Article by Moore Stephens
New Tax Rules for private company loans. ATP tightens Division 7A provisions applying to unpaid present entitlements and deemed dividend rules applying to private companies and trusts.
PSLA 2010/4 DISCUSSED
All Unpaid Present Entitlements created after 16 December 2009 must be on Division 7A terms (ie 7 or 25 year terms and annual principal and interest payments) unless a separate sub-trust for the private company beneficiary is created.
A separate sub-trust will only be accepted if it fits one of these categories:
- Maximum term of 7 years interest only (current rate 5.75%) and the annual interest is paid in cash to the company
- Maximum term of 10 years interest only (current rate 10.3%) and the annual interest is paid in cash to the company
- A separate asset is acquired and all of the return is paid to the company annually and at the disposal time.
There is an opportunity to correct past non compliant practices.
Unpaid Present Entitlements that existed before 16 December 2009 can be kept on present terms.
On 14 October 2010 the Australian Taxation Office ("ATO") released their final Practice Statement (PS LA 2010/4) providing guidance in respect to their intended implementation of the Taxation Ruling 2010/3 on the issue of unpaid trust entitlements to private company beneficiaries.
This Practice Statement ostensibly represents the final piece of the puzzle in respect to the ATO's stance on unpaid distributions to private companies.
As a result of the Practice Statement:
- Taxpayers that classified Unpaid Present Entitlements as loans (as the difference was not previously considered significant) have an opportunity, subject to strict conditions, to amend and correct financial statements;
- Taxpayers with existing loans not subject to a loan agreement have a limited window to allow for corrective action;
- Going forward, distributions to private companies are unable to go unpaid indefinitely. At a minimum, an unpaid distribution needs to be held on "sub-trust" for the company beneficiary, with terms that involve annual payment of the return on investment of the entitlement, and ultimate settlement in cash of the entitlement.
This practice statement is considered by many in the industry to be disappointing. While the relief mechanisms are applauded, the ATO's mandating of the timing of cash flows on unpaid entitlements means many private clients and small businesses will now have less flexibility in how they run their affairs, and may in fact have ineffective structures. The other disappointing aspect of the Practice Statement is that despite its long lead time it leaves more questions unanswered than one would have expected.
All clients are strongly encouraged to arrange to meet with us to assess the implications this has on your particular circumstances.
One of the major objectives of Division 7A of the ITAA1997 to ensure that private company loans to related parties would be treated as a deemed unfranked dividend, unless the loan was put on strict prescribed commercial terms, subject to interest and minimum repayment.
Over time, these rules have been expanded to ensure that personal use of money or assets would fall within Division 7A and more complex mechanisms involving the use of interposed entities would be covered. One such rule applied in circumstances where the trustees of a trust estate granted present entitlement to income to a private company, but then retained the funds for use and loaned funds to shareholders or associates of shareholders of the private company.
In Taxation Ruling 2010/3 the Australian Taxation Office ("ATO") has sought to extend these rules even further by taking the view that all Unpaid Present Entitlements ("UPEs") owing from a trust to a private company beneficiary are themselves treated as loans, irrespective of whether the money within the trust is being used by shareholders or associates of shareholders of the private company.
A UPE will be treated as a loan by the ATO essentially under two scenarios:
- In-substance Loans (referred to as Section 2 Loans): This is when a UPE is converted to an actual loan due to actions taken by the Trustee or Company; and
- Subsisting UPE's (referred to as Section 3 Loans): This is when a UPE is not settled in cash within a short time frame. In the ATO's view this represents "financial accommodation" to the Trustee of the trust estate, and therefore is within the definition of the term "loan" as it is used within Division 7A.
In respect to Section 2 Loans, in the absence of evidence to the contrary, the ATO has indicated that it will classify the amount as a loan if the only available evidence is the financial statements of the Trust and Company, and both financial statements describe the entitlement as a "loan". The ATO has also indicated that in certain circumstances (depending on the terms of the relevant trust deed), where the trustee has ascribed the term "loan" to an entitlement, this can also be sufficient for an entitlement to be treated as a Section 2 loan.
In respect to Section 3 Loans, the ATO has indicated its view is that all non-settled UPE's between a related trust estate and private company will be treated as loans subject to Division 7A.
The Taxation Ruling allows a genuine UPE in existence before 16 December 2009 to continue to remain unpaid and to not be considered to be a loan going forward. The only circumstance under which a UPE created after 16 December 2009 will not be a loan is when the entitlement is held on a "sub-trust" arrangement for the sole benefit of the beneficiary company.
The Practice Statement
The role of the practice statement is to provide a practical insight into how the ATO will apply the Taxation Ruling in practice. It is a non-binding statement, however taxpayers that operate within the context of the Practice Statement, will receive relief from penalties and interest if there is a change in position.
The key points of the practice statement are as follows:
- Where there is a prior year section 2 loan, the loan can be
converted into a UPE ("self corrected") in certain
circumstances. The circumstances include:
- Amending financial statements to reclassify the
"loan" as a UPE. This option is only available until 31
December 2011, and can only be used where:
- The financial statements of the trust and/or company misclassified the amount as a loan in the first instance;
- There is no other evidence indicating the amount is a loan;
- The private company has never disclosed the amount at Label 8N of the company's income tax return (being the "loan to shareholders and their associates" field);
- The trust has not paid or credited any interest on or in respect to the amount;
- The account consists only of amounts correlating to UPE's or repayments thereof. There must be no other unrelated transactions;
- The trustee or public officer of the trust estate signs and dates a declaration setting out that these conditions are met and declaring them to be true and correct.
- Where the section 2 loan is a genuine loan, 'corrective action' can be taken (i.e. putting the loan on complying Division 7A terms) by the Trustee without having to formally seek the Commissioner's discretion to not treat the loan as a dividend (as is usually required under section 109RB). This is only permitted where the mistake is an honest mistake, the entities involved are small business entities under section 328-110, the funds were used to carry on a business, and the entities have a good compliance record.
- Amending financial statements to reclassify the "loan" as a UPE. This option is only available until 31 December 2011, and can only be used where:
- The ATO will consider a UPE to be held on a sub-trust for a
private company where:
- The trustee of the sub-trust invests the funds representing the UPE in the main trust "on commercial terms";
- All the benefits from the investment "flow back" to the private company beneficiary; and
- All the benefits (eg annual returns) are actually paid to the private company by the lodgement day of the tax return of the main trust for the year in which the return arises.
- The ATO provides three, non-compulsory options, under which the
ATO will accept an effective sub-trust arrangement exists.
Importantly, once an option is selected, the entities can not
change the option used prior to settlement of the loan. In summary
these options are:
- Option 1: A 7 year loan agreement, based on using the benchmark interest rate as defined in sec 109N(2), with an obligation to pay the annual return in cash to the company, and settle the full principal on or before the 7 year period. For the 2010 year the interest rate was 5.75% pa.
- Option 2: A 10 year loan agreement as per the above, however the required interest rate is the Reserve Bank of Australia's indicator leading rate for small business variable (other) overdraft for the month of May immediately before the start of the income year. For the 2011 year the interest rate will be 10.3% pa.
- Option 3: investment of the UPE in specific income producing assets. This option requires preparing separate financial statements and income tax returns for the sub-trust, monitoring sales and acquisitions of assets, and passing all benefits from the sub-trust to the private company.
We are pleased that the ATO has allowed prior year financial statements to be corrected to properly disclose UPE's. This will prevent unnecessary pain for taxpayers.
Going forward however, the sub-trust treatment causes concern. The ATO states that it will accept any "appropriate arrangement", however the available Options give little insight into the breadth of opportunities available to taxpayers.
Furthermore, the requirement to pay the annual return and settle cash to the private company in prescribed time frames, adds a layer of planning complication that may make many existing structuring strategies ineffective or overly cumbersome.
All in all, these rules increase the complexity and uncertainty associated with the use of trusts, and all taxpayers are strongly encouraged to seek our advice on the appropriateness of their existing structures.
Should you wish to discuss this matter further do not hesitate to contact your Moore Stephens relationship partner.
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