The Australian Taxation Office (ATO) has outlined specific compliance guidelines under Section 100A (S.100A) of the Income Tax Assessment Act 1936, which includes scenarios for trust distributions. Among these are the "green zone" scenarios, which apply when a trust distribution to a bucket company (or corporate beneficiary) remains within the trust.

This article explores these green zone scenarios, highlighting the criteria that must be met to qualify for this status. Ensuring compliance with these requirements can help business owners and trustees manage their tax obligations effectively.

Additionally, the ATO identifies several scenarios which could complicate compliance with S.100A, particularly when distributions involve non-resident taxpayers. Understanding these complexities is crucial for managing trust distributions, optimising tax liabilities, and considering the impact of your own personal tax rate. Seek professional advice to navigate these tax laws and ensure proper handling of your trust's net income and distributions.

Setting up a bucket company to access the 25% or 30% capped tax rate

A bucket company structure pays a corporate tax rate that depends on its classification. If the company is considered a base rate entity, it is taxed at 25%. For companies that do not qualify as base rate entities, the tax rate is 30%.

In recent years, the corporate tax rate has changed. From the 2017–18 to 2019–20 income years, the rate was 27.5%. It then went down to 26% in the 2020–21 income year. Understanding these tax rates is crucial for effectively managing a bucket company's tax obligations. Seek professional advice to ensure your company is taxed at the appropriate rate.

If you're interested in exploring the benefits of setting up a bucket company, visit our service page on bucket company setup to learn more.

Tax warning: Section 100A adds complexity

Many trustees mistakenly believe that by placing funds equivalent to an outstanding present entitlement for a bucket company on compliant loan terms under Section 109N, they have unrestricted freedom to use these funds as they wish. This assumption is incorrect.

The context of the distribution and how the trustee plans to use the funds must also be considered to determine if Section 100A might be an issue. It's important to think about the purpose of the retained funds. If these funds are intended to be lent out, factors such as the loan recipient, the recipient's marginal tax rate, and the planned use of the funds must be carefully evaluated.

If you would like to learn more about how Section 100A can impact your trust, visit our recent articles: Section 100A changes: trust distributions to the controllers of a discretionary trust and Section 100A changes: trust distributions to adult children and grandparents.

There are several common situations where the 'working capital condition' may not be satisfied:

Certain situations can disqualify bucket company distributions from meeting the ‘working capital condition.’

Non-compliant loans to affiliated parties

If a trustee holds onto a trust distribution intended for a bucket company and lends it to an affiliated party under non-compliant Section 109N conditions, potential issues can arise. This is particularly pertinent if the loan recipient, such as a parent, is subject to a higher marginal tax rate than the bucket company and can benefit from the trust's income. Such scenarios may pose challenges under Section 100A of the Income Tax Assessment Act, especially if they become recurring patterns.

Loans for personal use

Consider a scenario where a trust distribution intended for a bucket company is held by the trustee and loaned to a connected individual for personal use, such as buying a car. If the loan recipient, such as a parent, is in a higher tax bracket compared to the bucket company and stands to gain from the trust's income, this could create Section 100A issues, particularly if it happens repeatedly. Additionally, the unpaid present entitlement and the overall tax liability need careful consideration.

In the two above cases, the risks associated with Section 100A should be assessed individually. Consideration should also be given to Division 7A to ensure any loans are structured correctly and comply with tax laws. Properly managing trust distributions and understanding the implications of corporate tax rates, personal tax rates, and tax payable is essential for effective tax optimisation strategies.

Seeking professional advice is recommended to ensure compliance and proper management of these distributions. This will enable you to maximise tax benefits and handle trust income in the most tax-effective manner.

Example of a bucket company in the green zone

The Johnson Discretionary Trust (referred to as the 'trust') operates a retail business focused on selling pet-related products.

The beneficiaries of the trust include members of the Johnson family and their associated entities, such as Emily and Robert Johnson, along with Johnson Pty Ltd (commonly known as the 'Bucket Company'). Emily oversees the trust, while her spouse, Robert, serves as the sole director and shareholder of the Bucket Company.

On 30 June 2023, the trustee of the trust resolved to allocate the entirety of its trust income to the Bucket Company. At the time of this resolution, an arrangement was established whereby the Bucket Company would allow the unsettled portion of its entitlement to remain within the trust.

Under a Section 109N compliant loan agreement, the trustee retained the disbursed funds and used them to improve the working capital of the business managed by the trust.

Throughout the 2024 financial year and subsequent income periods, the trust's trustee used the earnings derived from the trust (business revenue) to meet its repayment obligations in accordance with the Division 7A loan agreement.

The ATO's stance on S.100A application for bucket company distributions

The Australian Tax Office (ATO) will not seek to invalidate this distribution under Section 100A. This setup falls within the low-risk category of green zone scenario 3B, as outlined in the S.100A compliance guidelines.

This arrangement meets the criteria of the 'working capital condition,' where the distributed amount is used for the trust's working capital. Additionally, the Bucket Company is under the control of the spouse of the individual managing the trust. The retained distribution is structured in compliance with Section 109N terms.

This low-risk status ensures that, provided the setup adheres to these conditions, there is no need for the ATO to investigate the application of S.100A further. This approach effectively minimises tax liability while maintaining compliance with relevant tax laws and regulations.

Other considerations when using the bucket company strategy

The bucket company strategy is a popular tax optimisation approach for managing trust distributions. By distributing trust income to a bucket company, trusts can benefit from the lower corporate tax rate, providing significant tax savings compared to the higher personal tax rates of individual beneficiaries. This strategy can also help manage capital gains and avoid the highest marginal tax rate and the medicare levy. However, it's important to understand and comply with specific requirements to ensure the effectiveness and legality of this approach.

A good tax accountant can guide you. If you are worried Section 100A might be affecting your trust's distributions in adverse ways, reach out to us today.

Commitment to Distributions

When distributing trust income to a bucket company for the financial year, it's essential to transfer the distributed amount to the bucket company's bank account before lodging the tax return. This ensures compliance with the Australian Taxation Office (ATO) requirements and the Income Tax Assessment Act. Properly executing this step helps manage tax payable and maintain accurate financial statements.

Division 7A Loan

If you're unable to meet the bucket company's ATO obligations, setting up a Division 7A loan between the trust and the bucket company is an option. This loan must be repayable within seven years, with interest charged at benchmark rates. The Division 7A loan agreement helps manage the unpaid present entitlement and ensures compliance with tax laws, providing a structured repayment plan to avoid potential tax issues.

A Division 7A loan is established when the trust does not distribute all income in cash to the bucket company before lodging the tax return. This loan arrangement between the trust and the bucket company helps manage the trust's income and tax liability effectively.

To learn more about setting up a Division 7A Loan Agreement, visit our page.

Key Features of a Division 7A Loan:

Division 7A loan agreements have a maximum term of 7 years and a minimum annual repayment plan in which the trust must meet specific annual repayment requirements, with payments set to an interest rate, which governs the interest that's payable at a commercial rate prescribed by the government.

The trust must make the minimum repayments to the bucket company each year. The bucket company can declare dividends, which may offset the minimum repayment obligation. This ensures compliance with tax laws and helps manage the trust's tax liability.

Using a Division 7A loan can be part of a broader tax optimisation strategy. It allows the trust to distribute income to the bucket company while maintaining compliance with the Income Tax Assessment Act and other relevant regulations.

You should seek professional advice to ensure these loans are structured correctly and all tax obligations are met. This approach can potentially lead to significant tax savings, effective management of taxable income, benefiting the family trust and its corporate beneficiaries.