A recent case in the Administrative Appeals Tribunal (Pope v FC, known as Pope’s Case) is of interest to taxpayers and their advisers, with respect to the characterisation of unpaid trust entitlements (UPEs) as loans.
In this case, Deputy President Hack characterised amounts previously distributed to the taxpayer, Pope, from the Pope Family Trust, and remaining unpaid as being debt at the time, that the amounts were written off by the Pope as being bad. Pope had previously included the UPEs in his assessable income in the income years in which the distributions were made and sought to obtain a deduction for those UPEs when they were irrecoverable from the Trust.
Pope contended that the amounts considered bad were to be characterised as UPEs, and that the amounts written off bore the same character as the distributions from the Trust and included in his assessable income in the 2005 and 2007 income years.
The Commissioner of Taxation argued that the amounts written off were not Pope’s UPEs, but were instead debts. The Commissioner contended that the debts written off related to Pope’s outstanding loan account balance in the books of account of the Trust and, therefore, were of an entirely different character to the amounts included in Pope’s assessable income in 2005 and 2007.
The Commissioner’s contentions in Pope accorded with his expressed views in ATO ID 2013/15, in which the Commissioner outlined his view regarding UPEs from a trust and whether they could be bad debt deductions. The Commissioner stated his view that that no debt was created when a present entitlement was created, only a right in equity, although he conceded that that right may later become a debt (i.e. when payment of the entitlement is called for). Accordingly, he considered that the amount included in income as a result of the UPE was not referable to a debt.
The Commissioner considered that the amount included in the taxpayer’s assessable income was not actually the UPE, but an amount calculated in reference to the UPE (i.e. the taxpayer was entitled to a share of the trust’s income according to its deed, and it is that share of the trust’s taxable income that was included in their assessable income). The Commissioner considered that the requirements to claim a bad debt deduction were not met, and the taxpayer could not claim a deduction if they wrote off their UPE from an insolvent trust.
It is considered that Pope’s Case has relevance to the Commissioner’s views regarding UPEs and loans expressed in a practice statement relating to the Income Tax Assessment Act.
In reaching his decision in favour of the Commissioner, Deputy President Hack referred to the terms of the trust, which stated the trustee had the power to resolve to accumulate the whole or part of the income of a financial year. Where the trustee resolved to distribute, part of the act stated the payment may be effectively made:
- for a beneficiary who is not under a legal disability;
- by paying the income to the beneficiary or to such person on behalf of the beneficiary as the beneficiary may authorise or direct; or
- by setting the income aside to a separate account in the books of the Trust in the name of the beneficiary, whereupon such monies will constitute a loan at call and will not bear interest unless the Trustee and the beneficiary otherwise agree.
The decision in Pope’s Case rested on the terms of the Trust deed, and highlighted the importance of the trust deed in the characterisation of trust amounts. The fact that the Trust’s books of account supported the Trust deed, was not of assistance to Pope. Deputy President Hack noted that:
“… The difference, $321,355, is the balance of the account in Mr Pope’s name in the accounts of the Trust as at 30 June 2005. As the Commissioner submits, the only rational inference in these circumstances is that the balance of the distribution to Mr Pope was effected in the manner set out in clause 4.4(a)(ii) of the Trust deed and that the monies distributed in that way constituted a loan at call between Mr Pope and the Trust.”
It is arguable that Pope’s Case lends support to the Commissioner’s views that in certain situations, and depending on the factual circumstances (including the terms of the relevant trust’s deed), the nature of distributions made and remaining unpaid may have changed to that of a loan from the recipient to the trust.
Pope’s Case reinforces the popular refrain for taxpayers and their advisors to “read the trust deed” and to be aware of, and understand the implications of, the terms of the trust set out in its deed. Pope’s Case also emphasizes the evidentiary importance of financial records in dealing with the Commissioner and seeking redress from the AAT or the courts.
Download a PDF version of this article: Read The Trust Deed: Pope’s Case - Unpaid Present Entitlement and Bad Debt Deductions