Private ruling: Unpaid Present Entitlement
Published: June 2012
Ruling period: Year ended 30 June 2012
Date scheme commenced: 1 July 2011

Ruling: Q1: Can the beneficiary claim a bad debt deduction in the 2012 income year? No. If a bad debt deduction cannot be claimed, would a capital loss or a loss under traditional security provisions apply? No. Are there any tax implications for the trust with the "forgiveness" of its liability for the unpaid entitlement to the beneficiary? The Commissioner is unable to rule on this question. Do the commercial debt forgiveness provisions apply? No.


Relevant legislative provisions: Section 25-35 of the ITAA 1997 | Section 104-25 of the ITAA 1997 | Division 245 of the ITAA 1997 | Section 109C of the ITAA 1936 | Section 109D of the ITAA 1936 | Section 109F of the ITAA 1936 | Section 159GP of the ITAA 1936 | Section 357-55 of the TAA 1953 | Section 359-20 of the TAA 1953

Reasons for decision: Detailed Reasoning - Consideration of Division 7A: Division 7A of the Income Tax Assessment Act 1936 (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 are, unless they come within specified exclusions, treated as assessable dividends to the extent that a company has a distributable surplus. For the purposes of Division 7A, the term "loan" is given a broad meaning by ss109D(3) of the ITAA 1936. It is defined as: · an advance of money; · a provision of credit or any other form of financial accommodation; · a payment of an amount for, or on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; · a transaction (whatever its terms or form) which in substance effects a loan of money. Taxation Ruling TR 2010/3 expresses the Commissioner's opinion on the circumstances in which a private company with a present entitlement to an amount from an associated trust estate makes a loan to that trust within the meaning of ss109D(3) of the ITAA 1936, in circumstances where funds representing the present entitlement remain intermingled with the funds of the trust. 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. Section two of TR 2010/3 considers loans within the ordinary meaning. Essentially, if a trustee and a private company beneficiary have consistently maintained in its accounts that there is an outstanding UPE and not a loan, and both parties have acted consistently with this, this would be evidence suggesting that the private company has not agreed to the trustee treating the UPE as being satisfied and being replaced with a loan to the trust. In your situation, it is accepted that neither entity treated the outstanding UPE as a loan, within the terms of its ordinary meaning. Section three of TR 2010/3 considers loans within the extended meaning. This section discusses where a private company beneficiary provides financial accommodation to the trustee of a trust which in substance effects a Division 7A loan. This accommodation includes where the private company does not call for: · the payment of the UPE; or · the investment of the funds representing the UPE for the company's sole benefit rather than their use of the benefit of the trust. Accordingly, if a private company beneficiary has knowledge that funds representing its UPE are being used by the trustee for trust purposes, in not calling for payment of its UPE the private company provides the trustee with financial accommodation and, by extension, makes a Division 7A loan to the trustee. Relevantly however, this third section does not apply to all or any part of a UPE that arose before December 2009. In this instance, the UPE arose prior to this date. Therefore, for the purposes of this ruling, and s109D of the ITAA 1936, no Division 7A loan is deemed to arise in respect of the outstanding UPE. | Detailed Reasoning - Can the beneficiary claim a bad debt deduction in the 2012 income year?: To obtain a bad debt deduction under s25-35 of the Income Tax Assessment Act 1997 (ITAA 1997), a debt must exist before it can be written off as bad. The word "debt" is neither defined in the Income Tax Assessment Acts. Accordingly, it is necessary to apply the rules of statutory interpretation to attempt to determine the meaning intended by the legislature in drafting the provision. Australia's leading text on statutory interpretation is Pearce and Geddes' Statutory Interpretation in Australia . With respect to the interpretation of words with a legal technical meaning, the approach to be followed is, according to those authors, "best stated" by O'Connor J in Attorney-General (NSW) v. Brewery Employées' Union of New South Wales (1908) 6 CLR 469 at 531: Where words have been used which have acquired a legal meaning it will be taken, prima facie , that the legislature has intended to use them with that meaning unless a contrary intention clearly appears from the context. To use the words of Denman J in R v. Slator ((1881) 8 QBD 267 at 272): 'but it always requires the strong compulsion of other words in an Act to induce the Court to alter the ordinary meaning of a well known legal term'. 35. The legal technical meaning of the word "debt" is defined in Butterworths Australian Legal Dictionary 1997, Butterworths, NSW: 2. A sum of money owed: Director of Public Prosecutions v. Turner [1073] 3 All ER 124 at 126. A debt is a sum of money which is now payable or will become payable in the future by reason of a present obligation. It is a right which a creditor has to enforce by taking action [emphasis added]. When a beneficiary of a trust is made presently entitled to an amount that is not paid, trust property representing the unpaid present entitlement is (in effect) held by the trustee on a separate trust, arising in equity, in respect of which the unpaid beneficiary is the sole beneficiary (paragraph 35 of TR 2010/3). In the case of an unpaid beneficiary, the beneficiary's interest in the separate trust is proprietary in nature. That is, they have an equitable interest in the corpus, and in the income of the assets of the separate trust. An unpaid beneficiary has rights in equity and not as a result of any debtor-creditor relationship (paragraph 34 of TR 2010/3). The key difference between a UPE and a debt is that the UPE does not result in an enforceable obligation imposed by law (as distinct from the rights that attach to a creditor). Rather, the rights of an unpaid beneficiary arise in equity only - and not in law. It is for this reason that an unpaid beneficiary cannot "sue for their entitlement" To "sue" is "to bring a civil proceeding against a person"; and a "civil proceeding" is a proceeding or an action "commenced in the civil jurisdiction of a court of law" (both definitions from Butterworths Australian Legal Dictionary 1997, Butterworths, NSW). A beneficiary's cause of action is in the equitable jurisdiction of a court (a beneficiary's interest not being recognised at law). Whilst the rules of law and equity may be administered concurrently in the various State Supreme courts in Australia, a clear distinction between equitable and legal causes of action remains. In conclusion, in situations where a UPE has not been converted into a loan (such as those discussed in Taxation Ruling TR 2010/3) a UPE is not a debt within the legal technical meaning. Taxation Ruling TR 92/18 provides that a debt exists where a taxpayer is entitled to receive a sum of money from another either at law or in equity. However, the context of the ruling must be considered as a whole. A debt in these circumstances is clearly contemplating a debt that arose as a result of a debtor-creditor relationship during the course of carrying on a business. An unpaid beneficiary has rights in equity and not as a result of any debtor-creditor relationship (paragraph 34 of TR 2010/3). There is considerable authority that supports the principle that money owed to trust beneficiaries as UPE's have a materially different character to money owed to creditors. The Federal Court decision of Euroasian Holdings Pty Ltd v Ron Diamond Plumbing Pty Ltd (in liquidation) (1996) 64 FCR 147 confirmed that a UPE was not a debt. Further, in the context of TR 92/18, if there was considered to be a debt, the debt must be bad and the debt must have been included in assessable income. | Detailed Reasoning - Is the debt bad?: Paragraph 31 of TR 92/18 provides that a debt may be considered to have become bad in any of the following circumstances: (a) the debtor has died leaving no, or insufficient, assets out of which the debt may be satisfied; (b) the debtor cannot be traced and the creditor has been unable to ascertain the existence of, or whereabouts of, any assets against which action could be taken; (c) where the debt has become statute barred and the debtor is relying on this defence (or it is reasonable to assume that the debtor will do so) for non-payment; (d) if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt, or the part claimed as a bad debt; (e) where, on an objective view of all the facts or on the probabilities existing at the time the debt, or a part of the debt, is alleged to have become bad, there is little or no likelihood of the debt, or the part of the debt, being recovered. In terms of (e) above, paragraph 32 of TR 92/18 provides: While individual cases may vary, as a practical guide a debt will be accepted as bad under category (e) above where, depending on the particular facts of the case, a taxpayer has taken the appropriate steps in an attempt to recover the debt and not simply written it off as bad. Generally speaking such steps would include some or all of the following, although the steps undertaken will vary depending upon the size of the debt and the resources available to the creditor to pursue the debt: (i) reminder notices issued and telephone/mail contact is attempted; (ii) a reasonable period of time has elapsed since the original due date for payment of the debt. This will of necessity vary depending upon the amount of the debt outstanding and the taxpayers' credit arrangements (e.g. 90, 120 or 150 days overdue); (iii) formal demand notice is served; (iv) issue of, and service of, a summons; (v) judgment entered against the delinquent debtor; (vi) execution proceedings to enforce judgment; (vii) the calculation and charging of interest is ceased and the account is closed, (a tracing file may be kept open; also, in the case of a partial debt write-off, the account may remain open); (viii) valuation of any security held against the debt; (ix) sale of any seized or repossessed assets. While the above factors are indicative of the circumstances in which a debt may be considered bad, ultimately the question is one of fact and will depend on all the facts and circumstances surrounding the transactions. All pertinent evidence including the value of collateral securing the debt and the financial condition of the debtor should be considered. Ultimately, the taxpayer is responsible for establishing that a debt is bad and bears the onus of proof in this regard. In this instance, although the Ruling application stated that large carried forward losses existed, there is no evidence provided that this is in fact the case. The Commissioner queried why 100% of the net income in later years was paid to beneficiaries, and not utilised for the payment of the outstanding UPE. The Commissioner was advised in an email from the applicant that the trustee was required to distribute the net income each year, and not required to have regard in this distribution to outstanding debts of the trust. We contend that although the trustee may not be required to have regard to outstanding debts of the trust at the time of making a distribution, there is no requirement that it distributes all of the net income every year. It could, for instance, choose to accumulate income as part of the trust funds, and it could have utilised the after tax value of this income to pay the outstanding UPE if it chose to do so. In terms of capacity to repay it is also important to note that if the Commissioner were to accept the existence of large carried forward losses, those losses would be losses of the 'head trust', not the 'sub trust' that effectively exists in relation to the UPE. If the trustee is unwilling to make arrangements to pay the UPE, it is arguable that the appropriate steps to take in an attempt to recover an unpaid entitlement would be for the beneficiary to seek to enforce their rights in the equitable jurisdiction of the applicable Supreme Court. Potentially, the Supreme Court might enforce the debt personally against the trustee. We submit, therefore, that the beneficiary has not taken the appropriate steps in an attempt to recover the outstanding UPE and has, in fact, simply written it off as bad. We contend that the UPE is not "bad" in the context contemplated in TR 92/18. | Detailed Reasoning - Has the debt has been included in assessable income in the current or an earlier income year?: As explained above, an unpaid entitlement is an equitable right. It arises from a resolution made by the trustee in accordance with the trust deed and general law of trusts to allocate or appoint all or part of the income or capital of the trust to a beneficiary. Importantly, it is not the income or capital appointed under the trustee resolution that is included in a beneficiary's assessable income. The amount included in a beneficiary's assessable income is the item of statutory income determined under Division 6 of the ITAA 1936. Under section 97 of the ITAA 1936, a beneficiary includes in assessable income a share of the net income of the trust estate. Net income is calculated in accordance with section 95 of the ITAA 1936. The share is the fractional interest the beneficiary has in the distributable income of the trust estate calculated in accordance with the general law of trusts and the trust deed ( Bamford v FC of T 2010 ATC 20-170 ). That is, what the beneficiary has previously been taxed on is a share of the trust's taxable income, which in strict technical terms is a tax fiction and therefore cannot be written off in the sense contemplated by section 25-35 of the ITAA 1997. In consideration of all the points discussed above, a deduction under s25-35 of the ITAA 1997 for a bad debt cannot be claimed. | Detailed Reasoning - If a bad debt deduction cannot be claimed, would a capital loss or a loss under traditional security provisions apply?: A capital loss occurs when you dispose of a CGT asset and the proceeds you receive for the disposal are less then the reduced cost base of the asset. In this instance, if the beneficiary was to release the trustee from its obligation to pay the UPE, it may be possible that a CGT event C2 has occurred in accordance with section 104-25 of the ITAA 1997. That is, the beneficiary has disposed of an intangible asset - the right to receive the UPE. However, the cost base of that right is considered to be nil, as it did not cost the beneficiary anything to acquire that right - it was the exercise of the Trustee's discretion to make that beneficiary presently entitled to that income. Further, the capital proceeds for the disposal of that right would also be nil. Therefore, there is no capital loss in this situation. A traditional security is, broadly, a security that is not issued at a discount of more than 1.5%, does not bear deferred interest and is not capital indexed. The traditional securities provisions adopt the following definition of "security" at section 159GP of the ITAA 1936: · stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security; · a deposit with a bank, building society or other financial institution; · a secured or unsecured loan; · any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured. Paragraph 4 of Taxation Ruling TR 96/14 Income tax: traditional securities states that only those contracts that have debt like obligations will usually fall under paragraph (d) of the above definition. As the UPE in your situation was not considered a loan by either party, and does not otherwise fall within the definition of a traditional security, the traditional security provisions do not apply. | Detailed Reasoning - Are there any tax implications for the Trust with the "forgiveness" of its liability for the unpaid entitlement to the beneficiary?: Section 359-20 of the Taxation Administration Act 1953 (TAA 1953) specifies that a private ruling must identify the entity to whom it applies and specify the relevant scheme and the relevant provision to which it relates. Section 357-55 of the TAA 1953 provides a list of provisions that are relevant for rulings. The Commissioner is able to rule on any provision that falls within these provisions. As can be seen by section 357-55 of the TAA 1953, this list encompasses a wide scope of provisions including (but not limited to) income tax, withholding tax, goods and services tax, fringe benefits tax, indirect tax, excise duty, and franking tax. It would therefore be unreasonable to expect the Commissioner to provide a definitive ruling on whether there are 'any tax implications' for the Trust. However, some further comments are added here for your information: | Detailed Reasoning - Release or extinguishment of UPE: If a beneficiary under a trust wishes to relinquish his interest to the trustee, they must do so by releasing that interest to the trustee ( Crichton v. Crichton (1930) 43 CLR 536 at 562-563). At general law, equitable interests may be released by an instrument under hand, orally, or even by conduct. However, in all States of Australia and the Australian Capital Territory, legislation requires writing for the "disposition of an equitable interest" in property. Accordingly, in situations where the statutory and general law requirements are satisfied, the holder of an equitable interest may release the legal owner (the trustee) from an obligation to make a payment in respect of an UPE. It is noted that, in accordance with the discussion above, no debt (in the legal sense) exists. Therefore, section 109F of the ITAA 1936 (forgiven debts treated as dividends) cannot have application to your situation. However, the Commissioner draws your attention to s109C of the ITAA 1936. This section provides that payments from a private company to a shareholder or an associate of such a shareholder will be treated as a dividend being paid by the private company. A payment means: (a) a payment to the extent that it is to the entity, on behalf of the entity or for the benefit of the entity; and (b) a credit of an amount to the extent that it is to the entity, on behalf of the entity, or for the benefit of the entity; and (c) a transfer of property to the entity. As stated earlier, the UPE could be formally extinguished or released by the beneficiary, and, depending upon how this is executed, there is a prospect for s109C to apply which could have implications for both entities. How this might apply would depend on the facts of the situation, and the Commissioner would require a copy of the instrument to effect the extinguishment of the UPE to form a definitive view on this. If you have concerns about the application of s109C, or any other specific provisions, you are invited to apply for a further Private Ruling about how the Commissioner would consider these to apply to your situation. | Detailed Reasoning - Do the commercial debt forgiveness provisions apply?: For the reasons outlined above, the UPE is not considered to be a debt. As the trustee is not a debtor, any release by a beneficiary of their equitable right to the UPE cannot be the forgiveness of a debt by the beneficiary. Therefore, the commercial debt forgiveness provisions in Division 245 of the ITAA 1997 do not apply.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Relevant facts: A company is a beneficiary of the trust. | For several years, up until 30 June 2008, the beneficiary was made presently entitled to distributions from the trust. | A portion of those distributions were never received by the beneficiary but were retained by the trust and used in its operations creating an unpaid present entitlement (UPE). | The UPE was never converted to, or otherwise treated as, loans by either the beneficiary or the trust. | The recent financial statements of the trust reveal that the UPE continued to be recorded as "Beneficiaries Entitlement" in liabilities; it was never recorded as a loan. | At all relevant times, the beneficiary meets the continuity of ownership test. | The Ruling application advised that the trust has carried forward losses greater than the UPE balance to the beneficiary, however this claim is not substantiated by either the financial statements or the income tax returns lodged. | 100% of the net income of the trust in subsequent years has been distributed to beneficiaries. | During the current income year, the beneficiary reviewed the financial statements of the trust and, after discussions with the trustee, it was determined that the trust had a deficiency of assets when the market value of investments was assessed by an independent valuer. Accordingly, the beneficiary has determined that there are no enforcement actions available that would result in payment of the UPE, and has written it off as a bad debt.