The Commissioner of Taxation’s longstanding practice as to when an unpaid present entitlement (UPE) of a private company beneficiary of a trust will give rise to a deemed dividend under Division 7A of the Income Tax Assessment  Act 1936 has been dismantled by the Administrative Appeals Tribunal (AAT) in Bendel v. Commissioner of Taxation [2023] AATA 3074.

The Commissioner’s practice

That practice was set out by the Commissioner in Taxation Ruling TR 2010/3 and Practice Statement Law Administration PS LA 2010/4 and is now adjusted by Taxation Determination TD 2022/11 (the Practice).

Unfortunately the AAT decision in Bendel doesn’t directly deal with or critique the Practice, which has been foundational to the administration of Division 7A and trusts, and has dealt with the prospect of a trust UPE loophole in Division 7A, since 2010. It is clear that the AAT has diverged from the Practice by its approach to the Division 7A provisions in Bendel.

Sub-trusts?

The AAT in Bendel found that, despite the Commissioner’s position in the Practice and as a party in Bendel that a sub-trust arises where a trustee holds a UPE to income for a beneficiary of a family discretionary trust (FDT), no new or separate trust arises as a matter of law: On the authority of the High Court in Fischer v. Nemeske Pty. Ltd. [2016] HCA 11 which the AAT found “more to the point”, the AAT observed:

• it is difficult to see any reason in principle why such an unconditional and irrevocable allocation of trust property must take the form of an alteration of the beneficial ownership of one or more specific trust assets;
• there was no suggestion that the trustee’s exercise of the power to apply trust property involved a resettlement of trust property so as to result in the creation of a new trust;
• further, the exercise of that power effected an alteration of beneficial entitlements in property which the trustee continued to hold on trust under the terms of the existing settlement was orthodox as a matter of principle. It was also unremarkable as a matter of practice…; and
• An absolute beneficial entitlement to some part of a fund of property that is held on trust need not be reflected in an absolute beneficial entitlement to the whole or some part of any specific asset within that fund. That must be so whether the absolute beneficial entitlement to some part of a fund of property that is held on trust is defined by the terms of the trust settlement itself, or whether such absolute beneficial entitlement to some part of a fund of property that is held on trust is defined by an exercise of a power conferred on a trustee under the terms of a trust settlement.

[Italicised are extracts from the judgment of Gagelar J. of the High Court in Fischer v. Nemeske Pty. Ltd. [2016] HCA 11  at paras 95 to 99 included in the AAT decision.]

It follows that a UPE remains an entitlement of the beneficiary under the terms of the head or main trust.

But what of explicitly declared sub-trusts in the trust deed?

The AAT in Bendel did not consider the impact of the terms of the trust deed of the FDT on that reasoning. The deed explicitly sought to establish sub-trusts for UPEs arising under the FDT which counters the AAT finding, on the authority of Fischer v. Nemeske Pty. Ltd., that the UPE remains an entitlement under the main FDT. In my estimation these terms “settling” a UPE sub-trust could have been ineffectual in any case due to them having been:

• internally inconsistent: on the one hand a sub-trust was stated to be held for a beneficiary “absolutely” but on the other the trustee was given wide discretion to resort to and deal with the assets of the sub-trust and, in practice and in the accounts, the property of UPE sub-trusts, if they existed, was intermingled with the property of the main trust and so separate sub-trusts were thus perhaps a sham or without legal effect? and
• insufficiently clear to establish or “re-settle” sub-trusts or to alter beneficial interests as explained in Fischer v. Nemeske Pty. Ltd.: the sub-trust provisions of the deed had “no work to do” just like the Second Declaration of Trust in Benidorm Pty Ltd v. Chief Commissioner of State Revenue [2020] NSWSC 471.

Is a UPE an extended loan?

A UPE under a trust is not and is divergent from a loan in the ordinary sense. That is not disputed. Unfortunately, surprisingly and more controversially the AAT does not appear to directly deal with the question of whether a UPE from a trust is what was referred to in TR 2010/3 as a “section three loan” or a loan within the extended meaning of loan under sub-section 109D(3) of the ITAA 1936 (extended loan) although submissions of the parties on the questions of whether or not a UPE is either:

• a financial accommodation; or
• an in substance loan;

were received and outlined in the Bendel decision but received scant consideration in the decision.

It isn’t apparent that the AAT accepted the taxpayer’s contentions to the effect that a financial accommodation and an in substance loan are a subset of director/creditor type or loan-like relationships and are inapplicable to a trust entitlement and so concurred that a passive UPE owed to a beneficiary cannot be either a financial accommodation or an in substance loan that triggers an extended loan as considered by the Commissioner in paragraphs 19 to 26 of TR 2010/3. Rather the AAT gave a matrix in paragraph 101 of the decision (see below) to seemingly justify not giving a concluded view on these contentions.

Dictionary definitions and restrictive views

Maybe the AAT had financial accommodation front of mind when the taxpayer’s counsel referred to dictionary definitions being considered out of statutory context and legislative history as: a foundation for error where the outcome is contrary to statutory context and legislative history (SCLH)?

I am not so sure the SCLH, when considered in the context of twelve or more years of the Practice where the Commissioner has clearly relied on his wide view of financial accommodation in sub-section 109D(3) such that it can encompass an omission to pay out a UPE within the standard time frame allowed under paragraph 109D(1)(b), demands the restrictive view of when a UPE can be an extended loan the AAT has apparently taken in Bendel.

What should follow from legislative flaws in Division 7A concerning UPEs perceived by the AAT?

If I understand the AAT decision in Bendel correctly, the AAT have inferred from the SCLH, of which the AAT is critical, that the parliamentary intent on introducing section 109UB and, later, its replacement Subdivision EA, or that the effect of those provisions by dent of design fault, was that they are to apply to UPEs from trusts to the exclusion of the core provision governing what is a loan in section 109D.

If section 109UB, section 109XA et al. in the SCLH are so deficient, why would the AAT give them paramountcy over the core provisions which the Commissioner has been able to satisfactorily administer with the Practice over a long period? Couldn’t the AAT have inferred that the legislature, and the Commissioner prior to his adoption of the Practice, had acted on an unnecessary and untested assumption that a UPE from a trust could not be or would not be an extended loan under sub-section 109D(3)?

Does the Practice really tax two people over the one UPE?

A further departure of the decision of the AAT from the Practice is that applying section 109D:

raises the spectre of taxing two people in respect of precisely the same underlying circumstance, namely the same UPE

see paragraph 98 of the AAT decision in Bendel

In my view it is open to the Commissioner and reasonable, given the legislative policy of Division 7A, to treat the distribution from the FDT to a corporate beneficiary and the UPE arising in favour of the beneficiary as a distinct and earlier in time transaction from the failure to satisfy the UPE by payment within the standard time frame allowed under paragraph 109D(1)(b).

This is just as much taxing two people in respect of the same income as a private company earning income subject to company tax and a shareholder of the company thereupon receiving that already company taxed income as an unfranked dividend which is thereupon taxable to the shareholder. It is to this outcome that Division 7A, as an anti-avoidance regime underpinning the integrity of the company tax system, seems rightly directed.

Interpretation approaches to the provisions

It occurs to me that, that being so:

• the shortcomings of the Division 7A legislation insofar as it addressed UPEs from trusts set out in the decision;
• the restrictive reading of it by the AAT in the context of the SCLH;
• an interpretation based on generalia specialibus non derogant so that section 109UB and Subdivision EA, despite what the AAT says was its flawed passage into law, overrides the general provision: section 109D; and
• a possible further contention by the taxpayer that a financial accommodation, an in substance loan or both are part of a ejusdem generis list that should be confined to financial accommodations or in substance loans within or comparable to advances of money, provisions of credit and the like viz. strictly debtor creditor financial activity;

are approaches and considerations likely to be or should be subordinated to the need to “ascertain the legislative intention from the terms of the instrument viewed as a whole”: Cooper Brookes (Wollongong) Pty Ltd v. Federal Commissioner of Taxation [1981] HCA 26 understanding that the Acts Interpretation Act (C’th) 1901 provides:

In the interpretation of a provision of an Act a construction that would promote the purpose or object underlying the Act (whether that purpose or object is expressly stated in the Act or not) shall be preferred to a construction that would not promote that purpose or object.

section 15AA of the Acts Interpretation Act (C’th) 1901

and applies to taxing Acts as well as other Acts and that the purpose of Division 7A is directed to maintaining the integrity of the Australian system of taxation of private companies.

I think it unlikely that a court would be confused by or would miss the purpose of the provisions due to the AAT’s questionable matrix set out as follows:

Having regard to:

    (a)          the policy of Division 7A to tax those who in substance enjoy the benefit of corporate profits without bearing taxation that would arise had the company paid dividends in the usual way;

    (b)          statutory construction principles that call for

        (i)          regard to statutory context and legislative history; and

        (ii)         potentially competing provisions to be construed in a manner which ‘gives effect to harmonious goals’;

    (c)          there being no tiebreaker provision which mandates which of two competing assessing provisions would apply if an unpaid present entitlement constituted a loan within the meaning of s 109D(3);

    (d)          the s 109RB discretion not being designed to allow relieving discretions to be exercise outside the s 109RD(1)(b) gateways of honest mistakes and inadvertent omissions and thus not a discretion that would relieve inappropriate double taxing;

    (e)          Subdivision EA being a specific, and therefore lead, provision containing an express set of rules that can be regarded as a particular path has been chosen to deal with the taxation effect of unpaid present entitlements in favour of corporate beneficiaries in prescribed circumstances;

    (f)          the lack of clarity as to the nature of an unpaid present entitlement and the separate trust concept often broached in conjunction with the unpaid present entitlement topic;

    (g)          the expressed explanation accompanying s 109UB, the predecessor of Subdivision EA, to the effect:

        (iii)        that an unpaid present entitlement in favour of a corporate beneficiary and a contemporaneous loan by the trustee to a shareholder in the corporate beneficiary (or associate) is in substance a loan by the company to the shareholder; and

        (iv)         that an amount to which a company is entitled ‘held on a secondary trust for the benefit of the company’ is regarded as unpaid and within the ambit of s 109UB;

    (h)          the operation of Subdivision EA which taxes the shareholder in the foregoing circumstances as if the company had lent money directly to that shareholder which falls squarely within the Division 7A policy framework;

    (i)          there being no provision in either of the Assessment Acts that anyone points to that expressly allows assessment of two people arising out of the same circumstance with one of those people potentially not enjoying any benefit of the corporate profits that are the underlying cause of the assessment,

the necessary conclusion is that a loan within the meaning of s 109D(3) does not reach so far as to embrace the rights in equity created when entitlements to trust income (or capital) are created but not satisfied and remain unpaid. The balance of an outstanding or unpaid entitlement of a corporate beneficiary of a trust, whether held on a separate trust or otherwise, is not a loan to the trustee of that trust.

para 101 of the AAT decision in Bendel

Towards a purposive construction of the provisions

In adopting a purposive construction of these provisions of Division 7A I would be surprised if a court would replicate the AAT’s disdain for parliament’s efforts to plug the UPE loophole with section 109UB and, later, its replacement Subdivision EA. If I read the AAT decision correctly, these provisions and the manner of their introduction prejudice the Commissioner and the Revenue such that the language of sub-section 109D(3), as a generality, can no longer be applied to UPEs from trusts.

Ironically if the AAT decision is correct, and what is an extended loan is constrained by it, then the legislative clarity from the government the AAT appears to urge and seek in Bendel can no longer be achieved by the repeal of Subdivision EA.

In any case one can expect the government to amend the UPE rules in Division 7A to reverse Bendel should the Bendel decision originated by the AAT persist as authority.

It is clear from Fischer v. Nemeske Pty. Ltd. that a UPE from a trust is different to a loan but the differences between a trust and a loan conflate in that case too. Gagelar J. states:

In challenging the Court of Appeal’s holding concerning the effect in law of the Trustee going on to record a liability to Mr and Mrs Nemes in the sum of $3,904,300 in the Trust’s balance sheet, the appellants do not dispute that a trustee who admits to having an unconditional obligation to pay a specified amount of money to a beneficiary can thereby become liable to an action at law for the recovery of that amount as money had and received to the benefit of the beneficiary, so as to overlay the equitable relationship of trustee and beneficiary with the legal relationship of debtor and creditor.  That has been settled since at least the middle of the nineteenth century[107].

at para 105 of Fischer v. Nemeske Pty. Ltd.

It can be inferred that a trustee of a FDT given an unconditional obligation to pay money to a beneficiary under a UPE has been given a financial accommodation, an in substance loan or both under sub-section 109D(3). A loan and a UPE give rise to clearly comparable liabilities which is precisely the mischief to which section 109D is directed.

Further, an in substance loan is a particularly apt characterisation of the UPE in Bendel where the taxpayer, the FDT and the company beneficiary are related parties as they will be in most of these cases. Where they are related it is clearly commercially open to the trustee of the FDT and related parties to achieve the same liability as understood from para 105 of Fischer v. Nemeske Pty. Ltd. and the same financial goal by either a loan or by a UPE which, in substance, offers the related parties the same thing.