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Ruling

Subject: unpaid beneficiary entitlements

Question 1

Will the unpaid beneficiary entitlements owing to the Trust in the amount of $xxx as at 30 June 2011, be non-assessable and non-exempt income of the Trust under section 59-30 of the Income Tax Assessment Act 1997 (ITAA 1997) for the relevant income years?

Answer: No

Question 2

Will the unpaid beneficiary entitlements owing to the Trust in the amount of $xxx (the unpaid entitlements less the settlement sum received) as at 30 June 2011, be non-assessable and non-exempt income of the Trust under section 59-30 of the ITAA 1997 for the relevant income years?

Answer: No

Question 3

Will the unpaid beneficiary entitlements owing to the Trust in the amount of $xxx as at 30 June 2011 (or $xxx after receipt of the settlement sum) be deductible as a bad debt under section 8-1 of the ITAA 1997?

Answer: No

Question 4

Will the unpaid beneficiary entitlements owing to the Trust in the amount of $xxx as at 30 June 2011 (or $xxx after receipt of the settlement sum) be deductible as a bad debt under section 25-35 of the ITAA 1997?

Answer: No

Question 5

Will the settlement entered into in respect of the unpaid beneficiary entitlements owing to the Trust in the amount of $xxx as at 30 June 2011 (or $xxx after receipt of the settlement sum) constitute a forgiven debt for the purposes of Division 245 of the ITAA 1997?

Answer: No

This ruling applies for the following period

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

1 July 2007

Relevant facts and circumstances

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of, and are to be read with, this description. The relevant documents are:

o your application for a private ruling.

o the deed of settlement between the Trust and the non-related parties.

o a letter provided by your tax agent.

The X Company (X) is the trustee of the Trust. Mr X is the director of Company X.

The beneficiaries of Trust are Company X, Mr X and Mrs X.

From 2007 to 2012, the Trust held one third share of the unit holdings in the Y Unit Trust (Y) which conducted an investment business.

During the above period Y made income tax distributions to the Trust. The Trust then made distributions to its beneficiaries:

Each of the beneficiaries of the Trust included their distribution amounts in their assessable income in the relevant income years.

As at 30 June 2011, Y had unpaid beneficiary entitlements owing to the Trust in the amount of $xxx.

You state that the Trust remained presently entitled to unpaid beneficiary entitlements in the amount of $xxx as at 30 June 2011. This amount was recorded in the accounts of Y. Further, no distributions were received between 30 June 2011 and when the deed of settlement was entered into in 2012.

In 2012, the Trust, X, Mr X and Mrs X (X parties) entered into a deed of settlement (the deed) with other non-related third parties.

Under the deed, the non-related parties provided the following:

o $xxx

o The release of the X parties from listed guarantees

o The indemnity to the X parties against all claims and demands arising under those guarantees

o The release of the X parties from all actions, claims, demands, suits, proceedings, liabilities, sums of money, damages and costs

The X parties provided the following in return:

o The disposal of shares in entities related to Y to the unrelated parties

o The disposal of units in Y to the unrelated parties

o The resignation of the Mr X and Mrs X from the company offices

o Mr X and Mrs X agreement to the post employment restraint

o The release of the non-related parties from all actions, claims, demands, suits, proceedings, liabilities, sums of money, damages and costs

The market value of the Trust's one third share in Y was $xxx.

You state that $xxx of the $xxx settlement amount was attributable to the release of Y from paying the unpaid beneficiary entitlements.

You state that the unpaid beneficiary entitlements of $xxx were determined to be 'bad' in line with paragraphs 26 to 33 of Taxation Ruling TR 92/18. They have been determined to be bad on the basis that there is no likelihood of any part of the debt being recovered from Y in the future.

No amount has been written off as a bad debt as the accounts for the Trust have not yet been prepared for the year ending 30 June 2012. However, on the basis that the unpaid beneficiary entitlements of $xxx are not recoverable, they will be written off in the 2012 accounts.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 59-30(1)

Income Tax Assessment Act 1997 Subsection 59-30(2)

Income Tax Assessment Act 1997 Section 59-30

Income Tax Assessment Act 1936 Subsection 170(10AA)

Income Tax Assessment Act 1936 Division 6

Income Tax Assessment Act 1936 Section 97

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-35

Income Tax Assessment Act 1997 Division 245

Income Tax Assessment Act 1997 Section 245-10

Income Tax Assessment Act 1997 Subdivision 245-B

Reasons for decision

Summary

The unpaid beneficiary entitlements will not be re-characterised as non-assessable non-exempt income as;

· the Trust was not paid the entitlements

· the Trust had no obligation to repay the amount of the entitlements, and

· the Trust did not repay the amount of the entitlements

therefore, the Trust does not meet the requirements to apply section 59-30 of the Income Tax Assessment Act 1997 (ITAA 1997).

The unpaid beneficiary entitlements are not considered a 'debt' as they do not result in an enforceable obligation imposed by law, as distinct from rights that attach to a creditor. The rights of a beneficiary arise in equity only - and not in law. Therefore, as the unpaid entitlements are not considered a 'debt', there is;

· no bad debt to write off under section 8-1 of the ITAA 1997

· no bad debt to write off under section 25-35 of the ITAA 1997

· no commercial debt to forgive as defined under section 245-10 of the ITAA 1997.

Detailed reasoning

Non assessable non exempt income

Subsection 59-30(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that an amount you receive is not assessable income and is not exempt income for an income year if:

a) you must repay it; and

b) you repay it in a later income year; and

c) you cannot deduct the repayment for any income year.

The first requirement is that the taxpayer must 'repay' the amount. The term repay is not defined in income tax legislation. It is appropriate therefore to look at the ordinary meaning of the term repay.

The Australian Oxford Dictionary, 1999, Oxford University Press, Melbourne, defines the term as 'pay back (money) ... make payment (to a person) ... make payment'. It follows that the term requires the actual transfer of money rather than merely a promise or requirement to make a payment in the future.

Subsection 59-30(2) of the ITAA 1997 explains that it does not matter if:

a) you received the amount as part of a larger amount; or

b) the obligation to repay existed when you received the amount or it came into existence later.

Section 59-30 of the ITAA 1997 is designed to deal with cases such as lump sum retention bonuses paid by the ADF which must be repaid on a pro-rata basis if the ADF member resigns before the end of the agreed retention period. As the repayable amount includes tax payable on the bonus, the member would otherwise be financially disadvantaged. Section 59-30 of the ITAA 1997, in association with subsection 170(10AA) of the Income Tax Assessment Act 1936 (ITAA 1936), ensures that, where a taxpayer is required to repay previously assessable income, the taxpayer will be able to amend the assessment for the income year in which the amount was received and receive a refund of the tax paid.

In your case, the original amount in question was the unpaid present entitlement of $xxx owing from Y to the Trust. However, on entering into the deed of settlement, you provide that $xxx was attributable to the release of Y from paying the unpaid beneficiary entitlements. Therefore the amount of the unpaid present entitlements now in question is noted as $xxx.

As the amount in question is unpaid, it could not have been received by the Trust. Up until the date of the deed of settlement, the amount of unpaid entitlements was not something that the Trust was required to repay.

Under the deed of settlement, Y was released from the liability to pay the Trust the unpaid present entitlements owing to the Trust in exchange for, among other things, making a payment of $xxx to the Trust. As part of the settlement deed, the amount of unpaid present entitlements was not required to be repaid to Y, it only required the Trust to transfer its one third share of units in Y, with a market value of $xxx, to other Y unit holders and not Y itself.

Accordingly, as the Trust did not actually receive the amount and there was no obligation to repay the amount (as per the terms of the deed of settlement) and, no amount was actually repaid to Y, section 59-30 of the ITAA 1997 will not apply to re-characterise the unpaid present entitlements as non-assessable non-exempt income.

Is the unpaid beneficiary entitlement a 'debt'?

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).

Importantly, it is not the income or capital appointed under the trustee resolution that is included in a beneficiary's assessable income. The amount included in a beneficiary's assessable income is the item of statutory income determined under Division 6 of the ITAA 1936. Under section 97 of the ITAA 1936, a beneficiary includes in their assessable income a share of the net income of the trust estate.

The share is the fractional interest the beneficiary has in the distributable income of the trust estate calculated in accordance with the general law of trusts and the trust deed (Bamford v FC of T 2010 ATC 20-170).

When a beneficiary of a trust is made presently entitled to an amount that is not paid, trust property representing the unpaid present entitlement (UPE) is held by the trustee on a separate trust, arising in equity, in respect of which the unpaid beneficiary is the sole beneficiary (paragraph 35 of Taxation Ruling TR 2010/3).

In the case of an unpaid beneficiary, the beneficiary's interest in the separate trust is proprietary in nature. That is, they have an equitable interest in the corpus, and in the income of the assets of the separate trust.

The legal technical meaning of the word "debt" is defined in Butterworths Australian Legal Dictionary 1997, Butterworths, NSW:

2. A sum of money owed: Director of Public Prosecutions v. Turner [1073] 3 All ER

124 at 126. A debt is a sum of money which is now payable or will become payable in

the future by reason of a present obligation: debtum in praesenti, solvendum in futuro.

It is a right which a creditor has to enforce by taking action in a court of law

against the person who owes the money (the debtor).

It is clear that an unpaid present entitlement does not satisfy this definition.

The key difference between an unpaid present entitlement and a debt is that an unpaid present entitlement does not result in an enforceable obligation imposed by law (as distinct from the rights that attach to a creditor). Rather, the rights of an unpaid beneficiary arise in equity only - and not in law.

Taxation Ruling TR 92/18 provides that a debt exists where a taxpayer is entitled to receive a sum of money from another either at law or in equity. However, the context of the ruling must be considered as a whole. A debt in these circumstances is clearly contemplating a debt that arose as a result of a debtor-creditor relationship during the course of carrying on a business. An unpaid beneficiary has rights in equity only and not as a result of any debtor-creditor relationship (paragraph 34 of TR 2010/3).

There is considerable authority that supports the principle that money owed to trust beneficiaries as UPE's have a materially different character to money owed to creditors. The Federal Court decision of Euroasian Holdings Pty Ltd v Ron Diamond Plumbing Pty Ltd (in liquidation) (1996) 64 FCR 147 confirmed that the rights of beneficiaries to unpaid entitlements do no arise out of debt or contract and are enforceable in equity only. Accordingly, the unpaid present entitlements are not considered a debt.

Bad debt deduction under section 8-1

Section 8-1 ITAA 1997 allows a deduction for losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. A loss or outgoing is not deductible to the extent that it is of a private, capital or domestic nature.

It has been held that the phrase, "incurred in gaining or producing your assessable income", is to be read as meaning "incurred in the course of gaining or producing [your] assessable income". This principle is well established; see Amalgamated Zinc (De Bavay's) Ltd v FC of T (1935) 54 CLR 295 at p 303, where Dixon J said:

"The expression 'in gaining or producing' has the force of 'in the course of gaining or producing' and looks rather to the scope of the operations or activities and the relevance thereto of the expenditure than to purpose in itself."

In your case, an amount of unpaid beneficiary entitlements was owed to you by Y. You have determined that the amount of unpaid beneficiary entitlements is considered a 'bad debt' due to the fact that the entitlements are not recoverable. However, as the amount of the unpaid beneficiary entitlements is not considered a 'debt' (as discussed earlier), the non payment of the beneficiary entitlements can not be considered 'bad' as no debt exists.

Therefore, as there is no bad debt to be written off, there is no loss or outgoing that could be incurred in earning assessable income. Accordingly, a deduction for the amount of unpaid beneficiary entitlements owing is not available under section 8-1 of the ITAA 1997.

In any case, if we consider that the amount of unpaid entitlements is a debt for the purposes of this section, which we do not, the amount would represent an amount of money owing to the Trust which has come into existence only by virtue of the Trust holding the units in Y, which gave the entitlement to a share of the net income of Y. As such, the amount could not be considered to be incurred in gaining assessable income as no expense has been incurred to receive the share of the net income of Y. In addition, the amount could not be considered to be necessarily incurred in carrying on a business for the purpose of gaining assessable income as you are not in the business of lending money.

Accordingly, a deduction for the amount of unpaid beneficiary entitlements owing is not available under section 8-1 of the ITAA 1997.

Bad debt deduction under section 25-35

Section 25-35 of the ITAA 1997 provides that you can deduct a bad debt that you write off as bad in the income year if:

a) it was included in your assessable income for the income year or for an earlier income year; or

b) it is in respect of money that you lent in the ordinary course of your business of lending money.

Taxation Ruling TR 92/18 lists the factors to be satisfied:

· there must be a debt

· the debt must be bad

· the debt must be written off during the income year

· the debt must have been brought to account as assessable income

Taxation Ruling TR 92/18 provides that as a general rule, where a taxpayer is entitled to receive a sum of money from another either at law or in equity, it is accepted that a debt exists for the purposes of section 63 of the ITAA 1936 (now section 25-35 of the ITAA 1997). There is a debt for the purposes of this section where a taxpayer has merely an equitable entitlement to the debt.

Paragraphs 37 and 38 of TR 92/18 provide that no deduction will be allowed in a year, if the debt is written off after the year's end at the time when the books of account are being prepared (i.e. as a balance day adjustment made after the close of the income year). Furthermore, it is essential that a debt be in existence in order that it may be written off as bad. A debt cannot be written off after it has been settled, compromised, otherwise extinguished or assigned.

Based on the information you provided;

· there is a 'debt' for the purposes of section 25-35 of the ITAA 1997

· you have stated that the unpaid amount was determined to be bad in line with the explanation of when a 'debt' is bad contained in TR 92/18

· the unpaid amount has been brought to account as assessable income

· the 'debt' was not written off prior to entering into a deed of settlement to extinguish the 'debt'.

While the entitlement to receive a sum of money from another in equity could be considered a 'debt' for the purposes of section 25-35 of the ITAA 1997, we consider that an unpaid beneficiary entitlement is not a 'debt' under the legal technical meaning of a debt (as discussed above).

Accordingly, as we do not consider the unpaid entitlements are a 'debt', there is no 'bad debt' to be written off for the purposes of section 25-35 of the ITAA 1997.

In any case, if we consider that the unpaid beneficiary entitlement is a 'debt' for the purposes of this section, which we do not, the fact remains that the amount of the unpaid present entitlement or 'debt' no longer existed once the deed of settlement was entered into. Hence, there is no longer a 'debt' in existence to be written off as bad.

Accordingly, even if the unpaid entitlements were considered a 'debt', the fact that the debt is no longer in existence means you do not satisfy the necessary requirements to be able to write off the 'debt' as bad, therefore you would not be entitled to a deduction for a 'bad debt' under section 25-35 of the ITAA 1997.

Commercial debt forgiveness

Division 245 of the ITAA 1997 applies to any commercial debt (or part of a commercial debt) that is forgiven. Section 245-10 of the ITAA 1997 defines a commercial debt as being a debt which:

· bears interest and the interest is deductible;

· does not bear interest, but had it been interest bearing, that interest would have been deductible; or

· is interest or an amount mentioned in the first two dot points, that could have been deducted by you but for the operation of a provision of the Income Tax Act.

For the purposes of the commercial debt forgiveness rules, Subdivision 245-B of the ITAA 1997 provides that a debt is forgiven if and when:

· the debtor's obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full;

· the period within which the creditor is entitled to sue for the recovery of the debt ends, because of the operation of a statute of limitations, without the debt having been paid;

· the debt is assigned by the creditor to a new creditor under an arrangement where:

- either the new creditor is an associate of the debtor or the assignment occurred under an arrangement to which the new creditor and debtor were parties; and

- the right to receive payment of the debt was not acquired by the new creditor in the ordinary course of trading in a place where offers to sell, buy or exchange securities are made;

· the creditor subscribes for shares in the borrower company in order to enable to borrow to make payment towards the discharge of a debt the borrower company owes to the creditor to the extent the borrower applies any of the money subscribed towards the payment of the debt (a debt for equity swap); or

· the debtor and creditor enter into an arrangement where the obligation of the debt ceases at a particular future time, without the debtor incurring any financial or other obligation.

Again, as discussed earlier, we do not consider that the unpaid entitlements are a 'debt' under the legal technical meaning of a debt, and therefore there would not be a debt to forgive in these circumstances.

In any case, if we consider that the unpaid beneficiary entitlement is a 'debt' for the purposes of this section, which we do not, the fact remains that there is no indication that the unpaid amounts owing to the Trust bear interest which is deductible to Y, or that interest would have been deductible to Y had the amounts been interest bearing. Therefore, the amounts owing to the Trust do not meet the definition of a commercial debt as defined under section 245-10 of the ITAA 1997.

Accordingly, the amount of unpaid entitlements owing to the Trust cannot be considered under the commercial debt forgiveness provisions.