Changes to Trust Distributions and Division 7A
WHAT IS DIVISION 7A?
Division 7A is a specific anti avoidance provision designed to prevent private companies from making tax free distributions to shareholders, directors and/or their associates in the forms of loans, payments or debts that are forgiven.
HOW DOES DIVISION 7A AFFECTS TRUSTS?
Division 7A was originally focused on private company tax free distributions, as mentioned above, however trusts have now come under the scope of the Division 7A by virtue of Subdivision EA and Subdivision EB of ITAA 1936.
Subdivision EA will operate where a private company is presently entitled to income of the trust estate, of which income has not been actually paid. Subdivision EA applies to all loans, debts forgiven and or payments made on or after 12 December 2002.
This is a very common situation encountered by small to medium enterprises (SME's). Essentially the trading or investment enterprise will be operated through the trust and whatever profits are not able to be distributed to individual beneficiaries (due to higher tax rates) are 'dumped' into the corporate beneficiary where the tax rate is capped at 30%. The Trust will pay for the tax of the corporate beneficiary but will retain the funds the subject of the distribution.
Subdivision EB operates to enhance the effectiveness of Subdivision EA and to prevent it from being circumvented. Subdivision EA was able to be avoided where an entity was interposed between the trust and the shareholder, associate or corporate beneficiary. Subdivision EB allows the Commissioner to look through interposed entities to determine whether there is a Division 7A loan. Subdivision EB applies to all loans, debts forgiven and payments made on or after 1 July 2009.
Where the loan or payment does not fall within one of the listed exceptions, the most common being converting the loan to a section 109N loan, subdivision EA will deem the UPE to be a deemed dividend. Briefly, a loan will be a section 109N loan where the following conditions exist:-
- the loan agreement is made in writing;
- the rate of interest payable equals or exceeds the benchmark interest rate; and
- the term of the loan does not exceed the maximum term. The maximum term is either 25 years, if the loan is 100% secured over real property and at the time of making the loan the market value of that property is at least 110% of the loan, or 7 years if the loan is unsecured.
The ATO in TR 2010/3 has identified two (2) types of loan that will give rise to a Division 7A situation where a private company has an UPE from an associated trust:-
- Section 2 Loan – this type of loan will arise where a UPE is paid out in full by the trust, where the trust seeks external finance to pay the UPE to the company and then subsequently the company loans the external finance funds back to the trust.
- Section 3 Loan – this type of loan will arise where a trust retains the UPE to meet working capital requirements of business investments or activities and where the private company has knowledge that the funds are being used by the trust and not held for the benefit of the private company. Section 3 loans only apply to loans arising after 16 December 2009.
UPE's that were in existence prior to 16 December 2009 can be 'quarantined' in the entities financial statements. The ATO will not treat these UPE's as Division 7A loans unless they have converted to Section 2 loans. It should be noted that Subdivision EA will continue to apply to these 'quarantined' loans.
WHAT ARE THE CONSEQUENCES OF HAVING A DIVISION 7A LOAN?
Where a loan, payment or debt forgiven is considered to be a deemed dividend, dependant on the entities 'distributable surplus' it will be assessed to the beneficiary, director, shareholder or associate thereof at potentially 46.5% with no franking credit available.
WHY HAS TRADING THROUGH TRUSTS BECOME POPULAR?
Conducting business through a trading or investment trust has been a popular method of structuring for SBE's for a considerable time.
Trusts as opposed to companies offer more flexibility and concessions when it comes to the sale of assets. Trusts are eligible for general 50% CGT discount in addition to the 50% active asset reduction, the former of which is not available to companies and has been a significant draw card in favour of trusts in the past.
Trusts had the flexibility of paying or applying income on behalf of a beneficiary, to which the beneficiary would pay tax on (generally at a lower tax rate), whilst the trust could retain the money for reinvestment or other working capital purposes.
Asset protection was and still is a major consideration. Operating through a trading trust with an overarching corporate trustee provided a degree of limited liability against contractual and other risks associated with the taxpayers activities.
WHAT ARE THE NEXT STEPS?
Corrective action will need to be taken immediately in respect section 2 and section 3 loans.
Section 2 loans that have not been correctly identified as unpaid present entitlements on the financial statements will need to be corrected before 31 December 2011. A Division 7A compliant section 109N loan agreement should be put in place, unless the loan can either be fully repaid or the company or trust lacks the required distributable surplus.
Section 3 loans can be dealt with by one of the three sub trust arrangements outlined by the ATO in PSLA 2010/4 which require the UPE to be separately identified in the main trust as being held on trust for the sole benefit of the corporate beneficiary. Section three loans arising between 16 December 2009 and 30 June 2010 had until 30 June 2011 enter into a sub trust arrangement. This would be evidenced by a loan agreement or identification of a particular income producing asset. If the funds are not put on sub trust then the trustee must either pay out the UPE or make the loan a complying section 109N loan.
The result of the recent legislative additions and rulings issued by the ATO mean that a UPE can no longer be left indefinitely to be used as working capital by a trust.
There are options available to defer the payment of these loans and to manage the cash flow burden that would otherwise be imposed on a business.
If you would like to know more about Division 7A loans, Unpaid Present Entitlements and Section 109N loans and how it affects your business please contact Ramsden Lawyers.
The information in this bulletin represents general information only and should not be interpreted as legal, financial or accounting advice. We recommend that you obtain independent professional advice before making any financial or other decision.
By Shanan John Ramsden Lawyer and Managing Partner of Ramsden Lawyers.
28 Feb 2012