How does Div 7A impact distributions to a Bucket Company?

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Trustees of discretionary trusts often distribute income to private companies, commonly called ‘bucket companies.’ This strategy can be tax-effective because it limits the tax on the distributed income to the corporate tax rate, either 25% or 30%, rather than subjecting it to potentially higher personal tax rates.

However, when making such distributions, it’s essential to consider the Division 7A provisions under the Income Tax Assessment Act. If a private company receives income from a trust and does not fully pay or set off the amount, it may be treated as an Unpaid Present Entitlement (UPE). In such cases, Division 7A could deem the UPE as a dividend, leading to significant tax implications.

To avoid this, a complying loan agreement must be in place. The loan must adhere to the benchmark interest rate, have a maximum term of seven years for unsecured loans (or 25 years if secured by real property), and meet minimum yearly repayments. If the loan is not repaid according to these terms, it could be classified as a deemed dividend, adding to the company’s assessable income, potentially increasing the tax liability.

If you need assistance navigating Division 7A compliance for your distributions, contact us to schedule a complimentary consultation.

What is the ATO’s view on Unpaid Present Entitlements?

When a bucket company extends a ‘loan’ to a trust during an income year, the ATO may treat it as an unfranked dividend under Section 109O(1). The definition of ‘loan’ is broad, encompassing not just traditional loans but also any form of credit or financial assistance.

In 2009, the ATO clarified that Unpaid Present Entitlements (UPEs) between a trust and a bucket company could fall under this broad definition. A UPE arises when a trustee allocates income to a bucket company, but does not immediately pay it. This scenario can trigger Division 7A, potentially resulting in a deemed dividend unless appropriate actions are taken.

To mitigate this risk, taxpayers have traditionally entered into Division 7A loan agreements or demonstrated that the UPE is held in a sub-trust for the bucket company. However, with the ATO’s updated guidance in TD 2022/11, which applies to UPEs from 1 July 2022 onwards, there is further clarification on when a UPE is considered a provision of credit or financial accommodation. This updated view is particularly significant for distributions to bucket companies starting in the 2023 income year and beyond.

Tax warning: new rules for interest-only sub-trust arrangements

In the past, the ATO allowed Unpaid Present Entitlements (UPEs) to be managed through sub-trusts to avoid being classified as Division 7A loans. According to earlier guidelines, specifically TR 2010/3, trustees could use these funds for the benefit of the bucket company without triggering Division 7A, as long as the funds were kept in a separate sub-trust.

Taxpayers had three main options:

• Using the UPE funds for an interest-only 7-year loan.

• Using the UPE funds for an interest-only 10-year loan.

• Investing the UPE funds in a specific income-producing asset.

However, the ATO’s latest guidance in TD 2022/11 changes the landscape. Now, sub-trust arrangements where UPE funds are mixed with the main trust’s assets are no longer sufficient to avoid Division 7A. Specifically, the first two options, involving interest-only loans, are not acceptable for UPEs created after 1 July 2022. The third option, investing in a specific income-producing asset, remains rarely used and offers limited applicability.

For those with UPEs established before 1 July 2022, the ATO will not review sub-trust arrangements that were compliant with the old rules under TR 2010/3 and PS LA 2010/4. These existing arrangements should remain unaffected by the changes outlined in TD 2022/11.

If you need assistance in understanding these changes or ensuring your arrangements comply with current ATO guidelines, feel free to schedule a consultation with us.

How the ATO’s updated Division 7A approach affects UPEs

The ATO now considers an Unpaid Present Entitlement (UPE) as a potential Division 7A loan when a private company allows a trust to retain the UPE without immediate payment. This is treated as a financial accommodation under the Income Tax Assessment Act 1936, making the UPE subject to Division 7A rules.

To avoid the UPE being classified as a deemed dividend, which would be included in assessable income, the trustee must either pay the UPE to the company or enter into a complying Division 7A loan agreement before the company’s lodgment day. This agreement must include a written contract, a maximum term of seven years for unsecured loans, and minimum yearly repayments based on the benchmark interest rate.

If these requirements are not met, the UPE may be treated as a deemed dividend, resulting in tax consequences for the private company and its shareholders.

Example: managing division 7A loan deadlines

Emma, the trustee of a discretionary trust called “Aurora Trust,” decides on 30 June 2024 to allocate 50% of the trust’s income to Nova Pty Ltd, a related bucket company she controls. At that time, Nova Pty Ltd is unaware of the exact amount it is entitled to. By 15 August 2024, Aurora Trust’s income is calculated at $60,000, entitling Nova Pty Ltd to $30,000, which is then recorded in the accounts of both the Aurora Trust and Nova Pty Ltd.

On 15 August 2024, Nova Pty Ltd becomes aware of its $30,000 entitlement. If the company does not demand immediate payment, this is considered financial accommodation to the trust, triggering a Division 7A loan for the 2025 income year. To avoid this being treated as a deemed dividend, Emma and Nova Pty Ltd must take action before 15 May 2026, the lodgment day for the 2025 income year.

On 14 May 2026, just before the lodgment day, they agree to a Section 109N complying loan agreement. The first minimum yearly repayment is due by 30 June 2026, with repayments continuing over the 7 or 25-year term to prevent deemed dividends. Alternatively, a deemed dividend could have been avoided if Aurora Trust had paid the $30,000 to Nova Pty Ltd before 15 May 2026.

If you have similar arrangements and need guidance on Division 7A compliance, consider booking a consultation with us.

How Section 100A could impact distributions to a bucket company

While Division 7A is essential when distributing trust income to a bucket company, Section 100A of the Income Tax Assessment Act also plays a significant role. If a bucket company receives a trust distribution but allows the trustee to retain its entitlement, this action may be considered as the company providing a ‘benefit’ to the trustee. If this arrangement has a ‘tax reduction purpose’ and does not fall within an ‘ordinary family or commercial dealing,’ Section 100A could invalidate the distribution.

Two low-risk scenarios, referred to as the green zone in PCG 2022/2, are relevant when a trust distribution is retained by the trustee:

• The bucket company entitlement is paid out within two years.

• The bucket company entitlement is retained for two years or more.

The requirements for these green zone scenarios vary depending on the duration for which the entitlement is retained. Complying with these requirements typically aligns with the ATO’s expectations and helps avoid triggering a Division 7A deemed dividend for the unpaid present entitlement.

Managing bucket company entitlements: the ATO’s two-year green zone rule

When a trust distributes income to a bucket company, the trustee may retain the distribution under the ATO’s green zone scenario 2, as outlined in PCG 2022/2, if certain conditions are met:

• The bucket company must receive its entitlement within two years of the distribution date.

• Once received, the bucket company must use the funds, which may include holding them, purchasing goods or services, covering liabilities, investing for the company, or paying dividends to shareholders.

• No exclusion factors should apply, such as the company using the entitlement to make distributions to members that impair its ability to meet liabilities, using it to fund distributions to non-residents, or cycling the funds back to the originating trust.

The ATO permits a two-year window for the trustee to hold the trust distribution, provided the bucket company receives and uses the entitlement within this period, ensuring compliance with Division 7A requirements and avoiding the risk of a deemed dividend.

For detailed advice on managing these entitlements and adhering to ATO guidelines, consider booking a consultation with us.

Low-risk strategy: retaining bucket company entitlements for two years or more

The ATO outlines a low-risk green zone scenario (3B) under PCG 2022/2 for trust distributions to a bucket company where the funds are retained by the trustee for two years or more. To ensure this scenario remains low-risk and avoids Division 7A complications, several key conditions must be met:

Trustee retention of funds

The bucket company must allow the trustee to retain the distribution for at least two years, with no discharge and subsequent dividend payment back to the trustee.

Bucket company requirements

The bucket company must not be an exempt entity and must be part of the same family group as the trust. This can be verified if a Family Trust Election (FTE) is in place, or if the company is controlled by the same person who controls the trust.

Trustee’s use of retained funds

The trustee must use the retained funds for purposes such as working capital in an active business, improving investment assets, or lending within the family group on commercial terms.

Loan on commercial terms

The retained entitlement should be treated as a loan on commercial terms, similar to a 7-year complying Division 7A loan.

No exclusion factors

The scenario does not apply if the company has losses, the funds are used for non-resident distributions, or the funds are cycled back to the trust.

Tax warning: bucket company distributions outside the green zone

Exercise caution with bucket company distributions that fall outside the ATO’s green zone criteria. For instance, under the ‘working capital condition,’ a distribution will not qualify for green zone scenario 3B if the trustee retains the distribution and then loans it to another family group entity, such as the trust’s controller, under certain conditions.

Specifically, the distribution will be considered high-risk if:

• The loan terms do not comply with Section 109N.

• The loan is used for private purposes, such as purchasing a car.

Failing to meet the green zone criteria can lead to significant tax issues, as these distributions would not be regarded as low-risk under the ATO’s guidelines.

Need help managing Division 7A with your Bucket Company? Visit our service page on Bucket Company Setup.

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This outline is for general information only and not as legal, tax or accounting advice. It may not be accurate, complete or current. It is not official and not from a government institution. Always consult a qualified professional for specific advice tailored to your unique circumstances.