Corporate beneficiaries have long been used as part of effective tax planning and wealth protection strategies. However, when the ATO released Taxation Ruling TR 2010/3 back in June 2010, the landscape changed and many were left wondering if there was sufficient benefit to justify the continued use of a corporate beneficiary.
What is a corporate beneficiary?
A corporate beneficiary is a company that receives a distribution from a discretionary trust (a.k.a. family trust). The company is required to declare its share of trust income received and pay tax on that income at the corporate tax rate of 30%.
This 30% tax rate is typically substantially less than the tax rate that would apply if the income were to have been distributed to a family member or retained by the trust which can be up to 47%. As such, a tax deferral of up to 17% can be obtained.
The use of a corporate beneficiary also helps to protect the wealth generated where family members are exposed to business and investment risk.
What was the landscape pre TR 2010/3?
The amount of the trust distribution made to the corporate beneficiary that remains unpaid is known as an “unpaid preset entitlement” (UPE). Historically, UPEs were not regarded as loans for the purposes of Division 7A of the Income Tax Assessment Act 1936.
Consequently, so long as the UPE provisions in Subdivisions EA & EB were complied with, UPEs could subsist indefinitely without Division 7A creating an obligation on the corporate beneficiary to distribute profits to its shareholders. In other words, there was an indefinite tax deferral.
This indefinite tax deferral then allowed the corporate beneficiary to strategically distribute profits over time to achieve lower overall tax outcomes and to maintain the wealth protection benefits.
The pre TR 2010/3 landscape also meant that the trust did not need to physically pay the distribution and could retain the underlying cash to utilise in its business, for investment or to retire external debt.
What changed when TR 2010/3 was issued?
When the ATO issued TR 2010/3 in June 2010, they changed their long standing position on the status of UPEs in the context of Division 7A. To simplify a complex issue, the ATO view expressed in TR 2010/3 is that if a UPE is allowed to subsist, it would effectively convert to a loan that would be subject to Division 7A.
In recognition of this about face, the ATO quarantined UPEs that were in existence as at 15 December 2009.
The practical effect of TR 2010/3 is that there is no longer an indefinite tax deferral for distributions made to corporate beneficiaries after 15 December 2009.
What are the options to manage distributions to corporate beneficiaries post TR 2010/3?
The first option is for the trust to make physical payment of the distribution to the corporate beneficiary. This will mean that there will be no UPE that will be subject to Division 7A and the corporate beneficiary will have no obligation to distribute profits. In other words, the indefinite tax deferral is kept intact.
The downside of course is that the funds are locked up in the corporate beneficiary until such time as a decision to pay dividends is made.
The second option is to make the UPE subject to a complying Division 7A loan agreement. These loan agreements typically require that:
- the loan has a maximum term of 7 years;
- that minimum annual repayments be made; and
- that interest is payable at a commercial rate prescribed by the government.
The minimum repayments can be met by the trust physically making payment to the corporate beneficiary each year. Alternatively, it may be possible for the corporate beneficiary to declare dividends that can be off-set against the minimum repayment obligation.
The third option is to put the UPE on “sub-trust” in accordance with the ATO’s PS LA 2010/4. Under this option the UPE is held on sub-trust for the corporate beneficiary and the application of Division 7A is not triggered provided that the UPE provisions in Subdivisions EA & EB are also complied with.
There are three sub-categories under the third option with the
most commonly used being the 7 year option. Under this 7 year option the trust must pay interest on the UPE annually at the statutory interest rate and full payment of the UPE must be made by the trust to the corporate beneficiary at the end of the 7 year period.
Again, it may be possible for the corporate beneficiary to declare dividends that can be off-set against both the interest and repayment obligations.
Is there still a benefit in using a corporate beneficiary?
The short answer is yes. Whilst Division 7A implications now limit how long the profits can be retained by the corporate beneficiary, there is still a substantial tax deferral that can deliver significant benefit and create opportunities to access lower overall tax rates.
Having said all of that, it is vital that professional advice be sought to ensure that the use of a corporate beneficiary is appropriate. Also, to ensure that all of the technical requirements are fully understood and properly managed.