’ will only arise when the income of the trust is determined and that will often happen after year-end – i.e. in the next financial year. This will result in the ‘financial accommodation’ only arising in the next financial year and the UPE will need to be either repaid or placed on Division 7A terms before the lodgement date of the following year.
The above may lead to more trusts using percentage of income distributions rather than fixed dollar sums to gain an additional repayment year. Having said that, many trusts did cease using fixed dollar sum distributions following the Bamford case.
Looking forward and looking back
The ATO has decided not to apply compliance resources to most historical seven-year, 10-year and specific asset sub-trust arrangements.
The revised ATO position will apply from 1 July 2022, so for FY23 distributions.
Whilst the revised ATO position does not apply to FY22 distributions, we see FY22 as a transitional year for tax planning given these changes and the section 100A changes. Most family groups will need to reconsider their existing tax planning strategies starting with FY22.
To discuss how these changes impact you and the best ways to manage your situation, contact your local William Buck Tax advisor.