No 1: ATO looking to attack trust distributions to companies

Distributing income from trusts to companies has been a longstanding practice by taxpayers and practitioners to limit the tax on earnings initially to the corporate rate of 30%. Any “top up” tax is usually paid by the shareholder when the company declares dividends as a result of their marginal rate often being higher than the company rate of 30%.

The deemed dividend rules contained in Division 7A of the Income Tax Assessment Act (1936) (“the Tax Act”) operate mainly to catch loans, payments and forgiven amounts by private companies to shareholders and their associates. Unpaid present entitlements owing to companies were not immediately dealt with when Division 7A was introduced with effect from 4 December 1997. For trust law purposes, it has been a longstanding argument that an unpaid present entitlement owing by a trust to a company is held on trust by the trustee and it is not a loan at all.

On 17 September 2009, the ATO held its most recent meeting of the National Tax Liaison Group (“NTLG”) which includes members from the ATO, Treasury and public practice representatives. At the meeting, the ATO raised the issue of Unpaid Present Entitlements owing by trusts to company beneficiaries and highlighted the potential for such unpaid entitlements to be caught under the loan provisions contained in Division 7A of the Income Tax Assessment Act (1936).

At the NTLG meeting, the ATO presented a discussion paper which seeks to clarify the intended wide operation of the loan rules Section 109D(3), including by way of contrast, specific reference to the Explanatory Memorandum (accompanying the introduction of the former section 109UB) which explained the policy rationale behind the inclusion of section 109UB. This section was inserted into Division 7A as a specific integrity measure to counter any potential argument that section 109D did not apply where a private company has an unpaid present entitlement, that amount is held on a secondary trust (as distinct the main trust), and a loan is subsequently made by the trustee to a shareholder (or associate of a shareholder) of the private company from the secondary trust.

Section 109D(3) defines a loan to be any of the following:

  • an advance of money; and
  • a provision of credit or any other form of financial accommodation; and
  • a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; and
  • a transaction (whatever its terms or form) which in substance effects a loan of money.

At the NTLG meeting, it was noted that this was a significant issue with some $1billion of unpaid present entitlements identified in audit and review cases currently in action. There was also a concern that the position now being adopted by the Tax Office represented a u-turn as to how the provisions were previously applied.

At the conclusion of the meeting the external members were invited to comment upon the technical arguments advanced by the Tax Office to date, and they were also invited to make submissions on behalf of their members in relation to an appropriate administrative solution (including prior income years).

From a practical perspective, the ATO could be seeking to require that taxpayers treat unpaid corporate beneficiary entitlements as loans and subject them to the onerous annual interest and minimum loan repayment criteria. The basis for such a proposition is open to question in certain respects, all the more so if it is to be taken with retrospective effect.

Further discussion regarding this issue has been scheduled for the NTLG Division 7A working group and NTLG members on 25 September 2009.

We will provide further updates as they become available.