Potential application of Division 7A to unpaid distributions to Companies
It is important as a company Director or Private company Shareholder to be aware that Division 7A of the Income Tax Assessment Act 1936 (‘Division 7A’) treats loans by private companies to its shareholders (or their associates) as an unfranked dividend which is taxable in the hands of the recipient, unless certain requirements are met.
Division 7A generally also applies where a trust distributes to a private company but, instead of paying it, retains the funds in the trust. The amount still owing to the company is often referred to as an unpaid present entitlement (‘UPE’) or prior to 1997 as a Beneficiary Loan. Traditionally, the ATO has taken the view that such an UPE is not a “loan” to which Division 7A may apply, unless the trust and the company have agreed to treat the UPE as a loan.
However, on 16 December 2009, the ATO released draft taxation ruling TR 2009/D8 which indicates it generally now considers that an UPE in respect to a private company will be treated as a loan made by the company to the trust, except in limited circumstances. Further, there is a broad “carve-out” from this new interpretation for UPEs arising before 16 December 2009. We will be liaising with you to ensure these UPEs are properly quarantined.
Where an UPE arises post-15 December 2009 (i.e., from the year ended 30 June 2010), the UPE will be treated as a loan unless a limited exception applies. Where the outstanding amount is regarded as being a loan, and the loan is not repaid by the trust, it may result in an unfranked dividend being included in the income of the trust.
It may be that you have identified that your company has an UPE with a trust. If so then until the ATO finalises its position regarding UPEs, you should undertake the following courses of action:
a). ‘Quarantine’ any pre-16 December 2009 UPEs in the financial accounts of each entity. In particular, ensure the entities have not agreed or done anything that may suggest they have
agreed to treat the UPE as a loan; and
b). If the trust plans to distribute to a company for the 2010 income year, this amount will generally be treated as a loan and must be fully paid to the company as early as the date the company must lodge its tax return for the 2010 income year, unless
(i) the loan is documented as being on ‘commercial terms’ by this time. This means the loan will have to be repaid over the next seven years (or 25 years if the loan is secured) by making minimum interest and principal repayments; or
(ii) a limited exception applies, which we will need to discuss with you.
Please contact us to discuss the options outlined above and any queries in relation to this matter.
When you contact us, we can discuss any other options you may have, depending on whether the ATO has formalised its position at that point in time.