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ATO alert: purported alienation of income through discretionary trust partners

The Tax Office has issued Taxpayer AlertTA 2013/3, warning about the use of arrangements where an individual purports to make the trustee of a discretionary trust a partner in a firm of accountants, lawyers or other professionals (firm), but fails to give legal effect to that structure or fails to account for its tax consequences.

In the arrangements, an individual purports to alienate income attributable to their professional services to a trustee partner. In this context, “alienation” refers to a situation where income that would otherwise be assessable to an individual is the income of a different entity. This may occur as the result of the assignment of an existing partnership interest, or by the creation of a new interest.

Broad features of the arrangements

This alert applies to arrangements with features substantially equivalent, but not limited to, those described below. All factors should be weighed up in assessing whether any tax risks are posed by a particular arrangement.

  • (1) An individual causes transactions to occur which purport to make the trustee of a discretionary trust (trustee) a partner in a professional firm. The trustee may be the individual acting in their capacity as trustee or another entity. The beneficiaries of the trust include the individual or their associates.
  • (2) The individual purports to assign their existing interest in the partnership to the trustee. In such a case the individual may not report any capital gain associated with the assignment in their tax return, or report an understated capital gain.
  • (3) Alternatively, the individual may not have had an existing interest in the partnership, but transactions occur which purport to provide the trustee with a new partnership interest.
  • (4) The arrangement has some or all of the following features:
    • (a) the trustee does not actively engage in the conduct of the firm’s practice and may not hold professional qualifications
    • (b) the practice is carried on in much the same way as it had been before the trustee purported to become a partner, or would have been if the trustee had not purported to become a partner
    • (c) the amount of salary or other remuneration payable to the individual is considerably lower than the income which they formerly derived from the practice, or would have derived if they had been a partner, and/or
    • (d) the individual has the ability to remove the trustee, revoke or alter the trust arrangement, or otherwise control the trustee’s interest in the partnership.
  • (5) In each financial year:
    • (a) the firm directs distributions of net profits of the firm to the trustee as partner of the firm. This distribution may correspond to the amount the individual could reasonably be expected to have received if they had not entered into the arrangement, and
    • (b) the trustee resolves to distribute most or all of the income to lower taxed beneficiaries of the trust.
  • (6) The individual does not report any income from the professional firm in their tax return, except to the extent (if any) that such income is part of their entitlement as a beneficiary of the trust.
  • (7) The arrangements described above may alternatively be implemented using a unit trust, units in which are held by lower taxed beneficiaries.

Tax Office’s concerns

The Tax Office’s concerns with these types of arrangements include whether:

  • (1) the transactions referred to above are legally effective, such as:
    • (i) whether an interest in the net income of the partnership is an interest of the trustee or the individual for the purposes of s 92 of ITAA 1936
    • (ii) whether assessable income relating to work performed by the individual is derived by the individual or the partnership for the purposes of s 6-5 of ITAA 1997
  • (2) any transactions intended to make the trustee a partner in the firm give rise to or increase a net capital gain for the individual in the year of income, such as:
    • (i) whether a CGT event has happened to an interest held by the individual in a partnership
    • (ii) what capital proceeds are associated with the event, and
    • (iii) whether the individual’s net capital gain is reduced by the CGT discount or small business concessions in Div 152 of ITAA 1997, and
  • (3) the general anti-avoidance rules in Pt IVA of ITAA 1936 apply to cancel tax benefits obtained by the individual.

Tax Office’s actions

The Tax Office is currently reviewing these arrangements and conducting examinations in appropriate cases. It is also reviewing relevant tax rulings and determinations.

A number of the features described were identified in Taxation RulingIT 2330 as being factors which point towards the application of the general anti-avoidance provisions to income splitting arrangements. In this regard, the Tax Office is considering whether some of the arrangements identified involve a scheme to which Pt IVA applies.

IT 2330 also states that the anti-avoidance provisions will not apply to assignments of partnership interests of the same nature as that considered in FC of T v Everett80 ATC 4076. A similar statement was made in Taxation RulingIT 2501 in relation to the decisions in Everett and FC of T v Galland86 ATC 4885. The Tax Office is currently reviewing this position, although arrangements described in this alert may be distinguishable from the arrangements considered in those cases.

The Tax Office is also reviewing Taxation RulingIT 2540, which addresses the CGT consequences of disposing of an interest in a partnership.

The Tax Office is preparing further guidance on these arrangements in the form of an online publication to help professionals understand the risks and how to address them in practice.

The Tax Office is also consulting with relevant professional bodies on the action it is taking, including the potential application of Pt IVA.

The Tax Office will examine arrangements which it considers are a sham or ineffective in alienating the individual’s income, or where CGT has not been correctly recognised.

The Tax Office will apply compliance resources to consider the possible application of Pt IVA to arrangements of the type covered by this alert in relation to tax benefits arising in the 2013/14 and later income years.

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