In my last article I highlighted the importance of companies correctly applying Division 7A  and the significant tax penalties that can arise if you get it wrong. Here, in what is a companion article, I explore what you need to know about Unpaid Present Entitlements (UPE) between related private companies and trusts that arise where income of a trust is distributed to a related private company without paying some or all of the income to the company. Under certain circumstances, Division 7A can apply to these UPEs which, if not properly handled, can result in significant additional tax. This is a common trap for Trustees of trusts exposed to UPEs with private companies.

Below I outline what you need to do prior to the end of financial year or before the Trust’s  tax return is due.

Trustees often distribute income to a corporate beneficiary so that they may access a lower rate of tax as applicable to the company.  This is a sound and worthwhile practice when other Trust beneficiaries are subject to a higher rate of tax.  However, an issue arises when the Trust does not pay the income that’s been distributed ‘on paper’ to the corporate beneficiary. The result is what’s commonly known as an Unpaid Present Entitlement (UPE) and if it’s not attended to, the tax office could consider it a loan and deem it a dividend under Division 7A.  As you read in my earlier article, the amount would be taxable in full and without the use of any franking credits that may have otherwise been available to the corporate beneficiary.

However, the UPE can avoid being treated as a loan with exposure to Division 7A where the Trust has retained the UPE funds to fund its operations, invest within the Trust or refinance its own debts.

Further, to avoid exposure to Division 7A, the UPE must be set aside into a sub-trust for the exclusive benefit of the corporate beneficiary.  In accordance with tax regulations, the Trust would then pay annual interest to the corporate beneficiary associated with the UPE that’s held in the sub-trust.

Simply by adhering to the rules surrounding UPEs held in sub-trust, the Trust can avoid costly tax penalties. In addition, where company UPE funds are retained by the Trust to fund its operations, invest within the Trust or refinance its own debts, significant cash flow advantages can be achieved by enjoying a sub-trust financing arrangement on interest-only terms, rather than the more onerous Division 7A ‘principal and interest’ terms. In particular, retaining more funds in the Trust under an ‘interest-only’ arrangement enables the Trust to seek investment opportunities in a more tax concessional manner within a Trust.

To evidence the existence of these Division 7A protected sub-trust arrangements, it is imperative that the parties to the UPE enter into a sub-trust agreement where the terms of the arrangement are outlined in accordance with the requirements of the relevant tax rules on sub-trust arrangements. To be effective, these arrangements need to be documented within a prescribed time frame.

Now is the time to identify the UPEs that require action.  Trustees should discuss the options available so that action may be taken prior to the end of financial year, or before the due date of the Trust’s income tax return.

It is important for Trustees to seek advice not only to ensure that they comply with legislation but to make best use of the advantages and opportunities at their disposal and that’s how we can help.  Please accept our invitation to give us a call on (02) 9375 1200 to discuss your needs as they apply to your particular circumstances.

 

The information (including taxation) contained within this article is of a general nature only and neither represents nor is intended to be personal advice on any particular matter. Rosenfeld Kant SMSF Advisors strongly suggests that no person should act specifically on the basis of the information in this document, but should obtain appropriate professional advice based on their own personal circumstances.