Edited version of private ruling

Authorisation Number: 1011597023049

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Ruling

Subject: Undrawn beneficiary entitlements

Question

Is the undrawn present entitlement owing to the Company from the Trust a loan within the meaning of subsection 109D(3) of Division 7A of Part Ill of the Income Tax Assessment Act 1936 ('ITAA 1936') for the years ended 30 June 200X to 200Y?

Answer: No.

The subsisting undrawn present entitlement is not a loan within the meaning of subsection 109D(3) of the ITAA 1936.

This ruling applies for the following period:

I July 2005 to 30 June 2009

Relevant facts and circumstances

The Company is a private company whose shares were held, at the relevant time, by a particular number of family members:

The family members are the appointors of the Trust which is a discretionary trust.

The Trust is the holder of business premises used to conduct the business run by the Company. The purchase of the business premises was funded through contributions made by the shareholding family.

During each of the years that this application relates to, the Trust distributed 100% of its net income per the trust deed to the Company, a corporate beneficiary. The distribution from the Trust to the Company is disclosed as an "Undrawn Beneficiary Entitlement" in the financial statements of both entities for all these years.

The annual profit distribution from the Trust to the Company has always been disclosed as an "Undrawn Beneficiary Entitlement" in the signed financial statements of each entity.

The shares in the Company were sold to a third party on X date in the recent year. During the pre-sale negotiation period, financial statements (along with other information) were supplied to the buyer. This information is now being stored in a data room.

The data room has unsigned financial statements for the Trust for the years ended 30 June 200X to 200Y that describes the undrawn beneficiary entitlement as "Beneficiary Loan - the Company". These are the only financial statements that have ever described the undrawn beneficiary entitlement in this manner.

The data room copy of the financial statements for the Trust for the years ended 30 June 200X to 200Y are an unedited set of financial statements printed recently from the accounting software of the accountant for sale negotiations. Theses copies were not reviewed before being provided to the buyer. The data room financials have not been approved by the tax agent or signed by the taxpayer.

The final signed financial statements for the Trust that were prepared for the years ended 30 June 200X to 200Y disclose the entitlement from the Trust to the Company as an "Undrawn Beneficiary Entitlement - the Company."

The signed financial statements for the Company show the asset as "Undrawn Beneficiary Entitlements - the Trust".

The signed financial statements for both entities are held by the accountants as tax agent for the financial years mentioned.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 7A of Part III

Income Tax Assessment Act 1936 Section 109D

Income Tax Assessment Act 1936 Subsection 109D(3)

Background

Division 7A of Part III of the Income Tax Assessment Act 1936 ('ITAA 1936') is an integrity measure aimed at preventing private companies from making tax-free distributions of profits to shareholders (or their associates). In particular, advances, loans and other payments or credits to shareholders (or their associates) are, unless they come within specified exclusions, treated as assessable dividends to the extent that a company has a distributable surplus.

Taxation Ruling TR 2010/3 expresses the Commissioner's opinion on the circumstances in which a private company with a present entitlement to an amount from an associated trust estate makes a loan to that trust within the meaning of subsection 109D(3) of the ITAA 1936, in circumstances where funds representing that present entitlement remain intermingled with funds of the trust.

A beneficiary can become presently entitled to an amount from a trust pursuant to a direct term of the relevant trust deed, or as a result of the trustee of the trust exercising a power under a trust deed to make the beneficiary so entitled (usually by resolution). In situations where the funds to which the beneficiary is made presently entitled continue to be held on trust for that beneficiary until such time as the beneficiary calls for payment, the entitlement is commonly referred to as an 'unpaid present entitlement' ('UPE').

Meaning of 'loan'

For the purposes of Division 7A the term 'loan' is given a broad meaning by subsection 109D(3) of the ITAA 1936. A 'loan' is defined as:

(a) an advance of money; and

(b) a provision of credit or any other form of financial accommodation; and

(c) 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

(d) a transaction (whatever its terms or form) which in substance effects a loan of money.

This definition extends the definition of the term 'loan' beyond its commonly understood meaning to include advances of money, provision of credit, other forms of financial accommodation and any transaction which effects a loan of money.

Paragraph 109D(3)(a) of the ITAA 1936 provides that an 'advance of money' is a loan for the purposes of Division 7A. Where there is a UPE, a private company beneficiary has an equitable right to demand payment of the distributable amount. Accordingly, a mere subsisting UPE is not a Division 7A loan within the meaning of paragraph 109D(3)(a) of the ITAA 1936.

If a private company beneficiary has consistently maintained in its accounts that it has an outstanding UPE and not a loan, this would be evidence suggesting that the private company has not agreed to the trustee treating the UPE as being satisfied and being replaced with a loan made by the private company to the trust.

On the other hand, where there is an agreement between a private company beneficiary and the trustee of the trust, a loan can arise for Division 7A purposes. Paragraph 7 to 9 of Taxation Ruling TR 2010/3 states that:

7. A subsisting UPE is not of itself an ordinary loan.

8. However, in situations where a UPE is satisfied (for example, by being paid out) and loaned back to the trustee, the UPE is effectively replaced by an ordinary loan from the private company to the trust.

9. A private company makes an ordinary loan to the trustee of a trust if it provides moneys to the trustee pursuant to an agreement under which the trustee borrows the money on behalf of the trust and the private company lends the moneys to the trustee of the trust. Such a loan from the private company can be effected by an agreed set-off in satisfaction of the trustee's obligation to pay the private company its trust entitlement, rather than as a cash transaction.

Similarly, 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.

As a UPE has subsisted since the year ended 30 June 200X, this ruling will only deal with the potential application of 'section two' loans as set out in TR 2010/3 (loans within the ordinary meaning).

Section two of Taxation Ruling TR 2010/3 deals with situations where there are ordinary loans, including where the UPE has been replaced by a loan. Section two of TR 2010/3 applies retrospectively as well as prospectively.

There are two types of arrangement which give rise to a 'section two' loan.

The first is an express or implied loan agreement (Type 1). The ATO will treat an arrangement as being an express loan agreement where the agreement is evidenced by:

· a written agreement

· a trust resolution; or

· another document.

An implied loan agreement will arise where an amount is recorded in the financial accounts of a private company as an asset in the form of a loan and in the financial accounts of a trust as a liability in the form of a loan.

The second type of arrangement which can give rise to a 'section two' loan is where the trustee exercises a power under a term of the trust deed (Type 2). This type of loan will arise where the trustee has exercised the power under the trust deed to pay or apply money to or for the benefit of the beneficiary and the exercise of the power to apply the trust funds for the benefit of the corporate beneficiary is clearly evidenced in a trust resolution or other written document. As well, the financial accounts of the trust have recorded the amount as a loan.

Application to taxpayer's circumstances

For the years ended 30 June 200X to 30 June 200Y there has been a trustee resolution which states:

"Resolved that the company, as trustee of the Trust, in respect of the year ended 30 June 20xx distribute the whole of the net income of the trust by applying for the benefit of the undermentioned beneficiaries the following proportions, by crediting the same to such beneficiaries in the books of the trust, and on crediting to be held respectively for each such beneficiary.

Beneficiary: the Company. Proportion: 100%"

The relevant amounts for each year are recorded in the balance sheet of the Trust as a current liability: "Undrawn Beneficiary Entitlements - the Company."

The financial statements for the Company also record the relevant amounts as "Undrawn beneficiary entitlement - the Trust."

The relevant amounts are shown in the income tax returns of the Trust as a distribution to the corporate beneficiary. The amounts are also shown in the company's income tax returns as" Income: gross distributions from trusts".

As there is no written loan agreement or similar document it can be concluded that there is no express loan agreement.

For a Type 1 loan the ATO will not without additional evidence regard the following accounting entries as indicating that an implied loan agreement is in existence:

· where the financial accounts of the private company and the trust record the amount as a UPE

· where the financial accounts of the private company record the amount as a UPE, whilst the financial accounts of the trust record the amount as a loan, or

· where the financial accounts of the private company record the amount as a loan, whilst the financial accounts of the trust record the amount as a UPE

The relevant amounts are recorded in the balance sheet of the Trust as a UPE. Therefore it can be concluded that an implied loan agreement does not exist.

In relation to Type 2 loans the ATO will not without additional evidence consider that a Type 2 loan is in existence in the following circumstances:

· where the financial accounts of the private company and the trust record the amount as a UPE

· where the financial accounts of the private company record the amount as a loan, whilst the financial accounts of the trust record the amount as a UPE.

As the amounts have been shown in the balance sheet of the Trust as a UPE and there is no evidence of a Trustee resolution treating the amount as a loan or to pay or apply the money for the benefit of the beneficiary, it can be concluded that a Type 2 loan does not exist.

It is accepted that the financial statements provided are an accurate reflection of the financial relationship between the trustee and the corporate beneficiary.

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