In recent times, the ATO has clarified/revised its views on the application of Division 7A to private company UPEs. In a continuation of that theme, on 2 July 2014 the ATO issued guidance on the application of Section 100A of the Income Tax Assessment Act 1936 to UPEs.
Section 100A was initially introduced as an anti-avoidance measure to address what was referred to as ‘trust stripping’. In recent times, the ATO has applied Section 100A to arrangements not involving trust stripping.
There are four key elements for the application of Section 100A:
- a beneficiary becomes presently entitled to a share of trust income under an arrangement;
- the arrangement provides for the payment of money, transfer of property or the provision of services or other benefits to a person other than the beneficiary;
- the arrangement is entered into for the purpose of tax avoidance (or more correctly that a person would be liable to pay less income tax in respect of the year than that person would have been liable to pay if the arrangement had not been entered into);
- the arrangement is not entered into in the course of ordinary family or commercial dealings.
There are many arrangements that will be caught by items a and b. In those cases there are two outs, namely the arrangement is not for the purpose of tax avoidance or is entered into in the course of ordinary family or commercial dealing.
Where Section 100A applies the effect is the beneficiary is treated as if they where not presently entitled to the share of trust income which has the result that no beneficiary is presently entitled to that share of income and it is taxed to the trustee at the top marginal rate.
Following the change in the ATO position concerning the application of Division 7A to private company UPEs, some were suggesting the following arrangement as a means of overcoming the ATO position (which has been referred to as perpetual motion or washing machine)
It was always the writer’s view that such an arrangement would not be effective because Section 100A would apply.
The main purpose of the ATO guidance is to state the above arrangement is not considered ordinary commercial dealing and is within Section 100A.
The analysis of the ATO is:
- the company is presently entitled to a share of trust income;
- the present entitlement is made on the understanding that the company would pay a dividend to the trustee of a corresponding amount (less the tax paid);
- the arrangement is entered into to secure the reduction in tax that would otherwise be payable had the trustee simply accumulated the income;
- the arrangement does not satisfy the ordinary family or commercial dealing exclusion.
It serves as a warning to those implementing the above arrangement that it may devote compliance resources to the arrangement.
The argument against the application of Section 100A to perpetual motion is that there is no arrangement because the trustee of the trust (as sole shareholder of the company) can call for a payment of the dividend and determine to distribute the amount of the dividend back to the company in year 2. The argument is that in those circumstances, there is no arrangement or understanding, all actions are unilateral by the trustee of the trust.
A variation of the above arrangement is one under which the shareholder in the company is a separate trust that distributes the dividend to a second company. The argument described in the previous paragraph would not apply to the variation.
The ATO also confirms that Section 100A may apply even though the arrangement complies with Division 7A. For example, the arrangement outlined above, or alternatively, where the UPE is put on a sub trust and there are loans that comply with the requirements of Division 7A (for example, loans on principal and interest terms or loans to other companies which can be made on an interest only basis).
What about other forms of arrangement?
The question might be asked whether Section 100A could apply to an arrangement were the trustee is to distribute income to a low taxed beneficiary and make a loan of an equivalent amount to a high taxed person. The analysis of Section 100A might be:
- the distribution to a low taxed beneficiary is a present entitlement satisfying item a;
- the loan is a transaction satisfying item b;
- it might be suggested the arrangement is entered into to reduce the liability for tax of the high taxed person satisfying item c;
- the question remains whether the arrangement is ordinary family or commercial dealing.
In the guidance, the ATO confirms there is ordinary family or commercial dealing where:
- the funds represented by the UPE are retained in the trust for working capital (as in the traditional UPE arrangements involving private companies);
- where the funds are lent on ordinary commercial terms.
The ATO also recognises that loans made in the course of ordinary family dealings may be interest-free.
In most instances involving distributions to natural persons, loans would be considered to have been made in the course of ordinary family or commercial dealing. As is usual for the ATO, they have the rider that it depends upon the circumstances. Where there are loans or other benefits made by the trustee of a trust that has unpaid entitlements to any person or entity, the circumstances should be reviewed to consider the application of Section 100A.
Division 7A and Private Company UPEs
The essence of the ATO view is that it requires private company UPEs to be invested specifically for the benefit of the private company beneficiary.
In that light, the focus should be on the form of investment by the private company beneficiary, for which there are a number of options available.
- The ATO confirms Section 100A applies to the perpetual motion/washing machine arrangement.
- However, depending upon the facts, Section 100A would not apply to the other forms of arrangement described above.
- Existing UPEs should be reviewed to determine whether Section 100A may apply to the particular circumstances.
- We are able to:
- Assist taxpayers that become subject to review by the ATO of existing UPEs.
- Provide advice on the application of Section 100A to existing and future UPEs.
- Provide advice on the application of Division 7A.