The ATO has revised its view regarding unpaid present entitlements (“UPEs”) for Division 7A purposes that has been in effect since 16 December 2009. For UPEs arising on or after 1 July 2022, TR 2010/3 and PS LA 2010/4 will be withdrawn with the consequence that interest-only complying sub-trust arrangements will no longer be accepted.
Distributions made to corporate beneficiaries on or after that date will be treated as Division 7A loans if left unpaid. Where entitlements are set aside on a separate trust, they will be considered to give rise to Division 7A loans when the funds are used by a shareholder (or associate of a shareholder) of a private company. The precise timing of the Division 7A loan will depend on whether the corporate beneficiary is made entitled to a specified amount of income or a proportionate share, the latter potentially allowing for a 12-month deferral for the commencement of the Division 7A loan and first minimum yearly repayment.
History of Division 7A and the treatment of UPEs
Division 7A of Part III of the Income Tax Assessment Act 1936 is an integrity rule to prevent disguised tax-free distributions of profits from private companies by informal means such as payments, loans and forgiving debts. Such transactions may give rise to an unfranked deemed dividend to a shareholder (or an associate of a shareholder) of a private company. The definition of loan for Division 7A purposes has an extended meaning that includes the provision of any form of financial accommodation.
Historically, where a trust conferred a present entitlement to a private company that remained unpaid, this was not considered to be a loan or the provision of financial accommodation from the company to the trust. Provisions such as Subdivision EA and former section 109UB were introduced to treat certain transactions (e.g., loans) entered into by the trust as deemed dividends while a UPE to the private company remained unpaid.
The ATO reversed their position from 16 December 2009 (in what became Taxation Ruling TR 2010/3) and formed the view that the private company beneficiary’s failure to demand payment of the UPE was itself a form of financial accommodation provided to the trust unless the funds representing the UPE are held for the sole benefit of the company.
In Practice Statement PS LA 2010/4, the ATO provided three options for “complying sub-trust arrangements” which would be accepted as circumstances in which a UPE would not give rise to a Division 7A loan. These included 7-year and 10-year interest-only arrangements.
What is the revised ATO view on UPEs?
The revised view is contained in Draft Taxation Determination TD 2022/D1 (“Draft TD”) (click here). The revised view sets out two circumstances when a beneficiary will be taken to provide financial accommodation to a trust:
- Distributions that are unpaid and retained in the trust – There is a UPE which the beneficiary has knowledge of but fails to demand payment, thereby consenting or acquiescing to the trustee retaining those funds for trust purposes. This consent or acquiescence constitutes the provision of financial accommodation.
- Funds set aside on a separate trust – Where the trustee sets aside funds representing the beneficiary’s entitlement on separate trust, the UPE is satisfied, and a sub-trust comes into existence. The beneficiary has a new right to bring the sub-trust to an end by calling for payment of the funds. Simply not demanding payment does not amount to financial accommodation to the sub-trust However, if the funds of the sub-trust are used by another entity, the beneficiary’s consent or acquiescence to this use constitutes the provision of financial accommodation to the entity which uses the funds.
The Draft TD states that because UPEs will either be loans or otherwise be discharged (where set aside on separate trust), Subdivision EA will have limited ongoing operation in respect of post 1 July 2022 UPEs.
When do the changes apply from?
The revised view applies to trust entitlements that arise on or after 1 July 2022 and will not affect arrangements in the current (30 June 2022) financial year.
The Draft TD (when finalised) will come into effect and TR 2010/3 and PS LA 2010/4 will be withdrawn from 1 July 2022. As such, this is the final income year in which taxpayers can take advantage of complying sub-trust arrangements in PS LA 2010/4. The Draft TD confirms that the sub-trust arrangements can be put in place after year-end (e.g., by the 15 May 2023 lodgment day) so long as the trust entitlement arose before 1 July 2022.
Therefore, 30 June 2022 UPEs that are put on 7-year or 10-year complying sub-trust arrangements may run until 14 May 2030 and 14 May 2033 respectively.
How does this differ from the existing approach?
In the 2018-19 Federal Budget, the Government announced that it would codify the treatment of UPEs by expressly bringing them into Division 7A. However, this announcement has not been legislated in the four years since it was announced. The revised view appears to be the ATO’s attempt to give effect to this announcement by administrative means. The Draft TD notes that the view in TR 2010/3 is no longer supportable due to the weight of case law.
While the ATO’s reasoning and explanation in the Draft TD is somewhat complex and open to scrutiny, the practical consequence of their revised view is that distributions to corporate beneficiaries will generally give rise to Division 7A loans where the funds are not paid to the company (unless the sub-trust uses the funds to invest with unrelated parties).
This is not radically different in practical effect from the current approach. Currently, to avoid a deemed dividend, a UPE will generally need to be placed on complying terms (or replaced with a complying loan) requiring annual interest and principal repayments in accordance with section 109N or otherwise invested in a PS LA 2010/4 complying sub-trust.
The key difference under the revised view is that PS LA 2010/4 complying sub-trust arrangements, particularly the 7-year and 10-year interest-only options, will no longer be accepted. However, the revised view appears to in effect maintain “option 3” type sub-trusts where funds are actually set aside on separate trust for the beneficiary and invested for the corporate beneficiary (e.g., in bank deposit).
The timing of when financial accommodation arises and complying loan agreements need to be in place is discussed below.
When will the beneficiary be taken to provide financial accommodation?
The Draft TD sets out a view that the financial accommodation (and therefore Division 7A loan) is taken to be made when the company has knowledge of its entitlement and fails to demand payment. In most cases, the ATO asserts that the company will be taken to have the same knowledge as the trustee where both entities have the same controlling mind.
The Draft TD states that where the trust resolves to distribute a fixed or specific amount to the beneficiary, the ATO will hold that the knowledge of the entitlement (and Division 7A loan) will be instantaneous. Where the trust resolves to distribute a non-specified amount, such as percentage of its annual income, the beneficiary will generally be taken to have knowledge of the amount of its entitlement sometime after year-end such that the Division 7A loan will occur in the subsequent year of income.
It is unfortunate that the ATO has adopted a view that provides for two possible outcomes regarding the timing of the Division 7A loan as this appears to needlessly complicate administration and compliance. In contrast, TR 2010/3 took a uniform approach whereby the financial accommodation and Division 7A loan was always taken to be made in the year following the trust entitlement arising.
The complexity can be demonstrated where distributions flow through multiple trusts. For example, if Trust A distributes a fixed amount ($100,000) to Trust B, who then distributes a percentage (e.g., 100%) of its income to Company A. In this example, even though a percentage is distributed to the company, the ATO could argue that the company has knowledge of the fixed amount immediately.
The consequence of the two possibilities regarding timing are that UPEs arising in the 2023 financial year may give rise to Division 7A loans which need to be put on complying terms by 15 May 2024 or 15 May 20251, depending on whether the entitlement is to a fixed amount or a percentage of income. The first annual repayment would need to be made by 30 June 2024 or 30 June 2025 with the last repayment due on 30 June 2030 or 30 June 2031 where a 7-year loan term is adopted.
How will existing PS LA 2010/4 UPEs that mature be treated?
PCG 2017/13 was released in 2017 to allow PS LA 2010/4 complying sub-trusts that became due in the 30 June 2017 year to essentially be refinanced with a 7-year 109N complying loan with annual interest and principal repayments that would be ultimately repaid 15 years after the UPE arose.
PCG 2017/13 has since been updated three further times to cover complying sub-trusts maturing in the 2018, 2019, 2020 and 2021 income years, including 10-year “Option 2” complying sub-trusts.
At this stage, the ATO has not stated whether they will update PCG 2017/13 to all PS LA 2010/4 sub-trust arrangements. We would be hopeful that a similar approach is taken with respect to UPEs that mature in the 2022 and later income years as a means to wash these out of the system.
How will pre-09 UPEs be treated?
The Draft TD does not disturb the treatment of UPEs which arose before 16 December 2009. These can continue to be quarantined by trusts. However, Subdivision EA may apply to deem a dividend where a trust makes a loan to a related party while a pre-09 UPE remains outstanding.
Interaction with Section 100A
Regardless of whether UPEs are pre-16 December 2009, post 16 December 2009 or post 1 July 2022, these arrangements should not be considered from a Division 7A perspective alone. Existing and new UPE arrangements should also be reviewed from a section 100A perspective in accordance with the ATO’s new section 100A guidance released in conjunction with the Draft TD. Whether the particular arrangements will be considered low or high risk will depend on particular circumstances such as how the of funds were used by the trust.
What are the next steps?
It is critical that clients consider their position and how the rules apply. Clients should contact their Pitcher Partners representative to review their situation and determine what action is required well before 30 June.
1 Assuming the corporate beneficiary’s lodgment day for the 2023 year is 15 May 2024.
