Section 100A: Additional Complications for Trusts
Many people utilise discretionary trusts to gain access to the lower tax rates enjoyed by other family members. However, the Australian Taxation Office (ATO) have decided that they want to “clamp down” on this practice.
How does a Trust Distribution Work?
A discretionary trust does not pay any tax itself – it is merely a conduit for the distribution of taxable income. As such, it “distributes” taxable income amongst its various “beneficiaries”. For instance, if a trust has a profit of $108,200 the profit may be distributed as follows:
Terry (Father) $90,000
George (son- age 18+) $18,200
Why “split” the income?
Australia’s taxation system for individuals works on a progressive basis – as you earn more income, you pay a higher rate of tax.
The tax rates for individuals for 2018 / 2019 are as follows:
Tax on this income
0 – $18,200
$18,201 – $37,000
19c for each $1 over $18,200
$37,001 – $90,000
$3,572 plus 32.5% on each $1 over $37,000
$90,001 – $180,000
$20,797 plus 37% on each $1 over $90,000
$180,001 and over
$54,097 plus 45% on each $1 over $180,000
This means that you pay Nil tax on the first $18,200, then 19% on the next $18,800 (up to $37,000) etc. Various other levies and rebates may affect your actual tax payable.
The net effect is that, if you can “split” your taxable income, your tax can be reduced. In the example above, there is $108,200 taxable income in the trust. Outlined below are two possible outcomes for the distribution of this income:
Scenario 1 - 100% Distribution to Terry
Scenario 2 - Distribution to both Terry and George
Scenario “2”, in which a distribution of the income is split between Terry and George, results in an overall deduction of $6,734.
What are the potential issues with splitting trust income?
Assume that the trust is controlled by Terry. If the trust decides to distribute $18,200 to George, then that is a legally binding contract. If the money isn't paid to George, then there is a legally enforceable debt that the trust will owe George indefinitely. In the future, George may decide to demand the money, or more worryingly, the person who may demand the money could include:
- George’s estranged spouse
- The bankruptcy trustee if George is declared bankrupt in the future
Due to the above possible situations, historically any “beneficiary loan accounts” arising from any “profit distributions” may have been eliminated by way of a journal entry, possibly in favour of the controller of the trust (in this case, Terry).
What the ATO have recently stated?
Section 100A is a section of the Tax Act that has been in place for over 30 years, but it has not been enforced in this area until very recently. It basically states that if one beneficiary (for example George) is entitled to a distribution, but they have not received the “benefit” of this distribution, Section 100A may be enforced.
What is the effect of Section 100A?
The impact of Section 100A is that the ATO can change the tax treatment of the trust distribution. Instead of George having taxable income of $18,200 (and paying nil tax), the ATO could deem that amount to be “undistributed” and the trust must pay the tax on it – this will be at the highest possible tax rate – 45%.
In this scenario, the tax payable would be as follows:
|Trust (not George)||$18,200||$8,190|
How to ensure that Section 100A is not applicable
There are two distinct situations where Section 100A will not apply. These are as follows:
- Ordinary family dealings
- Physical payment of moneys to the beneficiary
The ATO have decided that Section 100A will not apply in the circumstance of “ordinary family dealings”, however there is very little definitive explanation of what is an “ordinary family dealing”.
For children under 18, the tax effective distribution is $416. The treatment in the accounts is that where the trust, or parents, have effectively “spent” any such distribution “made” to the children, is generally seen as “ordinary family dealing”.
Alternatively, the ATO have assessed Section 100A in a couple of cases where distributions of over $1 million were made to adult children (but who didn’t see any of the proceeds).
We can therefore see that $416 is almost certainly “safe” while $1 million is almost certainly “unsafe”. The issue is with distributions to beneficiaries that lie between $416 and $1 million per year – a fairly significant “grey area”.
The alternative solution is to ensure that there is a physical payment of monies to the beneficiary.
In our example this could be done in a number of ways:
- George will have received some cash from the trust during the year – say $3,000
- The trust may have spent money on expenses specifically for George during the year – say University costs of $3,200
This would leave the trust “owing” George $12,000 ($18,200 - $3,000 - $3,200) at the end of the year.
There are three possible options to deal with the $12,000 “balance” at the end of the year.
1. Leave the balance in the accounts owing to George. This has the negative of George deciding to ask for the money at some point in the future. This option is generally not recommended.
2. The balance is “journalised” to Nil. The amount owing by the trust is now recognised as being owed to the controller of the Trust (Terry). This has been the historical treatment. This is, in effect, an acknowledgement that the funds have either been:
- Expended on George’s behalf, or
- George has gifted the monies to Terry
In either case, this process relies upon the ”ordinary family dealings” exemption. The problem we now have is that the ATO has considered that there is an “upper limit” on “ordinary family dealings”; but there is nothing definitive in this area – it could differ from family to family.
3. A physical payment of monies from the trust to the beneficiary (George). There may be a formal gifting of monies from the beneficiary to someone else, as part of the process.
An example of this could be as follows:
George is owed $12,000 by the trust as at 30 June, 2018. However, this is only made clear when the accounts are finalised on 31 January, 2019.
On 15 February, 2019 a payment of $12,000 is made from the trust to George, into a bank account controlled by George.
On 16 February, 2019 George may transfer $10,000 to a bank account controlled by Terry, and signs a deed of gift to that effect.
On 17 February, 2019 Terry may lend this $10,000 back to the trust.
How could Section 100A Affect You?
If you believe that your trust distributions may exceed “ordinary family dealings”, it may be preferable to utilise the “physical cashflow” method, to eliminate the risk of Section 100A being invoked.
However, if you believe that there are risks involved in this system (i.e. George will not give money back to Terry), then you may need to review the utilisation of your family members in any future trust distribution strategy.
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