An update on the use of a corporate beneficiary

21 February 2022

It is common amongst private groups to have structures that involve discretionary trusts that have distributed to companies that are eligible beneficiaries of the trust.

Although it was always intended that these distributions were eventually paid down in cash to the company, invariably the trust would not have such sufficient available liquid assets to attend to payment at either the time of the distribution, or shortly thereafter. What consistently then occurred was that the assets supporting the unpaid distribution were retained by the trust and re-invested or otherwise utilised by it.

The ATO has provided guidance expressing concerns about this sort of arrangement whereby the distribution is left unpaid for a period of time and in recent announcements suggested they may use integrity measures to attack these arrangements particularly where the trust owns shares in the company.

Most certainly the ATO’s application of various tax provisions to the use of these structures have evolved into something that is a major source of complexity and confusion for private groups.

For private groups the landscape is changing and strategies that worked in the past will unlikely work into the future.

Corporations as beneficiaries

The advantages of distributing trust income to corporate beneficiaries include:

• a flat rate of tax that is usually less than the applicable individual tax rate;
• encouraging retention of profits and accumulating wealth;
• no ‘tax differential’ to pay on those distributions where they are fully franked;
• achieving asset protection objectives of a family group where the discretionary trust is commonly used to hold investment assets.

Such arrangements do introduce an element of complexity for private groups implementing such corporate structures. Invariably, unpaid distribution entitlements ( ‘UPE’)  strategies arise. There are various ATO rulings and guidelines which require care when structuring these arrangements so as not to trigger the provisions of Division 7A of the Income Tax Assessment Act 1936, which deems certain payments to shareholders or their associates as dividends.

The UPE strategy

A UPE strategy is where a discretionary trust resolves to make a company presently entitled to some or all of the net income of the trust.

To the extent that the company is required to pay income tax on this distribution, the trust would usually pay at least that amount to the company with the balance of the distribution retained by the trust.

The UPE strategy is used to enable reinvestment of the profits in either the business or by way of financing the acquisition of investment assets held in the trust. This structure brings with it an asset protection strategy.

The tax efficiency of such a structure is also a factor including;

• the trust is fiscally transparent, so use of this structure does not add further tax liabilities, 
• the discretionary trust has flexibility in who income is distributed to,
• this flexibility assists with managing tax liabilities across a family group,
• a trust can access the CGT 12 month 50% discount,
• the tax arbitrage on income is a timing difference, with top up tax being paid when the profits are ultimately distributed out of the structure to the individual family members,
• the tax arbitrage on capital gains is permanent where the gains are distributed directly to individuals.

A common approach to structuring a corporate beneficiary is illustrated below;

• Discretionary Trust 1 distributes income to the corporate beneficiary,
• this income will be taxed at the corporate rate of either 25% or 30% subject to whether the company qualifies for the lower base rate of tax,
• the income will then remain in the Company until the Company decides to distribute the income to its shareholders by way of a future dividend,
• typically, the only shareholder of the Company will be a second discretionary trust,
• the income of the Company will ultimately be distributed to the same individual beneficiaries of the first discretionary trust by way of fully franked dividends.

What to do with the distributions paid to the company

Long gone is the notion of using a corporate beneficiary to defer ‘top up tax’ on trust distributions.  Distributions to corporates like any beneficiary, are entitled to receive the benefit and payment of such distributions declared to it.

The distribution ultimately is now required to be paid to the corporate beneficiary and various strategies to utilise these funds include;

• hold the ultimate distribution until some point in the future when it can be distributed to individuals usually once they retire,
• in the meantime, invest that part of the overall investment portfolio allocated to non-capital growth type assets such as dividend yielding, revenue-based investments, mortgaged managed funds, property development investments, and fixed interest products,
• lend the cash to a related entity under an interest-bearing Division 7A-compliant loan arrangement or sub trust arrangement,
• investing in long term legacy investments acknowledging the compromise in tax efficiency, particularly if it is never foreseen that such investments will be sold but rather viewed as a strong source of franked dividend yield for future generations,
• undertake or transfer business activities to the company.

Recent ATO audit activity

In its 2020-21 Federal Budget, the Government announced that $1 billion would be provided over 4 years to extend the ATO Tax Avoidance Taskforce. The ATO has announced its “Next 5,000 program“, designed to see the ATO undertaking “streamlined assurance reviews” of relevant taxpayer groups over a 4-year period (mirroring the approach undertaken in the Top 1,000 tax performance program that applied to public and multi-national companies).

One of the areas of particular interest to the ATO is section 100A of the ITAA 1936 and recent guidance and ATO audit activity that is being tested in the courts signals a tighter and tougher application of section 100A to trust distributions.

The much-anticipated ATO ruling is expected to be released this week as to how it is likely that the Commissioner will apply this section to use of corporate beneficiaries.

Why the concern?

In simple terms, Section 100A has the effect of not recognising for tax purposes, distributions of trust income to beneficiaries where those distributions resulted in a reduction in the income tax payable by a taxpayer where they do not in the short term receive payment of the distribution and the arrangements around the distribution were not part of ordinary family or commercial reasons. Instead, the trustee is taxed on the income. 

It is anticipated that the ATO intends to take an extremely narrow view on what constitutes ordinary family or commercial dealings. For instance, the ATO may not accept that there is an ordinary family reason for not paying distributions owing to adult children.

A particular target appears to be where a Trust owns 100% of the shares in a company, which also receives distributions as a corporate beneficiary of the trust. Often such arrangements are put in place with a view to maintaining a simple structure and avoiding the incorporation of additional entities. Subject to the ATO ruling, consideration should be given to whether any UPEs can be paid out, or restructuring to use new companies going forward.

Furthermore, in a very important development, the Federal Court has recently ruled on Section 100A and the Part IVA anti-avoidance provisions in Guardian AIT Pty Ltd ATF Australian Investment Trust v Commissioner of Taxation [2021] FCA. This case involved an arrangement where a trust made a distribution of income to a corporate beneficiary, and the corporate beneficiary in sequence distributed a dividend back to the trust. This type of arrangement was one of several examples provided by the ATO of arrangements in its ruling that may attract section 100A.

On the particular facts of this case, the Court ultimately held that section 100A had no application to the taxpayer group’s circumstances, determining that no agreement or scheme existed at the relevant testing times particularly when the structure was established and when the distribution was declared to the corporate beneficiary.

Not surprisingly, the Commissioner has appealed this decision to the Full Federal Court in respect to this decision where we are hoping that they expand on the legal issue of ordinary family dealing in more depth to assist advisers in the application of this principal.

Key Takeaways

Although the use of corporate beneficiaries is common, simply taking advantage of their lower rates of tax is not without consequence or risk.

The ATO considers that Division 7A may apply to an unpaid present entitlement owing to a corporate beneficiary where the trust and the beneficiary are related entities.

Furthermore, where the distributions are not ultimately paid into the company but are directed to benefit other family members, the ATO are likely to approach this arrangement tougher in their audit activity.

Accordingly, it is important to review current arrangements, ensure appropriate structures are in place and use of a corporate beneficiary is correctly implemented for the valid reasons.

This article has summarised the potential benefits of using corporate beneficiaries such as:

• to hold retained earnings and franking credits until needed,
• an effective asset protection vehicle,
• to use loans to related entities to purchase assets tax efficiently,
• an effective structure to accumulate wealth and asset succession.

We will be issuing updates on ATO announcements expected in the following weeks on their application of various tax provisions as to how they apply to trusts, adult children and corporate beneficiaries.

If you would like to understand more about the above as to how it applies to you or would like a health check review of your corporate structures, please contact the authors of this article.

Authors:

This newsletter is current as of 21 February 2022, however, please note that announcements and changes are being made by the Government and the ATO regularly, and we expect that the tax and business-related responses will continue to evolve.  Before acting upon the content of this newsletter, please contact us to discuss how the above applies to your specific circumstances.

This information is general advice only and neither purports, nor is intended to be advice on any particular matter.
No responsibility can be accepted for those who act on the contents of this publication without first contacting us and obtaining specific advice.
Liability limited by a scheme approved under Professional Standards Legislation.
For further information please refer to our privacy policy