Taxation and trusts, what can you trust?

The ATO has had a longstanding compliance interest in family trusts and how they can be used flexibly to use the tax laws to the greatest advantage. How the tax laws apply to trust entitlements and who is taxed can be important. If it’s not done correctly then the trust can be taxed on an entitlement at the maximum personal tax rate.

An example is where a trust, rather than a beneficiary being taxed on the income, is where a reimbursement agreement exists. Currently the ATO is in the throes of issuing a draft ruling on clarifying what it means.

Under the tax law, a trust or beneficiary is taxed depending on whether the beneficiary is presently entitled to a share of the trust income and whether they are under a legal disability. If there is no beneficiary presently entitled to a portion of the trust income the trustee is taxed on that income at the highest personal tax rate. However, if a beneficiary is presently entitled to income but under a legal disability the trustee will pay income tax based on each beneficiary’s share of the income. A child under 18 who is a trust beneficiary is an example of someone under a legal disability and special rates of tax apply.

Around five years ago, the ATO provided guidance on some types of trust distributions used for tax planning purposes constituted reimbursement arrangements. As a result, the trustee was taxed on the distribution at the highest personal tax rate rather than the beneficiary receiving the distribution because they were presently entitled and not under a legal disability.

A reimbursement agreement is treated as being in place where a trust distribution is made to a beneficiary who is tax exempt or taxed at preferential tax rates, but another person gains the ultimate benefit from the distribution. Examples of beneficiaries include companies or others who have carry forward losses and end up paying a lower rate of tax than the maximum personal rate. A self-managed superannuation fund is unlikely to fall into the acceptable beneficiary category as distributions from family trust arrangements are taxed as non-arm’s length income at 45%.

As an example of a reimbursement agreement would include a trustee of a discretionary trust makes a distribution to a beneficiary such as an individual or entity that is presently entitled to income and is liable to pay tax at less than the maximum personal rate of 45%. However, rather than making the payment of the distribution to the beneficiary the trustee gifts or lends the distribution interest free to another person but they are not subject to tax on the amount received. Overall less tax is paid on the trust distribution.

The law does allow some distributions paid to beneficiaries that would normally qualify as reimbursement agreements to be taxed in the beneficiary’s hands rather than the trustee. These are referred to as ordinary family or commercial dealings and would include a will trust where the beneficiary is a minor, unpaid trust distributions which are converted to a loan under Division 7A of the tax law and where the arrangement is not considered to be part of a tax avoidance arrangement.

As with all tax law, whether the distribution is taxed in the hands of the trustee or the beneficiary depends on the circumstances of the case. The questions to be answered are:

• whether an arrangement exists for another person or entity to benefit from the distribution other than the original beneficiary who was presently entitled, and
• if there is an arrangement in place, whether it is in the nature of an ordinary commercial or family dealing.
  

The big trap in all of this is the power of the ATO to go back as far as it wants to tax the trustee if they consider a reimbursement agreement exists. Whether records exist in some of these cases is doubtful. This compares to normal taxpayers who are required to keep records for 5 years from the time their income tax return is lodged.

I’m sure advisers and anyone who has family trust arrangements where distributions are made to beneficiaries on lower than the maximum rate will be interested to see what the ATO has to say on reimbursement agreements whenever the draft ruling hits the streets.