Trust entitlements

When Division 7A may apply

Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) operates to ensure that private companies are not able to make tax-free distributions of profits to shareholders or their associates in the form of payments, loans or forgiven debts.

Division 7A may apply to private company beneficiaries' trust entitlements where the:

• trust and private company beneficiary are related entities
• trust entitlements are used for the benefit of the private company's shareholder or their associate (for example, the trust).

If the private company provides financial accommodation to the entity that has use of the funds, it is treated as having made a loan to that entity.

If Division 7A applies, the loan is treated as an unfranked dividend, in the same way a loan made directly from the company to the entity would be a deemed dividend.

How you manage trust entitlements to ensure Division 7A doesn't apply will depend on whether the entitlements arose:

• on or after 1 July 2022
• before 1 July 2022.

If you are unsure about how Division 7A applies to trust entitlements of your private company, you may need to seek professional advice.

Entitlements arising on or after 1 July 2022

We published a revised view on how Division 7A applies to trust entitlements created on or after 1 July 2022.

For trust entitlements created on or after 1 July 2022, see TD 2022/11 Income tax: Division 7A: when will an unpaid present entitlement or amount held on sub-trust become the provision of ‘financial accommodation’?.

Avoiding Division 7A consequences

To avoid triggering Division 7A, the trustee must act before the private company's tax return is lodged, or the date it's due to be lodged (whichever occurs first), to either:

• pay the private company its present entitlement, such as
  • pay in cash
  • distribute assets with a market value equal to the amount of the entitlement
   
• enter a Division 7A complying loan agreement with the private company, if the trustee wishes to retain the use of the funds the private company beneficiary is entitled to. If it does, the trustee will need to make minimum yearly repayments to the private company to avoid being deemed to receive dividends in the future.

Providing financial accommodation

A private company beneficiary, that is presently entitled to income from a trust, is considered to have 'provided financial accommodation' to its shareholder or their associate if either the:

• private company beneficiary has knowledge of its entitlement but doesn't demand payment from the trust – for Division 7A purposes this is treated as a loan made to the trust
• trustee holds an amount from the main trust fund on a new separate trust (a sub-trust) for the sole benefit of the private company beneficiary, and
  • all or part of the sub-trust fund is used by (or for the benefit of) the private company beneficiary's shareholder or their associate (the amount used is the amount of financial accommodation)
  • the private company beneficiary is aware of this use – for Division 7A purposes this is treated as a loan made to the private company beneficiary's shareholder or their associate.
   

Knowledge of entitlement

A private company beneficiary would know about its entitlement if either:

• the entitlement has been expressed verbally or in writing to the company
• the company and the trust share the same controlling mind, such as the director of the company is also the director of the corporate trustee of the trust.

A private company beneficiary would generally only know that it can demand a present entitlement be paid to it after the end of the income year in which the entitlement arises.

Use of sub-trusts

A sub-trust may arise where the trustee holds an amount from the main trust fund on a new separate trust for the sole benefit of the private company beneficiary. Where the entitlement to trust income is met by the setting aside of the income amount on sub-trust for the beneficiary, the trustee's obligation in respect of the entitlement to distributed income ends.

A sub-trustee must ensure that the sub-trust funds are held for the sole benefit of the private company beneficiary and are not used by, or applied for the benefit of, its shareholder or their associate. If this occurs and the private company beneficiary knows (or is taken to know) that this has occurred, Division 7A may apply.

To ensure Division 7A doesn't apply, a Division 7A complying loan agreement should be put in place directly between the private company and the user of the funds.

A sub-trust is treated as a separate trust to the main trust and the sub-trustee must lodge tax returns (and will need a separate tax file number (TFN)) unless an exemption applies.

Exemption from lodging a tax return

A sub-trustee is exempt from lodging a tax return if the sub-trust is a 'transparent trust' as described in Law Administration Practice Statement PS LA 2000/2 An exemption for the trustees of some trust estates from the requirement to furnish a tax return on behalf of the trust estate. Income derived by the sub-trustee will be included in the private company beneficiary's assessable income.

Entitlements that arose before 1 July 2022

For trust entitlements (referred to as unpaid present entitlements (UPEs)) that arose before 1 July 2022, the Commissioner of Taxation administers the law in a way that is consistent with the the view set out in TR 2010/3 (withdrawn) and PS LA 2010/4 (withdrawn).

A UPE is an amount of trust income which the trustee of a trust appoints, but has not yet paid, to a private company beneficiary.

These UPEs can amount to ‘the provision of financial accommodation’ by the private company beneficiary, in favour of the trust, and therefore may be loans for Division 7A purposes.

A UPE that results in a loan can occur with all types of trusts, including discretionary trusts and unit trusts, and particularly so where the trust and the private company are part of the same family group.

PSLA 2010/4 (withdrawn) provided options for dealing with UPEs which the Commissioner then accepted would not trigger Division 7A f.

The following materials provide a description of the views in the withdrawn guidance

Avoiding Division 7A consequences

The simplest way for the trustee to avoid Division 7A treating the UPE as a deemed dividend paid by the private company to the trust is by paying out the UPE.

Notwithstanding this, a trustee can still appoint a share of the income of a trust to a private company beneficiary without immediately paying out that entitlement, and without attracting Division 7A.

This can be done through either:

• the creation of a sub-trust for the sole benefit of the private company beneficiary
• providing the trust with a Division 7A complying loan.

The Commissioner will not treat UPEs created before 16 December 2009 as Division 7A loans.

Sub-trust arrangements

To avoid the UPE being treated as a Division 7A deemed dividend paid by the private company to the trust, the trustee must take certain steps to ensure the private company beneficiary is not financially accommodating the trust by allowing the trustee to retain the funds for use within the trust.

This can be done by placing the funds in a separate sub-trust for the sole benefit of the private company beneficiary by the lodgment day of the trust's tax return.

If the trustee fails to put the funds on a sub-trust for the sole benefit of the private company beneficiary by the date specified, we will consider that the private company beneficiary has provided the trust with a loan, by way of financial accommodation, to the amount of the UPE. Division 7A may then operate to deem the private company to have paid a dividend to the trustee of the trust.

Trustee accessing funds held in a sub-trust

The trustee may invest the funds held in the sub-trust back into the main trust on commercial terms, so that the main trust continues to have access to those funds.

However, we require certain formalities be adhered to by the trustee when investing funds from the sub-trust, such as the parties entering a legally binding investment agreement.

Legally binding investment agreements

Investment agreement documents may be prepared as part of the tax return working papers and don't have to be professionally prepared. However, you may choose to engage a professional to prepare one for you.

Investment agreement documents:

• must be legally binding
• must provide sufficient details of the investment from the sub-trust to the main trust, demonstrating that the trustee decided to hold the funds representing the UPE on a sub-trust for the sole benefit of the private company beneficiary in the first place
• may be ongoing to cover future income years
• aren't the same as a Division 7A complying loan agreement.

Details your investment agreement must contain

A legally binding loan agreement, between the main trust and the sub-trust, must contain:

• the names of the parties
• the loan terms, including the
  • amount of the loan
  • date the loan amount is drawn
  • requirement to repay the principal amount of the loan
  • period of the loan
  • interest rate payable on the loan
  • interest payment to be made annually on the last day of the income year
   
• that the parties named have agreed to the terms
• when the agreement was made, for example, the date it was signed or executed.

Failure to pay the annual repayments or returns

If the trust fails to pay the annual repayments or returns to the private company by the trust's lodgment day, we will consider that the requirements set by the Commissioner have not been satisfied. This is because the trustee would have breached the terms of the investment agreement.

The non-payment of the annual repayments or returns may result in a Division 7A dividend being deemed to be paid to the main trust.

Safe harbour investment options

The Commissioner has set out 3 investment options, as follows:

• Option 1 – invest the funds representing the UPE on an interest only 7-year loan
• Option 2 – invest the funds representing the UPE on an interest only 10-year loan
• Option 3 – invest the funds representing the UPE in a specific income producing asset or investment.

These investment options are 'safe harbour' options. This means that if the tax affairs of the main trust are reviewed by us and the sub-trust funds are invested in accordance with Options 1, 2 or 3, we will be satisfied that the conditions the Commissioner has set out have been met.

Funds not used for business purposes

The sub-trust can still invest the funds in the main trust via either Options 1 or 2, even if the funds are not used by the main trust for business purposes.

However, interest paid to the sub-trust by the main trust would not ordinarily be deductible to the main trust if the funds borrowed by the main trust are not used for business or other income producing purposes.

Investing in an existing asset held by the main trust

The trustee of the sub-trust can invest the funds representing the UPE in an existing asset (or in a share of an existing asset) held by the main trust using Option 3.

However, this would generally constitute a disposal of, or part of, the existing asset held by the main trust and an acquisition of the same asset by the sub-trust. Such a transaction may, for example, trigger capital gains tax (CGT) consequences.

Repaying loan principal at the end of the investment

The main trust is expected to repay the principal at the end of the term of the investment, in accordance with the investment agreement. Failure to do so may result in a Division 7A deemed dividend to the trustee of the trust.

Early repayment possible

You can repay some or all the principal any time during the term of the investment agreement. There would be no penalties associated with the early repayment of the principal. Interest should only be calculated on the funds actually owing at the time.

Administrative requirements of the sub-trust

Separate TFN for the sub-trust

As a general rule, a trustee who invests the funds in the sub-trust using either Options 1 or 2 in PS LA 2010/4 and satisfies the exemptions in paragraphs 72 and 84 of PS LA 2010/4 will not need to apply for a separate tax file number (TFN) for the sub-trust.

Separate trust deed for the sub-trust

There is no need to have a separate trust deed for the sub-trust. Many trust deeds already provide for the creation of a sub-trust. We strongly recommend you carefully read your trust deed before creating a sub-trust, to ensure it is within the trustee's powers to do so.

Trust deed silent on UPE to be held on sub-trust

We will consider that the trustee has the power to hold the UPE on sub-trust for the private company beneficiary as long as the trust deed contains words to the effect that the trustee has the power to set aside the income of the trust for the exclusive benefit of one or more of the beneficiaries.

If the UPE has been set aside in a manner consistent with paragraphs 50 to 53 of PS LA 2010/4, we will consider (subject to evidence to the contrary) that the UPE is held on sub-trust.

Separate financial accounts or tax return

As a general rule, a sub-trust is a trust estate and would ordinarily be required to lodge a tax return. However, we do not require a sub-trust to create separate sub-trust financial accounts or lodge a separate sub-trust tax return when the trustee decides to place the UPE on a sub-trust and the sub-trust invests all its funds using either Options 1 or 2, as long as the conditions in paragraphs 72 and 84 of PS LA 2010/4 are satisfied.

This is on the basis that both Options 1 and 2 are interest-only investment options involving one payment of annual return each year and the obligation to repay the UPE at the end of the investment period (of 7 or 10 years). These transactions should be readily visible in the financial accounts of the main trust and of the private company beneficiaries.

Accounting treatment

We are not aware of any specific accounting requirement for how the main trust should account for the sub-trust.

Where there is no requirement to produce separate accounts for the sub-trust, and the sub-trust has invested the funds representing the UPE back into the main trust under Options 1 or 2 set out in PS LA 2010/4, it is expected that the main trust would reflect its obligation to repay the money owing to the sub-trust within the liability section of its statement of financial position or balance sheet.

Division 7A complying loan agreement

Instead of implementing a sub-trust arrangement, the trustee can avoid a dividend being deemed under Division 7A if the private company agrees for its UPE to be set-off against a Division 7A complying loan. This means that they would satisfy the UPE, and lend back the funds representing the UPE.

In these circumstances, the private company would not have any subsisting UPE but rather a loan asset owing from the trust.

UPEs created before 16 December 2009

No requirement to pay out pre-16 December 2009 UPEs first

Where a trustee has several UPEs and they were created both before and after 16 December 2009, there is no requirement to pay out pre-16 December 2009 UPEs to the company first.

Pre-16 December 2009 UPEs not Division 7A loans

The Commissioner will not treat any pre-16 December 2009 UPEs as Division 7A loans, even when the UPEs are not placed on sub-trusts for the sole benefit of the beneficiary.

Therefore, there is no need for you to pay out any pre-16 December 2009 UPEs to prevent them being treated as dividends paid by the private company to the main trust. However, you should quarantine or isolate any pre-16 December 2009 UPEs in the books of the trust so they can be clearly identified.

Subdivision EA of Division 7A can still apply if the trust makes a payment or loan to, or forgives the debt of, a shareholder of the private company (or their associate) for as long as there is a UPE of the company to trust income, including any pre-16 December 2009 UPEs.

UPE by a trust to a trust beneficiary

The principles in TR 2010/3 and PS LA 2010/4 apply to UPEs owing by a trust to any entity, including another trust.

Therefore, if Trust A appoints income to Trust B (a trust within the same family group) but does not pay the funds to Trust B, the UPE can amount to financial accommodation and may be a loan for Division 7A purposes unless the conditions in PS LA 2010/4 are satisfied. This is illustrated in Figure 1.

Figure 1

Division 7A will not automatically apply even though the UPE is a loan for Division 7A purposes. Essentially, a UPE becomes a loan, within the extended definition in these circumstances if the funds representing the UPE are not reinvested for the sole benefit of the beneficiary by the lodgment day of the trust tax return. See paragraphs 46-48 of PS LA 2010/4.

However, it becomes particularly important where Trust B similarly appoints an amount of income, and does not pay the amount, to a private company beneficiary within the same family group. The paragraphs below highlight two scenarios as examples where Division 7A may potentially apply.

 

For more information about factors the Commissioner will take into account in determining the amount of any deemed entitlement arising under section 109XI of the ITAA 1936, see Taxation Determination TD 2011/15.

Section 100A reimbursement agreement

It is relevant to consider the operation of both section 100A and Division 7A in situations where a private company beneficiary makes its trust entitlement available to the trustee.

Practical Compliance Guideline PCG 2022/2 Section 100A reimbursement agreements – ATO compliance approach (Guideline) describes the circumstances in which a private company beneficiary making its trust entitlement available to the trustee on complying Division 7A terms will be considered to present a low risk of section 100A applying. We will not devote compliance resources to these arrangements other than to confirm they are in the green zone of the Guideline.

In situations outside the green zone, if the private company beneficiary’s trust entitlement arises out of a reimbursement agreement and section 100A applies, the effect of section 100A will undo the entitlement and deem it not to exist. The share of trust net income which would have been taxable to the beneficiary will instead be taxed to the trustee. The deeming by section 100A will mean there is no financial accommodation between the beneficiary and the trustee to which Division 7A will apply. This interaction is described in more detail in Taxation Ruling TR 2022/4 Income tax: section 100A reimbursement agreements.

Contact us if you need further assistance.

Commissioner's discretion under section 109RB

You can apply in writing to the Commissioner of Taxation to exercise their discretion under section 109RB to disregard a deemed dividend that has arisen under Division 7A.

For more information about this discretion, see:

• Division 7A – the Commissioner’s discretion under section 109RB
• TR 2010/8 Income tax: application of subsection 109RB(1) of the Income Tax Assessment Act 1936
• PS LA 2011/29 Exercising the discretion under section 109RB of Division 7A.

Work out when Division 7A may apply to trust entitlements of private company beneficiaries.