Tax Office Practice Statement on Div 7A and trust entitlements
The Tax Office has issued its highly anticipated Practice Statement (PS LA) 2010/4 on Div 7A and trust entitlements.
The practice statement provides practical ways on how to follow (TR) 2010/3, issued on 2 June 2010. That ruling contains the Commissioner’s view on when a private company with an unpaid present entitlement makes a loan to the trust estate which generated the entitlement, for the purposes of Div 7A of ITAA 1936.
Taxpayers have until 30 June 2011 to work out what to do and several options are available for private companies to self-correct the mistakes made in the past before 31 December 2011.
Background
TR 2010/3 considers two types of loans, which are referred to as Section two and Section three loans.
A Section two loan is a loan within the ordinary meaning of the term “loan”. Such a loan can arise in situations where a UPE is satisfied (for example, by being paid out) and the funds are loaned back to the trustee. The UPE will effectively be replaced by an ordinary loan from the private company to the trustee of the trust. The Tax Office has always considered that Section two loans are loans for the purposes of Div 7A.
A Section three loan deals with a subsisting UPE. A subsisting UPE means a UPE that has not been satisfied, including by being converted into (or replaced by) an ordinary loan.
A subsisting UPE is not a loan within the ordinary meaning of loan but may be a loan under the extended definition of a Div 7A loan if it is the provision of financial accommodation or an in-substance loan.
Section three of TR 2010/3 applies prospectively only. The Tax Office will not apply Div 7A (other than Subdiv EA) to UPEs in existence before 16 December 2009.
A UPE will not be considered to be a Section three loan if funds representing the UPE are held on sub-trust for the sole benefit of the private company beneficiary. PS LA 2010/4 sets out three options which satisfy the Commissioner that this has occurred. However, other arrangements may also result in the funds representing the UPE being used for the sole benefit of the private company such that a Section three loan does not arise.
Section two loans
TR 2010/3 deals with situations where there are ordinary loans, including where the UPE has been replaced by a loan. As set out in TR 2010/3, the following two types of arrangements are considered to be Section two loans:
- Type 1: loan agreement either express or implied — para 9 of TR 2010/3 states that a “private company makes an ordinary loan to the trustee of a trust if it provides moneys to the trustee pursuant to an agreement under which the trustee borrows the money on behalf of the trust and the private company lends the moneys to the trustee of the trust. Such a loan from the private company can be effected by an agreed set-off in satisfaction of the trustee’s obligation to pay the private company its trust entitlement, rather than as a cash transaction”. Paragraph 10 of TR 2010/3 states further: “The agreement between the private company beneficiary and the trustee may be an implied agreement. For example, if the private company has knowledge that the trustee has treated its UPE as having been satisfied and a corresponding amount borrowed back (as evidenced, for example, by crediting a loan account in the name of the private company beneficiary) and the private company acquiesces to that treatment, it will be inferred that it has consented to that loan being made.”
– Express loan agreement — the Tax Office will treat an arrangement as being an express loan agreement where the agreement is evidenced by a written agreement, a trust resolution, or another document.
– Implied loan agreement — subject to evidence to the contrary, the Tax Office considers that an implied loan agreement will arise where the amount is recorded in the financial accounts of the private company as an asset in the form of a loan and in the financial accounts of the trust as a liability in the form of a loan. Where a UPE has been forgiven the Tax Office may consider that a Section two loan has arisen, despite the fact that the amount had been recorded as a UPE in the accounts. Where a UPE has been misclassified as a loan in either, or both, the financial accounts of the private company and the trust, these accounts may be amended to correct this error, if conditions outlined in the practice statement are met.
- Type 2: where the trustee exercises a power under the trust deed — para 14 of TR 2010/3 states the following: “If an amount has been credited to a loan account in the name of the private company beneficiary and under the trust deed the trustee has the power to do so as a payment or application of trust funds for the benefit of that private company, in the absence of sufficient evidence to the contrary, the Commissioner takes the view that the trustee intended to, and in fact, created a loan in exercise of this power.” Subject to evidence to the contrary, the Tax Office considers that such a loan will arise where: the trustee has exercised the power under the trust deed to pay or apply money to or for the benefit of the beneficiary and the exercise of the power to apply the trust funds for the benefit of the corporate beneficiary is evidenced in a trust resolution or other written document; and the financial accounts of the trust have recorded the amount as a loan. The Tax Office will not consider that a type 2 loan is in existence where the financial accounts of the private company and the trust record the amount as a UPE. Where a UPE has been misclassified as a loan in the financial accounts of either, or both, the private company and the trust, these accounts may be amended to correct this error, if conditions outlined in the practice statement are met.
When has the Section two loan been made?
Subject to evidence to the contrary, PS LA 2010/4 provides that the Tax Office will consider a Section two loan to have been made at the following times:
- where there is a loan agreement: on the date the amount was loaned to the trust under the terms of the loan agreement
- where there is no loan agreement: the date the amount is recorded as being debited to the loan account according to the loan account ledger of the private company, or
- in situations where neither of the above dot points in this paragraph apply: the date the amount is recorded as being credited to a loan account in the name of the private company according to the loan account ledger of the trust.
Taxation consequences where a Section two loan arises
PS LA 2010/4 provides that the Section two loan will be subject to Div 7A. Generally, s 109D will apply to treat the private company as having paid an assessable dividend to the trust (equal to the Section two loan) at the end of the income year in which the loan is made, unless:
- an exception contained in Subdiv D of Div 7A applies (for example, if before the lodgment day for the income year in which the loan is made, the loan is put under a complying loan agreement) — whereby no amount of the Section two loan will be assessable under s 109D
- the loan is fully repaid before the private company’s lodgment day for the income year in which the loan is made, or
- the private company has insufficient distributable surplus such that s 109Y will operate to reduce the amount of the dividend that would otherwise be deemed to have been paid — whereby s 109D will apply to the extent of the amount of the distributable surplus.
Self corrective options — applicable until 31 December 2011
In recognition of the genuine concerns of small business and their willingness to comply, the Tax Office has introduced two self corrective administrative options for taxpayers. Provided certain conditions are met, these options allow taxpayers to:
- self correct accounts where a UPE has been misclassified as a loan
- operate on the basis that the Commissioner would exercise his discretion under s 109RB to disregard a deemed dividend.
Where a UPE has been misclassified as a loan
The Tax Office will accept that an amount is not a loan but a UPE where all the following conditions have been met:
(a) 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
(b) with the exception of the financial accounts, all available evidence supports the view that the amount is in fact a UPE
(c) 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”)
(d) the trust has not paid or credited any interest on or in respect of that amount
(e) 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)
(f) on or before 31 December 2011, the financial accounts of all relevant entities are amended to properly classify the amount as a UPE
(g) 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.
Where this is the case, the Tax Office will not treat the amount as a Section two loan for Div 7A purposes.
Section three loans
PS LA 2010/4 provides that a UPE may itself be a Div 7A loan if the UPE is considered to amount to the provision of financial accommodation or an in-substance loan.
Paragraph 23 of TR 2010/3 states the following: “… if a private company beneficiary has knowledge that funds representing its UPE are being used by the trustee for trust purposes (rather than being held and/or used for that private company’s sole benefit), in not calling for payment of its UPE the private company provides the trustee with financial accommodation and, by extension, makes a Division 7A loan to the trustee.”
Paragraph 25 adds that this: “… overall transaction also effects, in substance, a loan of money from the private company to the trustee of the trust.”
Paragraph 26 states further: “Where the trust and beneficiary form part of the same family group, in the absence of sufficient evidence to the contrary, the Commissioner takes the view that the private company has knowledge of the trustee’s use of the funds representing the UPE for trust purposes.”
At what point will the Tax Office consider that a UPE becomes a Section three loan to which Division 7A applies?
PS LA 2010/4 provides that a UPE owing from a trust to a private company in the same family group will become a loan to which Div 7A applies to the extent that:
(a) it has not been paid out to the private company beneficiary, and
(b) the trustee fails to hold the funds representing the UPE on sub-trust for the sole benefit of the private company beneficiary by the main trust’s lodgment day for the income year in which the present entitlement arises and all times thereafter.
For UPEs arising between 16 December 2009 and 30 June 2010, the trustee has until 30 June 2011 to put the funds representing the UPE on sub-trust for the sole benefit of the private company beneficiary.
A UPE will not be considered to be a loan to which Div 7A applies if the funds representing the UPE are held on sub-trust for the sole benefit of the private company beneficiary.
Where there is a Section three loan, when has it been made?
PS LA 2010/4 provides that due to the operation of other provisions of Div 7A (for example, Subdiv EA), it is generally considered appropriate that a Section three loan be taken to have been made at the trust’s lodgment date for the year in which the UPE arose. However, if a UPE arising between 16 December 2009 and 30 June 2010 was treated as a Section three loan made at the trust’s 2010 lodgment date, a taxpayer who wished to avoid such a UPE being taken to be a Section three loan may not be given sufficient time to put appropriate arrangements in place.
Accordingly, a Section three loan will be taken to have been made as at the later of: the lodgment day for the main trust for the income year in which the present entitlement arises, and 30 June 2011, as long as the UPE is still a subsisting UPE at that time (that is, if the UPE has not been satisfied by that time) and is not being held on sub-trust for the sole benefit of the private company beneficiary.
Taxation consequences where a UPE becomes a Section three loan
PS LA 2010/4 provides that the Section three loan will be subject to Div 7A. Generally, s 109D will apply to treat the private company as having paid an assessable dividend to the trust (equal to the UPE) at the end of the income year in which the Section three loan is made, unless:
- the loan is fully repaid before the private company’s lodgment day for the income year in which the loan is made. That is the lodgment day for the income year after the year in which the UPE arose, or
- an exception contained in Subdiv D of Div 7A applies (for example, if before the lodgment day for the income year in which the loan is made, the loan becomes subject to a complying loan agreement), or
- the private company has insufficient distributable surplus such that s 109Y will operate to reduce the amount of the dividend that would otherwise be deemed to have been paid.