Unpaid Present Entitlement (UPE)

An unpaid present entitlement (UPE) refers to a situation where a beneficiary is made presently entitled to trust income but where the trustee does not discharge its obligation to pay that amount out to the beneficiary, either by transfer or set-off.

There are a number of separate taxation considerations when it comes to UPEs. This article addresses the following:

• The application of the provisions dealing with distributions to entities connected with a private company as contemplated in Division 7A of the ITAA 1936.
• The relevance of the debt forgiveness rules contained in Division 245 of the ITAA 1997.
• The ability to recognise a bad debt deduction under section 25-35 and 8-1 of the ITAA.
• The implications under the MNAV test relevant to the small business CGT concessions contained in Division 152 of the ITAA 1997.
• The application of capital gains tax under the CGT regime.
• The risks of there being a reimbursement agreement as contemplated in section 100A of the ITAA 1936.
• The ability of a beneficiary to disclaim a trust interest for taxation purposes.

Division 7A of the ITAA 1936 is designed to capture otherwise tax-free loans and gifts made by a private company to shareholders and treat those amounts as notional unfranked dividend payments (capped at the companys distributable surplus).

The initial question you might have is why Division 7A (which is about private company distributions) has any relevance to UPEs?

The answer is that a payment can be deemed to be a dividend where it meets the definition of a loan. The definition of loan includes financial accommodation as set out in section 109D(3) of the ITAA 1936.

The prevailing ATO view expressed in TD 2022/11 is that the term financial accommodation extends to situations where a private company as beneficiary of a trust is made presently entitled to trust income and where the private company fails to demand payment of the amount (and it remains unpaid).

In essence, the non-receipt of the entitlement of a private company beneficiary is financial accommodation and thereby a loan which is necessary to treat as an unfranked deemed dividend which is assessable income of the trust.

The meaning of financial accommodation implies a number of key requirements. In particular:

• there must be a consensual agreement between the private company and the trustee regarding the accommodation. That can include the failure to enforce or demand a right, provided the private company makes an active decision to acquiesce from making a demand.
• The private company beneficiary needs to have been aware of the entitlement (i.e. an amount of trust income it can demand immediate payment of). That awareness is implied in situations where the trustee and the private company share the same directing mind and will (e.g. where the trustee of the trust is a director of the private company beneficiary).

The financial accommodation (and thereby the loan) is generally provided at the point in time when the private company beneficiary has knowledge of an amount of trust income that it can demand immediate payment of from the trustee but fails to do. This generally takes places once the financial accounts are finalised as this is when trust income and entitlements are ascertained. Noting that financial accounts are generally finalised in the income year which follows the income year in which beneficiaries are made presently entitled.

The ATO view expressed in TD 2022/11 is that it is also possible for a private company beneficiary to provide financial accommodation where the trustee sets aside funds commensurate with the beneficiarys interest on a sub-trust. In this situation, financial accommodation is provided where:

• those said funds are used for the benefit of the trust of the private companys shareholders or associates of those shareholders; and
• where the private company has knowledge or deemed knowledge (e.g. if the sub-trustee and the private company have the same directing mind and will) of the use of an amount of those funds but does not demand immediate payment.

Note that the trustee must generally have authority under a deed to establish a valid sub-trust. The amount held on sub-trust is no longer recognised as an asset of the trust but instead becomes corpus of the sub-trust to be held for the benefit of the relevant beneficiary.

If financial accommodation has been provided, the private company beneficiary can nonetheless avoid a deemed dividend by:

• paying the trust entitlement to the private company beneficiary; or
• entering into a complying loan agreement with the private company as contemplated under section 109N of the ITAA 1936.

Either steps must be taken before the tax lodgement date for the private companys tax return (or the due lodgement date, if earlier) in respect of the income year in which the financial accommodation arises.

Under a complying loan agreement, the first principal repayment is typically due by the end of the income year following the income year in which the financial accommodation is provided.

As at the date of writing, it is worth flagging the Federal Court Bendel case with a decision expected to be handed down in late 2024 or early 2025. The case is on appeal from the AAT where the taxpayer successfully argued that a UPE should not constitute financial accommodation (and therefore a loan which is a deemed dividend). AAT decisions do not carry precedential value. Therefore, the ATO is likely to continue to apply its interpretation of the law as articulated in TD 2022/11 until the Federal Court makes its decision and that decision either affirms the ATO position or warrants changes.

The decision of a beneficiary to release a trustee from its obligation to make payment of a UPE does not typically constitute debt forgiveness under the debt forgiveness rules.

However, that situation may be different where the beneficiary releases the trustee of a sub-trust from an equivalent obligation. This is because the corpus of the sub-trust may meet the test for commercial debt if the sub-trustee were able to obtain an allowable deduction for any interest paid to the beneficiary under the sub-trust arrangement.

For further information refer to the TD 2016/19 and section 245-10 of the ITAA 1997.

As mentioned, a beneficiary who is presently entitled has an equitable right to receive payment. The question is then whether a beneficiary who fails to receive that payment is entitled to a bad debt deduction under section 25-35 or section 8-1 of the ITAA 1997.

The ATO view expressed in TD 2016/19 suggests not.

To be eligible for a deduction under section 25-35, the amount of relevant debt needs to be included in the taxpayers assessable income for that income year or an earlier income in which the deduction is sought. The logic is that because a beneficiary is assessed on an amount based on their entitlement to trust income, the amount ultimately included in their assessable income is not precisely trust income. Instead, the beneficiary is being assessed on an amount determined under a statutory formula by reference to net income (as determined under the steps outlined in Division 6 of the ITAA 1936).

To put it another way, it is argued that the character of the amount the beneficiary is assessed on (based on net income) is sufficiently different to the character of the amount the beneficiary would be entitled to a deduction for (based on trust income) should the UPE become a bad debt. To be entitled to a bad debt deduction, the amount of debt included in the beneficiarys assessable income would need to based on trust income.

The following example can be found in TR 2016/19 and better explains this concept:

Archie is a beneficiary of the Woof Family Trust. In the 2009 income year, the trustee, Doggo Pty Ltd, derived $1,000 interest income. Pursuant to a power in the deed, Doggo Pty Ltd also chose to treat a $9,000 increase in the value of a trust asset as income of the trust for that year. Archie was made presently entitled to all of the income of the trust ($10,000). As a result he was assessed on all of the net income of the trust in that year ($1,000) under section 97 of the ITAA 1936.

The $10,000 entitlement was not paid to Archie but was recorded as a UPE. During the 2013-14 income year, Doggo Pty Ltd advised Archie that there was no likelihood his entitlement would be paid to him as the relevant asset is now worthless and the trust had no other property.

Archie determined that the $10,000 UPE was a bad debt and wrote it off. He cannot claim a deduction under section 25-35 of the ITAA 1997 for any part of the UPE. No part of his trust entitlement (his UPE) was included in his assessable income. Rather, Archie included his share of the net income of the trust in his assessable income.

In terms of a deduction for bad debt under section 8-1, the logic which suggests such a deduction is not available is that the beneficiary of a trust is probably unlikely (unless they are carrying on a money lending business) to incur the loss (i.e. the bad debt) in gaining or producing assessable income or as an incidence of carrying on a business.

The inability for a beneficiary to claim a deduction for a UPE which becomes bad means that the beneficiary can be assessed on a UPE they never receive and without the right to counteract that assessed amount in the future by claiming a deduction.

For a taxpayer to be eligible to utilise the small business CGT concessions, they must satisfy either the CGT small business entity test or the maximum net asset value asset (MNAV) at the relevant time in relation to a capital gain on an active asset which is sought to be discounted under the concessions.

Under the MNAV test, the taxpayer, together with connected entities and affiliates, must not have an aggregated MNAV which exceeds $6 million. The net asset value of the taxpayer is broadly the sum of the market value of non-excluded CGT assets less the sum of liabilities of the entity related to those assets. In this calculation, it is necessary to disregard the value of shares, units or other interests (except debt) in an entity connected with or affiliated with the taxpayer. This is essentially to prevent double-counting of assets.

In TR 2015/4, the ATO expresses its views on the way UPEs are incorporated into the taxpayers net asset value and those views are summarised below:

• Where funds representing the connected beneficiarys UPE are held on sub-trust:
  • The beneficiary does not include the UPE amount in calculating net asset value.
  • The main trust does not include the UPE amount in calculating net asset value.
  • The sub-trust includes the UPE amount as an asset but may not recognise a corresponding liability in calculating net asset value.
• Where funds representing the connected beneficiarys UPE are not set aside on sub-trust:
  • The beneficiary includes the UPE amount as an asset in calculating net asset value.
  • The main trust incudes the UPE amount in assets and is able to recognise liabilities related to the UPE (i.e. the liability to pay a presently existing equitable obligation) in calculating net asset value.
• Where a connected beneficiarys UPE is an absolute entitlement to trust assets, then the above points do not apply. Instead:
  • The beneficiary includes the value of any asset to which the connected beneficiary is absolutely entitled in calculating net asset value.
  • The main trust does not include the UPE amount in calculating net asset value.

In TR 2015/4, the ATO provides the following helpful example of a UPE where there is no sub-trust arrangement and no absolute entitlement.

Assume the same facts as Example 1, except rather than setting aside the amount of Emmetts UPE on sub-trust, Trusty Co records the amount as owing to Emmett in the books of account of the trust, and leaves it commingled with other trust funds.

Trusty Cos obligation as trustee of the Shiny Artichoke Trust to pay Emmett $3 million is a liability within the meaning of paragraph 152-20(1)(a). The liability is related to the CGT assets of the trust, and is subtracted from their market value in determining the net asset value of the trusts CGT assets just before the CGT event.

Net value of CGT assets of Shiny Artichoke Trust

As Emmett is a connected beneficiary of the Shiny Artichoke Trust, the net value of his CGT assets must be taken into account in calculating the trusts net asset value in accordance with paragraph 152-15(b). Emmetts right to payment of his UPE is a CGT asset. The UPE is not a share, unit or other interest that is disregarded under paragraph 152-20(2)(a), so the market value of the UPE is included in the net value of Emmetts CGT assets. Emmett has no other CGT assets relevant to determining this value.

Net value of CGT assets of Emmett

The net asset value of the Shiny Artichoke Trust is obtained by adding together the net value of it and Emmetts CGT assets.

Net asset value of Shiny Artichoke Trust

As Shiny Artichoke Trusts net asset value exceeded $6 million just before the CGT event, it does not satisfy the maximum net asset value test in section 152-15 and is not entitled to CGT small business relief under Division 152.

A UPE is an enforceable right that qualifies as a CGT asset. It is therefore important to consider any CGT implications, including the potential recognition of capital gains and/or capital losses.

Making a beneficiary presently entitled to trust income typically triggers CGT event D1 (to do with the creation of rights) for that beneficiary.

The trustee discharging an unpaid present entitlement to trust income typically triggers CGT event C2 (to do with cancellation, surrender and similar endings for CGT assets) for the beneficiary.

The conversion of a UPE to a loan by agreement will typically trigger CGT event A1 (to do with transfer of a CGT asset) or C2 for the beneficiary.

The assignment of a UPE will also typically trigger CGT event A1 for the beneficiary.

The occurrence of a CGT event means the taxpayer recognising the gain is required to calculate the capital gain or a capital loss.

The formula to calculate a capital gain or loss varies between CGT events. The relevant formulas for the above-mentioned CGT events are set out below:

• CGT event A1 (section 104-10): the taxpayer makes a capital gain if capital proceeds from the disposal are more than the assets cost base. The taxpayer makes a capital loss if the capital proceeds are less than the assets reduced cost base.
• CGT event C2 (section 104-25): the taxpayer makes a capital gain if the capital proceeds from the ending are more than the assets cost base. The taxpayer makes a capital loss if the capital proceeds are less than the assets reduced cost base.
• CGT event D1 (section 104-35): the taxpayer makes a capital gain if the capital proceeds from creating the right are more than the incidental costs the taxpayer incurred that relate to the event. The taxpayer makes a capital loss if the capital proceeds are less.

As mentioned, the basic position for taxing presently entitled beneficiaries is that they are assessed on their proportionate share of the net income of the trust estate. That said, there are a number of integrity measures in the tax law which are designed to counter certain avoidance-type arrangements.

Perhaps the most well-known of these is the general anti-avoidance rule contained in Part IVA of the ITAA 1936. That avoidance measure is designed to prevent a taxpayer from entering into an arrangement with the dominant purpose of obtaining a tax benefit.

There is another –until recently, lesser known- anti-avoidance measure which deals with present entitlements arising from reimbursement agreements. The relevant provision is contained in section 100A of the ITAA 1936. Its easiest for us to refer to this integrity measure as section 100A.

If section 100A applies, the relevant beneficiary or beneficiaries are deemed never to have been presently entitled to the relevant trust income. As put in TR 2022/4:

any assessment of the net income of the trust estate to a beneficiary that would arise under section 97 will be proportionately reduced by the share of the income of the trust estate that section 100A deems the beneficiary not to be presently entitled to or to have received or had applied for their benefit. Any proportionate assessment of the net income of the trust estate to the trustee that would otherwise have arisen under section 98 in respect of such a share would be likewise reduced, with section 98 then only having application in respect of any share of net income that remains as assessed under section 98. The trustee is assessed and liable to pay tax on the relevant share of the net income of the trust under section 99A relating to so much of the income of the trust estate covered by the section 100A deeming, as section 100A has created the statutory fiction that no beneficiary is presently entitled to this part.

If section 100A applies, there are also a number of further potential tax consequences relevant to the trust entitlement. As per TR 2022/4:

• No franking credits will arise for a corporate beneficiary in respect of tax otherwise payable in relation to an entitlement which has been switched off by the operation of section 100A.
• No withholding tax liability will arise in respect of entitlements which would be subject to subsection 128A(3) in respect of a non-resident beneficiary, where the present entitlement is switched off by the operation of section 100A.
• In the case of a corporate beneficiary, because the entitlement is taken not to arise, there will be taken to be no entitlement which could be the subject of a loan to the trustee under section 109D. Division 7A in those circumstances would not operate in respect of the entitlement.
• A capital gain or franked distribution which the beneficiary is specifically entitled to will be deemed not so entitled. This results in the allocation of the amount of the gain or distribution between the beneficiaries and trustees according to their respective adjusted Division 6 percentage, worked out in that deemed state of affairs.

There are four primary requirements to be satisfied for section 100A to apply.

1. There is a reimbursement agreement connected with the present entitlement.
2. There is a benefit obtained by someone other than the beneficiary.
3. There is a tax reduction purpose for one or more parties.
4. The arrangement is not an ordinary family or commercial dealing.

The ATO in TR 2022/4 expresses views on the meanings of these criteria which we summarise below:

1. Reimbursement agreement

Note that an agreement carries a wide meaning and can include an informal agreement and an implied agreement, for example, inferred by conduct. Also note that there can be a reimbursement agreement without an actual reimbursement of money. The meaning of a reimbursement agreement is better understood as an agreement whereby the beneficiary entitled to income does not ultimately attain the full benefit of their entitlement, but where it is conferred on someone else in some way.

There must be a nexus between the reimbursement agreement and all or part of the beneficiarys present entitlement for this condition to apply. That means the agreement must exist at the time (or prior to the time) the present entitlement arises.

2. Benefit

A benefit must be obtained by a person aside from the relevant beneficiary. A benefit is taken to have broad meaning and can include things such as:

• The payment of money (including via loans or the release, abandonment, failure to demand payment of or the postponing of the payment of a debt).
• The transfer of property.
• The provision of services.

3. Tax reduction purpose

A person who is a party to the agreement must possess a purpose of reducing the tax liability (or deferring tax) of an individual or entity (not necessarily a party to the agreement).

The purpose here need not be a sole purpose or even a dominant purpose. It is the actual purpose of the person that is relevant but which is determined by an assessment of evidence which informs that subjective intention, including an assessment of all the relevant facts and circumstances.

4. Not an ordinary family or commercial dealing

The agreement must not be entered into in the course of an ordinary family or commercial dealing (referred to as the ordinary dealing exception).

It is necessary to assess whether the whole dealing in totality is an ordinary dealing, not merely each step in a series of connected transactions.

To test whether there is an ordinary dealing, it is necessary to consider all the relevant circumstances, including what is sought to be achieved by the dealing (for instance, an ordinary family arrangement) and whether the steps taken under the dealing actually achieves that end.

An arrangement is less likely to be an ordinary dealing where any (or a combination) of the following features of the arrangement exist:

• it is artificial or contrived
• it is overly complex
• it contains steps that are not needed to achieve the family or commercial objectives
• it contains steps that might be explained instead by objectives different to those said to be behind the ordinary family or commercial dealing.

The ATO suggests that for the exemption to apply, the transactions must achieve family objectives or advance commercial interests. The ATO also cautions that the exemption will not be available merely because an arrangement is commonplace.

So what is an ordinary dealing? There is little definitive guidance on this point. That is at least in part because the exemption is highly dependent on the specific circumstances of each case. That said, it is worth noting that the courts have previously found that the ordinary dealing exemption was available in circumstances where certain transactions were ultimately entered into for risk mitigation purposes and that was an ordinary dealing. It is clear that the maximisation of wealth by the reduction of tax is not intended to qualify as an ordinary dealing.

In addition to TR 2022/4, the ATO in PCG 2022/2, provide some guidance on the types of arrangements that will attract ATO attention when it comes to reimbursement agreements. It sets out a number of helpful examples (and factors to consider) when determining if a taxpayer is in a white zone, green zone or red zone. Those colours denote the risk profile of an arrangement. Per the PCG, the ATO will not tend to allocate compliance resources to test the tax outcomes of arrangements which are in the white zone or green zone, except to confirm that the taxpayers arrangements meet the requirements of the zone. Please refer to the PCG to review those examples and guidance on offer. Also refer to TR 2022/1 which addresses the ATOs awareness of arrangements which involve parents benefitting from the trust entitlements of their adult children.

Disclaimers

A beneficiary can disclaim (revoke) a conferred interest in trust income. However, it is important to bear in mind important confines on that right as set out in the recent High Court decision of Carter. In that case, it was established that an effective disclaimer for trust law purposes could only absolve a beneficiary from being assessed on a present entitlement amount if the disclaimer was made prior end of the income year in which the present entitlement arose. The implication being that beneficiarys needs to make a disclaimer prior to the end of the income year to avoid being assessed on a present entitlement in their favour that income year. The somewhat odd outcome here is the possibility that a beneficiary can make an effective retrospective disclaimer for trust law purposes, but not for tax law purposes.