The ATO has long been uncomfortable with “unpaid present entitlements” – distributions by trusts to associated private companies or bucket companies that were not paid, but remained intermingled with other funds of the trust. On 16 December 2009 the ATO signalled that it would take a more aggressive approach to this practice by the issue of Draft Taxation Ruling 2009/D8. The draft taxation ruling has now been finalised as Taxation Ruling 2010/3. Does it spell the end of the use of unpaid present entitlements and bucket companies by family businesses?

How does Division 7A work?

In certain circumstances, Division 7A of the Income Tax Assessment Act 1936 deems economic benefits provided by private companies to shareholders and “associates” to be dividends. The result is that the economic benefits form part of the assessable income of the relevant shareholder or “associate” and are subject to tax.

One of the benefits that Division 7A seeks to attack is interest free loans. An interest free loan will be treated as a dividend unless the offending loan is put on Division 7A compliant terns (i.e. the loan will need to be documented in writing and interest charged at the benchmark interest rate). The amount of the dividend is restricted to the company’s distributable surplus.

Unpaid present entitlements and the “bucket company”

Family businesses are commonly structured using a combination of discretionary trusts and private companies. Due to the fact that trusts have to distribute all of their income to avoid paying tax at the highest marginal tax rate, it has become common practice for family discretionary trusts to declare a distribution of income to a private company beneficiary (“bucket company”) to cap the applicable tax at the company tax rate of 30 per cent. However, the declared distribution is often not paid, but retained in the trust. The unpaid distribution is referred to as an unpaid present entitlement (UPE).

If a UPE is loaned back from the private company to the trust Division 7A can attack that loan and deem it to be a dividend paid by the private company to the trust.

Draft Taxation Ruling

Although numerous submissions were made on the draft ruling by professional associations, emphasising the long standing use of unpaid present entitlement, and the ATO’s apparent acceptance of the practice, the ATO finalised the draft Ruling and released Taxation Ruling 2010/3 (TR 2010/3) and Draft Practice Statement PS LA 3362 (PS LA 3362) in June 2010. The final ruling represents a shift away from the ATO’s previous acceptance of this practice.

Relevantly, TR 2010/3 provides that an UPE from a trust to a private company beneficiary will be a loan for Division 7A purposes in the following two circumstances:

  1. a loan within the ordinary meaning (this is discussed in section two of the Ruling and, hence, the ATO refers to these arrangements as “section two” loans), and
  2. a loan within the extended meaning of “loan” (this is discussed in section three of the Ruling and the ATO refers to these arrangements as “section three” loans).

1. An ordinary loan (a “section two” loan)

The so-called “section two” loans are not a new concept and, according to the Ruling and the Practice Statement, have always been considered to be potential Division 7A loans by the ATO (albeit never specifically investigated).

Where a family group is concerned, the ATO will consider an existing UPE to be a loan if:

  • an amount has been credited by the trustee of the trust to a loan account in the name of the private company beneficiary, and
  • under the trust deed the trustee has the power to do so as a payment or application of trust funds for the benefit of that private company

unless there is sufficient evidence that the trustee did not intend to create a loan.

Thus, all UPEs need to be reviewed to determine whether they will be treated by the ATO as a “section two” loan.

2. A Division 7A loan within the extended meaning (“a section three” loan)

The ATO will only treat a UPE as a “section three” loan if the UPE arose after 16 December 2009, being the date the draft ruling (now finalised as TR 2010/3) was issued.

In the context of a family group, the ATO will now treat any UPE that is not “called for” by the private company as a “section three” loan unless a sub-trust is created for that UPE. Paragraphs 23-26 of the Ruling explain the ATO’s reasoning for this new practice:

“23. Accordingly, if a private company beneficiary has knowledge that funds representing its UPE are being used by the trustee for trust purposes (rather than being held and / or used for that private company's sole benefit), in not calling for payment of its UPE the private company provides the trustee with financial accommodation and, by extension, makes a Division 7A loan to the trustee.

24. The overall transaction between the private company beneficiary and the trustee includes:

  • the use of the funds representing the private company's UPE by the trustee for trust purposes (until such time as the UPE is called for), and
  • the private company's authorisation (or acquiescence with knowledge) of this use.

25. As such the overall transaction also effects, in substance, a loan of money from the private company to the trustee of the trust.

26. Where the trust and beneficiary form part of the same family group, in the absence of sufficient evidence to the contrary, the Commissioner takes the view that the private company has knowledge of the trustee's use of the funds representing the UPE for trust purposes.”

The only way to avoid the UPE becoming a “section three” loan in a family group setting is for a sub-trust to be established. In order to implement a satisfactory sub-trust, the funds representing the UPE need to be kept separately from the main trust funds, the entire net return on the funds in the sub-trust (where these are invested in a specific investment) will need to flow back into that sub-trust and there needs to be a requirement that the amount invested needs to be ultimately repayable to the sub-trust. The existence of these conditions will be evidence of the fact that the funds are not used for the trust’s broader purposes but solely for the private company beneficiary.

The final requirement is that the sub-trust needs to make minimum payments to the private company beneficiary each year. Such payments are intended to reflect the annual return of the net income of the trust that represents the funds held on sub-trust.


Family groups that have made use of UPEs should take the following action:

  • all UPEs, whether arising before or after 16 December 2009, need to be examined to determine whether they have been documented as a loan and whether that treatment is permitted by the trust deed,
  • UPEs arising after 16 December 2009 should be called for by the private company, or placed into a complying sub-trust. UPEs that remain outstanding (i.e those that are not paid to the private company or placed into a complying sub-trust) until the end of the income year after the income year in which the distribution was declared, will be treated by the ATO as a Division 7A loan.

We can assist in advising clients on the application of Division 7A to outstanding UPEs. Where UPEs are placing the structure at risk of compliance activity by the ATO, we can prepare documentation to place offending UPEs on Division 7A compliant terms.