2016 PRIVATE BUSINESS TAX RETREAT - Cloud Object …€¦ · · 2016-05-162016 PRIVATE BUSINESS ... 3.3 In specie transfer of asset ... Taxation Ruling TR 2010/3 was issued in final

© Chris Wookey 2016

Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2016 PRIVATE BUSINESS

TAX RETREAT

Cleaning up the Div 7A loans and UPE

mess

Written by:

Chris Wookey, CTA

Principal - Tax

Deloitte Private

Presented by:

Chris Wookey, CTA

Principal - Tax

Deloitte Private

Queensland Division

26-27 May 2016

The Palazzo Versace Hotel, Gold Coast

Chris Wookey Cleaning up the Div 7A loans and UPE mess

© Chris Wookey 2016 Page 2

CONTENTS

1 The journey so far .......................................................................................................................... 4

1.1 The near future ......................................................................................................................... 6

1.2 What might be… ....................................................................................................................... 6

1.2.1 Board of Taxation recommendations ................................................................................. 6

1.2.2 2016 Federal Budget announcement ................................................................................ 7

2 Market intelligence – practical application .................................................................................. 9

2.1 Observations ............................................................................................................................. 9

2.1.1 Options 0, 1, 2 and 3 ......................................................................................................... 9

2.2 What mess? ............................................................................................................................ 10

2.2.1 Option 0 trap .................................................................................................................... 11

2.3 Structures – change of preference ......................................................................................... 12

2.3.1 Unit trust .......................................................................................................................... 12

2.3.2 Partnership ...................................................................................................................... 13

2.3.3 Discretionary trust ............................................................................................................ 14

3 How to repay? .............................................................................................................................. 16

3.1 Cash ........................................................................................................................................ 16

3.2 Set off ...................................................................................................................................... 16

3.3 In specie transfer of asset ....................................................................................................... 16

3.4 Forgive .................................................................................................................................... 17

3.5 Refinance ................................................................................................................................ 18

3.5.1 Same lender .................................................................................................................... 18

3.5.2 Different lender ................................................................................................................ 19

3.6 Tax risks .................................................................................................................................. 21

3.6.1 Section 109R ................................................................................................................... 21

3.6.2 Section 100A and Part IVA .............................................................................................. 22

4 Non-payment consequences ...................................................................................................... 24

4.1 Ordinary loans ......................................................................................................................... 24



4.2 UPEs ....................................................................................................................................... 24

4.2.1 Annual interest ................................................................................................................. 25

4.2.2 Principal ........................................................................................................................... 26

5 Conclusion .................................................................................................................................... 29



1 The journey so far

For nearly twelve years, practitioners thought they had a reasonable understanding of how Div 7A

applied where a trust had an unpaid present entitlement (or UPE and also known as an unpaid

beneficial entitlement or UBE) in favour of a beneficiary that was a company. After all, first there was

s109UB, then subdivision EA and, although from a taxpayer’s perspective those provisions’

consequences were undesirable, at least they provided a level of certainty.

Then, at a TIA conference in early 2009, Deputy Commissioner Mark Konza publicly revealed what

has come to be a fundamental change to the Commissioner’s administration of Div 7A and set out in

Taxation Ruling TR 2010/3 (the ruling) and the revised version of Practice Statement PSLA 2010/4

(the practice statement) released in July 2011.

Taxation Ruling TR 2010/3 has its genesis in comments made by Deputy Commissioner Mark Konza

at a presentation to the TIA on 10 February 2009 in which it was said that unpaid present entitlements

in favour of companies could factually change so that they might become loans for the purposes of

Div 7A.

The ATO attempted to clarify this position in the NTLG meeting of March 2009. The minutes of that

meeting reveal the following:

Deputy Commissioner, Mark Konza advised members that the intent of the speech referred to was to engage in a

technical discussion with the members of the particular professional association. The Tax Office had noticed a

growing trend of a number of cases with large amounts of unpaid present entitlements and wanted to alert the

membership of issues that can arise.

Members were advised that the matters are fact dependent and need to be considered on a case-by-case basis.

There may be instances where the unpaid present entitlements are in fact a loan. Where there is no loan there is still

a need to consider what is happening in the trust as section 100A might apply.

After much uncertainty about this position, it is understood that a meeting was attended by

representatives of the ATO and the professions in September 2009 at which the ATO was requested

to clarify the circumstances in which it would be considered that a company’s UPE might evolve into

being a loan for Div 7A purposes. Draft Taxation Ruling TR 2009/D8 was issued as a result on

16 December 2009. Numerous submissions were lodged in response to the draft ruling and it

proceeded to the Public Rulings Panel on 5 May 2010 where, in an unusual step, the ATO invited four

representatives of the professional bodies to attend and make their submissions in person.

Taxation Ruling TR 2010/3 was issued in final form on 2 June 2010 following its clearance by the

Public Rulings Panel.

In essence, the Ruling puts forward the proposition that a company’s UPE may either become

factually a loan ab initio or convert into a loan either directly by way of the provision of financial

accommodation or in substance over time. UPEs which become loans ab initio are described in

Section 2 of the ruling and are referred to throughout it as Section 2 loans. UPEs which become

loans over time are described in Section 3 of the ruling and are referred to as Section 3 loans.



Section 2 loans are also referred to as ordinary loans and are said to arise when a company’s UPE is

satisfied and lent back to the trust. The ATO says that its position in relation to these loans has never

been the subject of any contrary public statements, so the effect of the ruling in relation to these loans

has been made retrospective.

The ATO considers that a Section 2 loan arises where, under an agreement, a trustee borrows from a

company and the trust’s obligation to pay the unpaid present entitlement is set off against the

proceeds of the loan borrowed from the company. According to the ATO, such an agreement may be

implied through the deemed or imputed shared knowledge of the trust and the company and the

actual or implied acquiescence of the company to this treatment.

Alternatively, a Section 2 loan is also said to arise where the trust deed allows the trustee to “pay or

apply” the company beneficiary’s present entitlement to income and does so by crediting a loan

account in the company’s name. In this regard it is important to note Paragraph 14 of the Ruling,

which says:

14. If an amount has been credited to a loan account in the name of a private company beneficiary and under the trust

deed the trustee has the power to do so as a payment or application of trust funds for the benefit of that private

company, in the absence of sufficient evidence to the contrary, the Commissioner takes the view that the trustee

intended to, and in fact, created a loan in exercise of this power.

Section 3 loans, on the other hand, have been commented on by the ATO in numerous publications.

As a result, the Ruling says that ordinary UPEs that arise on or after 16 December 2009 will

potentially be considered to have become Section 3 loans.

In paragraph 17 of the Ruling, the Commissioner acknowledges that an unpaid present entitlement

that has not been satisfied, including by being converted into (or replaced by) an ordinary loan, does

not amount to a Div 7A loan either:

Within the ordinary meaning of a loan;

Under paragraph 109D(3)(a) of the extended definition as there is no advance of money involving

a payment in advance of a due date or a payment in expectation of a repayment; or

Under paragraph 109D(3)(c) of the extended definition as there is no payment coupled with an

obligation to repay.

The Ruling then continues on to state that a company beneficiary may provide financial

accommodation to a trust or otherwise enter into a transaction which in substance effects a loan, such

that the company makes a Div 7A loan to the trust in respect of its UPE. Importantly, paragraph 26 of

the Ruling states that:

Where the trust and beneficiary form part of the same family group, in the absence of sufficient evidence to the

contrary, the Commissioner takes the view that the private company has knowledge of the trustee’s use of the funds

representing the UPE for trust purposes.

As a result of this presumed knowledge, the company is taken to be capable of acquiescing to the

treatment of its UPE as a form of financial accommodation extended to the trust, particularly because

the company typically does not call for payment of the amount due to it.



Practice Statement PS LA 2010/4 was issued in draft on 2 June 2010 as PSLA 3362 (draft) at the

same time as the finalised version of TR 2010/3. This practice statement attempts to provide practical

guidance to taxation officers in dealing with the application of TR 2010/3. It provides for a somewhat

softer approach than that capable of being read into the ruling.

1.1 The near future

At the time of writing this paper, it is nearly the sixth anniversary of the end of the first financial year to

which the Commissioner applies the above rules. The seventh anniversary of 30 June 2010

distributions may arrive faster than expected, along with the requirement to pay in full any remaining

2010 UPE owing to a corporate beneficiary. The following timeline illustrates.

Clients (and their advisers) need to plan ahead for the repayment obligations that are soon to arise.

1.2 What might be…

1.2.1 Board of Taxation recommendations

In November 2014 the Board of Taxation delivered to Government its report entitled Post

Implementation Review Of Division 7A Of Part III Of The Income Tax Assessment Act 1936. The

report’s recommendations were numerous and included treating existing loans and UPEs as

summarised in this table:



Source: Table 2, para 6.38 of the Board of Taxation’s report

As can be seen, it was recommended that existing 25-year complying loans be grandfathered and all

other existing loans and UPEs – whether or not arising before 2009 – would need to have ten-year

terms with payments being made so that the principal and interest accrued was paid down

progressively.

The report recommended that payments be required so that the outstanding balance would be

reduced to the following percentages of the original balance:

Balance reduction schedule

75% by end of year 3




1.2.2 2016 Federal Budget announcement

The 3 May 2016 Budget papers1 included the following announcement:

The Government will make targeted amendments to improve the operation and administration of Division 7A of the

Income Tax Assessment Act 1936 (an integrity rule for closely held groups).

These changes will provide clearer rules for taxpayers and assist in easing their compliance burden while maintaining

the overall integrity and policy intent of Division 7A. It includes a self-correction mechanism for inadvertent breaches

of Division 7A, appropriate safe-harbour rules to provide certainty, simplified Division 7A loan arrangements and a

1 2016 Budget Paper No.2, page 42



number of technical adjustments to improve the operation of Division 7A and provide increased certainty for

taxpayers.

These changes draw on a number of recommendations from the Board of Taxation’s Post-implementation Review into

Division 7A and will apply from 1 July 2018.

This was explained (slightly) further in Budget Tax Fact Sheet 042 where it was said:

The Coalition Government believes that it should be as easy as possible for businesses to comply with the regulations

and laws that apply to them.

For this reason the Government will work with stakeholders to develop targeted changes to simplify Division 7A and

make it easier to understand and apply. Subject to the outcomes of consultation, the Government will amend these

rules to include:

• A self-correction mechanism providing taxpayers whose arrangements have inadvertently triggered Division 7A with

the opportunity to voluntarily correct their arrangements without penalty;

• new safe harbour rules, such as for use of assets, to provide certainty and simplify compliance for taxpayers;

• amended rules, with appropriate transitional arrangements, regarding complying Division 7A loans, including having

a single compliant loan duration of ten years and better aligning calculation of the minimum interest rate with

commercial transactions; and

• technical amendments to improve the overall operation of Division 7A.

Regrettably, these changes are proposed to take effect from 1 July 2018; too late for 2018 UPE

repayment obligations.

At the time of writing no additional detail was available, so taxpayers and their advisers are left to

wonder whether all of the Board of Taxation’s recommendations will be implemented; in particular,

how grandfathered loans and UPEs will be treated under the new rules.

In the meantime, taxpayers and their advisers need to continue to deal with Div 7A in its current form.

2 http://budget.gov.au/2016-17/content/glossies/tax_super/downloads/FS-Tax/04-TFS-Less_red_tape_for_business.pdf

http://budget.gov.au/2016-17/content/glossies/tax_super/downloads/FS-Tax/04-TFS-Less_red_tape_for_business.pdf



2 Market intelligence – practical application

2.1 Observations

2.1.1 Options 0, 1, 2 and 3

The question of how to apply the ruling and practice statement has largely been tackled by

accountants in one of four ways:

Way Description

Option 0 Do not apply any of the options available under the practice statement.

By lodgement day of the year following distribution, either:

Pay out the corporate beneficiary’s UPE in full; or

Put it on s109N-compliant terms (usually 7 years).

Option 1 Put the UPE on 7-year interest-only terms as described in the practice

statement.

Option 2 Put the UPE on 10-year interest-only terms as described in the practice

statement.

Option 3 Set aside a specific asset for the sole benefit of the corporate

beneficiary as described in the practice statement.

In my experience, Options 0 and 1 predominate, with Options 2 and 3 rarely seen.

Those accountants who prefer Option 0 say they do so usually because either:

They feel they cannot rely on the practice statement because it is not legally binding on the

Commissioner; or

They are concerned at the sizeable cash flow obligations arising at the end of the seven year term

of Option 1 and prefer to smooth the payment obligations.

Further, many accountants have developed a preference for private expenditure not to be taken to a

debit loan account, but to be funded by fully franked dividends either in the year of the expenditure or

by the lodgement day in the one following. In this way, it is said that non-deductible interest is avoided

and clients better understand the tax implications of their spending.



2.2 What mess?

Few practicing accountants would dispute the assertion that we have a “mess” caused by how people

have needed to deal with UPEs and loans in order to avoid deemed dividends under Div 7A. Indeed,

with the devolution of lower level processing work to clients and external bookkeepers, some

accountants are reporting to me that they spend half of their time on a client’s annual compliance

work managing Div 7A obligations!

If that is surprising, consider that in a group of entities consisting of trusts and at least one company

the accountant might have to help the client manage:

At least one UPE per year owed to a corporate beneficiary – meaning that each UPE needs to be

recorded and tracked separately, with interest calculated on its daily running balance.

With one UPE per year, that means that someone (usually the unfortunate accountant) needs

to have set up sub-accounts or the like for a UPE for 2010, 2011, 2012, 2013, 2014 and 2015.

Where the client’s accounting system does not distinguish between the various UPEs, the

accountant needs to keep a separate record of the year-by-year UPEs and their running

balances. This separate record needs then to be reconciled and agreed to the client’s

financial records.

Where the client or an external bookkeeper records the day-to-day transactions such as tax or

other expense payments, such payments made by a trust on behalf of the corporate beneficiary

needs to be allocated to the most appropriate UPE account.

The allocations in the client’s general ledger need to be reviewed and corrected, if necessary.

If the strategy whereby tax payments and the like made on behalf of a corporate beneficiary by a

trust are captured in a debit loan instead of immediately being debited to the UPE account(s),

realising that the consequent higher UPE balance results in a higher interest liability.

This higher interest liability can cause particular problems for a trust that operates a business

if it suffers an operating loss and cannot afford to pay the higher interest bill. (But more of that

later.)

No doubt there are many more examples of complications caused by Div 7A obligations.

Whilst the above may sound simply like the complaints of a self-focussed accountant, there is also the

very real repayment burden falling on taxpayers. In 2011 I said:

The deferred cash flow burden of Option 1 can “creep up” on taxpayers from 2018 (and of Option 2 from 2021), with

annual obligations thereafter to pay amounts equating annual profits to the corporate beneficiary (assuming those

Options were consistently applied).

This temporary relief from payment may be of more benefit to taxpayers who are planning an exit of their trust’s

investments (e.g., by sale of the business carried on by the trust) before then than for those who are not.3

3 Wookey, C (2011), Getting Down to Business with Div 7A UPEs and s100A, TIA Victorian State Convention



2.2.1 Option 0 trap

Some accountants and tax advisers have reported to me that they refused to adopt one of the

Options under the practice statement because a practice statement is not legally binding on the

Commissioner and they simply did not trust the Commissioner’s auditors to abide by it. Some had had

unpleasant previous experiences in this regard.

In this case, they would usually apply what has been called Option 0, described above under heading

2.1.1. Consider the following timeline in respect of a 2014 distribution to a corporate beneficiary.

Dealing with the distribution to the corporate beneficiary in the above manner avoids Div 7A applying

to the amount distributed.

However, practitioners may omit to consider the implications for debit loans (or payments) made by

the trust in 2014. To illustrate, let us assume that an associate of a shareholder in the corporate

beneficiary became indebted to the trust in FY14 and Option 0 was applied in the above manner to

the corporate beneficiary’s unpaid entitlement to FY14 profits. We then have the following situation:

during the 2014 year, a trust has made a loan to an associate of a shareholder of a private

company;

the company becomes presently entitled to an amount from the net income of the trust estate

after the loan is made (ie, at year-end);

the above entitlement of the company arises before the due date for lodgement of the trust's 2014

tax return (which would be after year-end); and

the whole of the company’s entitlement has not been paid to the company before the due date for

lodgement of the trust’s 2014 tax return.

The above state of affairs is squarely within the terms of s109XA(2):



109XA(2) Loans.

Section 109XB applies if:

(a) a trustee makes a loan (including a loan through an interposed entity as described in section 109XG) to a

shareholder or an associate of a shareholder of a private company (except a shareholder or associate that is a

company) (the actual transaction); and

(b) either:

(i) …; or

(ii) the company becomes presently entitled to an amount from the net income of the trust estate after the

actual transaction takes place, but before the earlier of the due date for lodgment and the date of lodgment of

the trustee's return of income for the trust for the year of income of the trust in which the actual transaction

takes place, and the whole of the amount has not been paid to the company before the earlier of those dates.

In this way, taxpayers may unwittingly have an exposure to deemed dividends under Div 7A even

though they have thought they correctly and properly complied with their obligations.

2.3 Structures – change of preference

Perhaps because of the increasing complexity of dealing with loans and UPEs in business structures,

we are finding an increasing preparedness to incorporate businesses rather than operate them

through either a partnership or trust structure using corporate beneficiaries to cap the tax rate at 30%.

This is despite the chance of effectively doubling the tax cost for the vendor upon eventual sale if a

purchaser were to insist on an asset purchase instead of a share purchase.

So, how might this be done?

The answer depends on what legal structure the business is currently being operated through.

2.3.1 Unit trust

Where business is being operated in a unit trust structure – perhaps because there are two or more

non-family groups owning it – there are three CGT rollovers available apart from the new small

business restructure rollover under subdivision 328-G:

122-A – sale by trust to a wholly owned company

615-A (the former 124-H) – exchange of units for shares in an interposed company

124-N – exchange of units for shares and unit trust wound up

The different structural outcomes of the rollovers are illustrated in the following diagram.



Only following a 124-N rollover does the unit trust cease to exist as part of the rollover. Otherwise,

and especially following a 122-A rollover, the unit trust continues to exist and potentially interfere with

the tax outcomes for the owners of the business because of:

CGT event E4 – which interfere with the owners of the business accessing the likes of small

business CGT concessions (remembering that the Div 152-C additional 50% will be a non-

assessable distribution for the purposes of CGT event E4); and

passing through franked dividends from the company if the unit trust is not sufficiently ‘fixed’ within

the meaning of the trust loss rules – especially remembering that making a family trust election

may not be feasible for the unit trust if there are two unrelated families owning it.

Following a 615-A rollover, the unit trust continues to exist and, unless the new company opts to form

a tax consolidated group (with the attendant cost base resetting requirements and potential for step-

downs in values of depreciating assets), CGT event E4 remains potentially applicable if there were

distributions of non-assessable amounts from the unit trust to the company from the likes of tax timing

differences.

2.3.2 Partnership

Where a business is operated in a partnership, there is only one

CGT rollover available if the taxpayer is not eligible for the small

business restructure rollover: subdivision 122-B.

Following a 122-B rollover, the partnership effectively ceases to

exist and the business it previously operated is owned by the new

company.

Of relevance to Div 7A, the company can now retain profits to fund

its working capital requirements and the need to manage annual

distributions of the entirety of the business’ profits is removed.

However, losses are then locked into the corporate structure and

cannot be utilised by the trusts as they would previously have been.



2.3.3 Discretionary trust

Similarly to the above in relation to partnerships, where a business

is operated in a partnership, there is only one CGT rollover available

if the taxpayer is not eligible for the small business restructure

rollover: subdivision 122-A.

As with the 122-B rollover mentioned above, the company will then

be in a position to fund its working capital from its own profits and

the need to manage annual profit distributions is vastly simplified.

However, any future asset sale would not benefit from the Div 115

general CGT discount.

A possible future asset sale is further complicated when it comes to

extracting the proceeds from the corporate shell. This complication

comes from the requirement of the 122-A rollover that the company

only either assume liabilities “in respect of” the asset transferred or

issue fully paid shares in itself as consideration.

Take for example a discretionary trust with the following balance sheet:

$m $m

Debtors 1.0

Stock 1.0

Fixed assets 2.0

4.0

[Goodwill MV = $4m]

Overdraft 1.0

UPEs 3.0

4.0

If the UPEs were directly or indirectly owed to a corporate beneficiary and it were desired to remove

the need to make annual payments in respect of them by rolling it into a new company under 122-A,

the rollover company’s balance sheet would appear thus:4

4 For the sake of this example, it is assumed that the UPEs would be liabilities that are sufficiently “in respect of” the assets of

the trust so as to allow them to be assumed by the company – see s122-20(1)(b). The matter is not without doubt, but is

beyond the scope of this paper.



$m $m

Debtors 1.0

Stock 1.0

Fixed assets 2.0

Goodwill 4.0

8.0

Overdraft 1.0

Loans 3.0

Share capital 4.0

8.0

It is noted that the UPEs have been converted into loans. An equitable entitlement to receive payment

is not a contractual right (ie, a debt5), so it cannot easily be assigned and should first be converted

into a right under contract (eg, a loan) before it is assigned or assumed.

If the assets of the rollover company were then sold for their carrying values (ignoring tax payable by

the company on the sale), the company would have $8m of cash to be used first to discharge the

overdraft and loans. The remaining $4m representing share capital would then need to be extracted

from the corporate shell either by way of return of capital, share buy back, or liquidation; any of which

will cause a CGT event to happen in the hands of the shareholder trust, the capital proceeds for which

would be the amount received which can be expected to exceed the cost base of the shares and

produce a further capital gain.

5 As accepted by the Commissioner – see paragraph 34 of TR 2010/3.



3 How to repay?

3.1 Cash

Clearly, payment in cash of s109N minimum yearly repayments or UPE obligations simply discharges

those obligations and most cleanly complies with Div 7A requirements.

However, taxpayers often do not have the free liquidity available to make these repayments, often

because of the debtor having invested in illiquid or long-term assets. Where this is the case,

alternative arrangements need to be considered.

3.2 Set off

According to paragraph 56 of the practice statement:

For the avoidance of doubt, the annual return on investment can either be paid in cash or set off against an account

owing from the private company to the main trust, but it cannot be paid by crediting it to a liability account owing to the

private company from the main trust or sub trust. The payment of the principal funds invested in the main trust (that is,

the funds representing the UPE) and annual return to the private company must be such that if those payments had

instead been repayments of a Division 7A loan made by a private company, they would not be disregarded by section

109R.

This means that annual interest payment requirements can be satisfied by being set off against

amounts owing by the company to the trust; for example, where the trust has paid tax (instalments) on

behalf of the company or where the company had declared and credited (but not yet paid) a dividend

to the trust.

This comfort is tempered, though, by the reference to section 109R at the end of the paragraph

quoted above.

3.3 In specie transfer of asset

Similarly to an actual payment or setting off reciprocal debts, the transfer of an asset to a corporate

beneficiary in satisfaction of a UPE can discharge the trust’s Div 7A obligations.

However, it needs to be remembered that such a transfer of an asset causes CGT event A1 to

happen and can lead to the realisation of taxable capital gains. Stamp duty may also apply to the

transfer of an asset subject to it.

Unless the capital gain is streamed to the corporate beneficiary as described in subdivisions 6E of

ITAA36 and 115-C of ITAA97, the taxable capital gain will be assessed to the income beneficiaries:

see section 115-227.

Further, whilst the transfer of an asset in this way might deal with the current liability to pay an amount

to the corporate beneficiary, any future appreciation in the capital value of the transferred asset would



be realised in the hands of the corporate beneficiary and thereby no longer be eligible for the Div 115

CGT discount.

3.4 Forgive

In the light of some of the above difficulties, some might consider causing the corporate beneficiary to

forgive the UPE.

The Commissioner has addressed in TD 2015/20 the Div 7A implications if a corporate beneficiary

were to do so. In that TD, the Commissioner answers the question “Division 7A: is a release by a

private company of its unpaid present entitlement a 'payment' within the meaning of Division 7A of

Part III of the Income Tax Assessment Act 1936?” by saying:

1. Yes. A private company that releases all, or part, of its unpaid present entitlement (UPE) credits an amount within

the meaning of that word in paragraph 109C(3)(b) of the Income Tax Assessment Act 1936 (ITAA 1936). Such a

crediting is taken to be a payment for the purposes of subparagraph 109C(3)(b)(iii) to the extent that the release

represents a financial benefit to an entity.

That seems clear, but the Commissioner continues to provide three examples in the TD, one of which

has the opposite conclusion.

Example 2

8. Unlucky Bob (an individual) is the trustee of Unlucky Trust, a sub-trust (within the meaning in TR 2010/3) settled in

the 2011-12 income year with $1,000 of trust property to which a UPE relates. The sole beneficiary, and owner of the

UPE, is XYZ Beneficiary Pty Ltd. Unlucky Bob is a shareholder of XYZ Beneficiary Pty Ltd. The subsisting UPE was

not a Division 7A loan within the meaning of Taxation Ruling TR 2010/3 and was not a debt for the purposes of

section 109F.

9. Unlucky Bob entered into a range of investments with the proper care and skill that a person of ordinary prudence

would exercise.

10. During the 2013-14 income year, a market fall caused the value of the investments to become worthless. No

amount of the loss was caused by an act or omission intentionally or negligently done, and there was no breach of

trust which Unlucky Bob was required to make good to the Unlucky Trust estate.

11. XYZ Beneficiary Pty Ltd subsequently entered into a deed, by which it relinquished its entire equitable interest in

the Unlucky Trust. It accounted for the released interest by making a credit entry against a 'trust entitlement' ledger to

reflect that the interest ceased to be an asset of the company.

12. In these circumstances, the release by XYZ Beneficiary Pty Ltd confers no financial benefit upon Unlucky Bob.

Accordingly, the release is not a payment within the meaning in subparagraph 109C(3)(b)(iii).

Critical in the above analysis is the blamelessness of Unlucky Bob. The other examples in the TD

consider the position if either:

The corporate beneficiary forgives the UPE when the trust is capable of repaying it (Example 1);

and



The corporate beneficiary is unable to recover its UPE (and consequently forgives it) because the

trust’s assets were misappropriated dishonestly by its trustee (Example 3),

and, unsurprisingly, conclude that Div 7A could apply because an amount was credited to the UPE in

the books of the corporate beneficiary.

3.5 Refinance

3.5.1 Same lender

It has been proposed that an existing UPE – which could be approaching the time for payment –

could effectively be refinanced by a new seven-year interest-only UPE by the existing corporate

beneficiary. This, it is said,

could be achieved by the

corporate beneficiary (which

needs to be owned by the

trust which owes the UPE to it)

declaring and crediting a fully

franked dividend to its trust

shareholder. The entitlement to that dividend is then set off against the UPE owed by the trust and the

two extinguish each other. The trust then is left to deal with the dividend income it has received, and

the trustee resolves to distribute it to the same corporate beneficiary. No tax is payable by the

corporate beneficiary on the fully franked distribution received.

This arrangement has been nicknamed the ‘washing machine’ or the ‘perpetual motion’.

Perhaps unsurprisingly, the Commissioner considers that this arrangement does not work and points

to s100A as a weapon he might use to attack it. A detailed analysis of this position is beyond the

scope of this paper, but taxpayers would be well advised to avoid this arrangement if they prefer to

minimise the Commissioner’s attention to their affairs!

An alternative which risk-averse taxpayers might consider is refinancing the UPE with a complying

s109N loan from the same corporate beneficiary.

Remembering that the

practice statement contains a

warning about the potential

application of s109R (see

further below under heading

3.6.1), any such refinancing

needs to meet the

requirements of that section;

in particular, subsections

109N(3A) and (3B) which effectively require that when one complying loan is refinanced by another,

that the combined terms of the two loans together does not exceed the maximum term of the new



loan. This would mean, for example, that a seven-year UPE might be able to be refinanced by a 25 -

7 = 18 year complying loan provided that sufficient real estate security was available to cover it.

In my 2011 paper, Getting Down to Business with Div 7A UPEs and s100A, I said:

Can you refinance the Option 1 UPE with a s109N-compliant loan?

The practice statement also does not comment on this question. However, it is noted that payments of “interest” need

to be done in a manner which would not result in them being disregarded by section 109R had they been repayments

on a Div 7A loan…. In this context it would not be surprising if the Commissioner allowed such a refinancing applying

the same principles that apply to a refinancing of an ordinary Div 7A loan under section 109R; that is, an Option 1

UPE might be allowed to be refinanced by a complying section 109N loan for the remaining 18 years of a 25-year

secured complying loan.

This is not a stated position of the Commissioner, though, and it would be a brave taxpayer or adviser who applied it

in the absence of some favourable and binding advice from the ATO.

In hindsight, the description of a taxpayer who did refinance an Option 1 UPE with an appropriately

secured 18-year complying loan as “brave” might be considered overly conservative.

3.5.2 Different lender

A variation on the perpetual motion arrangement described above involves a dividend from a

corporate beneficiary being set off against a UPE owed by its shareholder trust and then distributed

not back to the same corporate

beneficiary but to a second one.

Section 100A does not as neatly apply to

such a situation as it might to the

perpetual motion arrangement because

of the introduction of a new taxpayer in

receipt of the fresh distribution.

That said, taxpayers could expect

heightened attention from the

Commissioner if this arrangement were

detected. That attention might be

expected to be more intense if the

transaction stream were repeated year on year rather than once only, indicating a pattern of

behaviour which might prompt the Commissioner to question the genuineness of the original

distribution.

Whether or not the Commissioner’s attention ultimately results in a tax liability that survives the

objection and appeal process, a taxpayer considering the above arrangement should be prepared to

need to fund the dispute.

The above scenarios address possible arrangements where the corporate beneficiary is owned by the

trust that owes the UPE to it.



What if that were not the case?

In the situation illustrated above:

Trust 1 owes a UPE to Corporate Beneficiary 1.

CB1 is owned by Trust 2.

CB1 declares a dividend to T2 and assigns to T2 the amount owed to CB1 by T1.

T2 then distributes to Corporate Beneficiary 2 the dividend received it received from CB1.

The UPE owed by T2 to CB2 is put on Option 1 terms.

T2 and T1 agree to put the amount then owed by T1 to T2 on terms that comply with s109N.

In the above way, T1 gets a further 7 years to make its original principal repayment obligation to CB1.

That original repayment obligation is effectively converted into a seven-year complying principal and

interest loan. However, we are left with a dual layer of amounts potentially subject to Div 7A: one

between T1 and T2 and another between T2 and CB2. In order to simplify ongoing compliance work,

T2 might assign to CB2 the amount receivable from T1.

At the end of this process:

CB1 would have no UPE receivable from T1



T1’s obligation to repay the principal amount of its UPE to CB1 in one lump sum has effectively

been put on seven-year repayment terms

T2’s UPE to CB2 is fully discharged

There is only one Div 7A complying loan to be managed each year between T1 and CB2.

This all sounds too good to be true.

It is understood that whilst the above arrangements might meet the letter of Div 7A and the practice

statement, the Commissioner might consider that they are contrary to the spirit and intention of the

practice statement. As a result, the Commissioner could be expected to give focussed attention to the

arrangement should it fall for review. As above, even if the Commissioner were ultimately unable to

attack the arrangement on technical grounds, taxpayers should be made aware of the likely

commercial (ie, financial) risk they take on if they were to adopt this strategy.

3.6 Tax risks

3.6.1 Section 109R

As mentioned above, paragraph 56 of the practice statement contains the following statement:

56. … The payment of the principal funds invested in the main trust (that is, the funds representing the UPE) and

annual return to the private company must be such that if those payments had instead been repayments of a

Division 7A loan made by a private company, they would not be disregarded by section 109R. (emphasis added)

Section 109R operates to disregard loan repayments in certain circumstances. Subsection (2) is the

primary operative provision, with exceptions to it provided in the following subsections. Subsections

109R(2) and (3) provide:

(2) [Payment related to loan] A payment must not be taken into account if:

(a) a reasonable person would conclude (having regard to all the circumstances) that, when the payment was

made, the entity intended to obtain a loan or loans from the private company of a total amount similar to, or

larger than, the payment; or

(b) both of the following subparagraphs apply:

(i) the entity obtained, before the payment was made, a loan or loans from the private company of a

total amount similar to, or larger than, the amount of the payment;

(ii) a reasonable person would conclude (having regard to all the circumstances) that the entity

obtained the loan or loans in order to make the payment.

(3) [Non-application] Subsection (2) does not apply to a payment made by setting off against an amount payable in

relation to the loan:

(a) a dividend payable by the private company to the entity; or



(b) work and income support related withholding payments and benefits payable by the private company to the

entity; or

(ba) payments covered by section 12-55 in Schedule 1 to the Taxation Administration Act 1953; or

(c) if the entity has transferred property to the private company—an amount equalling the difference between:

(i) the amount that a party at arm's length from the entity would have paid for the transfer of the

property to the party; and

(ii) the amount that the private company has already paid the entity (by way of set-off or otherwise)

for the transfer.

Of particular concern is the reference in s109R(2)(a) to an intention to obtain a replacement loan of a

similar or larger amount. In the context of a UPE to a corporate beneficiary and the need to make

annual “interest” payments, it may be queried whether an expectation that the company will receive

distributions of trust profits in future years (where those distributions are to have Options 0, 1 or 2

applied, making them appear as “loans”) could cause the annual interest payments to be disregarded.

One would certainly hope not – and there has been no indication from the ATO yet that section 109R

would be applied in this way – but experience has shown that only one thing is certain in the

administration of Div 7A: nothing.

3.6.2 Section 100A and Part IVA

Whilst a detailed examination of the potential application of section 100A and Part IVA to Div 7A

arrangements is beyond the scope of this paper, it is noted that these are two of the Commissioner’s

primary weapons against attempts to manipulate Div 7A outcomes.

In June 2011 the ATO published on its website6 the following statement about the interrelationship

between Division 7A and section 100A:

Briefly, section 100A will deem a presently entitled beneficiary to be not presently entitled where the present

entitlement arose directly or indirectly out of a reimbursement agreement.

However, the mere presence of a section 109N complying loan agreement or a UPE held on sub-trust that reinvests in

the main trust under one of the options set out in paragraphs 62-94 of PS LA 2010/4 would not ordinarily constitute a

reimbursement agreement for section 100A purposes. We will review the facts and circumstances of each case and

assess if there is a reimbursement agreement for the purposes of section 100A, having regard to the relevant law.

Although at first impression the above statement appears comforting, the use of “would not ordinarily

constitute a reimbursement agreement” instead of a more definitive statement which omits the word

‘ordinarily’ undermines that initial comfort.

Further, that the ATO indicates that a review of the facts and circumstances of each case will be

undertaken to ascertain whether a s100A reimbursement agreement exists reveals an expectation on

the part of the ATO that such reimbursement agreements are there to be found, even if that would not

6 See https://www.ato.gov.au/Business/Private-company-benefits---Division-7A-dividends/In-detail/Fact-sheets/Division-7A---

unpaid-present-entitlement/?page=20#Section_100A_reimbursement_agreement

https://www.ato.gov.au/Business/Private-company-benefits---Division-7A-dividends/In-detail/Fact-sheets/Division-7A---unpaid-present-entitlement/?page=20#Section_100A_reimbursement_agreement

https://www.ato.gov.au/Business/Private-company-benefits---Division-7A-dividends/In-detail/Fact-sheets/Division-7A---unpaid-present-entitlement/?page=20#Section_100A_reimbursement_agreement



“ordinarily” be the case. That the ATO has this view about actions taken by taxpayers pursuant to

what amount to instructions issued by the ATO is extremely concerning.

The potential application of Part IVA is extremely broad and made even more challenging to apply in

practice by the 2013 amendments. As a result, taxpayers and their advisers need to consider it very

carefully when working out how to deal with Div 7A obligations other than strictly in accordance with

either the legislation or the practice statement.



4 Non-payment consequences

4.1 Ordinary loans

The consequences under 109E of failing to meet minimum yearly repayments on ordinary Div 7A

loans should be very familiar to readers of this paper. In short, to the extent to which a taxpayer fails

to make a minimum yearly repayment on a complying Div 7A loan, that taxpayer is deemed by s109E

to have received a dividend from the company.

Similarly, if a company forgives a loan owed to it by a shareholder or associate, s109F can deem the

amount forgiven to be a dividend.

Should a deemed dividend arise in one of these circumstances (but not only in these circumstances),

a taxpayer may request the Commissioner exercise the discretion available to him under s109RB.

A further and more detailed examination of these matters is beyond the scope of this paper.

4.2 UPEs

The Commissioner’s pro-forma UPE agreement wording in relation to 2010 distributions reads thus:

PrivCo's entitlement to $10,000 of the income of DiscFamily Trust for the 2010 income year has been set aside and

held on sub-trust (known as PrivCo Sub-trust).

The trustee of PrivCo Sub-trust and the trustee of DiscFamily Trust have agreed that PrivCo Sub-trust will lend the

sum of $10,000 to DiscFamily Trust in accordance with Option 1 in PS LA 2010/4. This loan was made and this

agreement took effect from 30 June 2011 for a period of seven years with interest payable at the Division 7A

benchmark interest rate as defined in subsection 109N(2) of the Income Tax Assessment Act 1936.

The parties have agreed that interest payments will be:

•calculated annually on the last day of DiscFamily Trust's income year

•paid by DiscFamily Trust to PrivCo Sub-trust no later than the earlier of

–the date DiscFamily Trust lodged its income tax return for the year in respect of which interest was calculated

–the due date for lodgment of that return, with the exception of the final interest payment, which is to be paid by

DiscFamily Trust to PrivCo Sub-trust no later than 30 June 2018.

The trustee of PrivCo Sub-trust has further agreed to distribute and pay the interest it receives from DiscFamily trust

no later than that date.

DiscFamily Trust has agreed and is obliged to repay the $10,000 to PrivCo Sub-trust no later than 30 June 2018.

- Signed by the trustee of the PrivCo Sub-trust and DiscFamily Trust -



- Date -7

In relation to 2011 distributions, the Commissioner’s pro-forma investment agreement wording says

that interest should be:

•calculated annually on the last day of DiscFamily Trust's income year,

•paid by DiscFamily Trust to PrivCo Sub-trust no later than the earlier of

–the date DiscFamily Trust lodged its income tax return for the year in respect of which interest was calculated

–the due date for lodgment of that return, with the exception of the final interest payment, which is to be paid by

DiscFamily Trust to PrivCo Sub-trust no later than 14 May 2019.

As can be seen, the final interest payment for FY18 on FY10 distributions is expected on 30 June

2018 whereas the final interest payment for FY18 on FY11 distributions is expected by 14 May 2019.

Nowhere in the pro-forma agreement are the consequences of non-payment set out, either for annual

interest or the final principal.

4.2.1 Annual interest

Even though the pro-forma agreement does not contain those consequences, the ATO’s webpage

that publishes it concludes with the following statement:8

Failure to pay the annual return on time

If the trust fails to pay the annual return to the private company by the trust's lodgment day, we will consider that the

requirements in PS LA 2010/4 have not been satisfied and the trustee would have breached the terms of the

investment agreement. The non-payment of the annual return may result in a Division 7A dividend being deemed to

be paid to the main trust.

The technical position behind this statement is explained further in the practice statement at

paragraph 108.

Can Subdivision EA of Division 7A apply if the sub-trust does not pay the annual returns to the private

company under a sub-trust arrangement?

108. Yes, Subdivision EA may apply if the annual returns derived from the investment of the funds representing the

UPE back into the main trust are not paid to the sub-trust and then on paid to the private company beneficiary by the

lodgment day for the main-trust's tax return for the relevant year. This is because any unpaid returns will be trust

income to which the private company is entitled but has not been paid (UPEs). Certain payments, loans and the

forgiveness of debts from the sub-trust may then attract Subdivision EA.

7 Example 2 in https://www.ato.gov.au/business/private-company-benefits---division-7a-dividends/in-detail/fact-sheets/division-

7a---unpaid-present-entitlement/?page=8#Content_of_a_legally_binding_investment_agreement 8 https://www.ato.gov.au/business/private-company-benefits---division-7a-dividends/in-detail/fact-sheets/division-7a---unpaid-

present-entitlement/?page=8#Requirement_of_an_investment_agreement

https://www.ato.gov.au/business/private-company-benefits---division-7a-dividends/in-detail/fact-sheets/division-7a---unpaid-present-entitlement/?page=8#Content_of_a_legally_binding_investment_agreement

https://www.ato.gov.au/business/private-company-benefits---division-7a-dividends/in-detail/fact-sheets/division-7a---unpaid-present-entitlement/?page=8#Content_of_a_legally_binding_investment_agreement

https://www.ato.gov.au/business/private-company-benefits---division-7a-dividends/in-detail/fact-sheets/division-7a---unpaid-present-entitlement/?page=8#Requirement_of_an_investment_agreement

https://www.ato.gov.au/business/private-company-benefits---division-7a-dividends/in-detail/fact-sheets/division-7a---unpaid-present-entitlement/?page=8#Requirement_of_an_investment_agreement



This technical explanation focusses on the sub-trust, pointing out that in its hands there would be an

unpaid present entitlement owed to the corporate beneficiary and an amount owed by the main trust,

falling within the scope of s109XA(2).

This position appears quite clear and entirely consistent with the Commissioner’s view about the

existence of the sub-trust and how its interactions with the main trust and the corporate beneficiary

should be treated under Div 7A.

4.2.2 Principal

Where guidance from the Commissioner is lacking is in relation to the consequences if there were a

failure or refusal to pay the principal amount of the UPE at the end of the term of the investment

agreement.

In my 2011 paper, Getting Down to Business with Div 7A UPEs and s100A, I said:

What if the trust is unable to pay the principal amount at the end of year 7?

Does this invalidate the whole application of Option 1? Or does it just result in a provision of financial accommodation

at the end of year 7? Or is it just a commercial issue between the trustee and beneficiary?

Whilst, no doubt, taxpayers and their advisers would prefer such a situation to be a mere commercial issue between

the parties (because the “investment agreement” needs to be “legally binding”), the practice statement is silent about

the position the Commissioner might take if – for whatever reason – the trust was unable to pay the principal amount

of the UPE at the end of the seven-year term.

Is the Option 1 agreement enforceable?

Whilst some legal practitioners have questioned the enforceability of an investment agreement in the

form published by the Commissioner – not only in relation to the final principal payment obligation but

also in relation to the annual interest one – taking this position would be contrary to the practice

statement’s requirement in paragraph 64 that the agreement be legally binding on the parties and call

into question the treatment of the original distribution.

Does a failure to pay the principal amount invalidate the whole Option 1 arrangement?

Whilst there is no guidance available about this matter, if the Option 1 investment agreement were

legally binding as required and the parties entered into it in good faith, fully intending to comply with

its requirements at the end of the seventh year, it is difficult to imagine that the Commissioner could

successfully challenge the validity of the distribution that created the UPE. Essentially, doing so would

require an assertion of sham.

That said, it could well be imagined that the Commissioner might look long and hard at those initial

circumstances if there were a refusal or failure to pay the principal amount of the UPE at the end of

the term of the investment agreement.



Is there a new Div 7A ‘loan’?

At this point it is valuable to consider the definition of ‘loan’ for Div 7A purposes and the position taken

by the Commissioner about it in TR 2010/3.

109D(3) What is a loan?

In this Division, loan includes:

(a) an advance of money; and

(b) a provision of credit or any other form of financial accommodation; and

(c) a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or

implied obligation to repay the amount; and

(d) a transaction (whatever its terms or form) which in substance effects a loan of money.

The Commissioner takes the position in paragraphs 5 and 6 of TR 2010/3 that

For the purposes of Division 7A, a loan (a 'Division 7A loan') includes… the provision of credit or any other form of

financial accommodation, in the context in which it appears being the supply or grant of some form of pecuniary

assistance or favour, under a consensual agreement where a principal sum or its equivalent is ultimately payable

and

To be a loan that may be treated as a dividend under section 109D, the loan must be made by the relevant private

company. A private company may make a Division 7A loan by bringing a Division 7A loan into existence; or causing,

occasioning, effecting or giving rise to such a loan. Making a Division 7A loan need not necessarily involve

positive action on the part of the private company but may be inferred from all the surrounding

circumstances. (emphasis added)

As most practitioners would be aware, the Commissioner’s position on UPEs centres on the definition

of loan in s109D, in particular the specific inclusion of “a provision of credit or any other form of

financial accommodation” and “a transaction (whatever its terms or form) which in substance effects a

loan of money”.

A substantially similar set of words was considered by the AAT in the Montgomery Wools case9 which

was handed down on 6 February 2012. That case considered whether amounts which appeared to

be owed were loans within the meaning of s10 of the Supervision Industry (Supervision) Act for the

purposes of the in-house asset rules. That section provides that “loan includes the provision of credit

or any other form of financial accommodation, whether or not enforceable, or intended to be

enforceable, by legal proceedings”.

In short, Montgomery Wools involved the sale of a property that was owned by a unit trust (the

property trust) which was, in turn, owned by a SMSF. The property had been used as security for

borrowings from the Commonwealth Bank in the name of an associated trust through which a

business was conducted (the business trust). The sale was made under pressure from the bank and

9 Montgomery Wools Pty Ltd as trustee for Montgomery Wools Pty Ltd Super Fund v Commissioner of Taxation [2012] AATA

61



the proceeds were appropriated by the bank towards repayment of the business trust’s loans. Mr

Montgomery, who was the controlling mind of all entities involved, had chosen to sell the property

owned by the property trust rather than any other property that was potentially available to be sold.

The Tribunal then considered the facts and concluded that the financial result (that an amount would

not be paid to the SMSF) was what was intended and that, consequently, the SMSF had “provided

financial accommodation” to the property trust.

Whilst the Tribunal agreed with the taxpayer’s submission that there needed to be some positive act

or conduct for there to be a consensual arrangement leading to the creation of a loan or “the provision

of credit or any other form of financial accommodation,” the Tribunal said (at para 95):

A positive act may include acquiescence in relation to an event or transaction or the failure to enforce or demand a

right, provided the party makes an active decision to acquiesce or refrain from enforcing a right or making a demand.

As a result, where there is a common controlling mind behind a trust and its corporate beneficiary, the

Commissioner might well be tempted to use Montgomery Wools to attribute the actions of the sub-

trust to the corporate beneficiary. If so, the Commissioner might take the position that a refusal or

failure of the trustee of the sub-trust to seek to enforce payment of the principal amount should be

treated as if it were done by the corporate beneficiary.

The Commissioner would then say that the refusal or failure to insist on or enforce payment of the

principal amount of the UPE was at the minimum some form of pecuniary assistance or favour under

a consensual agreement. Div 7A might then be applied in the usual way where a private company

with a distributable surplus provides a loan to an associate of a shareholder.

Although the Commissioner would be heartened by the Montgomery Wools decision – especially

since it correlates with the position expressed in SMSFR 2009/4 – it needs to be noted that this case

involved a different definition of the word loan and a different statutory context.

The addition of the words “whether or not enforceable, or intended to be enforceable, by legal

proceedings” in the s10 definition arguably result in the inclusion of arrangements which would not

otherwise be covered by the s109D definition which only (relevantly) includes “provision of credit or

any other form of financial accommodation” (para 109D(3)(b)) and “a transaction (whatever its terms

or form) which in substance effects a loan of money” (para 109D(3)(d)).

Indeed, Montgomery Wools does not address the interpretation and application of para 109D(3)(d),

one of the cornerstones of the Commissioner’s position on UPEs.

Further, in Montgomery Wools the Tribunal considered the apparent intention behind the 1999 in-

house asset amendments and it is yet to be seen whether a Tribunal or Court would consider that the

wording of s109D(3) – which has not been changed since Div 7A was introduced – should be read as

widely as the Commissioner considers it should be.



5 Conclusion

The UPE ruling and practice statement have caused a fundamental change to the way beneficial

entitlements in trusts are administered by taxpayers and their accountants and although the

Commissioner has genuinely attempted to make the rules easy to follow and apply, there remain traps

for the unwary and usually a tangled financial “mess.”

In view of the complexities of dealing with the loan and UPE mess some clients find themselves

tangled in, it is perhaps unsurprising that corporate beneficiaries are becoming yesterday’s news and

that trading companies owned by discretionary trusts are becoming more popular. Conspiracy

theorists might be forgiven for suspecting that was the aim all along!

Since the rules now imposed introduce an additional layer of artificiality and complexity to what had

previously been thought to be reasonably well understood, the following quote attributed to Edward de

Bono seems apposite:

Dealing with complexity is an inefficient and unnecessary waste of time, attention and mental energy. There is never

any justification for things being complex when they could be simple.

We can all only hope that the Div 7A changes announced in the Budget might help taxpayers clean

up that mess and simplify the complexity.

Chris Wookey

Principal – Taxation

12 May 2016

This publication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms,

their related entities (collectively the “Deloitte Network”), or the author is, by means of this publication, rendering

professional advice or services. Before making any decision or taking any action that may affect your finances or your

business, you should consult a qualified professional adviser. No entity in the Deloitte Network or the author shall be

responsible for any loss whatsoever sustained by any person who relies on this publication.

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