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Ruling

Subject: Personal services income, PAYG withholding and fringe benefits tax

Issue 1

Question 1

Does Part 2-42 of the Income Tax Assessment Act 1997 affect how the company calculates its taxable income?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 2013

Year ending 30 June 2014

The scheme commences on:

1 July 2012

Issue 2

Question 1

Will the company be required to make PAYG withholdings from advances and dividends paid to the shareholder entities associated with the executive directors?

Answer

No.

Question 2

Will the company be required to make payments to the Commissioner under Division 13 of Part 2-5 of Schedule 1 of the Taxation Administration Act 1953?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 2013

Year ending 30 June 2014

The scheme commences on:

1 July 2012

Issue 3

Question 1

Will 'advances in anticipation of profits' made to shareholders of the company cause the company any liability to fringe benefits tax (FBT)?

Answer

Yes.

This ruling applies for the following periods:

Year ending 31 March 2013

Year ending 31 March 2014

The scheme commences on:

1 July 2012

Relevant facts and circumstances

The company will operate a business.

The business is established by certain individuals (the Founders) who will serve as executive directors.

There are X shareholders including entities which are associated with the executive directors. There is (will be) a Shareholder Loan Facility totalling $Y, provided by the Joint Venture Partner and the Founders.

The executive directors of the company involved in the day to day business activities will be entitled to be paid director's fees at the rate of $Z each per annum in recognition of their day to day management role in the company.

The minimal equipment that is required to operate the business is provided by the company.

The company will be liable to rectify any errors or defects in its work. The company will hold professional indemnity insurance as it will be exposed to legal claims if its work were to be held to be negligent.

The deal between the executive directors and the other shareholders is that the executive directors or entities associated with them will be entitled to receive between them the first $W per year of the company's before-tax profits, with the balance shared between the holders of both voting and non-voting ordinary shares in proportion to the quantity of shares held.

That $W is to be taken in the form of the director's fees ($Z a year each) and preference dividends to be declared on the Special shares held by entities associated with them.

The shareholder entities associated with the executive directors will be entitled to draw regularly advances in anticipation of profits of up to $V each per annum. It is noted that this amount represents $W of the profits after allowing for company tax at 30%.

These advances are to be interest free and repayable within Q years of each one being made. Security for these advances is to be over the shares in the company held by the relevant shareholder. Recourse is limited to those shares.

The proposed arrangements include the declaration and crediting of dividends once sufficient profits are available in the company so that the regular advances drawn are fully offset by those dividend entitlements. It is intended that the dividends will be declared and credited against the advances at the start of the financial year following that in which the profits are made.

As this is a business which is to be started afresh, there is some uncertainty about the cash flows expected by the company. The proposed arrangements allow the company's executive directors to draw cash for necessary living expenses without burdening the company with employment oncosts such as WorkCover premiums and superannuation guarantee obligations at a time before cash revenues have been earned sufficient to cover them.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 86-1

Income Tax Assessment Act 1997 section 86-10

Income Tax Assessment Act 1997 section 86-15

Income Tax Assessment Act 1997 section 86-30

Income Tax Assessment Act 1997 section 87-1

Income Tax Assessment Act 1997 section 87-15

Taxation Administration Act 1953 section 12-35 of Schedule 1

Taxation Administration Act 1953 section 12-40 of Schedule 1

Taxation Administration Act 1953 section 13-5 of Schedule 1

Taxation Administration Act 1953 section 13-15 of Schedule 1

Fringe Benefits Tax Assessment Act 1936 subsection 136(1)

Fringe Benefits Tax Assessment Act 1936 section 148

Fringe Benefits Tax Assessment Act 1936 section 18

Income Tax Assessment Act 1936 section 109D

Income Tax Assessment Act 1936 section 109N

Income Tax Assessment Act 1936 section 109XB

Reasons for decision

Issue 1 Question 1

Summary

The company will meet the results test and therefore will be conducting a personal services business. Consequently, it will not be affected by the personal services income (PSI) regime contained in Part 2-42 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Part 2-42 of the ITAA 1997 contains the provisions that set out the PSI regime.

PSI is income that is mainly a reward for an individual's personal efforts or skills (or would be mainly such a reward if it was the income of the individual who did the work).

It is considered that the income generated from procuring property investments for investors is mainly a reward for the personal efforts or skills of the two key individuals (the executive directors) who arranged and facilitated the investments, and is therefore PSI.

The company is a personal services entity as its income includes the PSI of one or more individuals (subsection 86-15(2) of the ITAA 1997).

Subsection 86-15(1) of the ITAA 1997 would include in the assessable income of each of the executive directors, an amount of the company's income that is their PSI. That is, the income that was generated by their personal efforts or skills would be included in their assessable income, notwithstanding that it was paid to the company. These amounts would not be included in the company's assessable income due to the operation of section 86-30 of the ITAA 1997.

However, Division 86 of the ITAA 1997 does not apply to an entity conducting a personal services business (sections 86-1, 86-10, and 87-1 of the ITAA 1997).

A personal services entity will be conducting a personal services business if it meets one of the four personal services business tests (paragraph 87-15(1)(c) of the ITAA 1997).

One of these tests is the results test. A personal services entity will meet the results test if in relation to at least 75% of the PSI of the individuals that is included in the personal services entity's income during the year:

(a) the income is for producing a result; and

(b) the personal services entity is required to supply the plant and equipment, or tools of trade needed to perform the work from which the personal services entity produces the result; and

(c) the personal services entity is, or would be, liable for the cost of rectifying any defect in the work performed.

In this case it is considered that the income earned is income for producing a result. The company is required to provide its own equipment in order to operate the business and will be liable in relation to any errors or defects in its work.

It is considered that the company will pass the results test and consequently will be conducting a personal services business. Therefore, Division 86 of the ITAA 1997 will not apply to the company. That is, the company will not be affected by the PSI regime contained in Part 2-42 of the ITAA 1997.

Issue 2 Questions 1 and 2

Summary

The advances and loans paid to the shareholder entities associated with the executive directors do not fall within any of the types of payments from which PAYG withholding is required. Also, the PSI regime will not result in the company being required to make payments under the PAYG withholding system as the company will be conducting a personal services business.

Detailed reasoning

The PAYG withholding system is contained in Part 2-5 of Schedule 1 of the Taxation Administration Act 1953. It specifies certain types of payments from which the entity making the payment must withhold an amount and remit it to the Commissioner. It also applies where PSI is included in an individual's assessable income under the PSI regime (Division 13 of Part 2-5).

The provisions of Part 2-5 that require consideration in this case are:

· section 12-35 - An entity must withhold an amount from salary, wages, commission, bonuses or allowances it pays to an individual as an employee.

· section 12-40 - A company must withhold an amount from a payment of remuneration it makes to an individual as a director of the company.

· section 13-5 - A personal services entity must pay an amount of tax to the Commissioner if it receives an alienated personal services payment and is a personal services payment remitter.

In this case, the advances and dividends are paid to shareholder entities associated with the executive directors, not the individuals themselves. It is not considered that either section 12-35 of section 12-40 applies in this case.

The company will be conducting a personal services business. Consequently, it will not be a personal services payment remitter (section 13-15). Therefore, the company will not be required to make a payment to the Commissioner under section 13-5.

Issue 3 Question 1

Summary

'Advances in anticipation of profits' made to shareholders of the company will cause the company to have a liability to fringe benefits tax (FBT).

Detailed reasoning

In order to establish whether the company has a FBT liability, we must firstly determine if the provision of the advances are fringe benefits as defined in subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 (FBTAA). Broadly, this means:

a benefit:

(a) provided at any time during the year of tax; or

(b) provided in respect of the year of tax;

being a benefit provided to the employee or to an associate of the employee by:

(c) the employer; or

(d) an associate of the employer; or…

(e)…

(ea)…

…in respect of the employment of the employee,

The benefit in this case is the use of the funds prior to the shareholder entities receiving dividends. This falls within the definition of a loan in subsection 136(1) of the FBTAA and is therefore a loan benefit. The loan benefits will be provided to associates of the executive directors. For those loan benefits to satisfy the definition of fringe benefits, they must be provided 'in respect of employment' of the executive directors.

The term employment is defined as including, broadly, the activity that results, will result or has resulted in the person being treated as an employee within the meaning of the FBT legislation. Therefore the benefit must be associated with some past, current or expected future employment activity which results in the person being treated as an employee.

The phrase 'in respect of' in relation to the employment of an employee is defined in subsection 136(1) of the FBTAA to include 'by reason of, by virtue of, for or in relation directly or indirectly to, that employment'.

In addition to this definition being provided by the FBTAA, paragraph 148(1)(a) of the FBTAA, further states that where a benefit that has been provided in respect of both the employee's employment and their shareholding, the benefit will be taken to be provided in respect of their employment.

 Despite these legislative provisions, paragraph 6 of Taxation Ruling MT 2019 Fringe Benefits Tax: Shareholder Employees of Family Private Companies and Directors of Corporate Trustees (MT 2019), recognises the situation that such a benefit might still have been provided solely in respect of this shareholding and in which case, the benefit would not be subject to FBT.

The proposed Shareholder's Agreement, a document which will govern the operation of the company's business, will include the proposed advances to the shareholder entities that are associates of the executive directors. In the Joint Venture Indicative Term Sheet, the proposed advances are described as 'advances in anticipation of profits' and the repayment of those advances will be by way of dividends declared on the Special shares held by the relevant shareholder entities. The description of the arrangement in such language, gives the impression that the benefit may be provided to the shareholder in respect of shareholding.

However it is necessary to consider whether the benefit, i.e. the loan, will be provided in respect of employment. The meaning of 'in respect of employment' was considered by the Federal Court in J & G Knowles v Federal Commissioner of Taxation [2000] 96 FCR 402; 2000 ATC 4151; 44 ATR 22 (Knowles). 

In Knowles, the Full Federal Court considered the judgements in Smith v FCT (1987) 164 CLR 513; 19 ATR 274; 87 ATC 4883 and Federal Commissioner of Taxation v Rowe (1995) 60 FCR 99; 31 ATR 392; 95 ATC 4691 before concluding that it is not sufficient for the FBTAA to conclude that there is causal connection between the benefit and the employment. 

At paragraph 26 the Court said: 

Whatever question is to be asked, it must be remembered that what must be established is whether there is a sufficient or material, rather than a, causal connection or relationship between the benefit and the employment. 

At paragraphs 28 and 29, the court said: 

While the width of the definition of "fringe benefit" was designed to capture benefits that, in truth, were other than remuneration, the stated purpose suggests that asking whether the benefit is a product or incident of the employment will be helpful. If it is not then the benefit is likely to be extraneous to the employment and will not bear FBT, notwithstanding that the employment might have been a causal factor in the provision of the benefit. In particular, the fact that a benefit is provided to a director because it was authorised by that director will not, of itself, be sufficient to characterise the benefit as one which is "in respect of" the employment. Without more, it is not a product or incident of that office. 

To put the matter another way, although the process of characterising the benefit provided in a particular case can involve questions of fact and degree, it is not sufficient for the purposes of the FBTAA merely to enquire whether there is a causal connection between the benefit and the employment. See FCT v Rowe (1995) 60 FCR 99 at 114 and 123; 31 ATR 292 at 404 and 412; 95 ATC 4691 at 4703 and 4710. Although Brennan, Deane and Gaudron JJ observed in Technical Products (at 47), that the requisite connection will not exist unless there is "some discernible and rational link" between the two subject matters which the statute requires to be linked, as was pointed out by Dawson J (at 51) the connection must be "material".

There are facts in this arrangement that indicate that the benefit is to be provided in respect of the executive directors' employment. The fact that the other shareholders of the company are not receiving the same benefit, not even in proportion to their shareholding, is particularly significant. If the relevant shareholders were receiving the benefit solely because of shareholding, then it would be logical that such advances would be made available to all of the shareholders. Instead, the benefits are only being provided to those shareholders who are associates of the executive directors.

The executive directors are receiving only $Z in director's fees for performing their duties as executive directors. The taxpayer has stated that the advances will allow the executive directors to:

draw cash for necessary living expenses without burdening the company with employment on-costs such as WorkCover premiums and superannuation guarantee obligations at a time before cash revenues have been earned sufficient to cover them.

The salient point is that by allowing the shareholder entities to have use of the advances, the company is minimising employment related costs. This further establishes the connection between the provision of the benefit and the executive directors' employment.

Additionally, the fact that there is a shareholder loan facility which will not be utilised for the advances is another indicator that the advances are in respect of the directors' employment.

It is concluded therefore that the provision of the benefits is a product of the executive directors' employment and that they will be provided to the shareholder entities in respect of their associates' employment.

The next issue to consider is whether the benefits might be excluded from the definition of a fringe benefit in subsection 136(1) by way of any of paragraphs (f) to (s). It is considered that the exclusions in paragraphs (f) to (q) would have no application. Therefore only the exclusions in paragraphs (r) and (s) will be considered.

Paragraph (r) excludes from the definition of a fringe benefit:

anything done in relation to a shareholder in a private company (as those terms are defined in section 6 of the Income Tax Assessment Act 1936), or an associate of such a shareholder, that causes (or will cause) the private company to be taken under Division 7A of Part III of that Act to pay the shareholder or associate a dividend;

Under subsection 109D(1) of the Income Tax Assessment Act 1936 (ITAA 1936) an amount lent by a private company to a shareholder during the current year is taken to be a dividend for the purposes of Division 7A if the loan is not fully repaid before the private company's lodgement day for that income year, and Subdivision D of Division 7A of the ITAA 1936 does not otherwise prevent the private company from being taken to have paid a dividend to the shareholder.

The lodgement day for a private company's year of tax in accordance with subsection 109D(6) of the ITAA 1936 is the earlier of:

(a) the due date for lodgement of the private company's return of income for the year of income; and

(b) the date of lodgement of the private company's return of income for the year of income.

It is intended that the advances provided by the company to its shareholders will be set-off by dividends declared on special shares held by the shareholders before the company lodges its income tax return. If this occurs, then the loan will not be a dividend under subsection 109D(1) of the ITAA. Consequently the exclusion under paragraph (r) will not apply and the loan benefit will be a fringe benefit.

Paragraph (s) excludes from the definition of a fringe benefit:

a loan (within the meaning of section 109D of the Income Tax Assessment Act 1936), if:

(i) a dividend is not taken to be paid under that section in relation to the loan, but would be if section 109N of that Act were disregarded; or

(ii) an amount is not included, as if it were a dividend, in the assessable income of an entity under section 109XB of that Act in relation to the loan, but would be if section 109N of that Act were disregarded.

Subparagraph (s)(ii) of the definition of a fringe benefit will not apply in this situation as section 109XB of the ITAA 1936 applies where a trustee makes a payment or a loan to a beneficiary who is a non-corporate shareholder (or their associate) of a private company. Therefore only subparagraph (s)(i) will be considered.

Section 109N of the ITAA 1936 prevents a private company from being taken to pay a dividend at the end of the income year provided the loan is made under a written agreement, at a minimum rate of interest, and for no more than a maximum term.

If as intended the loan is paid in full before the company lodges, or is due to lodge its income tax return, even if section 109N of the ITAA 1936 were disregarded a dividend would still not be taken to be paid under section 109D of the ITAA 1936. Consequently, the provision of the loan will be a fringe benefit.

Having established that there will be a fringe benefit, the final issue to consider is whether there will be any liability to FBT. Broadly, the company will have a liability for FBT if the taxable value of the fringe benefit is greater than nil.

The taxable value of loan fringe benefits is determined in accordance with section 18 of the FBTAA. The taxable value is the difference between:

· the interest that would have accrued during the FBT year if the statutory interest rate had applied to the outstanding daily balance of the loan, and

· any interest that actually accrued.

The statutory interest rate is set by reference to the standard variable rate for owner-occupied housing loans of the major banks that the Reserve Bank of Australia published most recently before the beginning of the FBT year.

The advances are to be interest free, therefore the taxable value of loan fringe benefits will be greater than nil. Consequently, the company will have a FBT liability.

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