Edited version of private advice

Authorisation Number: 1052226218637

Date of advice: 8 March 2024

Ruling

Subject: Issuing new units for unpaid present entitlements

Question 1

Does financial accommodation within the meaning of paragraph 109D(3)(b) arise where an unpaid present entitlement (UPE) arising on or after 1 July 2022 becomes a subsisting UPE, and the sole unitholder of the Trust is a company (the unitholder company)?

Answer

The financial accommodation within the meaning of paragraph 109D(3)(b) arises when the UPE arising on or after 1 July 2022 becomes a subsisting UPE and the sole unitholder of the Trust is the unitholder company.

Question 2

Will the subscription for units in the Trust by the unitholder company at market value, which are intended to be satisfied by offset against a subsisting UPE owed by the Trust to the unitholder company in accordance with clause 6.2 of the Trust Deed result in a dividend arising under section 109D or section 109C?

Answer

Subscription of units by the Trust to the unitholder company in accordance with clause 6.2 of the Trust Deed to offset a subsisting UPE results in a dividend arising under section 109C. Section 109J provides that such a payment is nottaken to be the payment of a dividend for the purposes of section 109C to the extent that it discharges an obligation of the private company to pay money to the entity and does not exceed the arm's length amount required to discharge that obligation.

This ruling applies for the following periods:

Year ended 30 June 20YY

Year ending 30 June 20YY

Year ending 30 June 20YY

Year ending 30 June 20YY

The scheme commenced on:

1 July 20YY

Relevant facts and circumstances

The Trust

The Trust is an Australian tax resident unit trust, treated as a fixed trust under the safe harbour provisions contained in Practical Compliance Guidance 2016: fixed entitlements and fixed trusts (PCG 2016/16).

The Trust was established for a non-resident investor to invest predominately in ASX listed equities via an Australian investment advisor.

All units on issue in the Trust comprise one class and each unit has equal value.

All the units issued in the Taxpayer are owned by the company - the only beneficiary of the Trust since the Trust's establishment.

No changes were made in the Trust's unitholding since the Trust's establishment.

The Beneficiary Unitholder

The unitholder company is a non-resident company for Australian tax purposes.

The unitholder company and the Trust are associates for the purpose of section 318 of the Income Tax Assessment Act 1936 (ITAA 1936).

The Trust Deed

Under Clause 6.1 of the Trust Deed. the Trustee of the Trust is entitled to issue Units to applicants or offer to issue Units provided that any issue is first offered to each of the existing Unitholders in proportion to the number of Units that the Unitholder already holds.

Under Clause 6.3 all new Units will be issued at a price per Unit equal to the Unit Value.

Clause 19.4 describes methods of payment made to the Unitholders and states as follows:

A determination to pay, apply or set aside any amount for any Unitholder and the implementation of that determination may be made by:

a)    placing that amount to the credit of the Unitholder in the books of the Fund;

b)    drawing a cheque in respect of that amount made payable to or for the credit or the benefit of the Unitholder;

c)    paying the same in cash to or for the benefit of the Unitholder; or

d)    issuing additional Units to the Unitholder as provided in Clause 6.

Under Clause 32, the Trustee may at any time and from time to time by deed, with the unanimous written consent of the Unitholders, vary all or any of the trusts, provisions, conditions and terms contained in this deed (as varied from time to time by any previous deed) provided that any amendment must treat all units equally and must not favour or result in any benefit to the Trustee.

Unpaid Present Entitlements

The Trust currently has several subsisting unpaid present entitlements (UPE's) owed to the unitholder company.

The UPEs owed to the unitholder company by the Trust were not treated as Division 7A loans in accordance with ATO guidance in Taxation Ruling 2010/3 Income tax: Division 7A loans: trust entitlements (TR 2010/3) and ATO Interpretative Decision 2012/74 Division 7A: unpaid present entitlements between a unit trust and unit holders (ATO ID 2012/74).

The Trust is seeking for a clarification regarding treatment of UPEs arisen after publication of Taxation Determination 2022/11 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of 'financial accommodation'?

Relevant legislative provisions

Income Tax Assessment Act 1936 section 109C

Income Tax Assessment Act 1936 section 109D

Income Tax Assessment Act 1936 section 109J

Does IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Question 1

Does financial accommodation within the meaning of paragraph 109D(3)(b) arise where an unpaid present entitlement (UPE) arising on or after 1 July 2022 becomes a subsisting UPE, and the sole unitholder of the Trust is a company (the unitholder company)?

Summary

The financial accommodation within the meaning of paragraph 109D(3)(b) arises when the UPE arising on or after 1 July 2022 becomes a subsisting UPE and the sole unitholder of the Trust is a private company.

Detailed reasoning

Section 109D provides that a private company is taken to pay a dividend to an entity if the private company loans an amount to the entity during the year that is not fully repaid before lodgement date and the entity is a shareholder in the private company (or an associate of the shareholder) or it is reasonable to conclude that the loan is made because the entity was a shareholder or associate at some time.

Subsection 109D(3) provides that a 'loan' to an entity is:

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.

Meaning of "financial accommodation"

Subsection 109D(3) gives 'loan' an extended meaning for Division 7A purposes. That extended meaning includes, at paragraph (b), a provision of credit or any other form of financial accommodation.

Taxation Determination TD 2022/11 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of 'financial accommodation'? (TD 2022/11) in paragraphs 6-10 further explains the meaning of "financial accommodation" as follows:

6. The phrase 'financial accommodation' in paragraph 109D(3)(b) has a wide meaning. It extends to cases where an entity with a trust entitlement has knowledge of an amount that it can demand and does not call for payment.

7. Where a private company beneficiary is made presently entitled to trust income and that entitlement is not satisfied, there is a UPE.

8. A private company beneficiary with a UPE, by arrangement, understanding or acquiescence, consents to the trustee retaining that amount to continue using it for trust purposes if the company:

•         has knowledge of an amount that it can demand immediate payment of from the trustee, and

•         does not demand payment.

9. This constitutes the provision of financial accommodation to the trustee under paragraph 109D(3)(b). As a result, the private company beneficiary makes a loan to the trustee under the extended definition of a 'loan' in subsection 109D(3).

10. The private company beneficiary makes a loan when the financial accommodation is provided. This will occur at the point in time when the private company beneficiary has knowledge of an amount that it can demand immediate payment of from the trustee and does not demand payment of the amount.

The Commissioner's view is that ' any other form of financial accommodation' extends to situations where a party has knowledge about an entitlement but fails to demand payment. This view has been confirmed by TD 2022/11 in paragraphs 59-73.

Relevantly, as per paragraph 62 of TD 2022/11, the following principles for interpreting this phrase can be drawn from relevant case law:

•         any other form of financial accommodation is to be construed broadly

•         there must be a consensual arrangement between the parties

•         failure to call for payment of a UPE constitutes a benefit to the trustee.

Moreover, this view has been also confirmed by the Full Federal Court in Corporate Initiatives Pty Ltd v Commissioner Of Taxation (Corporate Initiatives). In that case, the relevant beneficiary in the proceedings did not call upon the trustee to pay its UPE. By not demanding payment of the UPE, the trustee continued to have use of all the trust funds for trust purposes.

The Full Federal Court concluded that by not calling for payment of funds distributed to the private company beneficiary, the private company beneficiary with knowledge of the UPE provided a benefit to the trustee who could continue to use the trust funds for trust purposes.

TD 2022/11 applies to trust entitlements arising on or after 1 July 2022. Consequently, Taxation Ruling TR 2010/3 Income Tax: Division 7A loans: trust entitlements (TR 2010/3) and Law Administration Practice Statement PS LA 2010/4 Division 7A: trust entitlements (PS LA 2010/4) have been withdrawn with effect from 1 July 2022 for trust entitlements arising on or after that time.

Taxpayers can continue to rely on both TR 2010/3 and PS LA 2010/4 in relation to trust entitlements that arose on or before 30 June 2022.

Application to your circumstances

Any UPEs arising to the unitholder company on or after 1 July 2022, that were not called by the unitholder company are treated as providing financial accommodation, as explained above. Therefore, the unitholder company as a beneficiary entitled to a payment made by the Trust, provides a loan under Division 7A to the Trust by not demanding this payment. The loan is defined by subsection 109D(3) as financial accommodation provided by the unitholder company to the Trust.

Question 2

Will the subscription for units in the Trust by the unitholder company at market value, which are intended to be satisfied by offset against a subsisting UPE owed by the Trust to the unitholder company in accordance with clause 6.2 of the Trust Deed result in a dividend arising under section 109D or section 109C?

Summary

Subscription of units by the Trust to the unitholder company in accordance with clause 6.2 of the Trust Deed to offset a subsisting UPE results in a dividend arising under section 109C. Section 109J provides that such a payment is nottaken to be the payment of a dividend for the purposes of section 109C to the extent that it discharges an obligation of the private company to pay money to the entity and does not exceed the arm ' s length amount required to discharge that obligation.

Detailed reasoning

Section 109C

Subsection 109C(1) provides that a private company is taken to pay a dividend to a shareholder (or an associate of a shareholder) at the end of a year of income if the private company pays an amount to the shareholder or associate during the year.

Meaning of payment

The term "payment to an entity" is defined for the purposes of Division 7A in subsection 109C(3). The three types of payments under section 109C are:

1.    a payment to the extent that it is to the entity, on behalf of an entity or for the benefit of the entity

2.    a credit of an amount to the extent that it is to the entity, or on behalf of the entity, of for the benefit of the entity, and

3.   a transfer of property to the entity

Due to the extended meaning of " payment " which applies for the purposes of Division 7A generally, a wider range of circumstances than would be covered by the ordinary meaning of that term potentially gives rise to a deemed dividend under section 109C. The definition of a payment to an entity is exhaustive and therefore amounts not covered by the definition cannot be taken to be payments for the purposes of Division 7A.

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? (TD 2015/20) confirms that if a private company that releases all, or part, of its unpaid present entitlement (UPE) credits an amount within the meaning of that word in paragraph 109C(3)(b) of the Income Tax Assessment Act 1936 (ITAA 1936), such a crediting is taken to be a payment for the purposes of subparagraph 109C(3)(b)(iii) to the extent that the release represents a financial benefit to an entity.

The phrase " to the extent of " should also be considered when determining the amount that has been credited. This phrase implies that an amount credited can be apportioned: for example, if only part of an amount is credited on behalf of, or for the benefit of, a shareholder, only that part is treated as a payment for the purposes of Division 7A. Furthermore, it is the amount of the financial benefit conferred by the release of an unpaid present entitlement that determines the amount credited rather than the amount of the entitlement.

Therefore, it is considered that the release of a UPE (that ought to be properly reflected by a credit entry in the private company beneficiary's books of account) is a credit of an amount that is typically for the benefit (whether in their own capacity or not) of the entity to whom the UPE is released. Accordingly, the release of a UPE is a payment within the meaning of subparagraph 109C(3)(b)(iii) to the extent it represents a financial benefit to an entity.

Paragraph 3 of TD 2015/20 states as follows:

3. This Determination does not apply to the extent that an amount is included in the assessable income of the entity in favour of whom the UPE is released because of the application of another provision of Division 7A in respect of the UPE (section 6-25 of the Income Tax Assessment Act 1997) (ITAA 1997). This Determination also does not apply to the extent that the UPE has been converted to a debt to which section 109F may apply.

In addition, footnote 2 to this paragraph has been modified by TD 2015/20A1 - Addendum 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? (TD 2015/20A1 - Addendum) on 10 August 2022 and states:

For example, a UPE may be a 'Division 7A loan' to which section 109D has applied, resulting in an amount already having been included in assessable income (for example, because that Division 7A loan was not put on terms satisfying section 109N prior to lodgment day, and section 109Y (dealing with distributable surplus) did not apply).

Consequently, section 109C cannot be applied to the extent that section 109D is applied. As explained above, UPEs arising on or after 1 July 2022 and not demanded by the unitholder company are treated as providing "financial accommodation" to the Trustee associate under section 109D.

The amount of UPEs can be estimated at the end of the income year. Therefore, releasing the trust from its UPE obligation for that year by the beneficiary company constitutes payment for the purposes of section 109C. In other words, once a beneficiary company releases a unit trust from its UPE obligation as explained in TD 2015/20, section 109D does not apply to the extent the release occurs before the earlier of lodgment day or when the tax return is lodged.

Section 109J

As discussed above, the payment of an amount by a private company to a shareholder or an associate of the shareholder is treated as the payment of a dividend in the circumstances outlined in section 109C.

Section 109J provides that such a payment is nottaken to be the payment of a dividend for the purposes of section 109C to the extent that it discharges an obligation of the private company to pay money to the entity and does not exceed the arm's length amount required to discharge that obligation. Therefore, both conditions must be satisfied in order to apply section 109J. These conditions are discussed in further detail below.

(a) discharges an obligation of the private company to pay money to the entity

The term "obligation" is not defined in income tax legislation. As per Macquarie Dictionary, "obligation" is defined as:

1. a binding requirement as to action; duty: to fulfil every obligation.

2. the binding power or force of a promise, law, duty, agreement, etc.

3.

a. a binding promise or the like.

b. the act of binding oneself by a promise, contract, etc.

4.

a. Law a legal relationship between two persons, such that one person's right entails the other person's duty.

b. the document containing such an agreement.

5. a bond containing a penalty, with a condition annexed for payment of money, performance of covenants, etc.

6. any bond, note, bill, certificate, or the like, as of a government or a company, serving as security for payment of indebtedness.

(b) is not more than would have been required to discharge the obligation had the private company and entity been dealing with each other at arm's length.

While the expression "dealing with each other at arm's length" is not defined, a number of cases have dealt with its meaning in the context of other provisions of the Act and are relevant to its meaning in the context of Division 7A.

For example, in considering the provisions of former s 26AAA(4), Davies J said in Barnsdall v FC of T 88 ATC 4565 (at p 4568) that:

"The Commissioner is required to be satisfied not merely of a connection between a taxpayer and the person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arm's length. A finding as to a connection between the parties is simply a step in the course of reasoning and will not be determinative unless it leads to the ultimate conclusion."

Similarly, in The Trustee for the Estate of the Late AW Furse No 5 Will Trust v FC of T 91 ATC 4007, a case concerning s 102AG, Hill J stated (at p 4015):

"What is required in determining whether parties dealt with each other in respect of a particular dealing at arm's length is an assessment whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining."

As a result, section 109J requires consideration of the actual dealings between the parties rather than relationship between the parties.

Accordingly, issuing additional units in a trust and subscribing these units to the unitholder company entitled to UPEs and thus releasing the UPE also discharges the company's duty (obligation) to make a payment to the trust. To the extent the value of the issued units is arm's length, section 109J can be applied.

Application to your circumstances

Section 109C applies if the unitholder company releases the Trust from its UPE obligation. This would happen if upon estimating the value of UPEs at the end of the income year, the Trustee decides to issue additional units in the Trust and subscribe these units to the unitholder company in order to offset the value of those UPEs for that income year. Moreover, additional units should be issued in accordance with current clauses contained in the Trust Deed.

As per the Trust Deed, the units issued by the Trust can be only issued at a unit value.

Accordingly, the unit value is defined by the Trust Deed as:

e)    the aggregate of the gross values of all the constituent investments as calculated under Australian accounting principles; and

f)    less the sum of the aggregate of the liabilities of the Trustee as calculated under Australian accounting principles; and

g)    divided by the number of Units on issue at that time.

In the Commissioner's opinion, the arm's length value should be estimated not only by the price dictated by the market, but also by the other factors that may impact the value of the units. Only when this condition is satisfied, should the transaction be considered as an arm's length transaction, which results in application of section 109J.

In the unitisation arrangements it is important to note that the tax risk primarily relates to:

•         whether the arm's length value of the units the private company acquires is equal to the amount paid for those units; or

•         the trust providing a benefit to someone other than the presently entitled beneficiary where the purpose included someone paying no, or less tax.

There is no uncertainty as to how the law operates. However, because valuation of the units issued is the primary issue, there is uncertainty in determining the outcome.

As a result, proper valuation of units, including consideration of relevant clauses of the Trust Deed and their impact on Trustee powers that may affect the rights of beneficiaries and, consequently, the market value of units on issue, is required.

The Australian Taxation Office (ATO) currently focuses on arrangements involving private companies acquiring units in a unit trust as these arrangements may involve the application of Division 7A, section 100A or Part IVA of the ITAA 1936.

Further information about the unit trust arrangements and unpaid present entitlements can be found by searching ato.gov.au for 'QC 54321'.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).