What just happened with family trusts? And what does it mean for you?

The ATO did not get its way on family trust potential changes.

Last month, the Federal Court ruled against the Australian Taxation Office in regard to unpaid present entitlements (UPE) owing to company beneficiaries.

Put simply, the court affirmed that some payments owed by a family trust to a corporate beneficiary should not be treated as loans – despite the ATO’s wish to do so.

A UPE is created in a trust situation where the trustee makes an unpaid distribution to a corporate beneficiary. These distributions may typically be made over multiple years, but they may not necessarily be paid out.

The Commissioner for Taxation had argued that a UPE to trust income was effectively a loan. The matter was also the subject of an appeal by the ATO against an earlier ruling by the Administrative Appeals Tribunal in favour of the taxpayer. The AAT had held that a UPE to a corporate beneficiary was not a loan under Division 7A of the Income Tax Assessment Act.

For further context, in the AAT case the taxpayer had a corporate beneficiary of a discretionary trust. Under S97 of the Tax Act in Division 6 a beneficiary is taxed on their share of the net income from the trust both paid – and unpaid.

The ATO held that the corporate beneficiary had received a loan from the discretionary trust. Further, it said that the corporate beneficiary was presently entitled to a share of the income of the trust, and did not call for it to be paid. The ATO therefore treated the unpaid distributions as loans from the company back to the trust.

Conversely, the Federal Court took the view – as did the AAT in its original decision – that a UPE creates an obligation for the trustee to pay, but not to “repay” an amount to the company.

The relevant section of the act 109D (3) is helpful in its definition of a loan to include:

● An advance of money.

● Provision of credit or any other form of financial accommodation. Or

● A transaction (whatever its terms or form) that in substance effects a loan of money.

The Federal Court has therefore in a unanimous decision said UPEs paid to a corporate beneficiary are not loans under Division 7A. The ruling overturns a long-held view of the ATO to the contrary.

Brett Jackson, an expert in UPEs and partner at Blaze Acumen Accountants, points out that the commissioner has until the end of March to appeal against this decision in the High Court.

Given the decision was unanimous in favour of the taxpayer at both the AAT and Federal Court, the ATO must be granted special leave to lodge such an appeal.

Jackson says the ATO may look at what is known as integrity measures under S100A of the Act. These measures target arrangements where a beneficiary is made to be entitled to income from a trust, but the economic benefit is paid or applied for the benefit of another person, therefore reducing a person’s tax liability.

Related to this is the fact that other integrity measures within Division 7A will generally trigger a deemed dividend. Jackson advises that this is where a trust lends money to a beneficiary on favourable terms where a UPE to a corporate beneficiary exists.

What happens if the commissioner is not successful in leave to appeal (if the ATO decides to go down that path)? There may be further implications that taxpayers need to consider. I stress that this would be on further advice from a tax professional.

Options include:

● Seeking an amendment: If a taxpayer did not previously adopt the commissioner’s view and was issued amended assessments ­potentially being charged penalties and interest, they should consider seeking an amendment if they are within the four-year ­period of review.

● Income distribution by trustees: Trustees may once again distribute income to corporate beneficiaries and retain the funds (the unpaid element) in the trust. This has the benefit of being assessed at the corporate tax rate. Top-up tax at an individual marginal rate will only be deemed necessary when a dividend is required to be declared or paid from the corporate beneficiary.

● Retention of funds: This gives private groups more flexibility in capital funding opportunities by retaining these funds.

● Ordinary commercial dealing exclusion: Retention of funds needs to satisfy the “ordinary commercial dealing” exclusion from the application of S100A of the act.

Blaze Acumen stresses the importance of waiting to hear whether the ATO will appeal the Federal Court decision on UPEs.

Either way, the status quo is that the Federal Court has provided much needed clarity for taxpayers. It also gives rise to the potential ability of taxpayers to seek further amendments to tax paid – where that payment has now been considered unnecessary.

Will Hamilton is the managing director of Hamilton Wealth Partners.

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