Grant Thornton acts to avoid double taxation of private businesses

Commissioner releases draft tax ruling on the application of Division 7A to unpaid present entitlements to trust income

On 16 December 2009, the Commissioner of Taxation issued the draft tax ruling TR 2009/D8 Income tax: Division 7A loans: trust entitlements, which outlines his views on the tax treatment of unpaid present entitlements payable to trust beneficiaries.

Division 7A was introduced as an integrity measure in 1997 to target the private use of company funds by shareholders and their associates.  The measures were designed to ensure that shareholders were required to access company profits via a taxable dividend, instead of utilising funds without tax being paid at the shareholder level.

The situations contemplated by the Commissioner in TR 2009/D8 where a private company beneficiary has an unpaid present entitlement to trust income are quite different. As the entitlement remains unpaid, the related funds retained by the trust are commonly used to fund its business operations.  Consequently, shareholders of the private company beneficiary cannot access the funds and are unable to use them for private purposes. This situation is not dissimilar to a company in which the profits are retained and reinvested instead of being paid out as dividends. 

We believe that treating unpaid present entitlements as loans by the company beneficiary to the associated trust, where no actual loan has been made, goes well beyond the original policy intention of the Division 7A rules and is inequitable and unjustified.

Submission by Grant Thornton

We have lodged a submission with the ATO objecting to the proposals.  In particular, we are concerned that:

• the Commissioner’s views expressed in TR2009/D8 are inconsistent with the original policy objectives of Division 7A
• the draft ruling would result in double taxation applying to a large portion of family and private business taxpayers, given the extremely broad scope of the measures
• in particular, the draft ruling in its current form causes Division 7A deemed dividends to apply far too broadly
• the rules have potential for retrospective application
• given the potential retrospective application, and the fact that the Commissioner’s current view differs significantly from the previous interpretation and application of the law over many years the carve out proposed in the draft ruling is far too narrow
• further clarification is required as to the point in time at which unpaid present entitlements will be deemed to be loans for the purposes of Division 7A

Widespread double taxation

The scope of TR 2009/D8 is extremely broad and will impact on a significant segment of the family and private business taxpayer population, resulting in widespread double taxation. 

Trust beneficiaries are liable to tax in respect of the income year in which their present entitlement is declared, regardless of whether it is paid.  Thus, private company beneficiaries are already subject to 30% tax on their unpaid present entitlements.  By deeming unpaid present entitlements to be Division 7A loans and therefore, deemed dividends, the same amount of trust income will be taxed a second time.

Consequently, an overall tax rate of up to 76.5% (30%+46.5%) could be levied on any unpaid present entitlements to trust income.  This situation will apply in a very broad range of family and private business circumstances.

Loan instead of or in satisfaction of unpaid present entitlements

The draft ruling extends the concept of a loan to the extreme by arguing that a trustee applies amounts on behalf of a company beneficiary by converting unpaid entitlements to loans back to itself.  This appears to potentially apply even where no specific evidence exists of any intention to do so, as long as the trust deed allows the trustee to apply entitlements on behalf of beneficiaries.

In addition, in our experience, small business accountants quite frequently refer to unpaid present entitlements as “loans” in journal entries and financial statements. This occurs notwithstanding that trust deeds typically provide that unpaid present entitlements are held on sub trust. It can often occur with no agreement or understanding between the parties that the unpaid entitlements were to be converted to a loan.

In our view, this interpretation is excessively broad and will cause a significant portion of taxpayers to fall within Division 7A.

Subsisting UPEs and Division 7A loans

The draft ruling suggests that where a private company beneficiary allows a trustee to continue to utilise funds representing its entitlement then the company has provided financial accommodation to the trust. It follows that a loan has been made which would be subject to Division 7A.

In our view it is outrageous to seek to apply Division 7A, where a private company beneficiary does nothing other than fail to call for the immediate payment of its entitlement, particularly given that payment may have been deferred to allow for the working capital needs of the trust business. We consider that authorisation by acquiescence by the beneficiary is insufficient to constitute a loan to which Division 7A applies.

Retrospective application

The views outlined in the draft ruling are a major change in policy and in the interpretation and application of Division 7A. The Commissioner appeared to have accepted the position that unpaid distributions to companies were not loans, both by express comment and through consistent application of the law. A huge number of taxpayers have therefore allowed present entitlements to remain unpaid with no indication that a deemed dividend may be taken to arise under Division 7A.

The proposed carve out only applies in limited circumstances and would provide no protection from retrospective application for a significant number of taxpayers.

In our view it is critical that all retrospective application must be eliminated, particularly given the very significant change in policy and application of the law and the very widespread potential for significant double tax. Any retrospective application whatsoever would be profoundly unfair to a potentially massive number of family and private business taxpayers.

What happens next?

Once submissions close, the ATO will review them and decide on the next course of action. This may involve further consideration and consultation with the taxpayer community before a final tax ruling is released.

For more information on the Commissioner's draft tax ruling or Grant Thornton’s submission, contact your usual Grant Thornton advisor or the author of this article.

Author, Peter Godber, February 2010

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