100A trust reimbursement agreement not the tool to fix the bucket company dividend washing machine
This blog post is about tax avoidance. That is not apparent from the odd title of this blog which I should explain:
A bucket company is a private company included as a beneficiary of a trust and is used to receive income of a trust. It is a popular discretionary trust strategy for a trust to distribute trust income to a bucket company as a beneficiary of the trust when, as at present, company income tax rates are lower than income tax rates:
- for beneficiaries who are individuals typically on significant incomes (individual beneficiaries); and
- the (can be even higher – highest marginal) rate generally paid when no beneficiary receives (technically: is distributed or becomes presently entitled to) the income of the trust;
(the Higher Rates).
Thus the “bucket” takes the overflow of trust income which the trustee or trust doesn’t wish:
- to flow to high income individual beneficiaries; and
- to be taxed at their higher rates.
Not considered tax avoidance
The Commissioner of Taxation (Commissioner) doesn’t view the simple use of a bucket company as a beneficiary of a trust as tax avoidance. That is the case even though less tax will be collected from a trust’s trustee and beneficiaries when the Higher Rates won’t be paid by the trustee and the beneficiaries of the trust when a BC beneficiary is used. There are measures in place: notably the deemed dividend anti-avoidance rules in Division 7A of Part III of the Income Tax Assessment Act (ITAA) 1936 (Div 7A), which generally give the Commissioner assurance that:
- a private company is a no mere lowly taxed conduit or way for high income individual individuals to receive trust income; and so
- value either within and distributed to a private company stay within the company or are otherwise treated as non-frankable shareholder/associate dividends they are deemed to receive and to be taxable on.
The washing machine
The bucket company dividend washing machine (BCDWS) though pushes the Commissioner’s tolerance for the bucket company tax strategy.
The BCDWS is like this:
- A family discretionary trust (FDT) makes a substantial distribution of trust income (Distribution 1) to a bucket company (BC) in Year 1.
- Distribution 1 is not paid and thus becomes an unpaid present entitlement owed to BC by FDT to be paid later.
- BC is taxable on Distribution 1 in Year 1 at the company rate which is lower than the Higher Rates.
- In Year 2, but in the window before the income tax return for BC is due, and thus before Div 7A treats Distribution 1 to BC to be a deemed dividend based on the analysis of when unpaid present entitlements, including unpaid present entitlements of companies in trust income, can be loans and deemed dividends in Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements; the bucket company declares and pays a dividend to cover Distribution 1.
- BC has franking credits to frank the dividend from the payment of tax as a beneficiary on Distribution 1.
- The sole shareholder of BC entitled to the dividends is the (trustee of) FDT which has been set up as the owner of the shares in BC that can participate in these dividends.
- No actual payment is required as Distribution 1 has gone around the washing machine and has come back to FDT in Year 2 as dividends fully franked by BC.
- So in Year 2 the trustee of FDT distributes Distribution 2 of the same amount as Distribution 1 to BC again. It is again unpaid until early in Year 3. The distribution is fully franked which is how the dividends were received from BC so there is no further tax for BC to pay.
- The arrangement can be repeated on and on.
By using a concession in Div 7A, the BCDWS in effect enables BC to access a lower company income tax rate for an amount which is not actually paid over or intended to be paid over to a beneficiary but circulates back to the trustee.
Income tax rate integrity problem
So it’s like the trustee is accumulating the income and never having to pay it to a beneficiary but paying less tax as if the income had been paid to a company.
Understandably the Commissioner is concerned with the integrity of income tax rates, and the particularly the integrity of the Higher Rates including the highest marginal rate applicable where no beneficiary is presently entitled to income under section 99A of the ITAA 1936. The Commissioner would like to see that the BCDWS will have the same rate outcome. It does if a BCDWS is a trust reimbursement agreement: a share of trust income arising from a section 100A reimbursement agreement is deemed to be income to which no beneficiary is presently entitled: sub-section 100A(1).
So it is that, at the ATO website, https://www.ato.gov.au/General/Trusts/In-detail/Distributions/Trust-taxation—reimbursement-agreement/ where, at example 5, the Commissioner observes that the trust reimbursement agreement provisions in section 100A of the ITAA 1936 apply to a BCDWS arrangement.
Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation
The Commissioner’s observation in example 5 is put into doubt by the December 2021 Federal Court case Guardian AIT Pty Ltd ATF Australian Investment Trust v. Commissioner of Taxation  FCA 1619. In that case the Commissioner was unsuccessful assessing a BCDWS using anti-avoidance tax laws including section 100A. The taxpayer’s appeal to the Federal Court concerned the Commissioner’s assessments applying the anti-avoidance provisions in section 100A and, alternatively, based on the general anti-avoidance provisions in Part IVA of the ITAA 1936.
Logan J. found that there was no reimbursement agreement and that Part IVA didn’t apply.
The Commissioner had at least these significant difficulties in making out that the BCDWS in the case was a reimbursement agreement:
- firstly, that there was any agreement to which sub-section 100A(7) and (8) could apply, and particularly establishing a counterfactual as to whether Mr. Springer, who controlled Guardian AIT Pty Ltd, would have been liable to pay income tax had the “agreement” not been implemented;
- secondly, that there was provision of “payment of money or the transfer of property to, or the provision of services or other benefits for, a person or persons other than the beneficiary …” under that agreement: sub-section 100A(7); and
- thirdly, that the agreement was not an ordinary family or commercial dealing: sub-section 100A(13).
Mr. Springer was wealthy and conducted a well prepared case before the Federal Court in which the taxpayer was able to establish that the BC, Guardian AIT Pty Ltd, had not been set up with the intent, understanding or expectation that the BC would pay dividends back to the Australian Investment Trust (the FDT). That is what eventually transpired though, and a BCDWS, largely as described above and in the Commissioner’s example 5 happened.
There must be an agreement first
Logan J. accepted that even though it was legally possible for the BC to pay the dividends to the FDT there was no evidence of any timely agreement or plan (my words) to do so. To make out a section 100A reimbursement agreement the Commissioner had to make out that there was “agreement” (though widely defined) between the FDT and its beneficiary/ies before BC started paying dividends to the FDT to make the income tax saving.
Counterfactual not accepted
Logan J. found the Commissioner’s counterfactual under the section 100A(8) “would have been” hypothetical: that Mr. Springer personally would have been liable to pay income tax, that is Mr. Springer would presumably have to have been the beneficiary presently entitled to the income distributed to the BC rather than the BC, had it not been for the reimbursement agreement, could not be reconciled with the evidence in the case.
· payment, transfer etc.
Logan J. did not accept that there has provision for a payment , transfer etc. to another beneficiary…. The BC was a related entity of Mr. Springer that was a beneficiary of the FDT and a part of the family structure in its own right (that incidentally happened to be on a lower tax rate as an income beneficiary).
Unlike with a unrelated entity that takes, say, a payment to be made a beneficiary of trust income in a trust stripping, which is the use of trusts abuse to which section 100A is directed; the BC in this case can be seen as a beneficiary related to and having no reason for such arm’s length like dealing with Mr. Springer or other members of his family.
· ordinary family or commercial dealing
Section 100A was introduced to combat trust stripping typically involving unrelated parties (see Federal Commissioner of Taxation v Prestige Motors Pty Ltd (1998) 82 FCR 195) and “specially introduced beneficiaries having a fiscally advantageous status” particularly. Logan J. did not accept that this characterisation applied to the BC, Guardian AIT Pty Ltd. From the evidence Logan J. found that the implementation and use of Guardian AIT Pty Ltd as a “clean” (for instance, no carry forward losses or other utilisable positive tax attributes) company beneficiary of the FDT, Australian Investment Trust, was an ordinary family dealing.
Guardian AIT confirms that a reimbursement agreement contains a number of technical elements that the Commissioner can be hard pressed to establish where a taxpayer produces facts contrary to the Commissioner’s position on them. These elements can make section 100A, as a tool in the anti-tax avoidance armoury of the Commissioner, ill-suited to enforce the integrity of the Higher Rates applicable to trust income and the rate applicable under section 99A of the ITAA 1936 where there is no beneficiary presently entitled to income in particular. That is not to say that the Commissioner should not endeavour to enforce that integrity.
Based on authority referred to in Guardian AIT Logan J. was unwilling to accept that the reimbursement agreement rules in section 100A, directed as they are to the contrived introduction of specially introduced beneficiaries with a fiscally advantageous status, had application to a clean company introduced within Mr. Springer’s family structure despite the overtly unplanned tax arbitrage Mr. Springer could achieve due to the lower company income tax rate.
There is the prospect that the Commissioner will appeal to the Full Federal Court. The government could better protect the integrity of the trust tax rates with specific amendment so that circulating BCDWS distributions, which do or must have some aspect of artificiality or contrivance by virtue or their circularity or non-distribution, attracted the highest marginal rate of tax without the Commissioner having to contest assessments based on section 100A and Part IVA attack or sham characterisation which are more costly, fraught and complicated for the Commissioner to prosecute.
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