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Ruling

Subject: Division 7A

Question

Will the unpaid present entitlement (UPE) between the Trust and the company, that will be held on sub trust, be considered a loan for the purposes of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) where the funds are invested in a section three loan under the terms of an investment agreement?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

Year ended 30 June 2018

The scheme commences on:

1 July 2010

1 July 2010

Relevant facts and circumstances

By a deed dated 1 November 2005 made between the settlor and the trustee (Trust Deed) there was constituted a trust fund for the benefit of the beneficiaries therein defined and called the the Trust.

The company is the trustee of the Trust.

An individual is listed as the Director of the company by Australian Securities and Investment Commission (ASIC. They are also listed as the sole shareholder of the company.

The company is an "eligible corporation" as defined in clause 3.1(2) (a) of the Trust Deed.

The individual is a beneficiary of the Trust as defined in the Schedule Item 6 of the Trust Deed

The trustee intends to make a distribution of part of the net income of the Trust for the purposes of section 95 of the Income Tax Assessment Act 1997 (ITAA 1997) to the beneficiary (the company). in the year ended 30 June 2011. The net income will not be paid to the company. The Trustee is authorised to hold such funds under a separate trust for the company under the provisions of clause 4.1 of the Trust Deed.

The company, in its capacity as the trustee of the main trust and the sub-trust, then intends to put the funds representing the UPE on a 7 year interest only loan from the sub-trust to the main trust as per paragraphs 67 to 78 of the Practice Statement Law Administration PS LA 2010/4 (the Practice Statement).

The terms of the loan will be documented in an Investment Agreement which includes the following:

· an obligation and not a discretion on the part of the trustee to pay the interest to the trust of the sub-trust at the interest rate referred to in section 109N(2) of the Income Tax Assessment Act 1936 (ITAA 1936) (Benchmark Interest Rate);

· contain details of the 7 year interest only loan, including the amount of UPE on loan, the start and end dates of the 7 year loan; and

· an obligation to repay the principal amount back to the sub-trust no later than 30 June 2018.

The company will pay the sub-trust's entitlement to interest in accordance with paragraph 71 of the Practice Statement.

The interest paid by the Trust to the sub-trust for the company will be assessable to the company and included in its income tax return for the relevant year.

The interest paid by the Trustee will be a deductible expense for tax purposes as long as the Trustee satisfies the general deduction provisions in section 8-1 of the ITAA 1997.

In implementing the arrangements referred to above the Trustee will ensure that:

· the capital and income of the sub-trust to which Nautilus has an indefeasible entitlement will be sufficiently clearly identified in the financial accounts of the Trust; and

· the net income of the sub-trust as defined in section 95 of the ITAA 1997 will be included in the income tax return for Nautilus in that particular year.

Relevant legislative provisions

Section 95 of the Income Tax Assessment Act 1997

Division 7A of the Income Tax Assessment Act 1936

Section109D of the Income Tax Assessment Act 1936

Subsection 109D(3) of the Income Tax Assessment Act 1936

Paragraph 109D(3)(a) of the Income Tax Assessment Act 1936

Reasons for decision

Summary

As sole beneficiary of the sub trust, the company is solely entitled to any return received by the trustee of the sub trust from its investment back into the trust. The company has not made an ordinary loan to, or provided financial accommodation to the trust. Instead, an unpaid present entitlement (UPE) is being invested under terms where the full amount of the UPE and any benefit from its use, including interest on the loan, is held for its sole purpose.

Therefore, the company is not taken to have made a Division 7A loan under section 109D of the Income Tax Assessment Act 1936 (ITAA 1936).

Detailed reasoning

Division 7A of Part III of the ITAA 1936 (Division 7A) 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 specific 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 a 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:

· an advance of money; and

· provision of credit or any form of financial accommodation; and

· 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

· a transaction (whether 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 made no advance payment of an amount it owes and there has been no payment requiring repayment. There is merely an equitable right to demand payment of the distributable amount. Accordingly, a subsisting UPE is not a Division 7A loan within the meaning of paragraph 109D(3)(a) of the ITAA 1936.

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 51 of Taxation Ruling TR 2010/3 states that:

A private company beneficiary may make an ordinary loan to the trustee of a trust by:

· agreeing to make a loan to the trustee in satisfaction of a subsisting UPE; or


· having an amount applied by the trustee for the company's benefit in the form of a loan asset instead of having a UPE.

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.

However, if the funds representing the UPE are used solely for the benefit of the private company, the company has not provided any financial accommodation to the trust. The question of used solely for the benefit of the private company is considered in Practice Law Administration Statement PSLA 2010/4 at paragraph 55. Here the ATO considerers that the funds are held sole for the benefit of the private company where the:

The trustee of a 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 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 lodgement day of the tax return of the main-trust for the year in which the return arises

For example, where there exists a sub trust however the funds are loaned back to the main trust by the sub trust, the private company will not be providing financial accommodation to the main trust where there is an obligation to the main trust to pay any and all benefits from the use of those funds to the sub trust and the principal to be paid by a certain time.

In these circumstances, the investment by the sub-trust into the main trust is itself a Division 7A loan within the meaning of the extended definition in subsection 109D(3) of the ITAA 1936. However, as the loan is from the sub trust to the main trust, and not from the company itself, the Division 7A loan is not deemed a dividend for the purposes of Division 7A.

It should be noted that although the loan from the sub trust to the main trust is not a deemed dividend, any income earned by the sub trust on the corpus of the sub trust must be paid to the company, otherwise there is potential for a UPE to arise in respect of the sub trust.

PSLA 2010/4 indicates that evidence of a sub trust would include:

· where the amount representing the UPE is set aside separately in the accounts of the main trust as being held on trust for the private company beneficiary;

· where separate accounts are prepared for the subtrust; or

· where a separate bank account is opened in the name of the trustee as trustee for the private company beneficiary in respect of the funds within the sub trust.

Separate accounts for the sub trust need to be prepared in the situation where the funds invested back into the main trust are invested in a specific income producing asset.

Application to circumstances

The company as trustee of the trust intends to make a distribution to the company, an eligible corporation. The distribution will be held in a sub trust as per the Trust Deed. The sub trust will then loan the funds back to the trust under an investment agreement which provides interest is paid to the sub trust at the benchmark interest rate and that the principal must be repaid to the sub trust within 7 years of the date of the loan.

The distribution, or UPE, will be held within a separate trust for the sole benefit of the company. All of the income earned on the funds loaned back to the trust will be applied for the purposes of the company, as the interest and principal will be repaid back through the sub trust. Additionally this income will be included in the company's income tax return for the relevant year. Accordingly the conditions outlined in paragraph 55 of the PSLA would be met and we would consider that the funds held in the sub-trust would be being held for the sole benefit of the company.

As a beneficiary of the sub trust, the company is solely entitled to any return received by the trustee of the sub trust from its investment back into the Trust. Therefore, the company has not made an ordinary loan to, or provided financial accommodation to the Trust. Instead, a UPE is being invested under terms where the full amount of the UPE and any benefit from its use, including interest on the loan, is held for its sole purpose.

Therefore, the company is not taken to have made a Division 7A loan under section 109D of the ITAA 1936.

Provided that the investment back into the main trust by the sub trust is not used for a specific income producing assets, and provided that the amount representing the UPE is set aside in the accounts of the main trust as being held for the company's sole benefit, the sub trust will not need to prepare separate accounts nor a separate income tax return.