Payments and loans
Payments and loans made through interposed entities may attract Division 7A. This involves a private company indirectly distributing money to a shareholder or their associate through one or more interposed entities. An interposed entity can be an individual, company, partnership or trust and is inserted between a private company and its shareholder or their associate. Division 7A can apply if the shareholder or associate is the target entity to whom the private company's payment or loan is ultimately directed.
- guaranteeing a loan that an interposed private company with a low distributable surplus makes to the shareholder or their associate
- guaranteeing a loan that an interposed entity makes to the shareholder or their associate where a default occurs on the loan
- a trustee distributing money to a shareholder or their associate through one or more interposed entities where the private company has an unpaid present entitlement (UPE) to trust income.
A private company is taken to pay a dividend to the target entity as if the payment or loan was made directly to the target entity where:
- the private company makes a payment or loan to an interposed entity (called the 'first interposed entity')
- a reasonable person would conclude that the private company made the payment or loan solely or mainly as part of an arrangement involving a payment or loan to the target entity
- the first interposed entity or another interposed entity makes a payment or loan to the target entity
- The total of all dividends a private company is taken to pay under Division 7A is limited to its distributable surplus for the year.
If the interposed entity makes a loan to the target entity, then the private company is taken to make a loan to the target entity. Similarly, if the interposed entity makes a payment to the target entity, then the private company is taken to make a payment to the target entity.
A private company, A Pty Ltd, enters into an arrangement with an entity, X ,under which A Pty Ltd makes a payment to X and X then makes a loan to Y, a shareholder of A Pty Ltd. A Pty Ltd is taken to have made a loan to Y (the target entity) regardless of the fact that it actually made a payment to X (the interposed entity).
End of example
Arrangement for the purposes of interposed entity transactions includes agreement, understanding, promise or undertaking and doesn't have to be in writing or legally binding.
When determining what a 'reasonable person' would conclude in relation to the interposed entity provisions, the following circumstances may be relevant:
- the nature of any relationship between the private company, the interposed entity and the target entity
- the timing of the payments or loans
- the amount of the actual payments or loans
- how the payments or loans are recorded in the accounting records of the private company and the interposed entity
- whether there is a commercial basis for the transaction between the private company and the first interposed entity
- the role and attributes of the interposed entity. For example: why it was formed; what it does; and why it was a participant in the transactions.
- the capacity of the interposed entity to fund the payment or loan outside of any amount received from the private company
- any history or pattern to the transactions
- the primary requirement for, or intended use of, the funds by the target entity
- the target entity's financial position, annual income (including from the private company) and its capacity to make any relevant loan repayments
- the extent to which the target entity draws money from the private company in an assessable form - for example, dividends or salary.
Example 2 – purpose of the transaction
Bill is the sole shareholder of ABC Pty Ltd (ABC). Bill’s brother in law, Ben, is a shareholder and director of XYZ Pty Ltd (XYZ).
Bill and his wife Jessica have a son who in the 2014 income year required $20,000 for legal fees. Bill and Jessica have personal savings of $30,000 that can be accessed to raise funds for the fees.
ABC, a successful construction business, has made several loans to Bill and Jessica over the years.
XYZ, on the other hand, has suffered years of losses from unsuccessful business ventures and is heavily in debt.
In 2015, the Australian Taxation Office (ATO) is reviewing the taxation affairs of ABC, Bill and Jessica, and discover that:
- on 13 February 2014, ABC made a payment of $22,000 to XYZ
- on 14 February 2014, XYZ made a loan of $20,000 to Jessica, on an interest-free at-call basis.
All loans made by ABC directly to Bill and Jessica were put on Division 7A complying terms, and minimum yearly repayments made. Bill has some knowledge of the basic Division 7A rules gained from advice received while preparing company tax returns.
At the time of the February 2014 transactions, it was evident that XYZ would not have a distributable surplus at 30 June 2014.
- The loan is not from an arm’s length person, rather it is from family
- There was only one day between ABC's payment to XYZ and the loan to Jessica
- The two amounts are quite similar and is the amount of money required to pay the legal fees
- There is no apparent commercial reason for the payment from ABC to XYZ
- Bill and Jessica had capacity to pay the legal fees
- It was evident that XYZ would not have a distributable surplus at 30 June 2014.
Despite Bill and Jessica having access to alternative means of paying the legal fees, this is not sufficient to displace the conclusion that the payment by ABC to XYZ was made mainly or solely as part of an arrangement involving the loan from XYZ to Jessica. A reasonable person would conclude that ABC made the payment to XYZ so that it could lend the $20,000 to Jessica - accordingly, the interposed entity provisions operate to create a notional loan from ABC to Jessica.
It is noted that although it might also be reasonably concluded that Bill had an intention to avoid the operation of Division 7A, the existence of such an intention is not necessary to trigger the operation of the interposed entity provisions.
Note: While XYZ was taken to have paid a dividend to Jessica as a result of the loan made to Jessica, the amount taken to be paid as a dividend from XYZ is nil due to the lack of a distributable surplus in XYZ.
End of example
Example 3 – payment for services
Assume the same facts as in Example 1, except that the amount paid to Jessica by XYZ was not a loan, rather a payment (an arm’s length amount) for administration services provided by Jessica to the company in earlier income years. Due to the financial position of XYZ and the family connections, Jessica agreed not to invoice XYZ and not to receive payment until the company was in a position to pay for the services rendered.
A reasonable person would still conclude that, on balance, ABC made the payment to XYZ so that it could make the $20,000 payment to Jessica, and ABC would therefore be taken to have made a notional payment to Jessica. However, the fact that the payment relates to the provision of administration services would be taken into account in determining the quantum of the notional payment.
For the purposes of determining the amount of the notional payment, the Commissioner, to the extent that the payment to Jessica will be assessed to her, would determine the amount of the notional payment is nil (see TD 2011/16 - Income tax: Division 7A - payments and loans through interposed entities - factors the Commissioner will take into account in determining the amount of any deemed payment or notional loan arising under section 109T of the Income Tax Assessment Act 1936).
End of example
Timing of payment or loan
The private company is taken to have made a payment or loan to the target entity at the time the interposed entity made a payment or loan to the target entity. This is regardless of whether the amounts or timing of the payments or loans from the private company to the interposed entity are the same. The situation is different in arrangements involving default of loans with guarantees (see when the private company is taken to have made the payment to the target entity when a default has occurred).
Amount of the payment or loan
Generally, the amount the private company is taken to have paid or lent to the target entity is based on:
- the amount the private company paid or lent to the first interposed entity
- the amount the interposed entity paid or lent the target entity
- less any arm's length consideration payable to the target entity from either the private company or any of the interposed entities.
- less a proportion of any repayments (of a loan) made by the target entity to the interposed entity (see effect of repayments the target entity makes to the interposed entity).
The calculations are different in arrangements involving guarantees and arrangements involving UPEs .
- Guarantees: loans with guarantees
- Trusts: payments and loans
Example 4 – calculating the amount of the payment
Bill is the sole shareholder of ABC Pty Ltd. Bill’s friend Ben is a director of PQR Pty Ltd. Bill and Ben reach an agreement that on 10 February 2016 ABC Pty Ltd will pay $5,000 to PQR Pty Ltd. PQR Pty Ltd then makes a payment of $5,500 to Bill's wife Betty, an associate of Bill. Of the $5,500, $500 represents a payment to Betty for accounting services for PQR Pty Ltd. The $500 is an arm's length payment. The payments were made on 30 June 2016.
In this example, PQR Pty Ltd is the interposed entity and Betty is the target entity. ABC Pty Ltd is taken to pay Betty $5,000. This takes into account the $5,500 that PQR Pty Ltd paid Betty, reduced by the $500 for payment of accounting services.
On 30 June 2016, ABC Pty Ltd is taken to pay Betty an unfranked dividend of $5,000, subject to the distributable surplus of ABC Pty Ltd.
End of example
If the target entity makes a repayment on a loan made to it by an interposed entity, the amount that the private company is taken to have lent the target entity (the 'notional loan') is reduced by the following amount:
Repayment made by target
entity to interposed entity
Amount of notional loan
Amount actually lent to target entity
The effect of the repayments the target entity makes to the interposed entity is different in situations involving loans by an interposed private company relying on guarantees.
Example 5 – partial repayment
On 1 November 2015, Virgil Pty Ltd makes a loan of $10,000 to Tracy Pty Ltd (the interposed entity) under an arrangement in which Tracy Pty Ltd will lend the amount to Penelope (the target entity). Penelope is a shareholder of Virgil Pty Ltd.
On 15 November 2014, Tracy Pty Ltd lends Penelope $15,000. For the year ended 30 June 2016, Virgil Pty Ltd has a distributable surplus of $50,000.
Virgil Pty Ltd is taken to have made a notional loan of $10,000 to Penelope, as this was the arrangement between Virgil Pty Ltd and Tracy Pty Ltd. Before the end of the income year Penelope repays $3,000 to Tracy Pty Ltd. The amount Virgil Pty Ltd is taken to have loaned Penelope is reduced by a proportion of the repayment Penelope made to Tracy Pty Ltd. The amount of the reduction is:
$3,000 x ($10,000 / $15,000) = $2,000
Virgil Pty Ltd is taken to pay Penelope $8,000 (that is, $10,000 - $2,000). On 15 November 2015 Virgil Pty Ltd is taken to pay a deemed dividend of $8,000 to Penelope.
End of example
First interposed entity receives a dividend
If the payment or loan from the private company to the first interposed entity is an actual dividend, and certain conditions are satisfied, the private company may still be taken to have made a payment or loan to the target entity. This means, depending on the circumstances, although the amount may have been included in the assessable income of the interposed entity, the payment or loan from the private company to the target entity may be subject to Division 7A.
- TD 2018/13 - Income tax: Division 7A: can section 109T of the Income Tax Assessment Act 1936 apply to a payment or loan made by a private company to another entity (the 'first interposed entity') where that payment or loan is an ordinary commercial transaction?
Written loan agreement
If the actual loan from the interposed entity to the target entity is made under a complying Division 7A written loan agreement, the notional loan by the trustee to the target entity is deemed to be under that agreement.
In subsequent income years a dividend will not arise under Division 7A provided the required 'minimum yearly repayment' is made.