The ATO has released its draft ruling TR 2009/D8 on the application of Division 7A to unpaid trust distributions to a company. This is a brief note on the general approach adopted by the ATO. The draft ruling requires considerable scrutiny.

This issue has probably been the 'highlight' of 2009 for private client practitioners, although the Bamford decision regarding trust distributions more generally is probably only a short half head behind.

TR2009/D8 attempts to address circumstances in which it could be considered that an unpaid present entitlement (UPE) is turned into a loan for Division 7A purposes and, more particularly, the circumstances in which Subdivision EA, which deals specifically with UPEs, is inapplicable.

The most important aspect to note is that the ATO proposes that its new approach will only apply on a prospective basis to what I would call the standard UPE scenario [phew - breathe a sigh of relief]. At paragraph 55 it states:

'...In any case where Section 3 or Example 5 of this draft Ruling is less favourable to a taxpayer than the Commissioner's previous practice, it does not apply to UPEs arising before the date of issue of this draft ruling.'

Section 3 and Example 5 cover what I would call the typical UPE scenario: a present entitlement is declared in favour of the company beneficiary and the trust deed provides that, if it is not paid, it is held on a sub trust for the beneficiary, ...and it is accounted for in that way.

Paragraph 54 states:

'Subject to the exception mentioned in paragraph 55..., when the final ruling is issued, it is proposed to apply both before and after its date of issue.'

The ruling goes on to say that:

'Section 3 and Example 5 of this draft Ruling have this date of effect due to prior public statements the Commissioner has made which evidence a prior general administrative practice contrary to the view as set out in Section 3. Many former versions of the fact sheet Division 7A - Answers to frequently asked questions published prior to February 2009 advised that the retention on trust of an unpaid present entitlement was not a loan for Division 7A purposes.'

Further:

'Whilst the prior public statements referred to in paragraph 56...considered whether a subsisting UPE could be a loan for Division 7A purposes, they do not encompass the situation discussed in section 2 of this draft ruling.'

Section 2 addresses the circumstances where a UPE has been converted into a loan by the action or inaction of the trustee and the company beneficiary.

The scary part here is that, as Deputy Commissioner Mark Konza suggested in his initial address earlier this year which brought the whole issue to light, the way in which the accounts have been drawn up for the trust and the company may reflect the fact that the parties have adopted the arrangement as a loan and no longer as a UPE. In simple terms if, rather than reporting the UPE as a beneficiary's entitlement in the trust, and as a receivable in the company, it is recorded as a loan by both parties, the scenario will be outside Subdivision EA.

At paragraph 8 there is an example:

'If a trustee credits amounts to a loan account held in the name of the private company beneficiary, with the authorisation of the private company, the private company will have lent money to the trust within the ordinary meaning of a loan. Such authorisation may arise through acquiescence with full knowledge of what the trustee has done. As the trust and beneficiary form part of the same family group, the Commissioner will form the view that the private company has knowledge of what the trustee has done, subject to sufficient evidence to the contrary.'

Interestingly, in the background section of the ruling it is stated that:

'In relevant circumstances, a private company can cause a Division 7A loan to occur by the conscious non-doing of an act, such as intentionally not calling for payment of a UPE.'

The ATO accepts that, as a starting point, a UPE does not give rise to a loan. However, is there a point where the subsisting UPE amounts to the provision of financial accommodation or a straight out loan which flips you out of Subdivision EA and into the general provision of Division 7A?

This is what the ruling doesn't address in any detail: what is the trigger point? If the company beneficiary doesn't have a bank account or the entitlement isn't paid out within 7 days? 3 months? 1 year? How long can the company directors procrastinate before it becomes, "the conscious non-doing of an act"?

At paragraph 16 the ruling states:

'A private company beneficiary will be said to have provided financial accommodation to a trust in which it has a UPE if that private company has, under a consensual agreement:

supplied or granted some form of pecuniary aid or favour to the trust; and a principal sum or equivalent that is ultimately payable.

A consensual agreement may arise where the private company authorises (including by acquiescing with knowledge) the continued use by the main trust of funds representing the private company's UPE for trust purposes by not calling for:

  • payment of that UPE; or
  • investment of the funds representing the UPE for the private company's absolute benefit (and no benefit accruing to the main trust for the use of those funds).'

It goes on to say at paragraph 22:

  • 'Moreover, in these circumstances, the mere declaration of the private company's trust entitlements does not embody the real nature of the overall transaction between the trustee and the beneficiary. Here, the overall transaction between the private company beneficiary and the trustee includes the beneficiary's authorisation (or acquiescence with knowledge) that the funds representing the UPE can be used for the benefit of the main trust and effects, in substance, a loan of the money to the main trust'.

The ruling doesn't seem to require UPEs which will be quarantined pre -16 December 2009 UPEs to be paid out or turned into complying Division 7A loans.

Where to now?

Firstly, perhaps print a copy and add it to your summer reading; I shall leave it to you whether it goes in the fiction or non-fiction stack.

The ruling calls for comments by 12 February 2010 and, on behalf of CPA Australia, Michael Parker and I will be participating in the drafting of the professional bodies joint submission on the draft.

In the meantime, be mindful of the wording of paragraph 55 providing prospective application of the final ruling: that it does not apply to UPEs arising before the date of issue of this draft ruling. So, 16 December 2009 joins the list of iconic tax dates to become embedded in our already congested tax minds.

As in comedy, share trading and having a medical check-up, timing is everything, so if 2009 trust distributions have been completed, the real concern will be for 2010 distributions.

So, if the mistake hasn't been to account for or deal with the UPE to convert it to a loan the concern is "confined" (but in no small way) to the circumstances described in paragraphs 16-26 and Example 5 (paragraphs 46 - 50).

Fittingly perhaps, the final words of the ruling are: "...a tax benefit may arise and the application of Part IVA would need to be considered".

I leave you with an extract of the minutes of the Victorian Tax Technical Liaison Group meeting in June 1995 on the proposition:

"An allocation to a company beneficiary, but retained by the trust and used for the general purposes of the trust would not be subject to section 108."

The ATO response was:

"... assuming that the trustee can be found to have effectively exercised its discretion to favour a corporate beneficiary, in the circumstances given in the proposition, Part IVA could potentially apply. The favouring of the corporate beneficiary might be seen to be solely for the purpose of accessing corporate rates of tax. That impression could be formed if, for example, the company had been recently made a beneficiary and/or did not have an obvious use for the funds.  

If the arrangements are not a sham and Part IVA does not apply, and in the absence of any reimbursement agreement being found which would attract the operation of section 100A, the company beneficiary will be assessable [unless it has effectively disclaimed its entitlement] pursuant to the provisions of section 97 on the appropriate portion of net trust income to which it is presently entitled."