Edited version of your written advice

Authorisation Number: 1013091341960

Date of advice: 14 September 2016

Ruling

Subject: 109RB discretion

Question 1

Will the Commissioner exercise his discretion in section 109RB of the Income Tax Assessment Act 1936 (ITAA 1936) to disregard the operation of Division 7A of the ITAA 1936 in relation to a failure of the Shareholder to meet their minimum yearly repayment on their loan from The Company?

Answer

Yes

This ruling applies for the following periods:

• 1 July 20WW to 30 June 20XX

• 1 July 20XX to 30 June 20YY

• 1 July 20YY to 30 June 20ZZ

The scheme commences on:

1 July 20WW

Relevant facts and circumstances

1. The Shareholder entered into an unsecured loan agreement with a private company The Company for a loan at the greater of the variable home loan rate or statutory benchmark interest rate for a seven year term (The Loan).

2. The Shareholder drew down on The Loan in the year ended 30 June 20WW.

3. By 30 June 20XX the Shareholder had not made sufficient repayments of The Loan leaving a shortfall on the minimum yearly repayment for 20XX.

4. Late in 20YY The Company changed accountant and tax agent (New Tax Agent).

5. Prior to changing to the New Tax Agent the Shareholder was advised by the Former Tax Agent of an amount which, in their view, would be sufficient to repay the principle and interest outstanding on The Loan (Former Tax Agent Loan Balance).

6. In the year ended 30 June 20YY the Shareholder paid The Company the Former Tax Agent Loan Balance on the understanding that this amount would reduce The Loan to nil.

7. By 20YY The Former Tax Agent was elderly and suffering from illness.

8. Due to the advanced age of The Former Tax Agent and their ill health the Shareholder decided to engage the New Tax Agent as the accountant and tax agent for The Company.

9. As part of their 'on-boarding' review of The Company's accounts the New Tax Agent identified the shortfall in the minimum yearly repayment for The Loan in 20XX.

10. In reconciling The Loan the New Tax Agent identified that The Former Tax Agent had made an accounting error with The Loan which led to the shortfall in the minimum yearly repayment in 20XX.

11. The Shareholder sought legal advice on potential Division 7A issues with The Loan.

12. The Shareholder has now repaid the balance of the loan as advised by the New Tax Agent which has reduced the balance of The Loan to nil.

13. Based on the reconciliations provided by the New Tax Agent sufficient interest amounts were recognised in the accounts of The Company for The Loan, for the year ended 30 June 20XX, 20YY & 20ZZ.

14. The Company has a distributable surplus.

Relevant legislative provisions

Income Tax Assessment Act 1936, Division 7A

Income Tax Assessment Act 1936, section 109E

Income Tax Assessment Act 1936, subsection 109E(1)

Income Tax Assessment Act 1936, subsection 109E(2)

Income Tax Assessment Act 1936, section 109RB

Reasons for decision

Issue 1

Question 1

Summary

It is accepted that due to the advanced age and ill health of the Former Tax Agent of The Company, an error made in determining the minimum yearly repayment for The Loan for the year ended 30 June 20XX leading to a Division 7A deemed dividend was an honest mistake. Once the Division 7A breach was brought to the attention of the Shareholder by the New Tax Agent action has been taken by the Shareholder to remedy the Division 7A breach.

Under the circumstances the Commissioner should exercise his discretion to disregard the Division 7A deemed dividend as it resulted in an honest mistake and appropriate remedial action has taken place.

Detailed reasoning

Division 7A deemed dividend

In accordance with subsection 109E(1) of the ITAA 1936 a private company is taken to pay a dividend to an entity at the end of one of the private company's years of income (the Current Year) if:

• the private company made an amalgamated loan to the entity in an earlier year of income,

• the amalgamated loan is not repaid by the end of the Current year, and

• the amount paid to the private company during the current year in relation to the amalgamated loan falls short (Shortfall) of the minimum yearly repayment for the current year.

Subsection 109E(2) of the ITAA 1936 provides that the amount of the dividend is taken to be the amount of the Shortfall.

The Company made The Loan to the Shareholder during the year ended 30 June 20WW which became an amalgamated loan as at 30 June 20WW. The minimum yearly repayment on The Loan for the year ended 30 June 20XX was not made by 30 June 20XX resulting in a shortfall. Thus in accordance with subsection 109E(2) of the ITAA1936 the Shareholder is taken to have been paid a dividend by the Company.

Exercise of the Section 109RB discretion to disregard the deemed Division 7A dividend

Section 109RB of the ITAA 1936 provides the Commissioner with discretion to disregard a dividend occurring under Division 7A or to treat the dividend as a franked dividend if the dividend arises from an honest mistake or inadvertent omission.

Paragraphs 28 to 31 of Taxation Ruling TR 2010/8 Income tax: application of subsection 109RB(1) of the Income Tax Assessment Act 1936 provides an example of when an arithmetic error leads to an honest mistake:

28. A private company is taken to have paid a dividend to a shareholder because of a minimum yearly repayment shortfall.

29. The shortfall arose because the tax agent had made an error in calculating the minimum yearly repayment for one of the amalgamated loans. No similar errors were made in respect of other amalgamated loans, either in the current year or earlier income years. The error related to the remaining term used in the minimum yearly loan repayment formula. The term used was one year longer than it should have been.

30. The shareholder had made repayments based on the minimum yearly loan repayment advised by the agent. Both the taxpayer and tax agent were aware of the Division 7A obligations and had attempted to comply. There is no evidence to suggest that the error was anything other than an accidental oversight.

31. In these circumstances, the arithmetic error is an honest mistake.

Example 4 at paragraphs 168 to 178 of Law Administration Practice Statement PS LA 2011/29 Exercise of the Commissioner's discretion under section 109RB of Division 7A of Part III of the Income Tax Assessment Act 1936 to either disregard a deemed dividend or to permit a deemed dividend to be franked provides an example of a tax agent taking on a new client and discovering a breach of Division 7A in an earlier year where the return was prepared by another firm:

168. Fred and his wife, Wilma, jointly hold all the shares in Iron Age Pty Ltd, a small private company carrying on metal fabrication work. Fred and Wilma also operate a separate raised metal garden bed business through a partnership structure. Both Fred and Wilma are in their early 70's.

169. Fred recently engaged Nik, a tax agent, to review the tax affairs of Iron Age Pty Ltd. Fred tells Nik that since starting the business he entrusted all his accountancy work to Wilma's brother, Barney. Over the last few years, Barney has been very unwell and after a series of strokes he was incapacitated and is now living permanently in a high care nursing home.

170. Fred and Wilma are concerned that, because of Barney's failing health, he may have made mistakes with the private company returns. Nik advises that, given the smallish scale of their business, the ATO is not likely to review those tax returns. However, Fred says that he can't rest easy and that he instructs Nik to review the last three tax returns to make sure that they are correct as well as preparing their current tax returns.

171. As he reviews Barney's working papers, Nik observes that Barney has made many mistakes with his calculations and has often wrongly classified items. At first it is clear that Barney has self-corrected the mistakes on subsequent review of his own work, however, as Nik works through the successive years accounts he can see that Barney's ability to recognise the mistakes has reduced.

172. Nik discovers a loan that the company made to Fred and Wilma's partnership. Fred explains that the loan was to provide working capital during the early stages of the partnership. At the time, Barney suggested that the partnership borrows the required funds from the company, telling Fred and Wilma that it was fine because it was to help the partnership earn income. Fred tells Nik that the loan had been repaid, with no interest charged. Nik advises Fred and Wilma that the loan was subject to Division 7A, and that a deemed dividend should have been declared as the loan was not placed on Division 7A complying loan terms. Nik advises Fred and Wilma to apply for the Commissioner's discretion under section 109RB to disregard the deemed dividend.

173. Fred and Wilma instruct Nik to lodge a request to amend the relevant prior year returns and a request to exercise the Commissioner's discretion under section 109RB. At the time of applying for the discretion, Fred and Wilma also made back payment for interest forgone to the company. The interest was calculated based on the amount that would have accrued had a compliant section 109N loan agreement was in place.

….

177. …. [The Tax Officer] considers the evidence and concludes that the following contributing factors are relevant in deciding whether the Commissioner should exercise his discretion under subsection 109RB(2):

• Fred and Wilma have been proactive in instructing Nik to review the prior year returns as they were concerned with Barney's ability to carry out his duties. This factor would weigh in favour of the exercise of the discretion

• Fred and Wilma instructed Nik to notify the ATO as soon as they were made aware of the Division 7A loan. This factor also weighs in favour of the exercise of the discretion

• they have paid the net tax due with the exception of the deemed dividend. They have also taken corrective action regardless of the outcome the section 109RB decision from the ATO. This would weigh favourably towards the exercise of the discretion

• Iron Age Pty Ltd had previously made personal loans to Fred and that Barney had drawn up section 109N complying loan agreements and that minimum yearly repayments were made so attempted compliance with Division 7A was demonstrated. This factor weighs in favour of the exercise of the discretion

• there have been no other occasions where Division 7A has operated. This factor weighs in favour of the exercise of the discretion, and

• although Fred, Wilma and the company seem to be knowledgeable about Division 7A and therefore it would not be unreasonable to expect that care should have been taken to ensure that this particular loan did not breach Division 7A, this does not necessarily weigh against the exercise of the discretion as [The Tax Officer] also took note of the fact that there appears to be a degree of confusion in some areas of the tax profession around the time the loan was made that private company loans to non-individual entities for business purposes were not subject to Division 7A. It is possible that Barney believed that to be the case and therefore failed to advise them accordingly.

178. Having considered all of the relevant factors - [The Tax Officer] concludes that the Commissioner will exercise his discretion. As corrective action has already been taken, the Commissioner does not see a need to impose any conditions to the exercise of the discretion.

In the present instance The Company, a private company, is taken to have paid a dividend to the Shareholder because of a minimum yearly repayment shortfall in the year ended 30 June 20XX. The shortfall occurred due to an accounting error made by the Former Tax Agent of The Company. The Former Tax Agent is elderly and suffering from illness.

The Shareholder engaged The New Tax Agent to take over as the accountant and tax agent for The Company. As part of the due diligence process of taking on a new client, the New Tax Agent picked up on the error made by the Former Tax Agent. After being made aware of the error made by the Former Tax Agent, the Shareholder sought legal advice regarding the best way to resolve the Division 7A issue resulting from the Former Tax Agent's error. The Shareholder also repaid the whole Division 7A loan. Sufficient interest, in line with the Division 7A minimum repayments, on The Loan has been brought into account in the years ended 30 June 20XX, 20YY and 20ZZ.

Based on the examples in TR 2010/8 and PS LA 2011/29 it is accepted that the Former Tax Agent made an honest mistake in preparing the minimum repayment for The Loan in 20XX. Once becoming aware of the mistake, the Shareholder has taken appropriate action to remedy the error by advising the ATO of the Division 7A breach and taking action to fully repay The Loan. Under the circumstances it is considered appropriate that the Commissioner should exercise his discretion in section 109RB of the ITAA 1936 to disregard the deemed Division 7A dividend.

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