Edited version of private advice

Authorisation Number: 1051956222079

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Date of advice: 31 May 2022

Ruling

Subject: Division 7A - unpaid present entitlement - commercial debt forgiveness - CGT C2

Question 1

Will the release by C Pty Ltd of an unpaid present entitlement (UPE) owed to it by the Family Trust constitute a payment for the purposes of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 2

Does the Commissioner consider that the trustee of the family trust will derive a financial benefit as a result of a release of an unpaid present entitlement?

Answer

No

Question 3

Will there be a deemed dividend for the purposes of Division 7A of the ITAA 1936 in respect of the release of the UPE amount owing to C Pty Ltd by the family trust?

Answer

No

Question 4

Will the release of the UPE amount, as a debt, constitute commercial debt forgiveness for the purposes of Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 5

Will the release of the UPE amount, as a debt, be considered a dividend under section 109F of the ITAA 1936?

Answer

No

Question 6

Will the release of the UPE amount owing to C Pty Ltd cause a capital gains tax (CGT) event C2 to be triggered?

Answer

No

This ruling applies for the following period:

financial year ending 30 June 2022

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

D as trustee for the Family Trust (FT) made C Pty Ltd (C) presently entitled to an amount in prior years. Such amounts have not been repaid to C.

A is the executor of the estate of the late B, who died after 19 September 1985. A was appointed director of C Pty Ltd after the death of the deceased. The deceased had been the sole director of C prior to his death.

As at 30 June 20XX, the only liabilities reported by C are:

a)            loan to the late B

b)            provision for taxation of $x.

Also as at 30 June 20XX C had a franking credit balance of $x. These credits will be lost on a de-registration of C.

The estate of B will for the purposes of assisting with the winding up of C write-off the loan to C leaving the only liability as the provision for taxation. This provision will be reversed by an accounting entry.

After the above adjustments are made, the unpaid present entitlement (UPE) amount will be the only asset or liability that will need to be dealt with before a de-registration of C Pty Ltd under section 601AA of the Corporations Act 2001 (Cth).

C's financial position as at 1 x 20XX will be reported as follows:

The ABN for the family trust has been cancelled.

The family trust does not hold any property or assets.

The intention of the executor is that the family trust will be wound up should the UPE amount be forgiven without any adverse tax consequences to C.

D will also be subject to a voluntary de-registration following the winding up of another trust, of which D is the Trustee.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 section 109C

Income Tax Assessment Act 1936 section 109F

Income Tax Assessment Act 1936 section 109XA

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 112-20

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 section 245-10

Income Tax Assessment Act 1997 section 245-75

Income Tax Assessment Act 1997 section 245-195

Reasons for decision

Question 1

Summary

The release by C of a UPE owed to it by FT will constitute a payment.

Detailed reasoning

Division 7A 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 are, unless they come within specified exclusions, treated as assessable dividends to the extent that a company has a distributable surplus.

Section 109C of the ITAA 1936 provides that payments from a private company to a shareholder or an associate of such a shareholder will be treated as a dividend being paid by the private company.

A payment means:

(a)          a payment to the extent that it is to the entity, on behalf of the entity or for the benefit of the entity; and

(b)          a credit of an amount to the extent that it is:

(i)            to the entity; or

(ii)           on behalf of the entity; or

(iii)         for the benefit of the entity; and

(c)           a transfer of property to the entity.

Taxation Determination TD 2015/20 Income tax: Division 7A: is a release by a private company of its unpaid present entitlement a 'payment' within the meaning of Division 7A of Part III of the Income Tax Assessment Act 1936? states that a private company that releases all, or part, of its UPE credits an amount within the meaning of that word in paragraph 109C(3)(b) of the ITAA 1936. Such a crediting is taken to be a 'payment' for the purposes of subparagraph 109C(3)(b)(iii) of the ITAA 1936 to the extent that the release represents a financial benefit to an entity.

The crediting of the UPE, to forgive the UPE Amount, is considered a payment within the meaning of section 109C(3)(b) of the ITAA 1936.

Question 2

Summary

The Commissioner does not consider that the trustee of FT will derive a financial benefit as a result of a release of a UPE.

Detailed reasoning

TD 2015/20 explains that if the release of the UPE represents a financial benefit to the trustee, then this will amount to a payment under section 109C of the ITAA 1936 and a deemed dividend will arise under Division 7A.

Should the beneficiary have a cause of action against the trustee to recover the loss, and the trustee has exposure to make good the loss that is extinguished, then it may be deemed that a financial benefit has been conferred (paragraph 36 of TD 2015/20). A beneficiary will generally only have a cause of action in equity against a trustee in breach of trust for compensation to the extent that there is a causal connection between the breach of trust and the loss to the trust estate.

If a trustee is no longer able to satisfy 'a UPE due to circumstances beyond their control so that the beneficiary has no cause of action against the trustee to recover that loss', that release of the UPE does not confer a financial benefit. In that situation the release would not constitute anything 'of a monetary value that is capable of being enjoyed' (paragraph 35 of TD 2015/20).

In this circumstance the FT does not have the capacity to pay the UPE amount and the release of the UPE amount does not confer any financial benefit.

Question 3

Summary

There will not be a deemed dividend for the propose of Division 7A of the ITAA 1936 in respect of the release of the UPE amount owing to C by FT.

Detailed reasoning

A deemed dividend for the purposes of Division 7A may arise where a private company is presently entitled to an amount from the net income of the trust estate but that income has not been paid and the trustee shifts value from the trust to a shareholder of a private company (or an associate of the shareholder) in the form of a payment, loan or forgiven debt (section 109XA(1) of the ITAA 1936).

Pursuant to paragraph 109C(1)(a) of the ITAA 1936, a private company that makes a payment to a person is taken to pay a dividend to the person if they are a shareholder in the private company or an associate of the shareholder when the payment is made.

In TD 2015/20, the Commissioner states that a private company that releases a trustee from an obligation to pay an unpaid present entitlement effectively 'credits' an amount to the trustee within the meaning of section 109C, to the extent that the release represents a financial benefit to an entity.

To determine whether the release of an unpaid present entitlement represents a financial benefit to the trustee, it is necessary to consider the actual capacity of the trustee to pay the unpaid present entitlement. TD 2015/20 explains that if a trustee is unable to pay an unpaid present entitlement due to circumstances beyond its control so that the beneficiary has no cause of action against the trustee to recover the loss, then the release of the unpaid present entitlement confers no financial benefit on the trustee, and there is no 'crediting' under section 109C of the ITAA 1936.

In this case, there is no financial benefit derived by the FT as a result of the release of the UPE amount. If there is no financial benefit than the release cannot give rise to a deemed dividend.

Question 4

Summary

The release of the UPE amount, as a debt, will not constitute commercial debt forgiveness for the purposes of Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Division 245 of the ITAA 1997 applies when a commercial debt (or part of a commercial debt) is forgiven. It applies to debts forgiven from the 2010-11 income year onwards.

Commercial debt

Section 245-10 of the ITAA 1997 stipulates that a debt will be a 'commercial debt' if:

a.            the whole or any part of interest, or of an amount in the nature of interest, paid or payable by you in respect of the debt has been deducted, or can be deducted, by you; or

b.            interest, or an amount in the nature of interest, is not payable by you in respect of the debt but, had interest or such an amount been payable, the whole or any part of the interest or amount could have been deducted by you; or

c.             interest or an amount mentioned in paragraph (a) or (b) could have been deducted by you apart from the operation of a provision of this Act (other than paragraphs 8-1(2)(a), (b) and (c) of the ITAA 1997) that has the effect of preventing a deduction.

To determine whether a commercial debt exists we have to look at the borrower's purpose and not that of the lender (Federal Commissioner of Taxation v Tasman Group Services Pty Ltd 2009 ATC 20-138; 74 ATR 739). If the use of the loan could result in an allowable deduction of interest, were interest to be charged, a commercial debt exists.

There is a distinction between a debt and an obligation in equity, which is important in the context of interests in trusts. It has been held that a declaration by the trustee of a discretionary trust that an amount of the income of a trust will be distributed to a particular beneficiary does not, in itself, give rise to a debt owing from the trustee to the beneficiary: R v Brown [1912] HCA 6; 14 CLR 17, Fischer v Nemeske Pty Ltd [2015] NSWCA 6. Rather, the declaration of a distribution gives rise to a right of the beneficiary to make a claim against the trustee for relief in a court of equity if the declared distribution is not paid. This means that an unpaid present entitlement (UPE) is not a debt.

Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements provides further guidance on this issue and at paragraph 34 states that when a beneficiary is presently entitled to an amount from a trust estate, it has an equitable right to that amount. That is, the beneficiary has rights in equity and not, without more, as a result of any debtor-creditor relationship.

As the UPE is not a commercial debt to which interest is deductible, the Commercial debt forgiveness provisions do not apply. However, if it was considered that there was a debt owing by C to the Family Trust, applying Division 245, the 'gross forgiven amount' as defined in section 245-75 of the ITAA 1997, is incapable of being applied in the manner set out in Division 245. If there is any remaining unapplied total net forgiven amount after the application of Subdivision 245E of the ITAA 1997, it can be disregarded (section 245-195 of the ITAA 1997). As such the result is that the gross forgiven amount is disregarded.

Question 5

Summary

The release of the UPE amount, as a debt, will not be considered a dividend under section 109F of the ITAA 1936.

Detailed reasoning

Under subsection 109F(1) of the ITAA 1936:

a private company is taken to pay a dividend to an entity at the end of the private company's year of income if all or part of a debt the entity owed the private company is forgiven in that year and either:

a) the amount is forgiven when the entity is a shareholder in the private company, or an associate of such a shareholder; or

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

ATO Interpretative Decision ATO ID 2002/741 Amalgamated Loans and executors of deceased estates provides that where a shareholder to whom a private company has made a loan dies, there can be no deemed dividend payable following the date of death. This is because a deemed dividend can only be taken to be paid to the entity to whom the loan was made, and the deceased shareholder's legal personal representative is a different entity.

Although the view expressed in ATO ID 2002/741 relates to section 109E of the ITAA 1936 (regarding shortfalls in loan repayments), the principal also applies to section 109F of the ITAA 1936 as this section also specifies that the dividend can only be taken to be paid to the entity to whom the loan was made.

The amount of the loans the C made to the deceased will not be taken to be a dividend paid to the deceased on or before the date of death.

There is no financial benefit derived by the entity as a result of the release of the UPE amount. If there is no financial benefit than the release cannot give rise to a deemed dividend.

Question 6

Summary

The release of the UPE amount owing to C will not cause a capital gains tax (CGT) event C2 to be triggered.

Detailed reasoning

Subsection 108-5(1) of the ITAA 1997 defines a 'CGT asset' as being any kind of property or a legal or equitable right that is not property. A UPE is an equitable right that is proprietary in nature in the hands of a beneficiary that is presently entitled. It satisfies the definition of 'CGT asset' in subsection 108-5(1) of the ITAA 1997.

In the circumstances of this case, the UPE is a CGT asset of C.

As a UPE is satisfied or discharged and ends when the amount of a beneficiary's present entitlement is released or paid to them, CGT event C2 occurs at the time of the payment.

Consistent with the approach outlined in Commissioner of Taxation v Dulux Holdings Pty Ltd & Orica Ltd [2001] FCA 1344, (the Dulux case), the Commissioner's position has been that it is appropriate to look through the legal

rights incidentally created and discharged/satisfied when they are merely facilitating the real transaction, being the distribution of income from a trust to a beneficiary.

An equitable interest can be released for consideration or, voluntarily, without consideration.

A voluntary release needs to meet particular conditions for it to be effective and statute also requires 'a disposition of an equitable interest' to be in writing (where 'disposition' is defined to include a release). A release of an equitable right, voluntary or for consideration, ends any right to enforcement or protection that may have previously existed and, in accordance with the doctrine of merger of estates, give the trustee absolute title to deal with the property the property the subject of the equitable interest being released.

A waiver is a voluntary release and consequently an effective waiver of a UPE will trigger CGT event C2.

A UPE that is subsequently waived cannot be considered incidental to facilitating the distribution of income from a trustee to a beneficiary.

Consequently, CGT event C2 should not be ignored when a UPE is waived and any resultant capital gain should be brought to account by the beneficiary, which in this case will be C.

Cost Base

In most cases, the cost base of a UPE will be nil for the reasons that follow. However, the cost base will need to be determined on a case-by-case basis and after an analysis of the circumstances and the trust deed that led to the beneficiary becoming presently entitled.

Subsection 110-25(2) of the ITAA 1997 defines the first element of the cost base to be the money paid (or required to be paid) or the market value of any property given (or required to be given) in acquiring the CGT asset. As the beneficiary never has any legal right to payment of the amount of the UPE against the trustee (such as a debt), the amount of the UPE cannot be said to have been paid or given (or required to be paid or given) to the trustee, by the beneficiary, to acquire the equitable right to demand and receive payment.

The market value substitution rule in subsection 112-20(1) of the ITAA 1997 modifies the general rules about cost base provided in section 110-25, by replacing the first element of the cost base and reduced cost base of a CGT asset acquired from another entity with its market value (at the time of acquisition) if:

(a)          the taxpayer did not incur expenditure to acquire it, except where the acquisition of the asset resulted from:

                             i.                CGT event D1 happening; or

                            ii.                another entity doing something that did not constitute a CGT event happening; or

(b)          some or all of the expenditure incurred to acquire it cannot be valued; or

(c)           the taxpayer did not deal at arm's length with the other entity in connection with the acquisition.

Further, despite paragraph 112-20(1)(c), subsection 112-20(2) states that, if

(a)          you did not deal at arm's length with the other entity; and

(b)          your acquisition of the CGT asset resulted from another entity doing something that did not constitute a CGT event happening;

the market value is substituted only if what you paid to acquire the CGT asset was more than its market value (at the time of acquisition).

However, subsection 112-20(3) of the ITAA 1997 provides a table of situations in which the rule in subsection 112-20(1) does not apply. Item 1 of the table provides an exclusion for a right to receive income from a trust (except a unit trust or deceased estate) for no consideration and which was not acquired by way of assignment.

The market value substitution rule contained in section 112-20 of the ITAA 1997 will not apply because the exclusion contained in Item 1 of the table in subsection 112-20(3) will apply.

Capital Proceeds

Section 116-20 of the ITAA 1997 provides that the capital proceeds from most CGT events are the total amount of money or the value of any property you receive, or are entitled to receive in respect of the event happening.

As a waiver is a release without consideration, section 116-30 of the ITAA 1997 will apply to substitute the market value of the UPE at the time of waiver to be the capital proceeds received as a result of CGT event C2 occurring.

Subsection 116-30(3A) of the ITAA 1997 states that if you need to work out the market value of a CGT asset that is the subject of CGT event C2, work it out as if the event had not occurred and was never proposed to occur.

The market value of a UPE at the time of the CGT event will generally be the amount of the UPE. However, the determination of the market value at the time of the CGT event will need to be determined on a case-by-case basis. In this case, the market value of the CGT asset in respect of CGT event C2 is worked out as if the event had not occurred and was never proposed to occur. The market value of the UPE in this case will be the amount of the UPE.

The market value substitution rule contained in section 112-20 of the ITAA 1997 will not apply because the exclusion contained in Item 1 of the table in subsection 112-20(3) will apply.

Application of section 118-20 of the ITAA 1997 - waiver of a UPE

The anti-overlap provisions contained in section 118-20 of the ITAA 1997 reduce a capital gain made from a CGT event if another provision of the ITAA 1997 or the ITAA 1936 includes an amount in assessable income, for any income year, in relation to the CGT asset and that amount is also taken into account in working out the amount of the capital gain made.

Accordingly, where a beneficiary's assessable income includes, in any year of income, an amount or amounts in respect of a UPE, eg by virtue of Division 6 or Division 7A of the ITAA 1936, any capital gain made upon subsequent waiver or assignment of that UPE will be reduced by those amount or amounts pursuant to section 118-20 of the ITAA 1997.

The UPE was not included in the assessable income of C. The effect of the unpaid amount being forgiven is the happening of the CGT event C2, the giving up of an equitable claim by C against FT.

The cost base of the UPE is nil because C did not pay anything for the CGT asset and item 1 in the table at subsection 112-20(3) of the ITAA 1997 does not apply to substitute a market value.

The capital proceeds attributed to the forgiveness of the unpaid amount is worked out under subsection 166-30(3A) as if the event 'had not occurred and was never proposed to occur'.

According to the formula in subsection 116-30(3A) of the ITAA 1997, the market value of the unpaid amount is nil because the FT is unable to discharge the equitable obligation to pay the unpaid amount. Also, the notional buyer or assignee of such an equitable obligation would not pay the face value of the unpaid amount.

The capital proceeds is nil, the cost base is nil, and the capital gain is nil.

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