Trust Structures and Company Beneficiaries - Draft Ruling Released on Unpaid Present Entitlements
On 16 December 2009 the ATO released its keenly awaited Draft Ruling TD 2009/D8 relating to the Division 7A implications of unpaid present entitlements ("UPE") owing to company beneficiaries. An UPE broadly exists where a trust has made a distribution of income or capital to a beneficiary which remains unpaid. This circumstance is very common in private groups of structures, where the use of company beneficiaries is commonplace. Accordingly, this draft ruling has enormous implications for private business structures.
In a nutshell
The Draft Ruling is likely to cause significant concern to private company groups as the ATO have indicated that unpaid trust distributions will, in all but exceptional circumstances, be regarded as a loan. This will mean that such entitlements would be required to bear interest at the statutory rate and, more significantly, be progressively paid out in accordance with the terms applicable to Division 7A loans (generally over a seven year period), which would represent a very significant change in the way that such structures operate. The Commissioner recognises that this position is contrary to his previous practice and the Draft Ruling suggests that he will only apply this practice prospectively; that is, to new unpaid trust distributions post the release of the draft. However, the draft also contains suggestions that, depending on the terms of the relevant deed, he may also retrospectively treat some unpaid trust distributions as loans, which is a potential concern.
This issue deservedly received considerable press earlier in the year following comments from the ATO Deputy Commissioner that this issue was being considered by the ATO. This is an enormous issue for private client groups where the use of trusts and company beneficiaries is commonplace. In circumstances where such an arrangement exists, it is not uncommon for trust distributions to beneficiaries (both companies and others) to remain undrawn by those beneficiaries for some time. Taxpayer representatives have in recent months made strong representations to the ATO challenging both the technical correctness of the comments made and also in relation to the practical issues, not the least of which is that if this view was taken by the Commissioner, this represents a significant change in administrative approach and should only be adopted on a prospective basis. Unfortunately, it seems that many of concerns expressed by taxpayers and their representatives have not been addressed by the Commissioner in this Draft Ruling.
The ruling has been released in draft form for public comment, representing the Commissioner's preliminary, (although considered) view on the matter. A significant amount of comment will no doubt be received and Moore Stephens will be actively involved in the dialogue with the ATO in response to this pronouncement.
A more detailed analysis of the draft is set out below.
The Draft Ruling has been divided into three sections. The first section provides a background. The second and third sections discuss the circumstances in which the Commissioner will regard UPEs as a loan for Division 7A purposes.
Loan instead of or in satisfaction of UPE
The second section of the Draft Ruling discusses circumstances where a private company will be taken to have made a loan to a trust for Division 7A purposes. Importantly, the application of Division 7A to arrangements which fall under this section will apply retrospectively.
The Commissioner describes three scenarios in which a Division 7A loan would be considered to arise:
1. Agreement between private company and Trust
This scenario refers to the situation where the private company makes a loan to the trust pursuant to an agreement, whereby the loan is effected by an agreed set-off in satisfaction of the trustee's obligation to pay the private company an UPE.
Simplified example from Draft Ruling:
The trustee of AB Family Trust resolves that $10,000 of the trust income for the year is to be distributed to X Co. No cash payment has been made to X Co. X Co. enters into an agreement with Trustee Ltd in its capacity as trustee of AB Family Trust, under which X Co. agrees to lend Trustee Ltd. $10,000. No payments are made but Trustee Ltd. credits a loan account in the name of X Co. with $10,000 in satisfaction of X Co.'s trust entitlement to $10,000.
This example is reasonably straightforward and it is suggested that there is little surprise or controversy in relation to the above example. However, the more concerning scenarios, to varying degrees, are set out following.
2. Trustee creates a credit loan account in the name of the private company beneficiary
Under this scenario, the trustee credits amounts to a loan account held in the name of the private company beneficiary with the authorisation of the private company beneficiary. Importantly, the draft ruling expresses the view that authorisation will include acquiescence with full knowledge of the trustee's action. The ATO is of the view that in situations where the trustee and the private company beneficiary are entities within the same family group that share the same ultimate controllers, the private company has knowledge of what the trustee has done and hence in situations where the trustee credits an entitlement to a loan account held in the name of the private company beneficiary, it will be taken to have been authorised by that private company, subject to sufficient evidence to the contrary. It is difficult to envisage what contrary evidence might be sufficient in practice and the draft ruling gives no guidance as to what this might be.
By implication, in situations where the trustee and private company are not part of the same family group it may be arguable that, the existence of a credit loan account to the company beneficiary would, not on its own, be considered a loan from the private company to the Trust for Division 7A purposes.
3. Pursuant to the terms of the Trust Deed
This scenario envisages circumstances where the trust deed empowers the trustee to pay or apply money on behalf of a beneficiary and, pursuant to this power, the trustee acts on behalf of a company beneficiary and makes a loan on its behalf to the trust. In these circumstances, it is the ATO's view that the private company beneficiary, through the unilateral actions of the trustee in accordance with the terms of the trust deed, will be taken to have made a loan to the Trust.
The Ruling then goes on to say that in circumstances where an amount has been credited to a loan account in the name of the corporate beneficiary and under the Trust deed the trustee has the power to credit amounts for the benefit of the corporate beneficiary as a payment or application of trust funds, the Commissioner will take the view that the trustee has exercised this power, unless there is sufficient evidence to the contrary. Again, it is not clear what the Commissioner might regard as sufficient evidence to the contrary.
It is unclear from the draft whether the two issues discussed above are separate or interrelated. Hence, there is uncertainty as to whether the mere existence of a provision in the trust deed that allows the trustee to apply money to or for the benefit of the beneficiary will be sufficient for a Division 7A loan to arise if the trustee and the company beneficiary do not record the entitlement as a loan, but rather as an UPE. One would like to think that this should not be the case (these type of provisions are not uncommon in trust deeds), but the Draft Ruling does not make this clear. The issue that is a major concern with this scenario is that the Commissioner is proposing to apply his view on this scenario retrospectively.
Subsisting unpaid present entitlements
The third section of the Draft Ruling discusses situations where subsisting UPEs will be treated as loans. As mentioned above, fortunately the Commissioner has adopted a practical approach to only apply this section of the Draft Ruling prospectively.
This aspect is arguably the most contentious issue covered in the Draft Ruling, as the Commissioner' treatment under this Draft Ruling represents a significant change from the Commissioner's previous administrative treatment of UPEs.
The Commissioner states in this Draft Ruling that a private company is providing financial accommodation under a consensual agreement in circumstances whereby the private company has authorised (including by acquiescence with knowledge) the continued use of the UPE for trust purposes by not calling for payment of the UPE or investing the funds for the private company's absolute benefit. The provision of financial accommodation is considered a loan for Division 7A purposes.
The Commissioner does provide for an exception to the application of Division 7A in circumstances where sub trusts are created and the trustee holds the funds solely for the benefit of the beneficiary. However, to access this exception the relevant funds should not be intermingled with the remaining funds of the Trust. It will be a rare circumstance in practice whereby funds representing a subsisting UPE are not intermingled with the trust funds even if sub trusts exist.
The ATO states that the financial accommodation provided would be the whole amount of the UPE that the beneficiary has allowed the trustee to use otherwise than for the beneficiary's absolute benefit.
The Draft Ruling is open for comment until 12 February 2010. The content of the Draft Ruling raises a significant number of questions, both technical and practical, and the extent of its impact on the private business community will no doubt ensure that there will be extensive submissions made. Moore Stephens plans to be very active in this process, so should you wish to provide any feedback, please contact your Moore Stephens relationship partner.
In the meantime, taxpayers should review their current structures and consider the potential impact that the issues raised in the draft may have. Certainly the potential requirement to progressively pay out unpaid trust distributions owing to company beneficiaries may have a significant impact on the funding of trusts that undertake trading or investment activities.
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