Company Beneficiaries, Present Entitlements and Division
7A of the Income Tax Assessment Act 1997 - Private Groups' Funding
Arrangements under Attack
Introduction
The ATO's Draft Tax Ruling TR 2009/D8 (Draft
Ruling) deals with the intended tax treatment of
distributions to private company beneficiaries by
trustees of trusts within 'closely held groups' ('private company'
is defined for these purposes in s103A of the Income Tax Assessment
Act 1936 (Act)). It will remain open for comment
by the business community and their professional advisors until 12
February 2010. The ATO is now seeking, in certain circumstances, to
render unpaid distributions to income tax (Unpaid Present
Entitlements (UPEs)) as a dividend received by the
trust (which made the distribution) from the company beneficiary,
pursuant to Division 7A-s109D(1) of the Act. These forms of
dividends are not accompanied by franking credits.
Traditionally, UPEs have been viewed as only creating equitable
rights in the beneficiary and not (without some other circumstance
or factor) a debtor-creditor relationship. The ATO now contends a
UPE will constitute a loan - both in the conventional sense of the
word and pursuant to the extended definition contained in s109D(3)
of Act - to the trust that was the source of the distribution.
Unless the exceptions contained in the Division operate, or if the
transaction (considered as a whole) only gives rise to equitable
rights to payment of the amount distributed (circumstances which
will be rare having regard to the ATO's new stance), UPEs will need
to be repaid to avoid additional tax.
Significant adverse financial consequences for private groups'
operations may flow from the Draft Ruling, should it be
accepted.
The application of the proposed provisions and the meaning given
to 'closely held group' contained in the Draft Ruling will also
assist the ATO in expanding the operation of Division 7A. A
'closely held group' will exist where entities including or
comprising the private company and the trust (the source of the
income distribution) share the same ultimate controller or
controllers, being an entity or person who either directly or
indirectly has the practical ability or capability to control the
family group. 'Control' is not defined.
A UPE, without some other factor or circumstance, merely gives
rise to equitable rights. Where a trustee unilaterally applies a
company beneficiary's UPE to become intermingled with the trust's
assets, the ATO has traditionally viewed this as a fact or
knowledge not possessed by the beneficiary. Accordingly, this has
not been a situation where the UPE has been 'paid or applied' for
that beneficiary's benefit and, therefore, a loan has not been
made. With the introduction of the concept of controller of a
closely held group, knowledge of the trustee's actions will be
viewed as falling within the knowledge of the company beneficiary.
This knowledge, in the circumstances described above and in other
related instances, becomes critical to the question of whether a
'loan' exists. Further, it will be the not doing of
something, where the company beneficiary has knowledge of the
trustee's actions, which may also give rise to the relevant
Division 7A loan.
Ordinary Meaning of Loan
The Draft Ruling outlines the ATO's view of when a loan, as
ordinarily understood, is created. Fundamentally, a loan arises
where there is a requirement to repay an amount which has been
paid. Once there is an arrangement for the repayment of an amount
advanced, there will be a loan within the ordinary common law
meaning, irrespective of whether the rights surrounding that
arrangement arise under contract or in
equity.
Extended Definition of Loan under Division 7A of the Act
In addition to a loan as ordinarily understood, s109D(3) of the
Act extends the meaning of loan to include:
- an advance of money; and
- a provision of credit or any other form of financial
accommodation; and
- a payment of an amount for or on account of, on behalf of or at
the request of, an entity, if there is an express or implied
obligation to repay the amount; and
- a transaction (whatever its terms or form) which in substance
effects a loan of money.
The ATO considers that a transaction which in substance effects
a loan within its ordinary meaning - an advance of money, the
provision of credit, the provision of financial accommodation or a
payment on behalf or at the request of an entity (where
there is an express or implied obligation to repay the
amount) - will be taken to be a loan for Division 7A
purposes.
Distributions to Company Beneficiaries and Loans
First, a loan must be 'made'. The ATO suggests that a loan is
made where a company beneficiary by some action (or inaction)
brings into existence, causes, occasions, effects or gives rise to
a loan or to an arrangement or
circumstance that is deemed to be a Division 7A loan
under subsection 109D(3). This interpretation gives 'made' an
extremely wide meaning.
The ATO considers that Division 7A loans will occur in the
following instances, with varying consequences for the UPE:
1 Actual
Loans - UPE is Extinguished
(a) The company beneficiary agrees
to lend the amount to which it is entitled to the trust by way of
set-off. Thus a loan will arise in the case of an agreed set-off in
satisfaction of the trustee's obligation to pay the company
beneficiary its trust entitlement. Where parties meet together and
agree to set one demand against the other, they need not go through
the form and ceremony of handing money backwards and forwards. Thus
a journal entry in the books of account of the trust with the
agreement of the parties will amount to a set-off. The credit to
the loan account of the company beneficiary will constitute payment
of the entitlement. Thus instead of having a UPE, the beneficiary
company will now have a loan owed to it by the trustee of the
trust.
(b) A loan will arise if a trustee credits an
entitlement to a loan account held in the name of the company
beneficiary (with its authorisation). The credit to the loan
account will constitute payment of the entitlement. Thus, instead
of having a UPE, the company beneficiary will have a loan owed to
it by the trustee. Critically, the company beneficiary may
authorise the actions of the trustee by its acquiescence, provided
it has full knowledge of what the trustee has done. In
circumstances where a number of entities share a common controller,
the controller's knowledge of one of the group's affairs will be
generally attributed to another member of the same group.
Alternatively, knowledge will be deemed to exist where the same
individuals have the directing mind in respect of cash flows and
distributions within the family group (but sufficient evidence to
the contrary may refute this contention).
(c) Pursuant to the terms of the trust deed, a
trustee may make a loan on behalf of the company beneficiary by
acting pursuant to a term of the trust deed that permits the
trustee to pay money to or for the benefit of the beneficiary. The
application of trust funds for the benefit of the company
beneficiary by way of a loan investment in the trust - and the
corresponding assumption by the trustee of an obligation to repay
the sum to the company beneficiary - would be such a payment or
application for the benefit of the company beneficiary. The UPE is
extinguished and replaced with a loan asset (sufficient evidence to
the contrary may refute this contention).
2 UPE Subsists
and Division 7A Loan
As ordinarily understood, UPEs do not give rise to payment
requiring repayment in the sense necessary for a loan to exist.
Thus the ATO has confined the instances in which a loan for Divison
7A purposes can arise where a UPE subsists. A UPE is only a right
to enforce recovery of the amount in equity and is not a debt
enforceable at common law; thus there is also no deferred payment -
a further condition for a loan. However, the ATO regards a UPE as a
provision of credit, being an arrangement for the deferred payment
of the amount that is ascertainable and unavoidably due, whether
currently or in the future and not contingent on any event or
action. The ATO will look at the substance and effect of the
transaction relating to a UPE regardless of its form. The ATO will
regard a Division 7A loan as coming into existence in the following
two instances (although a UPE is still considered to exist):
(a) Financial
Accommodation - this form of loan will occur
where a consensual agreement between the company beneficiary and
the trustee can be said to exist which grants or supplies some form
of pecuniary aid or favour to the trust and the principal sum or
equivalent (the UPE) is ultimately payable. Where a UPE remains
intermingled with the trust's fund and is not applied for the
absolute benefit of the corporate beneficiary, a financial
accommodation will be said to arise. The consensual agreement to
the UPE's treatment by the trustee occurs because the beneficiary
does nothing to obtain repayment of the UPE (which is otherwise at
call) or seek its investment for a commercial return. The benefit
provided is the use of the funds representing the UPE for trust
purposes, which is the provision of pecuniary support to the trust.
A loan has been 'made' in the relevant sense because the acceptance
of the acts of the trustee will amount to authorisation (or
acquiescence with knowledge), and knowledge of the trustee's action
will be held to exist where the entities are part of a closely held
group.
(b) Transactions effecting in-substance
loans - these are arrangements which in substance
effect relationships that are properly described as loans at common
law (ie, requiring a payment and repayment). For a 'transaction' to
exist there must be a transaction 'with some other person'. Where a
trustee makes a company beneficiary presently entitled to an amount
from the trust and that company beneficiary allows the trust to
retain use of the funds, it is regarded as a transaction. While a
UPE may not involve a payment and repayment, in effect a UPE that a
beneficiary has allowed to remain outstanding for use by the
trustee for trust purposes is practically the same as a UPE that is
paid to the beneficiary and lent back to the trust to use for
broader trust purposes. In these circumstances, it is claimed that
the mere declaration of the company beneficiary's entitlements does
not embody the real nature of the overall transaction effected by
the parties. Again, the loan must be 'made' and the acceptance of
the acts of the trustee will amount to authorisation (or
acquiescence with knowledge), and knowledge of the trustee's act
will be held to exist where the entities are part of a closely held
group. As can be observed, this situation will cover any other
situation not covered by the extended definition of 'loan'
contained in Division 7A.
At present there is some uncertainty as to the extent of the
Draft Ruling's retrospective effect. We will keep clients advised
on any further developments as they occur.