The family trust blunder that could send you bankrupt
The tax office is scrutinising family trust distributions dating back decades. Some trustees have been shocked to receive bills worth hundreds of millions of dollars
By Michelle BowesWealth reporter
The bills for unpaid tax and associated penalties are “life-changing and unexpected”. That’s how Jonathan Ortner, one of the nation’s leading tax lawyers, describes the consequences of the Australian Taxation Office’s blitz on private wealth groups, with some families being pursued for large trust distribution tax bills and interest charges dating back decades
Ortner says some groups are being hit with bills running into hundreds of millions of dollars, and that family trust trustees could be forced into insolvency and directors into bankruptcy should they not be able to meet their tax liabilities.
Although families that hold their wealth in trust structures typically elicit little sympathy from Joe Public, tax experts say that in this case, most errors are a result of innocent mistakes because of complex rules, rather than attempts at tax avoidance.
“The ATO seems to be attacking cases where technical breaches of the family trust election rules might have occurred, albeit there’s no tax leakage or fancy dance inside or outside the family group,” says HWL Ebsworth tax lawyer Vincent Licciardi.
Ortner is a tax partner at Arnold Bloch Leiber, a firm that advises many of Australia’s wealthiest individuals and families in Australia, including a significant portion of those on the Rich List.
But this story doesn’t just apply to Rich Listers – many small business operators also use family trusts – and they’re not immune from ATO scrutiny.
The story starts in 1998, when trust loss laws were introduced to prevent trusts from engaging in funny business to minimise tax.
But family trusts distributing money to those in their family group were carved out, and could access tax concessions broadly available to all taxpayers, such as the ability to pass franking credits or offset prior year losses, provided they had a proper family trust election in place.
The rationale was that surely people within the same family should be able to make distributions to each other without triggering large tax bills and the law change was never intended to raise revenue from family trusts.
“It was always expected that distributions from family trusts would only ever go to family members. It simply wasn’t expected that people would fall foul of the provisions because it wasn’t in one’s interest to,” Ortner says.
All that trusts in the same family group had to do was elect the same person as their “test individual” (usually the patriarch or matriarch who founded the family business) – but if they distributed benefits outside that group, they would be hit with family trust distribution tax at the top marginal tax rate of 47 per cent.
Big trouble brewing
Fast-forward about 30 years, and there’s big trouble brewing.
In the years since, the laws involving family trusts have become increasingly complex – as have family groups.
Mums and dads who set up the business and used a family trust structure now have children and grandchildren, and in some cases, great-grandchildren. And some of those generations are also married, have de facto spouses or are divorced and remarried, further complicating matters.
Often, they have stuck with the same high street accounting firm all the way through; only that firm isn’t very well rehearsed in the enormous complexity of trust tax law. The family trust election paperwork might also be missing.
The ATO says poor governance and a lack of understanding of the law are to blame. “We’ve observed a range of situations where trustees and advisers may not be aware of the serious tax consequences of distributions outside of a family group,” an ATO spokesperson says.
Specifically, it is seeing distributions being made outside a family group before or after the implementation of a succession plan, or after the sale of businesses in a family group.
The ATO denies that it is specifically targeting family trust elections, but sources say all Tax Office general-risk reviews of private groups – being undertaken as part of its crackdown on the tax risks associated with succession planning – contain a question about them.
Easy errors
Although there are many ways to fall foul of the law, here is one hypothetical example:
In the early 1990s, Mum and Dad set up a discretionary trust that holds shares in an operating company – which owns a private business – and an investment portfolio. The trust has made a family trust election specifying Mum as the test individual.
The business is sold and Mum and Dad want to provide $1 million of the proceeds to their daughter and her family in the form of a fully franked dividend ($700,000 in cash and $300,000 in franking credits).
Their daughter asks that the dividend be distributed to her private investment company, which is owned by the daughter’s discretionary trust, and which made a family trust election specifying the daughter as the test individual many years ago.
This distribution should be subject to family trust distribution tax at 47 per cent of the cash dividend because the private investment company is not part of Mum’s family group. Therefore, a tax of $329,000 should be paid by the trustee of the Mum and Dad discretionary trust (who are Mum and Dad) and their daughter should receive only $371,000. The franking credits are also lost.
There is no way to fix this after the transaction; there is no family trust election that can be made to make it “right” even though the entities are all related to one another and controlled by the same family.
Additionally, the $371,000 received by the daughter’s private investment company carries no franking credits, so when these funds are paid out as a dividend to the daughter, they should be subject to another round of tax at the daughter’s marginal income tax rate of 47 per cent, meaning she pays tax of $174,370.
Due to the application of family trust distributions tax, their daughter receives only $196,630 of the original $1,000,000 intended for her. A general interest charge of 11.17 per cent calculated daily may also be payable on the family trust distribution tax, which would materially increase the losses.
To further complicate matters, someone cannot be elected as the test individual of a trust after their death.
“If the daughter’s structure has been created after Mum dies, nobody’s made a mistake, nobody’s done anything wrong, but it just can’t be fixed,” says Mark Molesworth, a tax partner at BDO Australia.
As ageing matriarchs and patriarchs of family groups – who are often the test individual for trusts in their family group – die, the inability for new trusts (perhaps those of grandchildren or great-grandchildren) to join the family group is complicating succession planning, Ortner says.
“The death of the test individual is leading to inadvertent breaches because newly established entities can never fall within that test individual’s family group, resulting in tax arising on distributions between related groups.”
Mistakes and consequences
“The provisions are bordering on impossible to apply in practice,” Ortner says, with mistakes arising due to a “lack of understanding particularly among advisers that do not deal with the rules daily”.
Family trust elections are “probably largely misunderstood among many accountants”, Licciardi says.
Drafting errors and poor record-keeping are also to blame, and many in the industry lament the inadequacy of family trust election records in the ATO’s tax agent portal.
For accountants taking on a new client, this means it can be impossible to establish whether they had previously lodged a family trust election with the ATO.
“The real vice is actually an inability to search reliably for the family trust election,” says David Marks, KC, a barrister who specialises in tax law.
“No wonder errors are made, and then the taxpayer bears an impossible burden of disproving whatever assessment the ATO might make.”
Molesworth says that for some families, the interest bills can outstrip the amount of tax owing because of the potential time span involved, and Licciardi says that in some cases, the effective tax rate is “well north of 70 per cent”.
But the consequences can be even more significant than a large tax bill.
“If the trustee can’t pay the debt, the commissioner can go after the individual directors. And if they can’t pay the debt, the family group may go insolvent and the directors may go bankrupt,” Ortner says.
“That is on the horizon for groups in reviews at the moment. It is certainly a real risk, and it will depend on how the matter proceeds between the taxpayer and the ATO.”
Jonathan Ortner says some groups face bills that could run into hundreds of millions of dollars.
Ortner’s firm is representing taxpayer Steven Bendel in his case against the ATO over the separate issue of whether certain payments owed by a trust to a corporate beneficiary should be treated as loans, which it is estimated could lead to tax refunds of up to $1 billion for family trusts across Australia.
But this issue could have greater significance.
“The capacity for one group to have a $100 or $200 million liability is there. So if you’re talking every private group, then clearly you’re getting into the billions,” Ortner says.
Can the ATO show leniency?
Under the law, the ATO cannot excuse a breach, even if it was unintended, Molesworth says.
And unlike with income tax, where it can typically pursue taxes dating back only four years, there is no limitation period, although Ortner says precedent means the ATO could choose to exercise discretion.
“This unlimited amendment period issue actually comes up for trustees in the context of other types of trustee tax liabilities, and the ATO – to its credit – adopts a practical administrative practice of only going back four years unless there has been fraud or evasion,” he says.
“This very practice should be adopted by the ATO in relation to family trust distribution tax to give certainty to the market that innocent and inadvertent errors (of which there are many) will not put that family group at risk of financial ruin.”
However, the ATO says that in these cases, “compliance administrative approaches are not able to be applied”.
The case for law reform
Molesworth is among those urging the next government to review the law.
“The provisions are a bit of overreach, in terms of their breadth, particularly in terms of their definition of who’s inside the family group, and who’s not,” he says.
“It would be more effective to look at the policy settings behind this law and actually amend the law to more appropriately target the mischief that was intended to be targeted by these provisions originally.”
With the death of increasing numbers of test individuals, many family trust elections are “coming to the end of their effective life, just in the practical context of who the family is, but you can’t revoke them”, Licciardi says.
“I don’t see any harm in at least revisiting the rules and saying: are they still fit for current purpose, is the objective of the rules still being met?”
Ortner echoes the sentiment.
“We clearly need law reform in this area, the rules are not fit for purpose and are overly complex.
“If Treasury refuses to fix these issues, then at the very least they need to limit the amendment period to four years if the ATO won’t adopt an administrative practice of doing so.”
Ortner says that if the law is not changed, it’s only a matter of time before cases end up in court, assuming the taxpayers have the financial means to fight them.
