Division 7A: unpaid present entitlements between a unit trust and unit holders

In circumstances where all unpaid entitlements (UPEs) in a fixed trust are mixed with the trust fund but employed by the trustee to benefit all corporate beneficiaries (by retiring trust debt) in the exact same proportion as each unpaid entitlement bears to the total of all unpaid entitlements, will a loan arise for the purpose of applying section 109D of Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936)?

No, in these circumstances a loan does not arise under section 109D of Division 7A of Part IIII of the ITAA 1936.

An Australian resident investment unit trust has 100 issued units.

The shareholders of the corporate trustee and the unit holders of the unit trust are the same and in the same proportion.

All units on issue in the trust are of equal value, carry equal rights to the income and capital of the trust fund and have a right to one vote per unit. In addition, the trustee's constitution states that there is the right to one vote for each share held.

Two unit holders are related to one another and account for 36% of the units in the Trust. The remaining 64% of the unit holders are not associated to each other.

Some of the unit holders are private companies.

Under the trust deed, appointments of income are made on a strictly proportional basis to unit holders based on units held. As at 30 June 2011 none of the appointments of past years have ever been called for or discharged and are subsisting UPEs in the sense used in Taxation Ruling TR 2010/3.

At a meeting of the unit holders during the 2012 income year it was agreed that all funds held by the trust representing unpaid entitlements would be used to retire trust debt'. The trustee has since applied the funds to that end.

Division 7A of Part IIII of the ITAA 1936 (Division 7A) is an anti-avoidance or 'integrity' provision, directed to ensuring that disguised or informal distributions of company profits to shareholders or their associates should be included in the assessable income of the shareholders or associates.

A private company may be taken to pay a dividend to an entity at the end of one of the private companies years of income under subsection 109D(1) of the ITAA 1936 where: (a) the private company makes a loan to the entity during the current year; and (b) the loan is not fully repaid before the lodgment day for the current year; and (c) Subdivision D does not prevent the private company from being taken to pay a (d) dividend because of the loan at the end of the current year; and (e) either: (i). the entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made; or (ii). a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time.

A loan is defined in subsection 109D(3) of the ITAA 1936. The section extends the definition of the term 'loan' beyond its ordinary meaning to include advances of money, provision of credit, provision of other forms of financial accommodation and any transaction which effects a loan of money.

A beneficiary can become presently entitled to an amount from a trust pursuant to a direct term of the relevant trust deed, or as a result of the trustee of the trust exercising a power under a trust deed to make the beneficiary so entitled (usually by resolution). In situations where the funds to which the beneficiary is made presently entitled continue to be held on trust for that beneficiary until such time as the beneficiary calls for payment, the entitlement is commonly referred to as a UPE. In Taxation Ruling TR 2010/3, references to a 'subsisting UPE' mean a UPE that has not been satisfied, including by being converted into (or replaced by) an ordinary loan.

Paragraph 17 of Taxation Ruling TR 2010/3 states that a subsisting UPE does not amount to a Division 7A loan specifically: • within the ordinary meaning of a loan; • under paragraph 109D(3)(a) of the ITAA 1936; or • under paragraph 109D(3)(c) of the ITAA 1936.

However, a subsisting UPE, in some circumstances, can amount to a loan for the purposes of Division 7A under paragraphs 109D(3)(b) or 109D(3)(d) of the extended definition in section 109D(3) of the ITAA 1936. Paragraphs 19 to 25 of Taxation Ruling TR 2010/3 provide a detailed explanation of when a private company provides financial accommodation or makes an in substance loan.

It follows from paragraph 19 of Taxation Ruling TR 2010/3 that a beneficiary is taken to provide financial accommodation where the following exist: • the unit holders supply or grant some form of pecuniary aid or favour to the trust; • under a consensual agreement; and • where a principal sum or equivalent is ultimately payable to the unit holders.

In the circumstances here, all the UPEs outstanding at 30 June 2011 are in proportion to the number of units held by the Unit Holders. Further, none of the entitlements have been discharged either partially or in full.

The unit holders have collectively agreed that all profits are to be retained in the trust for the trust purposes, in this case, to retire trust debt.. In doing so, the Unit Holders have collectively agreed to defer receiving their share of the profit for the relevant years in favour of an entitlement to receive a return equal to their respective share of the total funds, on the premise that all future profits (both capital and income) will also be distributed in accordance with the Deed.

As such, each of the unit holders will be entitled to receive a return completely commensurate with the funds it is allowing the trustee to use.

Therefore in the circumstances here and in accordance with the principles set out in Taxation Ruling TR2010/3, each of the unit holders has not and is not providing any pecuniary aid or favour to the trustee. Therefore, the retention of profits to retire debt does not constitute provision of financial accommodation and a loan has not been made for Division 7A purposes.