The deferral of minimum yearly repayments and interest under Division 7A

Once a Division 7A loan agreement is put in place, clients may be required to make minimum yearly repayments (MYR) and pay interest to ensure that a deemed dividend does not arise. However, these requirements could be deferred by one year – meaning less tax could be payable - if the source of the loan was an unpaid present entitlement owing from a trust to a bucket company. Read this article to find out more.

I have found that a typical strategy that accountants use to reduce the effective tax rate on profits in a private group is to distribute income from a family trust to a bucket company. However, by doing so, an exposure to Division 7A may arise. In particular, an ‘unpaid present entitlement’ or ‘UPE’ may arise when income is only distributed by the trust on paper and no money is actually paid by the trust to the bucket company.

Once a UPE arises, there are generally three ways to ensure that the ATO will be satisfied that Division 7A doesn’t apply:

1. Pay out the UPE in full before the lodgment date of the bucket company. Generally this option is not commercially possible because the trust doesn’t have the cash-flow to pay out the UPE in full, or, because it becomes too expensive to do so by setting-off a dividend from the bucket company. I won’t discuss this option further in this article;
2. Sub-trust agreement; or
3. Complying Division 7A loan.

Properly carried out, the ATO allows you to use a combination of options [2] and [3]. By doing so, clients may be able to defer the requirement to make the MYR and pay interest by one year. 

In simple terms:

• ABC Trust makes XYZ Co presently entitled to $100 of income on 30 June 2016. The Trust doesn't have the money to pay out the present entitlement and it sits on the balance sheet of the Trust as a UPE.
• Before the lodgment date of the Company, the Company and the Trust agree to convert the UPE to a loan by way of set-off. At this step, if the set-off did not occur and a sub-trust arrangement was not implemented, a deemed dividend of $100 could arise from the Company to the Trust.
• As at 30 June 2017, the Trust now records $100 as a loan owning to the Company.
• The Trust cannot repay the loan of $100 to the Company by May 2018 (being the lodgment time for the Company's 2017 tax return), and the parties enter into a complying Division 7A loan.
• Interest is generally calculated on the loan from 1 July 2017 and the first MYR is due by 30 June 2018.

In effect, the requirements to pay the MYR and interest may be deferred by one year.

The ATO acknowledges in its public guidance that it will administer the law in this way, so long as transactions are properly carried out and recorded correctly. Contact me to find out more about what the ATO expects from clients in this regard: +61 3 8644 3522.

This article is not tax advice and any strategy must be thoroughly reviewed by a tax professional before implementation.