ATO’s views continue to be challenged

The decision by the Full Federal Court was significant as it reversed the Australian Tax Office’s (ATO) longstanding view about the tax consequences of unpaid present entitlements (UPEs) from trusts to corporate beneficiaries.

Bendel’s facts were not uncommon and had been problematic for practitioners for many years. A discretionary trust makes a corporate beneficiary presently entitled to trust income which remains unpaid (the UPE). Prior to 16 December 2009, the ATO held the view that a UPE was not a loan unless the parties actually converted it into an ordinary loan. This meant the trust could retain the use of the distributed trust income (e.g. for working capital) without attracting any further tax implications under a specific tax avoidance provision, Division 7A. 

However, with effect from 16 December 2009, the ATO formed the view that if the present entitlement remained unpaid by the lodgment day for the trust’s tax return for the income year in which it arose, it became the provision of financial accommodation (by the company to the trust) and a loan for Division 7A purposes. Taxpayers had several options to deal with the consequences under the new ATO approach, but in order to avoid having a deemed unfranked dividend, most taxpayers chose to put in place a complying Division 7A loan agreement within specified timeframes.

Conducting one’s tax affairs in accordance with the ATO’s position has necessitated executing documents governing the arrangements (e.g. a “sub-trust agreement or complying loan agreement”) between the trust and corporate beneficiary, with the trust making payments of interest and principal (if required) to the corporate beneficiary. The practical outcome for many private business owners from complying with the ATO’s position over the years has been to incur “top-up” tax –the balance of tax from the company tax rate up to the owners’ personal marginal tax rate – on profits they have not drawn, but in fact have retained and reinvested in their business.

While the Full Federal Court decision may represent good news, the outcome has given rise to uncertainty as the ATO has affirmed their long-standing position and stated that they will continue to administer the law on the same basis while the judicial process continues. Even if the High Court were to rule against the ATO, uncertainty will remain for private business owners, such as what to do with pre-existing arrangements entered into in compliance with ATO guidelines. It is also likely that the Treasury and Parliament will revisit proposed reforms to Division 7A, many of which were considered unacceptable for private business owners. This is certainly a case of: Watch this space!

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Tony Nunes has over 25 years’ experience in providing tax advice to clients, especially on issues affecting cross-border transactions, acquisitions and restructures, and on all aspects of structuring the ownership and financing of corporations and their operations.