Beware: Part IVA could apply to Trust Distributions to Bucket Companies

In Commissioner of Taxation v Guardian AIT Pty Ltd ATF Australian Investment Trust [2023] FCAFC 3 (Guardian), the Full Federal Court held that the general anti-avoidance rules (known as ‘Part IVA’) could apply to effectively ‘cancel’ the appointment of income to a ‘bucket company’.

The decision highlights that trust distributions made by the trustee of a discretionary family trust are not immune from Part IVA. While the case has some unique facts, it throws significant doubt on the broader tax effectiveness of discretionary family trusts appointing income to a bucket company to ‘cap tax’ at the corporate tax rate. Read on to find out more.

Trust Distributions to Bucket Companies

It is relatively commonplace for discretionary family trusts deriving significant income to make individuals ‘presently entitled’ to some of income of the trust and a ‘bucket company’ presently entitled to the remaining income of the trust.

For example, say that the Smith Family Trust has $500,000 of trust income.

1. $180,000 is appointed to John Smith;
2. $180,000 is appointed to Jane Smith; and
3. the balance ($140,000) is appointed to Smith Investments Pty Ltd.

The above is a relatively commonplace method of ensuring that the balance of the trusts income ($140,000) is taxed at the corporate tax rate (either 25% or 30%). In contrast, the top marginal tax rate (47%) would apply if the trustee accumulated that income or appointed it to either John or Jane.

Continuing the above example, suppose that the trustee does not immediately pay the $140,000 to Smith Investments Pty Ltd (an ‘unpaid present entitlement’). The Commissioner of Taxation’s current position (since 16 December 2009) is that the unpaid present entitlement is a ‘loan’ that is subject to Division 7A. This means the unpaid present entitlement will result in the private company being deemed to pay an unfrankable dividend to the trust, unless the entitlement is either paid by a certain date or a complying repayment agreement is entered into (and adhered to).

It is relatively commonplace for the private groups in this situation to decide to ‘pay’ the unpaid present entitlement (either in one go or over time) by the bucket company declaring dividends, and those dividend entitlements offsetting the unpaid present entitlement. In the above example, this would mean Smith Investments Pty Ltd declares a dividend to the Smith Trust (either directly or indirectly), thus resolving the Division 7A compliance issues. The resulting dividend might then flow to John Smith or Jane Smith.

Following the decision in Guardian, it is entirely possible that the Commissioner of Taxation could apply Part IVA to the practice of declaring dividends to offset unpaid present entitlements – particularly if the transactions are all ‘paper transactions’ (i.e. not involving actual funds moving to the bucket company or being invested via the bucket company).

The Decision in Guardian

In its essence, the facts of the Guardian case were as follows:

1. a non-resident taxpayer (Mr Springer) practically controlled all entities;
2. a discretionary family trust (AIT) derived significant income;
3. a private company (AITCS) was incorporated, which was owned by AIT;
4. 2012 related events: in the 2012 income year, AIT derived income and made AITCS presently entitled to that income. AITCS subsequently paid tax on that income at the corporate tax rate. Then, in the 2013 income year, AITCS declared a fully franked dividend to AIT, which AIT then streamed to Mr. Springer;
5. 2013 related events: in the 2013 income year, AIT derived income and made AITCS presently entitled to that income. AITCS subsequently paid tax on that income at the corporate tax rate. Then, in the 2014 income year, AITCS declared a fully franked dividend to AIT, which AIT then streamed to Mr. Springer.

The Commissioner of Taxation issued assessments relying on section 100A of the Income Tax Assessment Act 1936 (ITAA36) to the trust distributions made by AIT to AITCS (that ultimately flowed to Mr Springer). If section 100A applied, the trustee of AIT would be assessed (at the top marginal tax) rather than AITCS (at the corporate tax rate).

The Full Federal Court (and the Primary Judge) both held that section 100A could not apply as there was no ‘reimbursement agreement’ at the times that AITCS was made presently entitled to trust income. An analysis of section 100A is beyond the scope of this article.

As an alternative to section 100A, the Commissioner of Taxation made a determination under Part IVA to cancel that ‘tax benefit’ that Mr Springer had received. It is the Part IVA aspect which is the subject of this article.

Part IVA – what is it?

The Australian tax law contains a series of anti-tax avoidance provisions to counter arrangements that would otherwise be legally valid for tax purposes. These provisions are contained within Part IVA of the Income Tax Assessment Act 1936. Part IVA is complex and difficult to apply in practice, even for experienced tax practitioners and advisors.

Broadly, Part IVA applies where:

1. scheme: there is a ‘scheme’;
2. tax benefit: a tax benefit results from the scheme (e.g. income is less than what it ‘should have been’); and
3. dominant purpose: the scheme was entered into for the dominant purpose of obtaining a tax benefit.

On appeal, the Commissioner alleged that the 2012 related events were a scheme (referred to as the 2012 related scheme) and the 2013 related events were a scheme (the 2013 related scheme). Both were accepted by the Full Federal Court as capable of being ‘schemes’ (noting that the definition of a scheme is incredibly broad).

The Commissioner alleged that both schemes resulted in a tax benefit. In essence, the tax benefit was that Mr Springer’s income was lower than it ‘would have been’, had AIT distributed its income directly to Mr Springer (and not first to AITCS). It is important to note that the events concerned essentially converted an amount of income that was not a franked dividend, into income in the form of a franked dividend. As a non-resident, no further taxes (after corporate tax) apply to a franked dividend. The Full Federal Court agreed that both of the 2012 related scheme and the 2013 related scheme resulted in a tax benefit being obtained.

Finally, the Commissioner alleged that dominant purpose of both schemes was to obtain a tax benefit. The Full Federal Court held that the 2012 related scheme was not entered into for the objective dominant purpose of obtaining a tax benefit, but that the 2013 related scheme was entered into for the objective dominant purpose of obtaining a tax benefit.

Observations from Guardian

A number of interesting observations regarding Part IVA emerge from the Full Federal Court decision in Guardian:

1. first, the case illustrates that Part IVA can apply to a trustee’s discretion to appoint income. This is the second case in the last 12 months where a Court has held that Part IVA applied to a discretion exercised by a trustee (along with the Federal Court decision of Minerva Financial Group Pty Ltd v Commissioner of Taxation [2022] FCA 1092);
2. second, the difference between Part IVA outcomes for the 2012 related scheme and the 2013 related scheme appear to be that the 2012 related scheme was the product of an evolving set of circumstances, whereas the 2013 related scheme was assessed on the backdrop that the parties had essentially taken the same actions in the previous year. Where something is repeated, the greater the risk of Part IVA applying;
3. third, the Court held that the intention of the 2013 related scheme was to obtain a tax benefit. This is despite the Court accepting that it was not Mr. Springer’s subjective intention at the time that AIT conferred an income entitlement to AITCS for the 2013 income year to obtain a tax benefit. It is important to note that Part IVA is concerned with ‘objective intention’, not subjective intentions. In this case, the objective circumstances gave rise to an expectation in an objective, reasonable observer that AITCS’s unpaid present entitlement would be cleared out in the same way as it was in respect of the entitlement created in the previous year;
4. fourth, the Court held that for the purposes of Part IVA, what ‘would have happened’ absent the schemes is that AIT would have paid trust income directly to Mr Springer (known as the ‘counterfactual’). This is despite that Primary Judge stating that “No competent adviser would have recommended such a course” (due to the significant extra tax involved with that outcome). That the Full Federal Court could still make the conclusion that a distribution to Mr Springer is what ‘would have happened’ is due to changes in Part IVA (section 177CB) which required any the higher Australian income tax cost that would have applied had the income been distributed directly to Mr Springer to be ignored. In essence, an unrealistic counterfactual;
5. fifth, the Court rejected that the purpose of appointing income to AITCS (rather than Mr Springer) was for asset protection reasons. In doing so, the Court noted that AITCS was not used in those years as a vehicle for wealth accumulation or asset protection given that the post-tax wealth appointed to it in the relevant years was paid out as a dividend; and
6. finally, it is interesting to note that prior to the Commissioner publishing his current view that unpaid present entitlements are loans for the purposes of Division 7A, the unpaid present entitlements owing from AIT to AITCS could have simply remained. Part of the very reason that AITCS declared a dividend was due to a concern with Division 7A exposure.

Broader Implications for Trust Distributions to Bucket Companies

It remains to be seen whether the taxpayer will seek leave to appeal to the decision in Guardian to the High Court of Australia.

As it stands, the decision in Guardian has significant implications for situations where a trust distributes income to a bucket company, however the income ends up in the hands of individual within a relatively short time period (through the bucket company declaring a dividend).

This is particularly the case where funds are not in fact paid to the bucket company and dividends are declared to offset unpaid present entitlements. In Guardian’s case, the key tax mischief was that a non-resident is not taxed on franked dividends, however ‘tax benefits’ could also arise for resident taxpayers. For example, the mere deferral of an individual being assessed on income can constitute a tax benefit and therefore open up the possibility of the Commissioner applying Part IVA to a broad range of bucket company situations.

For trustees of discretionary family trusts, one of the biggest developments during 2022 was the risk of section 100A applying to trust distributions. Unfortunately, one of the biggest developments during 2023 may be the risk of the ATO applying Part IVA to trust distributions. Outside of the most vanilla situations, trustees and their advisors should ensure that Part IVA is considered in detail before undertaken any significant action.

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‍This article in no way constitutes legal advice. It is general in nature and is the opinion of the author only. You should seek legal advice tailored to your individual circumstances before acting on anything related to this article.