Tax Alert -Federal Court delivers a Division 7A win for taxpayers in Bendel Case decision
Federal Court delivers a Division 7A win for taxpayers in Bendel Case decision
Last week the Full Federal Court handed down a unanimous decision that an unpaid present entitlement (or UPE) owed by a discretionary trust to a corporate beneficiary is not a “loan” for Division 7A purposes, which is a set of anti-avoidance provisions that could deem such a loan to be a deemed dividend.
This decision focuses on arrangements that will be familiar and common for many private groups across Australia that use discretionary trusts.
A brief history of the Bendel Case
The Bendel case involves two taxpayers, an individual and a private company, and both were beneficiaries of a discretionary trust. The individual was the director of both the corporate trustee of the discretionary trust and the corporate beneficiary.
For various income years, the trustee of the discretionary trust resolved to distribute income to the corporate beneficiary. The corporate beneficiary did not call for (or demand) payment of those entitlements. This is an unpaid present entitlement or UPE. This is a very common arrangement within private groups in Australia.
Since 2010, the Commissioner of Taxation has applied Division 7A on the basis that if a UPE owing by a discretionary trust to a corporate beneficiary is left unpaid, it could be a “financial accommodation” from the company to the trust and therefore be treated as a “loan”.
This loan is then deemed to be a dividend from the corporate beneficiary to the discretionary trust for the purposes of Division 7A.
In the Bendel case, the Commissioner decided that a deemed dividend would be included in the discretionary trust’s net income and assessed the taxpayers on their respective shares of that deemed dividend.
The taxpayers appealed to the Administrative Appeals Tribunal (AAT), which found for the taxpayers. Then the Commissioner appealed to AAT decision the Full Federal Court.
After waiting over a year, last week the Full Federal Court handed down a unanimous decision that a UPE owed by a discretionary trust to a corporate beneficiary is not a “loan” for Division 7A purposes.
Why is a UPE not treated as a “loan” now?
Broadly, a UPE arises where a trustee of a trust makes a beneficiary presently entitled to trust income, but the beneficiary does not receive payment for the entitlement.
The Full Federal Court’s decision clarified that for an arrangement to constitute a “loan,” there must be an obligation to repay an amount, rather than merely an obligation to pay an amount.
This critical finding distinguishes a UPE from a traditional loan, by reinforcing that a UPE does not inherently create a repayment obligation.
Beware Subdivision EA is still in play
While the decision provides a new interpretation regarding UPEs for Division 7A loan purposes, this decision does not change the potential for exposure to Subdivision EA.
Subdivision EA is a rule within Division 7A, which can be triggered if a trust makes a UPE to corporate beneficiary, and then the trust makes a payment or loan (for example) to the shareholders (or associates) of the corporate beneficiary.
Therefore we need to continue to monitor compliance with Subdivision EA, as it can still apply to deem the UPE to be a deemed dividend in certain circumstances.
What can the Commissioner do next?
While this decision represents a significant change in the interpretation of the Division 7A rules, it is unlikely to be the final word on the matter.
The Commissioner can still seek leave to appeal the Bendel decision to the High Court.
Another possibility for the Commissioner if he does not seek an appeal, is to approach the government to consider making amendments to the tax legislation and/or the Australian Taxation Office (ATO) guidance or administrative practices currently in place.
This decision is also likely to empower the accounting and taxation sector to continue to lobby the government to consider a broader review of the Division 7A rules, which we all agree is long overdue.
It is also worth noting that arrangements involving UPEs are still at risk of the ATO seeking to apply other taxation provisions such as Section 100A, which is an anti-avoidance provision that applies when a beneficiary’s entitlement to trust income results from a “reimbursement agreement”. Broadly, this is an arrangement where a beneficiary becomes presently entitled to trust income, and someone (other than the beneficiary) receives a ‘benefit’ in relation to the arrangement with one of the parties having the intent of reducing tax. If a company’s entitlement to income remains unpaid by the trust indefinitely with no commercial arrangements to address it, Section 100A could well be an issue.
What can we do now?
Unfortunately, there is an element of having to “wait and see” what the Commissioner does next. However, there are some actions we can take in preparation for what developments come next.
If a taxpayer has been subject to ATO review or audit based on the previous interpretation of UPEs as loans and been forced to pay penalties, it would be relevant to consider the process for lodging an objection or seeking an amendment to their previous tax assessments. This could potentially lead to the remission of primary tax, interest, and penalties.
It may also be relevant for any taxpayers currently being audited in this regard to discuss this new decision with their ATO audit case manager.
We will continue to stay updated on any new guidance or administrative practices issued by the ATO in response to the Full Federal Court's decision, as the ATO may provide further clarification or updates on how they may change their interpretation of UPEs going forward.
Please do not hesitate to contact your Lowe Lippmann Relationship Partner if you wish to discuss any of these matters further.
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