The public practitioner is often the first person the client turns to for advice when their relationship breaks down. However, determining net asset pools and contingent tax liabilities is rarely an easy process, and there are some ethical factors to consider.
By Tracey Dunn, Associate director – tax services, at RSM*
Statistics indicate that one in three first marriages in Australia end in divorce, while the divorce rate for second marriages is even higher at about 60%. Then there’s also long- term defacto relationships that break down. With around one in three Australians owning publicly listed shares and thousands either having an interest in a small- or medium- sized business or receiving trust distributions, tax and family law have become inextricably intertwined.
As trusted advisers, the public practitioner (the adviser) will generally be the first person the client turns to for advice when their relationship breaks down. Often the client will seek counsel with the practitioner well before the client’s relationship ends. This can place the adviser in a precarious position, particularly where one or both of the individuals seek advice on determining the net asset pool and inherent tax liabilities.
This reliance on the adviser will, at the very least, raise the question of conflict and leave the adviser to determine which one of the couple is the client, or if in fact that they can act for either of them. In many circumstances, advisers may find the most appropriate course of action to minimise risk of non-compliance with duties under the Tax Agent Services Act 2009 and professional ethical requirements under the APES 110 Code of Ethics for Professional Accountants will be to step aside and allow an independent expert provide tax and accounting litigation support in respect of the property settlement process.
The recognition of tax liabilities in family law matters is not a new concept. However, determining the contingent tax liabilities is not always an easy process, particularly where the individuals have either prepared their own tax returns, have multiple years of outstanding returns, or the adviser has perhaps lacked the necessary expertise to advise appropriately on Division 7A, capital gains tax (CGT), fringe benefits tax (FBT) and family law rollovers etc.
WHAT DOES THIS MEAN FOR FAMILY LAW SETTLEMENTS?
The family law process may seek, where possible, to finalise the distribution of assets between the individuals, but it has no impact on the personal or business tax obligations of the parties and the entities connected to them. Consent orders may include indemnities for tax liabilities, but if the inherent tax liabilities are not identified early or voluntary disclosure isn’t made where necessary, then the tax issues start to become more complicated. The problems are compounded if consent orders are not drafted appropriately to ensure access to relevant rollovers and action taken to ensure parties comply with the order.
This article will explore some of the key tax issues that may impact on the determination of the net asset pool, the recognition of contingent tax liabilities and the tax implications of proposed property settlements. These issues will be considered not only from the perspective of tax issues that arise on proposed transfers under a Family Court Order, but also pre-existing tax issues and inherent tax issues that may be triggered post settlement.
Division 7A has a broad application and is one of the most common tax issues that impacts more complex family law property settlements. Often, Division 7A issues, particularly breaches of the Division 7A rules, are not identified until a relationship breaks down and one or both of the individuals seek independent tax advice, or a single expert witness is appointed to identify tax issues.
In a family law context, common scenarios where Division 7A may have application when drafting consent orders include (but is not limited to) when:
- The Court orders a private company to pay an amount or to transfer property to one of the individuals.
- The Court compels the trustee of a trust to pay an amount or to transfer property to one of the individuals (or an entity controlled by them), which is not in satisfaction of an unpaid present entitlement where the trust owes an unpaid present entitlement to a private company.
- The Court issues an order for the forgiveness of a debt owed to a private company by a spouse who is a shareholder or associate of the private company. This can also apply where the court orders an associated trust to forgive a debt owed by a shareholder or associate of a private company (where the trust owes an unpaid present entitlement to the private company).
- A Division 7A loan is assigned to another party or entity raising the question of whether a forgiveness has occurred.
DIVISION 7A – BREACHES
Common breaches of the Division 7A rules that present in family law matters include:
- Lack of complying Division 7A loan agreements.
- Division 7A loan agreements between incorrect parties.
- Incorrect treatment or disregard of Division 7A loans.
- Private use of company assets not treated as Division 7A payments.
- Non-compliance with minimum repayments.
Where breaches of the Division 7A rules are not addressed when identified and, where necessary, and application made to the Commissioner to exercise his discretion under Section 109RB of the Income Tax Assessment Act 1936 (ITAA 1936) to disregard the application of Division 7A or frank the dividend, the individuals will be exposed to amended assessments in the event of an ATO audit or review. The fact that the two individuals have finalised the distribution of their marital assets does not finalise any inherent tax issues that may impact on them.
DIVISION 7A AND TRUSTS
Section 109T and section 109XA of the ITAA 1936 may apply where payments, including transfers of property, are made between interposed entities. The Commissioner has acknowledged that section 109T of the ITAA 1936 can apply to a payment ortransfer of property made to a former spouse under a Family Court order via interposed entities.
Section 109XA of the ITAA 1936 may apply where a trustee has an unpaid present entitlement to a corporate beneficiary and a loan, payment or transfer of property is made by the trustee to a beneficiary. Common scenarios where deemed dividends can arise under section 109XA ITAA 1936 include where the trustee has an unpaid present entitlement owing to a corporate beneficiary (including pre 16 December 2009 and pre 4 December 1997 UPEs) and:
- the trustee makes a loan to a beneficiary and the loan is not repaid or placed under a complying Division 7A loan by the relevant date
- the trustee makes a joint loan to one or more beneficiaries and records it as such in the financial records and only one of the parties has entered into a complying Division 7A loan agreement, and
- the trustee is required to make a payment or transfer of property to a former spouse under a Family Court order.
The application of section 109T and section 109XA to payments, loans or transfers of property between interposed entities is not confined to transactions made under Family Court orders. Advisers should be cognisant that parties may be exposed to deemed dividends under Division 7A where historical non-compliance has not been identified and/or appropriate rectification action not taken.
CGT CONSEQUENCES OF PROPERTY SETTLEMENTS
Utilising of CGT rollovers in family law property settlements provides an opportunity for parties to structure settlements in a tax effective manner. Accessing the CGT rollover provisions available under Subdivision 126A of the the Income Tax Assessment Act 1997 (ITAA 1997) can provide parties with an effective tax deferral opportunity. However, it is essential both parties understand both the tax liabilities involved and the consequences for when assets are realised within a short period of time post finalisation of the family law settlement process. The application of the CGT rollover under Subdivision 126A of the ITAA 1997 not only facilitates the opportunity for tax effective settlements, but also helps to preserve the net asset pool of the individuals.
Caution is advised, however, to ensure both parties understand and agree they will inherit the cost base of the asset along with the inherent tax liability. To ensure individuals can access the CGT rollovers as intended, it is essential that orders are drafted appropriately, and that they comply with the orders as written.
GST CONSEQUENCES OF PROPERTY SETTLEMENTS
There are no specific provisions under the GST Act covering transactions that are entered into as a consequence of a marriage or relationship breakdown. GST Ruling GSTR 2003/6 sets out the Commissioner’s view regarding the GST consequences of the transfer of assets following a marriage or relationship breakdown.
Whilst the transfer of private assets between former spouses who are not registered (or required to be registered) for GST will have no GST consequences, the transfer of ‘enterprise assets’ (for example a commercial rental property) may give rise to a taxable supply for the purposes of GST. Determining the GST consequences of the transfer of an ‘enterprise asset’ is not a simple process and will require consideration as to whether the supply was made for no consideration and where consideration is paid, whether the supply was made in furtherance of an enterprise.
Where GST is not required to be paid in respect of the transfer of an enterprise asset under a Family Court order to a former spouse, an adjustment may be required to the input tax credit previously claimed on the original acquisition of the asset, due to the change in use of the asset. If this is the case, the transferor spouse, or transferring entity, may be left with an unexpected GST liability.
TRUST PAYMENTS – SECTION 99B TRUSTEE ASSESSMENT
Whilst section 99B of the ITAA 1936 generally applies to distributions of income from a non-resident trust to a resident beneficiary, the Commissioner has indicated he may also seek to apply section 99B of the ITAA 1936 to payments made by a resident trust to a resident beneficiary. In addition, the Commissioner has indicated he may seek to apply section 99B of the ITAA 1936 where payments are required to be made to a resident beneficiary by a trust under a Family Court order.
TRUSTS – BENEFICIARY LOAN FORGIVENESS
It is common for loans owing by beneficiaries to a trust to be ‘forgiven’ under a Family Court property settlement. The Commissioner takes the view in TD 2019/D9 that the notion of forgiveness for the purposes of the commercial debt forgiveness rules is confined by the use of ‘natural love and affection’ and the requisite connection between the motivation and the forgiveness will only be satisfied where the creditor is a natural person.
In a family law context, this means that where a trust is compelled to forgive a debt owed by a beneficiary under a Family Court order, the commercial debt forgiveness rules will apply. As the forgiveness will not be considered to be arm’s length, there may be unintended tax consequences for both the trust and the beneficiary.
The tax issues discussed in this article merely touch on some of the key issues that impact family law property settlements and the application will vary depending on the facts and circumstances of each case. Further issues for consideration include:
- The impact of amended income tax assessments arising from ATO audit activity post finalisation of Family Court orders.
- The recognition of contingent tax liabilities in the net asset pool calculations.
- Director exposure to personal liability and compliance with DPN notices for non-payment of PAYG Withholding, compulsory superannuation or GST.
Tax issues that may arise from failure to have trustee income resolutions in place by the relevant date, or personal tax liabilities that may arise from trust distributions where the party does not have access to cash resources to pay the liability.
Tax issues impacting on family law matters can be complex, so it is essential that advisers are aware of the possible unintended consequences that can arise from providing conflicted, incorrect or incomplete advice.
This article is intended as general information only and is not to be relied as advice. The tax implications arising from family law matters will be dependent on the individual facts and circumstances of the case and advice should be obtained from a suitably qualified professional before Family Court orders are finalised.
*Tracey Dunn is an associate director in the Tax Services division of RSM in Perth. Tracey has a Bachelor of Business (Accounting), a Graduate Certificate in Commercial Law and is currently studying a Bachelor of Laws. She has significant experience in advising on the taxation implications surrounding fringe benefits, Division 7A, and trusts. Tracey provides litigation support in family law matters involving high wealth individuals and private groups and regularly presents on taxation topics.