On 13 July 2022, the ATO finalised Taxation Determination TD 2022/11. TD 2022/11 sets out the Commissioner’s revised extended view on the application of Division 7A (i.e. loans to shareholders) in relation to unpaid present entitlements (UPEs) and sub-trust arrangements.
With the finalisation of TD 2022/11, the ATO has withdrawn its previous Taxation Ruling TR 2010/3 and Law Administration Practice Statement PS LA 2010/4, effective 1 July 2022. These provided more concessional treatment of UPEs than for Division 7A loans. As a consequence, the TD 2022/11, which applies to trust entitlements arising on or after 1 July 2022, will likely trigger a Division 7A deemed dividend in a wider range of circumstances than TR 2010/3 and PS LA 2010/4.
The good news is that the final version of TD 2022/11 (previously issued as draft TD 2022/D1), contains welcome timing changes compared to TD 2022/D1, a comment raised in our BDO submission to the ATO on TD 2022/D1.
Division 7A is designed to prevent private companies from making tax-free distributions of profits to shareholders, or their associates, by way of payments, non-commercial loans or debt forgiveness.
In circumstances where a trustee resolves to make a private company beneficiary presently entitled to trust income but does not discharge its obligation to pay the private company beneficiary, there is a UPE created for the private company beneficiary. The ATO considers such a UPE can be a financial accommodation provided by the private company to the trust, and therefore this UPE can be deemed a Division 7A loan.
ATO’s view on financial accommodation
In TD 2022/11, the ATO's view is that "financial accommodation" provided by a private company beneficiary to the trustee or a shareholder, a loan for Division 7A purposes, extends to the following two situations:
- Where the trustee resolves to make the private company beneficiary presently entitled to trust income, and does not discharge its obligation to pay the private company (i.e. there is a UPE); or,
- Where the private company beneficiary is made presently entitled to trust income, and the trustee sets aside an amount on sub-trust for the benefit of the private company beneficiary.
1. Private company beneficiary with a UPE
The ATO’s view is that a private company beneficiary with a UPE will provide financial accommodation - a deemed Division 7A loan - to the trustee when the company has ‘knowledge’ of an amount that it can demand immediate payment of from the trustee, but does not do so. Thereby the company has consented to the trustee retaining that amount for continued use for trust purposes.
The ATO states that the company will be deemed to have the requisite knowledge if the company and trustee "have the same directing mind and will", which will be the case for most family trust/corporate beneficiary situations. This means the financial accommodation - deemed Division 7A loan - is given when the same directing mind has calculated the trusts ‘trust law income’ and knows the amount to be distributed to the beneficiary. This will usually be when the accounts for the year have been prepared (for example on 31 October 2023, for the year ended 30 June 2023). The ATO now considers that this applies, unless the unpaid distributed funds are put under a sub-trust in circumstances where the sub-trust funds are not mixed with the main trust funds, and are invested solely for the benefit of the company. This is a more stringent requirement than under TR 2010/3 and PS LA 2021/4, which under option 2, allowed such sub-trust funds to be mixed with the main trust’s funds, without it resulting in a deemed Division 7A loan. The new requirement is similar to option 3 under PS LA 2010/4, which was not seen as an attractive option in most cases.
Welcome timing changes in final determination
In the draft determination TD 2022/D1, the timing of when the UPE becomes a loan or is put under sub-trust was more complex than in the final determination, TD 2022/11. Under the draft determination, the timing of when the UPE becomes a loan or a sub-trust could have been 30 June of the year the UPE was created, or when the trust accounts were prepared, which usually occurred in the following year. This timing depended on the way the trustee expressed the present entitlement in the trustee resolution. Fortunately, the ATO has revised its view favourably to treat all relevant corporate beneficiary UPEs as loans or sub-trusts at the time when the accounts are prepared, usually in the following year. This change was in response to comments in our submission to the ATO.
2. A sub-trust held for the company’s benefit
The ATO states that unless the sub-trust funds are held separately from the main trust funds and are held 100% for the benefit of the corporate beneficiary; a Division 7A loan will arise even if the sub-trust fund is on commercial terms and with a return paid to the sub-trust fund. This is a change in the ATO’s view from TR 2010/3.
How to evidence a sub-trust?
In the Compendium to TD 2022/11, the ATO states that the existence of a sub-trust depends on the trust deed and the trustee’s exercise of power in each case. It also states that in most instances, a sub-trust will be a ‘Transparent Trust’ as referred to in Practice Statement PS LA 2000/2 and therefore, such sub-trusts will be exempt from the requirement to furnish a tax return. However, the corporate beneficiary will have to return the sub-trust taxable income in its income tax return. Whether a sub-trust is or is not a Transparent Trust will depend on various factors including the wording of the trust deed, and the resolution creating the sub-trust.
It should be noted that, if the funds are not put under a sub-trust, the deemed loan can be deemed an unfranked dividend unless it is put under a compliant Division 7A loan agreement, i.e. Seven year or 25 year if secured over real estate with annual minimum repayments. That is to say, the concessional arrangements in PS LA 2010/4 are gone.
Date of Effect
TD 2022/11 applies to trust entitlements arising on or after 1 July 2022.
In response to comments in our submission, the ATO has also clarified that TD 2022/11 does not apply to UPEs arising before 16 December 2009. These UPEs will continue to be grandfathered and the company is not taken to provide financial accommodation to the trustee where it does not demand payment of these pre-16 December 2009 UPEs. This is a welcome clarification and provides certainty for taxpayers and advisers.
With the ATO’s expanded view regarding when a UPE becomes a loan for the purposes of Division 7A, as well as its revised view requiring sub-trust funds not be mixed with the main trust’s funds, the attractiveness of converting UPEs to sub-trusts is much diminished. This is evident from the fact that the new requirement for the sub-trust funds to be held separately from the main trust’s funds is similar to option 3 in PS LA 2010/4. From our experience, option 3 has rarely been used in practice since the release of PS LA 2010/4. Now, the only advantage of sub-trust arrangements over the provision of a loan from a corporate beneficiary to the trust appears to be that the sub-trusts alternative have a one year deferral of the time when the deemed loan is taken to have been provided for Division 7A purposes.
Taxpayers operating via a trust with corporate beneficiaries should review their arrangements and contact their BDO tax adviser to discuss whether they are affected by these changes.