Private ruling: Income tax: Division 7A - unpaid present entitlements - sub trust arrangement
Date of advice: 14 March 2019
Published: May 2019
Ruling period: 1 July 20xx to 30 June 20xx
Date scheme commenced: 1 July 20xx

Ruling: Q1: Where the private company beneficiary is presently entitled to the income of the Y main trust for a year of income and an amount of that entitlement remains unpaid before the lodgement of the trust's tax return for that year (or due date for lodgement if this is earlier), will the proposed sub-trust arrangement entered into by the trustees of the sub trust and the private company beneficiary ensure that the private company beneficiary does not provide financial accommodation to the trustees of the Y main trust for the purposes of the extended meaning of loan in subsection 109D(3) of the Income tax Assessment Act 1936 (ITAA 1936)? | A1: Yes | Q2: Where the Y main trust is presently entitled to the income of the X main trust for a year of income and an amount of that entitlement remains unpaid before the lodgement of the trust's tax return for that year (or due date for lodgement if this is earlier), will the proposed sub-trust arrangement entered into between the trustee for the sub trust and the trustees of the Y main trust ensure that the Y main trust does not provide financial accommodation to the trustee of the X main trust for the purposes of the extended meaning of loan in subsection 109D(3) of the ITAA 1936? | A2: Yes

Relevant facts and circumstances: The X main trust The trust deed for the X main trust provides that the trustee shall stand possessed of the income of the trust of a financial year (or such portion of the income as the trustee determines) upon trust for one or more of the eligible beneficiaries in such shares and proportions as the trustee determines prior to 30 June of that year. The Y main trust is within the class of beneficiaries eligible to benefit from an appointment of income of the X main trust. The Y main trust was presently entitled to income of the X main trust for the income year ended 30 June 20xx as a result of the valid exercise of the trustee’s powers of appointment under the trust deed. The Y main trust Pursuant to the deed for the Y main trust, the trustee has the power to pay, apply or set aside an amount of income of the trust for the year to one or more of the eligible beneficiaries. The deed further provides that any amount set aside for a beneficiary in accordance with that determination does not form part of the main trust but, upon being set aside, is to be held by the trustee on a separate trust for the beneficiary absolutely. The private company beneficiary is within the class of beneficiaries eligible to be appointed income of the Y main trust. The private company beneficiary was presently entitled to income of the Y main trust for the income year ended 30 June 20xx as a result of the valid exercise of the trustee’s powers of appointment under the trust deed. Unpaid present entitlements and proposed sub-trust arrangements Certain amount of the Y main trust’s entitlement to income of the X main trust for the income year ended 30 June 20xx will be unpaid before the end of the income year or the lodgement date of the X main trust. Similarly, certain amount of the private company beneficiary’s entitlement to income of the Y main trust in the income year ended 30 June 20xx will remain unpaid before the end of the income year or the lodgement date of Y main trust. The entire amount of the unpaid present entitlements will be retained by the X main trust to fund expansion of its business. Before the end of the income year or the lodgement date of X main trust’s return for the relevant income year, a sub-trust arrangement (the first sub-trust) will be established as outlined in paragraph 55 of Law Administration Practice Statement PS LA 2010/4. Before the lodgement of the Y main trust’s income tax return, a sub-trust arrangement (the second sub-trust) will be established as outlined in paragraph 55 of the PS LA 2010/4. Separate financial statements will be prepared for the sub-trusts and an annual income tax return will be prepared for the sub-trust.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 109D(3)

Reasons for decision: Summary: Division 7A of Part III of the ITAA 1936 is an integrity measure aimed at preventing private companies from making tax-free distributions of profits to shareholders (or their associates). In particular, advances, loans and other payments or credits to shareholders (or their associates) are, unless they come within specific exclusions, treated as assessable dividends to the extent that a company has a distributable surplus. Taxation Ruling TR 2010/3 Income Tax: Division 7A loans: trust entitlements expresses the Commissioner’s opinion on the circumstances in which a private company with a present entitlement to an amount from an associate trust makes a loan to that trust within the meaning of subsection 109D(3) of the ITAA 1936 where funds representing that present entitlement remain intermingled with other funds of the trust estate. A beneficiary can become presently entitled to an amount of income from a trust pursuant to a direct term of the trust deed or as a result of the trustee exercising a power of appointment under the deed in the beneficiary’s favour. In situations where the funds to which the beneficiary is made presently entitled are unpaid, the entitlement is commonly referred to as an UPE. Meaning of ‘loan’ For the purposes of Division 7A, a ‘loan’ is defined in subsection 109D(3) of the ITAA 1936. Paragraph 109D(3)(b) includes within the meaning of loan ‘a provision of credit or any other form of financial accommodation’. The term ‘financial accommodation’ is not defined in the ITAA 1936 and is to be interpreted having regard to the statutory context in which the phrase appears. In the Commissioner’s view, the phrase is limited for Division 7A purposes to: ● the supply or grant of some form of pecuniary aid or favour; ● under a consensual arrangement; and ● where a principal sum or equivalent is ultimately payable (paragraph 96 of TR 2010/3). Accordingly, if a private company beneficiary has knowledge that funds representing its UPE are being used by the trustee for trust purposes, in allowing for this to continue the private company provides the trustee with financial accommodation and, by extension, makes a Division 7A loan to the trustee (paragraph 104 of TR 2010/3). However, a private company beneficiary does not provide financial accommodation in respect of a UPE where the funds representing the UPE are used only for the private company’s sole benefit. For example, if there is a sub-trust but the funds representing the UPE remain intermingled in the main trust as a consequence of an investment back by the sub-trust, the private company does not provide any financial accommodation to the main trust if this investment by the sub-trust is on terms entitling the sub-trust to: ● all the benefits from use of those funds; and ● a repayment of the principal of the investment (paragraphs 113 and 114 of TR 2010/3). The private company provides no financial accommodation in these circumstances because the main trust receives no pecuniary aid or favour from the private company. These circumstances may be evidenced by the terms of the agreement between the sub-trust and the main trust. The existence of a sub-trust can be evidenced by a resolution by the trustee to set aside the funds representing the UPE for the sole benefit of the private company beneficiary or it may be expressly provided for under the trust deed. Law Administration Practice Statement PS LA 2010/4 Division 7A: trust entitlements indicates that evidence of a sub-trust could also include: ● the amount representing the UPE is set aside separately in the accounts of the main trust as being held on trust for the private company beneficiary ● separate accounts are prepared for the sub-trust, or ● a separate bank account is opened in the name of the trustee as trustee for the private company beneficiary in respect of the funds within the sub-trust. The question of when funds in the sub-trust are held for the sole benefit of a private company beneficiary is considered in PS LA 2010/4 at paragraph 55 . Here, we will consider that the funds in the sub-trust are held for the sole benefit of the 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. As recognised in TR 2010/3, an investment in a trust on terms requiring all the benefits from the use of the funds invested to flow back to the investor can be structured in a number of ways. One way, as illustrated in Example 8 of TR 2010/3, is where the sub-trust is to be paid a reasonable percentage of the overall income each year generated by the main trust (calculated in that example by reference to the proportion of the amount invested by the sub-trust relative to other sources of funding or borrowings) and, on withdrawal of the investment, an amount equal to the principal sum originally invested. In the present case, the sub trust arrangements entered into by X main trust, Y main Trust and the private company beneficiary have satisfied the conditions outlined in paragraph 55 of PS LA 2010/4. Therefore, neither private company beneficiary made any financial accommodation to Y main trust nor X main trust made any financial accommodation to Y main trust for the purposes of the extended meaning of loan in subsection 109D(3) of the ITAA 1936