After our semi-serious opening statement on the Australian Taxation Office’s (ATO) recently released guidance on section 100A and unpaid present entitlements, this is one of a series of deep-dive articles on that guidance. These articles look at each of the ATO guidance products separately and then we discuss what the overall impact may be.
This article is on Draft Taxation Determination TD 2022/D1 (Draft Determination) that sets out the ATO’s views on when an unpaid present entitlement (UPE) with a private company beneficiary (corporate beneficiary) is a loan for the purposes of Division 7A of the Income Tax Assessment Act 1936.
How did we get here?
In December 2009, the ATO released its then draft views on when a UPE with a corporate beneficiary is a loan for the purposes of Division 7A. In (broad) summary, that view was that a UPE, while not an ordinary loan, falls within the extended definition of loan in section 109D in the income year following the creation of the UPE (the corporate beneficiary provides ‘financial accommodation’ to the trustee).
When the ATO finalised those views in 2010 in Taxation Ruling TR 2010/3, the ATO also released Practice Statement Law Administration PSLA 2010/4 that included three options to hold an amount representing a UPE on ‘sub-trust’ if the UPE had not been discharged or placed on ‘Division 7A complying terms’.
We refer to TR 2010/3 and PSLA 201/4 together as the Existing View.
What does the Draft Determination say?
It comes as no surprise that the ATO view in the Draft Determination is that a UPE with a corporate beneficiary will fall within the extended definition of loan in section 109D when the beneficiary has knowledge of the UPE and does not demand payment. This is consistent with the Existing View.
What changes is the time at which the ATO considers that the UPE becomes a loan and the administrative arrangements available to deal with that UPE.
No sub-trust
In the absence of a sub-trust arrangement (below), the ATO considers in the Draft Determination that:
where a corporate beneficiary is presently entitled to a fixed amount of trust income, the beneficiary is taken to have knowledge of that amount at the time of creation of the UPE and the UPE becomes a loan for the purposes of Division 7A from that time; and
where a corporate beneficiary is presently entitled to a percentage of trust income, the beneficiary is taken to have knowledge of the amount at the time the trust’s accounts are finalised (typically in the income year after the year in which the present entitlement arose).
The Existing View is that a UPE becomes a section 109D loan when the trust lodges its income tax return for the year in which the UPE is created (typically in the following income year). That applied to all UPEs – fixed amounts and percentages.
For percentage UPEs, the approach in the Draft Determination is not significantly different to the Existing View. For fixed UPEs, there is a change. The result of that change for fixed UPEs that are discharged and put on Division 7A complying terms is that the first minimum yearly repayment is due in the year following the creation of the UPE. This is a year earlier than under the Existing View.
For percentage UPEs, the first minimum yearly repayment is due in the year following the lodgment of the income tax return (the same as under the Existing View).
Sub-trusts
Where a corporate beneficiary is presently entitled to trust income and the trustee sets aside an amount and holds that amount on sub-trust for the exclusive benefit of the corporate beneficiary, there is no UPE.
The amount set aside by the trustee ceases to be an asset of the main trust and forms the corpus of the sub-trust. The corporate beneficiary has a new right to call for payment of the sub-trust fund and can call the sub-trust to an end.
The ATO in the Draft Determination takes the view that the corporate beneficiary's choice not to exercise its right to end the sub-trust does not result in creation of a loan for Division 7A purposes because the funds in the sub-trust fund are held for the corporate beneficiary's sole benefit.
However, if the funds are used by a shareholder or associate of a shareholder, including the trustee of the main trust, this could amount to a section 109D loan by the corporate beneficiary to the shareholder or associate.
The approach in the Draft Determination with respect to sub-trusts is a change from the Existing View that allowed the funds in the sub-trust to be invested in the main trust on a (typically) 7 or 10 year interest only term.
However, for UPEs that are placed under a sub-trust, it will be important for records to be maintained to substantiate that the monies representing the UPE are in fact set aside for the sole benefit of the corporate beneficiary (rather than being intermingled or used by the main trust). This has similarities to ‘Option 3’ under the Existing View (being the least favoured option due to larger administrative burdens).
While there is less flexibility, the approach in the Draft Determination with respect to sub-trust arrangements should simplify compliance. UPEs are either segregated and held on sub-trust or discharged and placed on complying Division 7A loan terms.
Under the Existing View sub-trust arrangements were often used where the amount in the sub-trust was invested in the main trust in working capital, plant and equipment or real property acquisitions. Interest only arrangements as allowed under the Existing View enabled trading trusts to finance the business on interest only terms. The new arrangements will require trustees to carefully consider anticipated cashflow and their ability to fund payments of both interest and principal under the Division 7A terms - typically 7 years where not secured against real property.
We note that the proposed amendments to Division 7A outlined in the 2017 Treasury Consultation Paper would have resulted in a similar principal repayment obligation although that would have come with a proposed new unsecured 10-year loan term. Longer than the 7-year unsecured loans under Division 7A (but less than the 25 years for secured loans). The change in ATO interpretation introduces the principal repayment obligation but without the legislative extension of the loan term for unsecured loans.
Application date and transitional rules
The Draft Determination will apply from 1 July 2022. That is, the Existing View will apply to UPEs arising from 30 June 2022 present entitlements.
The ATO proposes that TR 2010/3 and PSLA 2010/4 (together the Existing View) “will be withdrawn with effect from 1 July 2022 for trust entitlements arising on or after that time”. In that guidance the ATO accepted that a section 109D loan did not arise where the funds representing a UPE were held on sub-trust and re-invested in the head trust on terms in accordance with PSLA 2010/4.
The ATO also says in the Draft Determination that with respect to arrangements that arise or arose on or before 30 June 2022, the ATO says “[w]e will not devote compliance resources to sub-trust arrangements that correspond to the guidance in TR 2010/3 and PS LA 2010/4 where the trust entitlement has been created on or before 30 June 2022. For the avoidance of doubt, this would include a sub-trust arrangement commenced on or after 1 July 2022 in respect of a trust entitlement arising before that date.”
What is not clear from the Draft Determination is what the ATO means by “we will not devote compliance resources”. Is this limited to conducting audits of those PSLA 2010/4 arrangements or does it extend to PSLA 2010/4 arrangements that the ATO becomes aware of during an audit? If it does extend, will the ATO be out-of-time to amend?
It appears that for trust entitlements arising on-or-before 30 June 2022, including pre-December 2009 UPEs, taxpayers may be able to rely on the then withdrawn Existing View (see paragraph 46 of the Draft Determination). However, that is not completely clear in the Draft Determination.
We hope the ATO clarifies this on finalisation of the Draft Determination or, at a minimum, issues a clarifying statement.
What does the Draft Determination mean?
Where a trust only bestows percentage present entitlements and either pays those in full or the UPE is discharged and placed on complying Division 7A loan terms, the effect of the Draft Determination should be minimal. Much ado about nothing?
Where there has been a practice of fixed present entitlements and / or PSLA 2010/4 sub-trust arrangements, the views in the Draft Determination will be a material change. A seismic shift?
Whether the Draft Determination is much ado about nothing, a seismic shift, or something in between, there is a risk that ‘rolling-over’ proforma resolutions, accounting entries, and documentation to the 30 June 2023 year could result in non-compliance with the Draft Determination and by extension the ATO’s view on the operation of Division 7A.
Sladen Legal’s tax team regularly advises on Division 7A and UPEs. If you have any questions about what the ATO views may mean for you and your arrangements, please contact:
Neil Brydges
Principal Lawyer | Accredited Specialist in Tax Law
M +61 407 821 157 | T +61 3 9611 0176
E: nbrydges@sladen.com.au
Daniel Smedley
Principal | Accredited Specialist in Tax Law
M +61 411 319 327 | T +61 3 9611 0105
E: dsmedley@sladen.com.au
Rob Warnock
Principal Lawyer
T +61 3 9611 0155 | M +61 419 892 115
E: rwarnock@sladen.com.au
Edward Hennebry
Senior Associate
T +61 3 9611 0113 | M +61 405 847 261
E: ehennebry@sladen.com.au
