Published in Principal, September 28, 2010
Everyone knows the old saying about how only two things in life are certain. However, you may have some uncertainties surrounding tax on trust distributions as a result of recent changes to tax law. Matthew Schlyder clarifies the changes and what they mean for business owners.
In 1997, the Federal Government introduced Division 7A into tax legislation, which deals with loans made by companies to shareholders or associates. Up until 16 December, 2009, the ATO’s public view was that distributions to companies by trusts were not caught by Division 7A. They remained as what is referred to as an Unpaid Present Entitlement (UPE), not a loan.
This meant that where businesses or investors earned income in a trust prior to 16 December 2009, this income could be distributed to a company where it would be taxed at 30%, instead of potentially 46.5% if distributed to individuals.
The after tax cash (70%) could remain within the trust and be invested, either back into the business or into other assets. No further tax would be payable on these initial profits until either the company paid a dividend or the trust paid out amounts to beneficiaries. Therefore, the after tax income that could be re-invested was 70% of the income amount, not 53.5%. 16.5% is a significant amount of additional capital to invest. A trust is also a more appropriate vehicle to own assets. Trusts have access to the 50% capital gains tax exemptions, potentially the small business capital gains tax exemptions, as well as the flexibility of making different distributions to different beneficiaries each year. Companies do not necessarily have the same flexibilities or benefits.
For many Australian small and medium sized businesses and investors that operate through a trust structure, it is likely that those businesses also have a company beneficiary to achieve the tax outcome described above. The trust and the company beneficiary generally go hand-in-hand.
The New Ruling
On 16 December, 2009, the ATO announced a change in its position with regards to distributions to corporate beneficiaries and issued the public Income Tax ruling TR 2010/3: Division 7A Loans: Trust Entitlements.
The ATO now says that any distributions paid to a company by a trust will be a loan, which means that in most cases, this loan will need to be paid to the company over a 7 year period with annual principal and interest repayments. No longer can the amount be left unpaid to the trust. This means that without an appropriate taxation strategy, the additional 16.5% tax will be paid over 7 years. In addition, the interest received by the company will be taxed at 30%. If you do not have the correct income structure within the trust, you may not be able to claim a deduction for the interest.
The Impact for Real Estate Agents
From the Real Estate Industry perspective, this change in the ATO’s view will impact both Real Estate businesses and property owners.
For Real Estate businesses that operate through a trust, distributions that are made to a company will now be required to be paid over 7 years, which means you will need to develop an appropriate Taxation Plan to fund principal and interest repayments to maximise the amount of after tax income that is retained. Failure to address this issue could mean unexpected tax liabilities. This will impact on the business’ working capital as well as owners’ personal expenditure and investment strategies. For a business that earns a profit of say $500,000, this may mean an additional tax liability of $82,500 over 7 years. However, over a 7 year period, a business that earns $500,000 per annum may accumulate and additional $577,500. That’s a lot of additional after tax income that cannot be re-invested.
The same applies for investors. It is a very common structure to use a trust as an investment vehicle. Pre 16 December 2009, when a trust was combined with a company beneficiary, 70% of the undrawn investment returns could be reinvested within the trust, and the income tax and capital gains tax benefits that a trust structure provides could still be accessed. Now investors need to consider their taxation planning, as the post 16 December, 2009 taxation landscape is different. With potentially an additional 16.5% of tax payable, investors who structure their investment vehicle via a trust will not have the same after tax income to invest. This may reduce the extent to which they can borrow, their ability to fund repayments and hold property as a larger, single, less liquid asset.
Distributions made prior to 16 December, 2009
The reality is, in most instances, any unpaid present entitlements (UPE) made before 16 December 2009 won’t be a problem provided:
- there isn’t an express or implied loan agreement in place,
- the provisions of the trust deed don’t cause any unpaid amounts to be regarded as a loan, and;
- the financial accounts of the trust and company correctly record the amounts as UPEs.
If these requirements are not met, you may have a loan that Division 7A applies to, which could deem the payment to be a dividend, in which case, tax may have been payable on this amount in a prior year and could be 46.5% of the amount unpaid or 46.5% of the profits retained in the company. This amount could be significant.
Distributions made post to 16 December, 2009
For distributions made post 16 December, 2009, the easiest solution is to make a cash payment from the trust to the corporate beneficiary, equal to the accounting distribution. You have until the due date of the lodgement of your 2009/2010 tax return to repay the loan.
Otherwise, the company will need to apply the steps within Division 7A:
- Prepare a loan agreement between the borrower and lender
- Execute the agreement
- Charge interest between the parties at a rate no less than the ATO published rate
- Repay the loan within the loan agreement terms (7 years for unsecured loans and 25 years for secured loans)
Where to now
The fact is the new ruling is here to stay. This is the tax office’s view, and we now need to look at what tax strategies are possible under this new environment.
Distributing profits to a company is still a good strategy, and should remain part of your annual Taxation Plan.
The difference now is you need to work out your strategies to fund the repayment of the loan which can usually happen via payment of dividends from the company. By doing this, as a minimum, you get to pay any additional tax, which at the moment is a maximum of 16.5%, over a 7 year period. Any dividends paid by corporate beneficiaries should be fully franked.
With correct asset and income structuring within the trust, while the loan interest paid to the company will be taxed, the trust will usually be eligible for a tax deduction for the interest paid to the company. Therefore the tax outcome will minimal.
The opportunity to legally pay the least amount of tax possible still exists under this ruling, with the correct structuring of the shareholders of the corporate beneficiary. If trust structures are used as shareholders of corporate beneficiaries, you still have the flexibility to distribute any dividends paid by that company to a range of beneficiaries within the family group, which can include other companies and trusts.
Sure, it’s not a set and forget strategy as it used to be, but it remains an effective way to manage your tax.