Tag Archives: Division 7A

Has the AAT in Bendel reset the treatment of UPEs from trusts as Division 7A deemed dividends?

dismantle

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.

Tax risks of low or zero interest loans to private companies

zero %

Low or zero interest loans (LOZILs) to companies by their shareholders are generally not a tax problem in themselves.

Total Holdings

The well-regarded 1979 Full Federal Court decision in F.C. of T. v. Total Holdings (Australia) Pty. Ltd. [1979] FCA 53 allowed a tax deduction to a holding company for its interest costs of borrowing despite the holding company on-lending the borrowing to its operating subsidiary at zero interest.

The deduction for the whole of interest paid on the borrowing was allowed to the holding company as it could show its purpose in using the money borrowed was to improve the profitability of the subsidiary. That improvement meant an increased likelihood of the holding company deriving assessable dividend or interest income from the subsidiary company.

No Division 7A deemed dividend

When a LOZIL is by a private company to another private company who may either be:

  1. a shareholder of the lender; or
  2. associated with a shareholder of the lender;

the question of whether the LOZIL could be treated as a deemed dividend under Division 7A of Part III of the Income Tax Assessment Act (ITAA) 1936 arises. A LOZIL would not be immune from deemed dividend treatment under section 109M in Division 7A as it would be:

  1. neither a loan in the ordinary course of the business of the lender;
  2. nor on the usual terms on which the lender makes loans to other parties at arm’s length.

However section 109K excludes loans to standalone private companies that are not trustees of trusts from deemed dividend treatment under Division 7A:

A private company is not taken under section 109C or 109D to pay a dividend because of a payment or loan the private company makes to another company.

Note: This does not apply to a payment or loan to a company in its capacity as trustee. (See section 109ZE.)

Section 109K of the ITAA 1936

The protrusive LOZIL

Despite the above low or zero interest marks a LOZIL as uncommercial and potentially attracts greater scrutiny of:

  • the reason for the LOZIL; and
  • the transactions of a taxpayer to which the LOZIL relates;

by the Commissioner of Taxation.

From a company lender’s or a company borrower’s perspectives it is generally preferable that interest is charged and paid to as close to a commercial rate as possible if the Commissioner’s (See my blog “Only a loan? Impugnable loans, proving them for tax and shams” https://wp.me/p6T4vg-8a), non-loan party shareholder’s and creditor’s (interested parties) scrutiny of the loan is not to be attracted.

If, after that, a LOZIL to a company is still thought worthwhile to make then the company should carefully record the purpose of the loan to reduce opportunity for interested parties to allege the LOZIL was made for nefarious or unacceptable purposes to benefit the recipient.

LOZILs as de facto shareholder capital funding

LOZILs are commonly used by shareholders as de facto capital to fund private companies. A LOZIL has the disadvantage that it is not counted in the cost base of the shareholder’s shares for capital gains tax purposes. A LOZIL can complicate the position for shareholders either:

  • looking to sell their shares; or
  • to project a clean balance sheet of the company when the company is looking for more funding.

A tidying up of ad hoc and lazy LOZIL arrangements is frequently a feature of private company funding and restructuring deals.

Loans at will

These LOZILs are typically at will, that is with no set terms either for the payment of interest on the loan or the repayment of principal. They arise often in the void where a private company receiving shareholder funding has omitted to perform a routine share capital issue to the shareholders in exchange for the funding.

When might a LOZIL be a tax problem?

It is not possible to be definitive about when a LOZIL may be a tax problem without understanding the wider context, especially tax avoidance or illegal contexts, of why a LOZIL is being made. Usually LOZILs attract greater scrutiny from the ATO because of their uncommercial character, as stated. A LOZIL often needs to be put in place with some care so what the LOZIL is intended to achieve is above board.

Here are some specific situations where a LOZIL to a company will give rise to tax problems (definitely not an exhaustive list! – this is a list I may add to):

  • a LOZIL by an employer or associate of the employer to a company that is an associate of an employee subject to fringe benefits tax;
  • a LOZIL to a company as trustee of a trust by an outsider to the trust where the LOZIL is productive of scheme assessable income which cannot be applied to reduce trust losses: Division 270 of Schedule 2F to the ITAA 1936; and
  • where there may be cross-border transfer pricing see Draft Practical Compliance Guideline PCG 2017/4DC2.

Preparing to change land ownership from a company to a trust

A company controlled by X owns land. X would prefer it if the land was held by a trust or in an individual name such as X or Y, X’s spouse.

X_diag

Significant capital gains tax (“CGT”) on the transfer of the land is not expected by X and Y. Is a transfer of the land to a trust or to X or Y or both worthwhile? Here are some tax implications X may want to think about:

Capital gains tax

If the land has increased in value X will want to consider CGT more closely:

If the land is not an active asset, or if the small business CGT concessions or the new small business restructure roll-over, can’t apply for some other reason, the value of the land, when disposed of, will be taken into account in determining CGT. i.e. the market value substitution rule will apply in the event of an undervalue transfer of the land.  An undervalue transfer of the land is rarely likely to be effective under tax rules.

The small business CGT concessions and the new small business restructure roll-over don’t apply if the asset is not an active asset. The land won’t be an active asset if it is mainly used by the company, and related parties of the company, to earn rent. As the land is held in a company, the 50% CGT discount is not available to the company on the transfer of the land.

Problems with a gift or an undervalue transfer

If full value is not payable to the company for the land then, without more, a transfer of the land could be treated as a dividend taxable in full to the transferee as a shareholder of the company, as a deemed dividend taxable to the transferee as an associate of the shareholders of the company, or may possibly be taxable to the company as a fringe benefit.  Further if the company has taken the approach of gift there may be difficulties establishing that the company was legally entitled to give the land away to the transferee if that is what is done. Indications of a gift might give a creditor of the company additional rights to pursue the transferee for the value of the land that belonged to the company especially if the stance of the company is that the transfer was not any sort of dividend or remuneration to X or Y.

A sale of the land by the company for full value is more defensible. The sale can be on terms rather than for cash payable on settlement. If the transferee doesn’t follow through, and pay the value in cash or on the agreed terms, then the sale for value can be treated as a sham and the consequences of undervalue transfer can then follow.

So defensible transfers of the land include:

  1. sales at full value on (genuine) terms; and
  2. distribution of the value of the land to the shareholders of the company (not in the form of cash) on the voluntary liquidation of the company.

CGT event A1 – but watch out for CGT event E2 if a transfer to a trust

Usually CGT event A1 is attracted when land is transferred from one beneficial owner to another. CGT event A1 is taken to occur at the time of (in the income year of) the disposal, that is, the time of the transfer unless the transfer is made under a contract. If the transfer occurs under a contract and CGT event A1 applies, CGT event A1 is taken to occur at the time of making of the contract.

This can be significant where a contract and settlement straddle the end of an income year, with the time of the contract bringing forward the capital gain into the earlier income year if CGT event A1 applies. If the transferee is a related trust of the vendor then CGT event E2 can apply rather than CGT event A1.  CGT event E2 though, unlike CGT event A1, does not bring forward the time of the CGT event to the time of the contract so, if CGT event E2 applies, the capital gain will be made in the later income year.

Stamp duty on a transfer

Stamp duty varies from state to state but generally applies to acquisitions of land based on the market value of the land, not the price to the transferee/purchaser. Very generally speaking it is usually charged at around 5% of the land value. The states offer limited stamp duty relief when acquisitions occur without a change in ultimate beneficial or economic ownership of the land. For instance, in New South Wales and Victoria relief exists in the form of corporate reconstruction concessions. These concessions are generally not available where the acquisition is by a trust or an individual. Thus stamp duty would need to be budgeted for by X as a further cost of transferring the land.

Goods and services tax

If the company is registered or ought to be registered for the goods and service tax and the land in used in an enterprise carried on by the company then the company may be obliged to charge 10% GST to the transferee on the transfer (taxable supply) of the land. If the transferee is also registered for GST, and will use the land in the transferee’s enterprise, then the transferee can obtain an input tax credit/refund of the GST charged to the transferee. The company and the transferee, if registered for GST, may also:

  1. be able to claim the GST going concern exemption if they take the necessary steps for the exemption; or
  2. be members of a GST group;

which would relieve the company of the obligation to charge GST to the transferee.

Is a family trust a good way for setting up a new franchisor business?

A family discretionary trust structure is a slightly more complicated and costly structure but it has more flexibility than a holding company structure for distributing income tax effectively while also being capable of having limited liability protection for the franchisor along with potential access to the company tax rate through a beneficiary company.

But is one trust enough?

For asset protection and management reasons it may be multiple structures are desirable into the future to separately hold IP and property interests (including lease interests to be sub-let).

Trust a conduit to beneficiaries

A family trust can distribute business profits as trust distributions as a conduit of taxable income to adult resident beneficiaries.

Division 7A would not usually apply

A significant advantage with a family trust structure is that Division 7A does not apply to loans from the trust to associated parties (where companies are not involved) to treat them as taxable/unfrankable deemed dividends.

Capital gains tax advantages

The adult resident beneficiaries of a family trust can also use the CGT discount if the trust makes a capital gain. Sometimes a trust is a more difficult structure than a company if a new franchise venture makes losses (say due to difficulties finding and keeping franchisees on good terms).

Bringing in new equity

A family trust isn’t as good as a unit trust or a company for bringing in new equity participants however it appears that, with the new small business restructure CGT rollover relief, a later conversion to a unit trust structure can be done for a low cost.

CGT discount and small business CGT concessions

Capital gains made by a family trust structure could attract the CGT discount and the small business concessions (a company can only get the latter), such as the 50% active assets reduction. A family trust structure has the tax advantage over a company structure if CGT assets of the business, including goodwill, are at some stage sold for a capital gain by the trust.