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

In circumstances where all unpaid present entitlements (UPEs) in a fixed trust, are mixed with the trust fund but employed by the trustee to benefit all unit holders (by retiring trust debt) in the exact same proportion as each UPE bears to the total of all UPEs, 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 III 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 of the unit holders are related to one another and collectively hold 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 2011 income year it was agreed that all funds held by the trust representing UPEs would be used to retire trust debt. As at 30 June 2011, the trustee had not discharged the entitlements, however, if in the future any entitlements are so discharged (in full or in part), all unit holders will have their entitlements discharged (in full or in part) proportionately.

The trustee has since applied the funds to that end.

The trust capital is applied by the trustee in arm's length, income-generating investments.

Division 7A of Part III 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 company's 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 dividend because of the loan at the end of the current year; and (d) 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 (and is an in substance loan).

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 that the beneficiary is made presently entitled to, 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.

The unit holders have agreed that the funds representing the amount that they are entitled to should be applied to reduce the debts of the trust. But ultimately, the unit holders are still entitled to receive payment of their UPEs pursuant to the trust deed. That is, notwithstanding that the unit holders are not part of the same family group, there is a consensual agreement and a principal sum or equivalent, that will ultimately be payable to the unit holders.

However, the issue here is whether or not on the facts of this arrangement, there has been (or will be) the supply or grant of some form of pecuniary aid or favour.

In this case, all the UPEs outstanding at 30 June 2011 are in proportion to the number of units held by the unit holders. In addition, no entitlements have been discharged either in part or in full.

The unit holders have collectively agreed that all profits are to be retained in the trust for trust purposes in this case, to retire trust debt. Therefore, the unit holders have collectively agreed to defer receiving their share of profit for the relevant years in favour of an entitlement to receive a return equal to their respective share of the total funds. This is premised on the notion that the net asset position of the trust will be improved and all future profits (both capital and income) will also be distributed in accordance with the trust deed.

As such, each of the unit holders will be entitled to receive a return commensurate with the funds that they allow the trustee to use. The arrangement involves each unit holder agreeing that the funds that they are proportionately entitled to can be used to reduce the debts of the trust, and this use is proportionately for the benefit of each unit holder. Accordingly, the unit holders have not provided or are not providing any pecuniary aid or favour to the trustee or any other taxpayer. They are instead collectively agreeing that the funds be used for their sole benefit.

Under these circumstances and in accordance with the principles set out in Taxation Ruling TR2010/3, each of the unit holders has not and is not providing financial accommodation or an in substance loan to the trustee.

Therefore, where the unit holder of the 100 units are entitled to receive income and capital of the trust in proportion with their unit holdings and each has agreed to leave the entitlement they have to be paid from the trust outstanding, the UPE will not constitute a loan for Division 7A purposes.

Date of amendment Part Comment 24 September 2018 BSL Business line updated to Private Groups & High Wealth Individuals 16 November 2012 Facts Amended for clarity

Date of amendment | Part | Comment

24 September 2018 | BSL | Business line updated to Private Groups & High Wealth Individuals

16 November 2012 | Facts | Amended for clarity