Private ruling: Tax integrity measures - Division 7A
Date of advice: 25 March 2020
Published: May 2020
Ruling period: Year ended 30 June 20YY+2 | Year ended 30 June 20YY+3 | Year ended 30 June 20YY+4
Date scheme commenced: Relevant date

Ruling: Q1: Will unpaid present entitlements (UPE) for the relevant years conferred by the Family Trust on Company A be a loan for the purposes of subsection 109D(3) of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: Yes | Q2: Will any deemed dividend arising under Division 7A of Part III of the ITAA 1936 at the end of the relevant income years be reduced to nil to the extent that CETR has no distributable surplus in respect of those years pursuant to section 109Y of the ITAA 1936? | A2: Yes | Q3: Does Division 7A of Part III of the ITAA 1936 apply to deem dividends to the Family Trust, in relation to the "Initial loans" and Company A's UPE, by operation of section 109T of the ITAA 1936? | A3: No

Relevant facts and circumstances: Company A was established as a holding company to make investments in Company B. In these facts, Individual A and his associated entities are referred to as the Group. Company C and Company D (entities in the Group) have held shares in Company A since its establishment. The majority of shares in Company D are held by Company C and both companies are controlled by Individual A. Funding for Company A from the Bank Company A obtained funding for its operations from the Bank. Funding for Company A from shareholders Company B ran into financial difficulties during its operations and required significant funding from key shareholders to maintain its operations. Company C and an entity unrelated to the Group (the Lender) entered into a facility agreement with Company A (the Borrower) (Facility Agreement). The Facility Agreement provided that the Lenders had advanced to the Borrower an aggregate amount equal to the Existing Advance. The Facility Agreement set out the terms and conditions of the Existing Advance. The purpose of the Existing Advance was to enable the Borrower (Company A) to make an intercompany loan to Company B to be used for working capital purposes. The interest rate and repayment date were set out in the Facility Agreement. The Borrower was also required to pay an establishment fee to be capitalised and unused commitment fee calculated on the difference between the Existing Advance and the drawdown amount accruing and capitalised daily. The Facility Agreement provides that the Lender may make New Advances to the Borrower subject to the terms and conditions of the Facility Agreement. The Moneys Owing under the Facility Agreement, at any time, includes all Advances (Existing Advance and New Advances) made under the Facility Agreement and interest owing. Over a year, Company C made advances which (including the capitalised establishment fee, commitment fee, legal costs and capitalised interest) totalled $X. This amount was assigned from Company C to Company D for market value ($X). Company D assumed all obligations that Company C had under the Facility Agreement. Company D made additional advances (Further Advances) to Company A over a five year period. Advances made by Company D were split into what are referred to as 'working capital loans' and 'shareholder loans'. Company D had made 'working capital' loans to Company A totalling $Y. Company D had also made 'shareholder loans' totalling $Z. Working capital loans provided were made for the purpose of supporting the growth of the business. Shareholder loans represented the capitalisation of guarantee fees that were payable by Company A to shareholders that had guaranteed part of the facilities provided by the Bank. The total amount of 'shareholder loans' owed to Company D were forgiven. The working capital loans made by Company D are referred to in the Ruling as the "Initial Loans". Unrelated associated entities (unrelated to the Group) had also lent funds to Company A. According to the last audited financial statements for Company A, the working capital loans were repayable upon the earlier of a monetisation event occurring, a change in control or by a specified date. Toward the end of the period in which financial support was being provided by the shareholders, both Company A and Company B were placed into administration. Company B subsequently went into liquidation. In the year ended 20YY, the assets of Company A were sold. The proceeds were insufficient to repay the Bank. In the year ended 20YY+1, Company C and Company D together came to own all the shares in Company A. Company C controlled Company A In the year ended 20YY+1, Finance Unit Trust (FUT), a related entity to Company D, acquired by assignment: all outstanding debts owed by Company A to the unrelated associated entities including all amounts that Company A had previously owed to the Bank as the unrelated associated entities had previously acquired the loan from the Bank. In the 20YY+2 year, Company A wrote off and forgave all the loans it made to Company B. The balances owing of the Initial Loans and the loans assigned to FUT, including any capitalised interest and other associated costs, are presently existing obligations and are represented as such in the balance sheets of Company A and as related party receivables in the Financial Statements of the consolidated group of which Company D is the head company. The consolidated group has recorded a provision for impairment that is equal to the balances owing of the Initial Loans and the loans assigned to FUT such that the carrying value in the consolidated group balance sheet of all of the loans is currently zero. Company D and FUT have not forgiven, released, waived or otherwise extinguished the requirement for Company A to repay these debts. The loans to Company A from Company D and FUT remain substantially unpaid as at the date of this Ruling. The loans are now repayable on demand, but demand for repayment has not been made. Distributions from the Family Trust The Trustee of the Family Trust is Company C. Company A is a beneficiary of the Family Trust. The Family Trust is an associate of Company D and Company C under section 318 of the Income Tax Assessment Act 1936 . In the income years 20YY to 20YY+3, Company A was presently entitled to trust income from the Family Trust. These were unpaid present entitlements as at the relevant 30 June. The Family Trust has made some payments of the trust entitlements to Company A in the 20YY+2 to 20YY+5 income years. These amounts were used by Company A to discharge its income tax liabilities. Consequently, the Family Trust has paid in full the 20YY and 20YY+1 UPEs and has partly paid the 20YY+2 UPE to Company A. It is intended that the remaining UPEs will be paid in due course. Company A has not called for immediate payment of the remainder of the UPEs owing from the Family Trust because Company A, D and FUT are all directly or indirectly owned by Company C which is controlled by Individual A. The funds representing the 20YY+2 and 20YY+3 UPEs have not been held for the sole benefit of Company A. Balance sheets of Company A While Company A has not prepared financial statements since being placed into administration, its balance sheets for the years 20YY to 20YY+4 show that its liabilities (predominately the Initial Loans and the loans assigned to FUT) substantially exceed its assets (predominately its UPEs from the Family Trust). With the exception of the UPEs, Company A made no payments or loans to shareholders, forgave no shareholder debts, and neither made nor repaid any non-commercial loans in any of the relevant years. Anti-avoidance rules We have not considered section 100A or Part IVA of the ITAA 1936. Question 1 Will unpaid present entitlements (UPE) for the relevant years conferred by the Family Trust on Company A be a loan for the purposes of subsection 109D(3) of the Income Tax Assessment Act 1936 (ITAA 1936)? Answer Yes Detailed reasoning Section 109D provides: A private company is taken to pay a dividend to an entity at the end of one of the private company's years of income (the current year) if: (a) the private company makes a loan to the entity during the current year; and (b) the loan is not fully repaid before the lodgment day for the current year; and (c) Subdivision D does not prevent the private company from being taken to pay a dividend because of the loan at the end of the current year; and (d) either: (i) the entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made; or (ii) a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time. The extended definition of loan in subsection 109D(3) provides: In this Division, loan includes: (a) an advance of money; and (b) a provision of credit or any other form of financial accommodation; and (c) a payment of an amount for, on account of, on behalf of or at the request of, an entity, if there is an express or implied obligation to repay the amount; and (d) a transaction (whatever its terms or form) which in substance effects a loan of money. Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements (TR 2010/3) provides the Commissioner's view of when an unpaid present entitlement that has not been satisfied including by being converted into (or replaced by) an ordinary loan (subsisting UPE) is a Division 7A loan (paragraphs 19-26 of TR 2010/3). If a private company beneficiary authorises (including allowing with knowledge of) the trustee's continued use of the funds representing UPE for trust purposes, by not calling for: · the payment of that UPE; or · the investment of the funds representing the UPE for the private company's sole benefit rather than their use for the benefit of the trust; this is considered to be an 'other form of financial accommodation', and a loan for Division 7A purposes, under paragraph 109D(3)(b) of the ITAA 1936. Further, the overall transaction also effects, in substance, a loan of money from the private company to the trustee of the trust for the purposes of subsection 109D(3)(d) given the transaction involves: · the use of the funds representing the private company's UPE by the trustee for trust purposes (until such time as the UPE is called for), and · the private company's authorisation (or acquiescence with knowledge) of this use. Paragraph 103 of TR 2010/3 explains that funds representing a subsisting UPE are used for trust purposes if they remain intermingled with the trust funds of the trust (or of the main trust, if there is also a sub-trust) and are used other than for the sole benefit of a private company beneficiary. Paragraph 104 of TR 2010/3 states: Accordingly, if funds representing a subsisting UPE are used for trust purposes in such a way with the knowledge and acquiescence of the private company, in allowing this to continue the private company provides a benefit to the trustee of the trust. Even if there is a sub-trust, in allowing the funds representing the UPE to be used for the trust purposes of the main trust (such as is set out in subparagraph 103(ii) of this Ruling), the private company provides a benefit to the trustee of the main trust. In regards to the timing of the provision of financial accommodation or 'in substance' loan made by the private company beneficiary to the trust, paragraphs 111 and 112 of TR 2010/3 provide: 111. In the circumstances where the private company is taken to know the use to which the funds representing its UPE are being put, the private company beneficiary is taken to have made a Division 7A loan to the trustee of the trust when those funds are first used other than for the private company's sole benefit... 112. Accordingly, a Division 7A loan may not in fact arise in respect of a UPE until some time into the income year following that in which that UPE is taken to have arisen for tax purposes. Because of this, subject to sufficient evidence to the contrary the Commissioner accepts that a private company does not make a Division 7A loan as a result of providing the trustee with financial accommodation in the circumstances discussed in paragraphs 109 and 110 of this Ruling, until some time during the income year following that in which the UPE is taken to have arisen for tax purposes. (As Division 7A operates on an income year basis, pinpointing the precise time during that year is not necessary.) Practice Statement Law Administration PS LA 2010/4 Division 7A: trust entitlements provides practical guidance on TR 2010/3, and in paragraph 46 clarifies that: A UPE owing from a trust to a private company in the same family group will become a loan to which Division 7A applies to the extent that: (a) it has not been paid out to the private company beneficiary, and (b) the trustee fails to hold the funds representing the UPE on sub-trust for the sole benefit of the private company beneficiary by the main trust's lodgment day for the income year in which the present entitlement arises and all times thereafter. Application to these circumstances The entitlement conferred on Company A by the Family Trust in the year ending 30 June 20XX+2 has only been partly paid by the time of the trusts' lodgement date for that income year and continues to not be fully paid at the time of this Ruling. The Family Trust has enjoyed the continued use of the unpaid funds with the knowledge of and acquiescence of Company A. The funds have not been held for the sole benefit of Company A. In accordance with the PSLA we will accept that a Division 7A loan will arise by the time of the trust's lodgement date which is in the income year following the year of present entitlement, as such: · the 20YY+2 UPE is considered to become a Division 7A loan in the 20YY+3 income year; · the 20YY+3 UPE is considered to become a Division 7A loan in the 20YY+4 income year. Question 2 Will any deemed dividend arising under Division 7A of the ITAA 1936 at the end of the relevant income years be reduced to nil to the extent that Company A has no distributable surplus in respect of those years pursuant to section 109Y of the ITAA 1936? Answer Yes Detailed reasoning Subsection 109Y(1) of the ITAA 1936 provides that if, at the end of the income year, the sum of all the Division 7A deemed dividends that a private company is taken to pay would be more than the company's distributable surplus for that year, the amount of each dividend is worked out using the formula in subsection 109Y(3). Subsection 109Y(2) of the ITAA 1936 provides the formula for calculating a private company's distributable surplus as follows: A private company's distributable surplus for its year of income is the amount worked out using the formula: Net assets + Division 7A amounts - Non-commercial loans - Paid-up share value - Repayments of non-commercial loans Relevantly, net assets is defined in subsection 109Y(2) as follows: net assets means the amount (if any), at the end of the company's year of income, by which the company's assets (according to the company's accounting records) exceed the sum of: (a) the present legal obligations of the company to persons other than the company; and (b) the following provisions (according to the company's accounting records): (i) provisions for depreciation; (ii) provisions for annual leave and long service leave; (iii) provisions for amortisation of intellectual property and trade marks; (iv) other provisions prescribed under regulations made for the purposes of this subparagraph. If the Commissioner considers that the company's accounting records significantly undervalue or overvalue its assets or undervalue or overvalue its provisions, the Commissioner may substitute a value that the Commissioner considers is appropriate. Subsection 109Y(3) provides: The amount of a dividend that a private company is taken under this Division to pay is worked out using the formula: Provisional dividend × Distributable surplus for year of income Total of provisional dividends where: provisional dividend is the amount of the dividend that the private company would be taken to pay apart from this section. total of provisional dividends is the sum of all the dividends the private company is taken under this Division to pay at the end of the year of income apart from this section. Subsections 109Y(1) to (3) together, effectively limit the quantum of the deemed dividend to the extent of the private company's distributable surplus for that year of income. Taxation Determination TD 2007/28 Income tax: what is a 'present legal obligation' of a private company for the purposes of subsection 109Y(2) of Division 7A of Part III of the Income Tax Assessment Act 1936? e xplains that a 'present legal obligation' of a private company for the purposes of subsection 109Y(2) is an immediate obligation binding at law, whether payable and enforceable presently or at a future time. At paragraph 10 of TD 2007/28, the Commissioner states: ...The phrase 'present legal obligation' requires that the obligation enforceable by legal action be presently existing. At law, a 'legal obligation' is an obligation, right or duty arising from contract, statute or the operation of general law which is enforceable by legal action immediately or in the future... In Taxation Ruling TR 92/18 Income tax: bad debts, the Commissioner states [1] : 39. The mere writing-off of a debt does not necessarily relieve the debtor from ever having to pay the liability. If the financial position of the debtor subsequently improves or the circumstances which led to the debt being written off alter, action may be taken to collect the debt... Application to these circumstances The Initial Loans and the loans assigned to FUT have been acknowledged by Company A in its balance sheets each year. Company D and FUT have not forgiven, released, waived or otherwise extinguished the requirement for Company A to repay these debts. Although the Company D consolidated group has written off the loans, a decision to write off loans does constitute an extinguishment of the obligation to repay the debt. The Commissioner accepts that the amounts owed to Company D and FUT are present legal obligations of Company A. Therefore, the Commissioner accepts the distributable surplus calculations for Company A results in amounts significantly less than zero for each of the 20YY+2 to 200YY+4 income years. As Company A's distributable surplus for the years was less than zero, the amount of any deemed dividend arising in those income years will be reduced to nil. Question 3 Does Division 7A of Part III of the ITAA 1936 apply to deem dividends to the Family Trust, in relation to the "Initial loans" and Company A's UPE, by operation of section 109T of the ITAA 1936? Answer No Detailed reasoning Subdivision E of Division 7A contains the interposed entity provisions. The provisions operate to treat a private company as paying a dividend to a target entity if an entity interposed between the private company and the target entity makes a payment or loan to the target entity where the circumstances set out in section 109T apply. Section 109T of the ITAA 1936 provides that Division 7A applies as if a private company made a payment or loan to a target entity as described in section 109V or 109W if: · the private company makes a payment or loan to another entity (interposed entity); · a reasonable person would conclude (having regard to all the circumstances) that the payment or loan was made solely or mainly as a part of an arrangement involving a payment or loan to the target entity; and · the interposed entity makes a payment or loan to the target entity. · Under the circumstances, section 109T may apply as: · Company C and Company D (the lenders) provided loans to Company A for a period of income years (the Initial Loans), · Company A provided Division 7A loans to the Family Trust (the target entity) in later years after Company A went into administration came to be controlled by Company C and Individual A, in relation to the unpaid present entitlements of the previous year, and · The lenders are associates of both Company A and the Family Trust. However, it is accepted that the Initial loans were made for the purpose of, and used by Company A, to inject funds into Company B to support and maintain the operations of that company. Although the repayment terms of the loans appear to have been varied by agreement over time it is accepted that this did not give rise to new loans. It is considered that a reasonable person considering the circumstances of the loans would not conclude that the Initial Loans were made, either solely or mainly, as part of an arrangement to loan money to the Family Trust. Section 109T of the ITAA 1936 does not apply and no deemed dividend will arise to the Family Trust under Division 7A from the Initial loans and Company A's UPE. [1] See also Ashwick (QLD) No 127 Pty Ltd v FC of T [2009] FCA 1388, per Ryan J [210] - [216]