This post is intended for readers who are already familiar with the concepts of Division 7A, ‘unpaid entitlements to trust income’, section 109N complying loans, and “sub-trust” arrangements of the kind described in Taxation Ruling TR 2010/3 and Practice Statement PS LA 2010/4.

ATO ID 2012/74 is about the application of Division 7A to an unpaid present entitlement to trust income (“UPE”) owed by the trustee of a fixed trust to a private company unitholder (where the trustee is an associate of the private company’s shareholder(s)). The ATO states that the UPE is not “caught” by Division 7A – this is so even though the UPE has not been converted into a section 109N complying loan, and there is no explicit sub-trust arrangement in place.

THE SITUATION

The situation considered in ATO ID 2012/74 (“Specific Situation”) is as follows:

• the trust is a unit trust in which unitholders have proportionate, fixed entitlements to capital and income of the trust;
• the unitholders have unpaid entitlements to trust income (“UPEs) in proportion to their respective unitholdings;
• the trust capital is applied by the trustee in arm’s length, income-generating investments;
• the unitholders have consented to the trustee using the UPE amounts to reduce debts of the trust (which reduction is intended to improve the net asset position of the trust).

(If the UPEs constitute deemed loans from the unitholders to the trustee, adverse consequences could arise under Div 7A because:

• the unitholders are private companies; and
• the trustee is an ‘associate’ of the private companies’ shareholder(s).)

CONDITIONS FOR A DEEMED LOAN

Based on TR 2010/3, the ATO should treat a unitholder’s UPE as a deemed loan (from the unitholder to the trustee), only if, under a consensual agreement, the unitholder:

1. does NOT call for payment of their UPE; and
2. does NOT call for the trustee to invest their UPE at a commercial return solely for the unitholder’s benefit.

ATO’S REASONING

The ATO concludes that there is no deemed loan in the Specific Situation because, in the Specific Situation, the unitholder DOES call for the trustee to invest their UPE at a commercial return solely for the unitholder’s benefit.

This is because, in circumstances where:

• unitholders have UPEs in proportion to their respective unitholdings;
• the UPEs are applied by the trustee, in a commercial manner, for trust purposes; and
• unitholders have proportionate fixed entitlements to capital and income of the trust,

each unitholder’s UPE will, in effect, be invested at a commercial return wholly for the benefit of the unitholder.

WAYS TO KEEP PROFITS IN TRUST

Where beneficiaries under a trust consider that trust profits can be better utilised by the trustee than by the beneficiaries, beneficiaries may wish for the trustee to retain use of profits. However, if (i) the trustee has already created an entitlement in a beneficiary to profits (which is likely to be the case if the trustee has resolved to distribute all trust income for a year), (ii) the beneficiary is a private company whose ultimate owner’s marginal tax rate exceeds the company tax rate, and (iii) the trustee is an associate of the company’s owner, it may be difficult for the trustee to retain use of the profits without either a deemed dividend arising under Div 7A, or the ultimate owner becoming liable to pay “top up” tax on an actual dividend.

In order for the trustee to retain use of the profits without either of those unfavourable consequences resulting:

• usually it would be necessary to use a 109N complying loan or a sub-trust arrangement of the kind described in TR 2010/3 and PS LA 2010/4; but
• in the case where the beneficiaries of the trust are unitholders who have proportionate, fixed entitlements to the capital and income of a trust, and have UPEs in proportion to their respective unitholdings, 109N complying loans and explicit sub-trust arrangements might not be necessary.  Instead:
  • it may be possible for the trustee to retain use of the profits (to which unitholders have already become entitled) merely by keeping the UPEs on foot, provided that the trustee invests the UPEs on an arm’s length, commerical basis (cf how the UPE was used in the Montgomery Wools case [2012] AATA 61) (“UPE Method”). This is what ATO ID 2012/74 (discussed above) seems to suggest; or
  • it might be possible for the trustee to pay the unitholders their unpaid entitlement amounts, and for each unitholder to then invest the amount they have received back into the unit trust (“Investment Method”). On the basis that unitholders have proportionate, fixed entitlements to the capital and income of the trust, and have UPEs in proportion to their respective unitholdings, depending on the terms of the trust deed, the Investment Method would not necessarily trigger adverse consequences under Division 7A (see section 109J).

It is interesting to compare other tax consequences of these two Methods:

• Under the Investment Method, a unitholder could potentially obtain tax recognition for the amount they invest in the trust (ie, the amount that was formerly their UPE amount). The amount might be recognised as 1st element cost base of new units (if additional units are issued proportionately to all unitholders in respect of the invested amounts), or as 4th element cost base of the unitholder’s existing units (if no additional units are issued in respect of the invested) amounts).
• Under the UPE Method, query whether a unitholder could obtain tax recognition for the UPE amount.