Developments in trust taxation

Recently, there have been some major developments in trust taxation, with the release of the final ruling on trust unpaid present entitlements, TR 2010/3 and the accompanying draft practice statement PS LA 3362 as well as the ATO’s publication of the Decision Impact Statement on the Bamford case.

So, what is the ruling all about and how could it impact you?

Tax consequences of unpaid present entitlements under TR 2010/3
Broadly, under the rules contained in TR 2010/3, where a private company has an unpaid present entitlement (UPE) to an amount from a trust, the UPE may in certain circumstances be regarded as a loan for the purposes of Division 7A of the 1936 Tax Act. If so, a deemed dividend will arise which is assessable income in the trust.

The ruling distinguishes between two types of loans:

• section 2 loans – loans within the ordinary meaning
• section 3 loans – loans within the extended meaning

Under TR 2010/3, Division 7A will apply both retrospectively and prospectively for section two loans, while section three loans will only be caught under Division 7A prospectively. That is, only section 3 loans in existence after the issue of the draft ruling on 16 December 2009 will attract Division 7A treatment.

Section two loans
For the purposes of Division 7A, a section two loan will arise in situations where a UPE of a private company beneficiary is satisfied (either by payment or journal entry) and loaned back to the trust.  In this situation, the Commissioner would consider the UPE effectively replaced by an ordinary loan from the private company to the trustee of the trust. 
The ATOs view expressed in TR 2010/3 is that the agreement by the corporate beneficiary to lend funds back to the trust may be either express or implied and that acquiescence to its treatment as a loan in the trust accounts may be taken as consent.   

Generally, where the amount is recorded in the financial accounts of both the trust and the private company as a loan, a section two loan may be taken arise for Division 7A purposes in the absence of evidence to the contrary.

Where the trustee of the trust exercises the power to apply the trust funds for the benefit of the beneficiary under the trust deed and the trustee has recorded the amount as a loan in the financial accounts, the Commissioner may consider that the trustee has applied the corporate beneficiary’s entitlement by creating a loan in its favour.  If so, a section two loan will be taken to have arisen.
TR 2010/3 outlines how the accounting for the UPE by both the trust and private company may impact on whether a Section two loan has arisen.  These circumstances are outlined in the table below:

Financial accounts of private company	Financial accounts of trust	Subject to Division 7A
UPE	UPE	No
Loan	UPE	No
UPE or Loan	Loan*	Yes

* Applies where the private company had knowledge that the trust had treated the UPE as a loan.  The private company will be taken to have acquiesced to that treatment if it is part of the same family group. Where the trustee applies funds for the benefit of a private company beneficiary under the power accorded by the trust deed and accounts for the amount as a loan, the amount will be deemed an ordinary loan regardless of the treatment by the private company.

Section three loans
For Division 7A purposes, a section three loan will arise in circumstances where a UPE remains unsatisfied, thereby providing financial accommodation, or an in-substance loan to the trust. 
Under TR 2010/3, where a private company beneficiary does not call for payment of a UPE, the ATO argues that the result is the provision of financial accommodation to the trustee by way of a loan, except under limited circumstances.  Similarly, if the private company has knowledge of the trustee’s use of UPE funds for the benefit of all beneficiaries, rather than being held on sub-trust or used for the sole benefit of the private company, the UPE will also be deemed to be a section three loan and be potentially subject to Division 7A.

If the amount of the UPE is set aside on a sub-trust by trust resolution for the sole benefit of the private company beneficiary, a Division 7A loan will not arise.  There must be sufficient documentary evidence of the existence of the sub-trust (for example, the preparation of separate accounts and a bank account for the sub-trust).

Where the funds from the sub-trust are invested back into the main trust, the benefits from the use of the funds by the main trust must flow back to the sub-trust to avoid a deemed Division 7A loan arising. TR 2010/3 outlines two administrative approaches which can be used to calculate an acceptable return on investment in these circumstances.  The first is an annual return calculated at the Division 7A benchmark interest rate, and the second is a return calculated as a percentage of the trust net income.

Where Division 7A will not apply
The provision of a section two or section three loan will potentially attract the Division 7A provisions. Under section 109D the loans may be treated as deemed dividends which are assessable to the trust either at the time the loan was made (section 2 loans) or in the year after that in which the distribution was made, as long as the UPE is still subsisting (section 3 loans). 
However, where a complying loan agreement is in place, there will be no deemed dividend under section 109D. If the loan is fully or partly repaid prior to the lodgement of the income tax return of the private company, only the remaining unpaid amount will be assessable under section 109D.

Where the private company has insufficient distributable surplus funds the amount of the deemed dividend will be restricted to the amount of the distributable surplus.

The ruling also addresses how Subdivision EA will interact with the ruling in respect of private company UPEs where the trust in turn loans an amount to an individual.  Generally where this is the case, Subdivision EA will deem there to be a loan between the private company and the shareholder which is subject to Division 7A.

The Commissioner will not apply Subdivision EA to a Section three loan that will already be subject to the general Division 7A provisions.  Similarly, Subdivision EA will not apply to section two loans as the conversion to an ordinary loan satisfies the UPE otherwise in existence. 

For more information on these changes and how they may affect you, contact your usual Grant Thornton advisor or the author of this article.

Author, Mark Azzopardi, August 2010

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