Further to Client Alert No 2, the Australian Taxation Office (ATO) has finalised Draft Taxation Ruling TR 2009/D8 and released it in final form as Taxation Ruling TR 2010/3. In addition, the ATO has released Practice Statement PS LA 2010/4 which gives ATO employees guidance as to how TR 2010/3 should be interpreted (but also provides guidance to taxpayers generally).
The final ruling and Practice Statement outline the ATO’s position as to when a private company with a present entitlement to an amount from a trust will be taken to have made a loan to the trust under Division 7A of the Income Tax Assessment Act (1936) (“the Tax Act”) and when a loan will not be taken to arise.
Pre 16 December 2009 UPEs
In the first instance, where an Unpaid Present Entitlement (UPE) (an amount distributed but not actually paid to the company) existed prior to 16 December 2009 and nothing has occurred which would otherwise convert the UPE into a loan, the UPE can continue to exist without any tax consequences. In this regard, it will be necessary for the UPE to be identified as such in the accounts of both the trust and the company. Ideally the date that the UPE came into existence should be recorded.
Where the financial statements of either the trust or the company or both have incorrectly recorded a UPE as a loan, corrective action can be taken to properly classify the amount as a UPE provided the following conditions are met:
- There is evidence that supports that the amount is a UPE;
- The company has never disclosed the UPE in its tax return as a loan to shareholders or their associates;
- The trust has not paid or credited interest in respect to the amount;
- The amount is purely a UPE and not tainted by other amounts;
- The corrective action takes place on or before 31 December 2011; and
- On or before 31 December 2011, the trustee of the trust and public officer of the company sign a declaration setting out all the above conditions have been satisfied and declare them to be true and correct.
In circumstances where it was thought an amount was a UPE but the facts show otherwise and the corrective action as outlined above is not possible, under limited circumstances taxpayers can potentially take other corrective action for the deemed dividend under Division 7A to be disregarded without having to apply to the Commissioner of Taxation to exercise his discretion to disregard the deemed dividend. This is similar to the position that existed in respect to Division 7A corrective action that was available to be taken prior to 30 June 2008.
In order for this to occur the following conditions need to be satisfied:
- the failure to comply with one or more of the provisions of Division 7A in respect of the loan was the result of an honest mistake or inadvertent omission by the trustee, the private company or other relevant party;
- the trust and private company are small business entities. In summary, a small business entity is an entity which carries on a business and together with affiliates and other connected entities has a turnover of less than $2 million (this appears to eliminate trust or companies which do not carry on a business, eg. passive investors from being able to take this action). We understand the ATO is reconsidering this condition;
- the loan funds were used by the trustee of the trust only for the purpose of carrying on the business (or businesses) of the trust;
- ‘corrective action’ as defined in the practice statement (broadly putting documentation in place to make the loan a Division 7A loan and making catch up repayment under the loan) has been taken by the taxpayer on or before 31 December 2011;
- the private company and the trust have lodged all required income tax returns up to and including the 2009-10 income year if necessary;
- notwithstanding the current non-compliance with Division 7A, the private company, the trust and their associates have a history of good tax compliance; and
- the trustee of the trust is not a shareholder of the private company. We also understand the ATO is reconsidering this condition.
Post 16 December 2009 UPEs
Where a UPE comes into existence after 16 December 2009 for the amount to be treated as a UPE and not a loan for Division 7A purposes it is necessary for the following to occur:
- The trust place the funds which represent the UPE on sub-trust for the company beneficiary to which the distribution has been made;
- The UPE should be recorded as such in the books of the trust and the company;
- Income of the sub-trust is required to be distributed and paid to the company annually (it is not acceptable to the ATO to create a further UPE in respect to the sub-trust);
- In respect to the sub-trust the ATO will permit three investment options for the main trust to invest in the sub-trust:
- Have an interest only loan from the main trust to the sub-trust for a 7 year period at an interest rate equal to the benchmark interest rate (currently 7.4%). The loan amount must be paid to the company after 7 years.
- Have an interest only loan from the main trust to the sub-trust for a 10 year period at an interest rate equal to the prescribed interest rate (currently 10.3% for the year ending 30 June 2011). The loan amount must be paid to the company after 10 years.
- Invest the funds in a specific income producing asset such as an interest bearing investment or other income producing asset. The funds from the investment must be distributed to the company when the investment comes to an end. It is necessary for the income producing asset to generate commercial arm’s length income.
- For options i. & ii. the “interest” paid to the company by the main trust is deductible to the main trust and assessable to the company as the beneficiary of the sub-trust. The sub-trust is not required to lodge a tax return or maintain separate accounts.
- In respect to option iii. there is no deduction in the main trust for the income earned from the investment and the company as beneficiary of the sub-trust is assessable on the income from the investment. The sub-trust is required to maintain a separate set of accounts and lodge a tax return.
In respect to UPEs arising between 16 December 2009 and 30 June 2010 taxpayers have until 30 June 2011 to put the UPE on a sub-trust using either option i. or ii. (option iii. is not available in this situation). Interest under the sub-trust must then be paid by 30 June 2012 and included in the company’s 30 June 2012 tax return.
Taxpayers with private companies will need to carefully consider whether the ability to quarantine UPEs that exist prior to 16 December 2009 is likely to be available to them. In addition, whether there are circumstances which require or permit “corrective action” to be taken.
Consideration also needs to be given as to whether a sub-trust should be created for post 16 December 2009 UPEs or whether these should be converted to Division 7A loans or dealt with by way of dividend declarations and making payments to the company to extinguish the unpaid entitlement. It will also be necessary to determine whether the trust deed allows for a sub-trust.
In respect to option iii. it is likely to become an administrative nightmare complying with the ATO requirements.
A full copy of the Final ruling and Practice Statement can be found using the attached link:
Should you wish to discuss the impact of the Ruling and Practice Statement on your particular circumstances please do not hesitate to contact us.