TD 2022/D1 – Income Tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provisions of ‘financial accommodation’?
The ATO has released its eagerly awaited draft view on when unpaid present entitlements (UPEs) or distributions held on sub-trust for corporate beneficiaries of Australian resident discretionary trusts will be deemed to be unfranked dividends made by the corporate beneficiary back to the trustee of the trust under Division 7A of Part III of the Income Tax Assessment Act 1936 (Cth).
Division 7A operates to ensure that private companies are not able to make tax-free distributions of profits to shareholders or their associates in the form of payments, loans or forgiven debts.
Under Division 7A, a private company will be taken to pay an unfranked dividend in an income year if it makes a loan to a shareholder or their associate and the loan is not fully repaid before the private company's lodgement day. A 'loan' for the purposes of Division 7A includes 'a provision of credit or any other form of financial accommodation'.
The draft determination describes when a private company provides financial accommodation (and therefore a ‘loan’) where it is made presently entitled to income of a trust and either of the following circumstances occur:
- Circumstance 1: the private company’s entitlement remains unpaid – i.e., becomes a UPE; or
- Circumstance 2: the trustee sets aside an amount from the main trust fund and holds it on a new separate trust (sub-trust) for the exclusive benefit of the private company beneficiary.
The draft determination represents a departure from the ATO’s previous guidance in TR 2010/3 and PS LA 2010/4 where it was accepted that a private company beneficiary did not provide 'credit or any other form of financial accommodation' to a trustee where the funds representing a UPE were held on sub-trust and re-invested in the head trust on particular terms.
The ATO is currently proposing to withdraw this former guidance from 1 July 2022 to give effect to its new view in TD 2022/D1 but has confirmed that it will not apply compliance resources to sub-trust arrangements that the withdrawn guidance would apply to so long as the arrangement is created on or before 30 June 2022.
Arrangements within Circumstance 1 – where there is a UPE
If a trustee resolves to make a private company beneficiary presently entitled to trust income and does not discharge its obligation to pay the private company beneficiary, there is a UPE. The trustee has an equitable obligation to account to the private company beneficiary for the UPE and the private company beneficiary has a right to demand immediate payment of its entitlement.
The Commissioner takes the view in Circumstance 1 that a private company beneficiary that does not exercise its right to demand immediate payment of an amount of trust income provides financial accommodation to the trustee.
If the private company beneficiary exercised its right, the trustee would be required to arrange funds for the payment of the UPE, whether by selling or borrowing against other assets which would then no longer be available. As such, the UPE is treated as an unfranked dividend in the hands of the trustee.
Arrangements within Circumstance 2 – where there is a sub-trust
Where a trustee resolves to make a private company beneficiary presently entitled to trust income and sets aside an amount from the main trust and holds it on sub-trust for the absolute benefit of the private company beneficiary, the trustee discharges its obligation to the private company beneficiary in respect of that entitlement. The amount set aside by the trustee ceases to be an asset of the main trust and forms the corpus of the sub-trust. The private company beneficiary has a new right to call for payment of the sub-trust fund and can call the sub-trust to an end.
The Commissioner in TD 2022/D1 takes the view that the private company's choice not to exercise its right to end the sub-trust does not constitute financial accommodation in favour of the trustee of the sub-trust (in that capacity) because the sub-trust fund is held for the private company beneficiary's sole benefit. However, if the funds are retained for use by the trustee in its capacity as trustee of the main trust or otherwise used by another shareholder or associate of a shareholder, the Commissioner is of the view that this may, in fact, amount to the provision of financial accommodation by the private company beneficiary.
This current view represents a departure from the ATO’s previous position that sub-trust arrangements did not constitute loans for the purposes of Division 7A where the funds were re-invested in the head-trust on particular terms. The ATO’s change of heart effectively puts an end to the idea of re-investment arrangements whereby the only return received under the sub-trust arrangement results in interest only returns.
How to avoid Division 7A dividend in cases
where financial accommodation is provided
In cases where financial accommodation is provided as described in the ATO’s Determination, the trustee and the private company beneficiary can avoid a dividend being taken to be paid if, before the private company's lodgement day for the income year in which the financial accommodation arises:
- the trustee pays the trust entitlement to the private company beneficiary, or
- the private company beneficiary and the trustee enter into a complying loan agreement in respect of the financial accommodation.
Date of effect
When the final Determination is issued, it is proposed to apply to trust entitlements arising on or after 1 July 2022.
Due date for comments: 29 April 2022
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