Edited version of your written advice

Authorisation Number: 1051411813972

Date of advice: 14 September 2018

Ruling

Subject: Division 7A

Question

If the proposed Sub-Trust Investment Deed is implemented by 30 June 2019, would the unpaid present entitlement described in the ‘Proposed Sub-trust Arrangement’ be considered a ‘loan’ to which section 109D, Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) applies?

Answer

No

This ruling applies for the following periods:

27 June 20xx to 30 June 20xx

The scheme commences on:

27 June 20xx

Relevant facts and circumstances

The Trust

The Trust is an entity that has been established to carry on property development activities.

Pursuant to those property development activities, the Trust has entered into a series of contracts to purchase a development site with multiple titles, which are expected to settle progressively (collectively, the Land).

The Trust intends to develop and subdivide the Land before selling the lots to homeowners and investors. This is expected to take a number of years to complete. The proceeds received will be based on arms’ length commercial transactions.

ABC Pty Ltd owns 50% of the shares in the trustee of the Trust. E and F each own 50% of the shares in ABC Pty Ltd.

E is a Director of the trustee of the Trust.

The Private Company

The Private Company is a discretionary beneficiary of the Trust.

The Private Company was established to carry on property development projects. The majority shareholders of the Private Company will continue to use the Private Company to conduct their property development activities in the future. The majority shareholders also control the Trust, which commenced its operations prior to the incorporation of the Private Company.

XYZ Pty Ltd as trustee for the XYZ Trust owns the majority of the shares in the Private Company. E and G each own 50% of the shares of XYZ Pty Ltd.

E is a director of the Private Company.

Proposed Sub-Trust Arrangement

The Trust expects to receive income for the income year ending 30 June 20xx.

The trustee of the Trust will resolve to make its discretionary beneficiary, the Private Company, presently entitled to the trust income for the income year ending 30 June 20xx (proposed Distribution Minutes of The Trust).

The present entitlement will not be immediately paid. Accordingly, the Private Company will have an unpaid present entitlement (UPE) equivalent to the amount of the present entitlement.

The trustee of the Trust and the Private Company will establish a sub-trust arrangement in respect of the UPE (Proposed Sub-Trust Arrangement).

The trustee of the Trust and the Private Company will enter into a Sub-Trust Investment Deed (proposed Sub-Trust Investment Deed) in respect of the sub-trust arrangement.

The proposed Sub-Trust Investment Deed provides:

● The funds representing the UPE Funds in the sub-trust will be set aside and invested solely for the benefit of the Private Company. The Private Company is entitled to the return of its UPE and its share of profit in proportion to funds representing the UPE Funds used by the Trust to purchase and develop the Land.

● ‘UPE Funds’ is defined to include both the Private Company’s UPE and also any ‘Profit’ (i.e. in respect of a particular income year, Income minus Expenses) derived by the Trust from the investment of the UPE that is reinvested in the Investment.

● The UPE Funds must not be used for any purpose other than in connection with the investment which is defined as the ‘acquisition and development of the Land.

● If the Land is sold at a loss and there is a shortfall, the Private Company remains entitled to the return of the UPE.

● The Trust will retain legal and beneficial ownership of the Land.

● The trustee of the Trust may make pre-payments to the Private Company in respect of its UPE and towards the profit payment.

● Within 30 business days of the ‘End Date’ of the Sub-Trust Investment Deed, The trustee of the Trust must advance to the Private Company any remaining UPE and unpaid share of profit.

● The ‘End Date’ is defined as the earlier of: the xx anniversary of the Commencement Date; when the Trust disposes of its entire interest in all of the Land; and termination of the deed as provided for which allows termination with or without reason.

● The Private Company can demand payment of its remaining UPE and unpaid profit upon the termination of the Sub-Trust Investment Deed. The End Date of the proposed Sub-Trust Investment Deed allows termination without reason therefore the Private Company can terminate the arrangement at any time by providing one month’s calendar notice. The trustee of the Trust must then advance to the Private Company any amounts remaining to be paid within 30 business days.

● The Trust is required to maintain a complete set of separate financial accounts for the investment and must provide those accounts to the Private Company within 15 days of such a request by the Private Company. A final investment analysis of the investment must also be prepared after the End Date.

● An ‘Accountant’ is to be engaged to calculate the profit. The Trust must provide the Accountant with all accounting and other records pertaining to the investment to facilitate the calculations.

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(1)

Income Tax Assessment Act 1936 paragraph 109D(1)(a)

Income Tax Assessment Act 1936 subsection 109D(3)

Income Tax Assessment Act 1936 section 318

Reasons for decision

Summary

The Proposed Sub-Trust Arrangement is acceptable. The Private Company’s UPE will not be taken be a loan to the Trust within the meaning of section 109D of the ITAA 1936 and therefore will not be a loan to which Division 7A of Part III of the ITAA 1936 applies.

Detailed reasoning

One of the purposes of Division 7A of Part III of the ITAA 1936 is to ensure that private companies are not able to make distributions of profits to shareholders (or their associates) in the form of non-arm's length loans instead of in the form of dividends that would be assessable to the shareholder.

To achieve this purpose, subsection 109D(1) of the ITAA 1936 states:

A private company is taken to pay a dividend to an entity at the end of one of the private company’s years of income (the current year) if:

(a) the private company makes a loan to the entity during the current year; and

(b) the loan is not fully repaid before the lodgment day for the current year; and

(c) Subdivision D does not prevent the private company from being taken to pay a dividend because of the loan at the end of the current year; and

(d) either:

(i) the entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made; or

(ii) a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time.

A ‘loan’ includes a loan within its ordinary meaning (an ‘ordinary loan’), consisting of a payment and an obligation to pay. In addition, for the purposes of Division 7A the meaning of loan is extended by subsection 109D(3) of the ITAA 1936 which defines ‘loan’ for the purposes of Division 7A to include:

(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, 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.

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 these situations the funds to which the beneficiary is made presently entitled can remain unpaid and continue to be held on trust for that beneficiary until such time as the beneficiary calls for actual payment of the amount. This entitlement is commonly referred to as an unpaid present entitlement (UPE).

Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements (TR 2010/3) provides the Commissioner’s views on when a private company with a UPE from an associated trust estate will be taken to have made a loan to that trust within the meaning of subsection 109D(3) of the ITAA 1936, in circumstances where funds representing that UPE remain intermingled with funds of the trust.

Guidance on the administration of TR 2010/3 is contained in Practice Statement Law Administration PS LA 2010/4 Division 7A: trust entitlements (PS LA 2010/4).

TR 2010/3 considers in what circumstances a private company is taken to 'make a loan' within the meaning of subsection 109D(3) of the ITAA 1936 to the trustee of a trust, where:

● the trustee of the trust is an associate (within the meaning given in section 318) of one or more shareholders of the private company;

● the trust is part of the same family group as the private company;

● the private company has (or had) a present entitlement to an amount from the trust; and

● funds representing the present entitlement remain intermingled with other funds of the trust estate, or are otherwise able to be used for 'trust purposes', (including if they remain so intermingled or available to be used for trust purposes by being paid back to, reinvested in, or lent back to the trust by a relevant sub-trust).

As stated in paragraphs 17 and 18 of TR 2010/3 and paragraph 11 of PS LA 2010/4, a subsisting UPE is not an ‘ordinary loan’, however it may be a loan under the extended definition of loan in subsection 109D(3) of the ITAA 1936 for the purposes of Division 7A.

In some circumstances where a UPE exists, a private company beneficiary provides financial accommodation to the trustee of a trust, or enters into a transaction with the trustee of a trust which in substance effects a Division 7A loan by the private company to the trustee of the trust.

Paragraph 19 of TR 2010/3 states financial accommodation will be provided by a private company beneficiary to the trustee of a trust in which it has a UPE if under a consensual agreement the private company supplies or grants some form of pecuniary aid or favour to the trust and a principal sum or equivalent is ultimately payable to the private company.

Further, paragraph 97 of TR 2010/3 states:

97. As the amount of the UPE is payable on demand to a private company beneficiary, a principal sum is ultimately payable. The private company therefore provides financial accommodation to the trustee of a trust in the context of section 109D if it provides or grants, under a consensual agreement with the trustee, any pecuniary aid or favour to that trust.

Accordingly, where financial accommodation is provided as discussed above, there will be a Division 7A loan to the trustee of the trust by the private company (paragraph 23 of TR 2010/3).

However, paragraph 49 of PS LA 2010/4 provides that a UPE will not be considered a loan to which Division 7A applies if funds representing the UPE are held on sub-trust for the sole benefit of the private company beneficiary.

TR 2010/3 defines a sub-trust as being a separate trust arising in equity, in respect of which the private company is the sole beneficiary and upon which amounts that the private company is presently entitled to receive from another trust (called the main trust) are held. TR 2010/3 explains the following in relation to sub-trusts:

35. When a beneficiary is made presently entitled to an amount that is not paid, trust property representing the UPE may be held on a sub-trust (as corpus of that sub-trust). The trustee typically continues to legally hold property so held on sub-trust, but in its capacity as trustee of the sub-trust rather than of the main trust.

37. Any income derived from the investment of the corpus of the sub-trust (for example, by the sub-trust lending funds to the main trust) is properly the income of the sub-trust and not the main trust.

If the private company beneficiary allows funds representing UPEs to be used in aid of, or in favour of the trust, rather than for the sole benefit of the private company beneficiary, this is a form of financial accommodation. This is the case even if there is a sub-trust in respect of the UPE.

Therefore, certain criteria must be met in order to demonstrate that funds in a sub-trust are held for the sole benefit of the private company beneficiary. PS LA 2010/4 states:

55. The ATO will consider that the funds in the sub-trust are held for the sole benefit of the private company beneficiary where:

● the trustee of the sub-trust invests the funds representing the UPE in the main trust on commercial terms pursuant to a power as trustee to do so, and

● all the benefits from the investment flow back to the sub-trust and the private company beneficiary, and

● all the benefits (for example, annual return on investment) are actually paid to the private company beneficiary by the lodgment day of the tax return of the main-trust for the year in which the return arises.

56. For the avoidance of doubt, the annual return on investment can either be paid in cash or set off against an account owing from the private company to the main trust, but it cannot be paid by crediting it to a liability account owing to the private company from the main trust or sub trust. The payment of the principal funds invested in the main trust (that is, the funds representing the UPE) and annual return to the private company must be such that if those payments had instead been repayments of a Division 7A loan made by a private company, they would not be disregarded by section 109R.

57. A taxpayer may determine the appropriate terms of the investment, based on the criteria set out in paragraphs 55 and 56 of this practice statement or alternatively a taxpayer may adopt one of three investment options described in paragraph 58 of this practice statement. There is no requirement for the taxpayer to adopt any of the options.

58. The ATO will consider that the funds in the sub-trust are held for the sole benefit of the private company beneficiary if the funds are invested in the main trust using one of the following investment options:

Option 1 - invest the funds representing the UPE on an interest only 7-year loan (see paragraphs 62 to 73 of this practice statement)

Option 2 - invest the funds representing the UPE on an interest only 10-year loan (see paragraphs 74 to 85 of this practice statement)

Option 3 - invest the funds representing the UPE in a specific income producing asset or investment (see paragraphs 86 to 94 of this practice statement)

Proposed Sub-Trust Arrangement

The trustee of the Trust is an associate (as defined in section 318 of the ITAA 1936) of the Private Company. Therefore, the UPE owing from the Trust to the Private Company will become a loan to which Division 7A applies to the extent that:

a) it has not been paid out to the Private Company, and

b) the trustee of the Trust fails to hold the funds representing the UPE on sub-trust for the sole benefit of the Private Company by the main trust's lodgment day for the income year in which the present entitlement arises and all times thereafter.

As stated previously, a UPE will not be considered a loan to which Division 7A applies if funds representing the UPE are held on sub-trust for the sole benefit of the private company beneficiary.

In this case, the Trust and the Private Company propose establishing a Sub-Trust Arrangement whereby the funds representing the Private Company’s UPE will be held on sub-trust and will be invested in a specific investment. A Sub-Trust Investment Deed will be entered between the Trust and the Private Company in respect of the UPE and its investment.

To demonstrate that the funds in the sub-trust are held for the sole benefit of the Private Company, the funds must be invested on commercial terms and all benefits from the investment must flow back to the sub-trust and to the Private Company as the beneficiary of the sub-trust.

As stated in the proposed Sub-Trust Investment Deed, the funds representing the UPE in the sub-trust must not be used for any other purpose other than in connection with the acquisition and development of the Land. The Trust will purchase, develop and subdivide the Land before selling the lots to homeowners and investors.

In return for the investment of its UPE, the Private Company is entitled to the return of its UPE regardless of the success or otherwise of the investment. In addition, the Private Company is entitled to its share of profit from the investment which is calculated by reference to the proportion the UPE Funds represent of the total equity used to fund the investment.

Under the proposed Sub-Trust Investment Deed the UPE and any profit payment are not required to be paid to the Private Company until the End Date of the Sub-Trust Investment Deed. The Trust may however make pre-payments to the Private Company in respect of its UPE and share of profits prior to the End Date.

To ensure that the Trust does not benefit from ‘interim profits’ from any land sales that occur prior to the End Date (and therefore prior to the requirement to pay the Private Company its entitlements), the proposed Sub-Trust Investment Deed requires any interim profit from the investment of the UPE Funds to be reinvested in the investment for the sole benefit of the Private Company or to be prepaid to the Private Company towards the profit payment.

It is considered the proposed Sub-Trust Investment Deed ensures that the UPE in the sub-trust is held for the sole benefit of the private company beneficiary, and that the UPE is not used in aid of or in favour of the Trust.

The Proposed Sub-trust Arrangement in respect of the UPE is acceptable. The Private Company will not be taken to have made a loan to the Trust within the meaning of section 109D of the ITAA 1936 and therefore the UPE will not be a loan to which Division 7A of Part III of the ITAA 1936 applies.

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