The ATO draft public ruling issued on 16 December 2009 may significantly affect investments and business structures.

For many years it has been common for businesses conducted through a trust to distribute all or part of their annual profits to a related private company beneficiary. The aim is to cap the rate of income tax on those profits at the concessional corporate rate of 30%. By comparison the maximum individual marginal rate of tax is 46.5%!

Often those distributions are not physically paid across from the trust to the private company beneficiary - usually the private company beneficiary is said to hold an "unpaid present entitlement" to those profits. The underlying cash or property representing those profits may either be retained in the trust or made available by the trustee of that trust to other related parties in a variety of ways.

The ATO now considers (TR 2009/D8) that such arrangements may give rise to unfranked dividends under Division 7A of the Income Tax Assessment Act 1936.

Division 7A contains tax law provisions that deem certain payments, loans or forgiveness of debt made by private companies in favour of their shareholders or their associates to be unfranked dividends, regardless of the intention of the parties.

The ATO say that such arrangements may give rise to a "loan" as extensively defined in Division 7A from the private company back to the trust and thus lead to a breach of Division 7A.  This could occur where:

• the private company's entitlement to those profits is allocated to a loan account in the books of the entities; or
• in certain cases the private company simply does not call for the unpaid present entitlement to be paid.

This outcome will depend on the terms of the trust deed and the exact use of the retained funds by the trustee.

Where Division 7A is breached, the amount of the "loan" may be treated as a deemed unfranked dividend and included in the net income of the trust. This is potentially a severe tax outcome as the "loan"is likely to have been taxed as a trust distribution to the company at 30% and if taxed again at the trustee level would attract a further punitive tax rate of 46.5%.

Some aspects of the ruling will not take effect until the date of issue of the draft ruling - 16 December 2009. As the final version of this ruling may change, WHK will keep readers advised in coming months. Meanwhile if you are considering a review of  your business structure in light of potential risks and need guidance on appropriate actions going forward please call Gary Thomas or Alex Duonis on 5224 7700.

Gary Thomas
Principal, Tax Consulting
WHK Geelong

Readers should not act on the basis of this information as the contents are of a general nature and do not reflect individual circumstances. Liability limited by a scheme approved under Professional Standards Legislation other than for the acts or omissions of financial services licensees. WHK Pty Ltd ABN 84 006 466 351