This article was updated on 20 May, 2025.
As we await the outcome of the ATO’s application for special leave to appeal to the High Court in Bendel, some taxpayers may have taken the position of putting their unpaid present entitlements (“UPEs”) on complying loan terms without explicitly converting them to a loan. An article released by the ATO states that UPEs must be converted to loans in order to comply with section 109N. This article discusses this requirement in more detail.
Background
Earlier this year, the Full Federal Court overturned the ATO’s long-standing view that a UPE is a loan for the purposes of Division 7A in the decision of the Commissioner of Taxation v Bendel [2025] FCAFC 15 (“Bendel”). The ATO has appealed to the High Court (currently still pending) and there has been no mention of Division 7A in the recent Budget. Many taxpayers have been left to lodge their 2024 income tax returns amidst significant ongoing uncertainty on the treatment of UPEs.
The ATO recently released an interim Decision Impact Statement (“DIS“) (see here) on 19 March 2025. In it, the Commissioner confirmed that he does not intend to depart from his views in Taxation Determination TD 2022/11 (“TD 2022/11”) (that a UPE is a loan for Division 7A purposes) until the appeal process is finalised.
Can the ATO hold a view contrary to the full federal court decision?
Arguably, paragraph 14ZZQ(2)(b) of the Taxation Administration Act 1953 (Cth) (here) provides the ATO with the ability to administer the law contrary to a decision of the Full Federal Court in certain cases. That is, the ATO must apply an order of the court where:
“if the order is made by the court constituted other than as mentioned in paragraph (a) and no application for special leave to appeal to the High Court against the order is made within the period of 30 days after the order is made–the order becomes final at the end of the period.”
Given that the ATO has applied for special leave to the High Court within the required time period, it is understood that the ATO is not yet required to give effect to the decision in Bendel.
What has the ATO said subsequently on Bendel?
Recently, the ATO published an interview with Deputy Commissioner Louise Clarke on its website (see here) that provides some further insights from the ATO on how to treat UPEs (“Bulletin”). Explicitly the Bulletin encourages taxpayers to consider converting UPEs to loans. The Bulletin states that:
Where a UPE isn’t converted into a complying Division 7A loan, taxpayers face the prospect that other integrity provisions may apply to their arrangement (depending on the particular facts), for example Subdivision EA and section 100A.
Placing a UPE on Division 7A complying loan terms requires all the elements of section 109N to be satisfied, including that there’s a written loan agreement between the parties. That is, relevant UPEs must be converted to loans to comply with section 109N. (emphasis added).
Originally, we had interpreted this comment to mean that a UPE placed on terms must be treated as a loan (in accordance with the provisions of Division 7A) in order to comply with section 109N. We originally did not interpret this comment to be suggesting that a UPE placed on terms would be converted to a loan. However, since the release of our original article, the ATO have clarified that our understanding of the ATO’s view was not correct.
The ATO have clarified they hold the view that placing a UPE on terms will have the effect that the UPE is satisfied (or discharged) and replaced with a new obligation, being a Division 7A loan. Accordingly, we understand that the ATO hold the view that placing a UPE on terms should have the effect that there is a conversion of the UPE to a loan for Division 7A purposes. This article considers this view in further detail.
Do I need to convert a UPE to a loan in order to comply with section 109N?
In our view, in the strict sense, we do not believe that UPEs need to be legally converted into a loan in order to comply with section 109N in order to satisfy the requirements of the ATO’s current public guidance.
In TD 2022/11, the ATO identifies three acceptable options for managing UPEs that meet the definition of a “loan” under section 109D. The three options are specifically outlined in paragraph 101:
“101. This Appendix describes how a private company beneficiary and trustee in those circumstances can implement a complying loan agreement, in particular including the timing requirements, so that the financial accommodation does not give rise to a deemed dividend. This is illustrated by examples where:
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- a UPE is made subject to complying loan terms
- a UPE is in fact satisfied and replaced with a new loan, and
- a sub-trust is created and the use of the sub-trust funds by the main trust is made subject to complying loan terms (see Example 6 of this Determination).”
It is noted that the first option (Option 1) of the Taxation Determination specifically provides that a UPE can be made subject to complying loan terms. Paragraph 105 provides further commentary on the second option (Option 2) where the ATO states that the UPE can be refinanced with a loan or can be replaced via a mutual offset. This is discussed in more detail below.
It is further noted that TD 2022/11 treats a UPE as financial accommodation and therefore a loan for section 109D purposes. Accordingly, as outlined below, this should be sufficient in itself for the UPE to be considered a loan to which section 109N may apply.
What are the requirements in section 109N?
The requirements of section 109N are quite clear. Before the lodgement date for the relevant year of income in which the loan is made, four conditions must be satisfied:
- There must be a loan.
- The agreement that the loan was made under must be in writing.
- The rate of interest payable on the loan for years of income after the year in which the loan is made equals or exceeds the benchmark interest rate for the year.
- The term of the loan does not exceed the term (the maximum term) for that kind of loan worked out under subsection 109N(3) (typically 7 years).
This is consistent with paragraph 100 of TD 2022/11 which also outlines these basic requirements.
“Implementation of a complying loan agreement
100. In cases where financial accommodation is provided as described in this Determination, the trustee and the private company beneficiary can avoid a deemed dividend if, before the private company’s lodgment day[34] for the income year in which the financial accommodation arises:
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- the trustee pays the trust entitlement to the private company beneficiary, or
- the private company beneficiary and the trustee enter into a complying loan agreement[35] in respect of the financial accommodation.
…
[35] ‘Complying loan agreement’ refers to a written agreement which meets the minimum interest rate and maximum loan term as set out in section 109N.”
How can a UPE be made subject to complying loan terms?
It is noted that section 109N refers to a “loan” that would otherwise be a deemed dividend under section 109D. Accordingly, the reference to a “loan” in section 109N should include the extended meaning of the term under paragraph 109D(3)(b) (i.e. “financial accommodation” that is deemed to be a loan for the purposes of Division 7A). Accordingly, a UPE (that has become financial accommodation and therefore a Division 7A loan under the ATO view in TD 2022/11) should be capable of satisfying section 109N.
Therefore, if the UPE remains “at call” by the beneficiary but is made subject to a maximum term (no greater than 7 years) with interest charged in respect of any amounts owing under the UPE at the benchmark rate, the conditions of section 109N should be satisfied.
It is also prudent to ensure that the UPE is covered by the agreement (i.e. to ensure that the agreement is consistent with the requirements of Taxation Determination TD 2008/8 (“TD 2008/8”). In TD 2008/8, the ATO state that the amount of the loan should be included in the agreement. However, Example 3 covers a facility agreement that does not specify the loan amount. In Example 3, the ATO state the following.
“13. Although the formal written agreement does not specify the amounts lent, it clearly identifies the amounts covered by the terms of the agreement, and the company’s accounts record the amounts subject to the agreement. It also includes the names of the parties, the date it was executed, the interest rate and the period of the loans. Therefore, for each loan, all the essential elements of the loan agreement are in writing for the purposes of paragraph 109N(1)(a).”
It is noted that many Division 7A agreements are facility agreements. It is also noted that many Division 7A agreements simply cover loan amounts that are taken to be loans under section 109D. Accordingly, taxpayers could continue to use their Division 7A agreements with respect to UPEs consistently with TD 2022/11.
What is the difference between Option 1 and Option 2 in TD 2022/11?
Option 2 outlined in paragraph 101 involves the UPE being satisfied (i.e. paid to the beneficiary) and a new loan being made to the trust. This may not involve an actual transfer of cash; the trustee and corporate beneficiary could just agree to mutually set-off their respective obligations (to pay out the UPE and to advance the principal amount). These two alternative methods covered by Option 2 are outlined in paragraph 105 of TD 2022/11. These two options are different to Option 1 which simply requires the UPE to be placed on terms.
It is noted that Option 1 is very different to Option 2, whereby Option 2 can involve an “offset of mutual obligations”. The offsetting of mutual obligations was discussed in the Federal Court decision of East Finchley Pty Ltd v Commissioner of Taxation [1989] 20 ATR 1623, where the principles of Spargo’s case were considered. As outlined in East Finchley, “[t]he rule in Spargo’s case is not a principle confined merely to the company law context in which it was decided. At its heart is the undeniable futility of two parties, each obligated to the other, passing cheques backwards and forwards to accomplish a transaction.”
In East Finchley, there were two letters exchanged with respect to the beneficiary’s unpaid entitlements. A letter was provided to each beneficiary which advised that a distribution from the trust fund had been made in his or her favour, and that subject to the beneficiary’s approval, the amount would be credited to a loan account at call in his or her name in the books of the trust. A second letter was provided by each beneficiary that gave authorisation to this action was also circulated and signed by the beneficiaries. On this, Hill J stated:
“Further I can see no reason why the combination of the two letters should not in any event have constituted a sufficient demand for payment to bring about a situation that there was an obligation in equity by force of the trust deed to pay to the beneficiaries and an obligation by virtue of the loan agreement between the trustee and beneficiaries in law to pay by way of loan the moneys to the trustee by the beneficiaries so that the principle in Spargo’s case brought about the result that there was in law a payment.”
This can be compared to the actions that occur under Option 1. Arguably, under Option 1, no demand for payment occurs. There is no agreement to lend a separate amount to the trust, such that there are no mutual obligations that can be offset. All that has occurred is that the “financial accommodation” (being the UPE) has been placed on a maximum repayment term. Accordingly, there would seem to be some doubt as to whether Option 1 could amount to a discharge of the UPE and the replacement of the UPE with a loan.
Could the act of placing the UPE on terms result in a new loan?
This is a slightly different question to whether the act of placing a UPE on terms amounts to an offset. There would be a legal question as to whether placing the UPE on terms could result in changing the UPE to a loan or replacing the UPE with an ordinary loan.
In the AAT decision in Bendel v Commissioner of Taxation [2023] AATA 3074, the ATO put forward the argument that the placing of a UPE on ‘sub-trust’ “had the effect of discharging or replacing the obligation to pay entitlements to income”. That is, the ATO argued that the UPE was effectively discharged and replaced. While it is understood a similar argument was posited in the Full Federal Court, it is noted that the decision of the Full Federal Court did not discuss this issue. Further, we highlight that the application for special leave by the Commissioner does not appear to re-engage in this line of argument.
That being said, in a similar manner, the ATO may hold the view (pending the decision in Bendel) that a similar outcome occurs by placing a UPE on loan terms. However, it is questionable whether this conclusion would be consistent with the decisions of the AAT and the Full Federal Court.
Reference may also be had to the AAT decision in KKQY v Commissioner of Taxation [2019] AATA 204 (here) which discusses the effect of placing a loan on terms and whether this can constitute a new loan. While this is only an AAT decision, the decision outlines the case authorities on this issue at paragraphs 30 to 42. Further guidance can be obtained on this issue in Taxation Ruling TR 93/8W which discusses the difference between a mere variation and the discharge and refinance of a loan (here) and ATO Interpretive Decision ATOID 2012/60 (here) and ATO Interpretive Decision ATOID 2012/61 (here) which also discuss the same concepts.
This issue should only be relevant where special leave is not granted to the ATO (leaving the Full Federal Court decision to stand) or if the taxpayer is successful in the High Court. That is, if UPEs are held not to be a loan for section 109D purposes, taxpayers will need to consider whether placing a UPE on terms has amounted to transforming the UPE to an “ordinary loan” for Division 7A purposes (whether by way of discharge, conversion or refinance).
In summary, whether the placing of a UPE on terms will amount to a conversion of the UPE to a loan remains a question that may need to be addressed post Bendel depending on the outcome of the appeal to the High Court.
Do you need to make minimum loan repayments on a UPE that is covered by a section 109N loan agreement?
To comply with section 109N, section 109N does not require minimum loan repayments to be made. We believe this is a misconception of the operation of section 109N. Section 109N simply states that section 109D does not apply where the loan is to be repaid over 7 years and that interest be charged on the loan is at least the benchmark interest rate. While the contract may or may not require repayments to be made annually, this is merely a contractual issue.
However, if a taxpayer fails to make a repayment, section 109E will treat the shortfall of the statutory minimum yearly repayment as a deemed dividend. Accordingly, requiring minimum loan repayments (and making such repayments) is always prudent from a section 109E perspective in order to avoid a deemed unfranked dividend.
Should a prudent taxpayer convert their UPEs to a loan?
To date, many Division 7A loan agreements did not convert UPEs to loans. Instead, most have defined a loan to include amounts that are defined to be loans in accordance with Division 7A. Accordingly, many taxpayers may not have converted UPEs to loans (in the ordinary sense). This is obviously subject to the comment earlier (see comments on KKQY) and whether a loan agreement of itself can convert a UPE to a loan. That being said, compliance with TD 2022/11 should not require UPEs to be converted to loans in the legal sense as a precondition for satisfying the requirements of section 109N.
We do not believe that the ATO’s recent comments in their Bulletin change anything with respect to placing UPEs on complying terms. We do not believe that the ATO are saying that a taxpayer cannot place UPEs on complying terms. The ATO have simply outlined their view of the consequences of placing a UPE on terms. Whether the ATO’s view is correct at law is questionable and may be debated further once the decision in Bendel is handed down.
Are there other considerations?
If a UPE remains unpaid and is 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. The ATO accepts in TD 2022/11 that if a UPE is dealt with in a manner outlined in their ruling, that it will treat the UPE as a loan rather than a present entitlement. However, if Subdivision EA (and EB) issues exist, or if there is a risk of section 100A, you may need to seriously consider committing to treating the UPE as loan (in order to manage those risks). The ATO outline these risks in the Bulletin.
We further note that there is a significant chance that the Government will seek to amend the law to include UPEs as loans. Where this occurs, taxpayers will need to properly consider their compliance with the respective provisions.
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 30 June.
