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  • Unpaid present entitlement

    Division 7A may apply to an unpaid present entitlement (UPE) of a private company beneficiary to trust income in situations where the trust and private company are related entities ultimately sharing the same directing mind and will.

    A UPE is an amount of trust income which the trustee of a trust appoints, but does not pay, to a private company beneficiary.

    A UPE may be subject to Division 7A

    The Commissioner's view is that even if not converted to an ordinary loan, a UPE is capable of amounting to ‘the provision of financial accommodation’ by the private company beneficiary in favour of the trust, and therefore may be considered a loan for Division 7A purposes. It applies to all types of trusts, including discretionary trusts and unit trusts, and is particularly relevant in cases where the trust and the private company are part of the same family group.

    As the Commissioner first expressed his view on 16 December 2009, we will only apply this view to UPEs which come into existence on or after this date.

    See also:

    Avoiding Division 7A consequences

    The simplest way that the trustee can avoid Division 7A treating the UPE as a deemed dividend paid by the private company to the trust, is by paying out the UPE.

    Notwithstanding this, a trustee can still appoint a share of the net income of a trust to a private company beneficiary without immediately paying out that entitlement, and without attracting Division 7A. This can be done through the creation of a sub-trust for the sole benefit of the private company beneficiary, or if the private company beneficiary agrees to net off the UPE by providing the trust with a Division 7A complying loan.

    Sub-trust

    To avoid the UPE being treated as a Division 7A deemed dividend paid by the private company to the trust, the trustee of the trust must take certain steps to ensure that the private company beneficiary is not financially accommodating the trust by allowing the trustee to retain the funds for use within the trust.

    This can be done by placing the funds in a separate sub-trust for the sole benefit of the private company beneficiary by the lodgment day of the trust tax return.

    If the trustee fails to put the funds on a sub-trust for the sole benefit of the private company beneficiary by the date specified, we will consider that the private company beneficiary has provided the trust with a loan, by way of financial accommodation, to the amount of the UPE. Division 7A may then operate to deem the private company to have paid a dividend to the trustee of the trust.

    The trustee accessing funds held in the sub-trust

    The trustee may invest the funds held in the sub-trust back into the main trust on commercial terms, so that the main trust continues to have access to those funds. However, we require certain formalities be adhered by the trustee when investing funds from the sub-trust, such as the parties entering into a legally binding investment agreement.

    See also:

    Requirement of an investment agreement

    Content of a legally binding investment agreement

    The Commissioner requires an investment agreement to be legally binding. The document evidencing that legally binding agreement may be prepared as part of the tax return working papers.

    The agreement need not be professionally prepared and is not the same as a Division 7A complying loan agreement. You may, however, choose to engage a professional to prepare the agreement where you believe it is appropriate to do so.

    We will consider a document containing the following to be sufficient evidence of a legally binding loan agreement between the main trust and the sub-trust:

    • the names of the parties
    • the loan terms, including
      • the amount of the loan
      • the date the loan amount is drawn
      • the requirement to repay the principal amount of the loan
      • the period of the loan
      • the interest rate payable on the loan
      • interest payment to be made annually on the last day of the income year
       
    • that the parties named have agreed to the terms
    • when the agreement was made, for example, the date it was signed or executed.

    Example 1

    We would consider the following document prepared as part of the tax return working papers for the trust's tax return, when a UPE arises during that year, to be sufficient evidence of a legally binding agreement. The document has assumed that the 2015 trust lodgment day for DiscFamily Trust is 15 May 2016.

    PrivCo's entitlement to $10,000 of the income of DiscFamily Trust for the 2015 income year has been set aside and held on sub-trust (known as PrivCo Sub-trust).

    The trustee of PrivCo Sub-trust and the trustee of DiscFamily Trust have agreed that PrivCo Sub-trust will lend the sum of $10,000 to DiscFamily Trust in accordance with Option 1 in PS LA 2010/4. This loan was made and this agreement took effect from 15 May 2016 for a period of seven years. Interest is payable at the Division 7A benchmark interest rate as defined in subsection 109N(2) of the Income Tax Assessment Act 1936.

    The parties have agreed that interest payments will be:

    • calculated annually on the last day of DiscFamily Trust's income year
    • paid by DiscFamily Trust to PrivCo Sub-trust no later than the earlier of
      • the date DiscFamily Trust lodged its income tax return for the year in respect of which interest was calculated
      • the due date for lodgment of that return, with the exception of the final interest payment, which is to be paid by DiscFamily Trust to PrivCo Sub-trust no later than 14 May 2023.
       

    The trustee of PrivCo Sub-trust has further agreed to distribute and pay the interest it receives from DiscFamily trust no later than that date.

    DiscFamily Trust has agreed and is obliged to repay the $10,000 to PrivCo Sub-trust no later than 14 May 2023.

    Signed: - by the trustee of the PrivCo Sub-trust and DiscFamily Trust

    Date: - date

    End of example
    Investment agreement as evidence of trustee's decision

    The investment agreement not only evidences the investment from the sub-trust to the main trust, but also helps to demonstrate the fact that the trustee decided to hold the funds representing the UPE on a sub-trust for the sole benefit of the private company beneficiary in the first place.

    Ongoing investment agreement

    The main trust and the sub-trust may enter into an ongoing agreement for the holding on sub-trust and subsequent investment by the sub-trust into the main trust of all future distributions from the main trust to the private company beneficiary. However, such an agreement will need to be appropriately drafted and should clearly contain all the necessary terms of a legally binding agreement for all successive years. The trustee should ensure that the agreement does not lead to an unintended result, such as the resettlement of the relevant trust estate.

    Failure to pay the annual repayments / returns

    If the trust fails to pay the annual repayments or returns to the private company by the trust's lodgment day, we will consider that the requirements set by the Commissioner have not been satisfied, as the trustee would have breached the terms of the investment agreement. The non-payment of the annual repayments or returns may result in a Division 7A dividend being deemed to be paid to the main trust.

    Safe harbour investment options

    The Commissioner has set out three investment options, as follows:

    • Option 1 – invest the funds representing the UPE on an interest only 7-year loan
    • Option 2 – invest the funds representing the UPE on an interest only 10-year loan
    • Option 3 – invest the funds representing the UPE in a specific income producing asset or investment

    These investment options are the 'safe harbour' options made available. If the trustee chooses to adopt one of these three investment options, then we will consider that the funds of the sub-trust are held for the sole benefit of the private company beneficiary. This means, if the tax affairs of the main trust are reviewed by us, we will be satisfied that the conditions the Commissioner has set out have been met.

    The trustee can choose to invest in other investments, as long as they are able to demonstrate that the funds in the sub-trust are held for the sole benefit of the private company beneficiary.

    Funds not used for business purposes

    The sub-trust can still invest the funds in the main trust using either Options 1 or 2, even if the funds are not used by the main trust for business purposes.

    However, interest paid to the sub-trust by the main trust would not ordinarily be deductible to the main trust if the funds borrowed by the main trust are not used for business or other income producing purposes.

    Investing in an existing asset held by the main trust

    The trustee of the sub-trust can invest the funds representing the UPE in an existing asset (or in a share of an existing asset) held by the main trust using Option 3. However, this would generally constitute a disposal of, or part of, the existing asset held by the main trust and an acquisition of the same asset by the sub-trust. Such a transaction may, for example, trigger capital gains tax (CGT) consequences.

    Repaying loan principal at the end of the investment

    The main trust is expected to repay the principal at the end of the term of the investment, in accordance with the investment agreement. Failure to do so may result in a Division 7A deemed dividend to the trustee of the trust.

    Early repayment possible

    You can repay some or all the principal any time during the term of the investment agreement. There would be no penalties associated with the early repayment of the principal. Interest should only be calculated on the funds actually owing at the time.

    Administrative requirements of the sub-trust

    Separate tax file number (TFN) for the sub-trust

    As a general rule, where a trustee who invests the funds in the sub-trust using either Options 1 or 2 in PS LA 2010/4 and satisfies the exemptions in paragraphs 72 and 84 of PS LA 2010/4 will not need to apply for a separate TFN for the sub-trust.

    Separate trust deed for the sub-trust

    There is no need to have a separate trust deed for the sub-trust. Many trust deeds already provide for the creation of a sub-trust. We strongly recommend you carefully read your trust deed before creating a sub-trust, to ensure it is within the trustee's powers to do so.

    Trust deed silent on UPE to be held on sub-trust

    As long as the trust deed contains words to the effect that the trustee has the power to set aside the income of the trust for the exclusive benefit of one or all of the beneficiaries, then we will consider that the trustee has the power to hold the UPE on sub-trust for the private company beneficiary. If the UPE has been set aside in a manner consistent with paragraphs 50 to 53 of PS LA 2010/4, then we will consider (subject to evidence to the contrary) that the UPE is held on sub-trust.

    Separate financial accounts or tax return

    As a general rule, a sub-trust is a trust estate and would ordinarily be required to lodge a tax return. However, we do not require a sub-trust to create separate sub-trust financial accounts or lodge a separate sub-trust tax return when the trustee decides to place the UPE on a sub-trust and the sub-trust invests all of its funds using either Options 1 or 2 as long as the conditions in paragraphs 72 and 84 of PS LA 2010/4 are satisfied.

    This is on the basis that both Options 1 and 2 are interest only investment options involving one payment of annual return each year and the obligation to repay the UPE at the end of the investment period (of 7 or 10 years). These transactions should be easily visible from the financial accounts of the main trust and of the private company beneficiaries.

    Accounting treatment

    We are not aware of any specific accounting requirement for how the main trust should account for the sub-trust.

    Where there is no requirement to produce separate accounts for the sub-trust, and the sub-trust has invested the funds representing the UPE back into the main trust under Options 1 or 2 set out in PS LA 2010/4, it is expected that the main trust would reflect its obligation to repay the money owing to the sub-trust within the liability section of its statement of financial position or balance sheet.

    Division 7A complying loan agreement

    Instead of implementing a sub-trust arrangement, the trustee can avoid a dividend being deemed under Division 7A if the private company agrees for its UPE to be netted off against a loan that it makes back to the trust under a Division 7A complying loan agreement (that is, for its UPE to be satisfied and then lent back under such an agreement). In these circumstances, the private company would not have any subsisting UPE but rather a loan asset owing from the trust.

    See also:

    Example 2

    Company X receives $1,000 of distributions from Trust T on 30 June 2016 and the amount remains unpaid. Company X and Trust T both have income years ending on 30 June. The trustee of Trust T fails to put the $1,000 on a sub-trust for the sole benefit of Company X by the lodgment day for the 2016 return for Trust T. The trustee must then pay out the $1,000 to Company X by the lodgment day for the 2017 return for Company X in order to avoid Division 7A treating the UPE as a dividend paid by Company X to Trust T.

    End of example

    No requirement to pay out pre-16 December 2009 UPEs first

    Where a trustee has a number of UPEs and they were created both before and after 16 December 2009, then in paying out an entitlement to the company, the trustee is able to choose (whether or not at the company's request) whether they pay out a UPE that arose before or after 16 December 2009. That is, there is no requirement to pay out pre-16 December 2009 UPEs first.

    Pre-16 December 2009 UPEs not Division 7A loans

    The Commissioner will not treat any pre-16 December 2009 UPEs as Division 7A loans, this is so even when the UPEs are not placed on sub-trusts for the sole benefit of the beneficiary.

    Therefore, there is no need for you to pay out any pre-16 December 2009 UPEs to prevent them being treated as dividends paid by the private company to the main trust. However, you should quarantine or isolate any pre-16 December 2009 UPEs in the books of the trust so that any pre-16 December 2009 UPEs can be clearly identified.

    You should also note that Subdivision EA of Division 7A can still apply if the trust makes a payment or loan to, or forgives the debt of, a shareholder or associate of the shareholder of the private company for as long a there is a UPE of the private company to trust income, including any pre-16 December 2009 UPEs.

    Commissioner's discretion under section 109RB

    You may apply in writing to the Commissioner to exercise his discretion under section 109RB to disregard a deemed dividend that has arisen under Division 7A.

    See also:

    Other issues

    UPE by a trust to a trust beneficiary

    The principles in TR 2010/3 and PS LA 2010/4 apply to UPEs owing by a trust to any entity, including another trust. Therefore, if Trust A appoints income to Trust B (a trust within the same family group) but does not pay the funds to Trust B, the UPE is capable of amounting to financial accommodation and may be a loan for Division 7A purposes unless the conditions in PS LA 2010/4 are satisfied. This is illustrated in Figure 1.

    Figure 1

    Conditions required to comply with PS LA 2010/4

    Division 7A will not automatically apply even though the UPE is a loan for Division 7A purposes. Essentially, a UPE becomes a loan, within the extended definition in these circumstances if the funds representing the UPE are not reinvested for the sole benefit of the beneficiary by the lodgment day of the trust income tax return. See paragraphs 46-48 of PS LA 2010/4.

    However, it becomes particularly important where Trust B similarly appoints an amount of income, and does not pay the amount, to a private company beneficiary within the same family group. The paragraphs below highlight two scenarios as examples where Division 7A may potentially apply.

    Example 3 – potential application of Subdivision EA

    Trust A, Trust B and PrivCo C are part of a family group. Trust A and Trust B have the same corporate trustee. Trust A and Trust B are both shareholders of PrivCo C.

    In June 2016, Trust A appoints all of its net income, but does not pay the amount to Trust B. Similarly, Trust B appoints all of its net income, but does not pay the amount to PrivCo C. Before the lodgment day for Trust B's 2016 tax return, the trustee decides to put the UPE owing by Trust B to PrivCo C on a sub-trust for the sole benefit of PrivCo C using one of the investment options in PS LA 2010/4.

    The trustee decides not to put the UPE owing by Trust A to Trust B on a sub-trust before the lodgment day of Trust A's 2016 tax return. The trustee of Trust B is aware of this but does not call for payment of its UPE, or for the funds representing that UPE, to be held for its sole benefit. As a result, the UPE would constitute financial accommodation and therefore a loan by Trust B to Trust A for Division 7A purposes.

    The arrangement is diagrammatically illustrated in Figure 2.

    Figure 2

    Potential application of Subdivision EA

    Subdivision EA of Division 7A applies to certain trustee payments, loans and debt forgiveness made in favour of a shareholder (or associate of a shareholder) of a private company on or after 12 December 2002. Subdivision EA of Division 7A applies to this arrangement to treat PrivCo C as having paid an assessable dividend to Trust A in the 2016-17 income year. This will occur unless an exception contained in Subdivision D of Division 7A applies, or the loan is fully repaid before the 2017 lodgment day of the notional company (that is, the UPE has been paid out to Trust B by that date), or the notional company has insufficient distributable surplus such that section 109Y will operate.

    End of example

     

    Example 4 – potential application of Subdivisions EA and EB

    As with Scenario 1, Trust A, Trust B and PrivCo C are part of a family group. Trust A and Trust B have the same corporate trustee. Trust A, Trust B and Individual D are shareholders of PrivCo C.

    In June 2016, Trust A appoints all of its net income, but does not pay the amount to Trust B. Similarly, Trust B appoints all of its net income, but does not pay the amount to PrivCo C.

    On 1 July 2016, the trustee for Trust A decides to provide an interest-free loan to Individual D.

    Before the lodgment day for the 2016 trust returns, the trustee decides to put the UPE owing by Trust B to PrivCo C on a sub-trust for the sole benefit of PrivCo C using one of the investment options in PS LA 2010/4. The trustee also puts the UPE owing by Trust A to Trust B on a sub-trust for the sole benefit of Trust B using one of the investment options in PS LA 2010/4.

    The arrangement is diagrammatically illustrated in Figure 3.

    Figure 3

    Potential application of Subdivisions EA and EB

    Subdivision EA of Division 7A applies to certain trustee payments, loans and debt forgiveness made in favour of a shareholder (or associate) of a private company on or after 12 December 2002.

    From 1 July 2009, Subdivision EA can apply to (amongst other things) payments and loans from a trust of which a private company is taken to have an unpaid entitlement to income. Subdivision EB was introduced to ensure that the operation of Subdivision EA cannot be circumvented by interposing an entity between either the trust making a payment or loan to a shareholder (or their associate) or between a trust and the private company that holds an unpaid present entitlement to an amount from the net income of the trust.

    Section 109XI of Subdivision EB may apply in this arrangement to deem PrivCo C to be presently entitled to an amount of the net income of Trust A. Subdivision EA of Division 7A would then apply to treat PrivCo C as having paid an assessable dividend to Individual D in the 2017 income year. This will occur unless an exception contained in Subdivision D of Division 7A applies, or the loan is fully repaid before the 2017 lodgment day of the notional company, or the notional company has insufficient distributable surplus such that section 109Y will operate.

    End of example

    See also:

    Section 100A reimbursement agreement

    Both section 100A of the Income Tax Assessment Act 1936 and Division 7A may apply in certain circumstances.

    Where a loan from a beneficiary to a trust is a complying loan under Division 7A (or an unpaid entitlement is held by the trust on terms described in PS LA 2010/4) and the funds retained in the trust are used as working capital, the ATO would consider the arrangement, in the absence of other factors, to be in the course of an ordinary commercial dealing.

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      Last modified: 08 Feb 2017QC 24445