2012 SOUTH AUSTRALIAN TAX INTENSIVE

Transcription

1 2012 SOUTH AUSTRALIAN TAX INTENSIVE Case Studies and solutions Written by: Ian Snook, CTA Director William Buck Presented by: Ian Snook, CTA Director William Buck SA Division 1-2 November 2012 Novotel Barossa Valley Resort Ian Snook, William Buck 2012 Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2 CONTENTS 1 Background Question Question Question Question Question Question Question Question Question Question Question Question Answers Answer question Answer question Answer question Answer question Answer question Answer question Answer question Answer question Answer question Answer question Answer question Answer question Ian Snook, William Buck

3 1 Background In 2000 Sam Fusilli and his wife Rosa acquire a pasta manufacturing business from their paisano (Italian for friend ). A discretionary trust, the Fusilli Family Trust was established for this purpose, with a newly incorporated proprietary limited company, Al Dente Pty Ltd, as the trustee. Sam was appointed as the sole director of Al Dente Pty Ltd. The definition of income contained in the Trust Deed is the greater of: a. Section 95 income less imputation credits; and b. the sum of Net Accounting Income (which in turn is defined as the net profit in accordance with specified accounting policies which allow for the ability to re-classify receipts and payments as income or capital) plus Capital Gains. The Trust Deed also allows for the ability to stream income and capital gains. The purchase price for the business of $500,000 has allocated in the contract as: Goodwill $200,000 Equipment $200,000 Stock $100,000 The purchase price was funded by a $400, year bank loan (secured over their main residence held in Rosa s name) and $100,000 of savings. The business has been profitable over the years. More equipment has been acquired through a combination of bank loans and cash generated from the profits. Some business debt has been repaid. Distributions have been made to Sam and Rosa and their three children (especially in years when they were studying at University) such that the family income has been taxed with a marginal rate in the third highest tax bracket (i.e. 30% excluding medicare levy) but in some years some income has been taxed in the second highest bracket (i.e. 37%). The children are now independent and will no longer receive distributions. In recent years Sam and Rosa s drawings have been approximately $160,000 combined p.a. (including PAYG instalments of $20,000 each). Sam visits his long standing and trusted accountant, Mario Fantozzi in early June The business has had a superb year (notwithstanding the GFC!) and the profit for the year is estimated at $ m which has been used roughly as follows: Drawings for Sam and Rosa: $160,000 Increase in working capital (mostly stock): $500,000 Debt deduction on equipment finance $340,000 Increase in bank account $500,000 Ian Snook, William Buck

4 Mario recommends that a corporate beneficiary be established and Capaletti Pty Ltd is incorporated on 25 June On 28 June 2012 Sam as the sole director of Al Dente Pty Ltd resolved to distribute the income of the trust for the year ended 30 June 2012 as follows: Sam first $80,000 Rosa the next $80,000 Capaletti Pty Ltd the balance 1.1 Question 1 Mario tells Sam that he will prepare the TFN application for Capaletti Pty Ltd in July 2012 when he is less busy. Advise on the implications of this course of action. 1.2 Question 2 While playing cards at the local coffee shop one night Sam is told by his amico (a different Italian word for friend!) Nino that Nino had all sorts of trouble a few years ago when the ATO audited his trust s tax return and denied deductions for certain business expenditure. Sam starts to worry about $100,000 of travel expenses. Assume the Fusilli Family Trust s profit is $1.6m. Part 1: Comment on the resolution to distribute the balance to Capaletti Pty Ltd should the ATO deny the $100,000 of travel expenses as deductions. Part 2: Instead assume that the definition of trust income is income according to ordinary concepts (i.e. $1.6m) and ATO denies $100,000 of expenses as deductions. For the remaining questions ignore Question Question 3 Sam visits Mario in September 2012 to commence the preparation of the 2011/12 financial statements and tax returns for the trust and Capaletti Pty Ltd. Mario has a very busy practice and is generally short staffed. Mario finally completes the financial statements and tax returns at the end of April 2013 just before the 15 May 2013 deadlines for the trust and company. The financial statements for the trust show an accounting profit of $1.6m and there are no tax adjustments to reconcile to the net (tax) income. Mario is aware of PSLA 2010/4 Ian Snook, William Buck

5 Advise Sam on the alternatives for dealing with the UPE owing to Capaletti Pty Ltd, including the key terms of any relevant documentation and the key dates for actions. 1.4 Question 4 Mario has (very proactively!) modelled the financial implications of the trust making similar profits and similar profit distributions for the 2013 and 2014 financial years assuming: that an Option 1 7 year interest only loan is to be put into place in respect of each UPE, the benchmark interest rate remains at 7.05% a 15 May lodgment day for each year s tax returns. Part 1: Model/calculate the yearly payments (dates and amounts) in respect of each UPE. Use the format provided (print on A3 if possible). Part 2: Comment on the tax implications for the trust and company in respect of the interest payments 1.5 Question 5 Sam predicts that he will have further capital expenditure requirements in the next few years ($500,000 each year on average) that he will initially finance with debt but will use business profits to repay the debt (remember that the trust already has debt). Mario understands that there is an Option 3 in the PSLA but is sure that there must be other alternatives available. Advise Sam on how he may like to structure the acquisition of the equipment. 1.6 Question 6 Sam s son Anthony needs $100,000 for a new business venture in November 2012 and after reassurance from Mario that it will be all ok a loan is made from the trust. Part 1: Consider the implications if the loan is made to either: Anthony (personally) A trust set up for Anthony A company in which Anthony is a shareholder Part 2: Consider the implications if instead the UPE is treated as a Division 7A loan (instead of a sub/trust investment arrangement) Ian Snook, William Buck

6 1.7 Question 7 Joey Peroni is Sam s paesano (still another Italian word for friend). Joey has successfully run for Parliament and in a dramatic turn of events has been promoted to the position of State Treasurer. Joey s first act as Treasurer is to abolish non-realty stamp duty. On the back of the abolition Mario has recommended to Sam that the business be rolled over from the trust into a company. Assume that the balance sheet of the trust immediately before the rollover is as follows: Book Tax Market Cash $800,000 $800,000 $800,000 Accounts Receivable $600,000 $600,000 $550,000 Stock $400,000 $400,000 $350,000 Equipment (WDV) $2,500,000 $2,000,000 $2,200,000 Goodwill $200,000 $200,000 $5,000,000 Accounts Payable ($400,000) ($400,000) ($400,000) Bank Loans ($1,000,000) ($1,000,000) ($1,000,000) UPE Capaletti Pty Ltd ($3,000,000) ($3,000,000) ($3,000,000) UPE Sam ($49,995) ($49,995) ($49,995) UPE - Rosa ($49,995) ($49,995) ($49,995) Net Assets $10 $4,400,010 Part 1: Are the UPEs liabilities for the purposes of purposes of Subdivision 122-A? Part 2: On the assumption that they are liabilities, broadly discuss the operation of the rollover. Part 3: On the assumption that they are not liabilities, broadly discuss: the operation of the rollover the operation of the rollover if the trust first borrows from the bank to pay out the UPEs. For the remaining questions ignore Question 7. Ian Snook, William Buck

7 1.8 Question 8 Assume that the business structure is a unit trust, all of the units in which are owned by a private company. Nothing was done in respect of the UPE owing from the unit trust to the company. Consider the implications. For the remaining questions ignore Question Question 9 Assume that the business structure is a unit trust, all of the units in which are owned by the Fusilli Family Trust. On the advice of Mario, nothing was done in respect of the UPE between the unit trust and the Fusilli Family Trust ( because PSLA is only relevant in respect of a UPE to a company ). Consider the implications. For the remaining questions ignore Question Question 10 In early May 2020 funds ($1.008m) representing the outstanding June 2012 UPE are paid by the trust to Capaletti Pty Ltd and shortly thereafter the company pays a fully franked dividend of $1m to the shareholders of the company, namely: The Fusilli Family Trust (999 ordinary shares) $999,000 is paid into the trust s bank account Sam and Rosa (1 ordinary share held jointly) $1,000 jointly is paid into their personal bank account In June 2020 the trust then resolves to distribute all of its income (the business profit for the 2019/20 financial year and the dividend from Capaletti) as follows: Sam $80,000 Rosa $80,000 Capaletti the balance Part 1: Comment on the implications. Part 2: Would the implications be any different if instead the trust distributed to a newly incorporated company, Spirali Pty Ltd? Ian Snook, William Buck

8 Part 3: Would the implications be any different if instead: the 999 ordinary shares in Capaletti were held by the Fusilli Family Trust No. 2 the $999,000 dividend was paid into the No. 2 trust s bank account the trustee(s) of the No. 2 trust resolved to distribute all of the income to the Fusilli Family Trust and $999,000 was paid into the Fusilli Family Trust s bank account Question 11 The trust sells the business in July 2020 and makes a capital gain on the sale of the goodwill of $2,000,000 (pre discount). For the 2020/21 financial year the trust s profit and loss statement as as follows: Capital Gain (pre discount) $5,000,000 Dividend from Capaletti (fully franked) $1,000,000 Interest Income (from investing sale proceeds) $200,000 Net Business Income $50,000 Interest Expense on UPEs owing to Capaletti ($500,000) Net Profit $5,750,000 The trustee resolves in its distribution resolution to stream 50% of the capital gain to each of Sam and Rosa and to distribute the balance to Capaletti. Part 1: Calculate taxable amounts of trust distributions for each beneficiary and the taxable income and tax payable for Capaletti.. Part 2: Assume instead that the balance was distributed to a newly incorporated company beneficiary. Comment on any other tax implications for the company beneficiary. Ian Snook, William Buck

9 1.12 Question 12 Sam s compare (Italian for godfather) Vito Corleone has similarly structured one of his businesses as a family trust (the Corleone Family Trust) with a corporate beneficiary (Sleeps with the Fishes Pty Ltd). Vito suggests that they establish a moneylending partnership whereby: their respective family trust s pay $1m of the UPEs to their respective corporate beneficiaries the corporate beneficiaries each contribute $1m as partnership capital the partnership makes loans to their related entities Immediately after undertaking the steps listed above the balance sheet of the partnership is as follows: Assets Loan Fusilli Family Trust $500,000 Loan Anthony Fusilli $250,000 Loan Corleone Operating Company Pty Ltd $350,000 Loan Corleone Family Trust $400,000 Cash at Bank $500,000 Total Assets $2,000,000 Equity Capital Capaletti Pty Ltd $1,000,000 Capital Sleeps with the Fishes Pty Ltd $1,000,000 Total Equity $2,000,000 Comment on the effectiveness of the strategy in light of Division 7A. Ian Snook, William Buck

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11 2 Answers 2.1 Answer question 1 Mario tells Sam that he will prepare the TFN application for Capaletti Pty Ltd in July 2012 when he is less busy. Advise on the implications of this course of action. Suggested Solution From 1 July 2010, under section of Schedule 1 of the Taxation Administration Act 1953 a trustee of a closely held trust which is not an excluded trust has a withholding obligation when: a. an eligible beneficiary becomes presently entitled to a share of the income of the trust; and b. the beneficiary has failed to quote their TFN to the trustee prior to the end of the income year There is a penalty under sections and if the trustee fails to withhold. As the Fusilli Family Trust is a discretionary trust it is a closely held trust even if it has made a family trust election. It is not an excluded trust. It is likely that the prior disclosures of Sam and Rosa s TFNs in the trust s 2010 will satisfy the TFN reporting to the ATO of their TFNs. Capaletti Pty Ltd has not quoted its TFN to Al Dente Pty Ltd by 30 June 2012 (because it hasn t been allotted one by that date). The withholding event occurs at the end of the income year, namely 30 June The amount to withhold is 46.5% multiplied by the beneficiary s share of the net income (i.e. taxable income) of the trust. The Explanatory Memorandum provides no guidance as to what to do if the net income cannot be calculated by the time that Al Dente Pty Ltd must remit the amount withheld. At the September 2012 meeting of the Trust Consultation Sub-group an administrative arrangement in respect of the trust TFN withholding tax obligations were agreed upon. Failure to withhold penalties will be remitted if: the trustee had requested the TFN from the beneficiary by 30 June 2012; a valid TFN was quoted to the trustee by 30 September 2012; and the TFN was included in the TFN report due on and submitted by 31 October 2012 The TFN withholding for closely held trusts guide has been updated accordingly. A similar concession will apply for the 2013 year Ian Snook, William Buck

12 2.2 Answer question 2 While playing cards at the local coffee shop one night Sam is told by his amico (a different Italian word for friend!) Nino that Nino had all sorts of trouble a few years ago when the ATO audited his trust s tax return and denied deductions for certain business expenditure. Sam starts to worry about $100,000 of travel expenses. Assume the Fusilli Family Trust s profit is $1.6m. Part 1: Comment on the resolution to distribute the balance to Capaletti Pty Ltd should the ATO deny the $100,000 of travel expenses as deductions. Part 2: Instead assume that the definition of trust income is income according to ordinary concepts (i.e. $1.6m) and ATO denies $100,000 of expenses as deductions. For the remaining questions ignore Question 2. Suggested Solution Taxation Determination TD 2012/22 was released by the Commissioner on 24 October The determination provides the Commissioner s view that to determine the share of net income (taxable income) of a trust estate to be included in a beneficiary s assessable income under paragraph 97(1)(a) of the Income Tax Act 1936 the beneficiary must: (a) calculate how much of the income of the trust estate they are presently entitled to, as a percentage share of that income; and (b) apply that percentage to the net income of the trust estate. Income of the trust estate is the distributable trust income determined in accordance with trust law principles as modified by the trust deed (Bamford). Part 1: Here there is what is commonly known as an income equalisation clause, namely, the distributable income of the Fusilli Family Trust is defined in the trust deed as being equal to the trust s net income (taxable income). The Commissioner would appear to accept that outgoings that are not deductible will be treated as chargeable against capital. Both the income of the trust estate and net income are and always were $1.7m (i.e. $1.6m accounting profit plus $100,000 non-deductible expenses). Refer to example 10 in TD 2012/22. Accordingly applying the above formula provides the following amounts to be Beneficiary Share of income Share of income of trust % applied to net income of trust estate estate as a % EQUALS amount included in assessable income of beneficiary Sam $80, % (being $80,000/$1.7m) $80,000 (being % x $1.7m) Ian Snook, William Buck

13 Rosa $80, % (being $80,000/$1.7m) $80,000 (being % x $1.7m) Capaletti Pty Ltd $1,540,000 (being the balance of $1.7m less the distributions to Sam & Rosa) % (being $1.54m/$1.7m) $1,540,000 (being % x $1.7m) Query what happens if there are not sufficient funds available if all of Sam, Rosa and Capaletti demand their entitlements which total $1.7m. Part 2: Here the income of the trust estate is income according to ordinary concepts and assuming they were business related (albeit non-deductible) then the trustee was correct in calculating the income of the trust estate as $1.6m (i.e. it was properly chargeable against income for trust law purposes in working out the income of the trust estate ). See example 9 of TD 2012/22. Accordingly applying the above formula provides the following amounts to be Beneficiary Share of income Share of income of trust % applied to net income of trust estate estate as a % EQUALS amount included in assessable income of beneficiary Sam $80,000 5% (being $80,000/$1.6m) $85,000 (being 5% x $1.7m) Rosa $80,000 5% (being $80,000/$1.6m) $85,000 (being 5% x $1.7m) Capaletti Pty Ltd $1,440,000 (being the balance of $1.6m less the distributions to Sam & Rosa) 90% (being $1.44m/$1.6m) $1,530,000 (being 90% x $1.7m) Each beneficiary shares in a proportion of the net income arising from the non-deductible expense. Ian Snook, William Buck

14 Query whether the same outcome to Part 1 is achieved if the amount was incorrectly included as an accounting expense due to a book-keeping error i.e. the income of the trust estate was not calculated correctly. Can it not be argued that the correctly calculated income of the trust estate should have been $1.7m (and the $100,000 of private expenses should have been debited to Sam and Rosa s unpaid present entitlement accounts)? 2.3 Answer question 3 Sam visits Mario in September 2012 to commence the preparation of the 2011/12 financial statements and tax returns for the trust and Capaletti Pty Ltd. Mario has a very busy practice and is generally short staffed. Mario finally completes the financial statements and tax returns at the end of April 2013 just before the 15 May 2013 deadlines for the trust and company. The financial statements for the trust show an accounting profit of $1.6m and there are no tax adjustments to reconcile to the net (tax) income. Mario is aware of PSLA 2010/4 Advise Sam on the alternatives for dealing with the UPE owing to Capaletti Pty Ltd, including the key terms of any relevant documentation and the key dates for actions. Suggested Solution In order to be compliant with PSLA 2010/4 there are four broad alternatives: 1. Pay out the UPE to Capaletti Pty Ltd As the Commissioner considers that the UPE will be treated as a loan within the extended definition of the word in 109D(3) made on the lodgment day (the later of the due date and actual date of lodgment) of the Fusilli Family Trust s 2012 tax return (15 May 2013) by Capaletti Pty Ltd to the trust (i.e. in the 2012/13 financial year), the UPE must be paid to Capaletti Pty Ltd by the lodgment day of its 2013 tax return (15 May 2014) See paragraphs 97 and 98 of PSLA 2010/4 (especially the last sentence of paragraph 98 which in respect of a June 2011 UPE where the Commissioner notes that a payment by lodgment day of the company s 2012 tax return will avoid it being treated as an assessable dividend.) 2. Pay out the UPE to Capaletti Pty Ltd and have Capaletti Pty Ltd loan an equivalent amount back to Fusilli Family Trust This is a Section 2 loan. The loan may be made by way of an express agreement (either via set-off or a cash transaction (see paragraph 18 of PSLA 2010/4)), an implied agreement (see paragraph 19) or by the trustee exercising power under the trust deed (see paragraph 24) Presumably where the loan is not made under a written loan agreement (e.g. the accounts of both the trust and company show the amount as a loan ), the loan will be taken to be made on Ian Snook, William Buck

15 30 June 2012 (see second and third dot points in paragraph 28). A complying section 109N loan agreement will need to be entered into by lodgment day of Capaletti Pty Ltd s 2012 tax return (15 May 2013). If the loan is made under a written loan agreement, the loan will be made on the date the amount was loaned to the trust under the terms of the loan agreement (see first dot point in paragraph 28). This would presumably need to be before the lodgment day of Capaletti Pty Ltd s 2012 tax return (i.e. before 15 May 2013) else a Section 3 loan is taken to be made. Presumably the loan would be made under a written loan agreement that complies with paragraph 109N(1)(a) else further written documentation will be required. To comply with paragraph 109N(1)(a) TD 2008/8 states that the entire agreement between the parties must be in writing including: The names of the parties The loan terms (the amount of the loan, the date the loan amount is drawn, the requirement to repay the loan amount, the period of the loan and the interest rate payable) That the parties named have agreed to the terms; and When the written agreement was made, for example the date it was signed or executed. If the formal written loan agreement does not contain all the essential terms then paragraph 109N(1)(a) will still be satisfied provided there is supporting written evidence of the remaining elements of the agreement between the parties. The first annual minimum loan repayment will need to be made by 30 June in the year after the year in which the loan is made (either 30 June 2013 if the loan is not made under a written loan agreement or 30 June 2014 if the loan is made under a written loan agreement between 1 July 2012 and 14 May 2013) 3. Leave the amount unpaid and treat it as a Division 7A loan This is a Section 3 loan. The Section 3 loan will be taken to be made on the lodgment day of the Fusilli Family Trust s 2012 tax return (15 May 2013) (paragraph 97) As the Section 3 loan is made during the 2012/13 financial year, a complying section 109N agreement will need to be made by lodgment day of Capaletti Pty Ltd s 2013 tax return (15 May 2014) See comments regarding paragraph 109N(1)(a) and TD 2008/8 regarding requirements as to the contents of the loan agreement The first annual minimum loan repayment will need to be made by 30 June Leave the amount unpaid and place the funds representing the UPE on sub-trust for the sole benefit of Capaletti Pty Ltd Ian Snook, William Buck

16 Can self-assess the investment terms or use one of the three safe harbours (Option 1: 7 year interest only loan; Option 2: 10 year interest only loan Option 3: acquisition of a specific investment) Investment arrangements must be put in place by lodgment day of the Fusilli Family Trust s 2012 tax return (15 May 2013) The terms of the investment must (see paragraph 65 for Option 1 and paragraph 77 for Option 2): Include an obligation for main trust to pay the interest to the sub-trust Contain the details of the 7/10 year interest only loan, including the amount of the UPE on loan, the start and end dates of the loan Include an obligation to repay the principal amount back to the sub-trust no later than the end of the 7/10 year loan Calculation of interest for Option 1 and Option 2 is prescribed in paragraphs 63 and 75 respectively First years interest (from date loan put into place until 30 June 2013) to be recorded in the accounts of the Fusilli Family Trust and Capaletti Pty Ltd but must be physically paid to Capaletti Pty Ltd by the lodgment day of the Fusilli Family Trust s 2013 tax return (see paragraphs 66 and 78) See Question 5 for comments regarding Option Answer question 4 Mario has (very proactively!) modelled the financial implications of the trust making similar profits and similar profit distributions for the 2013 and 2014 financial years assuming: that an Option 1 7 year interest only loan is to be put into place in respect of each UPE, the benchmark interest rate remains at 7.05% a 15 May lodgment day for each year s tax returns. Part 1: Model/calculate the yearly payments (dates and amounts) in respect of each UPE. Use the format provided (print on A3 if possible). Part 2: Comment on the tax implications for the trust and company in respect of the interest payments Suggested Solution Part 1 See attached Ian Snook, William Buck

17 The purpose of this exercise was to demonstrate that modelling of the estimated future payments can be as simple or as complex as you wish. A simple one could just model yearly UPEs of $1.08m being that part of the regular business profits distributed to Capaletti Pty Ltd (i.e. $1.44m) less the company tax applicable (i.e. 30% being $432,000). Such a model omits the fact that the regular business profits will then be reduced by the UPE interest (and so future UPE amounts are reducing); and that interest needs to be paid annually. A more complex model may include: a growth rate to be applied to the business profit payments of PAYG instalments If funds representing the UPE interest payments are used to pay Capaletti Pty Ltd s PAYG instalments (with the remaining amount sourced from the UPEs) then it will probably be from May 2019 (almost 7 years after the end of the first year that the company was used) that the interest payments will exceed the annual PAYG instalments (with the result that funds will build up in the company from that time onwards). Accordingly it is only from that point onwards that the exercise becomes more than mechanical and results in funds that would otherwise be able to be retained in the trust having to remain in the company. Part 2 The interest paid by the main trust (Fusilli Family Trust) to the sub-trust is assessable to Capaletti Pty Ltd (see paragraphs 67 and 79 of PSLA 2010/4) The interest paid is an expense deductible to the main trust (Fusilli Family Trust) as long as the Fusilli Family Trust satisfies the general deduction provisions in section 8-1 of the ITAA 1997 (see paragraphs 68 and 80 of PSLA 2010/4). In TR 2005/12 the Commissioner provides his views as to the deductibility of interest borrowed in connection with the payment of distributions. Although not necessarily on point (given that Fusilli has not borrowed funds to pay out the distribution, however the main trust must have borrowed the 7/10 year interest only loan from the sub-trust) paragraph 21 of that ruling reproduced below gives some understanding of the Commissioner s view: 21. It will not always be a simple matter to determine which of the two possible outcomes (deductible/non-deductible) arises in any particular case. Ultimately this question can only be answered by determining the objective purpose of the trustee in borrowing the funds. To the extent that the objective purpose of the trustee was to replace an amount that had previously been provided to the trustee by, or on behalf of, a beneficiary of the trust estate, and had previously been used in an assessable income earning activity, or business, carried on by the trustee in the relevant capacity, then the principle set out in Roberts & Smith will apply. On the other hand, where the borrowing is simply to discharge an obligation to pay a monetary distribution to a beneficiary, then it is likely that interest incurred on the borrowing will not be deductible. Hayden's case is illustrative of this proposition. (emphasis added) Here the funds representing the UPE are no doubt invested in the business of the Fusilli Family Trust and accordingly the interest ought to be deductible. The case may be different if instead Fusilli has acquired private assets or made loans to associates at say the benchmark interest (7.05%) while the UPE is on a 10 year interest only loan (10%). Ian Snook, William Buck

18 2.5 Answer question 5 Sam predicts that he will have further capital expenditure requirements in the next few years ($500,000 each year on average) that he will initially finance with debt but will use business profits to repay the debt (remember that the trust already has debt). Mario understands that there is an Option 3 in the PSLA but is sure that there must be other alternatives available. Advise Sam on how he may like to structure the acquisition of the equipment. Suggested Solution Safe harbour Option 3 allows the trustee to invest on a sub-trust the funds representing the UPE in a specific investment see paragraphs 86 to 94 of PSLA 2010/4. The acquisition of depreciating assets is permitted if leased at arm s length rates (paragraph 87), which presumably would be the case so that a deduction for depreciation is allowable. The sub-trust must prepare its own financial statements and tax return (paragraph 90) and presumably register for GST (so as to claim the input tax credit on the acquisition) and prepared periodic GST returns (remitting GST charged on lease payments) The net income from the leasing of the depreciating assets must be paid annually to the private company by the lodgment day of the sub-trust s tax return for the relevant year (paragraph 92). Accordingly this amount will not be available for continued use by the sub-trust. It is likely that in the early years that the sum of the interest expense (on the borrowings) and the depreciation will exceed the leasing income such that a loss is made and so Option 3 may be tax ineffective in the early years though the losses should be available to offset net rental income in later years (as presumably such a trust is a fixed trust for the purposes of the Trust Loss provisions and the 50% stake test should be applicable). The PSLA makes no comments regarding any adverse consequences if there is no net income in a particular year and so presumably this is not an issue. Presumably acquiring an asset with debt satisfies the Option 3 requirements as there is no mention of this in the PSLA (i.e. are the funds representing the UPE invested in a specific investment when instead of an outright purchase of that investment those funds are used to make loan repayments?). Alternatively Capaletti Pty Ltd could acquire the depreciating assets with borrowed funds and then the Fusilli Family Trust could make the following payments to Capaletti Pty Ltd: lease payments interest payments on the UPEs current year distributions; and Part payments on previous year UPEs so that Capaletti Pty Ltd has sufficient funds to make its loan repayments. Ian Snook, William Buck

19 There should also be no issue with any net rental loss in the earlier years as Capaletti Pty Ltd s assessable income will also include interest payments on the UPEs and current year income distributions from the Fusilli Trust. In the later years the net rental can be used to repay the borrowings (unlike with the sub-trust alternative which must be paid from the asset owner/sub-trust to the private company beneficiary). There are no Division 7A use of asset/payment issues under the otherwise deductible exclusion in subsection 109CA(5). Capaletti Pty Ltd will have to register for GST (like with the sub-trust alternative) 2.6 Answer question 6 Sam s son Anthony needs $100,000 for a new business venture in November 2012 and after reassurance from Mario that it will be all ok a loan is made from the trust. Part 1: Consider the implications if the loan is made to either: Anthony (personally) A trust set up for Anthony A company in which Anthony is a shareholder Part 2: Consider the implications if instead the UPE is treated as a Division 7A loan (instead of a sub/trust investment arrangement) Suggested Solution NB: The identity of the shareholder(s) of Capaletti Pty Ltd has purposely not established in the Case Study. Part1: A UPE held on a sub-trust is still treated as an unpaid present entitlement for the purposes of Subdivision EA (see paragraphs 106 and 107 of PSLA 2010/4). Accordingly it is presumed that Anthony will be an associate (as defined in section 318) of a shareholder of Capaletti Pty Ltd. If a shareholder of Capaletti is Sam or Rosa then Anthony is their associate as he is a relative (paragraph 318(1)(a) of the ITAA 1936 and definition of relative in section of the ITAA 1997). If a shareholder of Capaletti Pty Ltd is a family trust (either the Fusilli Family Trust or a different family trust for the benefit of Sam s family) and Anthony is a potential beneficiary of that trust then he will be an associate of the shareholder trust under paragraph 318(3)(a) as he benefits under that trust (as under paragraph 318(6)(a) an entity benefits under a trust if the entity is capable of benefiting). Likewise a trust set up for Anthony s benefit will also be an associate of a shareholder of Capaletti under either paragraph 318(1)(d) (where a the shareholder(s) is an individual that is his relative) or paragraph 318(3)(b) (where the shareholder is a trust). Ian Snook, William Buck

20 Accordingly the loan from the Fusilli Family Trust to either Anthony or Anthony s trust must be put under a section 109N complying loan for no assessable dividend to occur (see subsection 109XB(1)). If instead the loan from Fusilli Family Trust was made to a company in which Anthony is a shareholder, then (ignoring the possible application of the interposed entity provisions in Subdivision E) there will be no assessable dividend in respect of the loan nor is there a requirement to place the loan on a complying section 109N loan (as a company to company loan does not give rise to an assessable dividend under section 109K and so there is no assessable dividend under subsection 109XB(1)). In respect of the interposed entity provisions if the company used the money to acquire business assets (rather than to make a further loan) then it is unlikely that the interposed entity provisions would apply (see the reasonable person requirement in paragraph 109T(1)(b)). Part 2: If instead the UPE owing from the Fusilli Family Trust to Capaletti Pty Ltd is treated as a Section Three loan then Subdivision EA will not apply to the loan from the Fusilli Family Trust to any shareholder or any associate of a shareholder of Capaletti Pty Ltd (see paragraphs 101 to 105 of PSLA 2010/4) 2.7 Answer question 7 Joey Peroni is Sam s paesano (still another Italian word for friend). Joey has successfully run for Parliament and in a dramatic turn of events has been promoted to the position of State Treasurer. Joey s first act as Treasurer is to abolish non-realty stamp duty. On the back of the abolition Mario has recommended to Sam that the business be rolled over from the trust into a company. Assume that the balance sheet of the trust immediately before the rollover is as follows: Book Tax Market Cash $800,000 $800,000 $800,000 Accounts Receivable $600,000 $600,000 $550,000 Stock $400,000 $400,000 $350,000 Equipment (WDV) $2,500,000 $2,000,000 $2,200,000 Goodwill $200,000 $200,000 $5,000,000 Accounts Payable ($400,000) ($400,000) ($400,000) Bank Loans ($1,000,000) ($1,000,000) ($1,000,000) UPE Capaletti Pty ($3,000,000) ($3,000,000) ($3,000,000) Ian Snook, William Buck

21 Ltd UPE Sam ($49,995) ($49,995) ($49,995) UPE - Rosa ($49,995) ($49,995) ($49,995) Net Assets $10 $4,400,010 Part 1: Are the UPEs liabilities for the purposes of purposes of Subdivision 122-A? Part 2: On the assumption that they are liabilities, broadly discuss the operation of the rollover. Part 3: On the assumption that they are not liabilities, broadly discuss: the operation of the rollover the operation of the rollover if the trust first borrows from the bank to pay out the UPEs. For the remaining questions ignore Question 7. Suggested Solution Broad discussion of the Rollover provisions The business can be rolled over from the trust to the company by virtue of the rollover in Subdivision 122-A: Disposal or creation of assets by an individual or trustee to a wholly-owned company. The rollover is conditional and various rules have to be complied with. For a disposal of all of the assets of a business the consideration received must only be nonredeemable shares in the newly created company (say New Co) and the company undertaking to discharge one or more liabilities in respect of the asset or assets of the business. The market value of the shares received must be substantially the same as the market value of the assets disposed of less the liabilities taken over by New Co. All of the shares in New Co must be owned by Al Dente Pty Ltd as trustee for the Fusilli Family Trust just after the assets are transferred. The trust must choose that the rollover applies. As all of the assets of the business are post CGT assets, the amount of the liabilities transferred/assumed cannot exceed the sum of the market value of the precluded assets and the cost bases of the other assets. Accordingly the liabilities cannot exceed $4,150,000 calculated as follows: Asset $ amount Precluded Assets Market Values Ian Snook, William Buck

22 Trading Stock $350,000 Equipment $2,200,000 Other Assets Cost Bases Cash $800,000 Accounts Receivable $600,000 Goodwill $200,000 TOTAL $4,150,000 Part 1: Liabilities in Subdivision 122-A is not a defined term. The word liabilities was considered recently in [2010] AATA 455 re Taxpayer and Federal Commissioner of Taxation 79 ATR 510 where Deputy President Hack allowed commissioner of a real estate agent to be treated as a liability for the purposes of the Maximum Net Asset Value Test in the Small Business CGT Concessions. The Deputy President said after considering numerous authorities at 521: What I draw from these authorities is that, in the absence of words of limitation or expansion, the width of the expression "liabilities" is determined, at least in part, by reference to the evident purpose of the provision to be construed and that, without more, it can be given a wide scope if the purpose of the provision requires that. The present is such a case. It would make no sense to exclude liabilities that are inextricably connected to the sale where it is the disposal of the asset that creates the CGT event and determines the market value of the asset which in turn allows the extent of the capital gain to be ascertained. That connection provides "the foundation for the liability or obligation" spoken of by Gaudron J in Crimmins.(emphasis added). Ron Jorgensen in his paper Unpaid Present Entitlements The Red Wine Experiment says that: it is unclear how the transferred UPE liability owed to the private company beneficiary is treated. A private company cannot have a UPE. At paragraph 34 of TR 2010/3 the Commissioner states that: When a beneficiary is presently entitled to an amount from a trust estate, it has an equitable right to that amount. That is, the beneficiary has rights in equity and not, without more, as a result of any debtor-creditor relationship. In Commissioner of Inland Revenue v. Ward 69 ATC 6050 at 6071 McCarthy J held that: it is misleading to speak of debtor-creditor relationship. The rights of the beneficiaries here do not arise out of debt or contract. They arise out of the trusts created by the deed, and the beneficiaries are entitled to invoke the powers of the Court by reason of a new title "consisting of the exercise of the trustees' discretion in the infant's favour". Ian Snook, William Buck

23 On the assumption that the UPE is a liability the liability must be in respect of the assets of the business. Subsection (2) provides that a liability incurred for the purposes of a business that is not a liability in respect of a specific asset or assets is taken to be a liability in respect of all the assets of the business. An example of a bank overdraft is given. Is the UPE incurred for the purposes of a business? The UPE is created (incurred?) once the trustee exercises its discretion to distribute income. It would appear that both the concept of liability and the in respect of requirement could well be problematic. Part 2: Assuming there can be an assignment of the UPEs the indebtedness taken over cannot exceed $4,150,000. The liabilities of the trust are bank loans and accounts payable of $1.4M which leaves a remaining amount that can be assumed of $2,750,000. Some of the UPEs remain in the trust and cannot be assigned. Part 3: It would seem that if the UPE is to be rolled over/assumed by and be a liability of New Co the benefit of the UPE would need to be made into a debt/liability. Again the liability must satisfy the in respect of requirement. For the rollover to be effective not all liabilities are required to be assumed so that the rollover can be effective with only partial assignment of liability or they can remain within the trust. If Capaletti Pty Ltd loaned $2.75m and Fusilli Family Trust paid $2.75m of the UPE via set off and the loan was then New Co undertook to discharge the liability would the exemption in section 109K for company to company loans apply? The loan was made by Capaletti Pty Ltd to Fusilli Family Trust and not to New Co; New Co has just undertaken to discharge it. However does this matter? Can it be interpreted that the loan from Capaletti Pty Ltd to Fusilli Family Trust has been repaid? Possibly more worryingly, could the loan from Capaletti Pty Ltd to Fusilli be forgiven such that there is an assessable dividend under section 109F? The definition of forgiven is as defined in the CDF provisions see section where a debt is forgiven if the debtor s (Fusilli) obligation to pay the debt is released or waived or is otherwise extinguished other than by repaying the debt in full. Is Fusilli s obligation to pay the debt released, waived or otherwise extinguished when New Co undertakes to discharge the liability to Capaletti Pty Ltd? Should the trust first borrow say $2.75m from the bank and discharge that part of the UPE owing to Capaletti Pty Ltd then assuming that this is a liability in respect of the business New Co can undertake to discharge that liability. Can Capaletti Pty Ltd which has now received $2.75m loan that amount to New Co as a section 109K company to company loan so that New Co has the funds to discharge the bank loan? Ian Snook, William Buck

24 2.8 Answer question 8 Assume that the business structure is a unit trust, all of the units in which are owned by a private company. Nothing was done in respect of the UPE owing from the unit trust to the company. Consider the implications. For the remaining questions ignore Question 8. Suggested Solution ATOID 2012/74 was released on 30 August That ATOID dealt with: a unit trust with multiple unitholders two unitholders are related to each other and collectively own 36% of the units the remaining unitholders being unrelated to each other Some unitholders are private companies Under the trust deed distribution of income is made on a strictly proportional basis to unitholders based on units held All unitholders agreed that the funds held by the unit trust representing UPEs would be used to retire trust debt. The ATO concluded that the UPEs did not constitute a loan for Division 7A purposes. Each unitholder was entitled to receive a return commensurate with the funds that they allowed the trustee to use. Each unitholder agreed that the funds they were proportionately entitled to can be used to reduce the debts of the trust and this use is proportionately for the benefit of each unitholder, Accordingly the unitholders have not provided or are not providing any pecuniary aid or favour to the trustee or any other taxpayer. Is there any reason why the same principle shouldn t apply here? The funds presenting the UPE(s) owed to the private company have been used by the unit trust to either pay trust debt or acquire further assets, both for the benefit of the sole unitholder company. As an aside there would appear to be a worrying inference regarding the threshold requirement to applying the Commissioner s views in TR 2010/3 to UPEs, namely that the trust must be part of the same family group as the private company. In the ATOID the family group requirement seems to be pushed to one side and instead the fact that there is a consensual agreement was all that was required to consider the Division 7A implications. 2.9 Answer question 9 Assume that the business structure is a unit trust, all of the units in which are owned by the Fusilli Family Trust. Ian Snook, William Buck

25 On the advice of Mario, nothing was done in respect of the UPE between the unit trust and the Fusilli Family Trust ( because PSLA is only relevant in respect of a UPE to a company ). Consider the implications. For the remaining questions ignore Question 9 Suggested Solution Examples 8 and 9 of PSLA 2010/4 are about UPEs in a chain of discretionary trusts and a corporate beneficiary and include a loan from the first trust to an associate of a shareholder of the corporate beneficiary. In question 9 there is no suggestion that the Unit Trust has made such a loan. This does not mean however that those examples are not relevant in this question. If the UPE owing by the Fusilli Family Trust to Capaletti Pty Ltd is put on a sub-trust then Subdivision EA is still live and accordingly the UPE owing by the Unit Trust to the Fusilli Trust will be treated as a loan from the Fusilli Family Trust to the Unit Trust (due to the Commissioner s views in TR 2010/3). This will be a loan to an associate due to the definition of associate in section 318 (as a shareholder/associate of shareholder of Capaletti Pty Ltd can benefit indirectly in the Unit Trust). Query whether ATOID 2012/74 can assist in treating the UPE owing to the unit trust s unitholder (i.e. the Fusilli Family Trust) not to be a loan. If the UPE owing by the Fusilli Family Trust to Capaletti Pty Ltd is treated as a Section 3 loan then there is no application of Subdivision EA in respect of the UPE from the Unit Trust or in respect of loans from either the unit trust or the Fusilli Family Trust to shareholders/associates of shareholders of Capaletti Pty Ltd Answer question 10 In early May 2020 funds ($1.008m) representing the outstanding June 2012 UPE are paid by the trust to Capaletti Pty Ltd and shortly thereafter the company pays a fully franked dividend of $1m to the shareholders of the company, namely: The Fusilli Family Trust (999 ordinary shares) $999,000 is paid into the trust s bank account Sam and Rosa (1 ordinary share held jointly) $1,000 jointly is paid into their personal bank account In June 2020 the trust then resolves to distribute all of its income (the business profit for the 2019/20 financial year and the dividend from Capaletti) as follows: Sam $80,000 Rosa $80,000 Capaletti the balance Ian Snook, William Buck

26 Part 1: Comment on the implications. Part 2: Would the implications be any different if instead the trust distributed to a newly incorporated company, Spirali Pty Ltd? Part 3: Would the implications be any different if instead: the 999 ordinary shares in Capaletti were held by the Fusilli Family Trust No. 2 the $999,000 dividend was paid into the No. 2 trust s bank account the trustee(s) of the No. 2 trust resolved to distribute all of the income to the Fusilli Family Trust and $999,000 was paid into the Fusilli Family Trust s bank account. Suggested Solution No separate solutions are provided and what follows are further questions to pose! In each of the variations the UPE, having been put on a sub-trust with a 7 year interest only loan back to the main trust, is paid to the corporate beneficiary in line with the requirements in PSLA 2010/4. What then precludes the corporate beneficiary from paying a full franked dividend to its shareholders the majority to Fusilli Family Trust (in Part 1) or the majority to the Fusilli Family Trust No. 2 (in Part 3)? Further, what then precludes the respective trust shareholders from again resolving to distribute to Capaletti Pty Ltd (in Part 1) or to Spirali Pty Ltd (in Part 2)? Who is the taxpayer(s) that the Commissioner will try to assess under Part IVA for the non-inclusion of income? What is the alternate postulate? What might be the result after the (still) yet to be seen Part IVA changes? Although the additional step in Part 3 being the trust distribution from No.2 trust to the No. 1 trust (where presumably the funds are needed for business purposes) appears to be more contrived is this fatal in a Part IVA attack? 2.11 Answer question 11 The trust sells the business in July 2020 and makes a capital gain on the sale of the goodwill of $2,000,000 (pre discount). For the 2020/21 financial year the trust s profit and loss statement is as follows: Capital Gain (pre discount) $5,000,000 Dividend from Capaletti (fully franked) $1,000,000 Ian Snook, William Buck

27 Interest Income (from investing sale proceeds) $200,000 Net Business Income $50,000 Interest Expense on UPEs owing to Capaletti ($500,000) Net Profit $5,750,000 The trustee resolves in its distribution resolution to stream 50% of the capital gain to each of Sam and Rosa and to distribute the balance to Capaletti Pty Ltd. Part 1: Calculate taxable amounts of trust distributions for each beneficiary and the taxable income and tax payable for Capaletti. Part 2: Assume instead that the balance was distributed to a newly incorporated company beneficiary. Comment on any other tax implications for the company beneficiary. Suggested Solution Part 1 The net (tax) income of the Fusilli Family Trust for 2020/21 is calculated as follows: Net Capital Gain $2,500,000 Dividend from Capaletti (fully franked) $1,000,000 Franking Credits $428,571 Interest Income (from investing sale proceeds) $200,000 Net Business Income $50,000 Interest Expense on UPEs owing to Capaletti ($500,000) Net Income $3,678,571 It is presumed that the interest expense is not deductions directly relevant to the dividend. As the net income disregarding the franking credits (i.e. $3,678,571 less $428,571 = $3.25m) is less than the sum of the net capital gain and the franked dividends (i.e. $2.5m plus $1m = $3.5m) then the amount of the trust distributions attributable to both the franked dividends and the net capital gain is proportionally reduced under subsections (3) and (3) respectively. The calculations are as follows: Ian Snook, William Buck