Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Ralph Willis, MP)
2.1 The Bill will reinstate Parliament's original intention to relieve, from taxation at higher rates, income derived by a minor from the investment of property transferred to or beneficially to a minor as part of a legal settlement in connection with a family breakdown.
2.2 The Bill will also clarify the anti-avoidance provisions which limit the relief available to minors where they are beneficiaries of 'income splitting' arrangements.
2.3 The amendments will make it clear that income derived by a minor, directly or beneficially, from the investment of property transferred to, or beneficially to, the minor in the event of a family breakdown qualifies as 'excepted assessable income' or 'excepted trust income'. In this respect the amendments will replace the ineffective previous provisions and will update the law to take into account the range of family breakdowns including breakdowns of defacto relationships and cases where people are responsible for the maintenance of children because they are not living together. [Paragraph 1(a) of item 14 of Schedule 1]
2.4 The amendments will also clarify the existing anti-avoidance provisions to ensure that the amount qualifying for relief from the Division 6AA rates is confined to no more than an arm's length rate of return. They will also clarify the requirement that property be transferred to, or beneficially to, a minor before income from its investment is capable of being excepted income. [Paragraph 1(b) of item 14 of Schedule 1]
2.5 The amendments referred to in paragraph 1(a) will apply to income derived from 1 July 1979. [Subitem 21(1) of Schedule 1]
2.6 The amendments referred to in paragraph 1(b) will apply in relation to income derived on or after 7 March 1994. [Subitem 21(2) of Schedule 1]
2.7 Division 6AA of Part III of the Act (which comprises sections 102AA to 102AJ) applies to tax at higher rates most income of minors. These provisions are designed to prevent taxpayers diverting income or the capacity to earn income to children for the purpose of avoiding or reducing income tax.
2.8 A minor who comes within Division 6AA is referred to as a prescribed person. The whole of such a minor's assessable income other than 'excepted assessable income' is subject to Division 6AA. Division 6AA also applies to so much of such a minor's share of the net income of a trust estate as is not 'excepted trust income' in relation to the minor.
2.9 The terms 'excepted assessable income' and 'excepted trust income' are defined under subsection 102AE(2) and subsection 102AG(2) respectively to be certain categories of income. Subsection 102AE(2) deals with income derived directly by a minor while subsection 102AG(2) deals with income derived by a trustee on behalf of the minor. The concepts of 'excepted assessable income' and 'excepted trust income' were included as a way of recognising that not all income of minors, whether derived directly or through trusts, should be taxed at a higher rate.
2.10 The definition of 'prescribed person' under section 102AC excludes some minors from the scope of the Division. It recognises that not all minors should have any of their income taxed at higher rates. So certain minors engaged in full-time work, minors who are double orphans without certain support and minors with disabilities that have particular effects or consequences are not 'prescribed persons' to whom the Division applies.
2.11 Broadly, subsections 102AE(2) and 102AG(2) list the following as 'excepted assessable income' or 'excepted trust income' qualifying for relief from the higher Division 6AA rates:
- employment or business income;
- income from the investment of property transferred beneficially to a child under a variety of particular circumstances; and
- the accumulation of income that is excepted or would have been excepted income but for the income having been derived before the excepted income rules were introduced.
These items are listed in the same terms and to the same effect. The two subsections, taken together, have a common purpose and a common policy.
2.12 Subsection 102AG(2) also defines 'excepted trust income' as including income from deceased estates, for example where the administration of the deceased estate is still pending or where life trusts postpone distribution of the estate. All such income is earned by a trustee, and so section 102AE needs no equivalent provision. This is to be distinguished from the situation common to both subsections 102AG(2) and 102AE(2) were income is earned from the investment of property which has actually devolved from the deceased estate. That situation is dealt with by subparagraphs 102AE(2)(c) and 102AG(2)(d).
2.13 Subsection 102AE(2) also defines 'excepted assessable income' as including:
- certain non-business partnership income. No equivalent provision is needed in subsection 102AG(2), as such income is comprehended by the categories of income derived by a trustee from the investment of property transferred beneficially to the child; and
- income included as assessable income of the child under section 97 or section 100. No equivalent provision is needed in subsection 102AG(2), as that provision is concerned only with income derived by a trustee and not with income derived by the minor.
2.14 Particular amendments in this Bill are concerned with the category of 'excepted assessable income' and 'excepted trust income' defined under subparagraph 102AE(2)(b)(viii) and subparagraph 102AG(2)(c)(viii). These amendments are necessary because the words used in the former subparagraph 102AE(2)(b)(viii) and subparagraph 102AG(2)(c)(viii) were, and have always been, inappropriate to transfers of property in family breakdowns to which the Family Law Act 1975 (FLA) applies.
2.15 In order for an amount to qualify as 'excepted assessable income' or 'excepted trust income' under the former wording, the income is required to have been derived from the investment of property transferred to or beneficially to the minor pursuant to a decree or order of dissolution or annulment of marriage that has effect in Australia under the FLA, or pursuant to a decree or order of judicial separation or a similar decree or order. Such a requirement was widely ineffective for the following reasons:
- the remedy of decrees or orders of judicial separation no longer exists, so transfers of property pursuant to such orders are now rare in Australia and impossible in most cases of family breakdown;
- no procedure exists for transfer of property pursuant to an order of dissolution or nullity of marriage under the FLA, so transfers of property pursuant to such orders are now rare in Australia and impossible in most cases of family breakdown.
2.16 The fact that these technical deficiencies have existed since the commencement of Division 6AA on 1 July 1979 means that property would never be transferred 'pursuant to' the order or decree as required under the relevant subparagraphs, in family breakdowns to which only the FLA applied. (See Case V 105, 88 ATC 678, sub nom AAT Case 4480 (1987) 19 ATR 3678.)
2.17 In cases of family breakdown, transfers of property may now arise under:
- the FLA;
- the Child Support (Assessment) Act 1989 (CSA) (whether by court orders made under the law or merely by operation of the law);
- certain state laws dealing with defacto relationships; and
- court orders or legal obligations arising under similar laws in Australia or in a foreign jurisdiction.
2.18 The policy of the law is that, where property is transferred to or beneficially to a child, and because of a family breakdown, the child's share of the income from the investment of that property should not be subject to higher rates of tax. This matches the policy of the law in relation to a number of other circumstances in which property is transferred to or beneficially to a child. Those other circumstances include the transfer of property by way of damages for loss of parental support; by way of compensation for criminal injuries; directly as the result of someone's death and by an employer, under the terms of a life policy or out of a provident, benefit, superannuation or retirement fund; by way of damages for personal injury to the child; or out of a public fund for relief of persons in necessitous circumstances.
2.19 The law is clearly deficient both in its application to transfers of property in FLA proceedings and also in relation to its failure to reflect child support obligations which exist under the CSA. For example, property might be transferred in satisfaction of maintenance obligations where parentage has been accepted by a person who is not a partner of the person who has custody of the child. Also, the provisions have failed to keep pace with the general social and legal recognition of defacto relationships. Property might be transferred in satisfaction of obligations towards a former defacto partner or a child who formed part of the defacto family.
2.20 The present provisions attempt to incorporate comparable overseas decrees etc. recognised as valid in Australia. Clearly, where property is transferred to or beneficially to a child because overseas jurisdictions recognise child support obligations in a similar way to the CSA or recognise and deal with breakdowns in defacto relationships, such recognition should also be reflected in any changes to the law.
2.21 The underlying policy of these two provisions is that where property is transferred to or beneficially to the child and the reason for that transfer is the satisfaction of responsibilities which arise from a family breakdown, such a transfer should be treated as a special category and the resultant investment income deserves special treatment. This is not to say that all income diversions which are entered into in order to satisfy maintenance obligations deserve special treatment. Such maintenance substitution arrangements only attract special treatment where they come under one of the heads of section 102AE(2) or 102AG(2).
2.22 It has also been suggested that, in the case of property transferred to a trustee for the benefit of the beneficiary, the property does not need to be transferred beneficially to the beneficiary. In other words the requirements of the law would be satisfied if the property were to revert to the settlor, or be transferred to another person, once the trust ends. This is clearly wrong under the law as it stands. Paragraphs 102AG(2)(c) and (d) require the property to be held by the trustee beneficially for the beneficiary. To give these provisions a meaning inconsistent with paragraphs 102AE(b) and (c) would mean there was a different policy underlying sections 102AE and 102AG. This is clearly not so.
2.23 The various heads of excepted income under paragraphs 102AE(2)(b) and (c) and paragraphs 102AG(2)(c) and (d) require, not only that others part with income which is to be excepted, but that they part with the underlying property from which that income is to be derived. Otherwise the categories of excepted income could be used to minimise tax, without making any real provision for the continuing advancement of the child. That would be inconsistent with the purpose of the excepted income provisions of Division 6AA.
2.24 Subsections 102AE(6) and 102AG(3) are provisions which allow income as excepted assessable income or excepted trust income only so far as the income does not exceed the amount that would have been derived had the income been derived on an arm's length basis. The question is:
- whether or not the income is derived directly or indirectly as the result of an agreement;
- whether or not any 2 or more parties to the agreement were dealing with each other at arm's length in relation to the agreement; and
- whether or not the income actually derived is more than it would have been if the parties had all dealt with each other at arm's length.
2.25 Arguments have been put forward that if parties to a family breakdown are dealing at arm's length in relation to the transfer of property to the child or the setting of maintenance for the child then that is sufficient evidence to ensure that income derived from investment of property transferred to or beneficially to the child is excepted income. This is not so because neither of these facts prove that the parties were dealing with each other at arm's length in relation to the derivation of income from property transferred to, or beneficially to, the child. In fact, a known maintenance obligation may serve to explain the payment of income representing more than an arm's length return on the investment of a child's property.
2.26 The proposed amendments will replace the requirement that transfers of property be pursuant to a particular kind of decree or order with the requirement that the transfers be as a result of a family breakdown. [Items 15 and 17 of Schedule 1]
2.27 The amendments will ensure relief from the higher Division 6AA rates where income is derived from the investment of property transferred to or beneficially to a minor as the result of a family breakdown. Item 20 of Schedule 1 will introduce new section 102AGA. Subsection 102AGA(1) specifies that property is transferred 'as the result of a family breakdown' if the requirements of either of subsections 102AGA(2) or 102AGA(3) are met. These new subsections list the requirements which need to be satisfied before a transfer of property will be 'as the result of a family breakdown'.
2.28 The amendments will cover marriage breakdowns and breakdowns in de facto relationships. [new subsection 102AGA(2)]. The amendments will also cover situations where there is no breakdown of a marriage or defacto relationship, perhaps because there never was one, but there is a child support obligation - that is, the 'one night stand parent' case [new subsection 102AGA(3)]. That sort of case is properly described as a type of family breakdown, and a child to whom, directly or beneficially, property is transferred because of the family breakdown will not be disadvantaged compared to a child to whom, directly or beneficially, property is transferred because of a family breakdown that consists of the breakdown of a marriage or defacto relationship.
2.29 Further, the amendments will recognise income from property transferred to, or beneficially to, a minor by operation of foreign law under similar conditions. [New paragraphs 102AGA(2)(c) and (3)(b)]
2.30 New subsection 102AGA(2) identifies 5 elements required to be present before a transfer of property will be a transfer 'as the result of a family breakdown'.
2.31 The first requirement is that two people must cease to live with each other as spouses on a genuine domestic basis. De facto relationships are included here; the income tax law has long recognised spouses even when not married [new paragraph 102AGA(2)(a)]. Obviously, temporary separations are not countenanced, but income may still be excepted where two people genuinely separate and property was transferred to, or beneficially to, a child because of the separation, even if the two people were later reconciled.
2.32 Secondly, at least one of the persons mentioned must be a person who has parental responsibility for the child. This includes a natural, adoptive or step parent or a person who has legal custody or guardianship of the minor or beneficiary. Foster parents are not included as they are not parents or in the same category as the above [new paragraph 102AGA(2)(b)]. This requirement is necessary in order to connect the child to the family breakdown.
2.33 The third requirement is that an order, determination or assessment of a court, person or body is made wholly or partly because the parties have ceased to live together on a genuine domestic basis [new paragraph 102AGA(2)(c)]. The requirement is not restricted to orders, determinations etc. made in Australia. The intention of this requirement is to include all obligations arising not only by way of court order but by operation of law (for example, an administrative assessment under the CSA). The intention is to further include any foreign law equivalent obligations, whether in relation to child support or in any other respect, that might lead to the transfer of property to or beneficially to the child as the result of a family breakdown. This could include obligations that are dissimilar to those arising in Australia; for example, obligations under a fault based divorce system, a system of judicial separation, or a system automatically settling property on a child. The critical test of family breakdown would be the cessation of a relationship in which two parties lived together as spouses, and a child connected in one of the parental ways to that relationship. This requirement ensures that there is an 'official' sanction to the transfer of property and that there is an effective connection between the separation of the parties and the order, determination or assessment.
2.34 The fourth requirement is that the effect of the order mentioned in new paragraph 102AG(2)(c) must be that a person becomes subject to a legal obligation to maintain, transfer property to, or do some other thing for the benefit of, the child or for the benefit of one of the spouses [new paragraph 102AGA(2)(d)]. The legal obligation created is one which does not necessarily need to fall upon the spouses involved in the family breakdown or even upon the person who actually does transfer the property. The requirement is expressed in such broad terms in order to take into account the variety of circumstances which arise in family relationships. For example, an obligation may fall on a trust or on a family company.
2.35 The fifth requirement is that the transfer of the property must be in satisfaction of the legal obligation mentioned in paragraph 102AG(2)(d). This requirement ensures that the transfer is effectively connected to the breakdown. Discretionary transfers are therefore excluded as they are not in satisfaction of any legal obligation but are related to a private decision to direct money in a certain way [new paragraph 102AGA(2)(e)]. The requirement is expressed in broad terms to take account of the variety of parties who might seek to transfer property in satisfaction of the obligation. For example, another family member, or an entity they control, might seek to meet an obligation falling on a spouse.
2.36 The requirement also contemplates that the obligation might not itself require the transfer of property to or beneficially to the child, but that such a transfer might discharge the obligation. For example, a defacto spouse might be obliged to transfer property to the other spouse, but the spouses might agree to a transfer of property to the child in satisfaction of that obligation. Or someone might have an obligation to pay arrears of maintenance, and meet this by the transfer of property.
2.37 This fifth requirement is mirrored in new paragraph 102AGA(3)(d) which deals with 'one night stand parent' cases.
2.38 New subsection 102AGA(3) covers the case of a transfer of property as the result of a family breakdown in situations where there is not a breakdown of a spousal relationship, perhaps because no such relationship was ever truly established, but child support obligations exist. This is the case where parentage is established or admitted at some time after the child is born and the parents were not living together as spouses on a genuine domestic basis when the child was born. [New paragraph 102AGA(3)(a)]
2.39 The other way in which this situation differs from the normal 'family breakdown' is the requirement that an order, determination etc. is made wholly or partly because the natural parents are not living together on a genuine domestic basis [new paragraph 102AGA(3)(b)]. This requirement would encompass situations where an order is made that a person should maintain a child because it has been determined that the person is the natural parent of the child.
2.40 New paragraph 102AGA(3)(c) is substantially the same as new paragraph 102AGA(2)(d) (referred to above) except for the reference to 'natural parents' rather than 'spouses'. Otherwise the proposed new paragraph has the same effect as new paragraph 102AGA(2)(d).
2.41 New paragraph 102AGA(3)(d) is identical to new paragraph 102AGA(2)(d) and has the same policy and effect.
2.42 The amendments that apply to transfers of property as a result of family breakdown are retrospective to the year of income that commenced on 1 July 1979. This makes the amendments apply to the whole period for which Division 6AA has applied. The amendments are made retrospective because the original intention of the Parliament in relation to transfers of property to, or beneficially to, children as a result of family breakdown was not given effect by the original legislation. Although the period of retrospectivity is substantial, these provisions are wholly beneficial to taxpayers, and accordingly no taxpayers are adversely affected by the date of effect.
2.43 The amendments make it clear that transfer of property for the benefit of the beneficiary means beneficial transfer. To achieve this item 18 of Schedule 1 will introduce new subsection 102AG(2A). The effect of that provision is that the property must vest in the beneficiary under the trust. This new provision will exclude transfers of property to a trustee, for example, on terms that the income from the investment of property is to be distributed to a child during its minority, while the corpus is either to be returned to the settlor or distributed to a choice of beneficiaries not limited to the child once the child grows up. This amendment confirms that the scope of subparagraph 102AG(2)(c)(viii) is not different from that of subparagraph 102AE(2)(b)(viii), which requires transfer of property to the minor.
2.44 The proposed amendments focus on the derivation of the excepted assessable income and excepted trust income (collectively referred to below as 'excepted income')and effectively confirm that, in relation to the derivation of that income, parties who are not dealing at arm's length cannot inflate the income beyond what it would be on an arm's length basis. For example, a parent cannot arrange for a child to be employed by a family company and paid far more than the arm's length rate of pay for services such as those provided. (For an example of such an arrangement see Kelly v. Raymor (Illawarra) Pty Ltd (1982) 13 ATR 5920 where children were employed as 'musicians' to play the recorder at company end-of-year parties.) Another example is the family member who arranges for high returns to be paid to a trustee investing nominal property held on a child's behalf, perhaps by exercising a discretion to distribute income to a trust with no property in which the trustee is persuaded to take units.
2.45 The law operates by providing that if 2 or more parties are not dealing at arm's length in relation to the derivation of income, the excepted income is reduced to what it would have been if the parties had been so dealing (under existing subsections 102AE(6) and 102AG(3)). The amendments confirm and clarify the existing law [item 16 of Schedule 1 and item 19 of Schedule 1, substitute subsections 102AE(6) and 102AG(3)]. The determinative factor is that parties are not dealing with each other at arm's length in relation to the derivation of the excepted income. That is, the fact that the parties may be at arm's length in that they are separating or have never been living as a couple is not determinative of whether the income is derived at arm's length.
2.46 The new subsections ask whether any parties to the derivation of what would otherwise be excepted income (under new paragraphs 102AE(6)(a) and 102AG(3)(a)), or parties to any act or transaction connected directly or indirectly with that derivation of income (under new paragraphs 102AE(6)(b) and 102AG(3)(b)), were dealing with each other at arm's length. If not, only the amount of income that would have been derived had all the parties been dealing at arm's length will be excepted income.
2.47 In relation to a unit in a unit trust, for example, the relevant question in determining the arm's length return is how much return would a person be entitled to if all parties were dealing at arm's length in relation to the return on that unit. The fact that property is transferred at arm's length does not establish that the income from investment of that property is an arm's length return. If the investment is by subscription of nominal property for a unit in a discretionary unit trust, then the arm's length return is nominal or zero. Any greater return is no arm's length return because a person who did not benefit from a non-arm's-length arrangement would get no significant return on his/her holding of such a unit.
2.48 In relation to subparagraphs 102AE(2)(b)(viii) and 102AG(2)(c)(viii) the new provision will ensure that substantial property will have to be transferred to ground an excepted income of any substantial amount. This is a crucial feature in deterring a transferor from entering into an artificial arrangement to provide income to a child.
2.49 Some arrangements have been attempted in which no, or no significant, property is transferred to or beneficially to a child. Because maintenance would otherwise have to be paid in relation to the child, these arrangements are sometimes attempted on the basis that any amounts of income paid to the child or to a trustee on behalf of the child will be taken to meet those maintenance obligations.
2.50 Maintenance is paid from after tax income and exempt from tax to its recipient. Substitute arrangements are not. When the substitute arrangement provides for the derivation of excepted income, that income is still taxable at normal rates. For children who have other income, their tax bill may be substantially higher where dollars of excepted income are substituted for dollars of maintenance. When the arrangement is based on a transfer of little or no property, it will produce little or no excepted income, and the higher rates of tax under Division 6 AA will apply to any excess. This will greatly reduce the income of children under such an arrangement.
2.51 The categories of excepted income in subsections 102AE(2) and 102AG(2) do not include maintenance substitution arrangements. They do not favour such arrangements. Diversion of income to meet maintenance obligations is not more favoured than other diversions of income to minors, for the purposes of Division 6AA.
2.52 The proposed amendments extend beyond the dealings between the party deriving the excepted income and the party from whom that income is derived. New paragraphs 102AE(6)(b) and 102AG(3)(b) extend to parties to any act directly or indirectly connected to the derivation of such excepted income. Take for example the situation of a minor investing (in partnership with another person) in a company. The proposed new provision ensures not only that the return from the partnership to the minor is at arm's length, but that the return from the company to the partnership is at arm's length. The provision allows inquiry into any transaction related to the derivation of excepted income, even if removed from that derivation. This confirms the former provisions.
2.53 Subitem 21(2) of Schedule 1 provides that proposed new subsections 102AE(6) and 102AG(3) will apply in relation to income derived on or after 7 March 1994 (the date of the Governments announcement). So will the new subsection 102AG(2A). This effectively means that these provisions will apply from that date, and to all years of income following the first year of income which includes that date.
2.54 Subitem 21(1) of Schedule 1 provides that the remaining amendments will apply in relation to the year of income that commenced on 1 July 1979 and in relation to all later years of income. This was the application date of Division 6AA when it was first introduced.
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