On June 2 the ATO issued Taxation Ruling TR 2010/3, a controversial ruling that could have disastrous tax and asset protection implications for small businesses that operate under a trust structure.
The ruling targets closely held trusts that distribute trust income to a related private company and creates what is called an Unpaid Present Entitlement (UPE) in the company. A UPE is a distribution of income by a trust to a beneficiary (in this case a company) which has not yet been physically paid.
Prior to the issue of this ruling, the ATO’s long held view was that UPEs were not loans. This ruling changes all that.
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The ATO’s view is now that in most instances UPEs to private companies will be a loan by the private company to the trust and subject to Division 7A rules. Under these rules the loan will be held to be a taxable unfranked dividend of the trust, unless the loan is put under a commercial footing within a certain timeframe. A significant aspect of the ruling is that it will have retrospective application. Many trusts will have already unknowingly breached the Division 7A rules, resulting in possible tax disaster. The worst-case scenario being that all company UPEs could be taxed to the trust at the top marginal tax rate.
The ruling will apply retrospectively to UPEs that are already loans either expressed or implied. The ATO will consider a UPE to a private company to be a loan if:
- The parties have entered into a loan agreement
- The accounts of the trust or company have recorded the UPE as a loan or
- The terms of the trust or a resolution of the trust indicate that the UPE is a loan.
For genuine UPEs this ruling will in most cases deem them to be loans from December 16, 2009. The ruling sets out the limited circumstances where a UPE will not be treated as a loan. Among other things, proper written arrangements must be put in place and the company must enjoy the returns from the investment of the UPE.
The unfortunate consequence, although intentional, is to catch UPEs that have been created for genuine business reasons. Small businesses operating through a trust will typically use a company beneficiary, to distribute profits that it retains in the trust as working capital. The profit is taxed at 30%, but the funds remain invested in the trust to help grow the business. Typically the company beneficiary is not trading and is purely a repository for trust retained profits, providing asset protection advantages. These arrangements will now have to comply with the ruling and possibly result in the trust having to repay any existing UPE to the company over a seven year period, which could be a problem if they don’t have the funds or can’t raise them.
For any trustee or family group that has distributed income to a corporate beneficiary, or is proposing to, an understanding of the new tax ruling is imperative. If the trust has had unpaid present entitlements to a company beneficiary in the past, there is a reasonable probability that you have contravened what the ATO now considers to be the law.
It’s essential that you obtain advice from your accountant to ensure:
- The accounting treatment of any UPEs is appropriate and doesn’t inadvertently treat it as a loan.
- The terms of the trust deed are consistent with the accounting treatment adopted.
- Appropriate detailed minutes and records reflect the treatment of the UPE between the trust and corporate beneficiary, and
- You plan for all UPEs to private companies arising on or after December 16, 2009 that would be caught by Division 7A.
Marc Peskett is a partner of MPR Group a Melbourne based firm that provides structuring and tax advice to businesses, as well as accounting, business advisory and financial services to fast growing small to medium enterprises.