ATO Attacks UPEs

Following the release of Taxation Ruling TR 2010/3 ‘Income tax: Division 7A loans: trust entitlements’ (TR 2010/3) on Wednesday 2 June 2010, many closely held trusts may now be assessed under the Division 7A deemed dividend rules.

TR 2010/3 provides the Commissioner’s opinion on the circumstances in which a private company with a present entitlement to an amount from an associated trust may be taken to have made a loan to the trust for the purposes of Division 7A.  The Ruling was previously released as Draft Taxation Ruling TR 2009/D8 and is unchanged from the Draft in its main effect.

Background

 A common arrangement involves a discretionary trust distributing income to a company beneficiary but some or the entire amount distributed is not actually paid to the company beneficiary.  This amount is commonly referred to as an unpaid present entitlement (UPE).  Instead of paying the amount of the distribution, the trust retains and uses those funds which represent the UPE.  Typically, the trust will invest the fund amounts to earn income for the wider trust fund.

The long-held view has been that as long as the UPE was not treated as a loan in the relevant financial statements and the substance of the arrangements did not reflect the UPE being converted to a loan then the UPE was not a Division 7A loan.

This was accepted as the position by the Australian Taxation Office (ATO) until late last year when it issued TR 2009/D8. 

 What is the change?

Broadly, the Ruling indicates that the Commissioner considers that a private company will have made a Division 7A loan to the associated trust under arrangements having two possible forms:  

• Loans within the ordinary meaning (Section two) - if the UPE has been satisfied and the company agrees to loan the amount to the trust; and 
• Subsisting UPEs and Division 7A loans within the extended meaning (Section three) - if the company does not call for payment of a subsisting UPE and thereby agrees that the amount can be used for trust purposes.

Conversion of UPE to an actual loan (Section two)

In this section the Ruling outlines the common scenario where the private company agrees to make a loan to the trust in satisfaction of its UPE. 

Whilst this has long been accepted as creating a Division 7A loan and is not controversial in itself, the Ruling substantially extends the scenarios involving UPEs in which a private company beneficiary is taken to have made a loan to the trust. 

It is now the Commissioner’s opinion that a loan can result from the unilateral action of the trustee.  Moreover, the Ruling indicates that, with few exceptions, this will be applied retrospectively to previous years.

The Ruling states that a trustee may make a loan on behalf of the private company: 

• Under an implied agreement where the private company has knowledge that the trustee has treated its UPE as having been satisfied and a corresponding amount borrowed back (evidenced, for example, by crediting a loan account in the name of the private company beneficiary) and the private company acquiesces to that treatment. 
• By acting pursuant to a term of the trust deed which permits the trustee to pay or apply money to or for the benefit of the beneficiary.  In this regard the trustee may apply trust funds for the benefit of the private company beneficiary by crediting a loan account in the private company’s name.

In this regard the Commissioner takes the view that where the trust and private company beneficiary form part of the same family group then the private company has knowledge of the trustee crediting a loan account in its name.

Action Required:

It is of critical importance to ensure that UPEs are not incorrectly described as ‘loans’ in the financial statements of the trust.

According to the Ruling the only exception to this outcome is if it is not within the power of the trustee to treat the funds otherwise than as a UPE and the amount to which the company beneficiary is entitled remains a UPE. 

This will require a review of each trust deed and may require amendments to the trust deed to confirm that the trustee’s power does not extend, if appropriate.
Provided the trustee continues to account for the UPE as a UPE, no loan should be taken to arise under Section two.

Even if the actions of the trustee have not caused a loan to arise, the potential application in Section three (discussed below) will still need to be considered.

 UPE as ‘financial accommodation’ (Section three)

Whilst the Ruling applies both before and after the date of issue, the Commissioner has adopted a practical approach to not apply Section three of the Ruling to UPEs that arose before 16 December 2009.

This aspect of the Ruling is arguably the most contentious issue as it represents a significant change from the Commissioner’s previous administrative treatment of UPEs.

Broadly, a Division 7A loan includes the provision of any form of financial accommodation.  Under the Ruling this extends to circumstances where a private company is providing financial accommodation under a consensual agreement where the private company has authorised (including by acquiescence with knowledge) the continued use of the UPE for trust purposes by not calling for: 

• Payment of that UPE; or
• Separate investment of the funds representing the UPE for the company’s absolute benefit.

In this situation the private company is considered to be providing pecuniary support to the trust by allowing it to use the relevant funds for trust purposes rather than for the absolute benefit of the private company beneficiary.  Accordingly, the Commissioner considers this the making of a Division 7A loan.

The Commissioner does provide for an exception to the application of Division 7A in circumstances where sub-trusts are created and the trustee holds the funds solely for the benefit of the beneficiary.  However, to access this exception the relevant funds should not be intermingled with the remaining funds of the trust.

 Action Required:

Where UPEs have arisen on or after 16 December 2009 the only ways to avoid a deemed dividend under Division 7A would, in most cases, be to either:

• Pay the UPE out to the beneficiary;
• Create a sub-trust (where the trust deed allows) and ensure the relevant funds are not intermingled with the remaining funds of the trust and are invested for the sole benefit of the corporate beneficiary.  This is likely to produce the best outcome; or
• Cover the UPE with a Division 7A complying written loan agreement under which the trust agrees to make the minimum loan repayments and interest payments in accordance with Division 7A.

The Ruling raises a number of issues for closely held trusts and it would be prudent to discuss these issues with your Lawler Partners tax adviser to consider your options.

For specific information please contact:

Newcastle - Darren Shone, Tax Partner : Email Darren
Sydney - Tina Louras, Tax Principal : Email Tina