Division 7A redefined – Navigating unpaid present entitlements post-Bendel decision

Last week’s unanimous Full Federal Court decision in Commissioner of Taxation v Bendel (“Bendel”) indicates that the Australian Tax Office’s (ATO) views since December 2009 about unpaid present entitlements (“UPEs”) should no longer be sustainable in the context of Division 7A.

While we wait for further announcements from the ATO or the Federal Government (regarding possible legislative change), we should be considering the potential implications sooner rather than later. Any potential course of action will require careful consideration of the particular circumstances. This bulletin outlines the key items that should be considered.

What did the court say in Bendel?

In a unanimous judgment, the Full Federal Court overturned the ATO’s long-standing view that a UPE is a loan for the purposes of Division 7A. Focussed on the words of the legislation, the Court found that a ‘loan’ for such purposes necessarily required a payment by the company and an obligation to repay.  The key decision is summarised at paragraph 93 of the judgement:

The Commissioner contended that Gleewin Investments had consented or acquiesced to Gleewin not paying the present entitlement by making a decision to refrain from calling for payment. However, the consensual arrangement relied upon by the Commissioner did not involve the payment of a sum by or at the direction of Gleewin Investments that was required to be repaid.

What does the Bendel decision mean for existing UPEs?

Pre-2023 UPEs are unlikely to be impacted significantly by this decision (however see our comments below). The critical current issue is the treatment of 2023 and 2024 UPEs which the ATO held were to be loans under Taxation Determination TD 2022/11 (“TD 2022/11”) (which applied from 1 July 2022).

With many trusts and companies finalising their accounts for 30 June 2024, taxpayers will now be in the uncertain position of having to determine how to account for their subsisting 2023 and 2024 UPEs: whether to treat them as loans for the purposes of Division 7A, and therefore put them on complying principal and interest loan terms consistently with the ATO’s (now erroneous) TD 2022/11, or to continue recognising them as UPEs.

The appropriate treatment of UPEs for Division 7A purposes will largely depend on the particular circumstances of the group, including consideration of historical transactions.

Under Bendel, it may now be possible to leave UPEs unpaid. However, taxpayers should carefully review their personal circumstances before making such a decision given Division 7A is not the only relevant legislation, especially in the context of distributions from trusts. In particular, if a UPE remains unpaid and not converted to a loan, this may have already given rise to a Subdivision EA or EB deemed dividend or may have consequences under section 100A. These considerations are outlined below in further detail.

Furthermore, as outlined in the decision such as Owies v JJE Nominees Pty Ltd [2022] VSCA 142, the treatment and repayment of UPEs requires consideration of more than just tax outcomes.

What is the ATO doing?

It is too early to know what action the ATO will take in light of the decision in the Full Federal Court. In its interim decision impact statement (“DIS”) (see here), released after the Administrative Appeals Tribunal decision, the ATO indicated that it would not change its views on the application of Division 7A to UPEs while the case was on appeal. With a unanimous (3-0) judgment by the Full Court, this position seems untenable, but the ATO is within its right to seek special leave to appeal to the High Court, which we understand must be done on or before 19 March 2025.

It is also very likely that the Government will seek to implement changes to introduce legislative remedies. To this end, an announced but unenacted measure from the previous Federal Government in the 2018‑19 Budget was to include UPEs in the scope of Division 7A.

What were the facts in Bendel?

The facts in Bendel were relatively simple. A discretionary trust resolved to distribute a large portion of its income for the 2013 to 2016 income years to a corporate beneficiary, totalling approximately $1.66m. The beneficiary did not call for the payment of the entitlement. Both the trust and corporate beneficiary were controlled by the same person. The trust also made a loan to an individual (Mr Bendel) for circa $1.8 million. Ordinarily this arrangement should have been caught by Subdivision EA of Division 7A (i.e. section 109XA(2) and section 109XB). For reasons unknown, the ATO did not seek to apply these provisions or issue an alternative assessment.

The ATO determined that the amount of the entitlement that remained unpaid at lodgment day (the earlier of the actual lodgment or the due date for lodgment of the company’s tax return) resulted in the corporate beneficiary having made a loan to the distributing trust in the following year, consistent with their Taxation Ruling TR 2010/3 (now withdrawn) and TD 2022/11. As the amounts were not put on complying principal and interest loan terms by lodgment day, the ATO determined that a deemed dividend arose for Division 7A purposes.

The taxpayer objected and appealed (and won) in the Administrative Appeals Tribunal on the basis that the UPEs did not give rise to loans within the meaning of subsection 109D(3) of the Income Tax Assessment Act 1936 (Cth) (“ITAA 36”). As outlined above, the taxpayer was successful in the appeal to the Full Federal Court.

What are the next steps in reviewing the outcome for a taxpayer?

Crucially, the first step in any analysis is to determine the status of existing UPEs. To simplify this, we believe it is prudent to consider UPEs in two categories. The first category are UPEs that are post- 1 July 2022. The second are UPEs that arose prior to that date (that may have been classified as loans in the books of account). For this latter category, it is noted that the decision in Bendel may hold that UPEs that are described as loans in the accounts may still continue to be UPEs. This includes previous sub-trust arrangements that were placed on Division 7A terms. From a legal perspective, it is possible that all of these arrangements may still qualify as being a UPE outstanding and not a loan for Division 7A purposes.

What about subdivision EA or EB?

While many credit the ATO’s 2009 view as bringing UPEs into Division 7A as a loan, the presence of a UPE owing to a corporate beneficiary could already have resulted in a deemed dividend under Subdivision EA or EB of Division 7A of the ITAA 36.

Under section 109XB, a deemed dividend can arise in certain circumstances involving the provision of a benefit (such as a loan, payment or forgiveness of a debt) by the trust to a shareholder (or associate) of a private company where there was a present entitlement owed to the company (or where the company was later made presently entitled to trust income). These can apply even through chains of trusts. A section 109XB dividend can occur in the year of the UPE and accordingly if a UPE is not converted to a loan, taxpayers may have adverse consequences arise under this provision.

After the release of the ATO’s view, many taxpayers converted their UPEs to loans, taking them outside the scope of Subdivision EA. If, as the Court found in Bendel, a UPE is not a loan but remains a present entitlement owed to the company, Subdivision EA or EB may become relevant once again as taxpayers decide not to convert the UPEs in this way. Due to the timing issue outlined above, it critical that the Subdivision EA and EB issues are considered as part of any decision to keep a UPE on foot as a UPE.

Can the ATO seek to apply section 100A or other provisions?

The ATO has already, in its interim DIS, put taxpayers on notice that it may seek to apply section 100A (or other provisions) to UPE arrangements it can no longer pursue under Division 7A.

Section 100A is an integrity provision that, broadly, can operate where a beneficiary’s entitlement arises out of an agreement that involves a benefit being provided to someone other than the beneficiary (including the trustee), that is intended to result in a reduction in someone’s tax liability. The application of these provisions, rather than Division 7A, may result in a more adverse outcome for taxpayers (i.e. a trustee assessment at the top marginal rate rather than a deemed dividend which may be taxed at a lower rate).

Importantly, under their section 100A guidelines in Practical Compliance Guide PCG 2022/2, an arrangement involving the retention of funds by the trustee does not fall into a Green Zone where a UPE to a corporate beneficiary is not put on complying Division 7A terms.

Similarly, the ATO may consider the application the general anti-avoidance provisions (Part IVA), or the application of the income injection rules where UPEs remain unpaid.

Are there other issues to consider?

Yes. The decision in Bendel raises issues about the meaning of financial accommodation, whether it extends to guarantees or facility agreements, and whether a UPE can be a debt under the debt forgiveness provisions of Division 7A. Accordingly, there are broader issues arising out of Bendel. These issues are outside the scope of this Bulletin.

What are the next steps?

It is critical that clients consider their position and how the rules apply. Clients should contact their Pitcher Partners representative to review their situation and determine what action is required well before lodging their tax returns or finalising their accounts for the year.