ATO’s changes to family trusts: No more treating children as tax mules

After years of reviewing the working of family trusts, the Australian Taxation Office is clamping down on using kids as ‘tax mules’ to reduce tax bills.

The tax office’s changes affect thousands of families that run family trusts. Picture: iStock

Investors and their advisers have been patiently waiting since 2014 on clarification around the rules regarding family trusts. This week the ATO finally made its determination: the implications are far reaching and affect thousands of families that run family trusts.

Importantly, if you fall foul of the new guidelines, the ATO can go back as far as it wants and audit each year with potentially large penalty taxes to apply.

Technically, a Section 100A has been inserted into the Income Tax Assessment Act (1936) to reduce tax avoidance in family trust arrangements.

This Section 100A was largely forgotten until 2014, when the ATO came out with guidance on how it intended to apply the legislation. And finally, eight years later, the tax office has released new draft guidelines along with Practical Compliance Guidelines (PCG).

What changed? Previously, it was common for accountants and trustees to undertake tax planning by looking within the family unit, and distributing income from the family trust to the lowest taxed beneficiaries.

The family trust may operate a business, so rather than the mum and dad being taxed personally at up to 47 per cent tax, they could pass the business income through the trust as a distribution to the children at lower tax rates. And if the child was over the age of 18, adult tax rates apply, which allow over $20,000 in tax-free income to be received per child each financial year.

And it gets better: the family trust sometimes did not even have to physically transfer cash distributions to the adult children, it could just do it on paper, allowing the parents to maintain use of the cash from the family trust, rather than having to pay it out to the children.

To do this, the accountant would create a loan account to the child. In other words, the family trust was saying it was paying cash funds to the adult children for tax purposes, but in reality there was no flow of cash. The loan account would build and build each year with more distributions and go on indefinitely.

Another way accountants and trustees got around having to physically transfer cash to the adult children was to say that the distributions from the family trust was to “repay” the costs previously incurred by the parents in raising the child.

The parents might have calculated that the cost of housing, feeding, educating their children was, say, $1m. So by distributing money to them via the family trust, but not actually giving them cash, is OK, because the child had “owed” $1m to the parents/trust for being born and raised. That is, the benefit had already been given to the child so now the child is repaying it by receiving family trust distributions on paper.

In other cases, the parents have tried to be more compliant by physically distributing cash from the trust to the child, and then making the child “gift” the money back to the parents. But in reality they would just keep the money aside for any tax they would have to pay due to the parents distributing family trust income and gains to them. The ATO calls this a “reimbursement agreement”.

But alas, the ATO now has all of these arrangements in its sights with the release of the S100A draft guidance and PCG. The crux of the ATO guidance is that any money paid to a beneficiary needs to be legitimately for the benefit of the beneficiary.

If the ATO deems that the distributions were made to the adult children with the primary purpose being to reduce tax, then S100A will come into play moving forward. No more will the ATO turn a blind eye to these arrangements where parents are using their children effectively as “tax mules” to reduce tax.

At this point the guidance is in draft form and, while the ATO does not usually change its guidance very much from draft to final, it is important to remember that a lot of the guidance is yet to be tested in the courts successfully and does not have case law to back it up. In one recent case, Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation [2021], the ATO lost its court battle in Section 100A, ­although it is appealing against the decision.

The key takeaway from this week’s ATO release is that family trust distribution methods that were not targeted previously by the ATO will come under increasing scrutiny moving forward around whether they are genuine, or a tool to avoid tax.

If you operate a family trust, now is a good time to ask your accountant if the family trust has a large beneficiary loan account.

And for those who pay their adult children distributions on paper only, or physically pay but then demand it back, it is also time to review and discuss these arrangements with your ­accountant.

James Gerrard is principal and director of financial planning firm www.financialadvisor.com.au

Originally published as ATO’s changes to family trusts: No more treating children as tax mules