Which bucket company distributions are now in danger of attack from Section 100A?
ATO releases final guidance attacking family trust distributions
The compliance guidelines of the Australian Taxation Office's (ATO's) Section 100A (S.100A) include two specific scenarios, referred to as "green zone" scenarios. These apply in cases where a trust distribution made to a bucket company (also known as a 'corporate beneficiary') remains within the trust.
In this article, we present an overview of these green zone scenarios and emphasize the necessary requirements that must be met to qualify for the green zone.
The ATO also draws attention to several scenarios that may pose challenges from a S.100A standpoint when handling distributions to bucket companies, particularly those involving non-resident taxpayers.
What is Section 100A?
Section 100A serves as an anti-avoidance rule that comes into play when a beneficiary's entitlement in a trust arises from a reimbursement agreement. In essence, a reimbursement agreement refers to a setup where a beneficiary gains immediate entitlement to trust income and:
someone other than that beneficiary receives a benefit in connection with the arrangement
at least one of the parties enters into the agreement for a purpose of reducing tax
What is a bucket vompany?
A bucket company (otherwise known as a corporate beneficiary) is a company that is set up as a beneficiary of a trust with the purpose of allowing any income the trust distributes to the bucket company to be payable at the company tax rate, currently 25% (only if it is a base rate entity), as opposed to the individual marginal tax rate (the top tax rate for individuals is currently 49% including Medicare levy).
Dealing with bucket company distributions that are retained in the trust
Frequently, trust distributions are directed to a bucket company, and the funds representing these distributions are kept by the trustee (with the company's share of net taxable income taxed at a maximum rate of 30%). The ATO has established specific criteria to determine whether a trustee's retention of funds falls within the low-risk green zone under the S.100A compliance guidelines.
In this context, it is essential to acknowledge that various "rules" or factors are applicable for the S.100A compliance guidelines, contingent upon whether the trust distribution is:
paid out to the bucket company (or applied on its behalf) within two years of the present entitlement arising
retained by the trustee for a period of two years or more
Bucket company entitlement is paid out within two years
A trust distribution to a bucket company that is retained by the trustee will fall within the S.100A compliance guidelines if:
the bucket company ‘receives its entitlement’ within two years of becoming presently entitled to it (i.e., the entitlement must be paid out within two years);
the bucket company ‘uses the entitlement’ once it has been received; and
the arrangement must not contain any ‘exclusion factors’ (e.g., the notification and lodgment requirements must be satisfied).
Essentially, the ATO allows the trustee a "two-year window" to utilize a trust distribution, given that the bucket company receives the present entitlement within two years of it being established, and the company puts this entitlement to use (which may involve paying dividends to shareholders using the distribution funds).
However, when dealing with such arrangements involving a company, it becomes imperative to consider not only S.100A, but also Division 7A.
Understanding the interaction between S.100A and Division 7A
Should a distribution to a bucket company go unsettled (termed an 'unpaid present entitlement'), this entitlement essentially transforms into a loan for the intentions of Division 7A (as it qualifies as the offering of financial support). Ordinarily, the loan arises in the year subsequent to the distribution. The Australian Taxation Office (ATO) stipulates that a Division 7A loan comes into existence when the bucket company becomes aware of the sum of its entitlement and refrains from requesting payment (usually occurring the year following the distribution).
After the emergence of this loan, the involved parties possess two alternatives to prevent the activation of a presumed dividend as per Section 109D by the conclusion of the year in which the loan originated (subject to the company's available distributable surplus). By the deadline for filing the company's tax return for the fiscal year in which the loan came into being, the subsequent course of action can be pursued:
The trustee retains the option to disburse the entitlement to the bucket company. It's important to note that this disbursement could involve transferring the funds into a separate account and holding them under a sub-trust arrangement for the company (ensuring the funds remain separate from the main trust's funds). If the trustee selects this approach, then in terms of Section 100A considerations, the arrangement will fall within the second scenario of the green zone as per the Section 100A compliance guidelines. This applies provided that the bucket company employs the entitlement once it's disbursed and no 'exclusion factors' come into play. The act of the bucket company 'using the entitlement' encompasses scenarios where the entitlement is retained or utilized for the purchase of goods or services, to fulfill obligations or expenses, invested on behalf of the company, or directed towards distributing dividends to shareholders.
The involved parties have the option to establish a loan agreement that adheres to Section 109N. This agreement would generally necessitate the trust to disburse the entitlement sum (inclusive of interest) in a fairly even manner over a span of seven years.
Should the trustee opt for this approach, the assessment of the arrangement's treatment under Section 100A compliance guidelines hinges on whether the loan is settled within the first two years from the inception of the present entitlement, and this determination unfolds as outlined below:
There exists a scenario where a distribution to a bucket company was structured under S.109N compliant loan conditions, and subsequently, the loan was settled within the first two years of the initial present entitlement emergence. While some uncertainty remains, it seems that under these circumstances, the arrangement could potentially align with the second scenario of the green zone (as per Section 100A compliance guidelines). This holds true provided the bucket company continues to employ the entitlement after its disbursement – for instance, by utilizing the distributed funds to cover expenses or by directing the funds towards investments.
In connection with this matter, please take note that the stipulated criteria of 'using the entitlement' in accordance with the S.100A compliance guidelines are not met by a bucket company if the distributed funds are utilized for an investment or any other transaction involving another affiliated party, and the compensation or sum paid by the bucket company surpasses the market value or is not in line with commercial terms.
If a distribution to a bucket company was structured under S.109N compliant loan conditions and the loan remains active for a duration of two years following the initial emergence of the present entitlement, the opportunity provided by the two-year timeframe in the second scenario of the green zone is no longer applicable. Instead, the assessment of the S.100A risk level must be made in relation to the context of green zone scenario 3B (pertaining to bucket company distributions retained for a period of two years or longer), as elaborated upon in the following discussion.
To provide a comprehensive perspective, it's worth mentioning that alternative sub-trust choices existed to prevent the activation of Division 7A consequences concerning bucket company trust entitlements established before July 1, 2022. The stance taken by the ATO regarding sub-trusts for these distributions was comparatively more lenient than its current stance. However, the exploration of these options falls outside the scope of this article.
Tax Warning – Paying out the entitlement does not remove the risk
Maintaining vigilance is crucial, as both Section 100A and Division 7A warrant ongoing oversight, even if a distribution to a bucket company is disbursed. From the perspective of Section 100A, the use of distributed funds might, in specific instances, lead to the nullification of the initial bucket company distribution. An illustrative instance is provided in the S.100A compliance guidelines, where the ATO clarifies that a bucket company distribution won't fit into any of the green scenarios:
if the private company beneficiary uses its trust entitlement to fund a distribution that is made directly or indirectly to a non-resident; or
if the private company beneficiary uses its trust entitlement to fund a distribution that is made directly or indirectly to the trustee that made the beneficiary presently entitled to income.
Further to the above, Division 7A must also be considered with respect to any use of distributed funds made by the bucket company. For example, if a bucket company loans distributed funds to a shareholder (or an associate), the loan must be repaid, or a S.109N complying loan agreement must be entered into, by lodgment day to avoid triggering a deemed dividend.
Example – Interaction between Division 7A and S.100A
On June 30, 2023, the trustee of the Frank Family Discretionary Trust (referred to as the 'trust') decides to allocate the entire trust income for the 2023 fiscal year to Bucket Company Pty Ltd.
As of June 30, 2023, Bucket Company Pty Ltd was unaware of the specific amount of trust income, if any, that it could immediately demand from the trust (this means no Division 7A 'loan' comes into existence at this point).
By August 1, 2023, the trust's trustee determines the trust income and the net taxable income for the 2023 fiscal year. No cash payment is made to Bucket Company Pty Ltd, except for the amount needed to cover its tax liability. Consequently, the remaining entitlement of $100,000 becomes an 'unpaid present entitlement.'
On August 1, 2023, Bucket Company Pty Ltd is considered to have granted a loan for Division 7A purposes to the trust. This stems from the fact that this is the time when Bucket Company Pty Ltd becomes aware of the sum it could demand immediate payment for, but fails to do so.
As Bucket Company Pty Ltd is deemed to have lent $100,000 to the trust in the 2024 fiscal year, the involved parties have until the 'lodgment day' for Bucket Company Pty Ltd's 2024 tax return (for instance, May 14, 2025) to either repay the loan or postpone the payment by establishing a S.109N compliant loan agreement. This action is taken to prevent the activation of a $100,000 presumed dividend on June 30, 2024.
For the sake of comprehensiveness, it's important to note that if triggered, the presumed dividend would be incorporated into the assessable income of the trust, contingent upon the distributable surplus of Bucket Company Pty Ltd.
On May 1, 2025, the trustee of the trust disburses the entitlement to Bucket Company Pty Ltd. This implies that the trust retained control of the distribution funds from July 1, 2023, until May 1, 2025 (approximately 1 year and 10 months, totaling 22 months).
Upon receiving the funds, Bucket Company Pty Ltd invested them in listed shares. Notably, the arrangement does not encompass any of the 'exclusion factors.'
Does this scenario create any exposure under Division 7A?
In brief, the answer is no. Through the prompt disbursement of the current entitlement, the trustee successfully averted the initiation of a presumed dividend according to Division 7A in connection to the distribution to the bucket company.
Does this scenario create any exposure under S.100A?
Apart from fulfilling their obligations under Division 7A, the involved parties must also take into account the potential exposure under Section 100A due to the retention of funds by the trustee for a span of 22 months.
In this instance, the parties can capitalize on the 'two-year window' as stipulated in the second scenario of the green zone within the S.100A compliance guidelines. This indicates that the ATO perceives a minimal risk of Section 100A being applicable to the arrangement. This conclusion is drawn from the fact that the current entitlement was received and disbursed within two years of its origination (meaning it was paid out) and the bucket company proceeded to employ the funds after receipt (illustrated by the company's investment of the funds).
Bucket company entitlement is retained for two years or more
If a trust distribution is directed towards a bucket company and the trustee maintains control of the funds for a duration of two years or more, it typically leads to the trustee retaining the funds under the terms of a S.109N compliant loan agreement. This type of agreement is established between the involved parties to address specific issues related to Division 7A, as explained earlier.
A common misconception that often arises regarding S.100A and entitlements of bucket companies is the belief that the presence of a complying loan agreement automatically excludes the potential application of S.100A. However, this assumption is incorrect, as both S.100A and Division 7A operate independently, with neither provision preventing the functioning of the other.
Should a trust distribution be allocated to a bucket company, and the trustee maintains control over the funds for a duration of two years or longer, the configuration aligns with the low-risk category of green zone scenario, granted that all the subsequent conditions are met:
A trustee retains possession of funds for a span of two years or beyond (excluding situations where the bucket company's entitlement is settled and the funds are subsequently provided to the trustee through a dividend, as elaborated later).
The bucket company is not an exempt entity.
The bucket company and the trustee of the trust estate belong to the same family group. This condition is fulfilled when the beneficiary of the bucket company is considered part of the 'same family group' as the trust's trustee, which is applicable in either of the following circumstances:
The trust has executed a Family Trust Election (FTE), and the company is part of the family group associated with the individual designated in the FTE. For instance, if a bucket company has opted for an interposed entity election indicating this arrangement, or if all the shares in the company are owned (either directly or indirectly) by the 'test individual,' their family members, and/or by family trusts that have made an FTE specifying the said test individual, then the bucket company is considered part of the family group of the individual specified in the trust's FTE.
No FTE has been made and the company is controlled by an individual who also controls the trust or that individual’s spouse.
The trustee fulfills the 'working capital condition' when, for instance, the funds are employed for working capital, investment endeavors, or lending to another entity within the 'family group' under 'commercial terms.' The borrowing entity, in turn, must utilize the funds in an approved manner, as discussed earlier.
The conditions under which the entitlement becomes available for a trustee to retain funds involve offering it as a loan under 'commercial terms.' In the scenario of a bucket company entitlement, this criterion is met when a S.109N compliant loan agreement is established. Although there isn't precise guidance regarding the timing of when this loan agreement must be initiated, the legislation seems to suggest that if the agreement is put into effect in a manner that aligns with the Division 7A stipulations mentioned earlier, it would also fulfill the criteria for green zone scenario 3B.
None of the 'exclusion factors' are applicable. To illustrate, the prerequisites related to notification and lodgment must be fulfilled. Moreover, the subsequent factors would also preclude the arrangement from falling within the scope of the green zone:
The beneficiary is a loss company that uses its trust entitlement to fund a distribution to its members and that distribution compromises the ability of the beneficiary to repay its existing or future liabilities.
The beneficiary is a private company that uses its trust entitlement to fund a distribution made directly or indirectly to a non-resident.
Tax Warning – Section 100A adds an additional layer of complexity
Many trustees tend to believe that by placing the funds equivalent to an outstanding present entitlement for a bucket company on compliant loan terms according to S.109N, they gain unrestricted liberty to use the preserved funds according to their preferences. Unfortunately, this presumption is incorrect.
The context surrounding the distribution and subsequent utilization of the funds by the trustee also requires examination to determine whether S.100A might pose a concern. For instance, it is essential to deliberate upon the intended purpose of the retained funds. Furthermore, if these funds are intended for lending, it becomes crucial to contemplate factors such as the loan's recipient, the recipient's tax rate, and the intended utilization of the funds.
Tax Warning – Bucket company distributions not in the green zone
Some common situations in which the ‘working capital condition’ would not be satisfied include:
If the trustee holds onto a distribution intended for a bucket company and subsequently lends it to an affiliated party under conditions that fail to adhere to S.109N, potential issues could arise. This is especially relevant in cases where the recipient of the loan, such as a parent, is subject to a higher tax rate than the bucket company and has the potential to benefit from the trust. Such a scenario might pose challenges from the standpoint of S.100A, particularly if the arrangement becomes a recurring pattern.
A scenario emerges where a distribution intended for a bucket company is held by the trustee and subsequently loaned to a connected individual for personal uses, such as purchasing a car. In situations where the loan recipient, like a parent, falls under a higher tax bracket compared to the bucket company and has the potential to gain advantages from the trust, this could pose challenges in terms of S.100A, especially if the arrangement becomes a recurring pattern.
In these cases, the S.100A risk should be considered and assessed on a case-by-case basis. Consideration should also be given to Division 7A.
Example – Bucket company distribution is in the green zone
The Mannon Discretionary Trust (referred to as the 'trust') operates a retail enterprise centered on selling pet-related products.
The beneficiaries of the trust encompass members of the Mannon family and their interconnected entities, including Patricia and Jerry Mannon, as well as Mannon Pty Ltd (commonly known as the 'Bucket Company'). Patricia holds sway over the trust, while her spouse, Jerry, serves as the exclusive director and shareholder of Bucket Company.
On June 30, 2023, the trust's trustee made a resolution to allocate the entirety of its trust income to Bucket Company. At the time of this decision, an arrangement was established between the parties, indicating that Bucket Company would permit the unsettled portion of its entitlement to remain within the trust.
Under a S.109N compliant loan agreement, the trustee retained the disbursed funds and utilized them to enhance the operational capital of the business overseen by the trust.
Throughout the 2024 fiscal year and subsequent income periods, the trust's trustee employed the earnings derived from the trust (business revenue) to fulfill its repayment obligations in accordance with the Division 7A loan agreement.
Will the ATO seek to apply S.100A to invalidate the distribution to Bucket Company?
In brief, the response is no. This setup falls within the low-risk category of green zone scenario 3B as outlined in the S.100A compliance guidelines. Consequently, the Australian Taxation Office (ATO) will not allocate regulatory resources to assess the potential application of S.100A. Specifically, this arrangement fulfills the criteria of the 'working capital condition' (where the distributed amount is used for trust's working capital), the Bucket Company is under the control of the spouse of the individual in charge of the trust, and the retained distribution has been structured in compliance with S.109N terms.
Circular trust distributions to a bucket company
A crucial matter to remain aware of concerning S.100A and distributions to bucket companies pertains to the concept of 'circular trust distribution arrangements.' The Australian Taxation Office (ATO) has verified that the subsequent circular arrangement falls within the high-risk category of red zone scenario 2 within the S.100A compliance guidelines. Consequently, this arrangement will be prioritized and scrutinized by the ATO.
The trustee of a trust owns shares in a bucket company and the bucket company is also a beneficiary of the trust. The trustees or directors of the trustee company, and the directors of the bucket company, are the same (or related) individuals.
The trustee resolves to make the bucket company presently entitled to all, or some part of, trust income at the end of Year 1. The company includes its share of the trust’s net (taxable) income in its assessable income for Year 1 and pays tax at the corporate rate.
The company pays a fully franked dividend to the trustee in Year 2, sourced from the trust income, and the dividend forms part of the trust income and net (taxable) income in Year 2.
The trustee makes the company presently entitled to all, or part of, the trust income at the end of Year 2 (which might include the franked distribution).
The preceding steps are repeated in subsequent years.
The ATO views this as an atypical arrangement that lacks justification based on any genuine commercial purpose. Instead, it seems to be more accurately explained by the intention of minimizing the tax liability that would have otherwise arisen if the trustee had chosen to retain the income.
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