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Monday Ramblings – Debt Forgiveness again – but with UPEs

Last week I wrote about claiming a capital loss for forgiving a debt. The follow up question is always about an unpaid present entitlement. 

As the beneficiary has included the UPE in their assessable income it seems like the conditions for a bad debt deduction under section 25-35 have been met. But the Commissioner has other ideas…

In Taxation Determination TD 2016/19 the Commissioner answers the question:

Is a beneficiary of a trust entitled to a deduction under section 25-35 of the Income Tax Assessment Act 1997 for the amount of an unpaid present entitlement to trust income that the beneficiary has purported to write off as a bad debt?

He states they cannot use section 25-35 and does so by the strange statement:

This is because the amount of the unpaid entitlement is not included in the beneficiary’s assessable income. 

What??? Yes it is, isn’t it? How can he come to this conclusion? Have a look at this for his logic…

Rather, the entitlement is used to determine the amount (if any) of the net income of the trust (as determined under subsection 95(1) of the Income Tax Assessment Act 1936 (ITAA 1936)) included in the beneficiary’s assessable income under Division 6 of Part III of the ITAA 1936. Consequently, the requirement in paragraph 25-35(1)(a) of the ITAA 1997 cannot be met.

As the High Court stated in the Bamford case, a trust’s “income” and “net income” are two different things – one is forgiven and the other one is included in assessable income.

Example

Archie is a beneficiary of the Woof Family Trust. In the 2009 income year, the trustee, Doggo Pty Ltd, derived $1,000 interest income. Pursuant to a power in the deed, Doggo Pty Ltd also chose to treat a $9,000 increase in the value of a trust asset as income of the trust for that year. Archie was made presently entitled to all of the income of the trust ($10,000). As a result he was assessed on all of the net income of the trust in that year ($1,000) under section 97 of the ITAA 1936.

The $10,000 entitlement was not paid to Archie but was recorded as a UPE. During the 2013-14 income year, Doggo Pty Ltd advised Archie that there was no likelihood his entitlement would be paid to him as the relevant asset is now worthless and the trust had no other property.

Archie determined that the $10,000 UPE was a bad debt and wrote it off. He cannot claim a deduction under section 25-35 of the ITAA 1997 for any part of the UPE. No part of his trust entitlement (his UPE) was included in his assessable income. Rather, Archie included his share of the net income of the trust in his assessable income.

But isn’t the answer to convert the UPE to a loan and then write it off? Unfortunately not for the same reason as above, as the loan was never included in the assessable income of the beneficiary. Have a look at this example from the Commissioner:

Example

The deed of the Meow Trust provides the trustee with a discretion to pay, apply or set aside the income, or any part of the income, to or for the benefit of the beneficiaries. Further, where the trustee resolves to distribute income, the deed provides that the payment, application or setting aside of income may be effectively made:

  1. by paying the income to the beneficiary or to such person on behalf of the beneficiary as the beneficiary may authorise or direct; or
  2. 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.

The trustee resolved to appoint all of the income of the Meow Trust for the 2011 year ($20,000) to Tio. No amount was paid to Tio. The effect of the deed is that any income appointed, but not paid, to Tio is loaned back to the trustee.

Tio included all of the net income of the trust ($20,000) in his assessable income.

Tio cannot claim a deduction under section 25-35 of the ITAA 1997 in respect of the $20,000 owed to him by the trustee if he later concludes that the loan is bad and he writes it off. The loan was not an amount that Tio included in his assessable income.

By Ken Mansell

As a stay at home Dad most of the week this is my way of pretending I am still the tax counsel of ASX and SEC listed companies, working at big 4 firms, working at the Federal Treasury, on the Henry Review and at Parliament House for the previous government.

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