Guide on Trust Funds – Part 21

The do’s and don’ts associated with making distributions to companies

The facts that presently entitled beneficiaries are taxed in their own right makes a company attractive due to the fact the company tax rate(currently 28.5%) will often be lower than individual beneficiaries’ marginal tax rates. By distributing to a company, any top-up tax can be deferred indefinitely, i.e., until the company chooses to pass the amounts out as a franked dividend. It may even be the case there is no top-up tax to pay by the shareholders or they may even be entitles to a full or partial refund of the franking credits.

Therefore, it is common when settling a discretionary trust to incorporate a company at the same time so the trust may be able to make distributions to it. Alternatively, depending on the trust deed, an existing company (or a company set up after the trust has been settled), may also be included in the class of beneficiaries entitled to receive distributions from the trust. Such companies are often referred to as ‘bucket companies’.

However, the above strategy should only be contemplated where the parties are fully aware of the limitations imposed by Division 7A, whilst Division 7A focuses mainly on loans made by a company to its shareholders (or associates), it can also impact upon trust distributions to companies.

By way of background, many trusts used to make companies presently entitled to trust income, utilising the corporate tax rate, but they then retained the funds indefinitely. The ATO’s traditional view was that an unpaid present entitlement (‘UPE’) owed to a company was not a loan (by the company back to the trust) for Division 7A Purposes. However, from 16 December 2009, the ATO advised that, where a trust has a UPE with a private company (e.g., a bucket company), the UPE will generally constitute a loan by the company to the trust (which, in most cases, would be an associate of a shareholder of the company), potentially resulting in a deemed dividend arising under Division 7A, which would need to be included in the assessable income of the trust. Refer to TR 2010/3 and PS LA 2010/4.

Specifically, a UPE owing to a bucket company may be liable to Division 7A in either of two ways:

• In-substance loan pursuant to TR 2010/3 – where the trust does not pay out the bucket company’s present entitlement by the lodgement day of its tax return ( for the year the present entitlement was created) the ATO will treat the ‘bucket company’ as having loaned the funds back to the trust; and
• Subdivision EA of Division 7A – Where there is an unpaid present entitlement (UPE) to a ‘bucket company’, and the trust makes a loan to a beneficiary who is a shareholder (or an associate of a shareholder) in the ‘bucket company’, Division 7A may apply to the loan.

In both of the above scenarios, which are considered in more detail below, it will generally be necessary for the loans to be covered by a complying Division 7A loan agreement to avoid a deemed divided arising (although, in relation to 1.above, a deemed dividend can also be avoided if the funds representing the present entitlement are held under an acceptable sub-trust arrangement).