‘Game changer’ tax ruling may lead to refunds for family trusts

The AAT ruling potentially questions the past 14 years of tax treatment of about 971,000 family trusts, most of which have corporate beneficiaries, and loans totalling around $100 billion.

“This decision throws into question the ATO’s view of the law since 2009,” Molesworth says. “This is significant for a large number of taxpayers.”

Laura Spencer, a senior associate with KHQ Lawyers, says the case could be a “game changer”.

“The law says one thing but the ATO’s interpretation arguably stretches it a little far. Taxpayers will hope this is the first domino to fall in a set of burdensome interpretations the ATO holds on the taxation of trusts.”

The Tax Office has yet to announce whether it will appeal. The ATO is “considering the decision, including whether any appeal may be appropriate”, a spokesman says.

“This will be a precedent setter if upheld on appeal,” Hall & Wilcox tax partner Michael Parker says. “It will cause people to revisit the way they use family trusts and company structures for funding investments and business operations.”

Tax authorities do not have to follow the Bendel ruling as the decision was made by a tribunal, despite pressure from tax professionals to establish its legal position on the issues.

There is also the risk a higher court could rule against them.

Trusts more attractive

“I would be surprised if they did not appeal,” Spencer says. “It is likely to be taken to the AAT and higher courts by other aggrieved taxpayers. Creating precedent at those higher courts would bind the ATO.”

Molesworth adds: “A defeat [of the ATO] would make trusts more attractive as it means income could be retained in trusts and taxed at a corporate rate of between 25 per cent and 30 per cent rather than an individual’s rate of up to 47 per cent (which includes the 2 per cent Medicare levy).”

The case involved the ATO and Melbourne-based Bendel, who according to the judgment ran a “busy suburban accounting and tax agent practice”.

Following an audit of Bendel’s tax affairs, the ATO deemed around $1.3 million of unpaid distribution to be a “loan” under Division 7A, which is intended to prevent profits or assets being provided to shareholders or their associates tax-free.

On September 28, AAT deputy president Frank O’Loughlin and senior member Keith James ruled it was not a 7A loan, adding that the ATO had misinterpreted the tax law set out in statute by the federal government.

Soft loans

”The balance of an outstanding or unpaid entitlement of a corporate beneficiary of a trust, whether held on a separate trust or otherwise, is not a loan to the trustee of that trust,” the decision says.

It challenges established practice of the ATO to deem, which means consider as income, “unpaid present entitlements” (UPE), which is the income that the beneficiaries leave inside the trust.

A popular strategy is for family trusts to distribute “residual” amounts, which is what is left over after beneficiaries have been considered, to a private company, also known as a “bucket company”.

The retained balance of funds in the trust is then used for business, investment, or soft (favourable) loans to shareholders, who are typically family members.

Before 2009, this meant that trusts paid the lower company tax rate on income and had access to the 50 per cent capital gains tax on future capital gains.

Since 2009, the ATO has ruled that UPEs were loans for tax purposes, subject to commercial interest rates and needed to be repaid, generally within seven or 10 years.

The cost of the loans – which is set for July 1 each year and broadly pegged to the variable standard, owner-occupier mortgage rate – this year increased from 4.7 per cent to 8.27 per cent, the highest rate in 15 years.

According to the Institute of Financial Professionals, the decision “puts the ATO’s longstanding practice on UPEs since 2009 in question. No doubt it is not going to be the last we hear of the matter.”

The decision comes as trusts and other tax-effective structures are being considered as a way to avoid the federal government’s proposed tax increases in super savings of more than $3 million.

Most 7A loan payments are not due until next June, which means trusts have time to assess their position, according to tax professionals.