Australia: ATO focuses on private companies with unpaid present entitlements – increased audit risk after PS LA 2010/4

EBIT (Emerging Business, Innovation and Tax)
This article is part of a series: Click Time to review restraint clauses – Are your restraint clauses enforceable? for the previous article.

On 14 October 2010, the ATO released the final version of its Practice Statement on Unpaid Present Entitlements (UPEs). Practice Statement PS LA 2010/4 (PS LA 2010/4) provides administrative guidance on the application of Taxation Ruling TR 2010/3 which sets out the circumstances in which the Commissioner will consider a UPE owing from a trust to a private company to be a 'loan' for the purposes of Division 7A.

The Ruling and Practice Statement deal with two scenarios:

  • Where the UPE has been satisfied by a loan from the private company beneficiary to the trust (this is referred to as a "section two loan"), and
  • Where the UPE is subsisting and constitutes "financial accommodation" from the private company beneficiary to the trust so as to be a loan (this is referred to as a "section three loan"). Section three loans can only arise on or after 16 December 2009.

The consequence of a UPE being a section two or section three loan is that the UPE becomes a "loan" for Division 7A purposes and, consequently, the amount of the loan becomes a deemed dividend from the private company to the trust.

Taxpayers with UPEs that are at risk of being "section two loans" can take "self-corrective action" to ensure that the UPEs that arose prior to 16 December 2009 are not subject to Division 7A.

What corrective action can be taken?

The self-corrective action is limited to taxpayers that meet the following criteria:

  1. the financial accounts of the trust and / or the private company have incorrectly classified the amount, which is in fact a UPE, as a loan from the private company to the trust
  2. with the exception of the financial accounts, all available evidence supports the view that the amount is in fact a UPE
  3. the private company has never included that amount in calculating the amount of loan reported at Label 8N of the private company's income tax return (label marked 'loans to shareholders and their associates')
  4. the trust has not paid or credited any interest on or in respect of that amount
  5. the loan account in which the amount is included is entirely comprised of amounts correlating to UPEs and repayments of such UPEs between the trust and the private company (that is, its balance is not affected by any unrelated transactions)
  6. on or before 31 December 2011, the financial accounts of all relevant entities are amended to properly classify the amount as a UPE, and
  7. on or before 31 December 2011, the trustee of or public officer of the trust, or public officer of the company, (as is relevant) signs and dates a declaration setting out all of the above conditions listed in this paragraph in the context of the amount and declaring them to be true and correct.

In other words, the ATO is prepared to ignore potential "section two loans" where a taxpayer has incorrectly classified a UPE as a "loan" in its financial statements. Taxpayers have until 31 December 2011 to correct their financial statements.

While this is a welcome change from the draft Practice Statement, the opportunities for self-corrective action are limited due to the strict criteria for eligibility outlined by the ATO.

Importantly, self-corrective action is not available for UPEs that arose after 16 December 2009 and are at risk of being "section three loans". Rather, TR 2010/3 provides that taxpayers can avoid a section three loan from arising by putting the UPE on a complying "sub-trust".

What is a complying sub-trust?

In order for a UPE not to give rise to a "section three loan", the funds need to be put on a complying sub-trust which means that the trustee will need to hold the funds for the sole benefit of the private company and cannot use the money as part of its circulating capital.

A complying sub-trust will be in place where:

  • the UPE is set aside separately in the accounts of the main trust as being held on trust for the private company beneficiary, or
  • separate accounts are prepared for the sub-trust, or
  • 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.

The final Practice Statement introduced some flexibility in how the funds held on 'sub-trust' can be 'invested'. The options available to taxpayers are:

  1. Option 1: An interest only 7 year loan, or
  2. Option 2: An interest only 10 year loan, or
  3. Option 3: Investing the funds in a specific income producing asset

The first two options require interest to be calculated and paid annually from the sub-trust to the private company beneficiary. The Practice Statement provides formulas to calculate the interest for each of Options 1 and 2. The principal sum must be repaid by the end of the term of the loan.

Option 3 (which was not contemplated in the draft Practice Statement) provides taxpayers with the most flexible investment as the 'principal' (being the UPE) needs not be repaid until the end of the investment.

This means that taxpayers could invest the UPE funds by acquiring an income producing asset and leasing that asset to derive rental income. Provided the asset is not a 'private' asset and, if leased to a related party, is leased on arm's length terms, the ATO indicates that such an investment would be acceptable. The drawback of Option 3 is that the sub-trust would need to prepare its own financial statements and lodge its own tax returns.

The terms of each investment need to be documented. Whilst the Practice Statement and Ruling indicate that 'tax return work papers' are sufficient as documentation, we would recommend that something more detailed is implemented (this could be achieved in a short-form loan agreement or detailed trust distribution minutes).

When does a sub-trust need to be in place?

For a UPE that arises before 1 July 2010, the key dates are as follows:

Date Event
30 June 2011 Sub-trust must be in place
30 June 2012 Interest payable from main trust to sub-trust
15 May 2013 Interest must be paid to the company by the date of lodgement of the trust's 2012 tax return. The interest must be included in the company's 2012 tax return.

For a UPE that arises on or after 1 July 2010, the key dates are as follows:

Date Event
15 May 2012 Sub-trust must be in place
30 June 2012 Interest payable from main trust to sub-trust
15 May 2013 Interest must be paid to the company by the date of lodgement of the trust's 2012 tax return. The interest must be included in the company's 2012 tax return.

The implications for taxpayers

The Tax Ruling and Practice Statement are signposts of the ATO's increased focus on Division 7A compliance, trust structures and private company groups. Since the issue of the Tax Ruling, the ATO has announced that it will send letters to selected tax practitioners who have business clients with an annual turnover of $2 million to $250 million and loans with shareholders or shareholders' associates. We are also aware of recent audits where the ATO has used section 100A (a relatively 'dormant' anti-avoidance provision that has generally always been used as a last resort) to attack trust structures with UPEs.

Given the ATO's focus on Division 7A and trusts, non-compliance with TR 2010/3 and PS LA 2010/4 will certainly increase the risk of being selected for an audit. For those taxpayers wishing to avoid this risk, following the Tax Ruling and Practice Statement will be an added tax compliance cost.

However, it should be remembered that Tax Rulings are not law but the Commissioner's interpretation of the law. Practice Statements have even lesser status and merely represent administrative guidance to ATO officers in administering the law and taxpayers in fulfilling their compliance obligations. Therefore, taxpayers should keep in mind that the concept of a sub-trust is an administrative shortcut offered by the ATO and that shortcut is contained in a statement that does not have the status of law and can be withdrawn at any time.

In fact, there may be other ways of ensuring that a UPE does not cause a Division 7A problem. This is acknowledged in the Practice Statement although no alternative methods are offered. Unless further ATO guidance is issued (which is unlikely), the treatment of UPEs will remain uncertain. In response to the submissions by professional bodies and tax advisors, the ATO has agreed to provide funding to test the issue in court.

Until the uncertainty has been resolved, private companies with trusts in the structure need to review past trust distributions to make sure that these are not subject to Division 7A.

The tax team at Norton Rose Australia can assist with reviewing trust deeds, documentation, trust resolution and financial statements and by advising on strategies to appropriately deal with pre and post 16 December 2009 UPEs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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This article is part of a series: Click Time to review restraint clauses – Are your restraint clauses enforceable? for the previous article.
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