Section 100A of the Income Tax Assessment Act 1936 (ITAA 1936) provides that where there is a deemed reimbursement agreement between the trustee and a beneficiary, then, instead of the beneficiary being taxed on that income, it is the trustee who is taxed at the maximum marginal tax rate plus the Medicare levy, pursuant to s.99A of the ITAA 1936.
A reimbursement agreement will exist where:
- a trustee declares a distribution to a particular beneficiary;
- a person other than that beneficiary receives the benefit of the distribution whether by way of cash or property; and
- the purpose of the arrangement was to allow the trustee, or the beneficiary, or both, to achieve a lower income tax liability.
It is important not to become alarmed at this point. The description of a reimbursement agreement immediately brings to mind most family trusts whereby Mum and Dad as trustees, or directors of the corporate trustee, declare distributions to themselves but never actually pay themselves because the money is retained in the trust for running the business. This arrangement is not at risk of being deemed a reimbursement agreement because s.100A does not apply to any arrangement which is an ordinary family or commercial dealing.
The Act does not define an ordinary family dealing or an ordinary commercial dealing. However, the ATO has expressed the view that just because all the parties are family members, does not mean the arrangement would automatically be an ordinary family dealing.
An agreement does not need to be a document in writing but can be an oral agreement, an understanding, an exchange of correspondence or even simply an arrangement that is repeated over several years without any documentation or agreement whatsoever.
Typically, for something to be a commercial dealing it needs to be on arm’s length terms. For example, this might mean putting in place a loan agreement and paying interest like what is done under Division 7A. If an arrangement does not make commercial sense then it is unlikely to come with the ordinary commercial dealing exemption.
The ATO provides a number of examples on its website of both allowable ordinary commercial or family dealings and a dealing it does not consider appropriate.
Example 3 from the ATO’s website provides that an ordinary family dealing will include the situation where a distribution is declared to a minor but not paid and the income is instead used to make investments.
There is no particular timeframe on when the minor must be paid. The beneficiary usually will be legally entitled to call in the debt when they reach 18 but there would not be a problem if the debt was held over for a period after this. The ATO has not indicated that it would expect a commercial loan agreement to be signed when the beneficiary reaches 18. Families do not typically do this.
Example 4 is also instructive for family trusts or testamentary trusts. In that example, the trustee of a family trust declared distributions to a range of beneficiaries for several years without cash flowing the distributions, except for sufficient cash for the beneficiaries to pay tax on their distribution. The trustee of the family trust, instead of investing the funds, lends the funds to the controller of the trust on commercial terms, requiring the payment of principal and interest over time. This is permitted.
The ATO also states that it would not usually apply s.100A where the beneficiary is a minor.
The following arrangement should be avoided because it is likely to be a reimbursement agreement:
- the trustee of a family trust or of a testamentary discretionary trust makes a number of distributions to adult children;
- the distributions are not paid; and
- at some later time the adult children each sign a deed of forgiveness forgiving those distributions or even a number of years of distributions.
It would also be inappropriate for an adult child who received large distributions as a minor to later sign a deed of forgiveness.
Example 5 from the ATO website is as follows:
- The trust is the sole shareholder in a company (bucket company).
- The trust distributes income to the bucket company.
- The bucket company pays tax on the income and pays a fully franked dividend to the trustee out of that distribution.
- The arrangement is repeated in the following years.
The ATO describes this, not unfairly, as a perpetual circulation of funds with no commercial purpose. The ATO advises that it will apply s.100A to this arrangement.
Where possible, converting an unpaid trust distribution to a complying Division 7A loan will prevent there being any risk of a s.100A issue.
Note that there is no limitation period for the Commissioner of Taxation when reviewing previous years of income for s.100A arrangements.
Distributions by a testamentary trustee are unlikely to be a reimbursement agreement for the purposes of the Tax Act if they make sense in the context of your family, or in a commercial setting. If the arrangement only makes sense when the tax effects are considered, then you may have a problem.
Returning to the title of this article – yes if you have declared distributions to your children from your testamentary trust (i.e. which you inherited from your parents) then you will need to cashflow that distribution at some stage unless you wish to run foul of the reimbursement agreement provisions.