Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 8 - Distributions to certain entities
Outline of chapter
8.1 Schedule 8 to this bill amends Division 7A of Part III of the ITAA 1936 by inserting new integrity rules that deem certain payments, loans and forgiven debts by a trustee to a shareholder (or their associate) of a private company to be an assessable dividend.
8.2 The rules are designed to ensure that a trustee cannot shelter trust income at the prevailing company tax rate by creating a present entitlement to a private company without paying it and then distributing the underlying cash to a shareholder of the company. The rules replace the former section 109UB of the ITAA 1936 that had a similar, but more limited, application.
Context of amendments
8.3 On 12 December 2002, the Treasurer announced that the Government would amend section 109UB of the ITAA 1936 dealing with distributions from trusts (Treasurer's Press Release No. 081 of 12 December 2002). The press release explained that the amendments would address two problems identified by the Board of Taxation in its report Taxation of Discretionary Trusts concerning the effectiveness and fairness of the deemed dividend rules contained in Division 7A.
8.4 In its report, the Board recommended that the Government introduce measures to:
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- improve the effectiveness of the deemed dividend rules so as to more effectively prevent beneficiaries accessing trust income that has borne tax only at the company tax rate; and
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- remove the unfairness in the operation of section 109UB that is currently inducing some small and medium-sized business operators to establish arrangements that enable them to avoid the operation of the section completely.
Summary of new law
8.5 Broadly speaking, these amendments deem certain transactions undertaken by a trustee of a trust estate to be an assessable dividend in the hands of a shareholder of a private company (or their associate), where:
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- the private company is presently entitled to income of the trust but that income has not been paid; and
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- the trustee distributes the underlying cash to a shareholder (or their associate) of the company in the form of a payment, loan, or forgiven debt.
| New law | Current law |
|---|---|
| The new provisions extend the operation of former section 109UB to cover distributions of the underlying cash that are in the form of a payment or forgiven debt in addition to loans. | Section 109UB prevents trust income being sheltered at the prevailing company tax rate in circumstances where a trustee creates a present entitlement to trust income to a private company without paying it and then distributes the underlying cash to a shareholder (or their associate) of the company in the form of a loan. |
| The new provisions allow loans provided by a trustee to a shareholder of a private company to be repaid or put on commercial footing and therefore avoid the operation of the deemed dividend rules. | Loans that attracted the operation of section 109UB were not capable of being repaid or put on commercial footing and therefore automatically attracted the operation of the deemed dividend rules. |
Detailed explanation of new law
When does new Subdivision EA apply?
8.6 Broadly speaking, a deemed dividend will arise under new Subdivision EA where a private company is presently entitled to income of the trust but that income has not been paid and the trustee shifts value from the trust to a shareholder of a private company in the form of a payment, loan or forgiven debt.
8.7 New subsection 109XA(1) applies where:
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- a trustee makes a payment to a shareholder (or their associate) of a private company (other than to a shareholder or associate that is a company); and
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- the payment discharges or reduces a present entitlement of the shareholder (or their associate) to an amount that is an unrealised gain; and
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- the private company is, or becomes, presently entitled to an amount from the net income of the trust; and
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- all, or part, of the present entitlement remains unpaid before the earlier of the due date for lodgement and the date of lodgement of the trust's return for the income year in which the actual payment takes place.
[Schedule 8, item 3, subsection 109XA(1); item 4, paragraph 109XA(1)(c)]
8.8 The means by which a payment can be effected relies on the definition of that term in section 109C of the ITAA 1936. Section 109C defines 'payment' to include:
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- a payment to the extent that it is to the entity, on behalf of the entity or for the benefit of the entity; and
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- a credit of an amount to the extent that it is:
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- to the entity; or
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- on behalf of the entity; or
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- for the benefit of the entity; and
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- a transfer of property to the entity.
8.9 Furthermore, only payments that have the effect of reducing or discharging a present entitlement of the shareholder (or their associate) attract the operation of new rules. Therefore, the mere creation and/or recording of a present entitlement is not taken to be a payment for the purposes of these rules. [Schedule 8, item 3, paragraph 109XA(1)(b); item 3, subsection 109XA(6)]
8.10 This will mean that the conversion of a beneficiary's entitlement into a loan back to the trust will be a payment, provided the terms in section 109C are satisfied, as the entitlement has been effectively discharged and replaced with a debt interest.
8.11 The rules only apply to payments that are wholly or partly attributable to an amount that is an unrealised gain. [Schedule 8, item 3, paragraph 109XA(1)(b)]
8.12 This ensures that only those payments that provide the means by which trustees distribute the underlying cash that has been sheltered at the company rate are caught by the rules.
8.13 The term 'unrealised gain' is intended to apply very broadly. It is defined to mean any unrealised gain whether of a capital or income nature. For the purposes of these rules, realisation will be taken to have occurred when a gain converts into a recoverable debt. [Schedule 8, item 3, subsection 109XA(7)]
8.14 However, not all unrealised gains attract the operation of these rules. Unrealised gains that have or will be included in the assessable income of the trust in:
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- an income year prior to the year when the actual payment was made; or
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- an income year in which the actual payment was made; or
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- the income year following that in which the actual payment was made,
are excluded. These rules ensure that unrealised gains that have already been assessed, or will be assessed in the near future, are not inappropriately caught by the amendments. A typical example would be an entitlement of a beneficiary generated from a transaction involving trading stock. [Schedule 8, item 3, subsection 109XA(7)]
8.15 In addition, the rules do not interfere with the outcome of a trustee's decision as to how a payment might have been applied to reduce or discharge a beneficiary entitlement including cases where a single payment is made in respect of composite entitlements. Therefore, if a trustee determines that a payment is to be applied to reduce a beneficiary's entitlement to a realised gain, the rules do not apply to the extent that the payment is applied to that entitlement.
8.16 However, if the trustee identifies the payment as reducing or discharging an entitlement to an unrealised gain, the rules will, subject to the other requirements in Division 7A, potentially apply. This could include the situation where the trustee is unable to identify the nature of the entitlement to which a payment is being applied, or where the trust's financial records suggest that, as a result of the payment (and reduction or discharge of the beneficiary's entitlement), the trust appears to have negative corpus.
8.17 This effect is achieved through subsection 109XA(5) which provides that to the extent that a discharge of, or reduction in, a present entitlement is only partly attributable to an amount that is an unrealised gain, the amount involved in the actual transaction is taken to be only the amount of the payment that was attributable to the unrealised gain. [Schedule 8, item 3, subsection 109XA(5)]
Example 8.1
A private company has a present entitlement to $1,000 of accounting income of a trust estate that remains unpaid.
The trustee creates an entitlement to an unrealised gain to a shareholder of the private company of $5,000.
The trustee makes a payment of $2,000 towards the beneficiary's entitlement to the unrealised gain.
The payment will attract the operation of the new rules and, subject to the operation of the remainder of the rules contained in new Subdivision EA and Division 7A, a deemed dividend of $1,000 will arise in the hands of the shareholder.
Example 8.2
A private company has a present entitlement to $10,000 of accounting income of a trust estate that remains unpaid.
The trustee creates an entitlement to a shareholder of the private company comprising $7,000 of unrealised gains and $3,000 of realised gains.
The trustee then makes a payment of $5,000 towards the beneficiary's entitlements. The trustee is permitted to determine the extent to which the payment is treated as a reduction in entitlements to realised or unrealised gains and determines that, of the $5,000 paid, the first $3,000 discharges the entitlement to the realised gain and the remaining $2,000 reduces the entitlement to the unrealised gain.
The payment will attract the operation of the new rules and, subject to the operation of the remainder of the rules contained in new Subdivision EA and Division 7A, a deemed dividend of $2,000 will arise in the hands of the shareholder.
Example 8.3
A private company has a present entitlement to $10,000 of accounting income of a trust estate that remains unpaid.
At the end of the income year the trustee creates an entitlement to a shareholder of the private company comprising $10,000. The entitlement is entirely attributable to interest income that has been accrued for accounting purposes, but is nonetheless an unrealised gain.
Shortly after the end of the income year, the trustee makes a payment of $10,000 towards the beneficiary's entitlement. However, at the time the payment is made, the accrued interest has been received, converting the profit entitlement to an entitlement to a realised gain.
It is also noted that even if the interest is not regarded as realised at the time of payment, provided that the unrealised gain would be included in the assessable income of the trust no later than the year of income following the year in which the payment is made, the payment would also not attract the operation of the new rules.
8.18 New subsection 109XA(2) applies where:
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- a trustee makes a loan to a shareholder (or their associate) of a private company (other than to a shareholder or associate that is a company); and
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- the private company is, or becomes, presently entitled to an amount from the net income of the trust; and
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- all or part of that present entitlement remains unpaid before the earlier of the due date for lodgement and the date of lodgement of the trust's return for the income year in which the loan takes place.
[Schedule 8, item 3, subsection 109XA(2); item 5, paragraph 109XA(2)(b)]
8.19 The term 'loan' for the purposes of these rules takes the meaning provided in section 109D of the ITAA 1936. Section 109D defines 'loan' to include:
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- an advance of money; and
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- a provision of credit or any other form of financial accommodation; and
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- a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; and
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- a transaction (whatever its terms or form) which in substance effects a loan of money.
Example 8.4
A private company has a present entitlement to $5,000 of accounting income of a trust estate that remains unpaid.
The trustee makes a non-commercial loan to a shareholder of the private company of $20,000. The loan is not repaid by the earlier of the due date for lodgement and the actual date of lodgement of the trustee's return of income for the trust in the year in which the loan was made.
The loan will attract the operation of the new rules and, subject to the operation of the remainder of the rules contained in new Subdivision EA and Division 7A, a deemed dividend of $5,000 will arise in the hands of the shareholder.
8.20 New subsection 109XA(3) applies if:
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- all or part of a debt owed to a trustee by a shareholder (or their associate) of a private company is forgiven (other than to a shareholder or associate that is a company); and
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- the private company is, or becomes, presently entitled to an amount from the net income of the trust; and
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- all or part of that present entitlement remains unpaid before the earlier of the due date for lodgement and the date of lodgement of the trust's return for the income year in which debt is forgiven.
[Schedule 8, item 3, subsection 109XA(3); item 6, paragraph 109XA(3)(b)]
8.21 The phrase 'forgiven debt' for the purposes of these rules takes the meaning provided in section 109F of the ITAA 1936. Broadly speaking, subsection 109F(3), in conjunction with section 245-35, provides that a debt is forgiven if the debtor's obligation to pay the debt is released or waived, or is otherwise extinguished.
What is the amount of the payment, loan, or forgiven debt?
8.22 The amount of a payment, loan or forgiven debt covered by subsection 109XA(1), (2) or (3) is calculated by reference to subsection 109XA(4). This subsection provides that the amount is the lesser of:
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- the amount actually involved in the transaction; and
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- the amount worked out using the following formula:
unpaid present entitlement - previous transactions
8.23 This calculation ensures that amounts that might have previously attracted the operation of former section 109UB or new Subdivision EA are not further subjected to the rules. The terms 'unpaid present entitlement' and 'previous transactions' are defined in subsection 109XA(4).
What are the consequences of Subdivision EA applying?
8.24 The broad scheme of the provisions is to treat the trust as a private company for the purposes of determining whether a deemed dividend arises in circumstances where the trustee has made a payment, loan, or forgiven a debt, of the kind covered by subsection 109XA(1), (2) or (3).
8.25 This is achieved through the hypothesis contained in section 109XB. Section 109XB provides that an amount is included in the assessable income (as a dividend) of the shareholder or associate if that amount, referred to as the 'Division 7A amount', would have been so included had:
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- the actual transaction (i.e. the payment, loan or forgiven debt provided by the trustee) been done by a private company; and
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- the shareholder (or their associate) been a shareholder of that company at the time of the actual transaction.
8.26 In applying this hypothesis, certain modifications have been made to the operation of Division 7A as it applies to affected trusts, to take into account that Division 7A is ordinarily restricted to transactions involving companies and their shareholders and in other cases to reflect commercial trust practice.
8.27 The effect of these modifications will also allow loans provided by a trustee to a shareholder to be repaid or put on commercial footing (i.e. minimum repayments made and written loan agreements put in place) and therefore avoid the operation of the deemed dividend rules. This feature addresses the fairness problems identified by the Board of Taxation in respect of former section 109UB. These modifications are set out in Table 8.1:
| Current law | Modification |
|---|---|
| General modifications to Division 7A | |
| Division 7A | References in Division 7A to amounts paid to a company, the income year of a company, or the ordinary course of a company, take the equivalent meaning within the context of the trust or the trustee of the trust. [Schedule 8, item 3, subsection 109XC(2)] |
| Specific modifications to Division 7A | |
| Section 109E | An amalgamated loan is taken to have been repaid at the end of the year if it is repaid by the earlier of the due date for lodgement and the date of lodgement of the trust's return for the income year in which the actual payment takes place. [Schedule 8, item 3, subsection 109XC(3)] |
| Section 109J | Payments made in satisfaction of a present entitlement are not covered by section 109J. [Schedule 8, item 3, subsection 109XC(4)] |
| Section 109N | A valid written loan agreement will be taken to have been in place if it has been made by the earlier of lodgement or due date for lodgement of the trust's return of income for the year in which the actual loan takes place. [Schedule 8, item 3, subsection 109XC(5)] |
| Section 109R | References to obtaining a loan from a private company, property transferred to a private company, or an amount paid by a private company take the equivalent reference within the context of the trust or the trustee of the trust. [Schedule 8, item 3, subsection 109XC(6)] |
| Section 109Y | The distributable surplus calculation is calculated by reference to the private company. [Schedule 8, item 3, subsection 109XC(7)] |
| Division 7A provisions which do not apply | |
| Subsection 109D(1A), sections 109K, 109NA, 109NB, paragraphs 109R(3)(a),(b) and (ba) | Generally, these provisions do not apply as they have no application to trusts or, in the case of section 109K, the equivalent effect has been embodied in section 109XA. [Schedule 8, item 3, subsection 109XC(8); item 3, paragraphs 109XA(1)(a),(2)(a) and (3)(a)] |
Application and transitional provisions
8.28 The amendments generally apply to payments, loans and debts forgiven on or after 12 December 2002.
8.29 However, in the event a private company becomes presently entitled to an amount from the net income of the trust after the actual transaction takes place (as opposed to before), and the other requirements of section 109XA are met, the amendments will have effect as from the date the bill is introduced into Parliament. [Schedule 8, item 9]
Consequential amendments
8.30 A minor consequential amendment has been made to section 109S to omit the reference to section 109UB.