Bendel: Full Federal Court says that UPEs are not loans for tax purposes

Facts

Statutory Framework 

Division 7A treats certain payments, loans and debt forgiveness of a shareholder or an associate of a shareholder as a “deemed dividend” if the amount isn’t placed on a “complying division 7A loan”.

The Bendel case concerns section 109D(3) and loans by the company to a shareholder or shareholder associates.

Whereas, effectively, subdivision EA expands Division 7A and captures certain amounts where a company has an UPE and the trustee makes a payment or loan to, or forgives a debt of, the shareholder or associate.

UPE v Loan

There has been tension in the tax community regarding the correct interpretation of section 109D(3) and its interaction with subdivision EA. Subdivision EA was enacted to close “loopholes” for companies with UPEs, allowing shareholders or associates of shareholders to “tax free money”.

The purpose of subdivision EA was a deciding factor in the tribunal’s decision that section 109(D) does not capture UPEs.

Since 16 December 2009, many individuals and small businesses have been following the Commissioner’s guidelines and views in relation to the interpretation of section 109(D).

Commissioner Position

The Commissioner assessed Investments on the basis that the UPEs comprised of loans within the meaning of section 109D(3) of the ITAA 36, which has been the Commissioner’s longstanding view since 16 December 2009.

The effect of the Commissioner’s longstanding position was that the UPE owed to Investments was a loan for the purposes of Division 7A.

Mr Gleewin was also assessed by virtue of the trust taxing provisions that make beneficiaries presently entitled to the income (i.e. the purported deemed dividend that arose).

There were three issues dealt with by the Full Federal Court.

First, was whether the Tribunal erred in the statutory construction of whether an unpaid present entitlement to income (or capital) of a trust estate is a loan.

The Commissioner argued that the unpaid present entitlement conferred a “debtor and creditor” relationship between the trustee of the Trust and Investments, which in turn was financial accommodation for the purposes of Division 7A. The Commissioner further argued that the retention by the trustee of the unpaid present entitlements had the same practical effect as a loan.

Secondly, the Commissioner asserted that the Tribunal did not give effect to the ordinary and plain meaning of section 109D(3). This argument was based on the fact that the Tribunal did not understand that subdivision EA operated separately to section 109(D). That is, subdivision EA concerned payments, loans and debt forgiveness made by a trustee, whereas section 109(D) concerns the company.

Thirdly, was whether the Tribunal failed to give effect to the legislative purpose of Division 7A. The Commissioner asserted that the Tribunal’s decision was contrary to the legislative purpose of section 109(D), being that private companies cannot make tax-free distributions of profits to shareholders.

Bendel’s Position

Bendel submitted that section 109D requires some positive act by the company to operate. That the company must make the loan. That is, the company must do a thing. Further, it was submitted that simply not calling for payment does not amount to the positive act required under section 109D.

Further, Bendel submitted that section 109D(3) did not apply as there was an entitlement to be paid but not repaid.

It was Bendel’s position that it was the clear intention of subdivision EA to operate only to deem a dividend where there is both a UPE and a loan made by the trustee to a shareholder or associate of a shareholder. By section 109(D) operating to deem a dividend it would undermine this clear intention and have the potential of causing a person to be taxed twice on the same amount.

Court's Decision 

This case was not won or lost on its evidence but rather required the Full Federal Court to undertake a statutory interpretation exercise to the operation of Division 7A.

The full Federal Court held that section 109(D) requires more than a debtor creditor relationship and that it requires an obligation to repay and not merely an obligation to pay.

It was further held that by Investments failing to call for the loan did not involve the payment of a sum that was required to be repaid. That is, there was no loan or creation of an obligation to repay an amount created.

On that basis, the appeal was dismissed.

Next Steps 

Practitioners and the tax community will be eagerly awaiting to see whether the Commissioner applies for leave to appeal this decision to the High Court or perhaps even looks to introduce retrospective legislation to address the perceived mischief outlined in the Commissioner’s position.

Irrespective of the next steps, this decision has the ability to have a raft of consequences for clients who have previously been caught by section 109(D), have taken action on UPEs that were considered to be loans for the purposes of division 7A.

Whilst the tax community will face some uncertainty for a bit longer, perhaps until a High Court decision, clients should be considering and reviewing their circumstances concerning unpaid present entitlements and companies through the lens of subdivision EA.

For taxpayers with matters currently with the Commissioner and in abeyance until the outcome of the appeal, it may be a little longer until these matters are finalised.

For now, we will wait for the Commissioner’s decision impact statement to see how the Commissioner will deal with this latest case update.