The ATO’s release of Tax Ruling 2022/4 (‘TR‘) and Practical Compliance Guideline (‘PCG‘) 2022/2 (both relating to section 100A reimbursement agreements) on 8 December 2022 changed the way we viewed family trust income and distributions. 

If we wanted to avoid the dreaded section 100A ‘reimbursement agreement’, it seemed that ‘normal’ family tax planning practices were out the window and accumulating unpaid present entitlement (‘UPE’) balances to beneficiaries was no longer an appropriate strategy for collectively managing and sharing family wealth. 

But what to do with historical UPEs?  Is it unforgiveable to forgive historical UPEs? 

As with all things tax and law, it depends.

Following release of the TR and PCG, the appeal decision of Commissioner of Taxation v Guardian AIT Pty Limited ATF Australian Investment Trust [2023] FCAFC 3 was handed down on 24 January 2023 and B&F Investments Pty Ltd as trustee for the Illuka Party Trust v FCT [2023] FCAFC 89 (taxpayer appeal of  the decision in BBlood Enterprises Pty Limited v Commissioner of Taxation [2023] FCAFC 114) was handed down on 9 June 2023.

In Guardian, the Court set out some helpful key principles including the need for a presence of consensus between multiple parties to form an agreement and such agreement must pre-exist the present entitlement.  Since then, we continue to have questions about what it means for our clients who have found themselves with historical UPE balances and unsure as to whether section 100A applies.

A quick refresher on section 100A and reimbursement agreements

At its simplest, section 100A operates to impose a tax liability (at the highest marginal rate) on the trustee of a trust where a beneficiary is made presently entitled to trust income, but another person enjoys the benefit of that trust income.  These types of arrangements will be subject section 100A where an agreement ('Reimbursement Agreement') is in place with the following qualities:  

• the Reimbursement Agreement provides for the payment of money, or transfer of property or services to a person other than the beneficiary;

• a purpose of one of at least one of the parties to the Reimbursement Agreement is to lessen the income tax liability of a person (irrespective of whether that person is a party to the Reimbursement Agreement);

• the Reimbursement Agreement is not entered into in the course of ordinary family or commercial dealings; and

• the present entitlement arises out of, in connection with, or as a result of the Reimbursement Agreement.

To navigate this intricate terrain, the ATO has broken down the playing field into three zones (white, green and red).

White Zone

The white zone covers arrangements that were in place and concluded prior to 1 July 2014.  The ATO generally will not apply its compliance resources to these arrangements except in certain circumstances (for example, where the ATO is reviewing the trust's tax affairs for fraud or evasion).

Green Zone

The ATO generally will not dedicate compliance resources to consider the application of section 100A with respect to arrangements that fall within the green zone.  The types of arrangements that are likely to fall within the green zone include those where:

• the income to which the beneficiary is presently entitled is distributed to that beneficiary (or an account held jointly by that beneficiary) and the beneficiary's spouse or children enjoy the benefit (for example, where the trust income is used to cover household expenses);

• where the trustee retains the trust income for less than two years and uses those funds in certain ways (for example, in the working capital of a business carried on by the trust); or

• where the arrangement satisfies the ‘ordinary dealing’ exemption.

Red Zone

While arrangements that fall within the red zone will not necessarily attract the application of section 100A, taxpayers with red zone arrangements should expect the ATO to dedicate compliance resources to consider those arrangements.

The types of arrangements that the ATO considers falling within the red zone will generally have some element of contrivance, may be circular in nature, may appear unusual or are not able to be explained by any commercial objective (for example, where trust income is returned to the trust by a beneficiary in the form of assessable income).

Are we any clearer, one year on?

As tax practitioners, we have some certainty that:

• the ATO continues to focus on its Top 500 and Next 5000 compliance programs, and that section 100A compliance is part of that focus;

• whether or not we agree with the ATO’s interpretation of the legislation, certain tax planning behaviour will fall into what the ATO calls the ‘red zone’ and may have the ATO applying compliance resources and determining section 100A applies; and

• tax planning advice for clients going forward should keep clients safely in the ‘green zone’ (or properly informed of the risks).

But what about the UPEs that already exist?

The safest option will almost always be to discharge the UPE amounts by paying them directly to the presently entitled beneficiary for their benefit.  By doing so, the trustee critically demonstrates that:

• the arrangement was not for the benefit of another person; and

• there was no intended result of reducing someone’s tax liability (the beneficiary that received the benefit also paid the tax).

However, it is not always possible to satisfy the UPEs. 

What happens if the payment of the UPEs could only be done by selling critical assets held in the trust such as a family home or by the trustee taking out a loan? 

What if the payment of the UPEs creates an asset protection risk or conflicts with the beneficiary’s succession plan? 

Pre-PCG 2022/2, a beneficiary might forgive a UPE or loan balance owed by a trust in order to solve the issues around payment, asset protection and succession planning.  This was typically considered uncontroversial for family members to make financial decisions for the benefit of the family as a whole, even if it was to the detriment of the individual. 

However, the ATO has indicated that the following act might be an indication that an arrangement is in the ‘red zone’ and might be a Reimbursement Agreement: 

‘the beneficiary disclaims their entitlement or forgives or releases the trustee from its obligation to pay their trust entitlement or an associated amount receivable from the trust (for example, if the UPE was converted into a loan),’

(paragraph 32(1) of the PCG).

Does this mean that forgiveness is completely off the table?

When can historical UPE be forgiven by the beneficiary?

There is no shortcut answer and the individual circumstances need to be properly understood before deciding whether a course of action is or is not available.  Some useful considerations might be:

• What is the history of how the relevant UPE was accumulated?  Is it the same behaviour of appointing income to the same beneficiary for the same reasons each year?   

• Reimbursement Agreements can only exist where there is an intent to obtain a tax liability reduction for someone.  Have a look at what was happening when the relevant amounts were appointed.  Does it appear to be for a tax reduction reason? 

• Is there a history of UPE forgiveness that might indicate to the ATO a pattern of behaviour?

• What are the reasons for wanting to forgive the UPE?  If the reason has nothing to do with how and why the UPE accumulated and nothing to do with a tax reduction outcome, then section 100A may not have any work to do here. 

• After understanding the history and individual circumstances, does it appear that the four qualities that indicate a Reimbursement Agreement exist in relation to the UPE? (see refresher on Reimbursement Agreements above for the four qualities)

For the forgiveness activity to be caught by section 100A as part of the Reimbursement Agreement, it arguably needs to be a feature of the arrangement that led to or existed at the time of the present entitlement arising. 

The ATO says at paragraph 16, TR 2022/4:

‘For a present entitlement to income or an amount of income that is paid or applied for the benefit of a beneficiary to arise from or in connection with or as a result of a reimbursement agreement, that agreement must have occurred simultaneously with or have been in existence prior to the time the entitlement arose or when the payment or application occurred, as the case may be.  An expectation that some arrangement will be entered into after the creation of the present entitlement is not sufficient for the purposes of section 100A.  However:

• the conduct of the parties before and after the time the present entitlement is created may be relevant to establishing the existence of an agreement by that time (for example, where behaviour is repeated); and

• neither the presently entitled beneficiary nor the trustee needs to necessarily be a party to the agreement or even be in existence when the agreement is made’.

Therefore, depending on the specific circumstances of how the UPE arose, how long it has existed, the history of distributions and forgiveness activity and the reasons behind wanting to forgive will all play a part in whether forgiveness is an appropriate way forward.  

To discuss your concerns about s100A, UPEs, or other trust and tax planning issues, please contact Caitlin Ashworth or Ben Wilson at CCK Lawyers on 08 8211 7955.

This article provides general comments only and does not constitute legal advice.  You should always seek specific advice on your particular circumstances.