Edited version of your written advice

Authorisation Number: 1012838493975

Date of advice: 15 July 2015

Ruling

Subject: Division 6AA

Question 1

If the trustee is taxable under section 98(1) of the Income Tax Assessment Act 1936 (ITAA 1936) in respect of income to which a minor beneficiary is presently entitled (where the minor is not an excepted person), will the trust income be trust income to which Division 6AA of the ITAA 1936 applies?

Answer

Yes

Question 2

Will Part IVA of the ITAA 1936 apply to the arrangement?

Answer

No

This ruling applies for the following periods:

Year of income ended 30 June 2015

Year of income ended 30 June 2016

Year of income ended 30 June 2017

Year of income ended 30 June 2018

Year of income ended 30 June 2019

Year of income ended 30 June 2020

The scheme commences on:

1 July 2014

Relevant facts and circumstances

Background

1. Taxpayer 1 and Taxpayer 2 are related.

2. Taxpayer 1 and Taxpayer 2 are directors of Company A which was incorporated a number of years ago. Company A is controlled by Taxpayer 2 and Taxpayer 1.

3. Taxpayer 1 and Taxpayer 2 have a long history of involvement in property development projects. The property development projects have been undertaken by their family by way of a separate trust vehicle being established for each particular project, quarantining development risk in a separate entity for asset protection purposes.

4. Typically, the property development project entity will be either a unit trust or a discretionary trust with a corporate trustee. A unit trust is generally used where there are family and non-family participants in the project, and a discretionary trust where the project only involves family members.

5. Company A, at least initially is the financier for each property development project undertaken, and Company A will also provide development services in relation to each project.

The will

6. The will of the late Taxpayer 3 (the Will) was signed a number of years ago, and a codicil signed at a later date.

7. Clause X of the Will provides for $Y to be given to sixty named beneficiaries for the purposes of establishing a trust or trusts in accordance with Part C of the Will.

8. Taxpayer 1 was one of the named beneficiaries in Clause X of the Will.

9. Taxpayer 3 is now deceased and probate has been granted.

10. Representatives of the family have stated to the ATO that:

(a) Taxpayer 3 gave specific instructions in relation to the drafting of her/his will, including the wish to create a variety of structures for her/his beneficiaries (and future generations of her/his family)

(b) In doing so, Taxpayer 3 was aware of the variety of businesses and professions being undertaken by her/his beneficiaries

(c) Prior to finalising her/his Will, she/he attended family meetings where the use of the proposed trust structures was explained to her/his and to other family members

(d) The ability to utilise testamentary trusts arising from Taxpayer 3's Will was offered to other family interests. The arrangement was not exclusive to Taxpayer 1 and Taxpayer 2.

11. The ATO has not identified any basis for disputing these statements. Representatives of the family also acknowledged that the income tax concessions offered via the use of a testamentary trust vehicle were "attractive" as they understood that infant beneficiaries would enjoy greater benefits from the trust. However they submitted that this was not the "dominant" purpose for using this structure, the dominant purpose was instead to form a part of the overall estate plan put in place by Taxpayer 3 for the benefit of her/his family so that her/his wishes could be carried out through her/his will.

The A Trust

12. In accordance with the terms of the Will, the A Trust (the Trust) was settled prior to 30 June 2014 with Taxpayer 1 as trustee.

13. Taxpayer 1 was replaced as trustee shortly afterwards when B Pty Ltd (the Trustee) was appointed trustee. Taxpayer 1 is a director of B Pty Ltd.

14. Taxpayer 1 is the primary beneficiary of the Trust.

15. Under clause X of the Trust Deed, as amended, the beneficiaries of the Trust are:

X The beneficiaries of the beneficiary testamentary trust shall be:

(a) The primary beneficiary and Taxpayer 2;

(b) The children and remoter descendants of any of the persons specified in the preceding paragraph;

(c) Any person who is a descendant of a grandparent of any of the primary beneficiary of the trust, a spouse of the primary beneficiary or a spouse of Taxpayer 2

16. Taxpayer 1's children are currently under 18 years of age and are not excepted persons for the purposes of Division 6AA of the ITAA 1936.

17. The Trustee in its capacity as trustee of the Trust has commenced a property development project.

The property development project

18. In addition to acquiring the relevant land, the development activity will involve obtaining rezoning and approval for development, planning and design work, and the undertaking of civil works necessary to subdivide land acquired into smaller lots for the purposes of later resale at a profit.

19. The development project in A Trust is expected to take more than twelve months to complete.

20. The Trustee initially obtained finance from Company A for the deposit, feasibility, design and other start-up costs. A commercial funder will provide construction finance.

21. The loan from Company A will be documented and meet the minimum conditions set out in section 109N of the ITAA 1936.

22. The interest rate charged by Company A will be at a variable rate, but subject to a minimum of the rate prescribed under section 109N of the ITAA 1936. The rate Company A currently charges related parties for similar loans is X%.

23. Land and construction finance has been obtained by the Trustee from a commercial funder (at market rates).

24. The development work will be undertaken by staff of Company A that has the necessary qualifications and experience to undertake such work. The Trustee and Company A will enter into an agreement for the provision of these services by Company A to the Trustee. A commercial rate will be charged by Company A for these services.

25. Developed lots will be listed for sale with arm's length real estate agents and sold over a commercially viable time-period.

26. Once the development project is completed, the Trust will not be involved in any further development activities.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 6AA

Income Tax Assessment Act 1936 section 102AG

Income Tax Assessment Act 1936 Part IVA

Reasons for decision

Division 6AA of the ITAA 1936

27. Division 6AA, Part III of the ITAA 1936 (Division 6AA) operates to tax certain income derived by minors at penalty rates.

28. A minor will be a prescribed person for the purposes of Division 6AA if, in relation to a year of income they are:

• less than 18 years of age on the last day of the income year and

• not an excepted person in relation to the year of income (subsection 102AC(1) of the ITAA 1936)

29. Excepted persons are defined in section 102AC(2) of the ITAA 1936. None of the beneficiaries of the A Trust will be excepted persons for the purposes of Division 6AA.

30. Section 102AG of the ITAA 1936 specifies the circumstances in which Division 6AA will apply to trust income. Specifically, where a beneficiary of a trust estate is a prescribed person, Division 6AA will apply to so much of the beneficiary's share of the net income of the trust estate as, in the opinion of the Commissioner, is attributable to the assessable income of the trust estate that is not, in relation to the beneficiary, excepted trust income (subsection 102AG(1)).

31. Subsection 102AG(2) of the ITAA 1936 specifies the types of trust income that will be 'excepted trust income'. In particular, subparagraph 102AG(2)(a)(i) provides that 'excepted trust income' includes an amount included in the assessable income of a trust estate to the extent to which that amount resulted from a will.

32. However, subsections 102AG(3) and 102AG(4) of the ITAA 1936 are anti-avoidance provisions that may operate to exclude income from being excepted trust income in certain circumstances.

33. Subsection 102AG(3) of the ITAA 1936 states:

Subject to subsection (4), if any 2 or more parties to:

(a) the derivation of the excepted trust income mentioned in subsection (2); or

(b) any act or transaction directly or indirectly connected with the derivation of that excepted trust income;

were not dealing with each other at arm's length in relation to the derivation, or in relation to the act or transaction, the excepted trust income is only so much (if any) of that income as would have been derived if they had been dealing with each other at arm's length in relation to the derivation, or in relation to the act or transaction.

34. Subsection 102AG(4) of the ITAA 1936 states:

Subsection (2) does not apply in relation to assessable income derived by a trustee directly or indirectly under or as a result of an agreement that was entered into or carried out by any person (whether before or after the commencement of this subsection) for the purpose, or for purposes that included the purpose, of securing that that assessable income would be excepted trust income.

35. Subsection 102AG(5) of the ITAA 1936 states:

In determining whether subsection (4) applies in relation to an agreement, no regard shall be had to a purpose that is a merely incidental purpose.

Is the income assessable income of a trust estate that resulted from a will?

36. In Re Trustee of the Estate of the Late AW Furse; A/C Jessica N Delaney and A/C Skye Nea Delaney) v the Commissioner of Taxation [1990] FCA 470 (27 November 1990) (Furse) concerned a similar arrangement. In Furse:

• A discretionary trust ('No 5 Trust') was established under a will. The initial trustee retired shortly after the establishment of the trust and a new trustee was appointed

• The new trustee of the No 5 Trust borrowed money to acquire units in a related unit trust (GSG Management Trust), the trustee of which performed services for a related firm of solicitors.

• Income from the units in the GSG Management Trust was included in the net income of the No 5 Trust.

• The trustee of the No 5 Trust distributed some of the income to three minor beneficiaries.

• The Commissioner assessed the trustee in respect of the three distributions under the provisions of Div 6AA at the rate of 46%.

37. The question for the Court was whether the distributions were 'excepted income' of the children under paragraph 102AG(2)(a)(i) of the ITAA 1936 or whether they were taxable at the top marginal rates under Division 6AA.

38. Although the main issue was whether subsection 102AG(3) operated, the Commissioner had also argued that the requirements of paragraph 102AG(2)(a)(i) of the ITAA 1936 were not satisfied, on the basis that for the subsection to operate it was necessary that the assessable income of the trust estate be sourced in the will or property of the deceased.

39. The Commissioner's argument was not accepted by the court. It was held that all that was necessary for assessable income of a trust estate to fall within paragraph 102AG(2)(a)(i) of the ITAA 1936 was that the assessable income be income of the trust estate, and that the trust estate be one of the forms of trust estate referred to in subsection 102AG(2)(a) - which includes a trust estate resulting from a will. Circumstances where the trustee of such a trust estate borrowed funds and used the borrowed funds to invest in such a way as to derive assessable income from the investment would also fall within the scope of the paragraph.

40. Therefore, applying the principle established in Furse, the assessable income of the A Trust to which minor beneficiaries (who are not 'excepted persons') become presently entitled, would be 'excepted trust income' in relation to the beneficiaries under paragraph 102AG(2)(a)(i) of the ITAA 1936.

Non-arm's length dealings - 102AG(3) of the ITAA 1936

41. Subsection 102AG(3) of the ITAA 1936 excludes income from being excepted trust income in circumstances where that income is derived from transactions between parties who are not dealing with each other at arm's length in relation to the derivation of that income.

42. This concept was also discussed by Hill J in Furse where he concluded (at paragraph 36):

The first of the two issues is not to be decided solely by asking whether the parties to the relevant agreement were at arm's length to each other. The emphasis in the subsection is rather upon whether those parties, in relation to the agreement, dealt with each other at arm's length. The fact that the parties are themselves not at arm's length does not mean that they may not, in respect of a particular dealing, deal with each other at arm's length. ...

43. The Trustee has stated that the arrangements to be entered into by the Trustee and Company A for the proposed development project will be on the same terms as arrangements for other development activities undertaken by Company A with trusts where there are non-family investors. All agreements between the related entities are said to be on commercial terms. On this basis subsection 102AG(3) of the ITAA 1936 would not apply to exclude any distributions from being excepted income under paragraph 102AG(2)(a)(i).

Sub-section 102AG(4) of the ITAA 1936

44. Subsection 102AG(4) of the ITAA 1936 excludes from the scope of subsection 102AG(2) "assessable income derived by a trustee directly or indirectly under or as a result of an agreement" that meets certain criteria.

45. The term 'agreement' is defined in subsection 102AA(1) to mean any agreement, arrangement, undertaking or scheme, whether formal or informal, whether express or implied and whether or not enforceable, or intended to be enforceable by legal proceedings.

46. In relation to the current case, the assessable income in question will be any assessable income derived by the Trustee from the development project. The formal agreements entered into by the Trustee with Company A for the project will, for the purposes of subsection 102AG(4) of the ITAA 1936, be agreements which give rise, directly or indirectly, to that assessable income.

47. Other informal agreements, arrangements or understandings relating to the establishment and operation of any of the trusts arising under Taxpayer 3's Will may have arisen, however there would be practical difficulties in identifying any the details of any such arrangements, particularly those which give rise to the relevant assessable income. The advisors to the family members referred to several family stakeholder meetings at which Taxpayer 3 was present, which discussed the use of structures to be established under her/his will. Whether or not Taxpayer 3 came to any specific understanding or informal arrangement (even an implied arrangement) with family members associated with Company A over the use or application of such structures for Company A development projects would depend on evidence that is likely to be difficult to obtain.

48. The applicant acknowledges that the services agreement between the Trust and Company A and the finance agreement between the Trust and Company A are "agreements" for the purposes of subsection 102AG(4). However, it was submitted that because these agreements were "ordinary commercial arrangements" subsection 102AG(4) would not apply. This argument was based on comments of Williams J in the Supreme Court of Queensland in Commissioner of Taxation v Bill Wissler (Agencies) Pty Ltd (1985) 81 FLR 471, also referred to in Taxation Ruling TR98/4, albeit in relation to child maintenance trust arrangements rather than testamentary trusts.

49. In Wissler, the Commissioner argued that an "agreement" existed in relation to a distribution of particular amounts of income derived by a trust providing services to another entity, such an agreement being evidenced by minutes of meetings of the directors of the trustee and the other entity relating to the receipt and distribution of that income. Williams J rejected the Commissioner's argument, finding that the evidence established nothing more than there being a payment for services rendered. Up to this point, the decision in Wissler may be distinguished from the circumstances of the Trust and the family dealings.

50. Williams J made a further observation (at 477):

Further, if it is necessary for me to so hold, I am of the view that [subsection 102AG(4)] would not apply merely where the parties were aware at the time they entered into an otherwise legitimate commercial agreement that a consequence would be that moneys received thereunder would be "excepted trust income" for the purposes of the Division.

51. Paragraph 85 of TR 98/4 refers to the above observation of Williams J:

85. Subsections 102AG(4) and 102AE(7) do not apply where income results only from ordinary commercial agreements, made for ordinary commercial reasons, even though parties to those agreements were aware that the resulting income would be excepted income … Therefore the subsections clearly do not mean that Division 6AA applies whenever someone transferring property beneficially to a child, or investing that property, is aware that income would be excepted income

52. However, it should be noted that paragraph 85 is part of a wider discussion in TR98/4 around the circumstances in which income being excepted income is a "more than merely incidental" purpose: see subsection 102AG(5) of the ITAA 1936. As with the comments of Williams J in Furse, there is a distinction between circumstances where there is merely an "awareness" of income being treated as excepted trust income and circumstances such as those described in paragraph 86 of TR98/4 where there is a choice between two courses of action, one of which will result in a minor beneficiary's income being excepted income. Wissler and TR98/4 do not appear to be saying that any agreement which reflects commercial terms and conditions is automatically/always excluded from subsection 102AG(4) without further examination of the "purposes" described in that provision.

53. The existence of a "choice" is more clearly seen in the example given in paragraph 86 of TR 98/4 (based on Case 44/95, AAT Case 10,321) where income from an existing discretionary trust is "rerouted" to a newly created child maintenance trust (although both such trusts might form part of wider commercial arrangements). Conversely, the operation of subsection 102AG(4) of the ITAA 1936 may be doubtful in relation to specific items of income arising under an ongoing trust agreement/arrangement (as may have been the case with Wissler).

54. The circumstances of the A Trust fall somewhere between these two points. It is accepted that there was no pre-existing trust (or other business vehicle) in operation which diverted income or assets to the Trust after Taxpayer 3's death. The applicant suggests that there was merely an awareness or recognition of the application of subsection 102AG(2) of the ITAA 1936 to a discretionary trust, being a trust that was always going to be established in accordance with Taxpayer 3's wish to make business structures available to her/his heirs.

55. In the circumstances surrounding the establishment of the Trust and its entering into agreements with Company A, there was an active choice of a particular vehicle to conduct the business/project. In selecting the Trust as the counterparty to the Company A financing and servicing agreement, the application of subsection 102AG(2) of the ITAA 1936 to give income arising to the Trustee "excepted trust income" status was a relevant consideration and point of distinction between this Trust and other discretionary trusts that had been or could be established by the Taxpayers. The excepted trust income status was more than a mere by-product of the selection of that trust vehicle.

56. Furthermore, Taxpayer 1 has made the choice to establish a number of separate trusts from the amount bequeathed to him under the will, rather than one trust only.

57. If "excepted trust income" status was a factor which influenced the selection of the Trust as the counterparty to the agreements with Company A could it be said that either or both of those agreements "entered into or carried out by any person … for the purpose, or for purposes which included the purpose, of securing that that assessable income would be excepted trust income"? A plain reading of subsection 102AG(4) of the ITAA 1936 suggests that the arrangements with Company A were entered into by one or both of the parties for purposes which included the purpose of securing that assessable income derived from the development project would receive "concessional" treatment.

58. The applicant has further submitted that it is incorrect to adopt a literal reading of subsection 102AG(4) of the ITAA 1936, and the provision should be construed such that it only applied to agreements which sought to shift income into a trust which provided "excepted income" treatment. That is, section 102AG(4) only operates where existing income streams (or income producing assets) are transferred into one of the trusts referred to in subsection 102AG(2); it does not operate on arrangements for the initial establishment of such trusts.

59. The Explanatory Memorandum to the Income Tax Assessment Amendment Bill (No 6) 1979 (EM) which introduced Division 6AA does not provide specific clarification on this point. The commentary in the EM on subsection 102AG(4) of the ITAA 1936 refers back to the commentary on subsection 102AE(7) which contains similar wording. In relation to subsection 102AE(7), the EM notes the provision:

"is designed as a safeguard against arrangements of any kind that might be entered into with the purpose of exploiting the exclusions of particular income from the new system."

60. The EM does not support the restricted interpretation suggested by the applicant. By contrast, the EM refers to "arrangements of any kind."

61. Parliament has expressed concerns about arrangements that bear some similarity to the present facts. The Treasurer in his second reading speech to the Income Tax Assessment Amendment Bill (No 2) 1977 made the following observation in relation to amendments to section 99A of the ITAA 1936:

"When in 1964 the Government of the day brought in extensive anti-avoidance legislation, it introduced a special rate of tax, 50 per cent, on some trust income to which no beneficiary is presently entitled. … Under section 99A of the Income Tax Assessment Act, that tax applies where the trust is clearly for tax avoidance purposes and, under the 1964 legislation, deceased estates were excluded from it. … Unfortunately, that exclusion has given rise to tax avoidance by most unpleasant means. … Some family groups, few in number I am pleased to say, have arranged for unrelated aged people who are expected not to live for any length of time, and who have little in the way of assets of their own, to set up multiple "shell" trusts under a will for the benefit of members of the sponsor family. … On the death of the aged person, the family channels income into these trusts which, because they qualify as deceased estates, are outside the scope of the special rate of tax under section 99A."

62. Taxpayer 3 was clearly not unrelated to the family/Company A parties. Unlike the arrangements being contemplated by the section 99A amendments, it would not be unexpected for Taxpayer 3 to make provision of some sort for her/his family and their heirs. However, the Treasurer's comments suggest arrangements for the establishment of trusts from deceased estates with a view to limiting the tax payable on income were a focus.

63. In summary, while acknowledging the commercial factors outlined by the applicant' and their views on Wissler and paragraph 85 of TR98/4, the better view on the current facts is that subsection 102AG(4) of the ITAA 1936 will apply to exclude any assessable income derived by the Trust from being excepted trust income under subsection 102AG(2).

64. Accordingly, the assessable income derived by the Trust will be income to which Division 6AA applies.

Part IVA of the ITAA 1936

65. Part IVA of the ITAA 1936 (Part IVA) applies to a scheme where, having regard to a number of objective factors or matters, it would be concluded that one of the scheme participants who entered into or carried out the scheme or any part of the scheme did so for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme.

Scheme

66. A 'scheme' is defined in subsection 177A(1) of the ITAA 1936. That definition is widely drawn and includes any agreement, arrangement, understanding, promise, undertaking, scheme, plan or proposal. The factual arrangement described above (being the creation of the trust under the terms of the late Taxpayer 3's will, entering into the arrangements with Company A and other parties to undertake the property development and resulting distributions that, but for the operation of subsection 102AG(4) would be excepted trust income under subsection 102AG(2)) will constitute a 'scheme'.

Tax benefit

67. Under paragraph 177C(1)(a) of the ITAA 1936 a tax benefit is defined to include:

an amount not being included in assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out.

68. Taxation ruling IT 2456 Income tax: Tax avoidance schemes - tax benefit discusses the scope of paragraph 177C(1)(a) of the ITAA 1936, in various circumstances including where, under the scheme, an amount of income may be included in assessable income by virtue of a different provision, or under a different description or nature if the scheme had not been entered into.

69. Paragraph 3 of IT 2546 gives an example of the kinds of arrangements considered by the ruling. The example in paragraph 3(b) includes schemes where the nature of the income is changed in a manner that reduces or postpones the tax liability.

70. Paragraph 4 of IT 2546 states:

4. The view is taken that, although a scheme may not result in a reduction overall in the assessable income of the taxpayer (and perhaps the assessable income might even be greater under the scheme), a tax benefit for the purposes of Part IVA may arise. Where the Part applies in such a case, sub-section 177F(2) requires the Commissioner, when making a determination under paragraph 177F(1)(a), to also determine the particular provision of the Act by virtue of which the amount is to be included in assessable income. This Ruling therefore rejects an interpretation of section 177C that would produce the result that Part IVA could not apply to include an amount under a particular income provision simply because the scheme included an amount in assessable income by virtue of a different provision or description, notwithstanding that the other requirements of the Part were satisfied and that the tax consequences under the different provisions or descriptions might be different.

71. In the current case, although the same monetary amounts of income arising from the development project may be included in assessable income under the same trust taxing/assessment provisions regardless of their status as excepted trust income, the status of that income for Division 6AA purposes affects the ultimate tax liability. This appears to be within the scope of the Commissioner's ruling at paragraph 3(b) of IT2456.

72. Therefore, it is arguable that there will be a tax benefit for the purposes of Part IVA.

Alternative postulate

73. Part IVA was amended in 2013 to insert section 177CB of the ITAA 1936 which applies in relation to schemes entered into after 15 November 2012. Under subsection 177CB(3) when postulating what might reasonably be expected to have occurred in the absence of a scheme, the alternative must represent a reasonable alternative to the scheme in the sense that it could reasonably take the place of the scheme (Refer paragraphs 1.85 to 1.97 of the Explanatory Memorandum to the Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Act 2013).

74. If the proposed scheme is not undertaken, it is considered that a reasonable alternative would be for the property development to be undertaken by a discretionary trust that had not been created under a will, and therefore would not be distributing income that could potentially be "excepted trust income" under subsection 102AG(2) of the ITAA 1936.

Dominant purpose

75. Part IVA will only apply to a scheme if, having regard to the seven matters listed in paragraph 177D(b) of the ITAA 1936, it can be concluded that the scheme was entered into with the dominant purpose of obtaining a tax benefit.

76. Having regard to the commercial factors outlined by the applicant, there would be difficulties in demonstrating that securing preferable rates of tax for some of the trust income was the dominant purpose of a scheme comprising the agreements between Company A and the Trust, or a wider scheme incorporating the drafting of Taxpayer 3's will to establish the testamentary trusts. In addition to the commercial factors directing the choice of a discretionary trust, they could argue that their dominant purpose was one of fulfilling the testator's wishes, rather than securing the potentially reduced tax payable in relation to distributions to Taxpayer 1's three children.

77. Accordingly it is considered that Part IVA will not apply to the arrangement.