In Practice Statement 2010/4, the Commissioner set out three safe harbour investment options that taxpayers could avail themselves of to ensure an Unpaid Present Entitlement (UPE) of a company from a trust, did not attract the application of Division 7A. These options involved having the UPE funds invested under a documented agreement between the main trust and the sub-trust in one of three ways:
- on an interest only 7-year loan (Option 1 loan);
- on an interest only 10-year loan (Option 2 loan); or
- in a specific income producing asset or investment (Option 3 investment).
Seven-year Option 1 loans are approaching their maturity date, and so, either:
- loan principal for Option 1 loans will soon need to be repaid; or
- alternatively, Option 1 loans may be converted into Division 7A complying loans to allow funds to be retained by the trust for an additional 7 years; or else
the unpaid principal will be deemed to be a dividend.
The Commissioner’s Treatment of Unpaid Present Entitlements
UPEs are distributions that have been declared by a trustee but not paid out to the beneficiary. For many years it was common for family discretionary trusts to make corporate beneficiaries presently entitled to trust income without paying out the entitlement so that the funds could be kept for use by the trust, or applied for the benefit of other beneficiaries, while paying tax at the corporate tax rate, rather than the higher rate of tax applying to trusts and non-corporate beneficiaries.
In a much criticised Tax Ruling (being TR 2010/3), the Commissioner, concerned that UPEs were being used by family groups to gain a tax advantage, decided to depart from previous practice by determining that a UPE owed to a corporate beneficiary is a loan back to the trust under Division 7A of the Income Tax Assessment Act 1997 (ITAA97). That Division deems purportedly tax-free distributions from a private company to a shareholder or their associate (such as loans) to be assessable, unfranked dividends in certain circumstances.
The Commissioner, however, provided a lifeline to taxpayers affected by the changed position on UPEs, by stating in the same Tax Ruling that taxpayers could avoid the application of Division 7A if the trustee holds the UPE funds on sub-trust for the sole benefit of the private company beneficiary. Those funds could still be used as working capital by the main trust, as long as the funds were invested back into the main trust on commercial terms under a legally binding investment agreement between the main trust and the sub-trust and the benefits from the investment were completely repatriated to the private company beneficiary. Three safe harbour options, outlined above, were created to ensure taxpayers could avail themselves of the administrative treatment set out in TR 2010/3.
To avoid unfairly prejudicing companies with UPEs arising before the Commissioner changed his position, the Commissioner also stated that UPEs that arose prior to 16 December 2009 would not be treated as loans to which Division 7A would apply. However, under proposed changes to Division 7A revealed in the 2016-17 Budget, and which are expected to commence from 1 July 2018, all (pre- and post-2009) UPEs must be rearranged into new complying 10-year loans or be caught under Division 7A.
What this means for taxpayers
Option 1 loans are approaching their maturity date after which time the safe harbour relief from Division 7A will expire.
The loan principal for Option 1 loans entered into in the 2010-11 income year (for UPEs created between 16 December 2009 and 30 June 2010) must be repaid by 30 June 2018, otherwise the unpaid loan principal will be treated as a non-complying Division 7A loan and assessable to tax as an unfranked deemed dividend under 109D.
Additional 7 years relief available for Option 1 loan agreements
Option 1 loans cannot be rolled into an Option 2 loans or 3 investments (or vice versa): PS LA 2010/4.
Practical Compliance Guideline 2017/13, however, which was released on 19 July 2017, may provide some relief to taxpayers. In it, the Commissioner maintains that a trustee must repay the principal of the loan at the end of the loan term.
However, the Commissioner also states that a 7-year Division 7A compliant loan under s 109N ITAA 1936 between the sub-trust and the private company beneficiary may be put in place prior to the private company’s lodgement day to allow a further period of 7 years for the principal to be repaid. If a taxpayer elects to enter into a Division 7A compliant loan, periodic payments of both principal and interest will need to be made.
Note, however, that if the Commissioner determines that there was never an intention at the end of the term of the 7-year Option 1 loan to repay the principal of the loan, the Commissioner may infer that the arrangement was a sham and deem it a dividend in the income year in which it arose.
What needs to be done
If you are a tax adviser, you need to check which clients have Option 1 loans in place and make sure they are aware that such loans may need to be completely repaid by 30 June 2018.
The impending repayment of these loans may pose significant cash flow problems for family groups and require urgent consideration. You may need to consider converting the Option 1 investment into a Division 7A compliant loan by the private company’s lodgement day (e.g. 15 May 2019) to extend the term of the loan for an additional 7 years.
Note, however, that the 30 June 2018 repayment date dovetails with the commencement date of the proposed changes to Division 7A outlined above, which may ultimately supplant the administrative treatment set out in PCG 2017/13 with the conversion of all UPES into 10-year Division 7A complying loans.
According to the Commissioner, some private companies entered into sub-trust arrangements in the 2010 income year, in which case the principal of the loan would have been due for repayment in the 2016-17 income year. Tax advisers and their clients should check that there are no sub-trusts that were created in the 2009-10 income year for which any outstanding loan principal repayments are now overdue.
For taxpayers and advisers who are still unaware that UPEs created after 16 December 2009 are treated as loans under Division 7A, they may need to seek to have the Commissioner exercise his discretion under s 109RB to disregard non-compliance with Division 7A as a result of “honest mistake or inadvertent omission”, as it is likely the Commissioner will soon start taking compliance action in this area. The first and only case so far involving an application under s 109RB was covered in our earlier article here:
 TR 2010/3 also states that trustees have the alternative options of simply paying out the UPE or entering into a Division 7A compliant loan in accordance with s 109N ITAA 1936.
 Note, however, if a private company beneficiary releases a trustee from paying a pre-16 December 2009 UPE, it may, depending on the circumstances, be deemed a dividend by the Commissioner under s 109C of Division 7A, which broadly deems a financial benefit provided by a private company to a shareholder or their associate to be a dividend (TD 2015/20). Further, even if a UPE is not caught under Division 7A, there is still a risk that the Commissioner will argue that the UPE constitutes a reimbursement agreement under s 100A of ITAA 1936, which means, subject to the relevant exceptions, the beneficiary’s entitlement is disregarded and the trustee is taxed at the top marginal rate under s 99A ITAA 1936. A reimbursement agreement arises where a third party receives the benefit of a trust distribution instead of the beneficiary that was presently entitled to the distribution. In a fact sheet issued on 3 April 2014, the Commissioner indicated that he will generally not consider whether s 100A applies to a UPE to a corporate beneficiary if the retained funds are used as working capital of the trust and, for post-16 December 2009 UPEs, a Division 7A complying loan or investment agreement is in place.