Private ruling: Division 7A loans and unpaid present entitlements
Date of advice: 4 October 2018
Published: November 2018
Ruling period: Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019 | Year ended 30 June 2020 | Year ended 30 June 2021 | Year ended 30 June 2022
Date scheme commenced: 1 July 2013

Ruling: Q1: Will the sub-trust arrangement continue to be acceptable to the Commissioner so that the beneficiary will not be taken to have made a loan to the trust within the meaning of subsection 109D(3) of the Income Tax Assessment Act 1936 ? | A1: Yes.

Relevant facts and circumstances: Trust X applied for a private binding ruling to the Australian Taxation Office on December 20XX, in respect of a proposed transaction that has since then been implemented. The Australian Taxation Office issued a private binding ruling on February 20XX that the proposed sub-trust arrangement will be acceptable to the Commissioner so that the beneficiary will not be taken to have made a loan to the Trust within the meaning of subsection 109D(3) of the Income Tax Assessment Act 1936 . This private binding ruling applied for three income years. In the income tax year ended 30 June 20XX, the trustee for Trust X acquired a commercial building (the property). Additional funds were subsequently paid for improvements to the property prior to 30 June 20XX. Total expenditure on the property was obtained from loan finance and an unpaid present entitlement (UPE) owing to Company Y, a Trust X beneficiary. Additional funds were spent on further improvements to the property subsequent to 30 June 20XX. The reason for purchasing the property in Trust X was to facilitate asset protection. Trust X received an interim trust distribution from another Trust on 31 March 20XY. This trust distribution income was dealt with by the trustee of Trust X as a second UPE owing to Company Y. The funds from the distribution were used to repay loan finance and finance improvements to the property. A copy of the Trust Deed for Trust X was provided which lists the powers of the Trustee. The Trust Deed includes a section relating to ‘Funds set aside form separate fund’ and is as follows: Any amount distributed to or held for a Beneficiary in default of the exercise of a discretion by the Trustee will not form part of the Fund, but will be held for the Beneficiary absolutely and must be paid to the Beneficiary immediately on demand. Pending payment the Trustee has power to deal with the amount in the manner provided for in this Deed in relation to the Fund and the Income. On or before 31 March 20XY, the trustee of Trust X confirmed the first UPE was held by it as trustee on sub-trust for Company Y pursuant to the Trust Deed. The sub-trust was set up in accordance with example 8 of paragraph 167 on pages 38 and 39 of TR 2010/3. The terms of the sub-trust were as follows: ● The sub-trust will be entitled to an annual return equal to the net rental income (after depreciation but before interest) multiplied by the proportion of the amount invested by the sub-trust as a percentage of the total funding for the trust, which will in simple terms be the sub-trust amount plus any loan finance amount owing at the end of the preceding financial year. ● The annual return to the sub-trust will be paid in cash by the due date for lodgment of the income tax returns for both Trust X and Company Y for the year in which the return relates. ● Separate financial statements will be prepared for the sub-trust and an annual income tax return will be prepared for the sub-trust. ● On withdrawal of the investment, the sub-trust will be paid an amount equal to the sum originally invested. The terms of the sub-trust also applied to the second UPE that arose during the year ended 30 June 20XY. The sub-trust continues to hold the annual returns on sub-trust and separate financial statements and income tax returns have been lodged for the sub-trust for three income years. For the second income year, Trust X made a net loss in relation to the property, largely as a result of depreciation on the recently acquired property. For the third income year, Trust X made a net return on the property, which was recorded in the sub-trust financial statements and income tax return and has been paid by the trust in cash to Company Y before 15 May 20XA, the lodgement date of Trust X’s income tax return for the third income year. It is expected that similar returns will continue to be made on the investment in subsequent years. Given that the funds the subject of the sub-trust were invested in land and buildings, it was envisaged that the sub-trust arrangement would continue until the investment of Company Y was withdrawn, i.e. until the land and buildings are eventually sold at which time Trust X would be able to repay the amount invested by the company in cash (providing the property is not sold at a loss, which at this stage appears unlikely). As such, the original private binding ruling covered three income years. As this arrangement is ongoing, the taxpayers are seeking a continuation of the ruling so that it will apply until the property is eventually sold and at least cover five more income years.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 109D(1) | Income Tax Assessment Act 1936 Section 109D(3)

Reasons for decision: Summary: Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements (TR 2010/3) provides advice on when a private company with a present entitlement to an amount from an associated trust estate will be taken to have made a loan to that trust within the meaning of subsection 109D(3) of Division 7A of Part III (Division 7A) of the Income Tax Assessment Act 1936 (ITAA 1936), in circumstances where funds representing that present entitlement remain intermingled with funds of the trust. Guidance on the administration of TR 2010/3 is contained in Practice Statement Law Administration PS LA 2010/4 Division 7A: trust entitlements (PS LA 2010/4). One of the purposes of Division 7A is to ensure that private companies are not able to make distributions of profits to shareholders (or their associates) in the form of non-arm's length loans instead of in the form of dividends that would be assessable to the shareholder. To achieve this purpose, subsection 109D(1) generally operates to treat such loans as assessable dividends of the relevant shareholders (or their associates) where: ● a private company makes a loan as defined in subsection 109D(3) to a shareholder (or their associate); ● the loan is not fully repaid before the company’s lodgment day for the year in which the loan is made; ● the exceptions in Subdivision D of Division 7A do not apply; and ● the private company has sufficient distributable surplus such that section 109Y does not operate to reduce the amount of the dividend that would otherwise be deemed to have been paid. TR 2010/3 considers in what circumstances a private company is taken to 'make a loan' (within the meaning of subsection 109D(3)) to the trustee of a trust, where: ● the trustee of the trust is an associate (within the meaning given in section 318) of one or more shareholders of the private company; ● the trust is part of the same family group as the private company; ● the private company has (or had) a present entitlement to an amount from the trust; and ● funds representing the present entitlement remain intermingled with other funds of the trust estate, or are otherwise able to be used for 'trust purposes', (including if they remain so intermingled or available to be used for trust purposes by being paid back to, reinvested in, or lent back to the trust by a relevant sub-trust). 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 the trust deed to make the beneficiary so entitled. 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 an unpaid present entitlement (UPE). Trust property representing a UPE may be held on ‘sub-trust’ by the trustee for the beneficiary. TR 2010/3 defines a sub-trust as being a separate trust arising in equity, in respect of which the private company is the sole beneficiary and upon which amounts that the private company is presently entitled to receive from another trust (called the main trust) are held. TR 2010/3 explains the following in relation to sub-trusts: 35. When a beneficiary is made presently entitled to an amount that is not paid, trust property representing the UPE may be held on a sub-trust (as corpus of that sub-trust). The trustee typically continues to legally hold property so held on sub-trust, but in its capacity as trustee of the sub-trust rather than of the main trust. 37. Any income derived from the investment of the corpus of the sub-trust (for example, by the sub-trust lending funds to the main trust) is properly the income of the sub-trust and not the main trust. Certain criteria need to be met to demonstrate that a valid sub-trust arrangement exists. In this regard, paragraph 55 of PS LA 2010/4 states that the Commissioner will consider that funds in a sub-trust are held for the sole benefit of a private company beneficiary where: ● the trustee of the sub-trust invests the funds representing the UPE in the main trust on commercial terms pursuant to a power as trustee to do so, and ● all the benefits from the investment flow back to the sub-trust and the private company beneficiary, and ● all the benefits (for example, annual return on investment) are actually paid to the private company beneficiary by the lodgment day of the tax return of the main trust for the year in which the return arises. PS LA 2010/4 provides further detail as follows: 56. For the avoidance of doubt, the annual return on investment can either be paid in cash or set off against an account owing from the private company to the main trust, but it cannot be paid by crediting it to a liability account owing to the private company from the main trust or sub trust. The payment of the principal funds invested in the main trust (that is, the funds representing the UPE) and annual return to the private company must be such that if those payments had instead been repayments of a Division 7A loan made by a private company, they would not be disregarded by section 109R. 57. A taxpayer may determine the appropriate terms of the investment, based on the criteria set out in paragraphs 55 and 56 of this practice statement or alternatively a taxpayer may adopt one of three investment options described in paragraph 58 of this practice statement. There is no requirement for the taxpayer to adopt any of the options. 58. The ATO will consider that the funds in the sub-trust are held for the sole benefit of the private company beneficiary if the funds are invested in the main trust using one of the following investment options: Option 1 - invest the funds representing the UPE on an interest only 7-year loan (see paragraphs 62 to 73 of this practice statement) Option 2 - invest the funds representing the UPE on an interest only 10-year loan (see paragraphs 74 to 85 of this practice statement) Option 3 - invest the funds representing the UPE in a specific income producing asset or investment (see paragraphs 86 to 94 of this practice statement) In this case, the trustee for Trust X (the Trustee) made a UPE in favour of Company Y (the Beneficiary) during both the income years ended 30 June 20XX and 30 June 20XY. The Trustee held both UPE’s on sub-trust for the Beneficiary pursuant to the Trust Deed, effected in the income years ended 30 June 20XY and 30 June 20XZ respectively. The funds representing the UPE’s in the sub-trust have been invested in a commercial property. The terms of the sub-trust are as follows: ● The sub-trust will be entitled to an annual return equal to the net rental income (after depreciation but before interest) multiplied by the proportion of the amount invested by the sub-trust as a percentage of the total funding for the trust, which will in simple terms be the sub-trust amount plus any loan finance amount owing at the end of the preceding financial year. ● The annual return to the sub-trust will be paid in cash by the due date for lodgement of the income tax returns for both the trustee and beneficiary for the year in which the return relates. ● Separate financial statements and an annual income tax return will be prepared for the sub-trust. ● On withdrawal of the investment, the sub-trust will be paid an amount equal to the sum originally invested. From the information provided, it is evident that: ● the Trustee of the sub-trust will continue to invest the funds representing the UPE in the main trust on commercial terms pursuant to a power as Trustee to do so, and ● all the benefits from the investment will continue to flow back to the sub-trust and the Beneficiary, and ● all the benefits (return on the investment) will continue to be actually paid to the Beneficiary by the lodgement day of the tax return of the main trust for the year in which the return arises. Therefore, the Commissioner considers that the funds in the proposed sub-trust will continue to be held for the sole benefit of the Beneficiary. Consequently, the proposed sub-trust arrangement will continue to be acceptable to the Commissioner so that the Beneficiary will not be taken to have made a loan to the Trust within the meaning of subsection 109D(3) of the ITAA 1936.