What are the Div 7A considerations when making a distribution to a bucket company?
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It’s common for trustees of discretionary trusts to distribute income to private companies, often referred to as 'bucket companies.' This strategy can be tax-efficient, as it caps the tax on the bucket company’s share of the trust’s net income at the corporate tax rate, currently 25% or 30%, rather than exposing it to higher individual tax rates.
Moreover, by distributing franked dividends to a bucket company, payment of these dividends can potentially be deferred until a shareholder is subject to a lower marginal tax rate. For this reason, bucket companies remain a crucial part of many family group structures.
If you need guidance on ensuring your trust distributions to private companies are compliant with Division 7A, schedule a complimentary consultation with us by using this link.
What is the ATO's stance on Unpaid Present Entitlements?
Under Section 109O(1), if a bucket company makes a 'loan' to a trust during the income year, it could be deemed to have paid an unfranked dividend. The term 'loan' is broad and includes not just loans but also any provision of credit or financial help.
In 2009, the ATO clarified that this definition could include Unpaid Present Entitlements (UPEs) between a trust and a bucket company. A UPE arises when a trustee decides to distribute income to a bucket company, but doesn’t actually pay it. This situation could trigger Division 7A, leading to a deemed dividend unless proper steps are taken.
Taxpayers have typically managed this risk by entering into Division 7A loan agreements or proving that the UPE is held in a sub-trust for the bucket company. However, the ATO updated its guidance in TD 2022/11, which applies to UPEs arising from 1 July 2022 onwards. This update provides more detail on when a UPE is considered a provision of credit or financial accommodation, potentially classifying it as a Division 7A 'loan.' This updated view is relevant for distributions to bucket companies in the 2023 income year and beyond.
Tax warning: interest-only sub-trust arrangements
Previously, in TR 2010/3, the ATO allowed Unpaid Present Entitlements (UPEs) not to be treated as Division 7A loans if the funds were held in a sub-trust solely for the benefit of the bucket company. PS LA 2010/4 provided three ways to manage these funds:
- invest the UPE funds on an interest-only 7-year loan
- invest the UPE funds on an interest-only 10-year loan
- invest the UPE funds in a specific income-producing asset
However, with the release of TD 2022/11, the ATO no longer accepts sub-trust arrangements as a way to avoid Division 7A loans if the funds remain mixed within the main trust. Therefore, the first two options, which involve interest-only loans, are not acceptable for UPEs arising after 1 July 2022. The third option is rarely used.
For UPEs before 1 July 2022, the ATO will not scrutinise sub-trust arrangements that complied with the old rules (TR 2010/3 and PS LA 2010/4). If you followed these earlier guidelines, the ATO’s updated position in TD 2022/11 should not apply to your arrangement.
What is the ATO's updated Division 7A approach?
The ATO views an unpaid present entitlement (UPE) as a potential Division 7A loan when a private company allows a trust to retain the UPE without demanding immediate payment. This action is considered a financial accommodation, making the UPE subject to Division 7A rules under the Income Tax Assessment Act 1936.
If the private company and the trust are controlled by the same parties, the company is deemed to have knowledge of the entitlement at the same time as the trustee. To avoid the UPE being treated 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.
A complying loan agreement must include a written agreement, a maximum term of seven years for unsecured loans, and minimum yearly repayments based on the benchmark interest rate. The first repayment is due by 30 June of the year following the year the loan is made.
Failing to meet these requirements could result in the UPE being treated as a deemed dividend, triggering tax consequences for the private company and its shareholders.
Example: timing of Division 7A loan requirements
Sarah is the trustee of a discretionary trust called the "Star Trust". Orion Pty Ltd, a related bucket company controlled by Sarah, is entitled to part of the Star Trust's income. On 30 June 2024, Sarah decides to distribute 50% of the Star Trust’s income to Orion Pty Ltd, but at that time, Orion Pty Ltd doesn’t know how much it can demand from the trust.
By 15 August 2024, the trust’s income is calculated at $60,000, meaning Orion Pty Ltd is entitled to $30,000. This amount is recorded in both the Star Trust’s and Orion Pty Ltd’s accounts. On 15 August 2024, Orion Pty Ltd is aware it can demand the $30,000. If it doesn’t demand immediate payment, it's considered to have provided financial accommodation to the trust, leading to a Division 7A loan starting in the 2025 income year.
To avoid a deemed dividend, Orion Pty Ltd and the Star Trust must take action before 15 May 2026, the lodgment day for the 2025 income year. On 14 May 2026, the day before the lodgment day, they agree to a Section 109N complying loan agreement. The first minimum yearly repayment on the loan must be made by 30 June 2026.
Minimum yearly repayments will be required over the life of the loan (7 or 25 years) to prevent deemed dividends in future income years. Alternatively, a deemed dividend could have been avoided if Star Trust had paid the $30,000 to Orion Pty Ltd before 15 May 2026.
When can Section 100A apply to invalidate a distribution made to a bucket company?
Division 7A is crucial when distributing trust income to a bucket company, but another important consideration is Section 100A. When a bucket company receives a trust distribution and allows the trustee to keep its entitlement, this is seen as the company providing a 'benefit' to the trustee. If certain conditions are met, such as the agreement having a 'tax reduction purpose' and not being part of an 'ordinary family or commercial dealing,' the distribution could be invalidated under Section 100A.
When a trust distribution is retained by the trustee, two low-risk green zone scenarios outlined in PCG 2022/2 may apply:
- the bucket company entitlement is paid out within two years
- the bucket company entitlement is retained for two years or more
The specific requirements for these green zone scenarios differ based on how long the entitlement is retained. Meeting these requirements generally aligns with the ATO's expectations, helping to avoid a Division 7A deemed dividend for the unpaid present entitlement.
Bucket company entitlement paid out within two years
A trust distribution to a bucket company that the trustee retains can fall within the ATO's green zone scenario 2 if the following conditions are met (as outlined in PCG 2022/2):
- The bucket company receives its entitlement within two years of becoming entitled to it (i.e., the distribution is paid out within two years).
- The bucket company uses the entitlement once received. This can include keeping the funds, using them to purchase goods or services, meeting liabilities or expenses, investing them for the company, or paying dividends to shareholders.
- None of the exclusion factors apply. These factors include situations where the company has losses and uses its entitlement to make distributions to members that affect its ability to repay liabilities, where the entitlement is used to fund distributions to non-residents, or where the funds are cycled back to the trust that made the distribution.
The ATO essentially allows a two-year period during which the trustee can retain the trust distribution, as long as the bucket company receives and uses the entitlement within this timeframe.
Bucket company entitlements retained for two years or more
The ATO provides a green zone scenario (3B) for situations where a trust distribution is made to a bucket company, and the funds are retained by the trustee for two years or more.
This scenario is considered low-risk if the following conditions are met (as outlined in PCG 2022/2):
Trustee retention of funds
The bucket company allows the trustee to keep the trust distribution for two years or more. This does not apply if the entitlement is discharged and then made available to the trustee as a dividend.
Bucket company is not exempt
The bucket company must not be an exempt entity.
Same family group
The bucket company must be part of the same family group as the trust.
This can be confirmed if the trust has made a Family Trust Election (FTE), and the company is within the family group of the individual specified in the FTE.
No FTE is made, but the company is controlled by the same person who controls the trust or by that person’s spouse. For more on Family Trust Elections read our article here.
Trustee working capital condition:
The trustee must use the retained funds for:
- working capital in an active business;
- acquiring, maintaining, or improving investment assets or servicing related debt;
- lending the funds on commercial terms within the family group, where the borrower uses the funds as described above.
Loan on commercial terms
The entitlement retained by the trustee must 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 and uses its entitlement to distribute to members, affecting its ability to repay liabilities
- the entitlement funds are used for distributions to non-residents
- the funds are cycled back to the trust that made the distribution
Meeting these conditions ensures the distribution falls within the low-risk green zone, helping avoid Division 7A issues.
Tax warning: bucket company distributions outside the green zone
Be cautious with bucket company distributions that don’t meet the green zone criteria. Specifically, under the 'working capital condition,' a distribution won’t qualify for green zone scenario 3B if the trustee retains the distribution and loans it to another family group entity (e.g., the trust's controller) under the following conditions:
- the loan terms do not comply with Section 109N
- the loan is used for private purposes, such as buying a car
These situations could lead to tax issues, as the distribution would not be considered low-risk under the ATO’s guidelines.
Need help with Division 7A and your Bucket Company distributions? Visit our page Bucket Company Setup to learn more about our service.
About Causbrooks
Causbrooks gives you a client manager supported by a team of knowledgeable small business experts. We’re here to take the guesswork out of running your own business.
Get in touch with us to set up a consultation or use the contact form on this page to inquire whether our services are right for you.
Disclaimer
Any advice contained in this document is general advice only and does not take into consideration the reader’s personal circumstances. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances.
What are the Div 7A considerations when making a distribution to a bucket company?
Download our Readers Guide to setting up your business
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.
It’s common for trustees of discretionary trusts to distribute income to private companies, often referred to as 'bucket companies.' This strategy can be tax-efficient, as it caps the tax on the bucket company’s share of the trust’s net income at the corporate tax rate, currently 25% or 30%, rather than exposing it to higher individual tax rates.
Moreover, by distributing franked dividends to a bucket company, payment of these dividends can potentially be deferred until a shareholder is subject to a lower marginal tax rate. For this reason, bucket companies remain a crucial part of many family group structures.
If you need guidance on ensuring your trust distributions to private companies are compliant with Division 7A, schedule a complimentary consultation with us by using this link.
What is the ATO's stance on Unpaid Present Entitlements?
Under Section 109O(1), if a bucket company makes a 'loan' to a trust during the income year, it could be deemed to have paid an unfranked dividend. The term 'loan' is broad and includes not just loans but also any provision of credit or financial help.
In 2009, the ATO clarified that this definition could include Unpaid Present Entitlements (UPEs) between a trust and a bucket company. A UPE arises when a trustee decides to distribute income to a bucket company, but doesn’t actually pay it. This situation could trigger Division 7A, leading to a deemed dividend unless proper steps are taken.
Taxpayers have typically managed this risk by entering into Division 7A loan agreements or proving that the UPE is held in a sub-trust for the bucket company. However, the ATO updated its guidance in TD 2022/11, which applies to UPEs arising from 1 July 2022 onwards. This update provides more detail on when a UPE is considered a provision of credit or financial accommodation, potentially classifying it as a Division 7A 'loan.' This updated view is relevant for distributions to bucket companies in the 2023 income year and beyond.
Tax warning: interest-only sub-trust arrangements
Previously, in TR 2010/3, the ATO allowed Unpaid Present Entitlements (UPEs) not to be treated as Division 7A loans if the funds were held in a sub-trust solely for the benefit of the bucket company. PS LA 2010/4 provided three ways to manage these funds:
- invest the UPE funds on an interest-only 7-year loan
- invest the UPE funds on an interest-only 10-year loan
- invest the UPE funds in a specific income-producing asset
However, with the release of TD 2022/11, the ATO no longer accepts sub-trust arrangements as a way to avoid Division 7A loans if the funds remain mixed within the main trust. Therefore, the first two options, which involve interest-only loans, are not acceptable for UPEs arising after 1 July 2022. The third option is rarely used.
For UPEs before 1 July 2022, the ATO will not scrutinise sub-trust arrangements that complied with the old rules (TR 2010/3 and PS LA 2010/4). If you followed these earlier guidelines, the ATO’s updated position in TD 2022/11 should not apply to your arrangement.
What is the ATO's updated Division 7A approach?
The ATO views an unpaid present entitlement (UPE) as a potential Division 7A loan when a private company allows a trust to retain the UPE without demanding immediate payment. This action is considered a financial accommodation, making the UPE subject to Division 7A rules under the Income Tax Assessment Act 1936.
If the private company and the trust are controlled by the same parties, the company is deemed to have knowledge of the entitlement at the same time as the trustee. To avoid the UPE being treated 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.
A complying loan agreement must include a written agreement, a maximum term of seven years for unsecured loans, and minimum yearly repayments based on the benchmark interest rate. The first repayment is due by 30 June of the year following the year the loan is made.
Failing to meet these requirements could result in the UPE being treated as a deemed dividend, triggering tax consequences for the private company and its shareholders.
Example: timing of Division 7A loan requirements
Sarah is the trustee of a discretionary trust called the "Star Trust". Orion Pty Ltd, a related bucket company controlled by Sarah, is entitled to part of the Star Trust's income. On 30 June 2024, Sarah decides to distribute 50% of the Star Trust’s income to Orion Pty Ltd, but at that time, Orion Pty Ltd doesn’t know how much it can demand from the trust.
By 15 August 2024, the trust’s income is calculated at $60,000, meaning Orion Pty Ltd is entitled to $30,000. This amount is recorded in both the Star Trust’s and Orion Pty Ltd’s accounts. On 15 August 2024, Orion Pty Ltd is aware it can demand the $30,000. If it doesn’t demand immediate payment, it's considered to have provided financial accommodation to the trust, leading to a Division 7A loan starting in the 2025 income year.
To avoid a deemed dividend, Orion Pty Ltd and the Star Trust must take action before 15 May 2026, the lodgment day for the 2025 income year. On 14 May 2026, the day before the lodgment day, they agree to a Section 109N complying loan agreement. The first minimum yearly repayment on the loan must be made by 30 June 2026.
Minimum yearly repayments will be required over the life of the loan (7 or 25 years) to prevent deemed dividends in future income years. Alternatively, a deemed dividend could have been avoided if Star Trust had paid the $30,000 to Orion Pty Ltd before 15 May 2026.
When can Section 100A apply to invalidate a distribution made to a bucket company?
Division 7A is crucial when distributing trust income to a bucket company, but another important consideration is Section 100A. When a bucket company receives a trust distribution and allows the trustee to keep its entitlement, this is seen as the company providing a 'benefit' to the trustee. If certain conditions are met, such as the agreement having a 'tax reduction purpose' and not being part of an 'ordinary family or commercial dealing,' the distribution could be invalidated under Section 100A.
When a trust distribution is retained by the trustee, two low-risk green zone scenarios outlined in PCG 2022/2 may apply:
- the bucket company entitlement is paid out within two years
- the bucket company entitlement is retained for two years or more
The specific requirements for these green zone scenarios differ based on how long the entitlement is retained. Meeting these requirements generally aligns with the ATO's expectations, helping to avoid a Division 7A deemed dividend for the unpaid present entitlement.
Bucket company entitlement paid out within two years
A trust distribution to a bucket company that the trustee retains can fall within the ATO's green zone scenario 2 if the following conditions are met (as outlined in PCG 2022/2):
- The bucket company receives its entitlement within two years of becoming entitled to it (i.e., the distribution is paid out within two years).
- The bucket company uses the entitlement once received. This can include keeping the funds, using them to purchase goods or services, meeting liabilities or expenses, investing them for the company, or paying dividends to shareholders.
- None of the exclusion factors apply. These factors include situations where the company has losses and uses its entitlement to make distributions to members that affect its ability to repay liabilities, where the entitlement is used to fund distributions to non-residents, or where the funds are cycled back to the trust that made the distribution.
The ATO essentially allows a two-year period during which the trustee can retain the trust distribution, as long as the bucket company receives and uses the entitlement within this timeframe.
Bucket company entitlements retained for two years or more
The ATO provides a green zone scenario (3B) for situations where a trust distribution is made to a bucket company, and the funds are retained by the trustee for two years or more.
This scenario is considered low-risk if the following conditions are met (as outlined in PCG 2022/2):
Trustee retention of funds
The bucket company allows the trustee to keep the trust distribution for two years or more. This does not apply if the entitlement is discharged and then made available to the trustee as a dividend.
Bucket company is not exempt
The bucket company must not be an exempt entity.
Same family group
The bucket company must be part of the same family group as the trust.
This can be confirmed if the trust has made a Family Trust Election (FTE), and the company is within the family group of the individual specified in the FTE.
No FTE is made, but the company is controlled by the same person who controls the trust or by that person’s spouse. For more on Family Trust Elections read our article here.
Trustee working capital condition:
The trustee must use the retained funds for:
- working capital in an active business;
- acquiring, maintaining, or improving investment assets or servicing related debt;
- lending the funds on commercial terms within the family group, where the borrower uses the funds as described above.
Loan on commercial terms
The entitlement retained by the trustee must 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 and uses its entitlement to distribute to members, affecting its ability to repay liabilities
- the entitlement funds are used for distributions to non-residents
- the funds are cycled back to the trust that made the distribution
Meeting these conditions ensures the distribution falls within the low-risk green zone, helping avoid Division 7A issues.
Tax warning: bucket company distributions outside the green zone
Be cautious with bucket company distributions that don’t meet the green zone criteria. Specifically, under the 'working capital condition,' a distribution won’t qualify for green zone scenario 3B if the trustee retains the distribution and loans it to another family group entity (e.g., the trust's controller) under the following conditions:
- the loan terms do not comply with Section 109N
- the loan is used for private purposes, such as buying a car
These situations could lead to tax issues, as the distribution would not be considered low-risk under the ATO’s guidelines.
Need help with Division 7A and your Bucket Company distributions? Visit our page Bucket Company Setup to learn more about our service.
About Causbrooks
Causbrooks gives you a client manager supported by a team of knowledgeable small business experts. We’re here to take the guesswork out of running your own business.
Get in touch with us to set up a consultation or use the contact form on this page to inquire whether our services are right for you.
Disclaimer
Any advice contained in this document is general advice only and does not take into consideration the reader’s personal circumstances. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances.
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