• Examples

    Example 1

     

    A private company makes a loan to a shareholder in the 2007-08 income year for $100,000. In making the loan, a written agreement is prepared and the term of the loan is seven years.

    However, after the return for the 2008-09 income tax year has been lodged the shareholder discovers that the company had made a mistake and advised the shareholder of the wrong interest rate when calculating the minimum yearly repayment. The shareholder only made minimum repayments of $19,000 in 2008-09 instead of the required $20,000. A deemed dividend has arisen as the repayments were lower than required. Once the shareholder realised the payments were lower than required, he corrected that mistake by paying an additional $1,000 in the 2009-10 income year. This additional payment meant that the shareholder had now paid an amount equal to the amount that would have been paid if the correct interest rate had been used in the previous income years. The shareholder also immediately advised the Commissioner that lower repayments had been made and requested that the Commissioner exercise the discretion.

    In order for the Commissioner to exercise his discretion, it must be established that the failure to pay the minimum yearly repayment was the result of an honest mistake or inadvertent omission. In the present example, it is necessary to show that the lower minimum repayments were the result of an honest mistake regarding the correct amount of those minimum yearly repayments. The attempt by the company to comply with the requirement of Division 7A by having a written agreement and making yearly repayments in respect of the loan are relevant in this context.

    If there has been an honest mistake or inadvertent omission that resulted in an under payment of the minimum yearly repayment, the Commissioner would have regard to the following when considering whether to exercise his power in favour of the taxpayer:

    • that there was a loan agreement in place between the company and the shareholder that satisfied all of the requirement of section 109N
    • the use of the wrong interest rate to calculate the minimum yearly repayment resulted in a relatively small under payment
    • once the shareholder discovered the mistake, the taxpayer took action to promptly advise the Commissioner of the mistake, and
    • the shareholder took steps to correct the mistake and to discharge their legal obligation under the loan agreement to make a minimum yearly repayment of $20,000.

     

    Example 2

     

    In the 2007-08 income year, the Commissioner undertakes an audit on ABC Pty Ltd. In the course of the audit, the Commissioner discovers that a loan was made to a shareholder in the 2005-06 income year. There was no documentation supporting the loan but loan repayments were made, albeit at a rate that was less than the benchmark rate for the relevant income years. The shareholder thought that loan documentation was not necessary provided the interest charged was commercial in nature.

    Since there was no written loan agreement in place before the private company's 2006 lodgment day, a dividend was deemed to have been paid to the relevant shareholder.

    The shareholder or the private company (or both) may apply to the Commissioner to exercise his discretion to disregard a deemed dividend. Alternatively, the Commissioner may make a decision under this provision without being asked to do so by the company or shareholder.

    In order for the Commissioner to exercise his discretion, it must be established that the failure to enter into a loan agreement that satisfies the requirement of section 109N was the result of an honest mistake or inadvertent omission. In this context, evidence of the shareholder attempting to comply with the intent of Division 7A (for example, by making yearly repayments in respect of the loan) would be relevant.

    In considering whether to exercise his discretion in favour of the taxpayer, the Commissioner would have regard to the following:

    • the nature of the two mistakes
    • the level of interest actually charged by the company on the loan
    • the actual making of yearly repayments on the loan for each year since the loan was entered into, and
    • whether Division 7A has operated previously in respect of either the private company or the shareholder.

    As a condition of exercising his discretion, the Commissioner could require that there be a written loan agreement that satisfied all of the requirements of section 109N and for the shareholder to make additional payments equal to the difference between the actual repayments made and the repayments that would have been made if the shareholder had satisfied the requirements of section 109E.

    Example 3

     

    A business consists of a private company (ABC Pty Ltd) and XYZ trust. Both entities are controlled by Sam and Mel. The trust's beneficiaries are Sam and Mel and they are also shareholders of the company. The trust owns land and buildings that are mortgaged to a financial institution. The company has a loan with a different financial institution. The interest on both loans is tax deductible as the loans are used for income generating purposes.

    In the 2005-06 income tax year, the company and the trustee of the XYZ trust decide to consolidate their debts. The company extends its pre-existing loan facility and pays out the loan that the trust has with its bank. The discharge by ABC Pty Ltd of the debt owed by the XYZ trust to the financial institution is a payment under section 109C and, given that the trust estate is an associate of the shareholders of ABC Pty Ltd, Division 7A will deem a dividend to be paid by the private company to the trustee of the XYZ trust as a deemed shareholder in ABC Pty Ltd.

    The trustee applied to the Commissioner to exercise his discretion to disregard the deemed dividend as soon as it became aware that Division 7A deemed a dividend to have been paid.

    In order for the Commissioner to exercise his discretion, it must first be established that the officers and employees of the private company and the trustee made an honest mistake as to the operation of Division 7A to the debt consolidation.

    If there has been an honest mistake or inadvertent omission, the Commissioner would have regard to the following when considering whether to exercise his discretion in favour of the taxpayer:

    • the circumstances surrounding the mistake or omission, including the amount of the deemed dividend
    • the commercial nature of the transaction between the company and the trust, and
    • that once the taxpayers discovered the problem they brought the matter to the Commissioner's attention.

    As a condition of exercising the discretion, the Commissioner could require that the payment of the debt be treated as a loan by ABC Pty Ltd to the trust, that the loan be in writing and satisfy all of the requirements of section 109N, and that minimum yearly repayments be made for relevant income years that would have been required had the written loan agreement be put in place by the required time..

    Example 4

     

    Fred and Jen operated a number of separate businesses through different entities including a private company and a trust. They were the trustees of the trust and the only shareholders and directors of the private company. The beneficiaries of the trust are Fred and Jen and members of their immediate family.

    During the 2005-06 income year, the trust was incurring substantial losses due to a downturn in business conditions. As no other source of funds was available, the private company made loans to the trust for working capital purposes during the year.

    In preparing the 2005-06 income tax returns, their tax adviser considered the application of Division 7A but mistakenly believed that only loans to individual shareholders would be subject to Division 7A. There was no qualifying section 109N written loan agreement put in place before the lodgment day of the private company's 2005-06 tax return and no loan repayments had been made to the private company. However, the loan is recognised in the balance sheets of the private company and the trust and the loan is minuted along with a note that the trust is envisaged to resume profitability by the 2008-09 year, at which time loan repayments will commence.

    Fred and Jen changed tax advisers during the 2006-07 income year and the new tax adviser brought to their attention the Division 7A problem in the 2005-06 year. On finding out about the problem, Fred and Jen wished to correct the mistake and promptly advised the Commissioner. Division 7A had not operated previously in relation to the private company or the trustee.

    The trustees or the private company (or both) may apply to the Commissioner to exercise his discretion to disregard the deemed dividend. If there has been an honest mistake or inadvertent omission, the Commissioner would have regard to the following when considering whether to exercise his discretion in favour of the trust:

    • the fact that the mistake was the result of a misreading of the legal requirements of Division 7A by a professional adviser
    • the relatively short period of time that has elapsed between the year in which the dividend was deemed to be paid and the notification to the Commissioner
    • the disclosure of the transaction as a loan in the balance sheets of the private company and trust
    • the quantum of the sums involved, and
    • that Division 7A had not operated previously in relation to the private company or the trustee.

    As a condition of exercising his discretion, the Commissioner could require that there be a written loan agreement put in place that satisfied all of the requirements of section 109N and for the trustee to make additional payments equal to the repayments that would have been made if the trustee had satisfied the requirements of section 109E.

    Example 5

     

    In the 2007-08 income year, the Commissioner undertakes an audit of EFG Pty Ltd. In the course of the audit, the Commissioner discovers that an interest free at call loan was made to a shareholder in the 2005-06 income year. There was no documentation supporting the loan and no repayments have been made. Nor was the loan disclosed in the company's books of account. In addition, the loan was made out of income that was not disclosed in the tax return of EFG Pty Ltd for the 2005-06 income year.

    On the basis of the objective evidence, the taxpayer has failed to establish that the deemed dividend was the result of an honest mistake or inadvertent omission. Rather it appears that the company has deliberately ignored the operation of Division 7A and has simply sought to distribute undisclosed profits to a shareholder. In such a situation the pre-requisite for the Commissioner to exercise his discretion has not been satisfied.

      Last modified: 27 Jul 2016QC 19545