For over 13 years, the Australian Taxation Office (ATO) has been enforcing a controversial interpretation of certain tax laws that has directly impacted business owners and investors. This concerns the tax treatment of trusts with a corporate beneficiary. Complying with the ATO’s interpretation has imposed an additional tax burden on many of you.
One business owner has sought to challenge the ATO on their interpretation of the Division 7A tax laws. The Administrative Appeals Tribunal (AAT) has now decided that the ATO’s interpretation is wrong.
Trusts and beneficiaries
Trusts are a common feature in the Australian business and investment landscape. Each year, you appoint your trust’s income to one or more beneficiaries, and each of those beneficiaries discloses their share of the trust’s taxable income in their tax return. When a trust appoints income to a beneficiary, the beneficiary becomes “presently entitled” to that amount, and can call for payment at any time.
Typically, a trust pays down on the present entitlement at least enough for the beneficiary to pay their income tax liability. Any remaining entitlement owing to the beneficiary is called an Unpaid Present Entitlement (UPE).
Use of a corporate beneficiary
A common practice is to incorporate a company that is a beneficiary of a trust. A share of trust income appointed to the company bears the company tax rate of 25% or 30%. As noted above, the trust typically pays down on the present entitlement owing to the company to enable it to pay its tax liability, leaving a remaining UPE owing of 75 or 70 cents in the dollar.
For example, a trust operating a business appoints $100 of trust income to a company beneficiary, creating a present entitlement of $100. The company is taxed on the $100, and the trust pays down on the present entitlement owing to the company by $25, so the company can pay its $25 tax liability. This leaves a remaining UPE of $75, which the trust owes the company, and the company has a receivable of $75.
This practice was a convenient means of reinvesting the trust’s after-tax profits at the company tax rate, in things like stock, equipment, working capital, and servicing debt. This means reinvesting profits at a rate as high as 75 cents in the dollar. At the other end of the spectrum is reinvesting profits at a rate as low as 53 cents in the dollar, having borne the top personal tax rate plus Medicare levy of 47%.
ATO’s revised interpretation
For many years, the prevailing view was that the above company’s remaining $75 UPE receivable did not fall within the definition of “loan” in Division 7A in the tax laws. Division 7A is an integrity regime designed to prevent shareholders drawing a company’s profits in a tax-preferred manner. The most common way of doing this is drawing profits by way of the company advancing a loan. However, typically there is no intention of repaying the loan owed to the company. That means the owners have drawn the company’s after-tax profits of 75 or 70 cents in the dollar with no further tax impost. In other words, the funds are drawn in the form of a loan but are, in substance, a dividend – but no top-up tax is borne. Division 7A’s main weapon in situations like this is the automatic triggering of a deemed unfranked dividend, which imposes a double-tax impost.
In 2010, the ATO issued a taxation ruling expressing the view that the above $75 UPE receivable owing to the company is in fact a “loan” advanced by the company to the trust. That means the UPE is a “loan” caught by Division 7A. This caused much consternation, with many experts questioning the legal soundness of the ATO’s new-found interpretation.
However, the reality was that if you didn’t follow the ATO’s view, they would enforce the deemed unfranked dividend arising under Division 7A, with the consequential double-tax impost. The usual method for complying with the ATO’s view, and thus avoiding a deemed unfranked dividend, involves the company beneficiary declaring an actual dividend, although franked. This usually triggers top-up tax, which is less than the double-tax impost from an unfranked dividend.
Practical impact
When the company declares the above actual dividend, it doesn’t pay out any money, because that is tied up in the trust’s business, in those profits reinvested in stock, equipment, working capital and servicing debt. This results in the business’s owners incurring top-up tax on after-company-tax profits that they have not drawn from their business.
Despite the perceived unfairness, complying with the ATO’s view remains the better option compared to incurring the double-tax impost. This is why virtually all have complied with the ATO’s view these past 13 years, but perhaps under silent protest.
AAT decision overturns ATO view
The AAT recently decided in Bendel and Commissioner of Taxation [2023] that the ATO’s interpretation regarding a company’s UPE – that it’s a “loan” to the trust – is wrong, and always has been.
However, it should be noted that the decision is only at the AAT level, which is not part of the judiciary. The ATO almost certainly will appeal the decision to the Federal Court.
Next step
For now, it is advisable to continue managing your trust and corporate beneficiary UPEs in the way you have been over the last 13 years. We are awaiting the ATO’s likely move to appeal the AAT’s decision, and for the courts to make the final decision on the matter.
Talk to your trusted Nexia advisor about how we can help you manage your tax affairs or if you have any questions about the matters discussed in this article.
