Unpaid Present Entitlements and Bad Debt Deductions

Posted on August 05, 2014

The AAT has denied a taxpayer a deduction for writing off an irrecoverable debt from his family trust.

Under s 25-35 of the ITAA 97 a taxpayer is able to deduct a debt that is written off as irrecoverable if the debt has previously been included in assessable income. The typical application of this section is for uncollectable trading invoices on accruals accounting.

In Pope v FCT [2014] AATA 532, Mr Pope received a number of distributions from his Family Trust. They were included in his income. The Trust Deed allowed distributions to be made by payment, application or “setting … aside to a separate account … as a loan”. The distributions were paid in part, the remainder was set aside as a loan. Later, the Family Trust was unable to pay its debts. Taking the advice of his accountant, Mr Pope wrote off the loan from his Family Trust. He then claimed a deduction for that amount. The Commissioner, and then the AAT, disallowed that deduction because:

“the debt that was written off was entirely different in character to the income included in Mr Pope’s assessable income”.

It was the present entitlement that was included in Mr Pope’s income, but it was not the (unpaid) present entitlement that was written off. The present entitlement was satisfied by creating the debt.

Some thoughts arising from this case are:

1. A s 25-35 deduction of a bad debt only applies to debts that:
   1. Are in their present form. Therefore it does not apply if the debt is forgiven, assigned or revalued; and
   2. have been included in the income of the person writing them off. Therefore the purchaser of a business is not entitled to a deduction for bad debts purchased from the vendor;
2. An unpaid present entitlement (UPE) is not a debt. It cannot be dealt with in the same way as a debt. If you wish to deal with a UPE it must first be converted into a debt;
3. Because a UPE is not a debt, writing off a bad UPE does not allow a s 25-35 deduction. This view is shared by the Commissioner (see ATO ID 2013/15);and
4. The Trust Deed allowed for the distribution to be set aside as a loan. That is useful. However, many trust deeds specify that distributions must be set aside on a separate trust. That is a highly problematic clause and should be removed.

If you have any questions on dealing with UPEs, debts or deductions, please contact Joe Subic.

View all articles