Taxation Issues on Release of a Company’s Unpaid Present Entitlement

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Taxation Determination TD 2015/20, released by the ATO on 25 November 2015, explains the Commissioner’s view on whether a release by a private company of its unpaid present entitlement (UPE) constitutes a “payment” under the Div 7A shareholder loan rules, contained in Pt III of the Income Tax Assessment Act 1936 (ITAA 1936). The TD was issued to address uncertainty about the ATO’s position on whether the “release” or waiver of a UPE amounts to a deemed dividend.

The Commissioner’s view, as outlined in TD 2015/20, is that Div 7A can apply where a private company with a UPE from a trust releases all or part of that UPE, and the trustee is either a shareholder or an associate of the private company. That is, the ATO considers the crediting of an amount to be a payment under Div 7A if the release represents a benefit to an entity.

This article examines the application of Div 7A in the context of UPE releases and payments based on TD 2015/20. It does not cover Div 7A rules more broadly.

Division 7A

The Div 7A rules in Pt III of ITAA 1936 state that unless they come within specified exclusions, certain private company payments, loans and forgiven debts are treated as dividends paid. The rules can apply to payments by a private company to a shareholder or their associates.

A payment is not treated as a dividend where, for example:

  • it is fully repaid or converted to a complying loan by the company’s lodgment day for the income year in which the payment occurs; or
  • it is assessable income (or is specifically excluded from being assessable income) under another part of the Act.

Principles outlined in TD 2015/20

TD 2015/20 provides that if a company releases a UPE, the release will typically be a payment under Div 7A, and therefore a potential deemed dividend, if the release is a benefit to the entity.

A UPE is a beneficiary’s right to receive trust income or capital that:

  • arises due to the beneficiary being made presently entitled to the amount; and
  • has not been satisfied, paid or effectively disclaimed.

According to TD 2015/20, there is a deemed dividend to a shareholder (or an associate of a shareholder) under Div 7A if:

  • there is a payment (according to the meaning in s 109C of ITAA 1936); and
  • that payment constitutes the release of a UPE as the result of an amount credited by the company for the benefit of the trust.

There must be a payment

Broadly, a private company is taken to have paid a dividend to a shareholder at the end of an income year if the company pays an amount to the entity during that year (s 109C(1) of ITAA 1936). For the purposes of Div 7A, a payment includes a credited amount to the extent that it is to the entity, on behalf of the entity or for the benefit of the entity (s 109C(3) of ITAA 1936).

The release involves crediting

Two requirements must be satisfied for the release of a UPE by way of a credit to be considered a “payment” and therefore a deemed dividend under the Div 7A rules:

  1. Credit must have been provided by the private company. The income tax legislation does not define the term “credit”, so it must be interpreted according to its ordinary meaning. The Macquarie Dictionary defines “credit” as “enter[ing] upon the credit side of an account; giv[ing] credit for or to; giv[ing] the benefit of such an entry to (a person, etc)”. Based on this, the Commissioner views the forgiveness of a debt in a company’s accounts, accompanied by an intention not to recover the debt to constitute “crediting of an amount”, which falls within the Div 7A meaning of “payment”. Crediting does not need to be formally recorded in the company’s books of account.
  2. The credit must be applied for the benefit of the entity. According to TD 2015/20, a UPE is an asset that stands as a debit entry in a private company’s accounts. The Commissioner’s position is that a “benefit” is provided where a UPE is released by the private company, because it leaves the other entity (eg the trustee of a trust) with full ownership of the UPE. A UPE release is considered a payment irrespective of whether it is held in the main trust or in a subtrust, or whether the UPE is released voluntarily or at the direction of a court order.

Exceptions: where the release of a UPE does not give rise to a benefit

The release of a UPE does not give rise to a benefit and would not be considered a payment under the Div 7A rules if:

  • the trustee cannot satisfy the UPE due to circumstances beyond its control, and the beneficiary has no cause of action against the trustee to recover that loss; or
  • the UPE is already a Div 7A loan or has previously been converted to a debt (s 109F of ITAA 1936).

Conclusion

The Commissioner’s position, according to TD 2015/20, is that the deemed dividend rules in Div 7A can apply where a private company with a UPE to the income or capital of a trust releases all or part of the UPE, and the trustee is either a shareholder of the private company or an associate of a shareholder.

When writing off or releasing a UPE, corporate beneficiaries should therefore be careful to ensure no benefit is provided through the release and a payment under Div 7A does not arise. As TD 2015/20 applies both before and after its date of issue, taxpayers should review the information carefully to manage any possible Div 7A risk.

SMSF – Policy Conditions

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Income protection insurance is worth considering for working people. It can pay a proportion of your salary if you are temporarily unable to work because of sickness or injury. When taking out any insurance policy, you should check carefully the terms and conditions, and also the way the key terms of the policy are defined. This helps to avoid disappointment or disputes with the insurer should an unfortunate event occur.

This article takes a look at a determination made by the Financial Ombudsman Service (FOS) in relation to a dispute over an income protection insurance policy.

FOS examines “offset” condition

In June 2014, the FOS issued a determination regarding a claim under an income protection insurance policy. At the commencement of the policy, and until he became disabled, the applicant jointly owned and operated a family business with his wife. When the applicant became totally disabled, the family business continued and made profits without the applicant’s participation.

The determination considered the insurer’s interpretation of a policy condition which stated that “the amount of the monthly total disability benefit will be reduced, where necessary, so that the total that month of: … the total disability benefit payment … and amounts payable from the insured person’s employer or business…does not exceed 75% of pre-disability monthly earnings”.

The FOS said the insurer did not dispute that the applicant was totally disabled. However, it applied the policy condition to offset the continuing profits of the family business against the benefits otherwise payable to the applicant. The financial services provider (FSP) said that it accepted the applicant’s application for cover on the basis that he was entitled to 50% of the profits of the family business, and said that it took this into account when calculating the applicant’s pre-disability monthly earnings. Therefore, the FSP considered it was entitled to apply the policy condition.

A FOS panel did not agree with the insurer’s interpretation of the policy condition. The FOS said the panel determined that:

  • The insurer was only able to apply the policy condition to amounts which were referable to the applicant’s total disability. These did not include amounts which may have been payable to the applicant as a result of the profitability of the family business after he became incapacitated, and to which he did not contribute through personal exertion.
  • There is no unfairness or inconsistency in taking into account business profits prior to disablement when the applicant was working full time but not after he became totally disabled when he took no part in the business. Ignoring pre-disability profits of the business that were due to the applicant’s activities would contravene the policy definition of pre-disability monthly earnings.

When the applicant became totally disabled, he ceased to earn any personal exertion income. Any amounts subsequently payable to him from the business were “passive” income, in the nature of dividends on a shareholding. These were not amounts referable to his disability, and were therefore not able to be offset under the policy condition.

Talk to us

Like many things in life, the devil is in the detail, so it’s important that you understand what you are (or will be) covered for. It’s also important to consider seeking professional advice tailored to your circumstances. If you have any concerns or questions, please contact our office on 02 9954 3843.

Article as seen at http://checkpointmarketing.thomsonreuters.com/

Personal Tax – CGT: Deceased Estates

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It is relatively common for a taxpayer to inherit residential property under a will. While an inherited dwelling can be a wonderful gift, it often results in capital gains tax (CGT) implications, particularly where the taxpayer later sells the property. Individuals who inherit deceased estates therefore need to be aware of how the CGT rules work.

Generally, a CGT liability arises when a capital gain is made on the sale of a property. However, a taxpayer may be fully or partially exempt from CGT if the transaction involves the sale of a deceased person’s main residence, provided certain conditions are satisfied.

This article examines the rules surrounding application of the CGT main residence exemption contained in the tax law, in the context of a beneficiary selling a dwelling they acquired from a deceased estate.

Main residence exemption: basic rules

The main residence exemption rules appear in Subdiv 118-B of the Income Tax Assessment Act 1997. They provide that a capital gain or loss made on the disposal of a dwelling is generally disregarded for CGT purposes if the dwelling is a main residence of the taxpayer throughout the ownership period.

The tax legislation defines “ownership” as a legal or equitable interest or a right or licence to occupy the land or dwelling. The ownership period of a dwelling is the period during which the individual had an ownership interest in the dwelling or land.

The definition of “dwelling” includes a unit of residential accommodation, a caravan or a houseboat, and a dwelling can be made up of more than one unit of accommodation – for example, a house with a granny flat – provided they are used together as a single residence (see Taxation Determination TD 1999/69).

The main residence exemption is only available to natural persons, so it does not apply where a company or trust owns a residence, except where the residence is vested in the trustee of a deceased estate and it is the main residence of a surviving spouse.

Deceased estates and main residence

For a beneficiary taxpayer who inherits a dwelling to have access to the main residence exemption, the dwelling must have been a “main residence” of the deceased person at the date of their death. This generally means the person lived in the dwelling and it was their main residence during their lifetime, or the person stopped living in the dwelling but continued to treat it as their main residence during their lifetime. This could occur, for example, when the person lived in a retirement home or aged care facility during their later years.

A taxpayer who inherits a main residence and subsequently sells the property may be able to access either full or partial exemption from CGT. The conditions to be satisfied to access the exemption depend on whether the deceased person acquired the dwelling before or after 20 September 1985:

Full CGT exemption

Deceased person acquired the dwelling before 20 September 1985 and beneficiary acquired it after 20 September 1985

Where the dwelling is a pre-CGT asset in the hands of the deceased person, the taxpayer can disregard any capital gain or loss on the sale of the dwelling if either of the following applies:

  • condition 1: the taxpayer disposed of the property within two years of the deceased person’s death; or
  • condition 2: the disposal did not occur within two years, but from the date of the death until the time of the sale, the dwelling was not used to produce income and it was the main residence of the surviving spouse, an individual with a right to occupy the home under the will, or a beneficiary of the estate.

There is no requirement for a pre-CGT dwelling to have been the main residence of the deceased person.

The Commissioner of Taxation has discretion to extend the two-year period under certain circumstances.

Deceased person acquired the dwelling on or after 20 September 1985

Where the dwelling is a post-CGT asset in the hands of the deceased person, the taxpayer can disregard any capital gain or loss on the sale of the dwelling, provided certain conditions are met. There are different conditions depending on whether the taxpayer acquired the post-CGT dwelling before or after 20 August 1996.

Where the dwelling passed to the taxpayer on or before 20 August 1996, the full exemption is available if:

  • the dwelling was the deceased person’s main residence for their entire ownership period during their lifetime and they did not use it to produce income; and
  • condition 2 (described above) is met.
  • Where the dwelling passed to the taxpayer after 20 August 1996, the full exemption is available if:
  • the dwelling was the deceased person’s main residence just before their death and it was not being used to produce income at that time; and
  • either condition 1 or condition 2 (described above) is met.
Illustrative example 1

Andrew was the sole occupant of a home he bought in Coburg, Victoria, in December 1998. It was his main residence throughout his ownership period. Andrew died in April 2011 and left the house to his only daughter, Leanne. Leanne rented out the house for a short period, then sold it 18 months after her father died.

Is Leanne entitled to the full CGT exemption?

Yes, because she disposed of it within two years of her father’s death, it was her father’s main residence just before his death and it was not used to produce income at that time.

Partial CGT exemption

Where a dwelling was not the deceased person’s main residence during the full period of their ownership, a full or part exemption from CGT may be still available. The taxable capital gain or loss amount is calculated according to a formula prescribed in the legislation:

 Term  Pre-CGT dwelling  Post-CGT dwelling
Non–main residence days The number of days from the deceased person’s death until the disposal date, when the dwelling was not the main residence of the surviving spouse, an individual with a right to occupy it under the will, or the beneficiary The sum of (a) the number of days after the date of the death when the dwelling was not the main residence of the surviving spouse, an individual with a right to occupy under the will or the beneficiary, and (b) the number of days during the deceased person’s ownership period when the dwelling was not their main residence.
Total days The number of days from the deceased person’s death until the date of the dwelling’s disposal The number of days from the date the deceased person acquired the dwelling until the date of its disposal

If the ownership interest is disposed of within two years of the deceased person’s death, the taxpayer can ignore the non-main residence days and total days in the period from the date of death until the date of disposal if this reduces the tax liability.

Cost base of the dwelling

Where the dwelling was a post-CGT asset of the deceased person, the taxpayer inherits the deceased person’s cost base. If it was a pre-CGT asset of the deceased person, the taxpayer is taken as acquiring the dwelling for its market value at the date of the death.

Illustrative example 2

Zoe bought a house on 8 October 1995 and used it solely as a rental property. When Zoe died on 7 June 2005, the house passed to her son, John, and he used it as his main residence.

John then sold the house in November 2009, making a capital gain of $250,000 from the sale.

Is John eligible for the full CGT exemption?

No. Zoe never used the property as her main residence, so John cannot claim the full exemption for a main residence.

Is John eligible for the partial CGT exemption?

Yes, because he used the house as his main residence. John must use the prescribed formula to calculate the taxable portion of his capital gain.

Zoe owned the house for 3,531 days. John then lived in the house for 1,635 days. This gives 5,166 total days.

Zoe used the house as a rental property from the time she acquired it, so there were 3,531 non-main residence days.

Using the formula, the taxable portion of John’s capital gain is $170,876 ($250,000 x (3,531/5,166)).

On the basis that he is eligible to access the 50% CGT discount, John has a capital gain of $85,438.

Talk to us

Do you think the full or partial CGT exemption could apply to your circumstances? Please contact our office on (02) 9954 3843 for further information.

Article as seen at http://checkpointmarketing.thomsonreuters.com/

Agistment Activities: Business

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Q. I propose to purchase about 20 acres of land which is used for cattle grazing. I will continue to use the land for agistment purposes, although my long-term plan is to subdivide the land and sell the subdivided blocks. Will the agistment activities amount to a business?

 

A. Whether your agistment operations constitute a business is generally a question of fact and law (and possibly Old English law). The following extract from para [22-250] of Thomson Reuters’ Australian CGT Handbook indicates it is possible for agistment activities to amount to carrying on a business in appropriate circumstances:

“Land used for agistment may fall outside the exclusion [for assets used in a business ‘mainly to derive rent’] as under old law “agistment” is the act of taking another’s stock to graze, pasture or feed on land with an implied agreement to redeliver it to the owner on demand: see, for example, Sinclair v Judge [1930] QSR 340. Therefore as the arrangement between the parties is more akin to bailment than a lease the payments may not be regarded as ‘rent’. Further it is possible to carry on a business of agistment (see, for example, AAT Case 10,331 (1995) 31 ATR 1146) – albeit, still the exclusion in s 152-40(4)(e) could be relevant as it applies to assets used in a business ‘mainly to derive rent’.”

The return on the activity may possibly be regarded as rental income. If so, the land may not be an active asset for the purposes of the CGT small business concessions – s 152-40(4)(e) ITAA 1997 excludes assets used in a business “mainly to derive rent”.

Carrying on a business

Whether a business is being carried on is a question of fact to be determined objectively on the specific facts of the case (eg Evans v FCT (1989) 20 ATR 922 at 939; Hart v FCT (2003) 53 ATR 371).

From the many court and tribunal decisions concerning this issue (eg Thomas v FCT (1972) 3 ATR 165, Ferguson v FCT (1979) 9 ATR 873, Hope v Bathurst City Council (1980) 12 ATR 231, FCT v Radnor Pty Ltd (1991) 22 ATR 344 and Spriggs and Riddell v FCT (2009) 72 ATR 148) ,it seems the following factors are particularly relevant – that is, when assessed objectively, their presence indicates a business is being carried on:

  • the person’s purpose and intention as they engage in the activities;
  • the intention to make a profit from the activities, even if only a small profit is made or a small loss incurred. (If a loss is incurred every year for a number of years, however, that suggests the activity may be more of a hobby.) It seems that an intention to make a profit is not of itself sufficient;
  • the size and scale of the activities – they must be in excess of domestic needs, but do not need to be the person’s only activities and can be carried on in a small way;
  • repetition and regularity of the activities – although the expression “carry on” does not necessarily require repetition (see FCT v Consolidated Press Holdings Ltd; CPH Property Pty Ltd v FCT (2001) 47 ATR 229 at 245) and an isolated activity may constitute beginning a business;
  • the activities being carried on in a systematic and businesslike way, as usual for that type of business (eg keeping detailed, up-to-date records and accounts); and
  • the existence of a business plan.

The factors must be considered in combination and as a whole, and no one factor is likely to be decisive: see Taxation Ruling TR 97/11. A person may carry on a business even if they are not actively engaged in the business: Puzey v FCT (2003) 53 ATR 614 at 624; Sleight v FCT (2003) 53 ATR 667 at 682 (decision upheld on appeal in FCT v Sleight (2004) 55 ATR 555).

Even if you are carrying on an agistment business, it is unlikely that it is a “primary production business” within the meaning in s 995-1 of the ITAA 1997. The Commissioner considers a landowner engaged in a primary production business if, under a share-farming arrangement allowing another person to cultivate the land, the landowner is carrying on business in partnership or is directly involved in that business with a degree of control or ongoing participation: Taxation Determination TD 95/62.

 

The above is a discussion only and further advice should be obtained. Please contact our office  on (02) 9954 3843 to discuss your circumstances and to obtain professional advice.

This article is sourced from Thomson Reuters TaxQ&A service.

SMSF ATO Powers

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The ATO – as the regulator of SMSFs (self-managed super funds) – has a range of treatments available to it to deal with SMSF trustees who have not complied with the super laws. The ATO says its primary focus is to encourage SMSF trustees to comply with the super laws. However, SMSF trustees should be aware of the range of penalties or actions that the ATO could apply in the event of a contravention.

These include the following actions:

  • Education direction – the ATO says it may give an SMSF trustee a written direction to undertake a course of education when they have been found to have contravened super laws. The education course is designed to improve both the competency of SMSF trustees and their ability to meet their regulatory obligations, and to reduce the risk of trustees contravening the law in future.
  • Enforceable undertakings – the ATO can decide whether or not to accept an undertaking from an SMSF trustee to rectify a contravention. The undertaking must be provided to the ATO in writing and must include the following:
    • a commitment to stop the behaviour that led to the contravention;
    • the action that will be taken to rectify the contravention;
    • the timeframe to rectify the contravention;
    • how and when the trustee will report that the contravention has been rectified; and
    • the strategies to prevent the contravention from recurring.
  • Rectification directions – the ATO may give a trustee or a director of a corporate trustee a written direction to rectify a contravention of the super laws. A rectification direction will require that a person undertakes specified action to rectify the contravention within a specified time, and provide evidence of compliance with the direction.
  • Administrative penalties – from 1 July 2014, individual trustees and directors of corporate trustees will be personally liable to pay an administrative penalty for various contraventions of the super law (breaching the SMSF borrowing rules or the in-house asset rules etc). The penalty cannot be paid or reimbursed from the assets of the fund.
  • Disqualification of a trustee – the ATO may disqualify an individual from acting as a trustee or director of a corporate trustee if they have contravened the super laws. The ATO can also disqualify an individual if it is concerned with the actions of that individual or if it doubts they are suitable to be a trustee.
  • Civil and criminal penalties – the ATO may apply through the courts for civil or criminal penalties to be imposed. Civil and criminal penalties apply where SMSF trustees have contravened provisions relating to these:
    • the sole purpose test;
    • lending to members;
    • the borrowing rules;
    • the in-house asset rules;
    • prohibition of avoidance schemes;
    • duty to notify the regulator of significant adverse events;
    • arm’s length rules for an investment;
    • promotion of illegal early release schemes.
  • Allowing the SMSF to wind-up – following a contravention, the trustee may decide to wind-up the SMSF and rollover any remaining benefits to a fund regulated by the Australian Prudential Regulation Authority (APRA). Depending on the actions of the trustees and the type of contravention, the ATO may continue to issue the SMSF with a notice of non-compliance and/or apply other compliance treatments.
  • Notice of non-compliance – serious contraventions of the super laws may result in an SMSF being issued with a notice of non-compliance by the ATO. A notice of non-compliance is effective for the year it is given and all subsequent years. A fund remains a non-complying fund until a notice of compliance is given to the fund.
  • Freezing SMSF assets – the ATO may give a trustee or investment manager a notice to freeze an SMSF’s assets where it appears that conduct by the trustees or investment manager is likely to adversely affect the interests of the beneficiaries to a significant extent. This is particularly important when the preservation of benefits is at risk.

Informal arrangements

The ATO says it may take one or several courses of action, depending on how serious the contravention is and the circumstances involved. In some circumstances, the ATO may enter into an informal arrangement with a trustee to rectify a minor contravention within a short period of time. The arrangement can be made verbally or in writing and includes how and when the contravention will be rectified. The ATO will consider the trustee’s compliance history in deciding whether to accept the arrangement. The ATO may also provide trustees with informal education about their trustee obligations.

ATO identification of risk posed by SMSFs

The ATO will apply a risk-based approach in response to auditor contravention reports (ACRs). The Commissioner said he will consider multiple indicators and use risk models to determine the appropriate action to take on each SMSF. The key indicators used will include non-compliance (including regulatory and income tax matters), information from the SMSF annual return, ACRs, and other data, including trustee and members’ records.

Under this approach, the ATO will treat all ACRs received with an audit, phone call or letter, shortly after lodgment, to provide more certainty to trustees. The ATO said this approach also recognises the increased SMSF auditor professionalism stemming from the new ASIC registration regime, warranting less intrusive action in many cases.

The ATO’s risk categories for SMSFs include the following:

  • High-risk SMSFs – will be selected for comprehensive audits that will see scrutiny of all regulatory and income tax risks displayed by the fund. There will be a particular focus on repeat offenders. This program will also involve an increasing number of ATO field visits to engage high-risk SMSFs. ATO administrative penalties for breaches by an SMSF trustee (up to $10,200 per breach) will be applied when the Commissioner confirms the breach is eligible for such a penalty.
  • Medium-risk SMSFs – the ATO will take less intrusive action on SMSFs assessed as medium risk. As trustees are responsible for their fund’s behaviour, the ATO says it will engage directly with trustees to discuss the reported contravention, remind trustees of their obligations, and encourage compliance in future. This action will usually occur within six to eight weeks of the ACR lodgment. In the majority of cases, if the trustee can assure the Commissioner that they understand their obligations, the issues reported in the ACR will be closed and no penalties applied. The ATO’s aim is to intervene before more serious comprehensive audits are required.
  • Lower-risk SMSFs – will be issued with tailored correspondence reminding the trustees of their obligations and encouraging compliance in future. The issue reported in the ACR will be closed with the issuing of this letter which will usually occur within six to eight weeks of the ACR’s lodgment.

Want to know more?

Please contact our office on (02) 9954 3534 or email admin@hurleyco.com.au for more information.

Article as seen at http://checkpointmarketing.thomsonreuters.com/