On 23 February 2022, the ATO released new draft guidance materials on the application and operation of section 100A (s 100A) and Division 7A (Div 7A) of Part III of the Income Tax Assessment Act 1936 (ITAA 1936). My column last month explored the operation of s 100A and how the Commissioner intends to apply the provision and devote compliance resources based on a risk assessment framework. This month, we will explore the draft guidance material on Div 7A.
While Div 7A was introduced with effect from 4 December 1997 for loans and payments (and loan forgiveness) made by private companies to its shareholders or their associates, the application of Div 7A to unpaid present entitlements (UPEs) of private company beneficiaries to a share of trust income has its genesis in former s 109UB of the ITAA 1936. That provision applied from 27 March 1998 until its repeal in 2004, and deemed certain trust amounts to be treated as loans. Subdivision EA replaced and expanded the operation of s 109UB from 12 December 2002; Subdivision EB further expanded the provisions from 1 July 2009.
The ATO’s position on whether the UPE of a private company beneficiary (CorpBen) constitutes the provision of financial accommodation (POFA) by the company to the trust was unequivocal following the release of draft taxation ruling, TR 2007/D8, on 16 December 2009. This position was finalised as TR 2010/3 (Ruling), and was accompanied by Law Administration Practice Statement, PS LA 2010/4 (PS LA).
The ATO explains in the Ruling that where CorpBen knowingly, and with acquiescence, allows funds representing a subsisting UPE (a UPE that has not been satisfied) to be used for trust purposes, CorpBen provides a benefit to the trustee of the trust. Where CorpBen enables those funds to be used for trust purposes, the UPE would not be used for the sole benefit of CorpBen. This is a form of financial accommodation provided by CorpBen, and therefore the company is taken to have made a loan to the trustee that is subject to Div 7A.
In the PS LA, the ATO explains that where funds are held on sub-trust for the sole benefit of CorpBen, the company will not have provided financial accommodation to the trustee and therefore not have made a loan that is subject to Div 7A. The PS LA sets out three investment options where the ATO accepts that the funds held on sub-trust are held for the sole benefit of CorpBen.
Of those UPE arrangements where the funds representing the UPE are held on sub-trust, the majority of taxpayers preferred so-called Option 1 (interest-only 7-year term) or Option 2 (interest-only 10-year term) over Option 3 where the funds representing the UPE are invested in a specific income producing asset or investment held for the sole benefit of CorpBen.
Practical Compliance Guideline PCG 2017/13 (PCG) explains that where the principal amount under an Option 1 or Option 2 sub-trust arrangement is not fully repaid by its maturity in the
2016–17 to 2020–21 income years, the outstanding amount may be placed on complying Div 7A loan terms. This provides a further 7-year period for the amount to be repaid with periodic payments of both principal and interest. It is unclear whether the ATO will extend the application of the PCG to include the 2021–22 income year.
In conjunction with the ATO’s package of new draft guidance materials on s 100A issued on 23 February 2022, the ATO released a new draft Taxation Determination, TD 2022/D1 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become ‘any other form of financial accommodation’? (draft Determination).
The draft Determination sets out the Commissioner’s preliminary view on when the UPE of a private company beneficiary will be treated as a loan for which there can be dividend consequences under Div 7A, as that beneficiary has provided ‘any other form of financial accommodation’ to the trustee.
Importantly, the draft Determination does not represent the long-awaited proposed legislative reforms. That is quite separate from ATO interpretive guidance on the operation of the existing law.
The draft Determination describes two circumstances where CorpBen provides financial accommodation where it is made presently entitled to trust income and either:
In this circumstance, CorpBen is taken to consent to the trustee retaining the amount of the UPE to continue using it for trust purposes if the company:
This constitutes the POFA to the trustee under s 109D(3)(b) of the ITAA 1936 (meaning of ‘loan’ for Div 7A purposes).
This outcome is not inconsistent with the ATO’s position in the Ruling. TR 2010/3 will be withdrawn with effect from 1 July 2022 for trust entitlements arising on or after that time.
The timing of when CorpBen is taken to provide financial accommodation is controversial. The draft Determination explains that where a UPE arises under a trustee resolution that makes CorpBen presently entitled to an amount that is expressed as:
In other words, the manner in which CorpBen’s present entitlement is expressed will determine the timing of when it is taken to provide financial accommodation and therefore have made a loan. This is clumsy and impractical for taxpayers to administer. Further, expressing a present entitlement as a fixed dollar amount does not assure the beneficiary that they will receive that amount — there may ultimately be insufficient trust income or depletions of trust income represented by expenses not identified at the time the resolution was made. The ATO should consider aligning the timing of the POFA so the manner in which the present entitlement is expressed in the trustee resolution is not relevant; the POFA should occur in the income year following that in which CorpBen became presently entitled regardless of the wording in the trustee resolution.
Where CorpBen is made presently entitled to trust income and the trustee sets aside an amount from the main trust and holds it on sub-trust for the exclusive benefit of CorpBen, the present entitlement to income is paid and there is no UPE. The ATO explains that the amount set aside by the trustee ceases to be an asset of the main trust and forms the corpus of the sub-trust (the sub-trust fund). The trustee’s obligation to pay the UPE comes to an end and a new obligation arises for the sub-trustee under a separate trust. CorpBen can call for payment of the sub-trust fund and can call the sub-trust to an end.
Importantly, the ATO does not regard a choice by CorpBen not to exercise its right to call for payment of the sub-trust fund as the POFA because the sub-trust fund is held for CorpBen’s sole benefit. This is the equivalent of holding the funds on sub-trust under Option 3 of the PS LA. Notably, the PS LA will be withdrawn with effect from 1 July 2022 for trust entitlements arising on or after that time. Accordingly, Options 1 and 2 — which allow the sub-trustee to manage CorpBen’s entitlement under a 7- or 10-year interest-only investment arrangement — will no longer be available from 1 July 2022.
If, however, CorpBen consents to the sub-trustee allowing those funds to be used by CorpBen’s shareholder or their associate — where all or part of the sub-trust fund is used by that entity and CorpBen has knowledge of this use — this will constitute the POFA by CorpBen to the entity using the sub-trust fund. This will be the case whether or not the use of the sub-trust fund is on commercial terms whereby a return is paid to the sub-trust fund. Accordingly, CorpBen will be taken to make a loan to the entity using the sub-trust fund under the extended definition of ‘loan’ in s 109D(3). The loan is taken to be made when CorpBen knows of the use of an amount of the sub-trust fund and does not call for payment of that part of the sub-trust fund.
It is unclear what is meant by ‘the use’ of the sub-trust funds by CorpBen’s shareholder or their associate. It is also unclear whether Subdivision EA has any residuary application during the period from when the present entitlement arises and when the financial accommodation is taken to have been provided.
This is a significant change in position by the ATO and is likely to effectively bring to an end sub-trust arrangements. The only sub-trust arrangements that will not constitute the POFA will be those held akin to Option 3 arrangements. Practically, these have not been embraced by taxpayers, as they required the separate preparation of financial accounts and an income tax return for the sub-trust, a separate TFN and the loss of the CGT discount on the eventual sale of the CGT asset held on sub-trust as the company effectively accounts for the net gain derived from the sale.
The ATO has advised that compliance resources will not be allocated to sub-trust arrangements conducted in accordance with the PS LA in respect of trust entitlements arising before 1 July 2022.
In the absence of advice from the ATO to the contrary, existing Option 1 or Option 2 sub-trust arrangements (pre-1 July 2022) may seemingly continue until their maturity. It may also be inferred that, given the ATO has not specifically advised that the PCG will be withdrawn, any principal amounts not fully repaid by maturity may be managed as a new Div 7A complying loan.
As with the draft guidance materials on s 100A, the new draft Determination will be of great interest and relevance to many practitioners and their clients. The relatively short consultative period will allow the opportunity to provide feedback on the draft Determination by submission to the ATO. Seeking clarity on some of the terms used in the draft Determination will be paramount so taxpayers have certainty managing their arrangements.
As with s 100A, the profession will be watching further developments with a keen and concerned eye.
About the author:
Robyn Jacobson is the Senior Advocate at The Tax Institute.
About The Tax Institute:
The Tax Institute is the leading forum for the tax community in Australia. Our reach includes membership of 11,000 tax professionals from commerce and industry, academia, government and public practice and 40,000 Australian business leaders, government employees and students. We are committed to representing our members, shaping the future of the tax profession and continuous improvement of the tax system for the benefit of all, through the advancement of knowledge, member support and advocacy. Read more at taxinstitute.com.au
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