In the Tax Institute’s weekly email to members: TaxVine (5, 25.2.22), their Vice President’s Report: Marg Marshall, CTA wrote about the long-awaited draft guidance materials on the application and operation of section 100A (s100A) [see related TT article] and Division 7A (Div 7A) of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) [see related TT article] were finally released on 23 February 2022. In last week’s TaxVine 4, The Tax Institute’s Senior Advocate, Robyn Jacobson, CTA provided some background and context for the release of the new guidance materials (see related TT article). Now that it’s here, members will need to discuss these important developments with their clients as trustees will need to reconsider the tax treatment of trust income and the manner in which distributions are made to beneficiaries. See also related TT article [AFR’s view].
What does the guidance say?
The package of draft guidance materials released comprises:
- Draft Taxation Ruling TR 2022/D1: section 100A reimbursement agreements (draft Ruling)
- Draft Practical Compliance Guideline PCG 2022/D1: section 100A reimbursement agreements — ATO compliance approach (draft PCG)
- Taxpayer Alert TA 2022/1 — Parents benefitting from the trust entitlement of their children over 18 years of age (TA)
- Draft Taxation Determination TD 2022/D1: Division 7A: When will an unpaid present entitlement or amount held on sub-trust become the provision of ‘financial accommodation’ (draft Determination).
Draft Ruling
The draft Ruling sets out the ATO’s view about arrangements that can attract section 100A and the basic requirements for section 100A to apply. The Commissioner’s preliminary view is that section 100A will apply when the following conditions are met:
- the beneficiary has a present entitlement to trust income;
- that entitlement is connected with (or has arisen as a result of) a reimbursement agreement;
- there is a benefit provided to someone other than the beneficiary;
- there is a tax reduction purpose (this need not be the sole or dominant purpose); and
- the agreement is not excepted as ordinary family or commercial dealing. [This is the real ‘killing ground’.]
The Commissioner takes the preliminary view that an agreement can arise out of the conduct of the parties, and in particular, does not require a full understanding by all parties. Nor is there is a requirement that the agreement be made in writing.
What is a reimbursement agreement?
The term ‘reimbursement agreement’ used in section 100A is not apt. Despite its name, there’s no need for any kind of actual reimbursement to occur. A reimbursement agreement provides for:
- the payment of money (including via loans or the release, abandonment, failure to demand payment of or the postponing of the payment of a debt);
- the transfer of property; or
- the provision of services or other benefits,
to or for one or more persons other than the beneficiary alone.
[There is an important ‘carve-out’, though, for Agreements that, though giving rise to a tax benefit (ss(8)), are not ‘entered into in the course of ordinary family or commercial dealing’ (ss(13)) which is what this article goes on to deal with next.]
What is the meaning of ‘ordinary family or commercial dealing’?
The draft Ruling notes that the ‘essential feature of ordinary family or commercial dealing is that it is ordinary’ (para. 79 of the draft Ruling). Essentially, the arrangement must be able to be explained as something that would ordinarily occur in a family setting or in the course of usual commercial actions. While the draft Ruling better articulates the meaning of the term ‘ordinary family or commercial dealing’ than previous guidance, it is likely that taxpayers and practitioners will still wrestle with applying these principles in practice.
The Commissioner considers that characterising an arrangement in the context of the exception for ordinary family or commercial dealing in subsection 100A(13) is an objective view, taking into account the circumstances of the parties, the type of relationship between the parties and the economic results of the dealing. The draft Ruling notes that it is not a test of what is common for either a family or the community. Rather, it is expected that the dealing is explicable as advancing normal or regular familial objects.
Nine examples are included in the draft Ruling to assist with understanding how the Commissioner views various arrangements.
Regarding ordinary commercial dealing, the Commissioner has less to say. The key points here are that the dealing should be as one would expect as normal or regular in trade or commerce. The draft Ruling helpfully notes that a commercial objective may exist even if parties are not dealing at arm’s length.
Draft Practical Compliance Guideline
The draft PCG provides a now somewhat familiar risk assessment framework, with four risk zones. The draft PCG also provides examples of arrangements that may fall into the different risk zones and the compliance action that may or may not be taken by the ATO based on the risk profile of each zone.
- The white zone applies to arrangements entered into before 1 July 2014 (the ATO’s web guidance on section 100A was first published in July 2014). The ATO will not take any action unless it would be outside the green zone and your client is already under audit or other scrutiny, is an arrangement that continues beyond 1 July 2014, or income tax returns for any years before 1 July 2014 were not lodged prior to 1 July 2017.
- If the arrangement is in the green zone, the ATO will not take compliance action.
- An arrangement in the blue zone is anything that is not white, green or red. These arrangements are less likely to be considered by the ATO but may be subject to questioning by the ATO in order to better understand them.
- Red zone arrangements will attract the attention of the ATO who will conduct further analysis on the facts and circumstances of the arrangement as a matter of priority. It may lead to audit.
The risk framework in the draft PCG differs from that in PCG 2021/4 on professional practice profits, which is based on a mathematical model [though why there might be ‘cross-over’ in the distribution of professional practice profits and remuneration, is not entirely clear to me – where the beneficiary gets and keeps all the distributed profit]. What we have here is different, and it will be challenging for taxpayers to ascertain which risk zone they fall into under the draft PCG.
Taxpayer Alert
The TA specifically targets arrangements whereby families use trust income appointed to adult children to offset expenses paid by the parents for usual parental responsibilities. The TA highlights such expenses as school fees for their education while a minor, and contributions to household expenses in excess of a normal board or rent amount. The TA points out that this common scenario often results in the adult children receiving income that keeps them below the highest marginal tax rate. [I note that it is common, in trusts, for the Trustee to be able to disburse a beneficiary’s entitlements, not to the beneficiary, but to others for their ‘maintenance, education, and advancement’. This ought to be taken into account, when the Commissioner is assessing what provisions might be applicable, when considering situations that he thought worthy of raising in an ‘Tax Alert’.]
The ATO’s view is that these arrangements may actually give rise to a section 100A issue; subsections 95A(1) and 97(1) of the ITAA 1936 may apply to treat the parents as presently entitled to those amounts; or Part IVA may apply.
The TA explains that registered tax agents involved in the promotion of these types of arrangements may be referred to the Tax Practitioners Board to consider whether there has been a breach of the Tax Agent Services Act 2009. [Which might arise, how … ?]
Draft Determination
The draft Determination specifically addresses the Commissioner’s view on whether an unpaid present entitlement (UPE) of a corporate beneficiary of a trust is taken to be the provision of financial accommodation, and therefore a loan for Division 7A purposes, if the corporate beneficiary does not call for payment of the UPE. As long as the corporate beneficiary has knowledge of the UPE and does not demand payment, the Commissioner’s view is that there will be a loan to the trust under the extended definition in section 109D(3) of the ITAA 1936.
Further, in the circumstances where the UPE is dealt with by way of sub-trust, if the corporate beneficiary allows a shareholder of the corporate beneficiary or their associate to use the funds held on sub-trust, this will be considered to be the provision of financial accommodation and has the same result as not calling for the UPE as discussed above. This will be the case even when the use of the funds is subject to commercial terms.
This is a significant departure from the position set out in TR 2010/3 and PS LA 2010/4, both of which will be withdrawn with effect from 1 July 2022.
Where the corporate beneficiary and the trustee have the same directing mind and will, the corporate beneficiary will be taken to know about these arrangements.
It should be noted that the draft Determination addresses just this one aspect of Division 7A, and we continue to wait for the long-promised legislative reform of Division 7A (see Robyn Jacobson’s preamble in TaxVine 4 from 18 February 2022).
When does the guidance take effect?
The draft Ruling applies to arrangements both before and after its publication. It’s important to remember that section 100A has an unlimited amendment period. The draft PCG does however provide some limitations:
- As noted above, the ATO will not apply compliance resources to arrangements entered into before 1 July 2014 unless they are considered to be one of the circumstances described above. However, this a compliance approach only, and does not provide a safe harbour or grandfathering of pre-1 July 2014 arrangements.
- The current ATO web guidance on section 100A (see Robyn Jacobson’s preamble in TaxVine 4 from 18 February 2022) will apply to arrangements entered into before 1 July 2022 where the web guidance provides a more favourable outcome to the taxpayer than the draft PCG.
The draft Determination will replace TR 2010/3 and PSLA 2010/4 with effect from 1 July 2022 and will apply to trust entitlements arising on or after that date. Attention will also need to be given to trust entitlements arising before 1 July 2022 held on existing sub-trust arrangements.
What does this mean for your clients?
The draft Ruling is the first clear and detailed guidance from the ATO on what constitutes a reimbursement agreement. The Commissioner’s view is that you don’t actually need full knowledge of the agreement in order for it to be effective. In many families, the parents manage the money and look after their adult children, and the tax impacts of those arrangements are handled by the parents in many instances with little or no involvement from the adult children.
It’s a common enough scenario that a family keeps track of expenses related to the upbringing of their children, in order to have the child repay the parents when they reach majority. With these draft guidance materials, the ATO is calling time on this! From 1 July 2022 (i.e. for income years ending 30 June 2023 and beyond), such arrangements are likely to attract the attention of the ATO.
Practitioners will need to discuss with their clients how decisions on trust distributions are made in their capacity as trustees, with particular attention being paid to amounts distributed to adult children. Under this Ruling, even common family arrangements may not be acceptable if the arrangements can’t be classified as ordinary family or commercial dealing. Just because something is common doesn’t mean the Commissioner will accept it as ordinary.
The draft Determination on UPEs will also have a big impact on common arrangements. While the draft Determination will apply only to trust entitlements arising on or after 1 July 2022, it will require a rethink of strategies; simply placing a corporate beneficiary’s UPE on sub-trust will no longer be enough to protect the amount from the impact of Division 7A.
Closing comments
The Tax Institute’s Senior Advocate, Robyn Jacobson, CTA, has posted in Community about this preamble. Join the conversation and share your thoughts and ideas and provide your feedback on the ATO’s draft guidance materials on section 100A and Division 7A.
Kind regards,
Marg Marshall, CTA