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Edited version of private advice
Authorisation Number: 1052006516234
Date of advice: 13 July 2022
Ruling
Subject: Section 109M - related party loans
Question
Does section 109M of the Income Tax Assessment Act 1936 apply to drawdowns under an existing loan facility?
Answer
Yes
This ruling applies for the following periods:
Year ending 30 June 20XX
Year ending 30 June 20XX
Year ending 30 June 20XX
The scheme commences on:
1 July 20XX
Relevant facts and circumstances
1. The Group invests in commercial and residential developments and other projects of interest.
2. ABC Pty Limited (ABC) was established to take advantage of commercial lending opportunities to optimise returns on the Group's available cash. The objective of ABC is to accomplish a profitable business in its own right.
3. Prior to the establishment of ABC, a number of entities within the Group undertook lending activities.
4. ABC has provided loans to both related and third parties.
5. The loans provided by ABC have differing terms such as the loan's:
• Amount
• Length
• Security
• Interest Rate
• Default Interest Rate
• Repayment Terms
6. As of XX January 20XX, ABC had provided X loans with a total principal amount of ~$XX million.
Lending Guidelines
7. The Credit Committee (the Committee) provides and maintains a framework for decision making relating to the lending activities of ABC.
8. The Credit Committee Charter (the Charter) sets out how the Committee is to consider loan requests. The Charter provides that the Committee is responsible for maintaining a framework to ensure ABC meets its commercial objectives including that:
• Lending terms are appropriate to risk and tenor of each loan
• ABC is profitable
9. The Committee:
• Considers risk relating to specific transactions the Group has referred to it
• Reviews potential lending opportunities and makes recommendations on them to the Board
• Approves loans within the limits of its delegation
• Periodically reviews the performance of the existing transactions.
10. The Committee can approve loans up to a value of $X million, with loans in excess of that referred to the Board. The Committee meets on a monthly basis to perform its duties.
11. The Charter requires all transactions to be properly documented, with a suite of template loan agreement prepared by legal practitioners to form the base document for loan agreements.
12. The Committee has flexibility in determining the terms of a loan, however it will have regard to the following:
• Character
• Capacity
• Capital
• Collateral
• Conditions
13. Character here is the character of the party (whether the transaction is entered into in the party's personal name or through entities controlled by that party) that is seeking to enter into a loan with ABC. It is a consideration of the business and employment history of the party in the context of their ability to generate future cash flows to meet their proposed obligations, the nature and history of the relationship of the party to the Group and existing external relationships of the party.
14. Capacity here is the capacity of the party to meet their obligations under the loan. This involves consideration of the party's income sources and will require information going to their capacity throughout the entire term of the loan.
15. Capital here is the party's capital base, being their assets, liabilities and overall net position. Particular attention may be paid to outstanding and upcoming taxation liabilities. The Committee may seek confirmation of any of these aspects.
16. Collateral here is the arrangements for securing the transaction. The Committee should obtain security in the form of a registered first mortgage over residential or commercial property where available however other forms may be required depending on the borrower.
17. Conditions here is the appropriate conditions for the loan from the perspective of the Group, going to factors such as: purpose, amount, interest, term and repayment types.
18. The Interest Rate Setting Guidelines (the Guidelines) set out factors to be taken into account in determining the interest rates for any loan that ABC may enter into. The key considerations are:
• ABC's cost of funds
• Risk assessment of the purpose of the loan
• The loan-to-value of the loan or the proportion of the purpose of the loan that will be funded by the loan
• How the balance of the funds for the purpose of the loan are being funded
• Term of the loan
• The strength of the security offered by the borrower
• Terms associated with alternate funding sources available to the borrower
• The interest rate exposure ABC would be taking on if the borrower requests a fixed rate
• Strategic relationship between the Group and the borrower
• That interest rates may be lower for principal and interest loans relative to interest only loans
• That interest rates for Capitalising loans should be higher
• Interest rates may be either fixed or floating. Floating rates should be set as a margin above the 3-month BBSW rate unless a more appropriate benchmark floating rate is appropriate
• The likely establishment costs, such as borrower due diligence and external and internal legal costs
• Whether a rate is to be applicable to undrawn amounts under loan facilities
• Interest rates applicable in the event of default should be determined to provide a reasonable incentive for timely payment
• Where considering distressed debt, the Committee should consider acquiring debt or providing lending at a discount among in combination with other commercial terms.
19. The Charter and Guidelines have been applied consistently to all loans made to both arm's length and non-arm's length parties.
Lending Process
20. The procedure for loan applications involves:
a. The prospective borrower makes a request for loan funding with ABC. The request will set out the proposed loan amount and the purpose of the loan
b. Prior to the next Credit Committee (the Committee) meeting, personnel of the Committee will fill out a loan application credit review template and obtain any necessary supporting information. Depending on the borrower, the supporting information will typically include:
i. Proposed terms of the loan
ii. Supporting financial data relating to the creditworthiness of the proposed borrower
iii. D&B Credit Watch Reports (where available)
iv. ASIC company and director searches as applicable
v. Loan and business references for the borrower
vi. Where available, summary of terms for comparable funding arrangements.
c. During the Committee meeting, the Committee reviews the documentation and considers the proposed loan terms against the Charter and the Guidelines.
d. For loans up to $X million in value, the Committee will approve or decline the loan application, or propose more stringent terms.
e. For loans over $X million in value, the Committee makes a recommendation to the Board which is considered and either approved or declined at the next Board meeting.
21. ABC does not exercise any influence over potential borrowers in order to have them enter into a loan agreement on any particular terms.
22. The entry, or not, of a potential borrower with a pre-existing connection to the Group's business into a lending agreement would not affect that potential borrower's pre-existing connection with the Group.
Loan Facility
23. On XX XXX 20XX, XYZ Unit Trust (XYZ) entered into a loan facility agreement with ABC. The terms of that loan facility are:
• Amount: Up to $X million
• Length: X years
• Security: 2nd mortgage over property
• Interest Rate: 4.5% per annum
• Default Rate: 5.5% per annum
• Repayment: Interest only, principal repaid on maturity
24. The purpose of the loan facility is to fund the fit out of the property.
25. A third party tenant will reimburse XYZ $X million of the fit out costs but XYZ intends to apply those amounts to other liabilities.
Loans at arm's length
26. ABC has provided loans to third parties without an existing connection to the business of the Group.
27. Third parties that are the borrowers for these loans include:
• Person D, an individual whose only connection to the Group was previously employed at a centre owned and managed by related entities of the Group
• Family E, whose only connection to the Group was that they bought a house and land package from a third-party builder who purchased the land from a joint venture that an entity of the Group was party to.
28. The loans provided to these parties have the following terms:
a. For Person D:
- Amount: $X
- Length: X months
- Security: None
- Interest Rate: 4% per annum
- Default Rate: 8% per annum
- Repayment: Interest only, principal repaid on maturity
b. For Family E:
- Amount: $X
- Length: X years
- Security: 1st mortgage over property
- Interest Rate: 4% per annum
- Default Rate: 12% per annum
- Repayment: Principal and interest
Assumptions
• Throughout the Ruling Period:
• ABC will continue to carry on a business of money lending
• ABC will provide loans to parties at arm's length
• The effect of the Charter and Guidelines will be to require that all loans made by ABC are to be made on a true commercial basis
• The Charter and Guidelines will not provide for differential treatment between arm's length and non-arm's length parties
• The Charter and Guidelines will be consistently applied by ABC to proposed loans to both arm's length and non-arm's length parties.
Relevant legislative provisions
Income Tax Assessment Act 1936 Section 109M
Income Tax Assessment Act 1997 Subsection 995-1
Reasons for decision
29. Section 109M of the Income Tax Assessment Act 1936 (ITAA 1936) provides:
Loans made in the ordinary course of business on arm's length terms not treated as dividends
A private company is not taken under section 109D to pay a dividend because of a loan made:
(a) in the ordinary course of the private company's business; and
(b) on the usual terms on which the private company makes similar loans to parties at arm's length.
30. Subsection 995-1(1) of the Income Tax Assessment Act 1997 provides:
"business" includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.
31. Taxation Ruling TR 2019/1 Income tax: when does a company carry on a business? (TR 2019/1) discusses the presumption that a company carries on a business providing at paragraph 19:
In Westleigh and American Leaf, it was observed that where a company aims to make, and has a prospect of profit, it is presumed that the company intends to, and does in fact, carry on a business. In American Leaf, Diplock LJ observed that this means any gainful use to which a company puts its assets will, on its face, amount to the carrying on of a business. However, this presumption can be rebutted if it can be shown that, on the facts, the company had no aim or prospect of making a profit.
32. TR 2019/1 summarises the key indicia, per Bowen CJ and Franki J in Ferguson v Federal Commissioner of Taxation [1979] FCA 29, to be taken into account when considering whether an entity is carrying on a business at paragraph 21:
• whether the person intends to carry on a business
• the nature of the activities, particularly whether they have a profit-making purpose
• whether the activities are
- repeated and regular
- organised in a business-like manner, including the keeping of books, records and the use of a system
• the size and scale of a company's activities including the amount of capital employed in them, and
• whether the activity is better described as a hobby, or recreation.
Intention to carry on a business
33. ABC was established for the purpose of utilising funds within the Group to take advantage of commercial lending opportunities and be a profitable business in its own right.
34. ABC provides loans in accordance with the Charter and the Guidelines which are aimed at ensuring the activities of ABC providing a commercial rate of return commensurate to the risk connected with any particular loan opportunity.
35. There is a clear intention for ABC to carry on a business.
Nature of the activities
36. TR 2019/1 provides at paragraph 26 that:
...a company's profitable activities are unlikely to be in the nature of a hobby or be undertaken to meet a domestic need. Thus, any profit-making activities a company conducts are unlikely to have a domestic or personal character, and are likely to be characterised as being commercial in nature.
37. Here, ABC engages in lending activities for the purpose of profit. There is nothing suggesting that the activities that ABC engage in should be characterised as something other than commercial in nature.
Repetition and regularity
38. The Committee meets on a monthly basis to evaluate proposed loans and to review the performance of ongoing and past loans. The Committee performs its duties on a consistent basis as dictated by the Charter and Guidelines.
39. The repetition and regularity with which ABC conducts its money lending activities is sufficient to suggest the carrying on of a business.
Organisation of activities
40. TR 2019/1 provides at paragraph 42:
Whether activities are carried out in a systematic and organised way, or carried on in a business-like manner, is relevant to determining whether they amount to carrying on a business. This may involve, for instance, keeping detailed records of income, preparing formal business plans or budgets, or seeking professional advice.
41. TR 2019/1 provides at paragraph 45:
A company's formal structure and the statutorily imposed requirements regarding how they must be managed and run are a point of difference to the activities of an individual. As a consequence, the gainful activities of a company must, as a matter of law, and typically are, carried on in a business-like manner. They normally support a conclusion that the activities of a company undertaken for the purpose of making a profit amount to carrying on a business.
42. The lending activities of ABC are guided by the Charter and Guidelines which set out the processes to the followed and considerations to be made in determining whether or not to provide any particular loan.
43. It is considered that ABC carries out its lending activities in a systematic and business-like manner.
Size and Scale
44. TR 2019/1 provides at paragraph 46:
The size and scale of the activities in question are relevant, but not necessarily conclusive, of whether they amount to the carrying on of a business
45. As of XX XXX 20XX, ABC had provided X loans with a total principal amount of ~$X million. It is considered that this is of such a size and scale that it supports a conclusion that ABC is carrying on a business.
Conclusion on lending activities
46. ABC is carrying on a business of money lending. The loan facility made by ABC to XYZ was made in accordance with the procedure imposed by the Charter and the Guidelines. As a result, the loan facility was made in the in the ordinary course of its business of money lending.
Parties at arm's length
47. In order for 109M to apply to a particular loan, it is necessary to establish that the lender provides loans to parties at arm's length.
48. Taxation Determination TD 2008/1 Income tax: if a private company provides trade credit to a shareholder (or their associate) on the usual terms it gives to parties at arm's length, will a failure by the shareholder (or their associate) to repay the amount within the agreed payment term prevent section 109M of the Income Tax Assessment Act 1936 from applying? (TD 2008/1) provides at paragraphs 20 - 21:
20. In paragraph 109M(b) the phrase 'at arm's length' is used. There is no reference to 'dealing at arm's length' in that paragraph. The meaning of 'at arm's length' is explained in the following paragraphs from Taxation Ruling TR 2006/7:
189. The phrase 'at arm's length' has been considered in many courts and used in various legislative contexts. As explained by Davies J in Re Hains (deceased); Barnsdall v. Federal Commissioner of Taxation[6] (Barnsdall) the term 'at arm's length' was developed in the law with respect to transactions between persons, one of whom, such as a trustee or a solicitor, is in a position of special influence with respect to the other, a beneficiary or client. His Honour referred to the classic statement of principles found in the speech of Lord O'Hagan in Macpherson v. Watt.[7]
190. Davies J pointed out, however, that such cases are of little assistance in the interpretation of statutes which are concerned with taxation.[8]
191. His Honour then went on to set out the interpretation of the phrase 'not at arm's length' that was provided in Australian Trade Commission v. WA Meat Exports Pty Ltd.[9] This is the leading case on the meaning of the phrase 'not at arm's length' in the definition of 'prescribed associate' in subsection 4(8) of the Export Market Development Grants Act 1974. The Federal Court decided in that case that the ordinary meaning of the phrase applies. After quoting legal dictionaries in order to ascertain the ordinary meaning of 'arm's length',[10] the Federal Court reached the conclusion that the ordinary meaning of the phrase 'not at arm's length' is the circumstance where one party 'has the ability to exert personal influence or control over the other'.[11]
21. Whether parties are at arm's length requires consideration of any connection between the parties and of all the relevant circumstances. In the context of Division 7A private companies, their shareholders and associates of such shareholders have sufficient connection to not be at arm's length.
49. ABC has entered into agreements with a number of third parties. These third parties all have some form of connection to the Group.
50. The example connections between borrower and lender at paragraph 27 of this ruling do not result in circumstances where either the lender or borrower had the ability to exert personal influence or control over the other.
51. As such it is considered that ABC provides loans to parties at arm's length.
52. TD 2008/1 provides at paragraphs 17 - 18:
17. Paragraph 109M(b) requires the loan to have been made on the usual terms on which the private company makes similar loans to parties at arm's length. The parties at arm's length for paragraph 109M(b) purposes can comprise a segment or section of the client or customer base. For a loan to be similar there is no requirement that the loan be identical. However, the loan should be similar in terms of both documentation and conditions.
18. The usual terms are those terms under which the private company usually contracts. The fact that a private company may be engaging in credit transactions for the first time will not of itself prevent those transactions from being made on the usual terms under which the company provides credit. The policy and procedures may have been established before entering into the contract or the terms of the contract may establish the usual terms. Whether or not the initial provision of credit establishes the usual terms will be evidenced by the terms upon which subsequent contracts are entered into.
53. ABC consistently applies the Charter and Guidelines to all of the loans it provides. As a result, there is a consistent process to follow and factors to be considered for all the loans it provides regardless of whether the potential borrower is at arm's length.
54. The loans provided by ABC vary in their terms, however the application of the Charter and Guidelines is done consistently for both arm's length and non-arm's length parties.
55. Therefore, it is considered that ABC has a policy and procedure in place that results in them entering into loans with both arm's length and non-arm's length parties that are similar in documentation and conditions.
56. Consequently, it is considered that the terms of the loan facility provided to XYZ are on terms similar to loans provided to arm's length parties.
Conclusion
57. Section 109M of the ITAA 1936 will apply with to any drawdowns on the loan facility between ABC and XYZ.