The smart practitioner will not cry over whether what happened was right or wrong. Instead he or she will think of what they can do to help their clients now.
The question then becomes what options do you have for these “section two” and “section three” loans?
Section two loans
If you had section two loans in place prior to 16 December 2009, Division 7A always applied to those loans and will continue to do so. These loans needed Division 7A complying loan agreements with minimum interest repayments so that a deemed dividend under Division 7A was not triggered. So you need to address how you deal with the loans going forward.
Pre-16 December 2009 UPEs
The Practice Statement PS LA 2010/4 confirms the Commissioner’s position that he will not apply Division 7A to UPEs created prior to 16 December 2009 (which are considered section three loans) as loans. This does not mean that these UPEs were not loans under his new definition but rather that the Commissioner will not pursue these pre-16 December 2009 UPEs for now (although there is nothing stopping him from changing his mind like he did with the characterisation of UPEs!).
Therefore the primary strategy right now will be to quarantine the pre-16 December 2009 UPEs in the accounts of both the trust and the company so that they will never have Division 7A apply to them. As a result the funds will be left in the trust to continue to invest in other assets.
What else can I do?
Under PS LA 2010/4, the Commissioner allows for two self-corrective administrative options for taxpayers who believe that Division 7A may affect them.
Provided certain conditions are satisfied, the options will allow taxpayers to:
- self-correct accounts where a UPE has been “misclassified” as a loan, or
- operate on the basis that the Commissioner would exercise his discretion under section 109RB to disregard a deemed dividend.
Where a UPE has been misclassified as loan, the taxpayer needs to sign a declaration and prove that the fact that the UPE is, and has always been, a UPE and not a loan.
Business entities that inadvertently trigger Division 7A will essentially need to declare and prove to the Commissioner that they have made an “honest mistake” or “inadvertent omission” in their treatment of the loans. The loans will be required to be placed into Division 7A complying loan agreements, with outstanding annual interest and principal amounts being payable by 31 December 2011.
The key to the self-correcting methods above is proving that an honest mistake or inadvertent omission has occurred by the taxpayer, the onus of which is on the taxpayer.
The last option is to pay down pre-16 December 2009 UPEs. However, taxpayers taking this action are disadvantaging themselves.
Options for “section three” loans
According to the Commissioner, a UPE owing from a trust to a private company in the same family group will become a section three loan to the extent that:
- it has not been paid to the private company beneficiary by the time the tax return of the trust is lodged, and
- the trustee fails to hold the funds representing the UPE on sub-trust for the sole benefit of the private company beneficiary.
In terms of what can be done (aside from what is described below as options), the trust may:
- pay down the UPE to the private company
- create a loan agreement between the company and the trust which would involve a written loan agreement in accordance with section 109N – a seven-year (unsecured) or 25-year (secured) loan.
A UPE held on sub-trust will be considered to be held and used for the sole benefit of the private company beneficiary where the sub -trust loans an amount to the main trust under the following terms:
- option 1: seven-year loan – at the variable benchmark rate (which is 7.4 per cent for the year ended 30 June 2011) with the interest paid annually and principal repaid at the end of the loan
- option 2: 10-year loan – at the variable Reserve Bank of Australia prescribed interest rate (which is 10.33 per cent for the year ended 30 June 2011) with interest paid annually and principal repaid at the end of the loan
- option 3: invest the funds representing the UPE in an income producing asset or investment – with annual distributions of a share of the income and associated net income (including any net capital gain) derived from the investment with principal repaid or re-invested at the time of the disposal of the investment.
Once the initial choice of investment has been made, the trustee cannot swap or change investment options. However, if option 3 is selected, the trustee can choose to invest in another asset or investment if the first asset or investment is disposed of.
Our view is that options 1 or 2 are to be preferred over the creation of a loan or the adoption of option 3. The reasons for our position include:
(a) the Commissioner of Taxation may be wrong. How would you like to explain to a client that you adopted the Commissioner’s view that a UPE was a loan only to find it was wrong and the client could have continued the same treatment with UPEs until legislation was introduced changing the law?
(b) the interest is to be treated as deductible where the UPE monies have been used to acquire an income producing asset.
(c) unlike the loan agreements generally required under Division 7A, the trust is not required to make principal repayments until the end of seven or 10 years (pursuant to options 1 and 2 respectively). Therefore it allows the trust a longer opportunity to deal with its UPEs.
(d) in the case of option 3, if the UPE is repaid before the asset is realised the sub-trust will be treated as having disposed of the asset to the main trust, whereas options 1 and 2 allow the trust to repay the UPEs in advance of selling the asset.
Conclusion
You need to read your trust deeds and consider whether you have any true loans or UPEs in place. To the extent you are unclear, you should seek advice from a practitioner familiar with these changes.
If you had UPEs in place before 16 December 2009 and the trust and the company have recorded the amounts as UPEs, then the changes will not apply to those rules – for now. This means you do not need to pay down these old UPEs. However, although there is no requirement to do anything with pre-16 December 2009 UPEs, this has not been confirmed formally, nor is it confirmed to be indefinite.
If the UPE is created after 16 December 2009, you may, depending on your trust deed, consider paying the UPE to the company or create a sub-trust.
If you chose to create a new UPE, it should be clearly classified as a UPE and separated from loans. Accurate documents, such as minutes, may be helpful in stopping a UPE being classified as a loan at first instance.
You may also be able to avoid a deemed dividend from arising if the UPE is repaid within 12 months of year end.
You may also consider entering into a Division 7A complying loan agreement if the circumstances mean it is required. If this option is selected, you need to ensure that minimum repayments are made under the loan agreement. You also need to consider how you will fund the payments.
If these are funded with the trust income, consider how the principal component of the loan repayment will be made. Given the trust rules require a trust to distribute all of its income, it may be difficult to repay the principal.
Disclaimer
The views in this article are those of the authors and do not represent the views
of Deloitte Private or Deloitte Touche Tohmatsu or any of its related practice entities. This article is provided as general information only and does not consider anyone’s specific objectives, situation or needs. You should not rely on the information in this document.
