Private ruling: Division 7A - debt forgiveness
Date of advice: 6 July 2020
Published: August 2020
Ruling period: Year ending 30 June 2021

Ruling: Q1: Will subsection 109G(4) of the Income Tax Assessment Act 1936 (ITAA 1936) apply, so that the company's proposed forgiveness of a debt owing to it by its sole shareholder will not be deemed a dividend under Division 7A of the ITAA36? | A1: No

Relevant facts and circumstances: XYZ Pty Ltd (you) was incorporated on 1 June 20XX and registered for GST on 1 July 20XX. You carry on a business that provides a service. X is your sole director and shareholder. In the 2015 financial year and subsequent years, you made loans to X pursuant to Division 7A compliant loan agreements. You advised that the balance of the loans currently is $X. You also advised that your distributable surplus currently is $Y. Since the advent of the Coronavirus Pandemic and associated lockdown measures, you have experienced a marked decline in turnover. Consequently, current year earnings as at May 2020 are a loss of $Z. You propose that you forgive the balance owing on the loans to X because payment of the debt would cause X to suffer undue hardship. You have provided us copies of your financial documents, as well as X's personal financial documents.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subsection 109(G)(4)

Reasons for decision: Summary: Under Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) amounts paid, lent or forgiven by a private company to certain associated entities are treated as dividends, unless they come within specific exclusions. The provisions apply where the recipient of the payment, loan or forgiven amount is a shareholder or an associate of a shareholder of the private company. Under subsection 109F(1) of the ITAA 1936 a private company is taken to pay a dividend to an entity (being a shareholder of or associate of a shareholder of the company) at the end of its year of income if all or part of a debt owed by the entity to the company is forgiven in that year. The amount of the dividend equals the amount of the debt forgiven, subject to section 109Y of the ITAA 1936. However subsection 109G(4) of the ITAA 1936 provides that a private company will not be taken to pay a dividend in such circumstances if: a) the debt was forgiven because payment of the debt would have caused the entity undue hardship; b) when the entity incurred the debt, the entity had the capacity to pay the debt; and c) the entity lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond the entity's control. X would have to meet all three criteria under subsection 109G(4) of the ITAA 1936 to apply so that you will not be taken to pay a dividend in forgiving the loans of X. Each paragraph will be addressed separately below. | Detailed Reasoning - a) payment of the debt would have caused the entity undue hardship: The phrase "undue hardship" is not defined in the ITAA 1936 and has not received judicial consideration in the context of Division 7A. Accordingly, it should be interpreted by having regard to its ordinary meaning, the statutory context in which the phrase appears and the object of the provision. The Macquarie Dictionary defines hardship as: A condition that bears hard upon one; severe, toil, trial, oppression or need. In Re Wilson and Minister for Territories (1985) 7 ALD 225, the Administrative Appeals Tribunal considered the ordinary meaning of 'undue hardship'. Deputy President Hall described 'undue hardship' as hardship that is excessive in the circumstances, and something more than substantial hardship. This has been followed in subsequent decisions. In the context of subsection 109G(4) of the ITAA 1936, hardship would necessarily involve a financial detriment resulting from the payment of the debt. While the phrase "undue hardship" is not defined in the ITAA 1936 or other ATO publications, Practice Statement Law Administration PSLA 2011/17: Debt relief, waiver and non-pursuit (PSLA 2011/17) contains the following definition of the phrase "serious hardship": | Detailed Reasoning - 8. Definition of serious hardship: 'Serious hardship' is given its ordinary meaning. We consider serious hardship to exist where the payment of a tax liability would result in a person being left without the means to afford basics such as food, clothing, medical supplies, accommodation or reasonable education. We have tests to apply in helping you decide whether serious hardship exists. The object of the tests is to determine whether the consequences of paying the tax would be so burdensome that the person would be deprived of what are considered necessities according to normal community standards. These tests are: · the income/outgoings test · the assets/liabilities test · other relevant factors. Also, the phrase "serious financial hardship" is explained in Practice Statement Law Administration PSLA 2011/4: Collection and recovery of disputed debts (PSLA 2011/4) as follows: 56. Serious financial hardship in the context of a personal taxation debt of an individual taxpayer, such as income tax, is likely to ensue where payment of the disputed debt would place a taxpayer in a situation where there are insufficient assets, which could be reasonably realised to cover the gap between personal income and the expenses associated with the basic necessities of everyday life (emphasis added). ... 59. A finding of serious financial hardship is unlikely where the taxpayer or entities associated with the taxpayer hold assets such as term deposits, shares, investment properties, boats, or where there appears to be considerable scope for economising on items such as accommodation, clothes, education or general living or business expenses. Similarly, the mere anticipation of inconvenience or disruption to the taxpayer's business or personal lifestyle which could result from the reorganisation of the taxpayer's financial affairs to pay 50% of the disputed debt would not amount to hardship. The Commissioner considers serious hardship for a person to be the deprivation of the basic necessities of everyday life, such as food, clothing, shelter or reasonable education. According to X's personal income statement, X's monthly expenses exceed his current monthly income (reduced currently due to Coronavirus) by $X. We do note however, that his expenses include several items that are not considered as basic necessities of everyday life. These include: · Pay TV · Life Insurance · health insurance · Boxing and GYM We also note that X has school aged children in private schools. According to PSLA 2011/4, there appears to be considerable scope for economising on items such as education or general living or business expenses. Therefore, we do not consider that X would suffer undue hardship if he was required to repay the loans to you. Since the requirement at paragraph (a) is not met, subsection 109G(4) will not apply. However, for the sake of completeness, paragraphs (b) and (c) will be considered as well. | Detailed Reasoning - b) when the entity incurred the debt, he had the capacity to pay the debt: You advised that X's sole source of income is either salary, or dividends received from you as your sole shareholder. Therefore, assessing X's ability to repay each loan in the year that it occurs requires consideration of your balance sheets. You provided your current Balance sheet, and the Balance sheets for the prior five years. In assessing X's capacity to repay the cumulative loan balance made to him in each year, the following was considered: · income from salary - X's taxable income · income from dividends - the retained earnings at the start of each year plus the current year earnings to reach a figure of cash available to you to lend to X, and potentially to pay X dividends in the future to repay those loans. It is accepted that X had enough funds from his salary and your retained profits to cover the loans in the 20XX, 20XY, and 20XZ financial years. It is noted from the above, that in the 20XW financial year, you made a loss, essentially depleting all your retained earnings and leaving no profits to issue dividends to X. X did have taxable income of $X to repay the Division 7A accumulated loans up to that point in time. Taking into account X's standard of living (he has approximately $V monthly living expenses as stated in his income statement), it is not accepted that he had the capacity to pay the Minimum Yearly Repayment on the accumulated balance of the loans made to him and meet his monthly expenses on his salary alone when you did not have any retained profits to pay him any dividends during that year. Overall, it is accepted that X had the capacity to repay the debts when they were incurred in all financial years other than the 20XW financial year. | Detailed Reasoning - c) the entity lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond its control.: Paragraph (c) is met if X has lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond his control. You state that due to the downturn in your business and your turnover that has been caused directly by the Coronavirus Pandemic and the associated lockdown measures: · X's salary has decreased by more than X%, and · You do not expect to pay any dividends for the foreseeable future. In the Explanatory Memorandum for the Taxation Laws Amendment Bill (No. 3) 1998 (which was later enacted as Act No. 47 of 1998) stated the following regarding the proposed operation of subsection 109G(4): Commissioner may treat forgiveness as not giving rise to dividend 9.47 The Commissioner has a power to exclude a forgiven debt from the operation of this Division where the Commissioner is satisfied that the shareholder or associate would suffer undue hardship. ... The Commissioner will only exercise his power if he is satisfied that the shareholder had the ability to pay at the time of receipt of the loan and lost the ability to pay, permanently, through no fault of his or her own. It is accepted that the Coronavirus Pandemic has had a huge effect on the Australian economy, and the associated lockdown measures have severely affected the turnover of most businesses. We also accept that the Coronavirus Pandemic and the associated lockdown measures are beyond X's control. However, the Coronavirus Pandemic and associated lockdown measures are considered temporary and transient in nature. Therefore, while it is accepted that X would have had trouble in repaying the loans in the near future, it is not accepted that he has permanently lost his ability to repay the loans, especially as the Pandemic passes and the lockdown measures are removed altogether. We also note that in PSLA 2011/17, which looks at release from a tax liability where the Commissioner considers that paying the debt would cause serious hardship, paragraph 11 lists some examples of situations in which the Commissioner may decide against granting release from a tax debt, even though implications of serious hardship may be drawn. These include where the serious hardship is likely only to be short term (to be determined on a case by case basis). In the circumstances, the Coronavirus Pandemic or the associated lockdown measures, do not represent a permanent loss of X's capacity to repay the Division 7A loans. Therefore, X has not met the requirement under paragraph (c). | Detailed Reasoning - Additional matters: Paragraph 11 of PSLA 2011/17 also lists two more examples of situations (both applicable here) where the Commissioner would not consider implications of serious hardship sufficient for granting release from a tax debt. | Detailed Reasoning - 1. The taxpayer has delayed lodgement of returns resulting in the accumulation of a large debt that they are unable to pay.: In your balance sheet, we note that the majority of your liabilities comprise an ATO Integrated Client Account debt of $XX. This amount of unpaid taxes has steadily been increasing. X's personal Balance sheet also shows a personal debt to the ATO. While there is no evidence of delaying lodgements, it is clear that there are large ATO debts accumulating over time which now form the majority of the liabilities of the company. | Detailed Reasoning - 2. Release would not alleviate hardship, such as where the person has other liabilities or creditors: In addition to the tax debts mentioned above, X's expenses exceed his income on a monthly basis by $XX. His personal liabilities exceed his total assets by $XY. Debt forgiveness of the Division 7A loans would not alleviate any hardship he may suffer. | Detailed Reasoning - Conclusion: As per the reasoning above, it is concluded that repayment of the Division 7A loans will not cause undue hardship for X, and that the Coronavirus Pandemic and associated measures will not cause a permanent loss of ability to repay the loans. Accordingly, subsection 109G(4) of the ITAA 1936 will not apply to treat any forgiveness of the Loan as not giving rise to a dividend.