ATO draft ruling casts doubt on trusts as an effective tax structure

Stephen Heath explains how a draft ruling by the Australian Taxation Office could see the tide turn on trusts.

A draft ruling from the Australian Taxation Office (ATO) has raised a big question mark over the long term use of trusts as an effective tax structure for family business owners.

The draft ruling — issued on 16 December 2009 on what is known as Division 7A — effectively reverses a previous ATO view on the common practice of trusts distributing, but not paying, income to associated private companies whereby tax payable on that income is capped at the 30 per cent corporate rate.

This is a major change in thinking by the ATO and, if ultimately accepted, will further limit the major role trusts have in family businesses or in holding investments.

Consequently, this will likely boost the role of companies and self managed superannuation funds as alternative wealth accumulation vehicles. This new attack on trusts is not unexpected.

Trusts have come under increasing pressure from the Treasury since the attempted introduction of the so-called “entity taxation” back in 1999. As a result, the flexibility of a trust to distribute income to low rate taxpayers has been a nagging issue for years.

With the deadline for comments on the ruling now past and June 30 fast approaching, accountants and financial advisers are busy schooling up on the proposed changes before the ATO makes a determination of its position.

For many SMEs and family businesses it could mean the need to completely re-think the role of trusts and perhaps rearrange their business and investment structures.

The particular issues at hand are:

• What should trusts with existing unpaid distributions to private companies now do; and perhaps more importantly,
• how should trusts handle their future distributions obligations (particularly this coming 30 June) to minimise business owners paying excessive tax.

The Draft Ruling

The Draft Ruling relates to situations where a private company holds the benefit of an Unpaid Present Entitlement (UPE) with a related trust.

This will invariably involve an intermingling of the trust’s funds, undifferentiated as between the liability to the beneficiary company and the trust’s funds at large.

Prior to 16 December 2009, the general understanding and the ATO interpretation was that a UPE would not be considered a “loan”.

However, the ATO’s revised view is that for a company’s UPE not to be taken to be a deemed dividend, the trust would need to maintain a discreet sub trust for the company’s exclusive benefit. In practice this is unlikely to ever happen.

This means that in future, trust distributions to companies will need to be paid and the distribution amount invested within the company is lent back to the trust on prescribed terms (usually seven years with interest at the statutory rate).

Failing that there will be a risk of tax being taxable at a rate of up to 46.5 per cent on a deemed unfranked dividend.

What to do next

The best approach for businesses is to hold steady until a final ruling has been issued.

This is likely to happen before June 30. In the past, the ATO approach to the deemed dividend rules in practical terms has been erratic.

In any event, one should not discount trusts and start reviewing structuring strategies until there has been an opportunity to digest the ATO’s final position on the issue.

In the meantime the Henry review of tax may give rise to further reason for consideration to the relative merits of trusts, companies and partnerships as structures.

In the meantime, however, there are a number of considerations that should be taken into account if the ATO makes its draft ruling final:

• Any UPEs established prior to16 December 2009 should be described as such, both from the perspective of the private company and the trust.
• The previous interpretation could be expected to still apply to UPEs established before 16 December 2009; that is on or before 30 June 2009. In that scenario there can still be a deemed dividend exposure where a trust carrying a UPE obligation makes a loan to a shareholder/associate of a shareholder of the company.
• UPEs to companies will, after 16 December 2009, give rise to deemed dividends. To avoid that outcome the distributions will need to be paid.

Each situation should be considered on its own merit and professional legal and financial advice sought on the best way forward.

Stephen Heath is a partner at Wallmans Lawyers.