Australia: Division 7A and Unpaid Present Entitlements (UPEs) - ATO provides relief for Option 1 UPE loans

WHO SHOULD READ THIS

  • Advisers to trusts with unpaid present entitlements owing to private companies

THINGS YOU NEED TO KNOW

  • The ATO is providing a concession to trusts that implemented a seven year interest only Option 1 loan under PSLA 2010/4 on or before 30 June 2011. The ATO will not require such loans to be repaid on their seventh anniversary where they are put on a 7 year complying Division 7A loan agreement by the company beneficiary's lodgment day.

WHAT YOU NEED TO DO

  • Review any Option 1 loans in place, and if the loan principal cannot be repaid by the seventh anniversary of the loan, consider whether a 7 year complying Division 7A loan agreement should be entered into before the company beneficiary's lodgment day.

The Australian Taxation Office (ATO) has published Practical Compliance Guideline 2017/13 (PCG 2017/13) which sets out the ATO's view on investment arrangements implemented under Option 1 of Practice Statement Law Administration PSLA 2010/4 (PSLA 2010/4) which are set to mature this year and be repayable in full.

For some taxpayers, the maturation of these investment arrangements has been a ticking time bomb – with the approach set out in PCG 2017/13, this issue may be managed with the repayments spread over seven years (albeit with additional interest payable).

Background

Seven years ago, the ATO caused shockwaves by announcing their view in Taxation Ruling TR 2010/3 (TR 2010/3) that unpaid present entitlements (UPEs) owed by a trust to a private company within the same closely held family group were financial accommodations and hence 'loans' made by the private company to the trust for the purposes of Division 7A of the Income Tax Assessment Act 1936 (Cth) (ITAA 36). This meant that, where the trust was a shareholder or an associate of a shareholder of the company (which invariably it is in the case of a privately owned group), then UPEs owed by the trust to the private company could be taxed as unfranked dividends in the hands of the trust under Division 7A.

The ATO's u-turn put an end to a common strategy in the SME market to use UPEs as a way to fund working capital. Over time, the change has caused many SME groups restructure to a company structure. No doubt this trend will grow as the company tax rate for small business companies carrying on active businesses progressively reduces to 25%.

In response to public consultations on TR 2010/3, the ATO set out in PSLA 2010/4 a number of options that, if complied with, would preclude the ATO from applying Division 7A to such UPE balances. These options were separate from the standard solution of entering into a Division 7A loan agreement to cover the UPE 'loan'.

One of these options is Option 1 which involved the company beneficiary (via the sub-trust) effectively 'lending' the UPE funds held on sub-trust back to the main trust on a 7 year interest only loan basis. Interest had to be paid at the benchmark Division 7A rate, with the loan principal being repaid entirely on the seventh anniversary of the arrangement. A failure by the main trust to repay the loan principal by this seven year date would cause the 7 year loan to become a Division 7A loan made by the company to the main trust.

Loans made under Option 1 in the early years of the ATO's u-turn on UPEs (i.e. before 30 June 2011) are set to mature over the next twelve months. Trusts who have only been paying interest on such Option 1 loans are facing a liquidity issue if they have not been progressively repaying loan principal over the years. The ATO's PCG 2017/13 offers a life line to manage this problem.

Practical Compliance Guideline 2017/13

PCG 2017/13 sets out the ATO's compliance approach for Option 1 loans which were entered into on or before 30 June 2011 – and which will mature in the 2017 and 2018 years. It does not apply to Option 2 or 3 investment arrangements set out in PSLA 2010/4.

The ATO indicates that an Option 1 loan cannot be rolled over into another investment option outlined in PSLA 2010/4, presumably because, if this were permitted, repayment of the loan could be deferred indefinitely.

However, PCG 2017/13 does state that the ATO will accept that an unpaid Option 1 loan entered into on or before 30 June 2011 will not become a Division 7A loan on its seventh anniversary provided a 7 year complying Division 7A loan agreement is entered into between the sub-trust and the private company beneficiary (for the sub-trust funds) prior to the day the private company is required to lodge its tax return for the income year in which the seventh anniversary occurs. The sub-trust would then be required to pay interest at the benchmark rate and repay principal over the term of the 7 year complying Division 7A loan.

Where a UPE was placed on sub-trust using Option 1 on 30 June 2011, then the trust must repay the Option 1 loan by 30 June 2018. However, the concession provided by the ATO in PCG 2017/13 prevents Division 7A occurring on 30 June 2018 provided the sub-trust and company enter into a 7 year complying Division 7A loan agreement by the company's lodgment day for the 2018 income year – generally 15 May 2019.

Section 109R ITAA 36 contains anti-avoidance provisions which prevent the taxpayers churning loans to avoid Division 7A by providing that repayments of loans are not recognised if a taxpayer borrows new loans from the relevant private company to pay out existing loans owed to the private company. Significantly the ATO indicates that it will not apply section 109R ITAA 36 when the sub-trust enters into the 7 year complying Division 7A loan.

It is not clear if the ATO will adopt this same approach when the 10 year Option 2 interest only loans under PSLA 2010/4 mature in the 2021 income year, or for Option 1 loans that mature in income years later than 2017 or 2018.

Whilst the technical basis of the ATO's position on UPEs and the policy behind the options in PSLA 2010/4 may be questioned, the concession provided in PCG 2017/13 is still useful for those who have not planned appropriately in relation to the repayment of early Option 1 loans. Affected taxpayers should consider whether to enter into a 7 year complying Division 7A loan agreement to prevent Division 7A applying once the term of the Option 1 loan ends.

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