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Division 7A and UPEs – new ATO guidelines

Taxation
Division 7A and UPEs – new ATO guidelines
On 19 July 2017, the Australian Taxation Office (ATO) released Practical Compliance Guideline PCG 2017/13.

The guidance should be of particular interest to family groups with discretionary trusts and private company beneficiaries who have previously placed funds representing an unpaid present entitlement (UPE) on a seven-year interest only loan in accordance with investment Option 1 in Law Administration Practice Statement PS LA 2010/4.  

Background

In 2009, the ATO announced in Taxation Ruling 2010/3 that UPEs owed by a trust to a private company beneficiary within the same closely held family group were financial accommodations and hence ‘loans’ made by the private company beneficiary to the trust for the purposes of Division 7A of the Income Tax Assessment Act 1936 (Cth). This meant that, where the trust was a shareholder or an associate of a shareholder of the company, 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. 

As many of our clients would be aware, the ATO previously indicated that it would not seek to apply Division 7A to the UPE if the funds representing the UPE were held on sub-trust for the sole benefit of the private company beneficiary using one of three investment options  set out in PS LA 2010/4. 

Under investment Option 1 in PS LA 2010/4, the ATO considered that the UPE funds in the sub-trust were held for the sole benefit of the private company beneficiary if they were lent to the main trust under a seven-year interest only loan with the principal of the loan repayable at the end of this term. A trustee that adopted this option was required to document the terms of the investment agreement in a legally binding manner. 

For some taxpayers, the maturation of these investment arrangements is now drawing to a close (either 30 June 2017 or 30 June 2018). The release of the guidelines is welcomed in this respect but taxpayers must ensure that they are aware of the relevant requirements that must be met in order to “refresh” their seven-year loan or else they face the risk of a deemed dividend arising.

Application of PCG 2017/13

The guidelines apply to a private company (or trustee) beneficiary of a trust and sub-trust where the trustee: 

  • has, in accordance with PS LA 2010/4, validly adopted investment Option 1 on, or before, 30 June 2011 to place funds representing an UPE under a sub-trust arrangement on a seven-year interest only loan with the main trust; and 
  • does not repay the principal of the loan when it matures in the 2017 or 2018 income year.

Under the guidelines, the ATO will allow the unpaid portion of the loan to be converted into a new Division 7A complying seven-year loan. The new loan must provide for principal and interest payments over the additional seven-year term. The ATO will not accept repayments of interest only or a refinance through a 25 year Division 7A compliant loan. 

If a complying Division 7A loan is not put in place between the trust and the private company (or trustee) beneficiary prior to the private company’s lodgment day, a deemed dividend will arise at the end of the income year in which the loan matures.

Whilst the guidelines only sanction a conversion of an Option 1 (seven-year) investment agreement into a complying seven-year Division 7A loan.  Under the existing provisions of Division 7A, it is permissible to convert or refinance a seven year loan into a 25 year secured loan. The guidelines are silent on the ATO’s attitude to extending the concessionary seven year loan to a 25 year secured loan in accordance with current law.

The ATO also commented that where the facts and circumstances indicate that there has never been an intention to repay the loan principal at the end of the 7-year interest only loan term, then this may lead the Commissioner to consider that the purported arrangement was a sham, and/or that there was fraud or evasion. We remind our clients of the importance of maintaining contemporaneous evidence to refute such claims. Evidentiary documentation would include an appropriately drafted loan agreement, journal entries evidencing payment of interest and principal (if applicable) and any other correspondence between the private company beneficiary and trust that establishes a bona fide loan arrangement.    

Where to from here?

Taxpayers should ensure that they 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 seven-year complying Division 7A loan agreement should be entered into before the company beneficiary’s lodgment day.

The concession is restricted to Option 1 arrangements put in place prior to 30 June 2011. It is currently unclear whether the guidelines will be extended to deal with those taxpayers that entered into investment Option 2 (ten-year loan) arrangements or seven-year loan arrangements that mature later than 2017 or 2018. 

Whilst the guidelines may provide a “lifeline” for many taxpayers dreading the impending repayment deadline, it is hoped that they are a stop-gap solution only. On the back of the Board of Taxation’s Post 2014 Implementation Review of Division 7A, the 2016-17 federal budget papers included the following announcement in relation to Division 7A:

Simplification of Division 7A

“Subject to the outcomes of consultation”, amendments that will include: A self-correction, no-penalty mechanism for taxpayers who have inadvertently triggered Division 7A; Amended rules, with appropriate transitional arrangements, regarding complying Division 7A loans, including having a single compliant loan duration of 10 years and better aligning calculation of the minimum interest rate with commercial transactions.

Whilst unclear at present, it is expected that any changes to Division 7A will also deal with the current treatment of UPEs. Of great significance would be the conversion of all pre-and post-2009 UPEs into new complying ten year loans starting from the application date of the new provisions.

Clients should consider contacting Arnold Bloch Leibler to review existing UPE arrangements and determine what action is required in light of the guidelines.