Div 7A: Issues when dealing with loans and unpaid present entitlements


It’s been 20 years since Division 7A was enacted, and, despite the passage of time, it remains one of the most complex and challenging provisions in our taxation legislation.

Treasury have released their proposed changes to Division 7A and suggested a number of measures from a new loan model for all existing 7 and 25 year loans and self-correction mechanism to rectify Div 7A breaches to safe harbour rules for the use of assets.

At the sold-out Division 7A Day in Perth on 22 November, Daniel Smedley, CTA, (Sladen Legal) presents the session ‘Issues when dealing with loans and unpaid present entitlements’.

Daniel’s session considers the issues that arise when dealing with loans and unpaid present entitlements primarily in a taxation context including the income tax and capital gains tax implications of forgiving and waiving loans, and the income tax and capital gains tax implications of creating, satisfying, waiving, releasing or assigning unpaid present entitlements (UPEs).

His paper is excerpted in this post.

Introduction

As soon as the business or investment structure involves entities such as companies, it is inevitable that there will be intra-group loans arising from either:
  • deliberate choices in respect of financing particular investments and the extraction of capital from the group on short or long-term arrangements; or 
  • unintentional loans arising from the operation of the group over time and the movement of funds often undocumented as at call loans appearing only in the financial statements of the entities. 
When trusts are involved in these structures, unpaid present entitlements further add to the complicated group structures.

A UPE arises where the trust has made an appointment of income or capital to a beneficiary but has not paid, or applied, the full amount of the appointment. This may have arisen where the trust does not have sufficient cash or fungible assets to use in discharging the entitlement created by the appointment or it is applying the amount in the continued operation of the trust through investing in assets or working capital. This results in an entitlement that may be called for by the beneficiary immediately upon its creation and hence the description “unpaid present entitlement”. 


A UPE, being a right held by a beneficiary of a trust to call for immediate payment of a specific amount, will be enforceable in equity and is proprietary in nature.

The presence of loans and UPEs in a group structure presents many challenges both in the day to day administration of the business or investment structure and in respect of estate and succession planning.

Dealings with loans and UPEs may trigger many various unintended consequences pursuant to Division 7A of the Income Tax Assessment Act 1936 (ITAA 36). Further, failure to carefully manage those dealings when addressing Division 7A concerns can trigger tax consequences under other provisions of the tax law. Finally, failure to correctly identify the loans and UPEs and incorporate those into financial accounts, business decisions and succession plans may result in significant unintended outcomes.

Daniel’s paper is focused on dealing with loans and UPEs in the context of daily business. This is intended to be a practical explanation of the key taxation risks associate with loan accounts and UPEs. The paper begins with a brief recap of Division 7A and the traps this poses when dealing with loans from trusts.

It then reviews issues in identifying loans and UPEs in the business and risk and exposures these pose to a business’ assets. The paper will explore practical solutions to deal with both loans and UPEs in a tax effective manner whilst maintaining flexibility for the business.

Proposed changes to the Division 7A regime

The Government first announced amendments to Division 7A as part of the “Ten Year Enterprise Tax Plan” in the May 2016 Federal Budget. The amendments proposed intended to incorporate recommendations from the 2014 Board of Taxation’s final report on the ‘Post Implementation Review of Division 7A of Part III of the Income Tax Assessment Act 1936’. The start date was to have been 1 July 2018, although the Government in the 2018 Federal Budget deferred the start date to 1 July 2019.

Whilst the exact amendments are yet to be finalized, and a recent consultation paper released by Treasury departs from the Board of Taxation’s recommendations, any paper presented in respect of loans and UPEs in 2018 should give consideration to these announced amendments. 

Daniel's paper looks at the current state of those amendments in more detail, including:
  • Federal Budget 2016-17– Ten Year Enterprise Tax Plan 
  • Post-Implementation Review of Division 7A 
  • The Board of Taxation’s proposed rules for pre-existing loans and UPEs 
  • Treasury’s Consultation Paper 
  • Division 7A proposed changes – What does it mean to your existing loan?
As a consequence of the proposed new rules and the start date of 1 July 2019, businesses need to start considering how they will address existing loans and UPEs within the new regime. Daniel’s paper covers a number of strategies to help businesses do so, before drawing some conclusions on the Division 7A changes.

The proposed changes to Division 7A currently create uncertainty for taxpayers and have the potential to significantly impact the funding and cash flow of businesses. Whilst we await further discussion and consultation from Treasury, this provides an opportunity for businesses to ‘clean up’ existing loans in preparation to ensure the impact the new regime on their business is minimized. This may mean anticipating shorter repayment terms and increased repayments and making provisions in cash flow or moving loans to complying 25-year agreements.

It is noted however, that when undertaking either approach it is important to consider the asset protection elements of the existing structure and not solely the taxation consequences. If undertaking steps to discharge, release, forgive or assign amounts between entities, taxpayers should ensure that such steps are consistent with the business’ succession plan. However often asset protection and succession planning objectives can’t both be achieved.

There is no one simple solution to these challenges. The key task is to identify the issues for the business and work with the business, the relevant shareholders and their associates as well as their advisors, to create a plan that achieves the best balance of asset protection, taxation efficiency and succession planning. This will need to consider both the current day issues and the future structuring of the business’ investments. Daniel discuss asset protection considerations in further detail at part 5 of the paper.

The paper goes on to cover:
  • Identifying loans and UPEs in a business 
  • Asset protection, including identifying risk exposure and balancing objectives, and issues with corporate beneficiaries 
  • Dealing with loans, including forgiven debts treated as dividends, assigning a Division 7A loan, statute barred loans, commercial debt forgiveness, and capital gains/loss implications31 
  • Dealing with unpaid present entitlements, including the creation and satisfaction/discharge of the UPE, conversions into loans, 7.4 Release, waiver or assignment of UPE by beneficiary – non-CGT issues, reimbursement agreements, CGT issues, and issues with wills.
The paper concludes with the point that the best way to both mitigate the risks and to maximise the opportunities is for all advisors to work together in a collaborative approach to providing the solutions.

Daniel’s paper can be accessed here.

Daniel Smedley is a Chartered Tax Adviser (CTA) with The Tax Institute, accredited as a specialist in Taxation Law with the Law Institute of Victoria. He enjoys solving complex taxation and trust law issues for private enterprise clients, and is a trusted confidant in planning the succession of his client’s personal and business affairs. 

In both 2016 and 2017, Daniel was named one of Australia's “Best Lawyers of the Year” in the practice of tax law. The list is compiled by Best Lawyers and published in the Australian Financial Review. Daniel has also been recognised in Doyles Guide as a recommended tax lawyer in 2016 and 2017. Daniel is a regular presenter at state and national industry conventions, conferences and workshops.

Daniel is also the principal author of the Trust Structures Guide, the leading resource for anyone advising on trusts, structuring and planning issues, published by The Tax Institute.


Further reading: Greg Travers, CTA on Practical issues with Div 7A

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