Private ruling: Debt forgiveness and deemed dividends
Date of advice: 24 June 2019
Published: September 2019
Ruling period: Year ended 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Q1: Will subsection 109G(4) of the Income Tax Assessment Act 1936 (ITAA 1936) apply, to treat any forgiveness of the Loans as not giving rise to a dividend? | A1: No

Relevant facts and circumstances: As at 30 June 2017 the Trusts owed the Company a combined total of $XXX under Division 7A ITAA 1936 compliant loans (the Loans). X is the sole director of the Company. They are also the sole director of the corporate trustees (the Trustees) of the Trusts. The Trusts have carried on businesses over many years. The industry the Trusts operated in experienced a decline. The Trusts were holding significant amounts of property when the market began to crash. Some of this property has been disposed of, but a number of properties are still held. The value of these properties was appraised by local real estate agents in as much lower than their recorded cost. You have unsuccessfully attempted to dispose of these properties. No trading has occurred by the Trusts since 30 June 2017. Historically, profits made by the Trusts were distributed to the Company. The unpaid present entitlements (effectively the trust distributions less expenses paid on behalf of the Company) were converted to Division 7A loans within the required timeframes and supported by the appropriate loan agreements. Up until the year ended 30 June 2016, the minimum loan repayments were made as follows: 1. The Trusts would pay expenses (including income tax) on behalf of the Company 2. The Company would pay X a dividend equal to the remaining minimum Division 7A loan repayment 3. X would then make loan repayments on behalf of the Trusts 4. The above transactions did not involve the transfer of cash, there would be reflected by journal entries of the relevant entities 5. X would pay top up tax in respect of the dividends paid to him, the funds would normally come from the Trusts or his own funds 6. The Company would accrue tax on the interest derived and the tax would be paid by the Trusts. Due to the decline in trading conditions during the year ended 30 June 2017, the minimum loan repayments were not met in this manner. The minimum repayments were treated as deemed dividends in the Trusts. These deemed dividends were absorbed by accumulated losses. During the 2016 financial year, the group's financier began to place pressure on X to reduce the group's debt with them due to the decline in value of the land being held as security. Over the past few years, personal assets of X have been sold to reduce the debt. X no longer holds any assets of substance. There are minimal tangible assets held in the Company, the Trusts other than the properties mentioned above. There are no related entities that are currently carrying on a business.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subsection 109(G)(4) | Income Tax Assessment Act 1936 Section 109ZD | Income Tax Assessment Act 1936 Section 109ZE | Income Tax Assessment Act 1997 Section 960-100

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. | Detailed Reasoning - 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. | Detailed Reasoning - Trustees: Subsection 109G(4) of the ITAA 1936 does not make reference to either 'trust' or 'trustee'. Rather, it makes reference to an 'entity' which owes a debt to a private company. Section 109ZD of the ITAA 1936 provides that 'entity' in Division 7A has the meaning given to it by section 960-100 of the Income Tax Assessment Act 1997 (ITAA 1997). Section 109ZE of the ITAA 1936 provides that the interpretation rules contained in subsections 960-100(2), 960-100(3) and 960-100(4) of the ITAA 1997, also apply. While subsection 960-100(1) of the ITAA 1997 includes a 'trust' within the concept of 'entity', the two notes to subsection 960-100(2) of the ITAA 1997 acknowledge that special provisions are needed for trusts as a result of the lack of separate legal personality inherent in the trust relationship. The effect of these provisions is that the 'office of trustee' is taken to be a separate entity. Accordingly, subsection 960-100(2) of the ITAA 1997 provides that the trustee of a trust is taken to be an entity 'consisting of the person who is the trustee, or persons who are the trustees, at any given time.' By subsection 960-100(3) of the ITAA 1997, the legal personality acting as trustee is taken to be a separate entity in each capacity in which they operate - personally and as trustee of one or more trusts. Trustees are personally liable for debts incurred in performance of the trust and may have corresponding rights of indemnity and exoneration. However, the statutory framework of section 109G of the ITAA 1936 and its reliance on section 960-100 of the ITAA 1997 makes it clear that, in the case of debts incurred by an entity acting as trustee, references to 'entity' for the purposes of the provisions are intended to refer the trustee in that capacity and not in its personal capacity. The leading words of subsection 109G(4) of the ITAA 1936 refer to 'a debt owed by the entity'. This is a reference to an obligation (being the debt owed), meaning subsection 960-100(2) of the ITAA 1997 is necessarily enlivened and causes the reference to 'entity' to be a reference to the 'trustee' of the trust in respect of which the obligation was incurred, acting in that capacity. Paragraph 109G(4)(a) of the ITAA 1936 also refers to 'entity' in testing the outcome if the debt was repaid. That is, whether the 'entity' would, in that event, suffer undue hardship. As a matter of statutory construction, the reference to 'entity' here must also be a reference to the same 'entity' contemplated by the leading words of subsection 109G(4) of the ITAA 1936. It follows from the statutory scheme that the relevant hardship referred to in subsection 109G(4) of the ITAA 1936 is to be tested in relation to the trustee in its capacity as trustee and not in its personal capacity. | Detailed Reasoning - Can a trustee suffer hardship due to the payment of a debt?: Payment of a debt would not result in a financial detriment to a trustee if trust assets exceed trustee liabilities. While trustees are personally liable for debts incurred in performance of the trust, they may have corresponding rights of indemnity and exoneration. These rights take priority over the beneficiaries' interests in trust assets so that a beneficiary's entitlement at any point in time is to the assets that are remaining after the trustee's rights to indemnity and exoneration have been exercised. Because in such circumstances trustees have recourse to trust assets before distribution to beneficiaries, trustees will always be able to exercise their rights to indemnity and exoneration in discharging trust debts where trust assets exceed trust liabilities. Accordingly, where trust assets exceed liabilities, a trustee cannot suffer any financial detriment, on the payment of a trust debt. It follows there can be no 'hardship' in terms of what is contemplated by paragraph 109G(4)(a) of the ITAA 1936. However, where liabilities exceed trust assets and the trustee's liability is not limited, the trustee's personal assets may be exposed to repay trust debts without effective recourse through their rights to indemnity and exoneration. Where the trustee's personal assets are so exposed, it might be argued that payment of a debt could, in those circumstances, cause a financial detriment. In any event, the detriment, if it exists in those circumstances, would be to the trustee personally, and as such to a separate entity, different from the entity which is the focus of subsection 109G(4) of the ITAA 1936. The operation of section 960-100 of the ITAA 1997 leads to the result that a trustee, as trustee, could not suffer undue hardship within the meaning of paragraph 109G(4)(a). The analysis applies equally to individual or incorporated trustees. | Detailed Reasoning - Conclusion: In this case the Company made the Loans to the Trustees. For subsection 109G(4) of the ITAA 1936 to apply, the Commissioner must be satisfied that payment of the debt would cause the Trustees undue hardship. The entity in this case that may endure undue hardship is a separate legal entity to the Trustees. Accordingly, subsection 109G(4) of the ITAA 1936 will not apply to treat any forgiveness of the Loans as not giving rise to a dividend.