For many people in small business it is frustrating that, although the Federal Government has recently reduced Company Tax, they have effectively taken away the opportunity of accessing this lower tax rate because many small businesses now operate under the wrong trading structure.

A recent change in interpretation by the Australian Taxation Office will mean many farmers and small businesses will either have to pay more tax, face more complicated taxation requirements or change their trading structure.

The new rules, issued by the tax Office on 3^rd June 2010, will discourage many in small business from taking advantage of the recent Federal Government initiative of reducing the small business company tax rate from 30% to 28%.

Prior to 16^th December 2009, a business entity operating under a family trust structure could distribute taxable income to a related company attracting a 30% tax rate.

The distribution of that income to a company was typically not drawn by the company and was called an Undrawn Present Entitlement (UPE). That is, the operating trust held the distribution (the UPE) with a view to paying it to the company at some time in the future.

The Tax Department did not consider an undrawn present entitlement a loan from the company to the trust.

As such, the UPE did not come under the scope of Division 7A, a part of the Tax Act which determines how loans between companies and trusts and other related parties are treated for taxation purposes.

Under Division 7A, any loan other than UPE?s from a company to a trust had to be set up on commercial grounds otherwise it would be treated by the tax office as the payment of an unfranked dividend?.creating an enormous tax headache.

A loan set up on commercial grounds requires legal documentation such as a loan agreement and possibly a mortgage. Such a loan also requires regular principal and interest payments to the company over a period of time, the interest has to be at a commercial rate and is assessable to the company as and when it is derived.

Tax Ruling 2010/3 (effective from 16^th December 2009) describes new tax rules for the tax treatment of companies which have undrawn present entitlements.

The new ruling now includes undrawn present entitlements as loans under Division 7A that must now either be put on a commercial footing or else the family business will be exposed to effectively a substantial taxation penalty in the form of tax on an unfranked dividend.

Fortunately, the new rules do not apply to undrawn present entitlements created before 16^th December 2009.

The following is case study illustrating the impact of the new rules.

Farmers Bob and Dianna operate their farming business through a family discretionary trust and derive a taxable income of $300,000 each year. They have a company (B & D Pty Ltd) as a third tax paying entity in the family business.

Each year they decide to distribute $80,000 income each to Bob and Dianna and the remaining $140,000 in income is distributed as an undrawn present entitlement to the company.

That is, the $140,000 taxable income is taxed in the hands of the company but the $140,000 is physically retained in the trust usually in the form business capital.

The $140,000 trust distribution is an undrawn present entitlement held by the company in the trust.

B & D Pty Ltd pays tax at 30% on $140,000 or $42,000 which is $13,300 less tax than the tax that would be paid had the income been distributed in total to Bob and Dianna.

Up to 16^th December 2009, distributing income to a company  as described above was an accepted practice supported by the tax office and was a real tax incentive for small businesses such as Bob and Dianna?s where a discretionary trust was the established operating entity.

Now, under the new rules, the trust must enter into a loan agreement for the $140,000 undrawn present entitlement with B & D Pty Ltd. The Division 7A requirements are such that the loan must be over no more than 7 years if there is no security and up to 21 years if there is mortgaged security put in place. If no loan is put in place, Bob and Dianna would still have to pay the company tax, but would also have to pay tax on an unfranked dividend from the company in respect to the undrawn present entitlement amount.

Under the new rules Bob and Dianna now have two choices:

1. Do not distribute income to the company and instead distribute all of the income to themselves and pay the extra tax.
2. Distribute $140,000 to the company and set up a commercial loan.

Setting up a commercial loan does not by itself sound that complicated. However, Bob and Dianna have consistently high incomes and each year they distribute income to the company, they will need to set up another loan. With several loans there will be several repayments and the company will have growing cash reserves or potentially those funds will be lent back to the trust creating extra loans.

The bottom line is, sooner than later, the loans will need to be repaid or dividends paid out by the Company to Bob and Dianna, severely limiting the advantage of them using a company to reduce the rate of tax in the first place.

For many in small business where most of the profits are reinvested in the business, a possible solution may be to move their operating entity from a trust structure to a company structure.

If Bob and Dianna operated the farming business through a company, most of the profit would be retained in the company attracting a lower rate of tax and no loans such as described above would be required.

Unfortunately, a farmer operating through a company structure puts at risk a whole range of tax breaks designed specifically for primary producers so that Bob and Dianna would need to carefully review the overall tax implications of a change in structure.

In any case, changing structure is a costly exercise for Bob and Dianna.

Many small businesses start with trust structures because ,during the early years in establishing the business, small businesses do not expect big incomes and paying a  company tax rate may not be beneficial to them.

When they do get to a size where a company structure may be beneficial, the cost of restructuring to a company is quite often prohibitive. For instance, there is stamp duty as well as capital gains tax considerations.

It is these emerging small businesses that have previously chosen a discretionary trust as their trading entity that will be most disadvantaged by this tax office ruling.

From a practical viewpoint, the need for loan documentation etc. seems unnecessary where the undrawn present entitlement is effectively reinvested in the trust business anyway.

For many thousands of Australian small businesses who operate through trading trust structures, the change would appear to fly in the face of genuine attempts by  the Federal Government to foster and encourage small business.

Media Contact

Mahesha De Silva

Marketing Advisor WA/SA

E: mahesha.desilva@rsmi.com.au

P: (08) 9261 9124