Covid-19 Cash Flow Boosts Tax Treatment

 

The cash flow boosts of between $20,000 and $100,000 give more than tax-free support to business.

  • The cash flow boosts aren’t part of most family and unit trusts’ income and therefore can’t be automatically distributed in the trust’s annual income distribution.
  • The cash flow boosts are a one-off opportunity to increase business capital. You should therefore retain and not distribute them.
  • The costs the boosts fund are tax deductible, except for capital expenditure (though capex is usually deductible under the capital allowances provisions, either over time or immediately).
  • Because they don’t pay for a supply, the cash flow boosts are free of GST.

The Taxation Institute of Australia has just published a feature article setting out how all this works.  It is different for trusts, companies and individuals/partnerships.

Trusts

Modern trust deeds make the trust’s net income equal to taxable income (excluding franking credits).  Thus, because the cash flow boosts aren’t taxable, they aren’t part of trust income.  The result is that a trust’s automatic division of income between at year end doesn’t include the cash flow boosts.

This, surprisingly, is a good thing.

Annual distribution of all income makes it hard for trusts to accumulate funds both to run the business and pay beneficiaries all their entitlements.  The usual answer is not to pay all the entitlements.  However, that is unsound finance, because beneficiaries can demand their money. If pressed by creditors, they do demand their unpaid entitlements, which may go back many years.  With the money tied up in the trust’s business, this can cause a business a financial challenge. A dire challenge if balances are large.

Failure to pay entitlements is also under attack by the Tax Office.  The Tax Office treats an unpaid company income entitlement from a family trust as an actual or an informal loan.  They then use Division 7A to make the amount taxable as if an unfranked dividend paid by the company to the trust. Even though it has been taxed already.  In practice, to avoid this, accountants ensure their clients either pay these company entitlements promptly or over time under complex loan structures, which helps keep the trust forever short of funds.

Treasury and the Tax Office have long been keen to use s 100A to tax the trustee on unpaid distributions at the maximum tax rate.  The argument is that leaving the entitlement unpaid is part of a formal or informal arrangement to fund the trustee.  This is called a reimbursement agreement.  There are some exits, such as “ordinary family or commercial dealing”.  But in an anti-avoidance provision like this, what is “ordinary” might be surprisingly narrow.  So far, s 100A is little used.  Long may it remain so.  However, it is a risk.

Given business’s need for funds, the risk of beneficiaries demanding payment of entitlements and tax threats on unpaid entitlements, the cash flow boost not being part of income and not automatically distributed is a good thing.

How then do you deal with the cash flow boosts?

You credit the cash flow boosts to a balance sheet reserve called Cash Flow Boost Reserve.  If you want, you can first pass them through the profit and loss to arrive at “Operating Income” and transfer it out to the Cash Flow Boost Reserve before arriving at the trust’s net income.

Accountants should keep working papers with a copy of the Tax Office client account showing the cash flow boosts credits to prove the reserve is tax-free.  They need to carry this forward each year (easy in a computer work paper system).

Can a Trust Distribute the Cash Flow Boost Tax-Free?

The government’s 23 March announcement said the payments were to “help businesses and not-for-profits keep operating, pay their rent, electricity and other bills and retain staff.”

The Tax Office writes:

“If your unit trust distributes all of part of the cash flow boost amount to a unit holder there will be no tax consequences for the unit holder … We would expect that such distributions will be rare, however, since the cash flow boost is intended to be used to support the business needs of the company or trust.”

Thus, you can distribute the cash flow boost tax-free from a unit trust.  Though the Tax Office doesn’t mention this, the same is true for a family trust.  It is also true if distributed through several trusts.  In each case, this requires the amount to be identified separately in the books and accounts.  And it needs the working papers described above.

Getting a tax-free distribution of the cash flow boost from your trust sounds like something for nothing.  But it isn’t.  You remain taxable on your share of the trust’s taxable income.  And for most business trusts, a distribution of the cash flow boosts will be only notional.  It will add to the beneficiary balances the trust can’t afford to pay.  If the trust has spare cash, it’s best used to pay out already unpaid balances.

You shouldn’t distribute the cash flow boost – at least not until the trust is wound up at the end of its life.  The amount’s tax-free character is written into the tax law at section 59-90.  It will be tax-free whenever it is distributed.  The more pressing need is usually to keep the trust funded.

A couple of castigated companies have funded executive bonuses out of JobKeeper augmented profits.  The government expectations in italics above suggest, as for those few companies, distributions of the cash flow boost won’t win brownie points.

Companies

Companies too get the cash-flow boosts tax-free.  They have the same need to fund the business.  So, distributing the cash flow boost is likely to be a poor idea.  Also, a cash flow boost distributed by a company is taxable to shareholders as a dividend.  This may be franked, but that uses franking credits and may create a net tax liability.

Like trusts, companies should credit the cash flow boosts to a Cash Flow Boost Reserve.  Unlike for most trusts, the cash flow boosts are always part of a company’s profit.  This follows from the 1984 High Court decision in FCT v Slater Holdings Ltd that a gift received was part of profit.  According to the High Court’s decision in Archer Bros, a company can create a reserve and identify its character.  Thus, a company can transfer the cash flow boost to a reserve.  This doesn’t make it non-distributable, but it puts in a separate envelope, labelled for preservation, rather than distribution.

Again, the right time to distribute is when the company has served its purpose and is closed down.

Individuals and Partnerships

They too can follow the strategies above.  As with trusts, the eventual distribution to the sole proprietor or the partners is protected by section 59-90 as tax-free, whenever it is distributed.

Notes

The above discussion doesn’t deal with special cases.  For example, some older trusts don’t make trust income equal to taxable income.  Section references are to the Income Tax Assessment Acts 1936 and 1997.  A reader should not act solely in reliance on this article which is written for general information only.  No liability is accepted.  Professional counsel on your individual circumstances is always advisable.  This article is written with the permission and help of the author of the Taxation Institute article, Stephen Page, CTA, FCA.  That article, titled Tax effects of COVID-19 cash flow boosts, appears in the December 2020/January 2021 issue of the Institute’s journal Taxation in Australia.

Article by Stephen Page & Co, Chartered Accountants

Gordon Garling Moffit Lawyers