The highly anticipated final version of Practice Statement PSLA 2010/4 was released on 14 October 2010.
The Practice Statement provides guidance on the application of Taxation Ruling TR 2010/3 which sets out the Commissioner's views as to when a private company with a UPE from an associated trust is considered to have made a loan for Division 7A purposes. The start date for the new 'rules' is 16 December 2009 which really means it applies to June 2010 distributions.
We have been heavily involved in the consultation process with the Australian Taxation Office (ATO) since February 2009 when the ATO's attitude first surfaced. Andrew O'Bryan, representing CPA Australia's Tax Centre of Excellence, has participated in each step of the consultation process, including assisting in drafting the professional bodies' submission on the draft ruling and attending the ATO's rulings panel and Division 7A Working Group meetings.
It has been emphasised to the ATO that, if it persisted with its approach and it became necessary for taxpayers to adopt different structures or funding arrangements for their investments or business, it may cause considerable financial stress. As such, the ATO was asked to adopt a practical approach which would enable and encourage compliance and not cause immediate financial stress.
One aspect that was emphasised to the ATO was the fact that there will be cases where the UPE is incorrectly recorded in the financial statements and/or general ledger as many of the accounting software packages do not accommodate UPEs in their standard chart of accounts. The ATO has recognized this and has proposed that taxpayers can correct their accounts if that is the case. Unfortunately, the opportunity is somewhat limited.
Even so, the Practice Statement is to be welcomed in that regard. There is always the concern that it is not a binding ruling, which means it may not be followed when it gets to the 'pointy' end of a dispute with the ATO.
While the debate continues to rage over who is correct, tax advisors and clients need to get on with making decisions. The ATO has agreed to fund a test case so it is now a matter of who will become famous as the 2011 equivalent of 2010's Bamford. In the meantime, the Practice Statement helps give some direction.
The Ruling and the Practice Statement contemplate two scenarios:
- the UPE has been satisfied and there is in fact a loan between the company and the trust (section two loans); and
- there is a subsisting UPE which is considered to be the provision of financial accommodation which falls within the extended definition of a 'loan' in Division 7A (section three loans).
Section two loans
The Practice Statement describes a section two loan as:
A section two loan is a loan within the ordinary meaning of the term 'loan'. Such a loan can arise in situations where a UPE is satisfied (for example, by being paid out) and loaned back to the trustee. The UPE will effectively be replaced by an ordinary loan.
There are two types of section two loans:
Type 1: Loan agreement either express or implied
Where the agreement is evidenced by:
- a written agreement;
- a trust resolution; or
- another document.
An implied loan agreement will arise where the UPE is recorded in both the company and trust's accounts as a loan.
The UPE won't be an implied loan if:
- it is recorded as a UPE in both sets of accounts; or
- it is recorded as a UPE in one set of accounts and as a loan in the other, or vice versa.
This gives rise to the issue of what do "financial accounts" encompass? At the Division 7A Working Group meeting in June 2010 it became apparent that, if the financials are ambiguous, the ATO will drill down to the underlying general ledger, looking for clarity, and that might cause some concern.
Type 2: Where the trustee exercises a power under the trust deed
A type 2 loan will arise where:
- the trustee has exercised the power under the trust deed to pay or apply money to or for the benefit of the corporate beneficiary and the exercise of the power to apply the trust funds in that manner is clearly evidenced in a trust resolution or other written document;
- the financial accounts of the trust have recorded the amount as a loan.
We doubt many type 2 loans actually exist.
Where there is a section two loan, the Commissioner has provided some taxpayers with a self corrective option, especially where there is an implied loan because of misclassification.
Until 31 December 2011, a company or trust may correct the accounts where a UPE has been misclassified as a loan.
A taxpayer must satisfy the following conditions:
- the financial accounts of the trust and/or the company have incorrectly classified the amount, which is in fact a UPE, as a loan;
- except for the accounts, all available evidence supports their being a UPE;
- the company has not included the UPE as a loan reported at Label 8N of the company's tax return;
- the trust has not paid or credited any interest on the UPE;
- the loan account in which the amount is included relates only to UPEs and is not affected by any unrelated transactions; and
- the trustee of the trust/public officer of the company signs and dates a declaration setting out all of the above conditions in the context of the UPE and declaring them to be true and correct.
If these steps are taken, the UPE will not be caught by the new rules.
Commissioner's discretion under section 109RB
Where a taxpayer cannot meet the requirements for the self-corrective option, they may seek to take advantage of the Commissioner's discretion under section 109RB to disregard any deemed dividends.
Usually, the taxpayer will need to apply for the exercise of the 109RB discretion. However, the taxpayer may undertake its own self-correction and self-assess the exercise of the discretion where:
- the failure to comply with Division 7A is the result of an honest mistake or inadvertent omission;
- the trust and the company are small business entities (ie they carry on a business with a turnover of less than $2 million);
- the loan was used by the trust solely for carrying on business;
- the taxpayer takes 'corrective action' on or before 31 December 2011;
- the company and the trust have lodged all required tax returns up to 2009/10 and have a good history of tax compliance; and
- the trustee of the trust is not a shareholder of the company.
This is similar to PSLA 2007/20 which provided for the first big corrective action opportunity in 2007/08.
We have serious concerns about the requirement that there has been an 'honest mistake' or 'inadvertent omission' which has caused the Division 7A breach.
The most practical issue is whether there can be considered an honest mistake or inadvertent omission where there is ignorance. In our experience, it is a practitioner's ignorance in perhaps not being fully aware of, or misinterpreting, provisions which results in a Division 7A breach.
The ATO's position is that ignorance cannot give rise to an honest mistake. Various statements made by the ATO lead us to believe that the ATO is intent on a very narrow interpretation of these gatekeeper terms. You should be cautious about assuming that the discretion will be exercised.
Section three loans
A section three loan is a subsisting UPE which, while not a loan within the ordinary meaning, may be a loan under the extended definition in Division 7A if it is the 'provision of financial accommodation'.
Subsisting UPEs at 16 December 2009 are quarantined from the new rules and no action needs to be taken. Of course, 'paying' them out in the future could be a good idea as it needs to happen at some stage!
The Practice Statement focuses on when the Commissioner considers that a UPE becomes an extended meaning loan. To escape that net, the UPE needs to be paid out, converted to a complying loan or be held on sub-trust and used for the company's sole benefit.
There has been much conjecture and disagreement on the question, when does a sub-trust exist? Notwithstanding this uncertainty, the Commissioner will consider that there is a sub-trust where:
- the UPE is set aside separately in the accounts of the trust as being held on trust for the company;
- separate accounts are prepared for the sub-trust; or
- a separate bank account is opened in the name of the trustee as trustee for the company for the UPE funds.
To meet the sole benefit requirement the sub-trust must be entitled to a proper commercial return which is paid to the company by the applicable tax lodgement day.
A taxpayer may determine the appropriate terms of the investment in light of these requirements (and hope it is applicable) or adopt one of three options.
The Practice Statement states that the trustee must not swap between the options once the investment is made until that investment is paid out to the corporate beneficiary.
Option 1: Invest the funds on an interest only seven year loan
Under this option, the trustee loans the UPE funds on a seven year interest only loan from the sub-trust to the main trust. The trustee must pay an annual return on the funds equal to the benchmark interest rate as defined by subsection 109N(2).
If Option 1 is used, the principal must be paid out within seven years. The taxpayer must document the terms of the investment agreement. The requirement to document the agreement will be satisfied if it is evidenced in the tax return working papers. However, we doubt that tax return working papers will actually satisfy that requirement, so it will be best to properly document the arrangement.
For 2010 UPEs, the key dates are: please click here.
Effectively it is an eight year loan, as the seven years doesn't start for a year.
For 2011 UPEs, the key dates are: please please click here.
Option 2: Invest the funds on an interest only 10 year loan
This option is the same as option 1 but with a higher interest rate: 'the prescribed interest rate'.
The prescribed interest rate for a particular income year is the Reserve Bank of Australia's (RBA) indicator lending rate for small business variable (other) overdraft for the month of May immediately before the start of that income year. The rate for the year ending 30 June 2011 is 10.3%.
The key dates are the same as those for Option 1, meaning it is really an 11 year loan.
Option 3: Invest the funds in a specific income producing asset or investment
Under this option, the trustee invests the UPE funds in a specific investment such as an interest bearing account or the acquisition of an interest in an income producing asset. The Commissioner defines an 'income producing asset' as one which is held with the intention of generating assessable income at an arm's length commercial amount.
The trustee's investment under Option 3 must be reflected in the accounts of the sub-trust. Unlike Options 1 and 2, the sub-trust is required to prepare its own accounts showing the investment and will also be required to lodge its own tax return. This seems odd to us, as the 'transparent trust' rules should apply in which case no return is required.
An investment under Option 3 must be recorded in the tax return working papers of the main trust and the sub-trust. If the UPE funds are used to acquire only part of an asset, the working papers must clearly identify the percentage of the specific asset that is held by the sub-trust.
As mentioned, the ATO is keen to fund a test case to clarify the issue. Apparently the Government is not interested at this stage in legislating to reflect the ATO's position.
We mentioned in earlier articles that the crux of the problem is not Division 7A but Division 6 – dealing with the taxation of trusts. Is the strategy behind longstanding UPEs to keep the profits in the trust but avoid a 46.5% tax assessment under section 99A of the ITAA 1936? In many cases it is. The ATO may attack the issue on this front, arguing that there is an ineffective distribution and no present entitlement to the company in the first place. Central to this is section 100A – the sleeping anti avoidance provision in Division 6. We understand the ATO has escalated section 100A as an issue requiring consideration which may result in a public ruling. Stay tuned!
The instability of both Division 6 pre and post Bamford and now Division 7A means that it is a good opportunity to step back and look at existing structures and funding arrangements. It might be time for a change.
The ATO is about to release discussion papers on two post-Bamford issues: What is income of a trust estate? and whether streaming is dead.
It is likely that the instability in the law will remain for some time yet, which makes it difficult to advise. As discussed in our June 2010 update, it is too early to tell whether deed amendments are necessary or appropriate. However, it might be a good idea to get ready, by finding the deed and reading it. We did review a bundle of deeds for a client in June ... and discovered that one trust holding millions of dollars worth of profitable shares was due to vest yesterday!!