ATO Taxation Ruling TR 2010/3

On 2 June 2010, the ATO released a Ruling, setting out the Commissioner's views on when a private company with an unpaid present entitlement from an associated trust is considered to have made a loan to the trust within the meaning of subsection 109D(3) of Division 7A of Part III of the Income Tax Assessment Act 1936 (Div 7A).

You can access a copy of the Ruling here.

What is an 'unpaid present entitlement'?

An ‘unpaid present entitlement’ is a distribution from a trust which a trustee has decided to make, but has not yet paid out. It also applies to an amount not yet paid out of a sub-trust.

Simply put, an ‘unpaid present entitlement’ arises when a trustee:

• makes a beneficiary (for present purposes assume the beneficiary is a company), entitled to some or all of the income of the trust for a particular income year; but
• continues to hold those funds on trust for that beneficiary, until the beneficiary calls for payment.

The Ruling: in brief

Broadly, the Ruling provides that if a private company that is the beneficiary of a trust has an ‘unpaid present entitlement’ from that trust, then the company will be considered to have made a ‘Div 7A loan’ to the trust if either:

• the ‘unpaid present entitlement’ has been satisfied (by the trustee paying it to the company) and the company agrees to loan that amount to the trust; or
• if the company does not call for payment of the ‘unpaid present entitlement’ and therefore ‘agrees’ that it can be used for trust purposes.

  This ruling has not materially changed from what was detailed in the draft ruling, TR 2009 D8.

What does the Ruling change?

Before the issue of this Ruling, the ATO's position was that ‘unpaid present entitlements’ were not treated as loans for Div 7A purposes.

Tell me about Div 7A

You can read a brief outline of Div 7A here.

When will an ‘unpaid present entitlement’ result in a Div 7A loan to the trust?

A loan by a private company can be taxed under Div 7A in each of the following circumstances:

1. The company has an ‘unpaid present entitlement’ (UPE) and there's an express loan agreement. The company loans money to the trustee (as trustee) under an express agreement, and the loan partly sets-off the trustee's obligation to pay the company its trust entitlement.
2. The company has an UPE and an agreement as to a loan can be implied. The company:
   • knows that the trustee has treated the UPE as having been satisfied and a corresponding amount borrowed back (as evidence for example, by crediting a loan account in the name of the private company beneficiary); and
   • agrees to that treatment.
   
   In that case, the ATO will infer that the company has consented to that loan being made. The agreement between the company and the trustee may therefore be an implied agreement. However, if the company acts inconsistently with treating the amount as a loan to the trust, then the company will not be seen to have given its consent.
3. The company has a UPE and the trustee credits the company's loan account. Rather than paying the money to the company, the trustee on behalf of the company, acts under a term of the trust deed and pays, or applies, the amount of the UPE to, or for the benefit of, the beneficiary. Again, this is documented by crediting the company's loan account.
4. The company has a UPE, and there's a loan within the 'extended meaning'. The company provides financial accommodation, or an in-substance, loan to the trustee and either:
   • chooses not to call for payment of the UPE; or
   • authorises the trustee to continue using those funds for trust purposes.

   The Commissioner considers this is a 'loan' within its 'extended meaning' for the purposes of Div 7A.

What ‘knowledge’ is attributable to companies and trusts in a family group?

A company is treated as knowing anything that is known to its directors. Consequently, if the same person or people are the 'directing mind and will' of both the relevant private company and the trustee in the same family group, then the company and trust will be treated as sharing the same directing mind and will.

In light of this, it is important to be mindful that (unless there is evidence to the contrary), if a trust and a private company beneficiary form part of the same family group, then the Commissioner takes the view that the private company has knowledge of the trustee crediting a loan account in its name. An example of this is described in paragraph 2 above under the heading above ‘When will an ‘unpaid present entitlement’ result in a Div 7A loan to the trust?’

What are the implications for small businesses?

The changes affect small businesses that use private companies as beneficiaries in an attempt to limit tax on trust distributions at the 30% company tax rate.

Essentially, the company:

• in tax year one is taxed on the UPE— even though the money has not actually been paid out (this is fairly common); and
• in tax year 2, is treated as having made a Division 7A loan to the trust which (because there is no principal or interest repayments) is then treated and taxed as an unfranked dividend to the trust.

As taxable income of the trust in tax year 2, the trustee again distributes the net income to the company as a beneficiary of the trust and the company is taxed again in tax year 2. Thus, over tax years 1 and 2 — although there has not been any actual distribution paid to the company — it has tax liabilities in both tax years.

When does the Ruling apply?

The Ruling applies to UPEs retrospectively.

Are there any exceptions?

If the UPE was created before 16 December 2009, then the Ruling will not apply to circumstances outlined in paragraph 3 under the heading above ‘When will an ‘unpaid present entitlement’ result in a Div 7A loan to the trust?’

What can trustees do to protect a tax position?

Trustees should:

• review the Ruling to determine how the position of the ATO will impact on the trust’s current arrangements;
• consider what changes (if any), need to be made to the trust, or to how distributions are paid and satisfied;
• review any earlier year UPEs of private company beneficiaries and determine whether the ATO would consider these to have been converted to a loan giving rise to a deemed unfranked dividend; and
• always seek professional advice.

Practical tips from the ATO

The ATO has published a Draft Practice Statement Law Administration PS LA 3362 (Draft Practice Statement) offering practical guidance on the administrative aspects of the Ruling. You can access a copy of the Draft Practice Statement here.

The Institute of Chartered Accountants has summarized the key implications set out in the Draft Practice Statement as follows:

• Has a UPE converted into an ordinary loan? If so when did that happen? – the Draft Practice Statement indicates that the ATO will initially look at how the UPE is accounted for in the trust's and private company’s accounts.
• When will the subsisting UPE become 'financial accommodation'? – the Draft Practice Statement indicates at the end of the income year after the income year to which the UPE relates.
• What, in the ATO's view, evidences an UPE held under a sub-trust which is held for the sole benefit of the private company beneficiary? – the Draft Practice Statement provides some guidelines on the investment of the UPE amount in the main trust by the trustee of the sub-trust.
• Is interest paid by the trust to the private company beneficiary deductible under a Div 7A compliant loan agreement put in place to replace the UPE? – the Draft Practice Statement indicates it is generally deductible.

The Draft Practice Statement does not represent the final view, or process, of the Commissioner. Even so, the ATO has advised that if taxpayers reasonably rely, in good faith, on the Draft Practice Statement to determine the tax treatment of trust distributions made in respect of the 2010 financial year, then they will be given the same protection from interest and penalties as would be the case if this was a final practice statement.

Public comments on the Draft Practice Statement

Public comment on the Draft Practice Statement was due on 25 June 2010.