Pitcher Partners Advisors Proprietary Ltd ABN 80 052 920 206
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Peter Glindemann Australian Taxation Office
By Email: peter.glindemann@ato.gov.auDear Peter
DRAFT TAXATION DETERMINATION TD 2022/D1 - DIVISION 7A: WHEN WILL AN UNPAID PRESENT ENTITLEMENT OR AMOUNT HELD ON SUB-TRUST BECOME THE PROVISION OF 'FINANCIAL ACCOMMODATION'?
1. Thank you for the opportunity to provide comments on the ATO’s Draft Taxation Determination TD 2022/D1 (“Draft TD”) in relation to the meaning of ‘financial accommodation’ for the purposes of Division 7A1
2. Pitcher Partners specialises in advising taxpayers in what is commonly referred to as the middle market. Accordingly, we service many taxpayers that are affected by the ATO’s interpretation of key provisions of Division 7A.
3. We have previously noted our concern with the new approach in the Draft TD and do not necessarily agree that the approach is consistent with the legislature’s intention in respect of the treatment of unpaid entitlements under Division 7A. We believe that the approach contained in TR 2010/3 is more consistent with the provisions contained in Division 7A and it would have been preferable for any change to have been made by Parliament.
4. That being said, we understand that the ATO is entitled to change its view and we support an approach that applies the new view prospectively. Accordingly, we generally do not have significant concerns with the proposed new approach and its practical effect.
5. One key item that we believe must be addressed in when the Draft TD is finalised is the need for a uniform approach regarding the timing of when a Division 7A loan arises to simplify both the compliance with and administration of the rules. While we understand
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this submission
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the ATO’s concern about taxpayers potentially” gaming the system”, we have included suggestions that can provide certain to the majority of taxpayers, while also maintaining the integrity of the rules.
6. We also outline some of our concerns regarding, what the Draft TD refers to as, “circumstance two” and the conclusion that a corporate beneficiary provides financial accommodation directly to the entity that “uses the sub-trust fund”. We believe that this undermines the entity concept under the income tax law and will create significant uncertainty if the principle supporting the ATO’s reasoning is to apply more to Division 7A more broadly.
7. Additionally, we recommend that the final TD provide further clarity regarding transitional arrangements and the application of Subdivision EA of Division 7A. Please see the attached Appendix for detailed comments on the Draft TD.
8. Finally, we would recommend that the ATO update its Practical Compliance Guideline PCG 2017/13 to cover all present entitlements created up to, and including, 30 June 2022. We believe that this will reduce the need for the ATO to update this product annually and will also provide appropriate transitional certainty to taxpayers for arrangements that occur before and after that date.
If you would like to discuss any aspect of this submission, please contact either Leo Gouzenfiter on (03) 8612 9674 or me on (03) 8610 5170.
Yours sincerely A M KOKKINOS Executive DirectorAPPENDIX – DETAILED COMMENTS
Timing
9. The view taken in the Draft TD regarding when the provision of financial accommodation has been provided by the private company beneficiary creates significant complexity and places an unnecessary compliance burden on taxpayers. That financial accommodation is provided when the private company has knowledge of the amount of its entitlement will inevitably lead to costly disputes about evidence of knowledge.
10. Further, without a uniform approach to timing, there is a significant risk of noncompliance as the precise date of the making of a Division 7A loan needs to be known in order for loan agreements to comply with section 109N (e.g., the term of the loan must be no more than 7 years from the specific day on which the loan is made).
11. The Draft TD takes a position that a trust resolution appointing income expressed as a fixed sum results in instantaneous knowledge of the beneficiary (and the instantaneous provision of financial accommodation), but a resolution expressed as a percentage or based on some other formula results in knowledge (and therefore the provision of financial accommodation) at some later time. This may not be true.
12. There would be many cases where a corporate beneficiary has knowledge of its precise entitlement well before year-end despite its entitlement being expressed as a percentage, as well as many examples where it does not know its precise entitlement despite it being expressed as a dollar figure (e.g. where the trust may simply not have the amount of income to distribute that is stated in the resolution). In particular, trusts with income equalisation clauses may be able to take actions after year-end that modify the section 95 income which would affect its distributable income (e.g. by making a particular choice provided by the tax legislation that allows for the choice to be made with the income tax return).
13. In reality, if the view in the Draft TD is finalised, many taxpayers may seek to reverse engineer amounts that would otherwise be expressed as a specified sum so that they may be expressed as a percentage in order to ensure that there is appropriate time to place the UPE on Division 7A obligations complying terms.
14. We believe having an inconsistent approach may give rise to unnecessary complexity. For example, assume that Trust A distributes a fixed amount ($50,000) to Trust B (which has no other income or expenses), which then distributes 100% of its income to a corporate beneficiary. Further assume that different tax agents manage the two trusts. It would not be entirely clear whether the financial accommodation is provided by the corporate beneficiary in the first or second year in respect of Trust B and determining this may involve time-consuming reviews or audits to ascertain what knowledge (actual or implied) certain individuals had.
15. Further, the view in the Draft TD may give rise to uncertainty for trustees that are behind in their lodgments and preparation of their financial statements. The Draft TD does not state that financial accommodation will be provided either in the year the present entitlement or the following year as it leaves open the possibility of the timing of the financial accommodation occurring at any subsequent point in time when accounts and tax returns are finalised. An approach which results in the timing of the Division 7A loan being completely open-ended will result in significant uncertainty for taxpayers as well as the ATO.
16. The Draft TD also does not consider the common way that trust resolutions are expressed which may provide for the first, say, $50,000 of income to be appointed to a particular beneficiary, the next $50,000 of income to be appointed to another beneficiary and so on. While resolutions expressed in this way specify a dollar sum, in effect they are creating a cap or ceiling on the beneficiary’s entitlement rather than fixing an amount of the entitlement. The precise amount is contingent on the trust having enough income to satisfy all of the distributions in the relevant order. The final TD should outline the ATO’s approach to resolutions of this kind.
16.1. We note that support for this position can be found in FCT v Bamford [2010] HCA 10 at paras 12-13:
12. The Trustee determined under the Deed that the income for the year ended 30 June 2000 be distributed, as to consecutive amounts of $643 each to a child of Mr and Mrs Bamford, the next $12,500 to Narconon Anzo Inc, the next $106,000 to the Church, the next $68,000 to Mr and Mrs Bamford in equal shares, and the balance to the Church. The Trustee determined pursuant to cl 7(n) of the Deed that certain outgoings be treated as expenses and, in error, treated them as allowable deductions in computing the net income of the trust estate for the purposes of s 97(1). This was shown as $187,530.
13. Upon making the distributions in the above sequence, there was insufficient remaining to provide the $68,000 to Mr and Mrs Bamford, and no balance to go to the Church. There remained $67,744, which was distributed equally between Mr and Mrs Bamford (ie each received $33,872).
(emphasis added)17. We understand that the ATO is concerned that simply taking a view (or compliance approach) that financial accommodation is provided by the corporate beneficiary in the income year following the conferral of the present entitlement could result in taxpayers “gaming the system”. That is, opening the door to an argument that in reality the Division 7A loan was made in the earlier year and that the Commissioner is bound by its determination in a way that would prevent it from applying section 109D to the earlier year, such that the company can then also utilise section 109G to forgive the loan without a deemed dividend arising.
18. However, the recent High Court decision in FCT v Carter [2022] HCA 10 may support a view that financial accommodation is provided after the end of the year in which the present entitlement was conferred. At paragraph 22, the majority judgment states that one must ascertain a beneficiary’s present entitlement to the distributable income of the trust estate “just prior to midnight at the end of the year of income”.
19. Based on this authority, example 5 in the Draft TD may not appear to be correct as Silver Pty Ltd cannot have knowledge of the amount it can demand immediate payment of from the trustee on 27 June 2023 as it does not yet have a present entitlement that can be ascertained.
20. The concept of “just prior to midnight” suggests a notional point in time at which rights are to be ascertained, even if they are ascertained much later in reality. That notional
point in time is a relevant testing point. However, the ability to demand immediate payment of an amount from the trustee should logically occur no earlier than just after this notional testing time. This would occur on the stroke of midnight and hence, the first moment of the new financial year so that the Division 7A loan cannot arise in the same year as the present entitlement was conferred.
21. While this is a somewhat complex legal issue, we believe that there is scope for the ATO to consider compliance approaches that would enable taxpayers to apply a uniform treatment to UPEs, while avoiding being bound by guidance inappropriately.
22. For example, if the ATO maintains its position about the instantaneous provision of financial accommodation, the ATO could also prevent taxpayers from gaming the system by taking a compliance approach that it will exercise its discretion under section 109RB where the loan is placed on complying terms by the lodgment day of the following year of income where interest and principal repayments have been made every year in accordance with section 109E. In these situations, there is no relevant mischief and the ATO would not be bound by a public ruling that would prevent it from applying section 109D to the entire loan made in the year of the present entitlement in the extreme cases where taxpayers are seeking to exploit the ATO view.
23. Alternatively, the final TD could be accompanied with an administrative treatment (either within the final TD or in an accompanying Practical Compliance Guideline or Practice Statement), such that the ATO will accept that the section 109D loan arises in the subsequent year in all cases where the taxpayer consistently treats the UPE in that manner (e.g. applies section 109E for all subsequent years in an appropriate manner). We believe that this would provide a simpler approach for the majority of taxpayers, while providing protection to the ATO for the minority of cases to which it is concerned with.
Loan terms
24. The details in the timelines in paragraph 110 and 123 of the Draft TD should be reexamined.
25. There is a risk that taxpayers who enter into loan agreements that state maturity dates of 30 June 2030 and 30 June 2031 in accordance with those paragraphs (for examples 5 and 6 respectively) may enter into non-complying loans. Such loans would have terms that exceed 7 years as the loan in example 5 is said to be made on 27 June 2023 (resulting in a term of 7 years and 3 days) and the loan in example 6 is said to be made on 1 August 2023 (resulting in a term of 7 years and 11 months).
26. Further, it is unclear whether the loans that were made on 27 June 2023 and 1 August 2023 respectively are merely being reduced to writing by the relevant lodgment day (as per ATO ID 2012/61) or whether those loans are being repaid with new loans entered into on those dates.
27. On the one hand, the timelines in paragraphs 110 and 123 state that the obligation in respect of the UPE is discharged and the trustee enters “into a new loan” which suggests that the loan is made at those later times, being 31 March 2024 and 15 May 2025 respectively. If that were the case (subject to section 109R), the first minimum yearly repayment would be due on 30 June 2025 and 30 June 2026 respectively (rather than 30 June 2024 and 30 June 2025 as stated in the timelines). This needs to be clarified.
28. ATO ID 2012/60 suggests this results in the application of section 109R and a deemed dividend in relation to the original loan (but section 109RB may apply to disregard the deemed dividend). In any case, the discharge of a loan and replacement with a new amalgamated loan should result in the first minimum yearly repayment being required in the year following the making of the loan rather than in the year the loan was made.
29. Accordingly, we believe that the final TD should ensure that the issues raised in ATO ID 2012/60 are not taken to occur where the UPE is discharged, and the trustee subsequently enters into a loan agreement.
Entities
30. The view in the Draft TD regarding sub-trust arrangements and use of funds tends to undermine the entity concept in section 960-100 of the Income Tax Assessment Act 1997 which is expressly reinforced for Division 7A purposes in section 109ZE.
31. In what is described as “circumstance two – where there is a sub-trust” the Draft TD concludes that funds which are the assets of one entity (i.e. a sub-trust) that are used by a second entity (i.e. the main trust or some other entity) result in a third entity (i.e. the private company beneficiary) providing financial accommodation to that second entity through its acquiescence or consent to the first entity’s actions.
32. By way of illustration, example 7 of the Draft TD states that the sub-trust makes a loan to the Pets Plus Trust and recognises this as a loan receivable in the accounts of the sub-trust. This appears to be an ordinary section 109D loan from the sub-trust to the main trust. However, the Draft TD effectively bypasses the middle entity and concludes that that there is also a loan made by the company directly to the main trust.
33. Such a view, if correct, would severely undermine the application of Division 7A and appears inconsistent with Subdivisions E to EB which provide specific rules for arrangements involving entities interposed between the company and its shareholder (or associate of its shareholder).
34. For example, a private company could own all the units in a unit trust. If the unit trust lends an amount to an associate, the reasoning in the Draft TD suggests that the company could be taken to have provided direct financial accommodation to the associate rather than as a result of a notional loan arising through the application of sections 109T and 109W. The corporate unitholder has full control of the trust and could take action to bring the trust to an end in the same way as it could bring an end to a sub-trust as outlined in paragraph 33 of the Draft TD.
35. Another example could involve a chain of three wholly owned companies where the company at the bottom of the structure makes a loan. It is difficult to see why, based on the reasoning in the Draft TD, that each company in the chain has not provided direct financial accommodation to the borrower through their consent and acquiescence to the use of the funds. This is contrary to the view contained in TD 2004/68.
36. Overall, this view results in an overly complex and confusing application of Division 7A as a whole and the ATO should consider revising its view as to which entity is taken to provide financial accommodation under “circumstance two” arrangements, given its broader implications. We submit that the sub-trust is a section 109ZE entity and it is the relevant entity that is providing financial accommodation in these circumstances. As the sub-trust is not a private company, either the application of section 109T or Subdivision EA will be necessary for a deemed dividend to arise.
37. Additionally, the ATO should also make clear whether example 2 results in the provision of financial accommodation to the deposit-taking institution or whether there is no financial accommodation provided to any entity whatsoever. In the former case, no deemed dividend arises because the financial institution is a company or otherwise not related to X Co.
38. It is important to clearly understand the reasoning in the Draft TD. If use of funds by the main trust constitutes the making of financial accommodation to the main trust, then it should similarly follow that use of funds by the financial institution should constitute the making of financial accommodation to the financial institution (whether or not a commercial return is provided for that use of funds such as interest on a savings account).
39. We also highlight that paragraphs 6 and 12 of the Draft TD only refer to “a private company beneficiary” with a UPE or present entitlement. However, the title of the Draft TD refers to the concept of the provision of financial accommodation more broadly. The ruling should be neutral as to what kind of entity the beneficiary is as there is nothing unique about private companies that results in their having provided financial accommodation where another kind of beneficiary would not.
40. In particular, it is important to understand clearly if the Draft TD applies to trustee beneficiaries to understand if and when a trustee beneficiary provides financial accommodation to the distributing trust. Where the trustee beneficiary has a pre-09 UPE this is necessary to understand the application of Subdivision EA.
41. Additionally, for back-to-back UPEs (e.g. Trust A to Trust B to X Co) it is important to understand whether X Co would be taken to have made a loan to Trust B as well as Trust B having made a loan to Trust A and, if so, how the Commissioner would generally seek to apply sections 109T and 109W in relation to any potential notional loan between X Co and Trust A.
Subdivision EA and transitional arrangements
42. The final TD should provide further clarity about the application of Subdivision EA. Paragraph 147 of the Draft TD suggests that Subdivision EA only has a limited scope going forward, being its application to instances where the trust and the beneficiary do not share common knowledge. It is not clear if this is only for post 1 July 2022 entitlements or whether that limited scope applies in relation to older UPEs, including pre-09 UPEs. The final TD should make absolutely clear whether the ATO views pre-09 UPEs as being loans (and not UPEs) or whether it views these as both loans and UPEs, but reserves the right to continue to treat these as UPEs for the purposes of Subdivision EA.
43. Similarly, the final TD should make it clear how post-09 (but pre 1 July 2022) UPEs are to be treated for Subdivision EA purposes going forward. Paragraph 148 suggests simply that there is no UPE where amounts are set aside on sub-trust. If this is correct, then it is difficult to see how Subdivision EA can apply where a trust with a subsisting post-09 (and pre-22) UPE on PS LA 2010/4 option 1 or 2 terms makes a loan to a shareholder/associate of the corporate beneficiary, unless the view is that these option 1 or option 2 arrangements are not actually sub-trusts. The views in the Draft TD and TR 2010/3 are contradictory and cannot both be correct on this (i.e. either a sub-trust arrangement is still a UPE as per para 178 of TR 2010/3 or it is not as per para 148 of TD 2022/D1).
Use of non-cash assets of a sub-trust fund
44. When addressing the circumstances involving sub-funds, the Draft TD appears to be premised on the notion that the assets of the sub-fund consist of cash or cash equivalents (e.g. paragraph 31 states a sub-account in a bank account is created). However, the sub-trust could also use its funds to acquire other assets such as shares or real property.
45. In particular, real property can be used by individuals (e.g. as private accommodation) or other entities (e.g. as a business premise) in a way that does not resemble a loan or a kind of financial accommodation.
46. The final TD should address whether the ATO considers the use of tangible assets such as real property as being the provision of financial accommodation directly by the corporate beneficiary to the user of the asset, and if so, how to quantify the amount of the Division 7A loan. Alternatively, if the view is that this is the provision of the use of an asset treated as a payment in accordance with section 109CA, whether it is the subtrust making that payment or whether it is the corporate beneficiary making that payment (or both).