The Commissioner’s view is that where a company beneficiary of a trust has an UPE, this entitlement will generally be treated as a loan for Division 7A purposes, if it is not discharged within the required time frames. The Bendel and Commissioner of Taxation [2023] AAT 3074 decision held that a UPE was not a loan for Division 7A purposes. If upheld, the case could have significant implications to the application of Division 7A, although we would recommend caution at this stage.

ATO views on UPEs tax treatment

If UPEs are treated as loans under Division 7A, this gives rise to a deemed unfranked dividend to the trust unless the relevant arrangement was placed on complying Division 7A  loan terms prior to the lodgement date of the relevant trust. Originally, the prevailing view was that a UPE would not generally constitute or give rise to a loan.  

However, with the publication by the ATO of TR 2010/3 and Law Administration Practice Statement PS LA 2010/4, the ATO’s position was made relatively clear. The ATO’s stated view was that a UPE of a corporate beneficiary, prospectively from 16 December 2009 would be regarded as the provision of ‘financial accommodation’ and/or an ‘in substance’ loan in circumstances where:  

• the funds representing the UPE were retained for use within the trust, and
• the private company beneficiary allowed this use by acquiescing to this retention with knowledge of it.

This is on the basis that the definition of a loan for the purposes of Division 7A included arrangements involving the provision of financial accommodation and ‘in substance’ loans. The view of the ATO is that such arrangements would be treated as a Division 7A loan in the income year following the income year in which the UPE arose.

As an administrative concession, the ATO’s position was that UPEs placed on certain ‘interest only’ subtrust terms (in compliance with PS LA 2010/4) would not be treated as a loan for Division 7A purposes. 

The ATO’s approach to UPEs was changed further in 2022 with the withdrawal of TR 2010/3 and PS LA 2010/4 and issuance of TD 2022/11 which removed the ‘complying subtrust’ concession.

It is surprising that it has taken this long for a judicial challenge and decision to occur on the Commissioner’s views reagarding Division 7A UPEs.   

The Bendel Case decision

In the Bendel Case, the court held that the UPEs payable from a discretionary trust to a corporate beneficiary are not loans for the purpose of section 109D(3) of the Income Tax Assessment Act 1936.

The case essentially involved the taxpayer disputing assessments raised by the ATO against beneficiaries of a trust on the basis of a deemed dividend arising to the trust under Division 7A. Whilst there were a number of related issues considered in the judgement, the key issue was whether Gleewin Investments Pty Ltd, as corporate beneficiary of the relevant discretionary trust, had made a loan within the meaning of that term in section 109D(3) of the Income Tax Assessment Act 1936 to the trust.

Section 109D(3) defines the term ‘loan’ for the purposes of Division 7A and encompasses arrangements that involve the provision of financial accommodation or credit regarded as ‘in substance’ loans.

The taxpayer asserted that the extended definition of ‘loan’ for in section 109D(3) needed to be interpreted within the statutory context of Division 7A and other provisions included in Division 7A, the express purpose of which was to deal with arrangements involving UPEs. These provisions included former section 109UB and its more complex successor provisions, Subdivision EA of Division 7A. This was supporting evidence for the proposition that UPEs were not intended to fall within the definition of loan for the purposes of Division 7A. The taxpayer also stated that a contrary interpretation would mean that UPEs could effectively result in a duplication of tax outcomes and double taxing in effect. 

The Commissioner argued that the extended wording of the term loan in section 109D(3) was sufficiently clear to include a UPE, and the prospect of double taxation under the provisions were played down as a practical issue by the Commissioner.

The taxpayer’s claims were favoured by the Tribunal who agreed with the double-taxing propositions and the relevance of statutory context. The Tribunal found that the UPE owing was not a loan under section 109D(3), stating at paragraph 101 that:

the necessary conclusion is that a loan within the meaning of section 109D(3) does not reach so far as to embrace the rights in equity created when entitlements to trust income (or capital) are created but not satisfied and remain unpaid. The balance of outstanding or unpaid entitlement of a corporate beneficiary of a trust, whether held on a separate trust or otherwise, is not a loan to the trustee of that trust.

So what does this decision mean?

The decision, whilst being a relatively junior judicial decision, is a significant decision for private group taxpayers. The Commissioner will most likely lodge an appeal to the Federal Court. It is unlikely that the Commissioner will resile from his views in TD 2022/11 unless a more senior court rules similarly in favour of the taxpayer. The ATO will likely also shortly release a Decision Impact Statement (DIS) in response to the AAT’s decision. 

There are some caveats in relation to this decision. As noted by the Tribunal, Division 7A implications may still arise (under Subdivision EA) where any UPE remains outstanding in favour of a private company beneficiary and the relevant trust undertakes certain transactions in favour of shareholders or associates of the company (such as a loan).  In addition, the Commissioner has also recently highlighted that another anti-avoidance provision, section 100A could also play a role in relation to some UPEs.

Although the decision will be welcomed by many taxpayers, caution is still recommended in the treatment of UPEs. SW will be closely monitoring any developments in this space and will keep you informed.

How SW can help 

If you would like to discuss the Bendel decision or need assistance with your Division 7A matters, please reach out to us.

Contributors

Ian Kearney

Ned Galloway

Mitchell Kenny

¹ Bendel and Commissioner of Taxation [2023] AAT 3074  decision

The post Division 7A UPEs | Bendel decision challenges ATO’s views appeared first on SW Accountants & Advisors.

The appeal decision is a win for the taxpayer regarding the application of section 100A, particularly with respect to whether an agreement was reached between the parties prior to a beneficiary becoming presently entitled to trust income – however, it is important to have the facts and evidence supporting that such an agreement was not in place.

The taxpayer was however unsuccessful with respect to Part IVA in the 2013 income year, which is a win for the ATO who will continue to apply Part IVA to arrangements involving trust distributions that are contrived to achieve tax benefits. Taxpayers need to be comfortable that trust distributions are not made for the dominant purpose of reducing income tax payable.   

Building on our previous article about this case, the SW team recaps the facts and looks at the detail of the Appeal and its outcome. 

Section 100A 

Firstly to recap, section 100A is an anti-avoidance provision that targets situations where one person is made presently entitled to income of a trust, but another person receives the benefit of the funds represented by the income. For section 100A to apply there must be a reimbursement agreement (very broadly defined) and: 

• the person who is made presently entitled to the income, but does not receive the income, is taxed at a lower rate than the actual recipient of the cash; and 
• the agreement, arrangement or understanding cannot be a reimbursement agreement where the agreement, arrangement or understanding arises from an ordinary family or commercial dealing. 

Summary of the Guardian case 

The case involves three key parties, being: 

• Australian Investment Trust (AIT) – an Australian discretionary trust 
• Mr Springer – a non-resident taxpayer that is the controller of AIT and other entities in the Springer Group 
• AIT Corporate Services Pty Ltd (Corporate Services) – a wholly owned subsidiary of AIT. 

Corporate Services was a newly incorporated ‘cleanskin’ company created for the purpose of receiving distributions from AIT. The other Springer group entities had previously traded and were being wound down or sold in order for Mr Springer to simplify his life and transition to retirement. 

2012 and 2013 

Corporate Services was made presently entitled to the income of AIT for the 2012 and 2013 income tax years, which did not include franked dividends. AIT paid to Corporate Services an amount in cash to cover the income tax liability arising from the distribution. The balance owing from AIT to Corporate Services remained as an unpaid present entitlement (UPE). 

In the following income years, Corporate Services declared a fully franked dividend to AIT. The UPE balance and the dividend payable were offset, so that the UPE was fully discharged. 

The franked dividend received by AIT in those subsequent years was distributed to Mr Springer. As a non-resident, Mr Springer was not subject to any further tax on the dividend. 

2014 

Corporate Services was made presently entitled to the income of AIT for the 2014 income tax year. Similar to 2012 and 2013, AIT paid to Corporate Services an amount in cash to cover the income tax liability arising the distribution. However, the UPE balance was converted to a loan that was placed on complying Division 7A terms. 

Guardian case appeal decision

In the appeal, the Commissioner appealed against the decision of Logan J (which was favourable to the taxpayer), in relation to: 

• section 100A in relation to the 2013 income tax year and 
• Part IVA in relation to the 2012 and 2013 income tax years. 

Therefore, the Commissioner did not appeal against the elements of the previous decision made in favour of the taxpayer in regard to section 100A (2012 income year) and section 100A and Part IVA (2014 income year).  

Outcome of the appeal 

The Full Court (Perry, Derrington and Hespe JJ) dismissed the Commissioner’s appeal in relation to: 

• Section 100A for the 2013 income tax year and 
• Part IVA for the 2012 income tax year. 

However, the Court allowed the Commissioner’s appeal under Part IVA in relation to the 2013 assessment of Mr Springer.   

Basis of the Full Federal Court decision  

The key reasons for the Court’s decision in relation to section 100A include: 

• The reimbursement agreement did not arise out of the present entitlement. There was no ‘agreement’ for the purposes of section 100A that existed prior to or at the time that the 2013 present entitlement of AIT arose – that is, there was no ‘reimbursement agreement’ involving the payment of a dividend by AIT at that time.  
• An agreement requires that there be a consensus or adoption of the arrangement. Generally, the beneficiary would need to be a party to a reimbursement agreement for section 100A to apply (this should be contrasted with the decision in Idlecroft and the Commissioner’s view in paragraph 16 of TR 2022/4). 
• The attribution of purpose from professional advisors is more limited in the context of section 100A compared to intention in Part IVA. Given that Mr Springer had not provided his advisors authority to act on behalf of the relevant entities, the intention of the advisors could not be attributed to Mr Springer. 
• Even if the intention of the advisors were attributable to Mr Springer, the advisors did not specifically contemplate the reimbursement agreement until 15 January 2014, being 7 months after Corporate Services was made presently entitled to the income. At the time of the present entitlement arising, the option of paying the dividend was not ‘wholly conjectural’ but the Court held there was insufficient evidence of an agreement. 
• Although the comments were made in obiter, the Court recognised (and the Commissioner was noted in the judgement as agreeing) that the ordinary commercial and family dealings exception could apply where trust income is appointed to a corporate beneficiary. However, the case provides limited guidance in relation to the ordinary commercial and family dealings exception and provides little comfort to taxpayers that were hopeful of the Courts rejecting the Commissioner’s views in his recent tax ruling on section 100A (TR 2022/4). 

Part IVA 

Part IVA of the income Tax Act is the general anti-avoidance provision of Australian income tax law. The Court held that Part IVA would apply in relation to the 2013 income tax year (although not the 2012 income tax year). For Part IVA to apply, the following elements need to be satisfied: 

• A person enters or carries out a scheme. 
• The scheme provides a taxpayer with a tax benefit. 
• The dominant purpose (based on the objective facts) of entering the scheme is to obtain a tax benefit. 

A key issue in determining whether Part IVA applies to any given situation involves consideration of an alternative postulate or counterfactual – what would have happened (annihilation approach) or what might reasonably be expected to have occurred (reconstruction approach) if the relevant scheme had not been entered into? 

For 2012 and 2013 income tax years, the Commissioner’s alternative postulate was based on AIT making a direct distribution of unfranked income to Mr Springer. Therefore, in each year there was a scheme and a tax benefit given that Mr Springer would have paid tax at marginal tax rates (45%) under the alternate postulate in relation to the distribution of unfranked dividend income, rather than actual tax paid by Corporate Services of 30%. 

The Court held that the formulation of the alternate postulate needed to be based on the commercial outcomes of the arrangement. As Mr Springer ultimately received the cash relating to the 2012 and 2013 unfranked income, it was reasonable for the Commissioner to form the alternate postulate whereby Mr Springer directly received a distribution of unfranked income from AIT. 

The Court emphasised that the taxpayer has the onus of what might reasonably be expected absence the scheme (not just proving that the Commissioner’s alternate postulate was unreasonable). For the 2013 income tax year, the Court emphasised that in determining the alternative postulate any adverse tax impacts should be disregarded (that is, it was not open to the taxpayer to argue that an alternative arrangement would not have been entered into because the tax costs would be too high).  

The Court held that the dominant purpose of entering or carrying out the 2012 scheme was not to obtain a tax benefit whereas the dominant purpose of the 2013 scheme was to obtain a tax benefit. The decision of the Court was based on the following: 

• The factors to establish the objective intention of the taxpayers requires an examination of the manner in which the scheme was entered into or carried out. For 2012, there was an evolution of steps that meant the dividend was paid from Corporate Services to AIT. However, at the time the scheme was entered into there was no objectively ascertainable circumstances that would give rise to an expectation that the dividend would have been paid. 
• In contrast, as the 2012 UPE was cleared via the dividend in 2013, it was not unreasonable to expect that the 2013 UPE would be cleared via a dividend particularly given that Mr Springer had concerns about holding cash in Corporate Services and Corporate Services had not been used as a wealth accumulation vehicle. 

Concluding remarks 

While the appeal decision is a win for the taxpayer regarding the application of section 100A, unfortunately the case does not provide guidance on the ordinary commercial and family dealings concept, which is crying out for judicial clarification. The appeal decision also provides further ammunition to the ATO with respect to the application of Part IVA to such arrangements. 

How can SW help? 

SW has assisted a number of taxpayers in recent years in relation to ATO reviews and audits on 100A. If you would like any further information, please contact a member of the SW tax team.  

Contributors

Ned Galloway

The post Guardian case – tax appeal decision on section 100A – Trusts  appeared first on SW Accountants & Advisors.

The contents of these pronouncements are both voluminous and complex and are still being digested, but essentially relate to the Commissioner’s views on the operation of two integrity measures – section 100A and Division 7A. 

Section 100A

What is it?

Section 100A is an anti-avoidance provision that has the potential of imposing a penal tax outcome where one person (beneficiary) is made presently entitled to trust income, but another person effectively receives the benefit of the income.  The provision was originally introduced (way back in 1979) to attack aggressive tax avoidance arrangements, but it is worded so broadly that it can technically apply to much more commonplace circumstances.

If it applies, the relevant trust income is generally subject to tax within the trust under section 99A at the top marginal rate of tax (currently 47%).

Historically, many taxpayers and their advisers have taken comfort from the rule in section 100A that ‘ordinary family or commercial dealings’ are excluded from the operation of section 100A.

What is changing?   

In recent years, it has become evident that the Commissioner has been looking to apply section 100A to circumstances well beyond its originally intended targets, and yesterday made public his detailed (preliminary) views on this troublesome provision in the form of:

• Draft Taxation Ruling 2022/D1 – Income tax: section 100A reimbursement agreements
• Taxpayer Alert TA 2022/1 – Parents benefitting from the trust entitlements of their children over 18 years of age
• Draft Practical Compliance Guideline 2022/D1 – Section 100A reimbursement agreements – ATO compliance approach

Whilst administrative guidance on this difficult subject is welcomed from a clarity perspective, the preliminary views expressed will present challenges to many and could fundamentally change the tax planning considerations for trusts and beneficiaries.

What does this mean?  

Whilst the detail of these lengthy and complex draft pronouncements is still being digested, we note the following key points:

• the Commissioner has expressed a very broad view of circumstances to which section 100A could apply
• the Commissioner has expressed a very narrow view of when the ‘ordinary family or commercial dealing’ exception is likely to apply.

The Commissioner has indicated that section 100A could apply to the following circumstances, including:

• gifts from individual trust beneficiaries on low marginal tax rates to other family members with a higher marginal tax rate – for example, gifts or reallocations from adult children that have unpaid trust distributions to their parents.
• a pattern of behaviour involving continuous gifts from beneficiaries back to the trust or even circumstances involving accumulation of unpaid trust distributions with the funds being retained in the trust
• non-commercial loans between family members funded by income distributions from a trust
• manipulation of income of the trust estate and net income.

The examples referred to above have far reaching implications for trusts and their beneficiaries (including corporate beneficiaries).  The approach that Commissioner proposes to adopt represents a significant departure from arrangements that many family groups will have adopted in the past.

The Taxpayer Alert TA 2022/1 specifically identifies circumstances which the Commissioner regards as high risk in relation to distributions to children of parents who control a discretionary trust.  The TA not only addresses 100A, but indicates the distributions may be legally ineffective or subject to Part IVA.

When will this new approach apply from?

The draft ruling indicates that the approach will apply retrospectively as well as prospectively, subject to some concessions set out in Draft Practice Compliance Guideline PCG 2022/D1.  This is significant, as section 100A (being originally intended for aggressive tax avoidance measures) is not subject to any statutory time limits – it can be applied retrospectively indefinitely, without the usual limitations upon the Commissioner.

Unfortunately, the draft PCG only provides limited concessions for arrangements entered into prior to the release of the pronouncements referred to above.  In very broad terms, certain pre-existing arrangements that are regarded as relatively benign will not be reviewed by the ATO. The limits to these concessions is one of the elements of the new suite of drafts that we believe is worthy of further dialogue and submissions in an effort to seek an outcome that is less harsh.

The PCG also provides something of a ‘heat map’ for taxpayers and advisers to rate the risks of arrangements under section 100A.

Division 7A – complying subtrusts no longer permitted

In addition to the section 100A developments, the Commissioner has also issued a draft determination in relation to Division 7A (TD 2022/D1: when will an unpaid present entitlement or amount held on sub-trust become the provision of financial accommodation). Whilst this TD is quite lengthy, the essence of it is that the Commissioner has announced a prospective (from 1 July 2022) change to his previous approach under which he allowed unpaid trust distributions owing to a company beneficiary to be put on interest-only terms for a 7 or 10 year period (depending on the interest rate).  The new approach will be more challenging for taxpayers in that such unpaid entitlements will need to be put on complying Division 7A loan terms, which broadly require both interest and principal repayments annually.   

Next steps

Section 100A in particular is a very technical and difficult provision and there is much to digest in the pronouncements referred to above.  SW will be considering the draft guidance in detail and propose to make submissions to the ATO prior to the finalisation of these pronouncements. 

Another factor to bear in mind (which is also referred to by the Commissioner in the draft ruling) is that the recent Guardian case concerning the operation of section 100A (refer to SW summary here: Guardian case – section 100A win for the taxpayer (sw-au.com), which was decided in favour of the taxpayer, is subject to appeal.  The draft views expressed appear to have been formed without any major regard to this decision, so the outcome of this appeal will be particularly relevant in this context. 

In addition to making submissions to the ATO in respect of these drafts, SW will be closely monitoring developments in this area and will keep its clients well informed as circumstances evolve.

Contributors

Ophelia Katrivessis

Ned Galloway

The post Trust distributions – the game has changed appeared first on SW Accountants & Advisors.