On 16 December 2009, the Australian Taxation Office (ATO) released Draft Taxation Ruling TR 2009/D8 (now TR 2010/3).
The draft ruling outlines the ATO’s position where a private company with a present entitlement to an amount from a trust may be taken to have made a loan to the trust under Division 7A of the Income Tax Assessment Act (1936) (“the Tax Act”).
A common arrangement involves a discretionary trust distributing a share of its income to a company beneficiary, but the distributed amount is not actually paid to the company (either in part or in full). This amount is commonly referred to as an Unpaid Present Entitlement (UPE). Instead the trust retains and uses those funds to invest and earn further income for the wider trust fund and beneficiaries.
For trust law purposes, it has been the longstanding position that an unpaid trust entitlement does not represent a loan from the beneficiary to the trust. However, the draft ATO ruling refers to the extended definition of the term “loan” in Division 7A of the Tax Act which can include any form of financial accommodation. The argument put forward by the ATO in the draft ruling is that by the company not demanding payment of the UPE and allowing the trust to invest the underlying funds for the trust’s purposes, this is a form of financial accommodation and should therefore be treated as a loan for tax purposes.
The ATO’s analysis and proposed application of the law will have wide ranging implications for taxpayers who use trusts and companies as part of their investment and business structures. The significance of a company UPE being treated as a loan is that a loan agreement may be required and minimum annual interest and principal repayments would need to be made to avoid the unpaid amount of the loan being deemed to be a taxable dividend. In addition, the rules contained in Division 7A of the Tax Act (the deemed dividend provisions) operate to treat the dividend as an unfranked dividend which results in a level of double taxation to shareholders and their associates.
The final version of the Ruling is proposed to apply both before and after its date of issue. However, the draft ruling states that where the Commissioner’s current view is less favourable than the Commissioner’s previous practice, taxpayers may be able to quarantine any unpaid company entitlements which arose prior to 16 December 2009.
Taxpayers with private companies will need to carefully consider whether the ability to quarantine entitlements prior to 16 December 2009 is likely to be available to them. Where the concession does not apply, taxpayers may need to consider steps to rectify their position, which could include bringing forward dividend declarations and making payments to the company to extinguish the unpaid entitlement.
Note that the Ruling is draft only and is open for industry comment until 12 February 2010. As part of the submissions we understand that it has been strongly recommended to the Commissioner that there be some form of once off opportunity given to allow taxpayers to deal appropriately with retrospective UPEs in light of the Commissioners views expressed in the ruling.
A full copy of the draft ruling can be found using the attached link:
We will provide further updates as they become available. In the meantime, should you wish to discuss the impact of this draft ruling on your particular circumstances please do not hesitate to contact us.