Unfinished business – time is running out on unpaid present entitlements
Since 2009 when the ATO changed its long-standing treatment of UPE’s (known as unpaid present entitlements), Division 7A has been a work in progress.
Tax ruling TR 2010/3 which has been in effect from 16 December 2009 outlines the ATO’s view that a UPE between a trust and a private company beneficiary is the provision of financial accommodation to the trust for the purposes of Division 7A and therefore could be taxed as an unfranked dividend in the hands of the trust.
In light of the significant ramifications of this change in heart, the ATO immediately issued PS LA 2010/4. Essentially PS LA 2010/4 assures taxpayers that the ATO would not apply Division 7A to UPEs that arose after 16 December 2009 where the funds representing the UPE are held on a sub-trust and the amounts held on the sub-trust are invested using one of the three investment options set out in PS LA 2010/4.
Effectively, this allowed corporate beneficiaries of discretionary trusts to continue to loan trust distributions back to the trust for working capital purposes. Trusts cannot retain undistributed profits like a company can, and therefore it was quite common for a trust to have a UPE in existence to fund an active business conducted in a trust structure.
Option 1 in PS LA 2010/4 requires that the sub-trust lends the funds representing the UPE to the trust under a documented legally-binding seven-year interest-only loan with the principal repayable at the end of the seven years. Many practitioners chose this option as it avoided making any principal repayments until the seventh year.
These loans are now coming to the end of their seven-year life span. In many cases the trust would have difficulty repaying the principal in its entirety. The IPA raised this issue with the ATO which responded with a stop gap remedy namely PCG (practical compliance guideline) 2017/13. A PCG is a public statement on how the ATO can facilitate practical difficulties within the operation of the law by providing administrative solutions.
The ATO issued PCG 2017/13 in July 2017 which applies to a private company or trustee beneficiary of a sub-trust where the trustee:
-Validly adopted Option 1 under PS LA 2010/4 on or before 30 June 2011; and
-Does not repay the principal of the loan when the loan matures in the 2017 income year or the 2018 income year.
The ATO states in PCG 2017/13 the following: “The commissioner maintains the clear expectation that this term of the investment agreement be met and that the principal of the loan, entered into under investment Option 1, must be repaid at the end of the loan term.
If the trustee fails to meet this term of the investment agreement, when an investment Option 1 matures in the 2017 income year or 2018 income year, any unpaid principal of the loan will be treated by the commissioner as the provision of financial accommodation and therefore a Division 7A loan. If all, or part, of the principal of the loan is not repaid on or before the date of maturity, the commissioner will accept that a seven-year loan on complying terms in accordance with section 109N may be put in place between the sub-trust and the private company beneficiary prior to the private company's lodgement day. This will provide a further period for the amount to be repaid with periodic payments of both principal and interest.”
PCG 2017/13 provides taxpayers an extension of the term of such loans for a further seven-year period.
“However, if such a seven-year loan on complying terms in accordance with section 109N is not put in place between the subtrust and the private company beneficiary prior to the private company's lodgement day, a deemed dividend will arise at the end of the income year in which the loan matures.”
Whilst PCG 2017/13 provides relief, there is a proviso. If there is evidence that there has never been an intention to repay the loan principal at the end of the seven-year Option 1 arrangement, the commissioner can go back and deem a dividend in the income year in which the provision of financial accommodation originally arose.
PCG 2017/13 provides an important one-off stop gap solution for loans maturing under Option 1 in the 2017 and 2018 income years only. It is unclear whether the ATO will extend the concession to option arrangements that mature later than 30 June 2018 or Option 2 arrangements that mature in 2020 or 2021 being the first years that repayments of those arrangements fall due.
The Board of Taxation made a number of recommendations in its post implementation review of Division 7A back in 2014 to the government. The Board of Taxation in its review acknowledged that UPEs provide a significant source of funding used by business taxpayers for working capital purposes.
Most in the tax profession believe the government will accept some of these recommendations as the way forward to resolving the long-standing UPE issue. The Board of Taxation proposes a single compliant loan with a duration of 10 years and better aligning calculation of the minimum interest rate with commercial transactions.
The single compliant loan however, would not only extend to post-16 December 2009 UPEs, but also to UPEs from before that date and loans that arose from before 4 December 1997 to which Division 7A does not apply.
At the time of writing we await the proposed changes that are meant to take effect from 1 July 2018.
In the meantime, taxpayers will need to rely on PCG 2017/13 if loans fall due before 30 June 2018 and there is no capacity to repay such loans.
Tony Greco, general manager of technical policy, IPA